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Consumer Choice

Consumer Choice. Unlimited Wants; Limited Resources. Main Ideas. The market demand is the outcome of decisions made by individual consumers about how to allocate income among competing alternatives. For normal goods, demand will slope down.

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Consumer Choice

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  1. Consumer Choice Unlimited Wants; Limited Resources

  2. Main Ideas • The market demand is the outcome of decisions made by individual consumers about how to allocate income among competing alternatives. For normal goods, demand will slope down. • Labor supply is outcome of decisions made by individuals about how to allocate time among competing alternatives. Labor supply may be backward bending.

  3. Assumptions • Consumer maximizes utility • Utility depends on the quantity consumed of X and Y • More is better • Diminishing Marginal Utility • Consumer is a price taker. • Consumer income, I, is also predetermined.

  4. Utility

  5. Choice is Constrained

  6. How Much X and How Much Y? • Allocate Income Such That the Marginal Benefit of an Additional Dollar Spent on Good X Equals Its Marginal Cost. • Marginal Cost is the Foregone Benefit of Spending Another Dollar on Y. (Opportunity Cost) • Operate Within Budget

  7. Optimal Consumption

  8. Geometry of Consumers Choice • Budget Line • Utility • Indifference Curves

  9. The Budget Line

  10. Budget Line Describes Consumption Opportunities. This bundle is unattainable This bundle does not use all income

  11. INTERCEPTS Quantity of Y Consumer Can Purchase If He Spends All of His Money on Y =Income/Py Quantity of X Consumer Can Purchase If He Spends All of His Money on X =Income/Px

  12. Slope of Budget Line

  13. Changes in Income An Increase in Income shifts budget line out. Consumer can buy more stuff

  14. Changes in Prices Decrease in Price of X allows consumer to buy more X with the same income

  15. Utility: Indifference Curve • Describes bundles of X and Y that make the consumer equally happy. • Each indifference curve represents a level of happiness. The further away from the origin, the greater the happiness • Slope of indifference curve is the rate of marginal substitution

  16. Indifference Curves Describe Tastes of Individual Consumer More is better. Consumer is happier at A than at B B A 5,20 10,10 20,5 Willing to give up 3 Y for every X here Give up only 1/3 Y for every X here

  17. Consumer’s Optimal Bundle A -- attainable, but yields less happiness than B D -- attainable, but more is better C -- preferred to B, but not available A B C D

  18. Derivation of Demand

  19. Individual Demand PQ 2.5 40 5 20 10 10

  20. Impact of Price Change • Budget set shrinks showing a decrease in real purchasing power • Slope of budget line changes showing a change in relative prices. As budget line gets steeper, Good X is more expensive relative to Good Y

  21. Two Effects of Price Change • Income Effect -- an increase in Price of X reduces purchasing power. (Shrinks budget set.) Consumer buys less of normal goods. • Substitution Effect -- an Increase In Price of X Means X is More Expensive Relative to Y. (Change in slope) Consumer substitutes away from X towards Y.

  22. Income and Substitution Effects 1. Price Increase shifts budget from green to light blue 2. Dk. blue budget line represents income level that allows consumer to return to old level of happiness with new prices X0-Xs - Substitution effect Xs-Xn -Income effect XN X0 Xs

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