FDA recommendation: people should consume less than 65 grams of fat per day.

Theory of Consumer Behavior “well-being” or “satisfaction” Goal of Consumers: maximize utility FDA recommendation: people should consume less than 65 grams of fat per day. Consumers’ problem: Choose diet to maximize utility subject to the budget constraint of 65 fat grams (ignore other costs) Utility maximization requires (prove later): Marginal utility—the utility from an additional Latte In this example, the price equals the number of grams of fat.

additional pleasure per gram must be the same for everything we eat, i.e, foods that contain twice the amount of fat must give us twice the amount of pleasure. In October, a portion of the sales of Pink Ribbon Bagels (with dried cherries and cranberries) go to benefit breast cancer charities. Versus Only the Cinnamon Crunch has more fat (8 grams)! Pink Ribbon Blueberry 7 grams 2 grams Do I enjoy pink ribbons more than 3 times as much as blueberries currently? NO. Hence, I’m not maximizing my utility by eating pink ribbons every morning. .

Law of Diminishing Marginal Utility—as more and more blueberry bagels are consumed, the marginal utility of eating blueberry bagels must eventually fall. works in both direction… Law of Diminishing Marginal Utility—as fewer pink ribbon bagels are consumed, the marginal utility of eating pink ribbon bagels rises. Hence, I’ll probably have a pink ribbon bagel occasionally but not every morning.

Grande Chocolate Chip Frappucino = = 580 Calories 6” Chicken & Bacon Ranch Sub = 580 Calories Models assume consumers act “as if” > < or = = On July 1st 2008, the New York Board of Health required chain restaurants to put calories on menu boards.

Russ sets aside $420 (Y) for tutoring (T) and fitness training (F) each year. PT =$14 per hour PF =$21 per hour Equation for the budget constraint: => Horizontal intercept:

Fitness Training (hours per year) Tutoring (hours per year)

Russ’s budget constraint shows his consumption options between fitness training and tutoring given his income (Y) and their prices (PF and PT). How do we show Russ’s preferences? Russ’s indifferencecurves show all the combinations of fitness training and tutoring that yield the same level of utility or well-being, i.e. Russ is indifferent between all the combinations along a given indifference curve.

Fitness Training (hours per year) Indifference curve Tutoring (hours per year) Slope = MRS = MUT/MUF Indifference curves are negatively-sloped and usually convex to the origin due to diminishing marginal utility.

Fitness Training (hours per year) Y = $420 PF = $21 PT = $14 Tutoring (hours per year)

Fitness Training (hours per year) Y = $420 PF = $21 PT = $14 F A E B Tutoring (hours per year) What combination should Russ choose to maximize his utility?

Fitness Training (hours per year) Y = $420 PF = $21 PT = $14 F A E B Tutoring (hours per year) Point F is on a high indifference curve but Russ cannot afford that combination, so we should ignore that combination.

Fitness Training (hours per year) Y = $420 PF = $21 PT = $14 A E B Tutoring (hours per year) Points A, B, and E are on the budget constraint. Which maximizes Russ’s utility? Point E, where the indifference curve is just tangent to the budget constraint.

Fitness Training (hours per year) Y = $420 PF = $21 PT = $14 A E B Tutoring (hours per year) At point E, MRS = MUT/MUF = slope of the budget constraint = PT/PF, so MUT/PT = MUF/PF→ last dollar spent on each yields the same increase in utility. At point A, |MRS| > PT/PF, which implies that MUT/PT > MUF/PF. Russ should increase tutoring (↓ MUT) and decrease fitness training (↑ MUF) by moving down his budget constraint to point E. At point B, |MRS| < PT/PF, which implies that MUT/PT < MUF/PF. Russ should decrease tutoring (↑MUT) and increase fitness training (↓ MUF) by moving up his budget constraint to point E.

Suppose Harvard subsidies tutoring, but makes it unlimited… PT=$7 per hour PF =$21 per hour Equation for the budget constraint: => Horizontal intercept:

Y = $420 PF = $21 PT = $14 P’T = $7 Fitness Training (hours per year) B1 Tutoring (hours per year)

Effect of Price Change • Substitution effect: the lower price of tutoring causes Russ to substitute tutoring for fitness training to make MUT/PT once again equal to MUF/PF. • Income effect: the lower price of tutoring increases Russ’s real income so he can afford to purchase more of both goods.

Y = $420 PF = $21 PT = $14 P’T = $7 Fitness Training (hours per year) B Income effect A S Substitution effect Tutoring (hours per year) Substitution effect Income effect

Russ sets aside $420 (Y) for tutoring (T) and fitness training (F) each year. PT =$14 per hour PF =$21 per hour

Suppose Harvard subsidizes tutoring, but only the first 10 hours

Suppose Harvard subsidizes tutoring, but only the first 10 hours Harvard policy causes the price to fall and induces both a substitution and income effect that increase consumption of tutoring.

Suppose Harvard subsidizes tutoring, but only the first 10 hours Harvard policy causes only an income effect for Russ since he was already consuming more than 10 hours of tutoring. As a result, his consumption of tutoring will increase.

India’s Public Distribution System (PDS) “evolved as a major instrument of the Government’s economic policy for ensuring availability of foodgrains to the public at affordable prices as well as for enhancing the food security for the poor.” PDS Ration Card

Annam is a maid who lives in Tamil Nadu with her 5 children. She has a PDS ration card that entitles her to purchase up to 20 kg of rice at the price of Rs 5 per kg. Annam allocates Rs 1000 per month to buy rice and Dhal (≈ lentils). The market prices of rice (Pr) and Dhal (PD) are Rs 25 and Rs 50, respectively. Annam says that she typically feeds her family 30 kg of rice per month, causing her to “fully utilize” her PDS entitlement (The Hindu, 9/23/2008). Y = Rs 1000 per month PD= Rs 50 per kg Tamil Nadu

Annam’s Budget Constraint and Indifference Curves Dhal (# kg / mn) Rice (# kg per month)

Annam’s Budget Constraint and Indifference Curves Dhal (# kg / mn) I0 BC0 Rice (# kg per month)

Suppose Annam's brother Babu also has a PDS ration card that entitles him to purchase up to 20 kg of rice at the price of Rs 5 per kg. He too allocates Rs 1000 per month to buy rice and Dhal. However, his family has a much stronger taste for Dhal, causing them to purchase only 20 kg of rice per month. At their consumption bundle, they would be willing to substitute 1 kg of Dhal for 4 kg of rice. Babu’s Budget Constraint and Indifference Curves Dhal (# kg / mn) I0 BC0 Rice (# kg per month)

KaushkiBasuearned a PhD in economics at the London School of Economics and is currently the Chief Economic Adviser to the Indian Government. He has recently proposed replacing the PDS ration cards with rice coupons given directly to poor families Suppose each coupon would entitle families to purchase 1kg of rice for Rs 5. Also, suppose that Annam and Babu would be given 20 coupons per month under the new program. Since one family’s coupons would look exactly like another’s, a market would develop for rice coupons. Suppose the market price of rice coupons was Rs 15 per coupon. Illustrate the effect of the coupon program on the consumption decisions of Annam’s and Babu’s families.

Annam’s Budget Constraint and Indifference Curves Dhal (# kg / mn) I0 BC0 Rice (# kg per month)

Babu’s Budget Constraint and Indifference Curves Dhal (# kg / mn) I0 BC0 Rice (# kg per month)

FDA recommendation: people should consume less than 65 grams of fat per day.