Dr.

Katie Sauer - Economics

The Theory of Consumer Choice (ch 21) The theory of consumer choice is based on the notion that consumers try to do they best they can given the constraints of their budgets the price of goods. I. Consumer Preferences A. Satisfaction from Consuming goods/services Utility is the satisfaction or happiness a person receives from consuming a good/service. Total Utility = sum total of all the satisfaction/happiness from consuming the good/service Marginal Utility = additional satisfaction/happiness from consuming one additional unit of the good/service __________________________________________________________________________________ Ex: You eat 4 slices of pizza for dinner. Total Utility = your total satisfaction Marginal Utility = the additional satisfaction you received from eating the 4th slice as compared to the 3rd slice Note: it is not really possible to quantify utility The 4 slices of pizza gave you 75 units of satisfaction? ___________________________________________________________________________________ _ An individual CAN determine if something gives them more or less satisfaction than something else. ex: pineapple gives me more utility than blueberries Because we cant quantify satisfaction, we cant compare satisfaction across people. ex: Jane like pineapple and Jack likes pineapple. We cant really determine who gets more utility from pineapple. We do know that consumption is subject to the law of diminishing marginal utility. Each unit of a good will increase total satisfaction but at a decreasing rate. ___________________________________________________________________________________ _ Ex: You are hungry. You eat a slice of pizza. It gives you some satisfaction. You eat a second slice. total satisfaction increases second slice didnt give you quite as much extra You eat a 5th slice total satisfaction increases not as much extra satisfaction as the 4th slice

satisfaction as the first

Dr. Katie Sauer - Economics

B. Preferences People have preferences over various combinations of goods/services. For simplicity, consider only two options at a time. Ex: Suppose you have 3 job offers: Minneapolis for $50,000 Washington DC for $40,000 Phoenix for $30,000 In choosing a job, you care about 2 things, high salary and high average temperature.
Salary

While Minneapolis has the highest salary, it is also the coldest. While Phoenix has the highest average temperature, it also has the lowest salary. Suppose each would give you the same level of utility.

Average Temp

An indifference curve is a graphical representation of all the different combinations of 2 options that yield the same level of utility for a person. Washington DC has a moderate salary and a moderate climate. It is preferred to both MN and AZ. Utility rises as indifference curves get further away from the origin. ___________________________________________________________________________________ Ex: You buy coffee and download music each month. Consuming 10 cups of coffee and buying 15 songs gives you a certain level of total utility. Lets call this utility level 1. To keep that level of utility constant you could adjust the amount of each good you consume. We could plot all the different combinations of coffee and songs that give us utility level 1. - if you buy more coffee, decrease C. Properties of Indifference Curves your downloads 1. - if you curves are preferred to lower curves Higher buy less coffee, increase your downloads - true as long as more is better is true

2. They are downward sloping. Reason: for a given level of satisfaction, you have to give up some of the Y good in order to get some more of the X good The slope reflects the rate at which you are willing to substitute one good for another. The slope of an indifference curve is called the marginal rate of substitution. - rate at which you will give up good Y to get good X

Dr. Katie Sauer - Economics

When you have a lot of good Y, you are willing to give some up to get an additional unit of X. When you have less of good Y, you are not as willing to give some up to get an additional unit of X.

IC1

X
The marginal rate of substitution (MRS) is not the same at each point on the indifference curve.
Y Steep slope (willing to give up Y), high MRS

Flat slope (not as willing to give up Y), low MRS IC1 X

The exact shape of the indifference curve depends on your preferences for the particular goods/services. You like good X quite a bit more than good Y You like good Y quite a bit more than good X

The goods are perfect complements

The goods are perfect substitutes

___________________________________________________________________________________ II. Consumers Budgets Most people cant afford everything they want. Purchases are limited by - income - prices For simplicity, lets assume that consumers spend all of their income and credit does not exist.

Dr. Katie Sauer - Economics

Ex: The disposable income you have available for coffee and downloaded songs each month is $30. A coffee costs $3 each and downloaded songs costs $1 each. If you spent all of your money on coffee, you could buy how many cups? If you spent all of your money on songs, you could buy how many songs? Lets show this on a graph. You could also purchase a combination of the goods. Suppose the price of songs increases to $2 each. The maximum number of coffee cups will The change. the Budget Constraint is equal to the not slope of The maximum number of songs will decrease: negative of the ratio of the prices. (- px / py)
_____________________________________________________________________________________

For our specific example: An increase in one goods price will rotate the budget line inward along that goods axis. A decrease in one goods price will rotate the budget line outward along that goods axis. ______________________________________________________________________________ Suppose that instead of having $30 to spend on coffee and songs you have $50. The maximum number of cups will change. ________________________________________________________________________________ The maximum An increase in income will shift the budget line outward.number of songs will change. A decrease in income will shift the budget line inward. The slope The slope will not change when income changes. will not change because the prices havent changed. ________________________________________________________________________________ III. Consumer Optimization The consumer will maximize their utility given their budget constraint. The consumer will be trying to get on the highest indifference curve that their budget will allow.

Dr. Katie Sauer - Economics

Q coffee

10

J K IC3 L BC IC2 IC1 30 Q songs

IC3: is the best for the consumer, but they cant afford it with their current budget constraint The consumer can afford bundles J, K, and L which lie on IC1 and IC2. Bundles J and L are affordable and lie on IC1. Bundle K is also affordable and lies on IC2, which is higher than IC1. Bundle K is the optimal combination of songs and coffee. a given income level, prices and For preferences, an optimal bundle can be found. The optimal bundle can be found by looking for the point of tangency between the indifference curve and the budget constraint. We can plot the price we are given and the optimal quantity. ___________________________________________________________________________________ _ Suppose that the price of apples decreases. The budget constraint will rotate out along the apples IV. Deriving the Demand Curve axis. A budget constraint and indifference curve can be used to derive an individuals demand curve.be A new level of utility can achieved and a new optimal bundle Assume everything is held constant except for the price and quantity is found. of one particular good. demanded

We can plot the new price and quantity demanded. We have just identified 2 points on the demand curve.