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Rational Consumer Choice: Mcgraw-Hill/Irwin

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38 views

Rational Consumer Choice: Mcgraw-Hill/Irwin

choice

Uploaded by

Kp Prakash
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 47

CHAPTER 3

McGraw-Hill/Irwin

RATIONAL CONSUMER
CHOICE

Copyright 2006 The McGraw-Hill Companies, Inc. All rights reserved.

What is Rational Consumer Choice?


Consumers have a choice of what
goods/bundle to consume Optimal
Bundle.
Scarcity results in RCC becoming an
economic problem.

3-2

Figure 3-1: Two Bundles of Goods

3-3

Rational Consumer Choice


Consumer choice entails :
The economically feasible set (budget
constraint)
Preferences (indifference curves)
Choice : Choose the bundle in the feasible set
which yields the highest utility.

3-4

The Opportunity Set / Budget


Constraint
Production Possibility Curve
Consumption Possibility Curve (budget
constraint).
Given : Income =R100/wk
Shelter = R5/sq m
Food = R10/lb
3-5

The Opportunity Set / Budget


Constraint
Slope = rise/run = -Ps/Pf = -1/2
The slope indicates the rate at which food
can be exchanged for shelter. Another term
for this is?
Defn. of budget constraint : M = PsS + PfF
3-6

Figure 3-2: The Budget Constraint,


or Budget Line

3-7

Price and Income Changes


What happens to the budget line as price
and income changes?
Income changes cause it to shift in or out.
Price changes result in it swiveling around
one (or both) of the intercepts.
3-8

Price and Income Changes


Case 1 : Only M increases to R120/wk
Case 2 : Only Ps increases to R10/sq m
Case 3 : Only Pf decreases to R5/lb

3-9

Figure 3-3: The Effect of a Rise


in the Price of Shelter

3-10

Figure 3-4: The Effect of Cutting


Income by Half

3-11

Figure 3-5: The Budget Constraints


with the Composite Good

3-12

Kinked Budget Constraints


If relative prices are constant then the
budget constraint is a straight line.
Relative prices may change depending on
the amount consumed.
For example, water prices become more
expensive the more water you use.
3-13

Kinked Budget Constraints


Example : R1/100L for 1st 1000L
R1.50/100L for 1001L 2000L
R5/100L for >2000L
What does the budget constraint look like, if
M = R50/w?

3-14

Figure 3-6: A Quantity Discount


Gives Rise to a Nonlinear Budget
Constraint

3-15

CONSUMER PREFERENCES
Preference ordering : ranking of different
bundles in order of preference.
4 simple properties of preference orderings :
Completeness
More-is-better
Transitivity
Convexity
3-16

Indifference Curves
Preference orderings enable us to generate
graphical descriptions of consumers
preferences indifference curves.
Bundles that lie above an indifference curve
are preferred to bundles on or below an
indifference curve, and vice versa.

3-17

Figure 3-8: Generating Equally


Preferred Bundles

3-18

Indifference Curves
4 preference ordering properties leads to 4
indifference curve properties :
Indifference curves are ubiquitous
Indifference curves are downward sloping
Indifference curves cannot cross
Indifference curves become less steep as we
move down them and to the right.

3-19

Figure 3-9: An Indifference Curve

3-20

Figure 3-10: Part of an Indifference


Map

3-21

Figure 3-11: Why Two Indifference


Curves Do not Cross

3-22

Marginal Rate of Substitution


MRS is the rate at which a consumer is
willing to exchange one good for another.
MRS is defined as the absolute value of the
slope of the indifference curve at that point.

3-23

Figure 3-12: The Marginal Rates


of Substitution

3-24

Marginal Rate of Substitution


The slope of the budget constraint illustrates
the rate at which we CAN substitute food
for shelter without changing total
expenditure.
MRS illustrates the rate at which we ARE
WILLING to substitute food for shelter
without changing total satisfaction.
3-25

Marginal Rate of Substitution


MRS declines as we move downward to the
right along an indifference curve.
Indifference curves with diminishing MRS
are thus convex.
Convexity illustrates that people like
variety.
3-26

Figure 3-13: Diminishing Marginal


Rate of Substitution

3-27

Figure 3-14: People with Different


Tastes

3-28

The Best Feasible Bundle


Tools needed to determine how consumers should
allocate their income between 2 goods :
Budget Constraint
Indifference Curves

Consumers strategy is to keep moving to higher


and higher indifference curves until he reaches the
highest one that is still affordable.

3-29

Figure 3-15: The Best Affordable


Bundle

3-30

The Best Feasible Bundle


Condition to be satisfied :
MRS = Ps/Pf

3-31

Corner Solutions
Corner solutions are as a result of the MRS
being everywhere greater/less than the slope
of the budget constraint.
Indifference curves that are not strongly
convex (perfect substitutes) corner
solutions.

3-32

Figure 3-16: A Corner Solution

3-33

Figure 3-17: Equilibrium with


Perfect Substitutes

3-34

Figure 3-18: Food Stamp Program vs.


Cash Grant Program

3-35

Figure 3-19: Where Food Stamps and


Cash Grants Yield Different Outcomes

3-36

Appendix 3 : The Utility Function


Represent consumers preferences using a
utility function.
A utility function is a formula that yields a
number (utils) that represents total
satisfaction provided by a specific bundle.

3-37

Utility Function
Eg. U(F,S) = F.S
If F = 4 lb/wk
S = 5 m/wk
Then U(F,S) = 4 * 5
= 20 utils/wk

3-38

Figure A3-1: Indifference Curves for


the Utility Function U=Fs

3-39

Utility Function
Similarly to indifference curves, the best
attainable bundle in the utility-function
framework is the bundle on the budget constraint
that provides the highest level of utility.
Optimal bundle condition :
IC : MRS = slope of the budget constraint
UF : ?

3-40

Marginal Utility
We need to use the concept of marginal
utility (MU) to derive the optimal bundle
condition.
MU is the rate at which total utility changes
as the quantities of food and shelter change

3-41

Figure A3-2: Utility Along an


Indifference Curve Remains Constant

3-42

Marginal Utility
MU f F MU s S
MU f

MU s F

MU f
MU s
MU f
Pf

Pf
Ps

MU s

Ps
3-43

Marginal Utility
The consumer should allocate his/her income
so that the last dollar spent on each product
yields the same amount of extra (marginal)
utility.
To make the amounts of extra utility derived
from differently priced goods comparable,
MU must be converted to a per-rand-basis.
3-44

Cardinal vs Ordinal Utility


Ordinal utility : People are able to rank each
possible bundle in order of preference. People
are not required to make quantitative statements
about how much they like various bundles.
Cardinal utility : Satisfaction provided by any
bundle can be assigned a numerical value by a
utility function.

3-45

Figure A3-3: A Three-Dimensional


Utility Surface

3-46

Figure A3-4: Indifference Curves


as Projections

3-47

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