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Chapter 3

Consumer Behavior

Introduction
How are consumer preferences used to determine demand? How do consumers allocate income to the purchase of different goods? How do consumers with limited income decide what to buy?

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Chapter 3

Introduction
How can we determine the nature of consumer preferences for observations of consumer behavior? How can cost of living indexes measure the well-being of consumers?

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Chapter 3

Consumer Behavior Applications


1. How would General Mills determine the price to charge for a new cereal before it went to the market? 2. To what extent did the food stamp program provide individuals with more food versus merely subsidizing food they bought anyway?

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Chapter 3

Consumer Behavior
The theory of consumer behavior can be used to help answer these and many more questions Theory of consumer behavior
The explanation of how consumers allocate income to the purchase of different goods and services

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Chapter 3

Consumer Behavior
There are three steps involved in the study of consumer behavior 1. Consumer Preferences
To describe how and why people prefer one good to another

1. Budget Constraints
People have limited incomes

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Chapter 3

Consumer Behavior
3. Given preferences and limited incomes, what amount and type of goods will be purchased?
What combination of goods will consumers buy to maximize their satisfaction?

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Chapter 3

Consumer Preferences
How might a consumer compare different groups of items available for purchase? A market basket is a collection of one or more commodities Individuals can choose between market baskets containing different goods

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Chapter 3

Consumer Preferences Basic Assumptions


1. Preferences are complete
Consumers can rank market baskets

1. Preferences are transitive


If they prefer A to B, and B to C, they must prefer A to C

1. Consumers always prefer more of any good to less


More is better

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Consumer Preferences
Consumer preferences can be represented graphically using indifference curves Indifference curves represent all combinations of market baskets that the person is indifferent to
A person will be equally satisfied with either choice

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Indifference Curves: An Example


Market Basket A B D E G H Units of Food 20 10 40 30 10 10 Units of Clothing 30 50 20 40 20 40

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Indifference Curves: An Example


Graph the points with one good on the xaxis and one good on the y-axis Plotting the points, we can make some immediate observations about preferences
More is better

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Indifference Curves: An Example


Clothin 50 g

B H A D E

40 30 20 10 10
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The consumer prefers A to all combinations in the yellow box, while all those in the pink box are preferred to A.

20

30
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Food
13

Indifference Curves: An Example


Points such as B & D have more of one good but less of another compared to A
Need more information about consumer ranking

Consumer may decide they are indifferent between B, A and D


We can then connect those points with an indifference curve

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Indifference Curves: An Example


50 40 30 20 10 10
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Clothin g

B H A D G E

Indifferent between points B, A, & D E is preferred to points on U1 Points on U1 are preferred to H & G

U1

20

30
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Food
15

Indifference Curves
Any market basket lying northeast of an indifference curve is preferred to any market basket that lies on the indifference curve Points on the curve are preferred to points southwest of the curve

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Indifference Curves
Indifference curves slope downward to the right
If they sloped upward, they would violate the assumption that more is preferred to less
Some

points that had more of both goods would be indifferent to a basket with less of both goods

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Indifference Curves
To describe preferences for all combinations of goods/services, we have a set of indifference curves an indifference map
Each indifference curve in the map shows the market baskets among which the person is indifferent

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Indifference Map
Clothing Market basket A is preferred to B. Market basket B is preferred to D.

D B A

U3 U2 U1
Food
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Indifference Maps
Indifference maps give more information about shapes of indifference curves
Indifference curves cannot cross
Violates

assumption that more is better

Why? What if we assume they can cross?

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Indifference Maps
Clothing

U
2

U1

A B D

B is preferred to D A is indifferent to B & D B must be indifferent to D but that cant be if B is preferred to D

U2 U1
Food

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Indifference Curves
The shapes of indifference curves describe how a consumer is willing to substitute one good for another
A to B, give up 6 clothing to get 1 food D to E, give up 2 clothing to get 1 food

The more clothing and less food a person has, the more clothing they will give up to get more food

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Indifference Curves
Clothing 16

A
Observation: The amount of clothing given up for 1 unit of food decreases from 6 to 1

14 12 10 8 6 4 2 1
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-6 1 -4 1 -2 1 -1

B D E
1

G
Food
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4
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Indifference Curves
We measure how a person trades one good for another using the marginal rate of substitution (MRS)
It quantifies the amount of one good a consumer will give up to obtain more of another good It is measured by the slope of the indifference curve

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Marginal Rate of Substitution


Clothing 16

A MRS = 6
-6 1 -4 1 -2 1 -1 1

14 12 10 8 6 4 2 1
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MRS = C

B D MRS = 2 E

G
Food
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Marginal Rate of Substitution


Indifference curves are convex
As more of one good is consumed, a consumer would prefer to give up fewer units of a second good to get additional units of the first one

Consumers generally prefer a balanced market basket

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Marginal Rate of Substitution


The MRS decreases as we move down the indifference curve
Along an indifference curve there is a diminishing marginal rate of substitution. The MRS went from 6 to 4 to 1

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Marginal Rate of Substitution


Indifference curves with different shapes imply a different willingness to substitute Two polar cases are of interest
Perfect substitutes Perfect complements

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Marginal Rate of Substitution


Perfect Substitutes
Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant Example: a person might consider apple juice and orange juice perfect substitutes
They

would always trade 1 glass of OJ for 1 glass of Apple Juice

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Consumer Preferences
Apple 4 Juice (glasses)

Perfect Substitutes

1 0 1 2 3
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Orange Juice (glasses)


30

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Consumer Preferences
Perfect Complements
Two goods are perfect complements when the indifference curves for the goods are shaped as right angles Example: If you have 1 left shoe and 1 right shoe, you are indifferent between having more left shoes only
Must

have one right for one left

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Consumer Preferences
Left Shoes

4 3 2 1 0 1 2 3
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Perfect Complements

Right Shoes
32

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Consumer Preferences
We have assumed all our commodities are goods There are commodities we dont want more of - bads
Things for which less is preferred to more

Examples
Air pollution Asbestos

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Consumer Preferences
How do we account for bads in our preference analysis?
We redefine the commodity
Clean

air Pollution reduction Asbestos removal

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Consumer Preferences: An Application


In designing new cars, automobile executives must determine how much time and money to invest in restyling versus increased performance
Higher demand for car with better styling and performance Both cost more to improve

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Consumer Preferences: An Application


An analysis of consumer preferences would help to determine where to spend more on change: performance or styling Some consumers will prefer better styling and some will prefer better performance

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Consumer Preferences: An Application


Styling These consumers place a greater value on performance than styling

Performance
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Consumer Preferences: An Application


Styling These consumers place a greater value on styling than performance

Performance
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Consumer Preferences: An Application


Knowing which group dominates the market will help decide where redesigning dollars should go A recent study in the US shows that over the past two decades, most consumers have preferred styling over performance

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Consumer Preferences
The theory of consumer behavior does not required assigning a numerical value to the level of satisfaction Although ranking of market baskets is good, sometimes numerical value is useful

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Consumer Preferences
Utility
A numerical score representing the satisfaction that a consumer gets from a given market basket If buying 3 copies of Microeconomics makes you happier than buying one shirt, then we say that the books give you more utility than the shirt

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Utility
Utility function
Formula that assigns a level of utility to individual market baskets If the utility function is

U(F,C) = F + 2C A market basket with 8 units of food and 3 units of clothing gives a utility of 14 = 8 + 2(3)
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Utility - Example
Market Basket A B C Food Clothing Utility

8 6 4

3 4 4

8 + 2(3) = 14 6 + 2(4) = 14 4 + 2(4) = 12

Consumer is indifferent between A & B and prefers both to C


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Utility - Example
Baskets for each level of utility can be plotted to get an indifference curve
To find the indifference curve for a utility of 14, we can change the combinations of food and clothing that give us a utility of 14

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Utility - Example
Clothing

15
C

10

Basket C 2.5(10) A B 10(2.5)

U = FC 25 = 25 = 5(5) 25 =

A B

U3 = 100 U2 = 50 U1 = 25 Food
45

0
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Utility
Although we numerically rank baskets and indifference curves, numbers are ONLY for ranking A utility of 4 is not necessarily twice as good as a utility of 2 There are two types of rankings
Ordinal ranking Cardinal ranking

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Utility
Ordinal Utility Function
Places market baskets in the order of most preferred to least preferred, but it does not indicate how much one market basket is preferred to another

Cardinal Utility Function


Utility function describing the extent to which one market basket is preferred to another

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Utility
The actual unit of measurement for utility is not important An ordinal ranking is sufficient to explain how most individual decisions are made

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Budget Constraints
Preferences do not explain all of consumer behavior Budget constraints also limit an individuals ability to consume in light of the prices they must pay for various goods and services

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Budget Constraints
The Budget Line
Indicates all combinations of two commodities for which total money spent equals total income We assume only 2 goods are consumed, so we do not consider savings

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The Budget Line


Let F equal the amount of food purchased, and C is the amount of clothing Price of food = PF and price of clothing = PC Then PFF is the amount of money spent on food, and PCC is the amount of money spent on clothing

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The Budget Line


The budget line then can be written:

PF F + PC C = I
All income is allocated to food (F) and/or clothing (C)

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The Budget Line


Different choices of food and clothing can be calculated that use all income
These choices can be graphed as the budget line

Example:
Assume income of $80/week, PF = $1 and PC = $2

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Budget Constraints
Market Basket A B D E G Food PF = $1 0 20 40 60 80 Clothing PC = $2 40 30 20 10 0 Income
I = PFF + PCC

$80 $80 $80 $80 $80

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The Budget Line


Clothing

(I/PC) = 40 30

A B 10 D 20 E

C 1 PF Slope = = - =F 2 PC

20 10

G
0 20 40 60
Chapter 3

80 = (I/PF)

Food
55

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The Budget Line


As consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the other The slope of the line measures the relative cost of food and clothing The slope is the negative of the ratio of the prices of the two goods

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The Budget Line


The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent We can rearrange the budget line equation to make this more clear

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The Budget Line

I = PX X + PY Y I PX X = PY Y I PX X =Y PY PY
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Budget Constraints
The Budget Line
The vertical intercept, I/PC, illustrates the maximum amount of C that can be purchased with income I The horizontal intercept, I/PF, illustrates the maximum amount of F that can be purchased with income I

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The Budget Line


As we know, income and prices can change As incomes and prices change, there are changes in budget lines We can show the effects of these changes on budget lines and consumer choices

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The Budget Line - Changes


The Effects of Changes in Income
An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant). Can buy more of both goods with more income

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The Budget Line - Changes


The Effects of Changes in Income
A decrease in income causes the budget line to shift inward, parallel to the original line (holding prices constant) Can buy less of both goods with less income

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The Budget Line - Changes


Clothing (units per week) An increase in income shifts the budget line outward

80 60 40 20
0
L3 (I = $40)

A decrease in income shifts the budget line inward


L1 (I = $80) L2 (I = $160)

40

80

120
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Food
(units per week)
63

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The Budget Line - Changes


The Effects of Changes in Prices
If the price of one good increases, the budget line shifts inward, pivoting from the other goods intercept. If the price of food increases and you buy only food (x-intercept), then you cant buy as much food. The x-intercept shifts in. If you buy only clothing (y-intercept), you can buy the same amount. No change in yintercept.

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The Budget Line - Changes


The Effects of Changes in Prices
If the price of one good decreases, the budget line shifts outward, pivoting from the other goods intercept. If the price of food decreases and you buy only food (x-intercept), then you can buy more food. The x-intercept shifts out. If you buy only clothing (y-intercept), you can buy the same amount. No change in yintercept.

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The Budget Line - Changes


Clothing (units per week) A decrease in the price of food to $.50 changes the slope of the budget line and rotates it outward.

40

L3
(PF = 2)
40

L1
(PF = 1)
80

L2
120
Chapter 3

An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward.

(PF = 1/2)
160
Food
(units per week)
66

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The Budget Line - Changes


The Effects of Changes in Prices
If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change However, the budget line will shift inward parallel to the original budget line

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The Budget Line - Changes


The Effects of Changes in Prices
If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change However, the budget line will shift outward parallel to the original budget line

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Consumer Choice
Given preferences and budget constraints, how do consumers choose what to buy? Consumers choose a combination of goods that will maximize their satisfaction, given the limited budget available to them

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Consumer Choice
The maximizing market basket must satisfy two conditions: 1. It must be located on the budget line
They spend all their income more is better

1. It must give the consumer the most preferred combination of goods and services

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Consumer Choice
Graphically, we can see different indifference curves of a consumer choosing between clothing and food Remember that U3 > U2 > U1 for our indifference curves Consumer wants to choose highest utility within their budget

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Consumer Choice
Clothing (units per week)

40 A 30 20 C D

A, B, C on budget line D highest utility but not affordable C highest affordable utility Consumer chooses C

U3 B
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U1
80

U2
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20

40

Chapter 3

Food (units per week)

Consumer Choice
Consumer will choose highest indifference curve on budget line In previous graph, point C is where the indifference curve is just tangent to the budget line Slope of the budget line equals the slope of the indifference curve at this point

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Consumer Choice
Recall, the slope of an indifference curve is:
C MRS = F
Further, the slope of the budget line is:

PF Slope = PC
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Consumer Choice
Therefore, it can be said at consumers optimal consumption point,

PF MS = R PC

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Consumer Choice
It can be said that satisfaction is maximized when marginal rate of substitution (of F and C) is equal to the ratio of the prices (of F and C) Note this is ONLY true at the optimal consumption point

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Consumer Choice
Optimal consumption point is where marginal benefits equal marginal costs MB = MRS = benefit associated with consumption of 1 more unit of food MC = cost of additional unit of food
1 unit food = unit clothing PF/PC

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Consumer Choice
If MRS PF/PC then individuals can reallocate basket to increase utility If MRS > PF/PC
Will increase food and decrease clothing until MRS = PF/PC

If MRS < PF/PC


Will increase clothing and decrease food until MRS = PF/PC
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Consumer Choice
Clothing (units per week)

40 30
-10C

Point B does not maximize satisfaction because the MRS = -10/10 = 1 is greater than the price ratio = 1/2

20

+10F
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U1
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40

80

Food (units per week)

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Consumer Choice: An Application Revisited


Consider two groups of consumers, each wishing to spend $10,000 on the styling and performance of a car Each group has different preferences

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Consumer Choice: An Application Revisited


By finding the point of tangency between a groups indifference curve and the budget constraint, auto companies can see how much consumers value each attribute

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Consumer Choice: An Application Revisited


Styling $10,000 These consumers want performance worth $7000 and styling worth $3000

$3,000

$7,000
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$10,000 Performance
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Consumer Choice: An Application Revisited


Styling $10,000 $7,000 These consumers want styling worth $7000 and performance worth $3000

$3,000
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$10,000 Performance
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Consumer Choice: An Application Revisited


Once a company knows preferences, it can design a production and marketing plan Company can then make a sensible strategic business decision on how to allocate performance and styling on new cars

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Consumer Choice
A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another
MRS is not necessarily equal to PA/PB

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A Corner Solution
Frozen Yogurt (cups monthly)

A U1 U2 U3

A corner solution exists at point B.

B
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Ice Cream (cup/month)


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A Corner Solution
At point B, the MRS of ice cream for frozen yogurt is greater than the slope of the budget line If the consumer could give up more frozen yogurt for ice cream, he would do so However, there is no more frozen yogurt to give up Opposite is true if corner solution was at point A

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A Corner Solution
When a corner solution arises, the consumers MRS does not necessarily equal the price ratio In this instance it can be said that:

PIceCream MRS PFrozen Yogurt


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A Corner Solution
If the MRS is, in fact, significantly greater than the price ratio, then a small decrease in the price of frozen yogurt will not alter the consumers market basket

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A Corner Solution - Example


Suppose Jane Does parents set up a trust fund for her college education The money must be used only for education Although a welcome gift, an unrestricted gift might be better

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A Corner Solution - Example


Original budget line, PQ, with a market basket, A, of education and other goods Trust fund shifts out the budget line as long as trust fund, PB, is spent on education Jane increases satisfaction, moving to higher indifference curve, U2

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A Corner Solution - Example


Other Consumption ($)

B A

U2

Jane better off on U2 B is corner solution MRS PE/POG

U1
Q
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Education ($)
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A Corner Solution - Example


Other Consumption ($)

C
P

U3

B A

U2

If gift is unrestricted, Jane can be at point C on U3 Better off than with restricted gift

U1
Q
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Education ($)
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Revealed Preferences
If we know the choices a consumer has made, we can determine what their preferences are if we have information about a sufficient number of choices that are made when prices and incomes vary.

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Revealed Preferences Two Budget Lines


Clothing (units per month)

l1

l2 A B D

I1: Choose A over B A is revealed preferred to B l2: Choose B over D B is revealed preferred to D

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Food (units per month)

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Revealed Preferences Two Budget Lines


Clothing (units per month)

l1
All market baskets in the pink shaded area are preferred to A.

l2 A
B is preferred to all market baskets in the yellow area

B D

Food (units per month)


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Revealed Preference
As you continue to change the budget line, individuals can tell you which basket they prefer to others The more the individual reveals, the more you can discern about their preferences Eventually you can map out an indifference curve

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Revealed Preferences Four Budget Lines


I3: E revealed preferred to A
Clothing (units per month)

l3 All market baskets in the pink area preferred to A

l1 l4

l2
B G

A: preferred to all market baskets in the yellow area


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I4: G revealed preferred to A


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Food (units per month)

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Marginal Utility and Consumer Choice


Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good
How much happier is the individual from consuming one more unit of food?

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Marginal Utility - Example


The marginal utility derived from increasing from 0 to 1 units of food might be 9 Increasing from 1 to 2 might be 7 Increasing from 2 to 3 might be 5 Observation: Marginal utility is diminishing as consumption increases

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Marginal Utility
The principle of diminishing marginal utility states that as more of a good is consumed, the additional utility the consumer gains will be smaller and smaller Note that total utility will continue to increase since consumer makes choices that make them happier

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Marginal Utility and Indifference Curves


As consumption moves along an indifference curve:
Additional utility derived from an increase in the consumption one good, food (F), must balance the loss of utility from the decrease in the consumption in the other good, clothing (C)

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Marginal Utility and Consumer Choice


Formally:

0 = MU F(F) + MU C(C)
No change in total utility along an indifference curve. Trade off of one good to the other leaves the consumer just as well off.

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Marginal Utility and Consumer Choice


Rearranging:

( C / F ) = MU F / MU C Since ( C / F ) = MRS of F for C We can say MRS = MU F/MU C


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Marginal Utility and Consumer Choice


When consumers maximize satisfaction:

MRS = PF /PC
Since the MRS is also equal to the ratio of the marginal utility of consuming F and C

MU F /MUC = PF /PC
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Marginal Utility and Consumer Choice


Rearranging, gives the equation for utility maximization:

MUF / PF = M UC / PC

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Marginal Utility and Consumer Choice


Total utility is maximized when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good. This is referred to as the equal marginal principle.

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Cost-of-Living Indexes
Social Security payments are given to qualifying individuals Each year the benefit increases equal to the rate of increase of the Consumer Price Index (CPI)
Ratio of the present cost of typical bundle of goods/services in comparison to the cost during a base period

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Cost-of-Living Indexes
Does the CPI give a good measure of inflation and therefore a measure of the cost of living changes? Should the CPI be used to measure how much cost of living has increased, determining increases in government payment programs?

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Cost-of-Living Indexes
The ideal cost of living index represents the cost of attaining a given level of utility at current prices relative to the cost of attaining the same utility at base prices

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Cost-of-Living Indexes
To obtain the ideal cost of living index would require too much information, such as consumer preferences as well as prices and expenditures Actual price indexes are based on consumer purchases, not preferences

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Cost-of-Living Indexes
Laspeyres price index
Amount of money at current year prices that an individual requires to purchase a bundle of goods/services chosen in a base year divided by the cost of purchasing the same bundle at base-year prices Ex: CPI

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Cost-of-Living Indexes
The Laspeyres price index assumes that consumers do not alter their consumption patterns as prices change Tends to overstate the true cost of living index Using the CPI to adjust retirement benefits will tend to overcompensate most recipients, requiring greater government expenditure
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Cost-of-Living Indexes
Paasche index
Focuses on the cost of buying the current years bundle Amount of money at current-year prices that an individual requires to purchase a current bundle of goods/services divided by the cost of purchasing the same bundle in a base year

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Cost-of-Living Indexes
Comparison of indexes
Both are fixed weight indexes Quantities of various goods and services in each index remain unchanged Laspeyres index keeps quantities at base year levels Paasche index keeps unchanged quantities at current year levels

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Cost-of-Living Indexes
Chain-Weighted Indexes
Cost-of-living index that accounts for changes in quantities of goods and services Introduced to overcome problems that arose when long-term comparisons were made using fixed weight price indexes

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