Session 4 Consumer choices and revealed preferences Consumer

Session 4: Consumer choices and revealed preferences 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

Session 4: Consumer choices and revealed preferences Consumer Choice • The maximizing market basket must satisfy two conditions: • It must be located on the budget line – They spend all their income – more is better • It must give the consumer the most preferred combination of goods and services

Session 4: Consumer choices and revealed preferences Consumer Choice • Graphically, we can see different indifference curves of a consumer choosing between clothing and food • Remember that U 3 > U 2 > U 1 for our indifference curves • Consumer wants to choose highest utility within their budget

Session 4: Consumer choices and revealed preferences Consumer Choice • A, B, C on budget line • D highest utility but not affordable • C highest affordable utility • Consumer chooses C Clothing (units per week) 40 A 30 D 20 C U 3 U 1 B 0 20 40 80 U 2 Food (units per week)

Session 4: Consumer choices and revealed preferences 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

Session 4: Consumer choices and revealed preferences Consumer Choice • Recall, the slope of an indifference curve is: Further, the slope of the budget line is:

Session 4: Consumer choices and revealed preferences Consumer Choice • Therefore, it can be said at consumer’s optimal consumption point,

Session 4: Consumer choices and revealed preferences 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

Session 4: Consumer choices and revealed preferences 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 = ½ unit clothing – PF/PC

Session 4: Consumer choices and revealed preferences 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

Session 4: Consumer choices and revealed preferences Consumer Choice Clothing (units per week) Point B does not maximize satisfaction because the MRS = -10/10 = 1 is greater than the price ratio = 1/2 40 30 B -10 C 20 +10 F 0 20 40 U 1 80 Food (units per week)

Session 4: Consumer choices and revealed preferences 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.

Session 4: Consumer choices and revealed preferences Revealed Preferences – Two Budget Lines Clothing (units per month) l 1 • I 1: Choose A over B • A is revealed preferred to B • l 2: Choose B over D • B is revealed preferred to D l 2 A B D Food (units per month)

Session 4: Consumer choices and revealed preferences Revealed Preferences – Two Budget Lines Clothing (units per month) l 1 All market baskets in the pink shaded area are preferred to A. l 2 B is preferred to all market baskets in the yellow area A B D Food (units per month)

Session 4: Consumer choices and revealed preferences • 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

Session 4: Consumer choices and revealed preferences Revealed Preferences – Four Budget Lines I 3: E revealed preferred to A Clothing (units per month) l 3 l 1 All market baskets in the pink area preferred to A E l 4 l 2 A: preferred to all market baskets in the yellow area A B G I 4: G revealed preferred to A Food (units per month)

Session 4: Consumer choices and revealed preferences 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?

Session 4: Consumer choices and revealed preferences 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

Session 4: Consumer choices and revealed preferences 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

Session 4: Consumer choices and revealed preferences 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)

Session 4: Consumer choices and revealed preferences Marginal Utility and Consumer Choice • Formally: No change in total utility along an indifference curve. Trade off of one good to the other leaves the consumer just as well off.

Session 4: Consumer choices and revealed preferences Marginal Utility and Consumer Choice Rearranging:

Session 4: Consumer choices and revealed preferences Marginal Utility and Consumer Choice • When consumers maximize satisfaction: Since the MRS is also equal to the ratio of the marginal utility of consuming F and C

Session 4: Consumer choices and revealed preferences Marginal Utility and Consumer Choice Rearranging, gives the equation for utility maximization:

Session 4: Consumer choices and revealed preferences 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.

Session 4: Consumer choices and revealed preferences References: § § Chapter 3 and 4 Microeconomics, R. S. Pyndick, D. L. Rubinfeld and Prem L. Mehta, Peason Publishing House. Consumer Behaviour: faculty. arts. ubc. ca/dqirjo/Teaching/PPLAM/ch 03_08_31_08. ppt

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