Consumer theory: Preferences, consumption and demand

8/7/2019 Consumer theory: Preferences, consumption and demand.

http://slidepdf.com/reader/full/consumer-theory-preferences-consumption-and-demand 1/28

Alexia Gaudeul

GSBC Basics Week

Consumer theory:Preferences, consumption anddemand.



“Friends”

GSBC Basics214 December 2009




Value and Utility in “Friends”

• In “Friends”, series 2, episode 6,Phoebe who played guitar for free at “Central Perk”, is replaced by a

“professional” musician.1

• Jealous Phoebe decides to sing in thestreet and collect alms from

passerby’s. She gets depressed whenher favorite song “Smelly Cat” earnsonly $0.50. 1 This turns out to be Chrissie Hynde of The Pretenders,

who performs "Angel of the Morning" on acoustic guitar.




Value and Utility in “Friends”

• Ethics: Why should Phoebe not be paidwhen a “professional” musician doing thesame job is?

• Psychology: Why does Phoebe refuse to

go on not being paid?• Sociology: What makes one a “professional” musician?

• Law: Should one need a license to play

music?• Economics: What is the value of Phoebe’s

performance?




What is the value of aperformance?

• Producer value:– How many additional drinks can I sell by

having a musician?

• Performer value:

– Utility from playing vs. alternatives.– Or intrinsic value = time in training? (Ricardo)

• Market value: How much are musiciansprepared to accept to play? How much are

bar owner prepared to play? How do theynegotiate?• How do I reconcile all those values?




Consumer theory

• Start from consumer preferencesamong goods.

• Find out their consumption of thosegoods.

• Determine how this translates intomarket demand.

• All this based on price of the goodsand wealth of the consumer.




Bread and Butter




A bread-and-butter issue

• An issue that is central or fundamental toone's business, survival, or income. Forexample, an election campaign may say

“Our focus is going to be on bread-and-butter issues”.

• How much butter will I put on my breadand why?

• What happens if the price of bread andbutter change?




Bread OR Butter?

• 100 g of bread (baguette) = 263 kcal

• Price of a baguette: 1 euro

• Weight of a baguette: 250 g

– 1 euro = 657.5 kcal• 100 g of butter = 700 kcal

• Price of butter: 1.5 euros

• Weight of a block of butter: 250 g– 1 euro = 1166.7 kcal

• Let them eat butter! (modified fromMarie-Antoinette’s “Let them eat cake!”).




How much butter on mybread?

• In practice, I use about 1 block of butterfor 4 baguettes (I like butter a lot!).– So I consume 1.5 baguette kcal for each butter

kcal.

– Why? This is what I prefer.

• How do I represent and measure andcompare my preferences with others?– U(Bread, Butter)=ABrαBuβ

– Br, Bu: Number of bread, resp. buttercalories…

– ln(U(Bread, Butter))=lnA+αln(Br)+βln(Bu)



Iso-Utility Curves

• A=1, α=β=1/2

• Curve for U1=10is such that10=√ Br√ Bu

• Curve for U2=20is such that20=√ Br√ Bu

• Any point along

a line gives methe same utility.





The utility of bread andbutter

• Price of bread: pbread (per kilo-calorie)=0.152 cents

• Price of butter: pbutter (per kilo-

calorie)=0.086 cents• Wage: w (e.g. 2 euros/day).

• My “program” is:

– Max lnA+αln(Br)+βln(Bu)– subject to: pbreadBr+pbutterBu<w

• Question: What is my α? What is my β?




Alexia’s dieting program

–Max lnA+αln(Br)+βln(Bu)

– subject to: pbreadBr+pbutterBu < w

–Max lnA+αln(Br)+βln(Bu)–λ(pbreadBr+pbutterBu-w)

–α /Br- λpbread

=0

–β /Bu-λpbutter=0

–pbreadBr+pbutterBu=w




Alexia’s α

– α /β = (Br*pbread)/(Bu*pbutter)– pbread*Br+pbutter*Bu=w

– α /β=w/(pbutter*Bu)-1– β /α=w/(pbread*Br)-1

– In my case, I consume 1.5 baguette kcal for each butterkcal so Br=1.5*Bu

– Budget constraint: 0.152*1.5*Bu+0.086*Bu=200– Bu= 637 kcal Br=955 kcal

– α /β=200/(0.086*637)-1=2.65– β /α=200/(0.152*955)-1=0,38 (=1/2.65)




Alexia = 2.65

• So, the reason I eat 1.45 baguette perday, along with 36.4% of a block of butter, is that my α /β=2.65.

• I enjoy (the logarithm of) bread 2.65

more than (the logarithm of) butter, whichexplains why I don’t eat only butter eventhough it is much cheaper per kcal.

• Question:

– What if my α /β increased?

change inpreferences– What if my wage increased? income effect– What if the price of butter increased?

substitution effect.




Alexia = 2.65?

• I can compare my preferences withothers (though comparing utilities ismeaningless).

• What could change my α /β?

–Better bread?

–High cholesterol?

–What would be the consequences?




Alexia = 2.65?

• What about the shape of my utility function?

• In my family, for example, we were forbidden(for ethical reasons?) to have both jam andbutter superposed on the same piece of bread,

irrespective of anything including our bestarguments.– Then I cannot write U(Bread, Butter, Jam)=ABrαBuβJaγ,

since it would lead to predictions that would not beconsistent with my behavior (though maybe with mypreferences?)

• In practice, I only know my preferences aroundsome point (local preferences), in so far as theyexplain my reaction to (small) price changes.




2.65 = losing w eight

• I am supposed to need 2000 kcal/day tomaintain my weight while given my salary,prices and preferences, I get only 1592kcal/day.

– I would lose 500 g per week with this diet,though this rate of decrease would decreaseafter a while, so in the end I would probablybe able to survive on this (Basal MetabolicRate).

– e.g. the official ration in the U.S. zone forGerman citizens in May 1946 was no morethan 1275 kcal/day, though this had increasedto 2000+ by 1948.




Potatoes rather than bread

• Therefore, I will actually have to spend my2 euros in such a way that I get at least2000 kcal.

• I need to sacrifice a bit of bread for butter

such that:– Br+Bu>2000– subject to: pbreadBr+pbutterBu<w– Br=424 kcal 2/3 of a baguette

– Bu=1576 kcal

90% of a block of butter• Now, I look like I don’t like bread thatmuch!




Potatoes rather than bread

• Maybe I could switch to potatoes?(Antoine-Augustin Parmentier)– 1 Jacket potato = 180g = 245 kcal– 1 kg potatoes, which cost 1 euro, provides

1361 kcal, twice as much as bread!– I should thus be able to satisfy my needs withbutter + potatoes rather than bread + butter.

• Note: Parmentier tried to make bread outof potatoes in order for it to gain

acceptance among the French, but it wasfamine in the early 1770s that establishedit into their diet.




What are preferences?

• In the previous example, was 2.65 anaccurate measure of my preferences?

• To what extent are my preferencesdependent on my environment?– E.g. my diet will likely differ if in France or if in

Germany.

• To what extent does my environmentdepend on my preferences?– E.g. a country with a large butter consumption

will likely have a large dairy industry.

– Does that means dairy prices will be lower?




“True” preferences?

• Given an environment, how can Iretrieve my “true” preferences?

–Revealed preferences? (observe what I

do) this is what we did up to now.–Stated preferences? (ask me what I

would like to do)

P f f k t




Preferences for non-marketgoods

• What about the value of clean air andwater, healthy fish and thriving wildlifepopulations?

• Not priced, difficult to measure theirconsumption difficult to measureconsumers’ preferences w.r.t. those goodsaccording to previous method.– What is the value of a green park? The number

of times you go jogging there?– If you have never been to a beach, does that

mean you don’t value their cleanliness?




Central Park

New York’s Central Park’s estimated value is 529 billion dollars (asestimated by how much it could be sold for to property developers)about $70,000 per inhabitant, or about 10 times NYC‘s annual budget.




Methods

• Contingent valuation: use surveys todirectly elicit individuals' preferencesand willingness to pay for a good.

–E.g. the value of a green park is thesum of how much people would beprepared to pay to preserve it.

–Problem: Difference between WTP andWTA, confusion over the question, littleaccount of budget constraints…




Methods

• Hedonic Pricing: treat marketgoods/services as a bundle of attributesand decompose market prices into

“shadow prices” (i.e., values) forindividual attributes.

– E.g. the value of a green park is how muchmoney I save on a sport club membership.

– The value of environmental regulation of foodproduction is how much I am prepared to payfor bio-certified products vs. others.




Methods

• I can also look at how much wouldbe lost in economic activity if I gotrid of the green park, by using data

from other cities.–E.g. if Central Park disappeared, how

much would surrounding properties lose

in value? How many companies wouldswitch headquarters? What about healthmeasures (long term impact).



GSBC Basics

Green park

• Social values free access, neutralground.

• Environmental values biodiversity,

micro-climate, reduced pollution.

• Economic value value of nearbyhouses, decrease in health bills,

employment.

Documents

Consumer theory: Preferences, consumption and demand