MICROECONOMICS: Theory & Applications Chapter 3 The Theory of Consumer Choice By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 9 th Edition,

MICROECONOMICS: Theory & Applications

Chapter 3 The Theory of Consumer Choice

By Edgar K. Browning & Mark A. ZupanJohn Wiley & Sons, Inc.9th Edition, copyright 2006PowerPoint prepared by Della L. Sue, Marist College

Copyright 2006John Wiley & Sons, Inc.3-2

Learning Objectives

Develop an approach for analyzing consumer preferences. Explain how a consumer’s income and the prices that must be

paid for various goods limit consumption choices. Understand how the market basket chosen by a consumer

reflects both the consumer’s preferences and the budget constraints imposed on the consumer by income and the prices that must be paid for various goods.

(Continued)


Learning Objectives (continued)

Determine how changes in income affect consumption choices. Show how altruism can be explained by the theory of consumer

choice. Relate the utility approach to the indifference curve method of

analyzing consumer choice.


Consumer Preferences

Economists make three assumptions about the typical consumer’s preferences:

1. Preferences are complete.

2. Preferences are transitive.

3. More of any good is preferred to less.


Definitions

Indifferent – when a consumer finds two options to be equally satisfactory

Economic “bads” – commodities of which less is preferred to more over all possible ranges of consumption

Economics “goods” – commodities of which more is better than less


Consumer Preferences Graphed as Indifference Curves

Indifference curve – plots all the market baskets that a consumer views as being equally satisfactory

Figure 3.1


Characteristics of Indifference Curves

Characteristics:– An indifference curve has a downward slope if the good is

desirable.– An indifference curve that lies farther from the origin is

preferred to one that is closer to the origin.– Two indifference curves cannot intersect.

An indifference map is a set of indifference curves. A set of indifference curves represents an ordinal

ranking.


Curvature of Indifference Curves

Indifference curves are convex to the origin.

Why?– Diminishing marginal

rate of substitution: a consumer’s willingness to give up less and less of some other good to obtain still more of the first good

Figure 3.4


Individuals Have Different Preferences [Figure 3.5]


Graphing Economic Bads and Economic Neuters [Figure 3.6]


Perfect Substitutes and Complements [Figure 3.7]


The Budget Constraint [Figure 3.8]


Geometry of the Budget Line

The intercepts with the axes show the maximum amount of one good that can be purchased if none of the other is bought.

The slope indicates how much of one good must be given up to buy one more of the other good:

Slope = ΔY/ΔX = -PX/PY


Shifts in Budget Lines

A change in income with constant prices produces a parallel shift in the budget line.

A change in the price of one good, with income and the other good’s price remaining unchanged, causes the budget line to rotate about one of the intercepts.


The Consumer’s Choice

Marginal benefit– The value the consumer derives from consuming one more

unit of a good– Measured by the MRSXY

Marginal cost– The cost of consuming one more unit of a good– Measured by the price ratio

Consumer’s optimal choiceMRSXY = PX/PY


A Corner Solution

The consumer’s optimal choice is not characterized by an equality between the MRS and the price ratio.

Figure 3.12


The Composite-Good Convention [Figure

3.13]


Changes in Income and Consumption Choices

Income-consumption curve: the curve that joins all the optimal consumption points generated by varying income

The curve slopes upward for normal goods.

Figure 3.14


Income-consumption Curve for an Inferior Good

The curve slopes downward for normal goods.

Figure 3.15


The Food Stamp Program [Figure 3.16]


Are People Selfish? [Figure 3.18]


The Utility Approach to Consumer Choice

Total utility - assuming that it is measurable, the total satisfaction a consumer receives from a given level of consumption

Marginal utility - the amount by which total utility rises when consumption increases by one unit

Diminishing marginal utility – the assumption that as more of a given good is consumed, the marginal utility associated with the consumption of additional units tends to decline, other things equal.


The Consumer’s Optimal Choice

The utility-maximizing market basket is one for which the consumer allocates income so that the marginal utility divided by the good’s price is equal for every good purchased:

MUX/PX = MUY/PY

The equality between the marginal utility per dollar’s worth of both goods is the same as the equality between the MRS and the price ratio.


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MICROECONOMICS: Theory & Applications Chapter 3 The Theory of Consumer Choice By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 9 th Edition,