Rational Choice

Professors Farhoud Kafi

2010

1

Consumer Preference and Behavior

What are the consumer opportunity? Array of goods and services they can afford.

What are the consumer preference? Bundles which they actually buy

Can we develop a model that shows how they buy these bundles? Yes, we can develop a utility/attribute

functionWhat would be the ultimate goal?

Maximizing Utility , subject to Budgetary (Income) constraint.

How the Objective is Achieved• Given the choices among the bundles, consumers will pick each bundle based on the value he/she assigns to that bundle while considering; budget, price, and all other attributes important to his/her choice.

How to model the consumer choiceWe assume consumer is rational decision

makerWe assume the bundles ranked higher by

consumer are superiorWe assume additional bundles, inevitably will

lead to diminishing marginal satisfaction (DMU)

Based on information received from the consumer, we can map and develop the consumer utility function

Given the constraint, we can then identify the best possible bundle

Use of indifference map in modeling consumer behavior

We assume consumer has only two bundles to choose

We assume consumer assigns budget to acquire these bundles

We assume money left over provides no marginal benefit to consumer

We assume consumer can express preference We assume more is preferred to lessWe assume substitution has DMR We assume consumer is constraint by the budget

and prices are exogenous to the model

Consumer preferences can be described with indifference curves.

The Properties of Indifference CurvesDo not intersectMore is always betterNegatively sloped throughoutSlope: MRS = “Marginal rate of substitution”

Here MRS = CD / Pizza

The Consumer’s Budget Constraint

Income = 100, Ppizza = $5.00,

PCDs = $10.00

Slope = - Ppizza/ PCDs20

10

Pizza's

CDs

Consumer in Equilibrium at EMRS = Ppizza/PCDs

Consumer in disequilibrium at B

Pizzas

CDs

CD0

P0

B

E

Difference in Preferences

FIGURE A: JIM FIGURE B: JANE

CDs CDs

Pizzas Pizzas

Different Preferences lead to Different Choices

FIGURE A: JIM FIGURE B: JANE

CD CDs

Pizzas PizzasP1

D1E

E

P1

D1

Assignment Question 11. Alex’s preferences for bagels and wine can

be isolated and examined. Assume that Alex’s budget is $200. Bagels cost $2.00 each and wine costs $10.00 per liter. Assume that Alex spends all of his income on bagels and wine in order to maximize his total utility.

a) Write the equation for his budget line. What is the slope of the budget line and what does it mean? Draw the budget line. Use the X-axis for bagels and the Y-axis for wine.

Budget EquationPBQB + PWQW = I

PB = 2PW = 10I = 200

2QB + 10QW = 200

Graph of the Budget Line

QB

QW

20

20 40 60 80 100

40

Bagels and Wine (continued)c) Draw Alex’s preferences map and

superimpose the budget line. Label Alex’s utility-maximizing combination of bagels and wine as point “A.” What is meant by the “utility-maximizing combination of bagels and wine?”

Alex’s Preference Map

QB

QW

20

20 40 60 80 100

40

U1U2

U3

U4

Rational Consumer (Alex) Choice

QB

QW

20

20 40 60 80 100

40

U1U2

U3

U4

A

Utility-Maximizing Combination of Bagels and Wine

Slope of Indifference Curve = MRSMRS = - (Wine/Bagels)MRS = - (QW/QB)

Slope of Budget Line = Relative Price Ratio = – (PB/PW)

Utility-maximizing combination is where the slope of the indifference curve is equal to the slope of the budget line.

Utility-Maximizing Combination of Bagels and Wine

MRS = (PB/PW)

This is also the point where the highest possible indifference curve is just tangent to the budget line.

Bagels and Wine (continued)c) Sally is currently spending her entire

budget on bagels. She purchases no wine. Draw Sally’s indifference curves and explain her consumption choices in term of marginal utility.

Sally’s Indifference Curves and Budget Line

QB

QW

20

20 40 60 80 100

40

U1 U2 U3

Marginal UtilityMU = U/QSally’s Marginal Utility for Wine

MUW = U/QW = 0

MRS = - (QW/QB)

MRS = - (U/QB)/(U/QW)

MRS = - MUB/MUW = UndefinedSally will not give up any bagels to

gain any wine

Bagels and Wine (continued)d) Consider alternative strategies wine

manufacturers could use to target Sally and consumers like her (i.e. lowering price of wine, advertising, free samples).