Engineerin Economics IC CURVES

45
1 Consumer Behavior Ordinal Approach

Transcript of Engineerin Economics IC CURVES

Page 1: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 1/45

1

Consumer

Behavior

Ordinal Approach

Page 2: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 2/45

2

Topics to be Discussed

Consumer Preferences

Budget Constraints

Consumer Choice

Revealed Preferences

Cost-of-Living Indexes

Page 3: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 3/45

3

Consumer Behavior

In Chacterizing consumer Behavior, there are two important but distinct factors to consider:

Consumer opportunities (Possible Goods and services consumer canafford to consume)

Consumer preferences (which of these goods will be consumed). In today’s global economy millions of goods are offered for 

sale, however to focus on essential aspects of individual behavior and to keep things manageable, we assumes thatonly two goods exist in the economy. X and Y be any twogoods i.e. chicken and beef.

Assume a consumer is able to order his preferences for alternatives bundles or combinations of goods from best toworst i.e. Bundle A > B (A is preferred to B), A ~ B(indifferent means equally satisfying)

Page 4: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 4/45

4

PREFERENCES: WHAT THE

CONSUMER WANTS

A consumer’s preference amongconsumption bundles may be

illustrated with indifference curves.

Page 5: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 5/45

5

Representing Preferences withIndifference Curves

An indifference curve is acurve that showsconsumption bundles thatgive the consumer the

same level of satisfaction.

 Marginal rate of  substitution: The rate atwhich a consumer is

willing to substitute onegood for another goodand still maintain thesame level of satisfaction.

 Y

U1

1 2 3 4

3

6

4

5

2

1

Page 6: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 6/45

6

Consumer Preferences

Three Basic Assumptions

1. Preferences are complete.

2. Consumers always prefer more of any good to less.

3. Diminishing MRS

4. Preferences are transitive. 

Market Baskets

Page 7: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 7/45

7

The consumer prefersA to all combinationsin the blue box, whileall those in the pink

box are preferred to A.

Consumer Preferences

Food

10

20

30

40

10 20 30 40

Clothing

50

G

A

EH

B

D

Page 8: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 8/45

8

U1

Combination B,A, & D yield the same satisfaction•E is preferred to U1 

•U1 is preferred to H & G

Consumer Preferences

Food

10

20

30

40

10 20 30 40

Clothing

50

G

D

A

EH

B

Page 9: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 9/45

9

Properties of Indifference Curves

Higher indifference curves are preferred tolower ones.

Indifference curves are downward sloping.

Indifference curves do not cross.

Indifference curves are bowed inward.

IC cannot touch the Horizontal or VerticalAxis

Page 10: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 10/45

10

Properties of Indifference Curves 

Property 1: Higher indifference curves are

 preferred to lower ones.

Consumers usually prefer more of something to less of it.

Higher indifference curves represent

larger quantities of goods than dolower indifference curves.

Page 11: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 11/45

11

Quantity 

of Pizza 

Quantity 

of Pepsi 

Indifference 

curve, I 1 

I 2 

 A 

The Consumer’s Preferences 

Page 12: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 12/45

12

Properties of Indifference Curves 

Property 2: Indifference curves are downward

sloping.

A consumer is willing to give up one good only

if he or she gets more of the other good in order to remain equally happy.

If the quantity of one good is reduced, the

quantity of the other good must increase. For this reason, most indifference curves slope

downward.

Page 13: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 13/45

13

Quantity 

of Pizza 

Quantity 

of Pepsi 

Indifference 

curve,I 1 

The Consumer’s Preferences 

Page 14: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 14/45

14

Properties of Indifference Curves 

Property 3: Indifference curves do not cross.

Points A and B should make the consumer equally

happy.

Points B and C should make the consumer equallyhappy.

This implies that A and C would make the consumer 

equally happy.

But C has more of both goods compared to A.

Page 15: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 15/45

15

The Impossibility of Intersecting Indifference Curves

Quantity 

of Pizza 

Quantity 

of Pepsi 

C  A 

Page 16: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 16/45

16

Properties of Indifference Curves 

Property 4: Indifference are convex to the origin.

People are more willing to trade away goods that

they have in abundance and less willing to trade

away goods of which they have little.

These differences in a consumer’s marginal

substitution rates cause his or her indifference

curve to bow inward.

Page 17: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 17/45

17

Bowed Indifference Curves

Quantity 

of Pizza 

Quantity of Pepsi 

Indifference 

curve 

 A 

MRS  = 6 

MRS  = 1 4 

14 

Page 18: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 18/45

18

Marginal Rate of Substitution

The marginal rate of substitution ( MRS ) 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.

Along an indifference curve there is a diminishing 

marginal rate of substitution.

Indifference curves are convex.

Consumers prefer a balanced market basket

Page 19: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 19/45

19

Consumer Preferences

Food

Clothing

2 3 4 51

2

4

6

8

10

12

14

16A

B

D

E G

-6

1

1

1

1

-4

-2-1

MRS = 6

MRS = 2

 F C  MRS 

Page 20: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 20/45

20

Consumer Preferences

Perfect Substitutes

Two goods are perfect substitutes when themarginal rate of substitution of one good for 

the other is constant.

Perfect Complements

Two goods are perfect complements when the

indifference curves for the goods are shaped asright angles.

Page 21: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 21/45

21

Consumer Preferences

Orange Juice(glasses)

AppleJuice

(glasses)

2 3 41

1

2

3

4

0

PerfectSubstitutes

Page 22: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 22/45

22

Consumer Preferences

Right Shoes

LeftShoes

2 3 41

1

2

3

4

0

PerfectComplements

Page 23: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 23/45

23

THE BUDGET CONSTRAINT: WHAT THECONSUMER CAN AFFORD

The budget constraint  depicts the limit on the

consumption “bundles” that a consumer can afford. 

People consume less than they desire because their 

spending is constrained, or limited, by their income. The budget constraint shows the various

combinations of goods the consumer can afford given

his or her income and the prices of the two goods.

Page 24: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 24/45

24

The Consumer’s Budget

Constraint

Page 25: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 25/45

25

THE BUDGET CONSTRAINT: WHAT THE

CONSUMER CAN AFFORD 

The Consumer’s Budget Constraint 

Any point on the budget constraint line

indicates the consumer’s combination or tradeoff between two goods.

For example, if the consumer buys no

 pizzas, he can afford 500 pints of Pepsi(point B). If he buys no Pepsi, he can

afford 100 pizzas (point A).

Page 26: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 26/45

26

The Consumer’s Budget Constraint 

Quantity 

Quantity of Pepsi 

Consumer’s budget constraint 

500 B 

100 

 A 

Page 27: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 27/45

27

THE BUDGET CONSTRAINT: WHAT THECONSUMER CAN AFFORD

The slope of the budget constraint line

equals the relative price of the two

goods, that is, the price of one good compared to the price of the other .

It measures the rate at which the

consumer can trade one good for theother.

Page 28: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 28/45

28

Budget Constraints

The Budget Line

The slope of the line measures therelative cost of food and clothing.

The slope is the negative of the ratioof the prices of the two goods.

The slope indicates the rate at which

the two goods can be substitutedwithout changing the amount of money spent.

Page 29: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 29/45

29

OPTIMIZATION: WHAT THE CONSUMERCHOOSES

Consumers want to get thecombination of goods on the highestpossible indifference curve.

However, the consumer must also endup on or below his budget constraint.

Page 30: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 30/45

30

The Consumer’s Optimal Choices 

Combining the indifference curve andthe budget constraint determines theconsumer’s optimal choice. 

Consumer optimum occurs at thepoint where the highest  indifferencecurve and the budget constraint are

tangent.

Page 31: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 31/45

31

The Consumer’s Optimal Choice 

The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative

 price.

At the consumer’s optimum, theconsumer’s valuation of the two goods

equals the market’s valuation. 

Page 32: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 32/45

32

The Consumer’s Optimum 

Quantity 

of Pizza 

Quantity 

of Pepsi 

Budget constraint 

I 1 

I 2 

I 3 

Optimum 

 A B 

Page 33: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 33/45

33

How Changes in Income Affect theConsumer’s Choices 

An increase in income shifts thebudget constraint outward.

The consumer is able to choose abetter combination of goods on ahigher indifference curve.

Page 34: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 34/45

34

Budget Constraints: Income Changes

Food 

Clothing 

80 120 16040

20

40

60

80

0

A increase inincome shifts

the budget lineoutward

(I = $160)

L2

(I = $80)

L1

L3

(I =$40)

A decrease inincome shifts

the budget line

inward

Page 35: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 35/45

35

 An Increase in Income ( normal goods)

Quantity 

of Pizza 

Quantity of Pepsi 

New budget constraint 

I 1 

I 2 

2. . . . raising pizza consumption . . . 

3. . . . and 

Pepsi 

consumption. 

Initial 

budget 

constraint 

1. An increase in income shifts the 

budget constraint outward . . . 

Initial 

optimum 

New optimum 

Page 36: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 36/45

36

How Changes in Income Affect the

Consumer’s Choices 

Normal versus Inferior Goods  If a consumer buys more of a good

when his or her income rises, the good

is called a normal good .

If a consumer buys less of a good whenhis or her income rises, the good iscalled an inferior good .

Page 37: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 37/45

37

An Inferior Good (pepsi as inferior good)

Quantity 

of Pizza 

Quantity 

of Pepsi 

Initial 

budget 

constraint 

New budget constraint 

I 1  I 2 

1. When an increase in income shifts the 

budget constraint outward . . . 3. . . . butPepsi 

consumption 

falls, making 

Pepsi an 

inferior good. 

2. . . . pizza consumption rises, making pizza a normal good . . . 

Initial 

optimum 

New optimum 

Page 38: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 38/45

38

Budget Constraints: Prices Change

If the two goods increase (decrease)in price, but the ratio of the twoprices is unchanged, the slope will

not change.

However, the budget line will shiftinward (outward) to a point parallel

to the original budget line.

Page 39: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 39/45

39

How Changes in Prices Affect Consumer’s

Choices

A fall in the price of any goodrotates the budget constraintoutward and changes the slope of 

the budget constraint.

Page 40: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 40/45

40

Budget Constraints: Price Changes

Food(units per week)

Clothing(units

per week)

80 120 16040

40 

(PF = 1)

L1

An increase in theprice of food to$2.00 changesthe slope of thebudget line and

rotates it inward.

L3

(PF = 2)(PF = 1/2)

L2

A decrease in theprice of food to$.50 changes

the slope of thebudget line and

rotates it outward.

Page 41: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 41/45

41

 A Change in Price of pepsi.

Quantity 

of Pizza 

Quantity of Pepsi 

1,000  D 

500  B 

100 

 A 

I 1 I 2 

Initial optimum 

New budget constraint 

Initial 

budget 

constraint 

1. A fall in the price of Pepsi rotates

the budget constraint outward . . . 

3. . . . and 

raising Pepsi 

consumption. 

2. . . . reducing pizza consumption . . . 

New optimum 

Page 42: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 42/45

42

Summary

A consumer’s budget constraint showsthe possible combinations of differentgoods he can buy given his income

and the prices of the goods. The slope of the budget constraint

equals the relative price of the goods.

The consumer’s indifference curvesrepresent his preferences.

Page 43: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 43/45

43

Summary

Points on higher indifference curvesare preferred to points on lowerindifference curves.

The slope of an indifference curve atany point is the consumer’s marginalrate of substitution.

The consumer optimizes by choosingthe point on his budget constraint thatlies on the highest indifference curve.

Page 44: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 44/45

44

Summary

When the price of a good falls, theimpact on the consumer’s choices can bebroken down into an income effect and a

substitution effect. The income effect is the change in

consumption that arises because a lowerprice makes the consumer better off.

The income effect is reflected by themovement from a lower to a higherindifference curve.

Page 45: Engineerin Economics IC CURVES

7/29/2019 Engineerin Economics IC CURVES

http://slidepdf.com/reader/full/engineerin-economics-ic-curves 45/45

Summary

The substitution effect is the change inconsumption that arises because aprice change encourages greater

consumption of the good that hasbecome relatively cheaper.

The substitution effect is reflected by a

movement along an indifference curveto a point with a different slope.