Principles of Microeconomics- Consumer Theory

8/3/2019 Principles of Microeconomics- Consumer Theory

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Theory of Consumer Choice

Dr. Katherine Sauer

Principles of Microeconomics

ECO 2020


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Overview:

I. Preferences

II. Budget Constraint

III. Optimization

IV.The Demand Curve


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The theory ofconsumer choice is based on the notion that

consumers

try to do they best they can

given the constraints of

their budgets

the price of goods.


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I. Consumer Preferences

A. Satisfaction from Consuming goods/services

Utility is the satisfaction or happiness a person receives

from consuming a good/service.

Total Utility = sum total of all the satisfaction/happiness

from consuming the good/service

Marginal Utility = additional satisfaction/happiness from

consuming one additional unit of the good/service


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Ex: You eat 4 slices of pizza for dinner.

Total Utility = your total satisfaction

Marginal Utility = the additional satisfaction

you received from eating the 4th slice as

compared to the 3rd

slice

Note: it is not really possible to quantify utility

The 4 slices of pizza gave you 75 units of satisfaction?


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An individual CAN determine if something gives them

more or less satisfaction than something else.

ex: pineapple gives me more utility than

blueberries


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Because we cant quantify satisfaction, we cant

compare satisfaction across people.

ex: Jane like pineapple and Jack likes

pineapple. We cant determine who gets more

utility from pineapple.


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We do know that consumption is subject to the law of

diminishing marginal utility.

Each unit of a good will increase total satisfaction but at a

decreasing rate.


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Ex: You are hungry. You eat a slice of pizza. It gives you

some satisfaction.

You eat a second slice.

total satisfaction increases

second slice didnt give you quite as much extrasatisfaction as the first

- 5th slice

total satisfaction increases

not as much extra satisfaction as the 4th slice


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B. Preferences

People have preferences over various combinations ofgoods/services.

For simplicity, consider only two options at a time.

Ex: Suppose you have 3 job offers:

Minneapolis for $50,000

Washington DC for $40,000

Phoenix for $30,000

In choosing a job, you care about 2 things, high salary and

high average temperature.


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Salary

Average Temp

While Minneapolis has the

highest salary, it is also the

coldest.

While Phoenix has the highest

average temperature, it also has

the lowest salary.

Suppose each would give you

the same level of utility.

MN

AZ

IndifferenceCurve


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An indifference curve is a graphical representation of allthe different combinations of 2 options that yield the

same level of utility for a person.


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Salary

Average Temp

Washington DC has a moderate

salary and a moderate climate.

It is preferred to both MN and

AZ.

Utility rises as indifference

curves get further away fromthe origin.

MN

AZ

DC

IC1

IC2


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Ex: You buy coffee and download music each month.

Consuming 10 cups of coffee and buying 15 songs

gives you a certain level of total utility.Lets call this utility level 1.


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Q coffee

Q songs

10

15

Achieving

Utility Level 1

To keep that level of utility

constant you could adjust the

amount of each good you

consume.- if you buy more

coffee, decrease your

downloads

- if you buy less coffee,

increase your

downloads

more

coffee

fewer

songs

Still Achieving

Utility Level 1

lesscoffee

more

songs

Still AchievingUtility Level 1


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Q coffee

Q songs

10

15

more

coffee

fewer

songs

lesscoffee

more

songs

Still AchievingUtility Level 1

Indifference Curve

for Utility Level 1We could plot all the different

combinations of coffee and

songs that give us utility level 1.

- indifference curve


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C. Properties of Indifference Curves

1. Higher curves arepreferred to lower curves- true as long as more is better is true

Good Y

Good X

IC1 (Utility Level 1)




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2. They are downward sloping.

Reason: for a given level of satisfaction, you have togive up some of the Y good in order to get some more of

the X good

The slope reflects the rate at which you are willing tosubstitute one good for another.

The slope of an indifference curve is called the marginal

rate of substitution.- rate at which you will give up good Y to get good X


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IC1

Y

When you have a lot

of good Y, you are

willing to give someup to get an additional

unit of X.

When you have less ofgood Y, you are not as

willing to give some

up to get an additional

unit of X.

X


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The marginal rate of substitution (MRS) is not the

same at each point on the indifference curve.

IC1

X

Y

Steep slope (willing to give up Y), high MRS

Flat slope (not as willing to give up Y),low MRS


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The exact shape of the indifference curve depends on

your preferences for the particular goods/services.

You like good X quite a bit You like good Y quite a bit

more than good Y more than good X

Y

X

Y

X

IC

IC


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The goods are perfect The goods are perfect

complements substitutes

Y

X

Y

X

ICIC


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II. Consumers Budgets

Most people cant afford everything they want.

Purchases are limited by- income

- prices

For simplicity, lets assume that consumers spend all oftheir income and credit does not exist.


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Ex: The disposable income you have available for coffee and

downloaded songs each month is $30. A coffee costs $3 each anddownloaded songs costs $1 each.

If you spent all of your money on coffee, you could buy how

many cups?

30/3 = 10 (Income / price of coffee)

If you spent all of your money on songs, you could buy how many

songs?

30/1 = 30 (Income / price of songs)

Lets show this on a graph.


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Q coffee

Q songs

I/Pc = 10

30

You could also purchase a combination

of the goods.

The slope of the Budget Constraint is

equal to the negative of the ratio of the

prices.

(- px / py)

For our specific example: - 1/3

Budget Constraint

I/Ps


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Q coffee

Q songs

10

30

Budget Constraint

Suppose the price of songs increases to $2 each.

The maximum number of coffee cups will not change.

The maximum number of songs will decrease:

30 / 2 = 15

15

BC2


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An increase in one goods price will rotate the budget

line inward along that goods axis.

A decrease in one goods price will rotate the budget line

outward along that goods axis.


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Q coffee

Q songs

10

30

Suppose that instead of having $30 to spend on

coffee and songs you have $50.

The maximum number of cups will change.50 / 3 = 16.67

The maximum number of songs will change.

50/1 = 50

Budget Constraint

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50

The slope will not

change because the

prices havent changed.

BC2


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An increase in income will shift the budget line outward.

A decrease in income will shift the budget line inward.

The slope will not change when income changes.


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III. Consumer Optimization

The consumer will maximize their utility given their

budget constraint.

The consumer will be trying to get on the highest

indifference curve that their budget will allow.


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Q coffee

Q songs

10

30

BC

IC3

IC1

IC2

IC3: is the best for the consumer, but they

cant afford it with their current budget

constraint

The consumer can afford bundles J, K, and

L which lie on IC1 and IC2.

J

K

L


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Q coffee

Q songs

10

30

BC

IC3

IC1

IC2

Bundles J and L are affordable and lie on

IC1.

Bundle K is also affordable and lies on IC2,which is higher than IC1.

Bundle K is the optimal combination of

songs and coffee.

J

K

L

S*

C*


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The optimal bundle can be found by looking for the

point of tangencybetween the indifference curve and

the budget constraint.


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IV. Deriving the Demand Curve

A budget constraint and indifference curve can be used to

derive an individuals demand curve.

Assume everything is held constant except for the price

and quantity demanded of one particular good.


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Q oranges

Q apples

Q apples

Price of

apples

Qo1

Qa1

IC1

BC1

For a given income level,

prices and preferences, an

optimal bundle can be found.

Qa1

We can plot the price we are

given and the optimal

quantity.Pa1


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Q oranges

Q apples

Q apples

Price of

apples

Qo1

Qa1

IC1

BC1

Suppose that the price of

apples decreases.

The budget constraint willrotate out along the apples

axis.

A new level of utility can beachieved and a new optimal

bundle is found.

We can plot the new price and

quantity demanded.

We have just identified 2

points on the demand curve.

Qa1

Pa1

IC2

BC2

Qa2

Qo2

Qa2

Pa2

Demand

Principles of Microeconomics- Consumer Theory

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