...7 TOPICS FOR FURTHER STUDY The Theory of Consumer Choice 21 Copyright©2004 South-Western The theory of consumer choice addresses the following questions: Do all demand curves slope downward? How do wages affect labor supply? How do interest rates affect household saving? Copyright©2004 South-Western THE BUDGET CONSTRAINT: WHAT THE CONSUMER 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. Copyright©2004 South-Western THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD 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. Copyright©2004 South-Western The Consumer s Budget Constraint Copyright©2004 South-Western 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). Copyright©2004 South-Western Figure 1 The Consumer s Budget Constraint Quantity of Pepsi 500 B Consumer s budget constraint A 0 100 Quantity of Pizza Copyright©2004 South-Western THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD ...
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...| | Comparison Between Indifference Curve Analysis and Marginal Utility Analysis: There is difference of opinion among economists about the superiority of indifference analysis over cardinal utility analysis. Professor Hicks is of the opinion that the indifference analysis is more objective and scientific. Professor D.H. Rebertson is of the view that the Hicksian indifference curve technique is simply “old wine in new bottle”. We give in brief the main points of similarly between these two types of analysis and then discuss the superiority of Hicksian indifference curve analysis over the Marshallian Utility Approach. Similarities Between the Two Approaches: (i) Rationality assumption: In the two approaches, it is assumed that the consumer behaves rationality for obtaining satisfaction from his expenditure on consumer goods. Marshall uses the term utility, and Hicks satisfaction. (ii) Proportionality rule: The equilibrium condition of the consumer in both the analysis is the proportionality rule. In cardinal utility analysis , the equilibrium condition of the consumer is: MUa / Pa = MUb / Pb = MUc / Pc …………. = MUn / Pn In the Hicksian analysis, this ratio of marginal utility has been substituted by marginal rate of substitution is: MRSxy = Px / Py (iii) Diminishing MU and MRS: Another similarity between the two types of analysis is that both assume that as the consumer gets more and more of a commodity, there is diminishing satisfaction...
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...preferred to bundle C; (3) More is preferred to less: this means that all goods are desirable, and that the consumer will always prefer to have more of a good; (4) Diminishing marginal rate of substitution: this means that indifference curves are convex, and that the slope of the indifference curve increases (becomes less negative) as we move down along the curve. As a consumer moves down along her indifference curve she is willing to give up fewer units of the good on the vertical axis in exchange for one more unit of the good on the horizontal axis. This assumption also means that balanced market baskets are preferred to baskets that have a lot of one good and very little of the other good. 2. Can a set of indifference curves be upward sloping? If so, what would this tell you about the two goods? A set of indifference curves can be upward sloping if we violate assumption number three; more is preferred to less. When a set of indifference curves is upward sloping, it means one of the goods is a “bad” in that the consumer prefers less of the good rather than more of the good. The positive slope means that the consumer will accept more of the bad good only if she also receives more of the other good in return. As we move up along the indifference curve the...
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...besa44438_ch03.qxd 10/12/04 5:45 PM Page 68 3 3.1 3.2 C H A P T E R CONSUMER PREFERENCES AND THE CONCEPT OF UTILITY R E P R E S E N TAT I O N S OF PREFERENCES UTILITY FUNCTIONS APPLICATION 3.1 APPLICATION 3.2 APPLICATION 3.3 APPLICATION 3.4 Influencing Your Preferences How People Buy Cars: The Importance of Attributes Taste Tests Hula Hoops and Pet Rocks Why Do You Like What You Like? If you are thinking about buying a car, your choices can be overwhelming: Should you buy or lease? New car or used? A sport utility vehicle, a sedan, a sports car, or a minivan? Should you get a sunroof or four-wheel drive? How much extra would you pay for a vehicle that will have a high resale value in the future? What are the expected operating expenses for each model—insurance, repairs, gasoline, and so on? Finally, what opportunities will you forgo if you buy a car? How else could you spend your money, either today or in the future? Making decisions about a product with many options is not easy. Before buying a car, for example, you might draw on the experiences of friends and family, read advertisements, visit dealers, and test-drive vehicles. You might also research different models and financing options on the Web, read Consumer Reports, price insurance rates for favorite models, or even visit chat rooms frequented by car buffs. As a consumer, you make choices every day of your life. Besides choosing among automobiles, you must decide what kind of housing to rent...
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...Giffen Indifference By: Brett Dowling October 20, 2012 100 100 Price ($) Price ($) Indifference Map: Bananas vs. Everything Else Indifference Map: Bananas vs. Everything Else Qev Qev Demand Graph: Bananas Demand Graph: Bananas Qb Qb 60 60 50 50 40 40 20 20 12 12 5 5 2 2 Units Units 12 12 2 2 5 5 5 5 10 10 20 20 In order to understand and create a Giffen Good indifference curve, one first must examine the elements Relating a Demand Schedule to an Indifference Curve This demand graph depicts a survey relating the price of Bananas to the number of Bananas the sample would be willing to buy at that price. From this demand curve, we are able to create an indifference curve showing the maximizing relationships between the quantity of bananas we could buy (Qb) and the quantity of everything else we could buy (Qev), assuming one unit of everything else costs $1 and the budget is $100. How does this happen? When Qb = 2, the consumer would be willing to pay $20 for each banana, according to the demand curve. That means that $60 will be left over for everything else. Hence, a coordinate on the curve A of (2, 60) is formed as a point which maximized utility within the budget constraint. If the price of bananas were to be reduced to $10, then according to the demand curve, the consumer would be willing to buy 5, or $50 worth of bananas, and therefore $50 of everything else. This creates a new indifference curve, B, because the price change in bananas...
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...the price of q1, p1, changes there are two effects on the consumer. First, the price of q1 relative to the other products (q2, q3, . . . qn) has changed. Second, due to the change in p1, the consumer's real income changes. When we compute the change in the optimal consumption as a result of the price change, we do not usually separate these two effects. Sometimes we might want to separate the effects. The Substitution Effect is the effect due only to the relative price change, controlling for the change in real income. In order to compute it we ask what is the bundle that would make the consumer just as happy as before the price change, but if they had to make their choice faced with the new prices. To find this point we consider a budget line characterized by the new prices but with a level of income such that it is tangent to the initial indifference curve. In the diagram on the next page, the initial consumer equilibrium is at point A where the initial budget line is tangent to the higher indifference curve. Consumption at this point is 11 units of good 1 and 8 units of good 2. After an increase in the price of good 1, the consumer moves to point E, where the new budget line is tangent to the lower indifference curve. Consumption of good 1 has fallen to 4 units while consumption of good 2 has increased to 10 units. The substitution effect is the movement from point A to point G. This point is characterized by two things. (1) It is on the same indifference curve as the original...
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...Consumer behaviour is the behaviour of individuals when buying goods and services for their own use or for private consumption. The consumer has to decide on how much of each of the different goods he would like to consume and the choice of the consumer depends on the alternatives that are available to him and on his tastes and preferences regarding those alternatives. Accordingly, the economists study the two aspects of consumer behaviour. First, on what basis a rational consumer allocates the limited income between different goods and services the consumer desires. Of course, the objective behind the allocation is maximisation of satisfaction. Technically, it is called consumer’s equilibrium. Second, what is the reaction of a consumer to change in price of a good or a service he intends to buy? How does he usually react? Does he buy more? Does he buy less? Does he buy the same quantity? The generalisation of behaviour in this respect is called law of demand. Preliminary Notations and Assumptions...
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...CHAPTER 2 The Theory of Individual Labor Supply I. THE WORK-LEISURE DECISION: BASIC MODEL A. Indifference Curves 1. Negative Slope 2. Convex to Origin 3. Indifference Map 4. Different Work-Leisure Preferences B. Budget Constraint C. Utility Maximization D. Wage Rate Changes: Income and Substitution Effects 1. Income Effect 2. Substitution Effect 3. Net Effect E. Graphic Portrayal of Income and Substitution Effects F. Rationale for Backward-Bending Supply Curve G. Empirical Evidence H. Elasticity versus Changes in Labor Supply II. APPLYING AND EXTENDING THE MODEL A. Nonparticipants and the Reservation Wage B. Standard Workday 1. Overemployment 2. Underemployment C. Premium Pay versus Straight Time D. Income Maintenance Programs 1. Three Basic Features a. The Income Guarantee or Basic Benefit, B b. The Benefit-Reduction Rate, t c. The Break-Even Level of Income, Yb 2. Illustration 3. Controversy 4. The End of Welfare as an Entitlement WORLD OF WORK 1. Sleep Time Linked to Earnings 2. The Carnegie Conjecture 3. New Overtime Rules 4. The Labor Supply Impact of the Earned Income Tax Credit GLOBAL PERSPECTIVE 1. Annual Hours of Work per Employee ...
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...response to changes in total firm revenues. The variability of earnings relative to revenues is determined by two categories of risk. The first source of risk is business risk and is related to the basic industry and operating decisions of the firm. Business risk depends on a number of factors including the variability of demand for the firm’s products, the stability of sales prices and basic product input prices, and the extent to which the firm’s costs are fixed. Each of these factors is determined to some extent by the character of the firm's industry, but each of them is also controllable to some degree through the firm's strategic operating decisions. The second source of risk is financial risk. This risk is related to the firm’s financial policies, specifically the use of debt in financing operations. The use of debt obligates a firm to make interest and principal payments, regardless of profit levels. These fixed financial expenses compound fluctuations in operating income (EBIT) and introduce additional risk to stockholders. Separating business and financial risk convenient illustrates the division between firm operating and financial policies. Both are important and poor management in one area can easily undo good management in the other. Operating Leverage Business risk depends in part on the extent to which a firm builds fixed costs into its operations. If fixed costs are high, even a small change in sales can result in a large change in EBIT. ...
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...of a price change into two components, the substitution effect and the income effect. The substitution effect involves the substitution of good x1 for good x2 or vice-versa due to a change in relative prices of the two goods. The income effect results from an increase or decrease in the consumer’s real income or purchasing power as a result of the price change. The sums of these two effects are called the price effect. Sir John Hicks (1904-1989) awarded the Nobel Laureate in Economics (with Kenneth J. Arrow) in 1972 for work on general equilibrium theory and welfare economics was the founder of the income compensated demand curve, we are going to look at the hicks income compensated demand curve and why it differs from the Marshallian demand function (named after Alfred Marshall) (26 July 1842 – 13 July 1924) was one of the most influential economists of his time. The Compensated Demand Curve Definition: the compensated demand curve is a demand curve that ignores the income effect of a price change, only taking into account the substitution effect. To do this, utility is held constant from the change in the price of the good. We will graphically derive the compensated demand curve from indifference curves and budget constraints by incorporating the substitution and income effects, and use the compensated demand curve to find the compensating variation (refers to the amount of additional money an agent would need to reach its initial utility after a change in prices...
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...CONSUMER EQUILIBRIUM The consumer is assumed to be rational, that is, given his income and market prices of the different commodities, he aims at attaining the highest possible satisfaction or utility. However in order to achieve this objective, he must be able to compare the satisfaction of the different baskets of goods he can buy with his income. Utility is the measure of personal satisfaction. Marginal utility is the additional satisfaction that a consumer derives from an additional unit of a commodity or service. Total utility is the total satisfaction derived from consumption of a given combination of commodities. Consumer equilibrium is attained when the consumer purchases a combination of commodities that achieves utility maximization, given his income and price of commodities. The theory of demand tries to analyse consumer behaviour during the process of utility maximization. Once utility maximization is achieved, a consumer cannot increase utility by consuming more of one good and less of another because the marginal utility-price ratio equated. That is to say, utility is maximised when the consumer equates utility to the last amount spent on each good consumed. A summary equation to explain this is as follows: Marginal Utility of Good 1 = Marginal Utility of Good 2 Price of Good 1 Price of Good 2 Sometimes, the rule of consumer equilibrium is not satisfied, which means that utility is not maximized. This utility can be increased by changing...
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...Principles of Microeconomics Consumer Behavior and Utility Maximization – Lecture 9 Income & Substitution Effect: * We have earlier mentioned to explanations for the downward sloping demand curve: * Income & Substitution Effect – Purchasing Power * Law of Diminishing Marginal Utility (DMU) * The income effect is the impact that a change in the price of a product has on a consumer’s real income and consequently on the quantity demanded of that good. * The substitution effect is the impact that a change in product’s price has on its relative expensiveness and consequently on the quantity demanded. The cheaper the product is, the more attractive it becomes. * Income and substitution effect combine to increase consumer ability and willingness to buy a product as price falls Law of Diminishing Marginal Utility: * A second explanation of the downward sloping demand curve is that although consumer wants in general may be insatiable, wants for particular commodities can be satisfied. * In a specific span of time over which consumer’s tastes remain unchanged, consumers can get as much of a particular good or service as they can afford. * But the more of that product they obtain, the less they want still more of it. * This is the Law of DMU that causes the demand curve to be downward sloping. Utility: * A product has utility if it can satisfy a want. * Utility is want-satisfying power. * Important points to keep...
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...consumers obtain from the goods and services that they consume. Total Utility: The amount of benefit consumer obtains from the entire consumption of a product. Marginal Utility: The increase of total utility a consumer obtains from an additional (marginal) unit consumed. Indifference Curve: A line representing different bundles of goods and services, each yielding the same level of total utility. B. Graphical Explanation First looking at one item, Borsch. Total utility (TU) is a function of the amount of borsch (X) consumed TUX = f(X) Marginal Utility (MU) can be found by dividing the change in total utility by the change in the quantity of borsch. MUX = ∆TUX / ∆X Law of Diminishing marginal utility: The marginal utility of a good declines as more of it is consumed in a given time period. [pic] Each bowl of borsch provides less utility. By the seventh bowl marginal utility is zero, you would be just as well off without it. By the eighth bowl MU is negative, and total utility starts to decline. The eight bowl makes your stomach hurt, and you would have been better off not eating it. Now looking at two items, borsch (X) and bread (Y) where TU is: TU = f(X, Y) Graphically it appears so: [pic] Indifference curves are convex (bowed inward) to show that we require increasing amounts of bread to give up additional borsch (and visa versa)....
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...the budget line. 2. It must give the consumer the most preferred combination of goods and services. For example, Three indifference curves describe a consumer’s preferences for food and clothing. The outer-most curve, U3, yields the greatest amount of satisfaction, curve U2, the next greatest amount, and curve U1, the least. Point B on curve U1, is not the most preferred choice, because a reallocation of income in which more is spent on food and less on clothing can increase the consumer’s satisfaction. Point A – the consumer spends the same amount of money and achieves the increased level of satisfaction associated with indifference curve U2. The baskets located to the right and above indifference curve U2, like the basket associated with Point D on the indifference curve U3, achieved a higher level of satisfaction but cannot be purchased with available income. Therefore, Point A maximizes the consumer’s satisfaction. Satisfaction is maximized when: * The marginal rate of satisfaction (of F for C) is equal to the price ratio. * The marginal benefit (benefit associated with the consumption of one additional unit of food) is equal to the marginal cost (the cost of the additional unit of food). Marginal benefit is measured by the MRS. Point A – equals to ½ (the magnitude of the slope of the indifference curve), which implies that the consumer is willing to give up ½ unit of clothing to obtain 1 unit of food. The marginal cost is...
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...1. Suppose the price of regular-octane petrol were 20 paisa per gallon higher in Gujranwala than in Lahore. Do you think there would be an opportunity for arbitrage (i.e., that firms could buy petrol in Lahore and then sell it at a profit in Gujranwala)? Why or why not? ANS: Lahore and Gujranwala represent separate geographic markets for gasoline because of high transportation costs. There would be an opportunity for arbitrage if transportation costs were less than 20 cents per gallon. Then arbitrageurs could make a profit by purchasing gasoline in Lahore, paying to transport it to Gujranwala and then selling it in Gujranwala. If the transportation costs were 20 cents or higher, however, no arbitrage would take place. 2: The price of long-distance telephone service fell from 40 cents per minute in 1996 to 22 cents per minute in 1999, a 45% (18 cents/40 cents) decrease. The Consumer Price Index increased by 10% over this period. What happened to the real price of telephone service? Ans: Let the CPI for 1996 equal 100 and the CPI for 1999 equal 110, which reflects a 10% increase in the overall price level. Now let’s find the real price of telephone service (in 1996 dollars) in each year. The real price in 1996 is 40 cents. To find the real price in 1999 divide CPI1996 by CPI1999 and multiply the result by the nominal price in 1999. The result is (100/110) (22) = 20 cents. The real price therefore fell from 40 to 20 cents, a 50% decline. 3: Suppose the demand...
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