Consumer Choice

Consumer Choice

• Cardinal Utility Analysis
• Ordinal Utility Analysis
• Utility Function:   assigning a level of utility to each market basket; C= u (F + C); 8 units of F and 2 units of C – 8 + 2(3) =14,; 6 + 4(2) = 14
• Consumer Preferences—finding the practical way of knowing the reasons people might prefer one good to another
• Budget Constraints—limited incomes restricted the quantities purchased
• Consumer Choices—combination of goods chosen by consumers at given prices
• Market Baskets—list with specific quantities of one or more goods, also called bundle. Consumers will select a market basket that will make him well off as much as possible
• Completeness—consumer will prefer A to B or B to A, he is indifferent between the two
• Transitivity—consumer will prefer A to B and B to C, and hence A to C
• More is Better—consumer will prefer more of any good to less (bads are ignored here)
• Indifference Curve—represents all combinations of market baskets that provide a consumer with the same level of satisfaction
• Properties of IC
• Indifference Map
• Marginal Rate of Substitution—the MRS of F for C is the maximum amount of clothing that a person is willing to give up to obtain an additional unit of food. For e.g., if MRS is 3, a consumer is willing to forego 3 units of C for 1 additional unit of F (Fig. 3.5)
• MRS-- -∆C/∆F. We add the minus sign to make MRS a positive number(∆C is always negative; the consumer gives up clothing to obtain additional food)
• Convexity—an IC is convex if the MRS diminishes along the curve. The MRS of food for clothing is -∆C/∆F = - (-6)/1. As food consumption increases, the slope of IC falls in magnitude. Thus the MRS also falls
• Perfect Substitutes—MRS of apple juice for orange juice is 1. Raman is willing to trade 1 glass of one for 1 glass of the other. The slope of IC need not be -1 in the case of perfect substitutes (e.g. memory chip in pg. 70, MRS = -2)
• Perfect Compliments—MRS of left shoes for right shoes is zero when there are more right shoes than left shoes; Sita will not give up any left shoes to get additional right shoes. MRS is infinite when there are more left shoes than right shoes because Sita will give up all except one of her excess left shoes to obtain an additional right shoe ( right angles ICs)
• Budget Line—all combinations of goods for which the total amount spent is equal to income; PfF + PcC = 1 (price of food times quantity + price of cloth times quantity) See table 3.2 and Fig 3.10. The vertical intercept (1/Pc) represents the maximum amount of C that can be purchased with income I; the horizontal intercept (1/Pf) gives us the maximum of food. The slope of the line measured between B and D is –Pf/Pc = - 10/20 = -1/2. The slope of the line ∆C/∆F = -1/2, measures the relative cost of food and clothing
• Effects of Changes in Income—a change in income changes the vertical intercept of the budget line but does not change the slope. Fig. 3.11 shows if income increases doubled, the Budget Line shifts to the right and vice versa
• Effects of Changes in Price—a change in the price of one good causes the BL to rotate about one intercept. When the price of food falls, the BL rotates outward from L1 to L2 and vice versa (Fig. 3.12)
• Maximizing market must satisfy 2 conditions: must be located on the budget line, and must give the consumer the most preferred basket. Marginal benefit = Marginal Cost. In Fig. 3.13, at point At A, MRS between the two goods equals the price ratio. At B, MRS =  -10/10 = 1 is greater than the price ratio (1/2), satisfaction is not maximized
• Corner Solutions—a consumer is purchasing only one commodity. The MRS is not equal to price ratio for all levels of consumption. Fig. 3.15. A small decrease in price of yogurt will not alter the consumer’s choice, but if the price of yogurt falls big enough, the consumer could shift from ice cream to yogurt
•  Revealed Preference—it helps us to understand the implications of choices that consumers must make in particular situations
• Marginal Utility and Consumer Choice
• Cost- - of Living Indexes:

• Ideal Cost of Living Index:  Cost of attaining a given level of utility of current prices relative to the cost of attaining the same utility of basic year price.
• Laspeyres Index: Amount of money at current year price that an individual requires to purchase a bundle of goods and services chosen in a base year divides by the cost of purchasing the same basket at base – year prices.
• Comparing 1 and 2: The LI is far better than the IC. It over compensates Rachel for the higher cost of living by overstating the true cost of living.
• Paasche Index: Amount of money of current year prices that an individual requires to purchase a current basket of goods and services divided by the cost of purchasing the same basket in a base year.
• Chain – Weighted Index: Obtaining an estimate of real GDP after adjusting inflation. It was introduced to overcome problems that arose when long term comparisons of real GDP were made using fixed – weigh price index (Paasche & Laspeyeres) though prices were rapidly changing.