Ranking commodity bundles. Topic 1: Consumer choice theory. Utility theory. Main ingredients of CCT: Preferences over bundles, prices and income

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1 Topic 1: onsumer choice theor Ranking commodit bundles Main ingredients of T: Preferences over bundles, prices and income ssumptions on preferences 1: ompleteness: if confronted with an 2 bundles, consumer can tell which one prefers more (or is indifferent): >, >, ~ 2: Transitivit: >, > then logicall > 3: Nonsatiation: More is alwas better 4: Diminishing marginal rate of substitution: undles less preferre d than D D undles preferred to D (nonsatiation) implies that cannot look like this (upward sloping) Indifference curves slope downwards [Marginal rate of substitution, MRS the rate at which the consumer is willing to trade for ] MRS () MRS () Idea is simple: if more of both goods preferred then consumer cannot be indifferent between and 3 4 Negative slope follows from diminishing marginal rate of substitution 4 2 (transitivit) implies that crossing in impossible Utilit theor Preferences do not require us to attach to bundles numerical measures of how much satisfaction the give (all we need is >) Utilit function: formula showing the total utilit associated with each commodit bundle Ordinal utilit (allows for ranking of bundles b their amount of utilit) ardinal utilit (tells eactl how much better some bundles are than other) 5 6 1

2 Tpes of indifference curves Perfect substitutes (straight lines with slope -1) Perfect substitutes (total consumption matters: e.g butter, margarine) Perfect complements (joint consumption matters: e.g coffee, sugar) There are also bad goods (dislike consumption of: e.g pollution, war) 7 8 Perfect complements (right angled indifference curves): joint consumption matters ad goods (e.g pollution) 9 10 Prices onve information Ration scarce resources Determine income udget constraint onsumers have income, I, to spend on goods, p + p I p Slope of budget constraint is p hange in income shifts budget constraint hange in prices rotates budget constraint

3 Which bundles the consumer will select? Maimisation (interior) onsumer maimise when (fundamental condition) E D MRS = p p Equilibrium is at! (and is an interior solution) 13 L.h.s is rate at which the consumer is willing to trade one good for the other, R.h.s is the rate at which she is able to do so. 14-1/4-1/1 Marginal utilit p MRS < p p MRS = p Marginal utilit: The change in total utilit associated with consumption of one additional unit MU + MU = 0. p MRS > p MU =. p MU MU = MU. =. MU p MU p p Last sas: When the marginal utilit of last is same for each good there is no wa that m can be reallocated so U increases omparative statics omparative statics and demand n increase in price rotates the budget constraint p MRS = p Price changes affect welfare: 2 effects (Hicks decomposition) Substitution effect (change in quantit demanded induced b the price change keeping the consumer at initial utilit level) Income effect (change in quantit demanded induced b the change in income)

4 Normal and inferior goods pplication: Transfer in kind/cash reduction in income shifts the budget constraint, are normal goods is inferior good Is it better to give transfers in kind or in cash? (e.g medicare (US), donations, education) nswer depends on fungibilit of good (whether it is freel ehangeable to another good) but also on preferences Indifference between kind and cash ash is then preferred: consumer can get on higher indifference curve. What is transfer in kind is echangeable? kind: pament in form of commodit (best ou can do is at ; assuming that good is not echangeable) Price changes and consumer welfare Government policies affect prices and consumer satisfaction E.g., Governments restrict the import of goods to protect domestic producers from foreign competition (as a result consumer pa higher prices) Some policies favour consumers: state subsidies for education, flood insurance What do all these different prices mean for consumer welfare? In previous discussion we talked about the law of demand but this is not enough To know what happens to consumer satisfaction we need to understand the welfare consequences of price changes. piece of warning: Most people have trouble deciphering the V, EV and the Slutsk equation (so etra care/stud is needed)!

5 Income and substitution effects When the price of a good goes up, that good become more epensive relative to other goods (relative price increases). The change in consumption that comes eclusivel from this is called substitution effect ut a person s income is worth less now. Relative income has decreased (this is the income effect) Mechanics: How do I find the two effects? 1. Determine the change in consumption that occurs from a price change 2. Restore sufficient income so that the original utilit level is restored (though with a different mi of goods so income is fied) 3. The change in step 2 is the substitution effect 4. Take income given in step 2 awa. 5. dd steps 2 and 4: The change in consumption from the change in real income is the income effect Income effect Negative (inferior good) Substitution effect is alwas negative V Price of decreases, budget constraint (blue) rotates to the Right (dark red). Initial optimum at. Substitution effect -; Income effect -; Good is a normal good (price decreased quantit demanded increased) 27 Price of decreases, budget constraint rotates to the right Initial optimum at. Substitution effect -; Income effect -, (inferior good) 28 Price of decreases, budget constraint rotates to the right Initial optimum at. Substitution effect -; Income effect -, (Giffen good) Income effect (negative) offsets subst.effect Giffen Summar (on SE,IE) For normal goods: income effect reinforces substitution effect (both negative) For inferior goods: income effect partoffsets substitution effect For Giffen goods: income effect offsets substitution effect Slutsk equation: = p p comp I

6 ompensating and equivalent variations V and EV provide useful was to analse significant economic problems. The change in consumption holding utilit constant is called the compensated response ompensating variation (V) is the amount of mone an individual would need to be given to restore their initial utilit after a price change. Equivalent variation (EV) is the amount of income we must take from an individual if prices DO NOT change to cause the same utilit loss as the price increase 31 V and EV V EV In general V is not equal to EV 32 6