The Rational Consumer The Objective of Consumers 2 Finish Chapter 8 and the appendix Announcements Please come on Thursday I ll do a self-evaluation where I will solicit your ideas for ways to improve the course. We have studied demand curves. We now need to develop a model of consumer behavior to understand where demand comes from. Optimal consumption decisions. Where do demand curves come from? Individual to market demands. Effects of price and income changes. Income and substitution effects. We assume consumers wish to maximize. Utility is like happiness or pleasure. We generally assume increases with consumption. And we generally assume that marginal, the incremental from an additional unit of consumption, declines at some point. The Budget Set for Consumers Wants are insatiable. But as the Rolling Stones remind us, we can t always get what we want. Why? There is a budget constraint. Our incomes are limited. In most of our examples we are going to simplify things by considering only two goods (though the theory is easy to generalize). The budget constraint can be written as: Income = P * + P * The slope of the budget constraint: P Slope = P 3 4 Indifference Curves are Like a Topographical Map for Utility An indifference curve is a line that shows all the consumption bundles that yield the same amount of total for an individual. An indifference curve map shows indifference curves for several different levels of. Utility increases Rooms U3 U2 U1 1
5 Properties of Indifference Curves #1: More is better Utility is higher as you move outward in the indifference curve map. #2: Indifference curves never cross Otherwise, will violate assumption #1. #3: Indifference curves are downward sloping and convex They are bowed in toward the origin as a result of diminishing marginal. 6 The Marginal Rate of Substitution: Tradeoffs Along an Indifference Curve The marginal rate of substitution (MRS) is The rate at which consumers will tradeoff goods (holding constant); and The slope of the indifference curve; and How much of the good on the axis is the household willing to give up for the good on the axis. MRS ΔQ = Δ Q along the indifference curve 7 More on the Curvature of Indifference Curves 8 Optimal Consumption: Slope of the I.C. = Slope of the B.C. Indifference curves for perfect substitutes Constant MRS Indifference curves for perfect complements Jelly Peanut butter Consume in fixed ratios Optimal Q of At optimal consumption, P MRS = Slope of BC = P = Optimal Q of Rooms Rooms Different preferences will clearly result in different choices And you are on the B.C. U3 U2 U1 U4 2
Thinking Like an Economist What is the Effect of a Price Increase (in rooms)? #1: The optimal consumption rule: the marginal per dollar spent must be the same for all goods and services that are consumed when consumers maximize. Optimal consumption rule: = P P The intuition of this should be clear you want the happiness () to be equal for each dollar you spend. #2: ou want to be on (and not inside) the budget constraint. Q of M1 M2 As the price of rooms increases, you optimally consume fewer rooms. The two ordered pairs the price and quantity of rooms at the old and the new equilibriums - identify two points on the individual s demand curve. 9 R2 R1 Q of Rooms Responding to a Price Increase, But with Different Preferences, Meal Consumption Goes Up 12 Summing Individual Demands to Get Market Demands Kate: Q=-P Libby: Q=-.5P At P>=, P=-2Q, at P<=, add Kate and Libby s Q s. Q K +Q L =-1.5P Solve for P and find P=40/3-(2/3)*Q when P<. P 5 Market Demand Q 3
13 Price Changes and Perfect Substitutes (MRS~=-1!) P BM =$2, P W =$1, =$ 25 P BM =$0.80, P W =$1, =$ Optimal C 14 Income and Consumption: Normal Goods Restaurant 80 =$2400/mo 40 An increase in income lead to an increase in both the size of housing and the number of restaurant meals. We call both these goods normal goods since consumption goes up (down) when income goes up (down). Optimal C 25 =$10/mo 8 16 Rooms in your house 15 Income and Consumption: An Inferior Good 16 Price Changes and Income and Substitution Effects Restaurant 80 =$2400/mo 40 =$10/mo An increase in income lead to a decrease in 2 nd hand furniture consumption. This is an example of an inferior good since consumption moves inversely with income. Quantity of Second-Hand Furniture The substitution effect refers to the substitution of the good that is now relatively cheaper for the good that is now relatively more expensive, holding constant. The income effect is the change in consumption that results from a change in income, ceteris parabus. For normal consumption goods, the SE and IE works in the same direction. For inferior goods, the SE and IE work in opposite directions. Since SE is generally stronger than the IE, demand curves still slope downwards (except for Giffen goods). 4
17 Income and Substitution Effects (price of rooms rises) 18 IE and SEs: (price of 2 nd hand furniture rises) SE: Find a hypothetical budget line with the new price ratio just tangent to the original IC. Income effect Substitution effect Rooms IE SE 2 nd hand Furniture 5