Reading 14 LOS's

Question 1

LOS 14a: Describe consumer choice theory and utility theory

Answer 1

Axioms of the Theory of Consumer Choice

• Assumption of complete preferences- Given two bundles, a consumer is positively able to state which bundle they prefer to the other, or that they are indifferent
• Assumption of Transitive Preferences - given three bundles, A, B, and C, if a consumer prefers A to B and B to C, then they prefer A to C
• Assumption of nonsatiation It can never be the case that the consumer could at some stage have so much of the good that she would refuse more of the good even if it were free

The Utility Function

The utilit function translates each bundle of goods and services into a single number, that allows us to rank the different bundles based on consumer preferences.

Question 2

LOS 14b: Describe the use of indifference curves, opportunity sets, and budget constraints in decision making

LOS 14c: Calculate and interpret a budget constraint

Answer 2

Indifference Curves- The graphical portrayal of the Utility Function

Indifference curves represent all the bundles of two goods that yield exactly the same level of satisfaction for a consumer. Any points that lie below an indifference curve are dominated by the curve (combination on the curve is more preferred to that below it). Any points that lie above the curve are preferred to the curve.

The indifference curve is downward sloping. This implies the tradeoff between the two goods to stay on the same level of satisfaction. If you had 5 units of good A and B, and were given another unit of B without having to give up a unit of A, you should be more satisfied and would have to move to another indifference curve. To stay indifferent, to receive one more unit of B, we would have to give up a unit of A.

The slope of the curve won’t always be straight. This is represented by the marginal rate of substitution(MRS) of good A for good B. If in our example it was a one for one substitution, we would have a linear decreasing line. The MRS states how much of one good you are willing to give up to receive another unit of the other good. Normally with consumers, if they have an extreme quantity of good A, they would be willing to give up more of it to get another unit of good B. But when they have very little of good A, they are willing to give up less to get another unit of good B. This causes most indifferent curves to be convex

Indifference curve Maps

An indifference curve map represents a consumer’s entire set of indifference curves, where each indifference curve offers the consumer a different elvel of utility

• Due to completeness assumption, there must be one indifference curve that passes through every point
• Due to the transitiviy assumption, indifference curves for a particular consumer can never intersect each other

Therefore indifference curves are generally convex and negatively sloped.

Gains from voluntary Exchange: Creating Wealth Through Trade

Indifference curves for different consumers can intersect. At this point they will have equally quantities of A and B. At this point, the two consumers will have different slopes on their curves. The consumer with the steeper slope has a greater MRS of A for B, than the other consumer (if A were on vertical axis and B on horizontal). The other consumer will have a greater MRS for B than A, at this point.

If at this point the one consumer has an MRS of A for B of 2 and the other consumer has an MRS of A for B of .5 ( of an MRS of B for A of 2) , they would be better off trading 1 unit each to each other, maximizing their utility. While one was willing to give up 2 units of A for 1 of B, the other was willing to give up 2 units of B for one of 1. In this trade they both only have to give up one unit to receive another.

The opportunity Set: Consumption, Production, and Investment Choice

This deals with the choices and tradeoffs that consumers are actually able to make, due to the fact that consumers have limited incomes to purchase goods and services

The Budget Constraint

The income constraint for two goods will simply be their prices and quantities that can fit in the consumers income or:

• P_MQ_M + P_CQ_C = I

We can manipulate this in the following way:

• Q_M = (I /P_M) - (P_CQ_C / P_M) where the slope equals - P_C/ P_M

Note the following important points:

• (Quantity of good M is on Veritcal axis, while quanitty of good C is on horizontal)
• The slope identifies the amount of good M that the consumer would have to give up to receive one more unit of good C
• If the price of good C were to rise (fall), the horizontal intercept would decrease (increase)
• If the price of good M were to rise (fall), the vertical intercept would decrease (increase)
• If the price of both of them were to increase (decrease), both the intercepts would decrease (increase)

The Production Opportunity Set

Just like a consumer’s income places a limit on the quantities of two goods she can consume, a producer’s production capacity places a limit on her ability to produce two goods. A company’s Production Possibility Frontier (PFF) shows the maximum units of one good that can be produced at each level of production for the other good.

Question 3

LOS 14d: Determine a consumer’s equilibrium bundle of goods based on utility analysis

Answer 3

The consumer’s equilibrium will occur where their budget constraint touches their highest indifference curve. That is they spend all their income on the max bundle of goods they can afford to maximize their utility. At this point:

• The slope of the budget constraint (BC) equals the slope of the indifference curve
• Consequently the ratio of the price of good A to good B must equal the MRS of good A to good B
• the MRS is the rate at which the consumer is willing to sacrafice A for B, and the price ratio is the rate at which she must sacrafice A for B.
• Therefore at equilibrium, the consumer is willing to pay the opportunity cost that he must pay to obtain more B

Any point above this equilibrium point will

• MRS is greater than price ratio
• This implies that they are willing to give up A for B at a rate that is a higher price for B to increase his consumption

Any point below will be:

• MRS is lower than price ratio

Also both points will be on less indifference curves, meaning utility will be less.

Consumer Reponse to Changes in Income : Normal and Inferior Goods

Case 1: Increase in Income

An increase in income results in a parallel, outward shift in the budget constraint. If both goods are normal goods, the consumer will consume more of both.

If one good is normal but the other is inferior, the consumer will increase consumption of the normal good but decrease consumption of the inferior good

Case 2: Changes in Price

If one of the goods price changes, then whatever axis that good is on, the intercept will change (increase in intercept for decrease in price). Say that good A decreases in price and good B stays constant, either of these can happen

1. The quantity of good A consumed may increase by a relatively significant amount, which would imply that the demand for A is relatively elastic
2. The quantity of good A consumed may increase by a relatively small amount, which would imply that demand for chocolate is relatively inelastic

Consumer’s Demand Curve from Preferences and Budget Constraitns

To derive an individuals demand curve for a particular product, we can use indifference curves and different budget constraints. For changes in budget constraints, different quantities will be desired. We can use these quantities at the prices to map out a consumers demand curve for the good.

Question 4

LOS 14e: Compare substitution and income effects

LOS 14f: Distinguish between normal goods and inferior goods, and explain Giffen goods and Veblen goods in context

Answer 4

Substitution and Income Effects for a Normal Good

The law of demand states that when the price of a good falls, quantity demanded increases. There are two main reasons for this:

1. Subsitution effect- The good becomes relatively cheaper compared to other goods, so more of the good gets substituted for other goods in the consumer’s consumption basket
2. Income Effect- The consumer’s real income increases ( in terms of the quantity of goods and services that can be purchased with the same dollar income). If the good is a normal good, the increase in real income leads to an increase in quantity purchased.

These effects can be separated to find the significance of each effect. Say we start with a budget constraint tangent to our indifference curve at point A. When the price of one good falls, the budget constraint line moves out. With the new budget constraint, there is a new consumer equilibrium (say point B), and thus the consumer moves to a new indifference curve.

On the old indifference curve, there will be a new point of tangency with the new budget constraint, say point C. The substitution effect can be measured as our old equilibrium quantity at point A, to the quantity at point C.

Our income effect can be measured as the quantity from point C to the Quantity at our new equilibrium, point B.

Sellers try to isolate the income and substitution effects when they analyze demand for their products and try to come up with creative pricing schemes to extract consumer surplus from customers.

Income and Substitution Effects for an Inferior Good

An inferior good is one that has negative income elasticity of demand. When income increases demand for these goods falls. When price falls, demand for inferior goods is also influenced by income and substitution effect, but the two effects draq quantity demanded in opposite directions.

To find them both, follow the same procedure as before. What we will notice in inferior goods, is that while the substitution effect is positive, the income effect is negative. To be classified as an inferior good, the substituion effect must outweigh the income effect, resulting in higher consumption from the decrease in price.

Giffen Goods

A Giffen Good is a special case of an inferior good where the negative income effect of a decrease in price of the good is so strong that it outweighs the positive substitution effect. Therefore, for a Giffen good, quantity demanded actually falls when there is a decrease in price, which makes the demand curve upward sloping.

Note all Giffen goods are Inferior Goods, but not all Inferior Goods are Giffen

Veblen Goods

Sometime the price tag of a good itself determines its desirability for consumers (ex. jewlery). Consumers prefer the higher price as a status thing. These goods are know as Veblen goods, and it is argued that their demand curves are also upward sloping just like Giffen Goods, however there remains a fundamental difference between the two:

• Giffen goods are inferior goods. An increase in income would reduce demand for them
• Veblen goods are not inferior goods. An increase in income would not lead to a decrease in demand