Unit 5 Utility.ppt

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1、Copyright2004 South-Western5The Theory of Consumer Choice(Principles of Economics,Chapter 21)Copyright2004 South-WesternTHE BUDGET CONSTRAINT:WHAT THE CONSUMER CAN AFFORDThe budget constraint depicts the limit on the consumption“bundles”that a consumer can afford.People consume less than they desire

2、 because their spending is constrained,or limited,by their income.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.Copyright2004 South-WesternThe Consumers Budget ConstraintCopyright2004 South-WesternTHE BUD

3、GET CONSTRAINT:WHAT THE CONSUMER CAN AFFORD The Consumers Budget ConstraintAny point on the budget constraint line indicates the consumers 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

4、100 pizzas(point A).Figure 1 The Consumers Budget ConstraintQuantityof PizzaQuantityof Pepsi0Consumersbudget constraint500B100ACopyright2004 South-WesternCopyright2004 South-WesternTHE BUDGET CONSTRAINT:WHAT THE CONSUMER CAN AFFORD The Consumers Budget ConstraintAlternately,the consumer can buy 50 p

5、izzas and 250 pints of Pepsi.Figure 1 The Consumers Budget ConstraintQuantityof PizzaQuantityof Pepsi0Consumersbudget constraint500B25050C100ACopyright2004 South-WesternCopyright2004 South-WesternTHE BUDGET CONSTRAINT:WHAT THE CONSUMER CAN AFFORDThe slope of the budget constraint line equals the rel

6、ative price of the two goods,that is,the price of one good compared to the price of the other.It measures the rate at which the consumer can trade one good for the other.Copyright2004 South-WesternPREFERENCES:WHAT THE CONSUMER WANTSA consumers preference among consumption bundles may be illustrated

7、with indifference curves.An indifference curve is a curve that shows consumption bundles that give the consumer the same level of satisfactionFigure 2 The Consumers PreferencesQuantityof PizzaQuantityof Pepsi0Indifferencecurve,I1 I2CBADCopyright2004 South-WesternCopyright2004 South-WesternRepresenti

8、ng Preferences with Indifference CurvesThe Consumers PreferencesThe consumer is indifferent,or equally happy,with the combinations shown at points A,B,and C because they are all on the same curve.The Marginal Rate of SubstitutionThe slope at any point on an indifference curve is the marginal rate of

9、 substitution.It is the rate at which a consumer is willing to trade one good for another.It is the amount of one good that a consumer requires as compensation to give up one unit of the other good.Figure 2 The Consumers PreferencesQuantityof PizzaQuantityof Pepsi0Indifferencecurve,I1 I21MRSCBADCopy

10、right2004 South-WesternCopyright2004 South-WesternFour Properties of Indifference CurvesHigher indifference curves are preferred to lower ones.Indifference curves are downward sloping.Indifference curves do not cross.Indifference curves are bowed inward.Copyright2004 South-WesternFour Properties of

11、Indifference Curves Property 1:Higher indifference curves are preferred to lower ones.Consumers usually prefer more of something to less of it.Higher indifference curves represent larger quantities of goods than do lower indifference curves.Figure 2 The Consumers PreferencesQuantityof PizzaQuantityo

12、f Pepsi0Indifferencecurve,I1 I2CBADCopyright2004 South-WesternCopyright2004 South-WesternFour Properties of Indifference Curves Property 2:Indifference curves are downward sloping.A consumer is willing to give up one good only if he or she gets more of the other good in order to remain equally happy

13、.If the quantity of one good is reduced,the quantity of the other good must increase.For this reason,most indifference curves slope downward.Figure 2 The Consumers PreferencesQuantityof PizzaQuantityof Pepsi0Indifferencecurve,I1 Copyright2004 South-WesternCopyright2004 South-WesternFour Properties o

14、f Indifference Curves Property 3:Indifference curves do not cross.Points A and B should make the consumer equally happy.Points B and C should make the consumer equally happy.This implies that A and C would make the consumer equally happy.But C has more of both goods compared to A.Figure 3 The Imposs

15、ibility of Intersecting Indifference CurvesQuantityof PizzaQuantityof Pepsi0CABCopyright2004 South-WesternCopyright2004 South-WesternFour Properties of Indifference Curves Property 4:Indifference curves are bowed inward.People are more willing to trade away goods that they have in abundance and less

16、 willing to trade away goods of which they have little.These differences in a consumers marginal substitution rates cause his or her indifference curve to bow inward.Figure 4 Bowed Indifference CurvesQuantityof PizzaQuantityof Pepsi0Indifferencecurve83A37B1MRS=61MRS=146142Copyright2004 South-Western

17、Copyright2004 South-WesternTwo Extreme Examples of Indifference CurvesPerfect substitutesPerfect complementsCopyright2004 South-WesternTwo Extreme Examples of Indifference Curves Perfect SubstitutesTwo goods with straight-line indifference curves are perfect substitutes.The marginal rate of substitu

18、tion is a fixed number.Figure 5 Perfect Substitutes and Perfect ComplementsDimes0Nickels(a)Perfect SubstitutesI1I2I3362412Copyright2004 South-WesternCopyright2004 South-WesternTwo Extreme Examples of Indifference Curves Perfect ComplementsTwo goods with right-angle indifference curves are perfect co

19、mplements.Figure 5 Perfect Substitutes and Perfect ComplementsRight Shoes0LeftShoes(b)Perfect ComplementsI1I27755Copyright2004 South-WesternCopyright2004 South-WesternOPTIMIZATION:WHAT THE CONSUMER CHOOSESConsumers want to get the combination of goods on the highest possible indifference curve.Howev

20、er,the consumer must also end up on or below his budget constraint.Copyright2004 South-WesternThe Consumers Optimal ChoicesCombining the indifference curve and the budget constraint determines the consumers optimal choice.Consumer optimum occurs at the point where the highest indifference curve and

21、the budget constraint are tangent.Copyright2004 South-WesternThe Consumers Optimal ChoiceThe consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.At the consumers optimum,the consumers valuation of the two goods equals the markets valuatio

22、n.Figure 6 The Consumers OptimumQuantityof PizzaQuantityof Pepsi0Budget constraintI1I2I3OptimumABCopyright2004 South-WesternCopyright2004 South-WesternHow Changes in Income Affect the Consumers ChoicesAn increase in income shifts the budget constraint outward.The consumer is able to choose a better

23、combination of goods on a higher indifference curve.Figure 7 An Increase in IncomeQuantityof PizzaQuantityof Pepsi0New budget constraintI1I22.raising pizza consumption.3.andPepsiconsumption.Initialbudgetconstraint1.An increase in income shifts thebudget constraint outward.InitialoptimumNew optimumCo

24、pyright2004 South-WesternCopyright2004 South-WesternHow Changes in Income Affect the Consumers Choices Normal versus Inferior GoodsIf a consumer buys more of a good when his or her income rises,the good is called a normal good.If a consumer buys less of a good when his or her income rises,the good i

25、s called an inferior good.Figure 8 An Inferior GoodQuantityof PizzaQuantityof Pepsi0InitialbudgetconstraintNew budget constraintI1I21.When an increase in income shifts thebudget constraint outward.3.but Pepsiconsumptionfalls,makingPepsi aninferior good.2.pizza consumption rises,making pizza a normal

26、 good.InitialoptimumNew optimumCopyright2004 South-WesternCopyright2004 South-WesternHow Changes in Prices Affect Consumers ChoicesA fall in the price of any good rotates the budget constraint outward and changes the slope of the budget constraint.Figure 9 A Change in PriceQuantityof PizzaQuantityof

27、 Pepsi01,000D500B100AI1I2Initial optimumNew budget constraintInitialbudgetconstraint1.A fall in the price of Pepsi rotates the budget constraint outward.3.andraising Pepsiconsumption.2.reducing pizza consumption.New optimumCopyright2004 South-WesternCopyright2004 South-WesternIncome and Substitution

28、 EffectsA price change has two effects on consumption.An income effectA substitution effectCopyright2004 South-WesternIncome and Substitution EffectsThe Income EffectThe income effect is the change in consumption that results when a price change moves the consumer to a higher or lower indifference c

29、urve.The Substitution EffectThe substitution effect is the change in consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution.Copyright2004 South-WesternIncome and Substitution EffectsA Change in Price:Subst

30、itution EffectA price change first causes the consumer to move from one point on an indifference curve to another on the same curve.Illustrated by movement from point A to point B.A Change in Price:Income Effect After moving from one point to another on the same curve,the consumer will move to anoth

31、er indifference curve.Illustrated by movement from point B to point C.Figure 10 Income and Substitution EffectsQuantityof PizzaQuantityof Pepsi0I1I2AInitial optimumNew budget constraintInitialbudgetconstraintSubstitutioneffectSubstitution effectIncomeeffectIncome effectBC New optimumCopyright2004 South-Western