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# Consumer Theory

## What is Consumer Theory?

of how people use their limited means to make purposeful choices.  Assumes that consumers understand their choices (possibilities) and the prices (opportunity costs) associated with each choice.  Assumes that consumers consider the alternatives and choose the one they like best.
 Study
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## Consumer Theory - Why?

 Two

important reasons:

to understand the foundations of market demand (bake the demand curve from scratch) to address several interesting consumer theory issues that are best understood using this model rather than the aggregate demand model

## Two Components of Consumer Demand

 Opportunities:

What can the consumer afford? What are the consumption possibilities? Summarized by the budget constraint
 Preferences:

What does the consumer like? How much does a consumer like a good? Summarized by the utility function
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## What is a Budget Constraint?

A

budget constraint shows the consumers purchase opportunities as every combination of two goods that can be bought at given prices using a given amount of income.  The budget constraint measures the combinations of purchases that a person can afford to make with a given amount of monetary income.
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## Lis Demand for Wheat and Rice

of consumer theory  Lis demand for wheat and rice depends upon the prices for these goods, her income, and her preferences.  Suppose we look first at her budget constraint:
 Illustration

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## Lis Budget Constraint

 The

mathematical expression for Lis budget constraint is: I = PW W + PR R R = I/PR - (PW / PR)W
like to refer to the |slope| of the budget line as the ERS=Economic Rate of Substitution this case it is PW / PR

I

 In

 For

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## Graph of Lis Budget Constraint



The graph to the right shows a picture of Lis budget constraint. Each blue diamond is a point from the table. The slope is equal to -2, as shown on the last slide.

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15 Rice

10

0 0 5 10 Wheat
8

15

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## Budget Line gymnastics

 An

increase in income only.  An increase in the price of wheat only.  A decrease in the price of rice only.  Income doubles as do the prices of wheat and rice.
 Note:

Changes in the price of wheat relative to the price of rice will change the ERS.

Preferences
 Let

R = at least as good as

## B0 R B1 means: B0 is at least as good as B1

 Let

IN = indifferent to
B0 IN B1

B0 R B1 and B1 R B0 impli
 Let

P = strictly preferred to
B0 P B1

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Preferences
 Basic

## assumptions about an individuals preferences (R) over bundles (B)

mor i b tt r: If B0 has more in it than B1 then B0 R B1 transitivity: If B0 R B1 and B1 R B2 t n B0 R B2

av rage b ndles are at least as good as extreme b ndles: If B0 IN B1 and B2 is an average of B0 and B1, then B2 R B0 and B1

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## Utility and Preferences

is the way economists represent preferences.  Among two bundles, the one with the higher utility is the preferred bundle.  If two bundles have the same utility, we say that the consumer is indifferent.
 Utility

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Indifference Curves
 Preferences

that satisfy the conditions I have noted above can be represented by indifference curves.  The set of all indifference curves that describe an individuals preferences are referred to as an indifference curve map.  An indifference curve connects all of the bundles that a consumer likes equally.  We will assume only two goods when using indifference curve analysis.
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 An

## indifference curve should not slope

up.  Indifference curves can not cross one another.  Better bundles are to the northeast.  Indifference curves will not be bowed out.

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## Lis Preferences in Indifference Curves



An indifference curve connects all the bundles that have the same utility. Higher indifference curves indicate more utility (IC2 is preferred to IC1). Lower indifference curves indicate less utility (IC1 is preferred to IC0). The indifference curve map is FULL of indifference curves.

L s nd erence

ur es

30 25 20 I2 I1 I0

ce

15 10 5 0 0 10 20

hea

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## The Marginal Rate of Substitution



The Marginal Rate of Substitution(MRS) tells us how much of one good Li would willingly trade for an incremental unit of the other good and remain indifferent. The MRS=|slope| of the indifference curve at a bundle. Common to assume the MRS declines as we move down an indifference curve.

L s nd erence

ur es

30 25 20 I2 I1 I0

ce

15 10 5 0 0 10 20

hea

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## How Much Wheat and Rice

optimal amount of wheat and rice to consume is the amount that maximizes Lis utility subject to her budget constraint.  In the graph...
 Lis

Get to the highest indifference curve possible Stay on the budget constraint (b/c more is better)

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## How to Find Lis Best Combination

 

The black bundle is best. The pink bundle is not the best. Li has spent all her income but is not on the highest indifference curve possible. Bundles n/e of IC0 are better and some are affordable. At (W*, R*) she is doing the best she can subject to her budget constraint.

Rice

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## How to Find the Best Combination

 Utility

is maximized when:

## the indifference curve is just tangent to the budget line.

 Utility

is maximized when:

you are on the budget line and the slope of the indifference curve equals the slope of the budget line
 Utility

is maximized when:

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 Let

## MUW = Lis marginal utility of wheat

it measures the change in utility as we change wheat consumption by an incremental unit while holding rice constant
 Let

## MUR = Lis marginal utility of rice

it measures the change in utility as we change rice consumption by an incremental unit while holding wheat constant
 Common

to assume that marginal utilities decline as we increase consumption - the law of diminishing marginal utility
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## The bang per buck story

 The

MRS = MUW / MUR  The ERS = PW / PR  At an optimal bundle: MRS=ERS  Rewritten we have:
MUW / MUR = PW / PR MUW/PW = MUR/PR bang/buck in wheat = bang/buck in rice
 Get

## same optimal bundle either way

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Handling a change in PW


Li wants to achieve the highest indifference curve that the budget constraints permit. The points A, B, and C represents the best that Li can do at prices of \$4, \$2, and \$1 for wheat. The equation MRS=ERS is satisfied at each of the points.
Rice

## Li's Demand for Wheat

30 25 I2 I1 I0 4 2 1 20

20 15 10 5 0 0 5 10 15

C B A

Wheat

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## Lis Demand for Wheat

 The

table shows the amount of wheat that Li demands at each price. are the points of tangency from the previous slide.

 These

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## Graph of Lis Demand for Wheat



Pr e

When we connect the points from the table in the previous slide we get Lis demand for wheat. The points A, B, and C correspond to the tangencies of the budget constraint and the indifference curves.

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## Lis Best Choice Reconsidered

  

Consider the choice at PW=\$2/lb. The point B is optimal. The point A is feasible but inferior to all points on the red budget line between E and F. The point C is preferred to B but cannot be purchased with Lis \$40 income at the given prices; it is above the red budget line. The point E is feasible but Li prefers more wheat and less rice (B). The point F is feasible but Li prefers less wheat and more rice (B, again). There is no combination that Li prefers to B that she is able to buy.

## heat and Rice

E B C

15 10

I2 I1 I0 2

A
5

F
0 0 5 10 heat 15 20

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Handling a change in PW


Li wants to achieve the highest indifference curve that the budget constraints permit. The points A, B, and C represents the best that Li can do at prices of \$4, \$2, and \$1 for wheat. The equation MRS=ERS is satisfied at each of the points.
Rice

## Li's Demand for Wheat

30 25 I2 I1 I0 4 2 1 20

20 15 10 5 0 0 5 10 15

C B A

Wheat

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## Lis Demand for Wheat

 The

table shows the amount of wheat that Li demands at each price. are the points of tangency from the previous slide.

 These

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## Graph of Lis Demand for Wheat



Price

When we connect the points from the table in the previous slide we get Lis demand for wheat. The points A, B, and C correspond to the tangencies of the budget constraint and the indifference curves.

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## From IC Map to Lis Demand for Wheat

Li's e and f r Wheat
4

i
A

e a

W heat

30 25 20 I2 I1 I0 4 2 1 20
3

ice

ice

B
2 1

15 10 5 0 0 5 10

C B A

C
0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

15

Wheat

ua tit

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## Income and Substitution Effects



Economists decompose the effect of a change in price on the quantity demanded into an income and a substitution effect. Income effect: due to the increase in real income associated with a fall in prices (you can buy more with the same nominal income) or the loss of real income associated with a rise in prices (you cannot buy as much as you once did with the same nominal income). Substitution effect: due to the change in the relative price of the good, cheaper goods are substituted for more expensive ones.
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## Income and Substitution Effects: Price Decline, X normal



When the price of a good falls, the quantity demanded rises for two reasons. The income effect: real income is higher because the same money income buys more at the lower prices. For normal goods, then, the income effect of a price fall is positive. The substitution effect: consumers substitute the now cheaper good for ones whose price has not fallen, real income held constant. This increase in demand is called the substitution effect of a price decline.

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## Lis Income and Substitution Effects: Price Fall, Rice normal



Graph shows the income and substitution effects of the fall in the price of wheat from \$4/lb. (A) to \$1/lb. (C). The movement from point A to point D is the substitution effect: Li buys less rice and more wheat, and would do so even if she had an income of only \$20 (as the black budget line shows). The movement from point D to point C is the income effect, the price decline is like giving Li an additional \$20 of real income.

C A D

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## Lis Substitution Effect

 The

substitution effect is the amount by which Li's wheat consumption increased holding real income constant.  Substitution effect is the difference between Li's consumption of wheat at the new and old prices holding her real income constant, that is, staying on the same indifference curve (compare points A and D).
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## Lis Income Effect



When the price falls from \$4/lb. of wheat to \$1/lb. per wheat, Li is able to buy both more wheat and more rice. The income effect is the difference between what she would have bought on the old indifference curve at the lower wheat price (point D) and what she actually did buy with her nominal income (\$40) at the lower price (point C). Li increases her consumption of wheat and rice because of the increase in her real income from the price decline.
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## General effect of a price fall

PX falls
Income effect - you feel richer Substitution Effect X now looks relatively cheaper

X normal

X inferior

## uantity demanded increases

Total effect is the substitution effect AND the income effect working at the same time.

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## From Individual to Market Demand

 Market

demand is the sum of all individual demands in the economy.  In the following example there are two consumers of wheat: Li and Juanita.  The market demand, then, is the sum of the quantities demand by Li and Juanita.

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## Juanitas Demand for Wheat



Juanitas income is also \$40. Juanita faces the same price for rice as Li: \$2/lb. Her preferences are different from Lis. Her demand for wheat is derived in the figure at the left.

B A

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## Graph of Juanitas Demand for Wheat

 The

points A, B and C correspond to Juanitas best choices given her income and the three prices of wheat illustrated.  This is her demand curve for wheat.

Juanita' D 4 3 ri 2 1 0 0 2 4 6 8

and for

at

10 12 14 16 18 20 uantit

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Market Demand


The market demand (green) is the sum of Lis (blue) and Juanitas (red) demand for wheat at each price. At PW=4, Li demands 6 lbs., Juanita demands 5 lbs. and the market demand is 11 lbs. At PW=2, Li and Juanita demand 10 lbs. and the market demand is 20 lbs. At PW=1, Li demands 16 lbs., Juanita demands 18 lbs. and the market demand is 34 lbs.

Mark t for
4

h at

h at

Pri

of

0 0 20 40

Quantity of

h at

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## Application: Effect of a Tax & Transfer Program



Suppose I have the preferences illustrated at the right. Question A: If Income = \$16 If Price of food = \$1 If Price of shelter = \$1 Food = ? Shelter = ? Indifference curve = ?

references
16 15 14 13 12 11 10 9 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7

Shelter

I6 I5 I4 I3 I2 I1 9 10 11 12 13 14 15 16

Food

40



## Point A: If Income = \$16 If Price of food = \$1 If Price of shelter = \$1

Shelter

Initial oint
16 15 14 13 12 11 10 9 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7

## Food = Shelter = Indifference curve = I4

I6 I5 I4 I3 I2 I1 9 10 11 12 13 14 15 16

Food

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## Effect of a Tax and Transfer Program: Addition of Tax



Shelter

Question B: If Income = \$16 If Price of food = \$1 If Price of shelter = \$1 and Tax on shelter = 100% Tax-inclusive price of shelter = ? Food = ? Shelter = ? Indifference curve = ?

Initial oint
16 15 14 13 12 11 10 9 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7

I6 I5 I4 I3 I2 I1 9 10 11 12 13 14 15 16

Food

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

Shelter

Point B If Income = \$16 If Price of food = \$1 If Price of shelter = \$1 and Tax on shelter = 100% Tax-inclusive price of shelter = 2 Food = Shelter = 3.5 Indifference curve = I2

Tax Only
16 15 14 13 12 11 10 9 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7

I6 I5 I4

B
I3 I2 I1 9 10 11 12 13 14 15 16

Food

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## Effect of a Tax and Transfer Program: Tax & Transfer



Question : If Income = \$16 If Price of food = \$1 If Price of shelter = \$1 and Tax on shelter = 100% and Transfer payment = \$8 Food = ? Shelter = ? Indifference curve = ?

Tax Only
16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6

Shelter

I6 I5 I4

B
I3 I2 I1 7 8 9 10 11 12 13 14 15 16

Food

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

Point C If Income = \$16 If Price of food = \$1 If Price of shelter = \$1 and Tax on shelter = 100% and Transfer payment = \$8 Food = 10 Shelter = Indifference curve = I4

## Tax and Transfer

16 15 14 13 12 11 10 9 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7

Shelter

A C

I6 I5 I4

I3 I2 I1

9 10 11 12 13 14 15 16

Food

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## Tax and Transfer Systems Give Pure Substitution Effects



Notice in the example that the consumer ends up on the same indifference curve after the tax and transfer program as in the initial choice (I4). In public finance (the study of tax and transfer systems) this result usually occurs when the tax and transfer system is combined with a balanced budget. In our example, tax receipts are \$ per person (= units of shelter x \$1 tax), while the transfer is \$8 per person. This is as close to balanced as we can get and still be able to graph the consumers choice legibly. Knowledge of the substitution effect of the price change induced by the shelter tax is sufficient to predict the effect of the complete tax and transfer system.

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 Suppose

 Consider

## three alternative government

policies
no support \$200 in food stamps \$200 in cash
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## Food Stamps vs. \$\$\$\$\$

\$aog

Notes:
the budget line under the food stamp program is the thick black segment and the purple segment The budget line with cash is the red and purple segments the Parkers are indifferent between food stamps and cash

200

100 200

Food
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## Food Stamps vs. \$\$\$\$\$

\$aog

Notes:
the budget line under the food stamp program is the thick black segment and the purple segment The budget line with cash is the red and purple segments if this is the case then the Parkers prefer cash to food stamps

IC\$\$

ICFS

IC0

BL0 Food
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