NHM 373: Consumer EconomicsMicroeconomics and BehaviorChapter
Five: Consumer Equilibrium
Economic Puzzle Why doesnt Food Stamp increase food demand?
Utility Utility: a measure of the relative satisfaction or
desiredness from consumption Marginal Utility (MU): The gain in
utility a person gets from the last unit of a good or service
consumed, other things being equal. We make two assumptions about
utility Diminishing marginal Utility Positive Marginal Utility
Diminishing MU: Too much of one thing? As you increase
consumption of a product, you get less and less marginal utility
from consuming each additional unit of that product. Example:
All-you-can-eat buffet
Diminishing MU
Positive MU: The More, The BetterZ is preferred to A because it
has more of each good than A has. For the same reason, A is
preferred to W. It follows that on the line joining W and Z there
must be a bundle B that is equally attractive as A. In similar
fashion, we can find a Bundle C that is equally attractive as
B.
QuestionSuppose you are eating hamburgers. The first hamburger
gives you 15 utils of satisfaction, the second hamburger 8
additional utils, and the third brings the total utilty to 29. What
was the Marginal Utility of the third hamburger?A. 6
Indifference Curve In a world of two goods, consumer preference
between the two alternatives can be visually mapped. Since several
different bundles can be equally satisfying, a curve can be defined
by connecting a set of bundles among which the consumer is
indifferent.
For Examplean indifference curve is a set of bundles that the
consumer considered equally attractive. Any bundle, such as L, that
lies above an indifference curve is preferred to any bundle on the
indifference cure. Any bundle on the indifference curve, in turn,
is preferred to any bundle, such as K, that lies below the
indifference curve.
A Set of Indifference Curves A consumers preference can be
represented by a set (or a family) of indifference curves. Four
properties of Indifference Curves1. Have a negative slope (willing
to give up some to get more of other goods)2. Further from the
origin (0,0) preferred (the more, the better)3. Convex toward 0
(decreasing marginal utility)4. Indifference curves cannot
cross.
Satisfaction Can Be Mapped as ContoursThe entire set of a
consumers indifference curves is called the consumers indifference
map. Bundles on any indifference curve are less preferred than
bundles on a higher indifference curve, and more preferred than
bundles on a lower indifference curve.
Just like a contour map
Why Two Indifference Curves Cannot CrossIf indifference curves
were to cross, they would have violate at least one of the assumed
properties of preference orderings.
Slope of the Indifference Curve Marginal Rate of Substitution
(MRS) Slope of the indifference curve at a given point Willingness
to trade between food and shelter MRS at any point along an
indifference curve is defined as the absolute value of the slope of
the indifference curve at that point. It is the amount of food the
consumer must be given to compensate for the loss of 1 unit of
shelter.
Diminishing Marginal Rate of SubstitutionThe more food the
consumer has, the more she is willing to give up to obtain an
additional unit of shelter. The marginal rates if substitution at
Bundles A,C, and D are 3, 1, and respectively.
People with Different TastesRelatively speaking, Tex us a potato
lover; Mohan, is a rice lover. This difference shows up in the fact
that at any given bundle Texs marginal rate of substitution of
potatoes for rice is smaller than Mohans.
Consumer Equilibrium Best affordable Bundle The consumption
bundle that maximizes satisfaction under income and price
constraint Among all affordable bundles, you would want to choose
the one that makes you most satisfied. In the graph, the
equilibrium is where the budget line and the indifference curve are
tangent to each other. Best: it is on the highest attainable
indifference curve. Affordable: it is still on the budget line
Consumer Equilibrium: The Best Affordable BundleThe best the
consumer can do is to choose the bundle on the budget constraint
that lies on the highest attainable indifference curve. Here, that
is bundle F, which lies at a tangency between the indifference
curve and the budget constraint.
Now Consider Food Stamps Suppose a person with an income of
$400/m receives $100/m worth of food stamps, or $100/m cash
allowance Would the consumer be better off if he is given cash? (=
Which would give him a higher level of satisfaction, cash or food
stamps?) Would the program goal be better achieved with food stamp?
Can food stamp make people spend more money on food than cash
allowance can?
Food Stamps vs. Cash ProgramBy comparison with the budget
constraint under a cash grant (AE), the budget constraint under
food stamps (ADF) limits the amount that can be spent on nonfood
goods. But for the consumer whose indifference map is shown, the
equilibrium bundles are the same under both programs.
Initial income $400 Price of food: Px AE: Budget constraint
under cash program ADF: Budget constraint under food stamp.
Comparison of the Two Programs For Y < $400, the budget
constraint under food stamps is exactly the same as the budget
constraint under the cash program. Both programs will move the
consumer choice from J Lets the customer attain the same level of
utility (I2) Increase both food and non-food consumption Not all
$100 value is spent on food only, even with Food stampsThen, what
is the difference? The difference: with the food stamp program, the
consumer is not able to buy $500 of nongood goods. A kinked budget
constraint Is it possible that some customers prefer cash to food
stamps?For the consumer whose indifference map is shown, a cash
grant would be preferred to food stamps, which force him to devote
more to food than he would choose to spend on his own. The only
case where food stamps are different from cash is when you normally
consume less than the food stamps. If given cash, change from J L
If given Food Stamps, change from J D In this last case, the food
stamps program causes the recipient to increase food consumption
more than the cash program sold. For the majority of food stamp
participants, food stamp covers only (small) part of food
expenditures. Therefore, the effect of of foods stamp would be the
same as the effect of cash program.
Policy Choice Economic choice model suggests giving cash may be
better than giving a gift The budget constraint shows that not
being able to use stamps to buy other things is a meaningless
restriction On efficiency grounds, cash assistance might be a
simpler program achieving is equivalent (or better) effect. Then
why did Congress not decide to just give cash?
Mathematical Representation of Consumer equilibrium Tangency
condition revisited At equilibrium, the slope of the budget line
equals the slope of indifference curve Opportunity Cost = MRS
Opportunity Cost: slope of the budget line Marginal Rate of
Substitution (MRS): slope of the indifference curve Px = MUX PY
MUY
Utility Maximizing Rule at Consumer Equilibrium Given positive
and declining marginal utility, the utility maximizing consumer
buys goods X and Y at prices PX and PY such thatMUX =MUPXPxPy This
is, a rational consumer focuses on the last unit of goods being
purchased and make sure that the utility from the dollar spent on
the last unit of each good to be the same.
QuestionJane decides to buy a $75 ticket to a particular
professional hokey game rather than a $50 ticket for a particular
Broadway play. We can conclude that Jane:
A consumer is choosing between books and movies. The price of a
book is 10 and the price of the movie is 5. The marginal rate of
substitution is 4, with books on the horizontal axis and movies on
the vertical axis. The consumer is purchasing:
Suppose it costs Frank $3 to go to the club, and $6 to go to the
game (Px = 3, Py = 6). How many nights in one week.
How does a price change affect consumer choice? Price changes
affect customers in two ways: Income Effect A decline in the price
of any product will make the household better off, all else equal.
The change in consumption of the good due to this improvement in
the households purchasing power is called income effect.
Substitution Effect A decline in the price of a product, that
product becomes relatively cheaper, becoming more attractive
relative to potential substitutes. The change in consumption of the
good due to changes in its relative attractiveness compared to
alternatives is called substitution effect.
Substitution and Income effects
When price of shelter goes up, Budget line changes from B0 B1
Equilibrium moves from A D A C BY SUSTITUTION EFFECT C D by Income
Effect
Income and Substitution Effects for a Normal Good
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