Lecture Notes for Dartmouth College's ECON 1. Taught by Andreas Bentz during 2002.
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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 1
Dartmouth College, Department of Economics: Economics 1, Fall ‘02Dartmouth College, Department of Economics: Economics 1, Fall ‘02Dartmouth College, Department of Economics: Economics 1, Fall ‘02
Topic 3: Consumer TheoryTopic 3: Consumer Theory
Economics 1, Fall 2002Andreas Bentz
Based Primarily on Frank Chapters 3 - 5
2
Rational Consumer ChoiceRational Consumer Choice
“A rational individual always chooses to dowhat she most prefers to do, given the optionsthat are open to her.”
Two questions:– How do we describe the options open to a
consumer?» Individuals operate under constraints.
– How do we describe preferences?» We use indifference curves to represent preferences.
DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 1
In what follows, we will only study the choicebetween two goods.
– This allows us to draw (two-dimensional) diagrams.
– (And: Two goods are often enough: for instance, ifwe are interested in your choice about how muchpizza to consume, we could make the two goods“pizza” and “money spent on everything else.”)
Dartmouth College, Department of Economics: Economics 1, Fall ‘02Dartmouth College, Department of Economics: Economics 1, Fall ‘02Dartmouth College, Department of Economics: Economics 1, Fall ‘02
ConstraintsConstraints
Open Opportunities
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This is the relative price of good 1 in terms of good 2:– As you move down the budget constraint, you trade off more
of good 1 for less of good 2.
– To buy one more unit of good 1, you need to have p1 availableto spend. Since you are on your budget constraint, you needto give up some of good 2 in order to “free up” enough moneyto buy more of good 1.
– How much of good 2 do you need to give up to “free up”amount p1?
– If you give up one unit of good 2, you “free up” amount p2. Soif you want to “free up” an amount p1, you need to give upp1/p2 units of good 2.
14
Buzz GroupBuzz Group
A family with an income of $32 to be allocatedto drink chooses its consumption of milk andbeer.
– 1 quart of milk costs $1,
– 1 sixpack of beer costs $8.
What is the budget constraint? Draw it!– The government wants to encourage people to
drink more milk, and therefore distributes vouchers;each voucher gives you a free quart of milk. Eachfamily gets 10 vouchers.
Draw the budget constraint!
DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 1
Dartmouth College, Department of Economics: Economics 1, Fall ‘02Dartmouth College, Department of Economics: Economics 1, Fall ‘02Dartmouth College, Department of Economics: Economics 1, Fall ‘02
PreferencesPreferences
As You Like It
24
PreferencesPreferences
We have now developedour tool for modeling“the options open to theconsumer.” We haveused this consumptionspace:
We need some way ofrepresenting yourpreference ordering overdifferent bundles ofgoods.
Now we need torepresent yourpreferences overdifferent bundles ofgoods.
DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 1
Transitivity: A Refresher, cont’dTransitivity: A Refresher, cont’d
Why is this a rationality requirement?– Suppose you prefer apples to bananas, and bananas to
cactus fruit.» Transitivity says that you should then also prefer apples to
cactus fruit.
– You start out with a cactus fruit. Then you should be willing toswap the cactus fruit for a banana (and give me a centbecause you prefer the banana), and then swap the bananafor an apple (and give me a cent).
– If your preferences were not transitive, i.e. you did not alsoprefer apples to cactus fruit, you should then be willing toswap your apple for a cactus fruit.
– You are back at the start (cactus fruit), but have lost 2 cents!
36
Properties of Properties of IndiffIndiff. Curves, cont’d. Curves, cont’d
Indifference curves are convex:– convexity assumption: averages are preferred to
extremes
2
8
1 7
5
4
– Bundle A is (1, 8),bundle B is (7, 2).
– The averagebundle is (4, 5).
– If averages arepreferred toextremes,indifference curvesare convex.
A
B
DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 1
Definition: A graph is convex if every straightline connecting two points on the graph liesentirely above the graph.
38
Marginal Rate of SubstitutionMarginal Rate of Substitution
The slope of the budget constraint had a “nice”interpretation:
– The slope of the budget constraint is the rate at which you cantrade off less of good 2 for more of good 1.
The slope of an indifference curve has a similarinterpretation:
– The slope of the indifference curve is the rate at which you arewilling to trade off less of good 2 for more of good 1 … withoutmaking you any better or worse off.
The (absolute value of the) slope of the indifferencecurve is therefore referred to as the marginal rate ofsubstitution (MRS).
– (Note that the MRS changes along an indifference curve.)
DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 1
In order to acquire a little more of good 1, howmuch of good 2 are you willing to give up (sothat you are neither better nor worse off)?
– At bundle A, to acquirea little (∆x1) more ofgood 1, you need togive up ∆x2 of good 2.
∆x1
- ∆x2– If ∆x1 is small enough,
this ratio approximatesthe slope of theindifference curve at A.
A
Slope=-MRS at A
40
MRS, cont’dMRS, cont’d
Why is it called the marginal rate ofsubstitution?
– It tells us at what rate (or, ratio) the consumer iswilling to substitute one good for the other … at themargin:
– “at the margin” means that this refers to smallchanges: how much is the consumer willing to giveup of one good in order to get just a little more ofthe other good?
» Remember Topic 1 (Thinking Like an Economist): theimportance of marginal analysis.
DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 1
You have to choose between two “goods:”general consumption and work. Draw some ofyour indifference curves.
(Presumably you don’t like work, but do likeconsumption. Also assume that you arerational, i.e. that you prefer averages toextremes.)
Dartmouth College, Department of Economics: Economics 1, Fall ‘02Dartmouth College, Department of Economics: Economics 1, Fall ‘02Dartmouth College, Department of Economics: Economics 1, Fall ‘02
… only connect… only connect
Choosing the Most Preferredof the Available Options
DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 1
– At bundle A, the MRS isgreater than the (absolutevalue of the) slope of thebudget constraint, that is:
– In order to get one moreunit of good 1, theconsumer would bewilling to give up more ofgood 2 (MRS!) than shehas to at given prices(slope of budgetconstraint!).
– At bundle B, the MRS isless than the (absolutevalue of the) slope of thebudget constraint, that is:
– In order to be willing togive up unit of good 1, theconsumer would need tobe compensated with lessof good 2 (MRS!) thanshe could get at givenprices (slope of budgetconstraint!).
B
DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 1
Dartmouth College, Department of Economics: Economics 1, Fall ‘02Dartmouth College, Department of Economics: Economics 1, Fall ‘02Dartmouth College, Department of Economics: Economics 1, Fall ‘02
Application:Application:Cash or In-Kind Transfers?Cash or In-Kind Transfers?
Medicare or Money?
54
Budget ConstraintBudget Constraint
A direct money transfershifts the budgetconstraint out:
– this is just an increase inincome.
– Example: $100
money spent on healthcare
y
An in-kind transferallows the individual toconsume morehealthcare - not more ofanything else:
– Example: $100 inhealthcare
DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 1
Buzz Group: True or False?Buzz Group: True or False?
The price of food rises by 10% and disposableincome by 5%. A man initially spending halfhis income on food would be neither better norworse off as a result of these changes.
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DemandDemand
Individual DemandMarket Demand
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Dartmouth College, Department of Economics: Economics 1, Fall ‘02Dartmouth College, Department of Economics: Economics 1, Fall ‘02Dartmouth College, Department of Economics: Economics 1, Fall ‘02
Behind Individual DemandBehind Individual Demand
Income and Substitution Effects
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Behind Individual DemandBehind Individual Demand
What happens as price falls (holding moneyincome constant)?
– The good is now relatively cheaper (relative toother goods).
» Typically, the consumer will substitute away from othergoods, and towards the good for which the price hasfallen.
» This is the substitution effect.
– The consumer is now “wealthier” (she could stillbuy the same bundle and have money left over).
» Typically, this will lead the consumer to buy more of thatgood as her wealth increases.
» This is the income effect (wealth effect).
DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 1
To isolate the substitution effect, ask:– How much extra income would the consumer need
to be able to reach her original indifference curve,after the loss of purchasing power due to the priceincrease?
– If (hypothetically) the consumer were to get thisextra income, she would be back on her originalindifference curve. But since relative prices havechanged, she will typically choose to consume adifferent bundle to that consumed originally.
The substitution effect isthe movement frombundle A to bundle B.
The substitution effectisolates the effect that aconsumer is likely tosubstitute away from agood whose price hasincreased.
– Given just enough extraincome to reach heroriginal indifferencecurve, the consumerwould still (typically)choose to consume abundle (B) different fromthe original bundle (A).
DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 1
To isolate the income effect, ask:– How much extra income would the consumer need
to be able to reach her original indifference curve,after the loss of purchasing power due to the priceincrease?
– If (hypothetically) the consumer were to get thisextra income, she would (most likely) consumedifferent amounts of the good than she would if shewere not compensated with this extra income.
– This is the income effect (Hicks).
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Income Effect, cont’dIncome Effect, cont’d
The income effect isthe movement frombundle B to bundle C.
The income effectisolates the effect that aconsumer is likely toconsume less after aprice has increased(lower purchasing power).
– Given just enough extraincome to reach heroriginal indifference curve,the consumer would(typically) choose toconsume a bundle (B)different from the finalbundle (C).
y
x
AC
B
DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 1
When a good is so strongly inferior that theincome effect outweighs the substitution effect,it is called a Giffen good.
– How likely is this?» Not very. (Any examples?)
– Giffen goods imply an upward sloping demandcurve.
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Consumer SurplusConsumer Surplus
How are you?Good.
How good?
DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 1
Changes in Consumer SurplusChanges in Consumer Surplus
The blue shaded area isthe change in consumersurplus.
Suppose the price of agood falls from p’ to p’’.
What happens toconsumer surplus?
Compare consumersurplus when the price isp’ (and you buy q’) withconsumer surplus whenthe price is p’’ (and youbuy q’’).
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Market DemandMarket Demand
1 + 1 = ?
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Individual to Market Demand, Individual to Market Demand, contcont..
person Ap
qA
person Bp
qB
market demandp
q
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The income tax is repealed. Instead, Paradise nowintroduces the following unemployment benefitscheme:
– If you don’t work you get $50 per day. As you start earning(e.g. by working for one hour at $10/hr), your unemploymentbenefit is withdrawn dollar-for-dollar (i.e. if you work for 1 hourand earn $10, your unemployment benefit receipts are only$40).
Draw the new budget constraint. What happens toEve’s choice about how much to work?