Consumer%20Choice

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Consumer Choice
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Historical Backdrop

• The objective of business maximize profits, to
  increase the difference between incoming revenues
  and outgoing expenses
• This has characterized business activity for
  centuries.
• Principle of utility generalizes maximization
  principle to individuals.

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Utilitarianism

• A philosophy created by Jeremey Bentham.
• His purpose to create a science of morality
  based on Newtonian physics.
• Bentham sought to reform Britains penal code,
  and base it on utilitarianism

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Jeremy Bentham (1748-1832)

• Bentham left his estate to the University of
  London on condition that he be present at all
  future board meetings.
• His body was placed in a glass case, clothed, and
  his head was placed at his feet and a wax head
  placed on his shoulders, where he can be viewed
  to this day

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Banthams' view of Human Nature

• Nature has placed mankind under the governance
  of two sovereign masters, (pain and pleasure). It
  is for them alone to point out what we ought to
  do, as well as to determine what we shall do. On
  the one hand the standard of right and wrong, on
  the other the chain of causes and effects, are
  fastened to their throne.

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• They govern us in all we do, in all we say, in
  all we think every effort we can make to throw
  off our subjection, will serve but to demonstrate
  and confirm it. In words a man may pretend to
  abjure their empire but in reality he will
  remain subject to it all the while. The principle
  of utility recognizes this subjection, and
  assumes it for the foundation of that system, the
  object of which is to rear the fabric of felicity
  by the hands of reason and of law.

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• Utility means satisfaction, pleasure, happiness,
  and so on. Utility is an ambiguous concept
  because it is inherently subjective. In
  microeconomic theory utility is a function of the
  quantity of goods and services that one consumes.

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• Total utility is the satisfaction derived from
  consuming a quantity of a good in a specified
  amount of time.
• Marginal utility is the increment in satisfaction
  derived from consuming one more unit of a good.

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Law of Diminishing Marginal Utility

• The defines the relation between total and
  marginal utility.
• This law states the following As a person
  consumes successive units of a good, satisfaction
  increases but at a decreasing rate.
• Put differently as a person consumes successive
  units of a good, the satisfaction derived from
  each successive unit declines.

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Cardinal Utility

• A util is a measure of utility (a measure of
  pleasure).
• The early economists assumed that satisfaction
  could be measured using money.

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Consumers surplus

• difference between the price the individual would
  be willing to pay, and what he actually pays if
  the alternative is to do without the good.
• difference between the total utility received and
  the utility given up to buy the good, if the
  alternative is to do without the good.

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Rational Choice

• Allocating resources in such a way as to maximize
  or minimize some objective.
• rational choice involves weighing the costs
  (market price) and benefits (marginal utility) at
  the margin. That is, weighing the costs and
  benefits for each additional good consumed.

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Equilibrium Condition for Utility Maximization

• The equilibrium condition for one good MU
  market P.
• Intuition each unit consumed prior to
  equilibrium yields more utility than the
  individual gives up to purchase it and each good
  consumed after equilibrium yields less utility
  than the individual gives up.

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Equilibrium Condition for 2 or more goods

• MUa/Mub Pa/Pb
• MUa/Pa Mub/Pb
• This means that the last dollar spent on applies
  yields the same satisfaction as the last dollar
  spent on bananas
• Paradox of value why are the price of diamonds
  so high, and the price of water so low?

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Information and rational choice

• Uncertainty and the Prisoners dilemma
• rational ignorance
• Maze of choices
• Quality and prices

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Asymmetric information

• Moral Hazard--occurs when one pary to a contract
  can raise the costs or lower the benefits
  independent of the other party
• Adverse selection--one party to a bargain
  conceals information injuring the other party
• Market for lemons
• Consumer Policy

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Cardinal Utility and Income Distribution

• Apply the concept of diminishing marginal utility
  to income
• A dollar to a poor man yields more satisfaction
  than a dollar to a rich man
• Implication take from the rich and give to the
  poor.

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Objections

• 1930s Lionnel Robbins asserted that income
  redistribution to maximize social welfare is not
  a scientific proposition, that is, it requires
  making value judgements
• That is, taking from the rich and giving to the
  poor requires making interpersonal utility
  comparisons, or comparing states of mind.

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• Robbins criticism effectively destroyed cardinal
  approach, and economists sought to find an
  alternative foundation for utility theory.

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Ordinal Utility

• Rejects the idea that we can measure utility
• Asserts that all we need to know is an
  individual's preference ordering
• A P B or is A I B
• Transitivity principle A P B, and B P C then A P
  C
• (P stands for preferred to)

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Budget constraint

• Defines the attainable set, that is, what the
  individual may buy with his income
• Slope of the budget line represents the ratio of
  prices
• Distance of the budget line from the origin
  represents the amount of income

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Indifference Curves

• Definition defines the different combinations of
  goods yielding the same level of utility
• Hence, the individual is indifferent to different
  points on the same indifference curve
• Assumption more is always preferred to less

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Characteristics

• Negatively sloped
• convex to the origin
• cannot intersect

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Slope of the Indifference curve

• Slope is the marginal rate of substitution (MRS)
• MRS is the rate at which an individual is willing
  to substitute one good for another, yielding the
  same level of utility
• MUa/MUb

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Consumer Equilibrium
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Substitution and income effects

• Substitution effect--change in quantity demand
  resulting from a change in prices, holding the
  level of utility constant
• income effect--change in quantity demanded
  resulting from a change in real income owing to a
  change prices

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Changing Income, Ceteris paribus

• Income consumption curve set of consumer
  equilibrium points resulting from a change in
  money income, holding prices constant
• Engels curve relates income to quantities
  purchased
• Normal good
• Inferior good

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Changing Prices, Ceteris Paribus

• Price consumption curve set of consumer
  equilibrium prices resulting from a change in
  prices, holding money income constant
• Demand curve relates price and quantity demanded

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Market Demand Curve

• Horizontal summation of all the individual demand
  curves