Consumer Choice

1
Consumer Choice
1. Limited Incomes
requires choices be made
2. Diminishing Marginal Utility
3. Rational
same cost - greater benefit
same benefit - least cost
4. Substitutes Available
5. Limited Information
2
1. Budget Constraint
PA 12 PB 2.40 Income 72
A B
0 __
1 __
2 __
3 __
4 __
5 __
6 __
7
6
5
4
3
2
1
0
15
20
25
30
35
40
45
50
5
10
3
Consumer Response to Changes in Price


. . .

Choices are based on Comparisons of MU per
spent on each good
4
Consumer Response to Changes in Price
Would a person maximize satisfaction by buying a
15 product that adds twice as much satisfaction
as a 5 product?
5
What to buy with 60?
Maximizing Satisfaction
Utility-Price Rule
MUa/Pa
MUb/Pb
vs
Item Price Utility
Pants 60 125
Shirt 40 100
Wallet 20 50
6
Two Goods Available
Marginal Utility per
Domestic 1 MU
Imported 2 MU
With Constraint
Number Bought
Domestic MU/
Imported MU/
24 20 18 16 12 6 4
10 8 7 6 5 4 3
____ ____
1 2 3 4 5 6 7
____ ____
____ ____
____ ____
____ ____
____ ____
____ ____
Without Income Constraint?
With 12?
7
2. Budget Increase
PA 12 PB 2.40 Income 72 84
A B
0 35
1 30
2 25
3 20
4 15
5 10
6 5
7 0
8
3. Price Change
PA 12 PB 2.40 3 Income 72
A B
0 24
1 20
2 16
3 12
4 8
5 4
6 0
9
Consumer Demand
Why the Demand Curve slopes down
One Reason
Substitution Effect
At a lower price consumers can switch to the
cheaper good, substituting the cheaper for the
more expensive.
10
Consumer Demand
Why the Demand Curves slopes down
A Second Reason
Income Effect
A lower price of a good will increase purchasing
power of the consumer. They can buy more than
before.
11
Consumer Demand
Why the Demand Curves slopes down
A Third Reason
Diminishing Utility
Consumers get less satisfaction as they buy more
of a good. For the consumer to buy more the
price must be reduced.
12
The Pizza Demand Curve

• The demand for frozen pizzas reflects the law of
  diminishing marginal utility.

Price

• Because marginal utility (MU) falls with
  increased consumption, so does a consumers
  maximum willingness to pay -- marginal benefit
  (MB).

3.50
3.00
2.50

• A consumer will purchase until MB Price . .
  .

2.00
so at 2.50 they would purchase
3 frozen pizzas and receive a consumer surplus
shown by the shaded area (above the price line
and below the demand curve).
Frozen pizzasper week
4
2
1
3
13
Individual and Market Demand Curves

At 3.50 Jones demands
1 pizza

• Consider Joness demand for frozen pizza.

and so on
at 2.50 3 pizzas

• Consider Smiths demand for frozen pizza.

At 3.50 Smith demands
2 pizzas
and so on
at 2.50 3 pizzas

• The market demand curve is merely the
  horizontal sum of the individual demand
  curves (here Jones and Smith).

• The market demand curve will slope downward to
  the right, just as the individual demand
  curves do.

Jones
Smith
2-Person market
Price
Price
Price
3.50
3.50
3.50
2.50
2.50
2.50
1
3
2
3
3
6
2
4
5
7
6
8
1
4
5
7
6
8
2
1
4
5
7
8
Weekly frozen pizza consumption
14
4. Labor-Leisure Budget Constraint
a. 70 hour week, 10 per hour wages b. 12 per
hour wages
Work Income
0 0
10 100
20 200
30 300
40 400
50 500 (550?)
60 600 (700?)
70 700 (850?)
15
5. Present versus Future Consumption
a. 6 annual rate of return b. 9 annual rate
of return.
16
5. Present versus Future Consumption
a. 6 annual rate of return b. 9 annual rate
of return.
Present Present Future
Consumption Future Consumption Consumption
Savings (6 annual return) (9 annual
return) 1,000,000 0 0 0
900,000 100,000 574,000
1,327,000 800,000 200,000
1,148,000 2,654,000 700,000
300,000 1,722,000
3,981,000 600,000 400,000
2,296,000 5,308,000 400,000
600,000 3,444,000
7,962,000 200,000 800,000
4,592,000 10,616,000
0 1,000,000 5,740,000
13,270,000
17
Present Value
The interest rate connects the value of dollars
today with the value of dollars in the
future. The present value (PV) of a single (100)
payment to be received one year from now is
18
Present Value n Years in the Future
The present value (PV) of that single (100)
payment to be received n years from now is
The present value of the future payment is
inversely related to the interest rate, and, how
far in the future the payment will be received.
19
Present Value n Years in the Future
The present value (PV) of a stream of payments
(each of nominal magnitude R) to be received
each year for n years is
20
Investing in Human Capital
Annual earningsor costs
0
Age
22
18
65
Consider a somewhat simplified example of a
human- capital investment decision confronting
Juanita, an 18-year old who just finished
high-school.
We have graphed Juanitas expected earnings both
with
and without college. Should Juanita attend
college or not?
If Juanita chooses to attend college, she will
incur both the direct cost of a college
education (tuition, books, etc) Cd
and the opportunity cost of earnings forgone
while in college Co .
21
Investing in Human Capital
Earningsw/ college
Annual earningsor costs
Earningsw/o college
Co
0
Cd
Age
22
18
65
With a college education, though, Juanita can
expect higher future earnings (B) during her
career (even though they may begin lower,
they end higher).
If the discounted present value of the
additional future earnings exceeds the
discounted value of the direct and indirect
costs of a college education, then the college
degree will be a profitable investment for
Juanita.
22
Level of Education and Earnings (and
Discrimination)
Less than9th grade
The earnings of both men and women
increase with education.
HighSchool
Some college
Note, though, that womens earnings were only
about 2/3 those of similarly educated men.
Bachelorsdegree
Mastersdegree
Doctoraldegree
56 of mens
23
Level of Education and Earnings
Less thanhigh school
Updated in 2001
Highschool
Both still increase with education.
Some college
Womens earnings still about 2/3 those of
similarly educated men.
Bachelorsdegree
Mastersdegree
10 above 2000
Doctoraldegree
14 above 2000
66 of mens
24
Level of Education and Earnings
Less thanhigh school
Updated in 2005
Highschool
Both still increase with education.
Some college
Womens earnings still about 2/3 those of
similarly educated men.
Bachelorsdegree
Mastersdegree
14.9 from 2001
Doctoraldegree
14.9 from 2001
47 of mens
25
Level of Education and Earnings
Less thanhigh school
Updated in 2007
Highschool
The earnings of both men women increase
with education.
Some college
Womens earnings still only about 2/3 those
of similarly educated men.
Bachelorsdegree
Mastersdegree
Doctoraldegree
26
Comparison over time
2000
Bachelors Degree
2001
2005
2007
27
If Mr. Smith thinks the last dollar spent on
shirts yields less satisfaction than the last
dollar spent on cola, and Smith is a
utility-maximizing consumer, he
should a. decrease his spending on
cola. b. decrease his spending on cola and
increase his spending on shirts. c. increase his
spending on shirts. d. increase his spending on
cola and decrease his spending on shirts.
Which of the following would be the best example
of consumer surplus? a. Jane does not get
cell-phone service because she feels that it is
worth less than the 30 a month fee. b. Sam pays
8 for a haircut that is worth 10 to
him. c. Ralph buys a house for 104,000, the
maximum amount that he would be willing to pay
for it. d. Sue purchases a book for 20 and uses
a credit card to pay for it.
28
I like ice cream, but after eating homemade ice
cream last night, I want to have something else
for dessert today. This statement most clearly
reflects a. the budget constraint. b. consumer
irrationality. c. the second law of demand
Price elasticity increases with time. d. the law
of diminishing marginal utility.
If Sarahs income rises by 20 percent, and, as a
result, she purchases 40 percent more designer
clothing, her income elasticity for designer
clothing is a. 0.5. b. 1.0. c. 2.0. d. serious
ly distorted.
Suppose the state of New York imposes a one
dollar per pack tax on cigarettes, which
increases their price by 30 percent, and as a
result, the quantity sold declines by 20 percent.
The price elasticity of demand for cigarettes is
equal to a. 0.20. b. 0.67. c. 1.50. d. 3.0
0.
29
Studies indicate that the demand for fresh
tomatoes is much more elastic than the demand for
salt. These findings reflect that a. tomatoes
are a necessity while salt is a luxury. b. it
takes longer for consumers to adjust to a change
in the price of salt than to a change in the
price of tomatoes. c. salt will not spoil as
easily as fresh tomatoes. d. more good
substitutes exist for fresh tomatoes than for
salt.
If a Krispy Kreme doughnut shop near campus
increases its prices by 5 , but revenues from
its sales are unchanged, the price elasticity of
demand for the services offered by the doughnut
shop must be a. elastic. b. of unitary
elasticity. c. inelastic. d. equal to 0.5.
If the price of gasoline goes up, and Dan now
buys fewer candy bars because he has to spend
more on gas, this would best be explained
by a. the substitution effect. b. the income
effect. c. the highly elastic demand for
gasoline. d. weight watchers effect.
30
Which of the following is true for this demand
curve? a. An increase in price from 2 to 3
will reduce total expenditures on the
product. b. In the 2 to 3 range, the price
elasticity of the demand curve is approximately
unitary. c. At a price of 2, the price
elasticity of the demand curve equals
approximately 2.5. d. In the 2 to 3 range,
the demand curve is inelastic.