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MicroEconomics theory and application 12th by browning an zupan chapter 03

Prepared by Dr. Della Lee Sue, Marist College

MICROECONOMICS: Theory & Applications

Chapter 3: The Theory of Consumer Choice
By Edgar K. Browning & Mark A. Zupan
John Wiley & Sons, Inc.
12th Edition, Copyright 2015

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.


Learning Objectives






Develop an approach for analyzing consumer preferences.
Explain how a consumer’s income and the prices that must

be paid for various goods limit consumption choices.
Describe how the market basket chosen by a consumer
reflects both the consumer’s preferences and the budget
constraints imposed on the consumer by income and the
prices that must be paid for various goods.
Determine how changes in income affect consumption
choices.
(continued)

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Learning Objectives




(continued)

Explain how altruism can be explained by the theory of
consumer choice.
Relate the utility approach to the indifference curve method
of analyzing consumer choice.
Explain the mathematics behind consumer choice.

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

3


Develop an approach for analyzing consumer preferences.

3.1 CONSUMER PREFERENCES

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Consumer Preferences
Economists make three assumptions about the typical
consumer’s preferences:
 Preferences are complete.
 Preferences are transitive.
 More of any good is preferred to less.
 aka “nonsatiation”

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Definitions





Indifferent – when a consumer finds two options to be
equally satisfactory
Market baskets – combinations of goods
Economic “bads” – commodities of which less is preferred
to more over all possible ranges of consumption
Economics “goods” – commodities of which more is better
than less

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

6


Figure 3.1 – An Indifference Curve



Indifference curve – a plot
of all the market baskets
the consumer views as
being equally satisfactory

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Figure 3.2 - An Indifference Map

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Characteristics of Indifference
Curves





Characteristics:
 An indifference curve has a downward slope if both
goods are desirable.
 An indifference curve that lies farther from the origin is
preferred to one that is closer to the origin.
 Two indifference curves cannot intersect.
An indifference map is a set of indifference curves.
A set of indifference curves represents an ordinal ranking.

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Figure 3.3 - Why Intersecting
Indifference Curves Are Inconsistent

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Marginal Rate of Substitution


“MRS”
 A measure of a consumer’s willingness to trade one good
for another
 The maximum number of one good the consumer is
willing to give up to obtain one more of another good
 Depends upon the initial endowment
 Related to the slope of an indifference curve

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Figure 3.4 - Curvature of Indifference
Curves



Indifference curves are
convex to the origin.
Why?
 diminishing marginal
rate of substitution
(MRS): a consumer’s
willingness to give up
less and less of some
other good to obtain
still more of the first
good

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

12


Convexity of Indifference Curves



Assumption
 both goods in the market basket are economic “goods”
Declining MRS
 pertains to a movement along a given indifference curve
 NOT to a movement from one curve to another
 slope of each curve becomes flatter as move down the
curve

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

13


Individuals Have Different Preferences


Indifference curves – indicate the relative desirability of
different combinations of goods

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Figure 3.5 – Indifference Map of Two
Consumers

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Categories of Goods







“Good” – when more is preferred to less
“Bad” – when less is preferred to more
“Neuter” – when the consumer does not care about a
particular good
Perfect Substitutes – when a consumer is willing to
substitute one good for another at some constant rate and
remain equally well off
Perfect Complements – when goods must be consumed
in a precise combination in order for the consumer to
remain equally well off

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

16


Figure 3.6 – Indifference Maps for a “Bad”
and a “Neuter”

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Figure 3.7 - Perfect Substitutes and
Complements

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Explain how a consumer’s income and the prices that must be paid for
various goods limit consumption choices.

3.2 THE BUDGET CONSTRAINT

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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The Budget Constraint


Budget constraint – the way in which a consumer’s income
and the prices that must be paid for various goods limit
choices



Budget line - a line that shows the combinations of goods
that can be purchased at the specified prices and assuming
that all of the consumer’s income is expended.

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Figure 3.8 - The Budget Line


Budget line: a line that
shows the combinations of
goods that can be
purchased with a given
income.



See Table 3.1 for data used
in graph. [next slide]

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Table 3.1 – Data used in Figure 3.8

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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Geometry of the Budget Line




The intercepts with the axes show the maximum amount of
one good that can be purchased if none of the other is
bought.
The slope indicates how much of one good must be given
up to buy one more of the other good:
Slope = ΔY/ΔX = -PX/PY

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

23


Shifts in Budget Lines


Two underlying factors:
 Income Changes
 A change in income with constant prices produces a
parallel shift in the budget line.
 Price Changes
 A change in the price of one good, with income and
the other good’s price remaining unchanged, causes
the budget line to rotate about one of the intercepts.
 Indicative of change in real or relative prices

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

24


Figure 3.9 - Effect of an Income Change
on the Budget Line

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.

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