1 Consumer choice 2 Central question of the

1 Consumer choice

2 Central question of the topic… Say you’re a junk food devotee. You live on two goods: chocolate bars and cans of cola. That’s all you purchase. In making your consumption choices, you’re trying to get as much pleasure as possible. The question is: HOW MANY CHOCO BARS AND COLA CANS DO YOU CHOOSE IN A GIVEN TIME INTERVAL?

3 …and answer to the question The answer is: IT DEPENDS ON TWO THINGS: BUDGET CONTRAINTS (INCOME AND PRICES), PREFERENCES (TASTES). Note that all of them are key demand determinants.

4 Initial assumptions (quite reasonable, aren’t they?) In making consumption choices, you’re going to maximize your utility You prefer to have more than less You’re able to value affordable baskets of goods from the point of view of their utilities Your choices are logical

5 First step in the analysis: the contraints part Income (per week): I = $50 Price of choco bar: PCHOCO = $5 Price of cola can: PCOLA = $10 Before you make the consumption decision, you must figure out affordable budget options

6 Affordable options (exhausting your budget)

7 Graphical analysis Key terms: BUDGET SET: shows all the affordable baskets BUDGET LINE: shows the baskets that exhaust the budget Three groups of points: on the budget line: affordable and exhausting the budget below the budget line: affordable but not exhausting the budget above the budget line: unaffordable

8 Algebraic analysis Universal straight-line equation: y = ax + b Budget line equation: I = PCHOCO×QCHOCO + PCOLA×QCOLA After rearranging:

9 Combined graphic and algebraic analysis Suppose your weekly income increases from $50 to $60. Suppose price of choco bar doubles. Suppose price of cola can drops to $5. In each of these three cases – what is the effect on budget line equation and location?

10 Budget constraint is just part of the story Now that we know all baskets within your reach, the following question arises: WHICH ONE DO YOU ACTUALLY CHOOSE? A, B, C, D, E or F? To answer the question we need another factor: your preferences.

11 Second step in the analysis: the pleasure part Key term: INDIFFERENCE CURVE („Just-as-happy curve”) Indifference curve: a curve showing all combinations of two goods (choco bars and cola cans in our case) that generate the same level of utility. Let’s explore indifference curves in three steps that are devoted to: how are they plotted, what are their properties, how do they relate to preferences.

12 Plotting the indifference curves Imagine that you choose randomly a point that illustrates a basket of two goods. All other baskets can be categorized into: superior (preferred) combinations, inferior (not preferred) combinations, equivalent.

13 Properties of indifference curves They’re downward sloped: as budget line, they show trade-off(compromise) between two goods, trade-off that must keep your utility constant They’re bowed inward (bowed toward the origin): their shape is consistent with the law of diminishing marginal rate of substitution

14 Marginal rate of substitution (MRS) Marginal rate of substitution: the quantity of one good (COLA) a consumer would give up to obtain one more unit of another good (CHOCO) while being made neither better off nor worse off by the trade (in other words – assuming that the consumer’s utility doesn’t change).

15 The law of diminishing MRS (quite reasonable, isn’t it?) The law of diminishing marginal rate of substitution: MRS of one good (COLA) for another good (CHOCO) tends to decline as more of one good is substituted for another along any consumer’s indifference curve. People usually don’t like extremes. They prefer balanced consumption. That’s the rationale behind the law.

16 Properties of indifference curves (cont.) Each indifference curve represents a given level of utility that is constant along the curve. For each consumer, there is infinite number of indifference curves, each with a different level of utility. All of them consitute an INDIFFERENCE MAP. The farther indifference curve is located from the origin, the higher level of utility is represents. Indifference curves can’t cross one another on the indifference map.

17 Utility maximization and indifference map Remember your ultimate goal: TO MAXIMIZE UTILITY. By the spoken of indifference curve it means that you want to get to as high indifference curve as possible, given your budget constraint.

18 Indifference curves as a mirror of consumer’s preferences Imagine two students having extremely different preferences in our hypothetical two-goods-world.Let’s say that Natasha prefers choco to cola while Boris prefers cola to choco. How would their indifference maps look like?

19 Best affordable choice or consumer equilibrium Graphic interpretation: the point on your budget line and on your highest attainable indifference curve; the point at which highest attainable indifference curve touches (is tangent to) your budget line

20 Historical perspective The way we study consumer choices represents new (modern) school of theoretical research on the subject. Old school was based on the notion of utility measurement. Economists even invented special measurement unit: UTIL. Contemporaneous economists consider the concept questionable and the usage of such „utilometer” is troublesome for them.