ECON 356 - Outline Three
Consumer Behavior
The Rational Consumer Choice Model (the mainstream theory)
Assumptions: Consumers enter the marketplace with well-defined preferences - they are given and don't change. Prices are also given to the consumer - and the consumer allocates their budget to best serve their preferences.
Two steps:
1. Describe the various combinations of goods the consumer is able to buy.
2. Select from among feasible combinations the particular one that the consumer prefers to all others.
Bundle of goods: combination of two or more goods
Budget Constraint (or budget line): the set of all bundles that exactly exhaust the consumer's income at given prices
Assumption: Only two goods in the world. If food and shelter are the two goods in question -- the budget constraint must satisfy the following equation:
P of shelter x amount of shelter + P of food x amount of food = Budget or Income
Given: Budget = $100 wk, P of food = $10 lb., P of shelter = $5 sq. yd.
Affordable set: bundles on or below the budget constraint; bundles for which the required expenditure at given prices is less than or equal to the income available.
Budget Shifts Due to Price or Income Changes:
Price Changes:
Income Changes:
Budgets Involving More Than Two Goods:
Composite good: in a choice between a good X and numerous other goods, the amount of money the consumer spends on those other goods.
The Budget Constraint with the Composite Good:
Kinked Budget Constraints:
Given: Budget = $400/month, price per kwh is .10 for the first 1000 units, and then .05 thereafter.
If the Budget Constraint is the Same -- the Decision Should be the Same (according to the model) - but people don't always behave that way. Why?
Example: Gowdy fills his tank to go fishing. He wakes up the next morning and finds that someone has siphoned out all but 1 gallon from his 21 gallon tank.
On another occasion, he plans to stop for gas on his way out the next morning before he goes fishing. He wakes up to discover that he has lost $40 from his wallet. If gas sells for $2.00 per gallon and the round-trip will consume 5 gallons, how, if at all, should Gowdy's decision about whether to go fishing differ in the two cases? (Assume that, monetary costs aside, the inconvenience of having to refill his tank is negligible).
Consumer Preferences
Assumption: Only two goods in the world.
Preference Ordering: a scheme whereby the consumer ranks all possible consumption bundles in order of preference.
Assumptions about preference ordering:
1. Completeness: a preference ordering is complete if it enables the consumer to rank all possible combinations of goods and services.
2. Transitivity:
3. More Is Better: prefer more goods to less, prefer fewer bads and a neutral good -- we could care less.
4. Convexity:
Indifference (or utility) curves: a set of bundles among which the consumer is indifferent.
Indifference map: a representative sample of the set of a consumer's indifference curves, used as a graphical summary of her preference ordering.
All of this implies:
1. Completeness assures that any bundle has an indifference curve passing through it.
2. Indifference curves are downward sloping (otherwise more is not better).
3. Indifference curves cannot cross.
4. Indifference curves become less steep as we move downward and to the right along them - they are convex.
Trade-Offs Between Goods -
Marginal Rate of Substitution: at any point on an indifference curve, the rate at which the consumer is willing to exchange the good measured along the vertical axis for the good measured along the horizontal axis, equal to the absolute value of the slope of the indifference curve.
The Best Feasible Bundle:
Best affordable bundle: the most preferred bundle of those that are affordable.
The consumer wants to reach the highest indifference curve he can given his budget constraint. This is a point of tangency where the marginal rate of substitution is equal to the absolute value of the slope of the budget line.
Corner solutions: the consumer does not consume one of the goods.
Question: How would indifference curves look in each of the following cases?
Perfect Substitutes:
Perfect Complements:
A Neutral Good:
A Bad:
Application of the Rational Choice Model
Is it better to give poor people cash or food stamps?
Given: Budget = $400/month. Subsidy = $100 in either cash or food stamps (can only purchase food)