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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 Britain’s 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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Consumer’s 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 Prisoner’s 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

Qa

Qb

x

y

z

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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

• Engel’s 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