FDA recommendation: people should consume less than 65 grams of fat per day.

Theory of Consumer Behavior

Goal of Consumers: maximize utility “well-being” or “satisfaction”

Consumers’ problem: Choose diet to maximize utility subject to the budget constraint of 65 fat grams (ignore other costs)

Utility maximization requires (prove later):

Latte

Latte

Bagels

Bagels

PMU

PMU

Marginal utility—the utility from an additional Latte

In this example, the price equals the number of grams of fat.

Latte

Latte

Bagels

Bagels

PMU

PMU additional pleasure per gram must be the

same for everything we eat, i.e, foods that contain twice the amount of fat must give us twice the amount of pleasure.

In October, a portion of the sales of Pink Ribbon Bagels (with dried cherries and cranberries) go to benefit breast cancer charities.

Pink Ribbon Blueberry

Versus

7 grams 2 grams

Do I enjoy pink ribbons more than 3 times as much as blueberries currently? NO. Hence, I’m not maximizing my utility by eating pink ribbons every morning. .

Only the Cinnamon Crunch has more fat (8 grams)!

Law of Diminishing Marginal Utility—as more and more blueberry bagels are consumed, the marginal utility of eating blueberry bagels must eventually fall.

Law of Diminishing Marginal Utility—as fewer pink ribbon bagels are consumed, the marginal utility of eating pink ribbon bagels rises.

works in both direction…

Hence, I’ll probably have a pink ribbon bagel occasionally but not every morning.

On July 1st 2008, the New York Board of Health required chain restaurants to put calories on menu boards.

Grande Chocolate Chip Frappucino = = 580 Calories

6” Chicken & Bacon Ranch Sub = 580 Calories

=Models assume consumers act “as if”> < or =

Russ sets aside $420 (Y) for tutoring (T) and fitness training (F) each year.

PT =$14 per hour

PF =$21 per hour

Equation for the budget constraint:

Horizontal intercept: =>

0 10 20 30 40 50 600

5

10

15

20

25

Fitness Training (hours per year)

Tutoring (hours per year)

Russ’s budget constraint shows his consumption options between fitness training and tutoring given his income (Y) and their prices (PF and PT).

How do we show Russ’s preferences?

Russ’s indifference curves show all the combinations of fitness training and tutoring that yield the same level of utility or well-being, i.e. Russ is indifferent between all the combinations along a given indifference curve.

0 10 20 30 40 50 600

5

10

15

20

25

Fitness Training (hours per year)

Tutoring (hours per year)

Indifference curve

Slope = MRS = MUT/MUF

Indifference curves are negatively-sloped and usually convex to the origin due to diminishing marginal utility.

0 10 20 30 40 50 600

5

10

15

20

25

Fitness Training (hours per year)

Tutoring (hours per year)

Y = $420PF = $21PT = $14

0 10 20 30 40 50 600

5

10

15

20

25

Fitness Training (hours per year)

Tutoring (hours per year)

A

B

E

F

What combination should Russ choose to maximize his utility?

Y = $420PF = $21PT = $14

0 10 20 30 40 50 600

5

10

15

20

25

Fitness Training (hours per year)

Tutoring (hours per year)

A

B

E

F

Point F is on a high indifference curve but Russ cannot afford that combination, so we should ignore that combination.

Y = $420PF = $21PT = $14

0 10 20 30 40 50 600

5

10

15

20

25

Fitness Training (hours per year)

Tutoring (hours per year)

A

B

E

Points A, B, and E are on the budget constraint. Which maximizes Russ’s utility? Point E, where the indifference curve is just tangent to the budget constraint.

Y = $420PF = $21PT = $14

0 10 20 30 40 50 600

5

10

15

20

25Fitness Training (hours per year)

Tutoring (hours per year)

A

B

E

At point E, MRS = MUT/MUF = slope of the budget constraint = PT/PF, so MUT/PT = MUF/PF → last dollar spent on each yields the same increase in utility.

At point A, |MRS| > PT/PF, which implies that MUT/PT > MUF/PF. Russ should increase tutoring (↓ MUT) and decrease fitness training (↑ MUF) by moving down his budget constraint to point E.

At point B, |MRS| < PT/PF, which implies that MUT/PT < MUF/PF. Russ should decrease tutoring (↑MUT) and increase fitness training (↓ MUF) by moving up his budget constraint to point E.

Y = $420PF = $21PT = $14

Suppose Harvard subsidies tutoring, but makes it unlimited…

PT =$7 per hour

PF =$21 per hour

Equation for the budget constraint:

Horizontal intercept: =>

0 10 20 30 40 50 600

5

10

15

20

25

B2

Fitness Training (hours per year)

Tutoring (hours per year)

Y = $420PF = $21PT = $14P’T = $7

B1

Effect of Price Change

• Substitution effect: the lower price of tutoring causes Russ to substitute tutoring for fitness training to make MUT/PT once again equal to MUF/PF.

• Income effect: the lower price of tutoring increases Russ’s real income so he can afford to purchase more of both goods.

0 10 20 30 40 50 600

5

10

15

20

25

Fitness Training (hours per year)

Tutoring (hours per year)

A

B

S

Substitution effect

Income effect

Substitution effect

Income effect

Y = $420PF = $21PT = $14P’T = $7

Russ sets aside $420 (Y) for tutoring (T) and fitness training (F) each year.

PT =$14 per hour

PF =$21 per hour

0 10 20 30 400

5

10

15

20

25

Suppose Harvard subsidizes tutoring, but only the first 10 hours

0 10 20 30 400

5

10

15

20

25

Suppose Harvard subsidizes tutoring, but only the first 10 hours

Harvard policy causes the price to fall and induces both a substitution and income effect that increase consumption of tutoring.

0 10 20 30 400

5

10

15

20

25

Suppose Harvard subsidizes tutoring, but only the first 10 hours

Harvard policy causes only an income effect for Russ since he was already consuming more than 10 hours of tutoring. As a result, his consumption of tutoring will increase.

India’s Public Distribution System (PDS) “evolved as a major instrument of the Government’s economic policy for ensuring availability of foodgrains to the public at affordable prices as well as for enhancing the food security for the poor.”

PDS Ration Card

Annam is a maid who lives in Tamil Nadu with her 5 children.

Y = Rs 1000 per month PD = Rs 50 per kg

𝐏𝐫={Rs 5 for 0<Qr ≤ 20 kg per monthRs 25 for Q𝑟>20 kg per month

She has a PDS ration card that entitles her to purchase up to 20 kg of rice at the price of Rs 5 per kg. Annam allocates Rs 1000 per month to buy rice and Dhal (≈ lentils). The market prices of rice (Pr) and Dhal (PD) are Rs 25 and Rs 50, respectively. Annam says that she typically feeds her family 30 kg of rice per month, causing her to “fully utilize” her PDS entitlement (The Hindu, 9/23/2008).

Tamil Nadu

0 4 8 12 16 20 24 28 32 36 40 44 48 52 5602468

10121416182022242628

Annam’s Budget Constraint and Indifference Curves

Rice (# kg per month)

Dhal (# kg / mn)

0 4 8 12 16 20 24 28 32 36 40 44 48 52 5602468

10121416182022242628

Annam’s Budget Constraint and Indifference Curves

I0

BC0

Rice (# kg per month)

Dhal (# kg / mn)

Suppose Annam's brother Babu also has a PDS ration card that entitles him to purchase up to 20 kg of rice at the price of Rs 5 per kg. He too allocates Rs 1000 per month to buy rice and Dhal. However, his family has a much stronger taste for Dhal, causing them to purchase only 20 kg of rice per month. At their consumption bundle, they would be willing to substitute 1 kg of Dhal for 4 kg of rice.

0 4 8 12 16 20 24 28 32 36 40 44 48 52 5602468

10121416182022242628

Babu’s Budget Constraint and Indifference Curves

I0

BC0

Rice (# kg per month)

Dhal (# kg / mn)

Kaushki Basu earned a PhD in economics at the London School of Economics and is currently the Chief Economic Adviser to the Indian Government. He has recently proposed replacing the PDS ration cards with rice coupons given directly to poor families Suppose each coupon would entitle families to purchase 1kg of rice for Rs 5. Also, suppose that Annam and Babu would be given 20 coupons per month under the new program. Since one family’s coupons would look exactly like another’s, a market would develop for rice coupons. Suppose the market price of rice coupons was Rs 15 per coupon. Illustrate the effect of the coupon program on the consumption decisions of Annam’s and Babu’s families.

0 4 8 12 16 20 24 28 32 36 40 44 48 52 5602468

10121416182022242628

Annam’s Budget Constraint and Indifference Curves

I0

BC0

Rice (# kg per month)

Dhal (# kg / mn)

𝑌+20𝑃𝑐𝑜𝑢𝑝𝑜𝑛𝑠

𝑃 h𝐷 𝑎𝑙=

(1000+20 (15))50

=26

0 4 8 12 16 20 24 28 32 36 40 44 48 52 5602468

10121416182022242628

Annam’s Budget Constraint and Indifference Curves

I0

BC0

Rice (# kg per month)

Dhal (# kg / mn)

𝑌+20𝑃𝑐𝑜𝑢𝑝𝑜𝑛𝑠

𝑃 h𝐷 𝑎𝑙=

(1000+20 (15))50

=26

0 4 8 12 16 20 24 28 32 36 40 44 48 52 5602468

10121416182022242628

Babu’s Budget Constraint and Indifference Curves

I0

BC0

Rice (# kg per month)

Dhal (# kg / mn)

0 4 8 12 16 20 24 28 32 36 40 44 48 52 5602468

10121416182022242628

Babu’s Budget Constraint and Indifference Curves

I0

BC0

Rice (# kg per month)

Dhal (# kg / mn)