Topic 2 Consumer Choice Theory

Welfare Economics

Topic 2 Consumer choice theory

Lecture slides, notes & topic handouts for this module are available from:

1. Introduction

• Individualism and models of consumer choice: the relevance to welfare economics.

1. Consumer choice theory

• Explains the choices consumers make given their limited incomes

Key ideas:

a. Consumers are rational

b. Consumers have preferences

• they prefer more to less
• they can compare and rank consumption options
• their preferences are transitive

c. Utility

• cardinal
• ordinal

d. Maximisation of utility: consumers seek to obtain maximum satisfaction from limited incomes.

1. Total and marginal utility

Utility: a measure of the benefit or satisfaction that consumers get from a good or service

Total utility (TU): the benefit or satisfaction that consumer gets from consuming a particular quantity of a good or service

Marginal utility (MU): the increase in total utility obtained by consuming one extra unit of a good or service.

MU = ΔTU/ΔQ

The principle of diminishing MU:

As more units of a good are consumed, additional units will provide less satisfaction than previous units.

If we could measure utility…

[e.g. in units ‘utils’ or ‘hedons’]

Total utility

Marginal utility

1. Optimal choice: one good

• In practice we can’t measure utility directly
• But we can proceed on the basis that MU = the amount of money a person would be prepared to pay to obtain one more unit of the good.

D = f(Px)

MU = f(Qx)

Optimal choice: choose that Qx where MU = price

1. Consumer surplus

1consumer spending = P x Q

At Q*, MU = P*

But for every Qx up to Q*, MU > P

Consumer surplus: the excess of what a person would have been prepared to pay for a good over what the person actually pays.

• In the diagram, this is the area under the demand curve out to Q*, minus the consumer’s spending

1. Optimal choice: two goods

• We have a budget to spend on coffee and magazines.

• The marginal utility of a coffee is MU(X); the price (in £) of coffee is P(X).

• The marginal utility of a magazine is MU(Y); The price (in £) of a magazine is P(Y).

Utility is maximised when

i.e. the marginal utility of coffee per £ spent is = the marginal utility of magazines per £ spent.

This is the ‘equimarginal principle’

7. The budget line

What consumption is feasible for the consumer depends on their income and the prices of goods.

e.g. In a ‘2 good world’;

1The total income to be spent on bananas and magazines is £10 per week.

2The price of a magazine is £1

3The price of a bunch of bananas is £2

The consumer can choose to:

• buy 10 magazines and no bananas

or

• 5 bunches of bananas and no magazines

or

• some combination of bananas and magazines.

All possible consumption possibilities form the budget line

The budget line

• Horizontal intercept = Income/Pmagazines
• Vertical intercept = Income/ Pbananas
• Slope = Pmagazines/ Pbananas

8. Budget line: changes in price

• An increase in the price of one good causes the budget line to rotate in.
• A decrease in the price of one good causes the budget line to rotate out.

e.g.

9. Budget line: changes in income

• An increase in income shifts the budget line out.
• A decrease in income shifts the budget line in.

e.g. an increase in the consumer’s income from £10 to £20 per week:

Budget lines show the ‘bundles’ of goods between which consumers can choose, given their income and the prices of goods. Which feasible ‘bundle’ will maximise their utility?

10. Preferences

11. Indifference curves

Marginal rate of substitution:

The amount of bananas that must be given up if the consumer receives one more magazine, in order for utility to remain the same.

MRS = Δbananas/ Δmagazines

• MRS falls as we move along the indifference curve. Thisis related to the principle of diminishing marginal utility.

• Utility at point a = utility at point b

• Utility sacrificed by ‘giving up’ 2 units of Y = utility gained by getting one extra unit of X
• MU of X must be 2 times as great as the MU of Y
• MRS = MuX/MUY = slope of the indifference curve
  

12. Indifference maps

• Ordinality
• An IC further out from the origin = more utility
• Utility is equal along any one IC

13. Maximising utility

• Points a, bc are feasible for the consumer.
• Point b gives more utility than points a or c.
• Point d would give higher utility than b, but is not feasible.

The consumer chooses 2 bunches of bananas at £2 each, spending £4 on bananas, plus 6 magazines at £1 each, spending £6 on magazines and spending a total of £10 overall - the total income.

Utility is maximised where

• MRS = PX/PY

MRS = MuX/MuY, therefore…

• PX/PY = MuX/MuY
• MUX/PX = MUY/PY

[ the ‘equimarginal principle’ again]

14. Change in income

• The consumer buys more of both bananas and magazines
• Why?

15. Change in price

• The consumer buys more of both bananas and magazines.
• Why? Is this a general result?

16. Analysing a change in price: Hicks income and substitution effects

When a good’s price increases, consumers decrease their consumption of that good (‘the law of demand’) for two reasons:

The substitution effect: the good is now more expensive relative to other goods. Consumers substitute towards other goods.

The income effect: they cannot afford so much of it, given their limited money income.

Money income and ‘real income’ are different things.

→ e.g. if your money income stays the same, but prices increase, your ‘real income’ has fallen.

→ real income refers to how much you can buy; your ‘purchasing power’.

→ specifically (Hicks 1943) real incomeis said to be constant if the consumer’s level of utility is held constant i.e. the consumer stays on their original indifference curve.

B1 = Original budget line, with original prices and original real income

B2 = New budget line, with new prices and new real income

B3 = Budget line with new prices but original real income

• Substitution effect of price change

• The substitution effect is always negative for the good whose relative price has fallen - consumers substitute it for the other good.

↓ Price → ↑Qd due to the substitution effect
Income & substitution effects: normal goods

• The income effect may be positive or negative, with respect to the price change, for either good.

• In the above diagram, the income effect is negative and the good is a “normal good”.

↓ Price → ↑Qd due to the income effect
Income & substitution effects: inferior goods

• In the above diagram, the income effect is positive and the good is an “inferior good”

↓ Price → ↓Qd due to the income effect

But overall, the ↑Qd due to the substitution effect outweighs the ↓Qd due to the income effect.

• If the income effect is positive and dominates the substitution effect, this would be a ‘Giffen good’.

Q: what would the demand curve for a Giffen good look like?

17. Deriving the demand curve

• Price consumption curves
• Marshallian (‘ordinary’) demand curves
• Hicks (‘income compensated’) demand curves