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Consumer Choice
1
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
•
•
•
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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
APC
• (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
Qb
x
y
z
Qa
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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
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