Daniel l. Rubinfeld

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82 Part 2 Producers, Consumers, and Competitive Markets :3 Consumer Behavior 83 i§§& §§2 5tvlin a _ 0 T 510,000 53,000 ------------- 510,000 57,500 = "J: 2 P .3 -:l c: t ~ U .3 r:: R > - "J: 2 .2 > " '- A 57,000 510,000 Performance (a) 52,500 510,000 Performance (b) o 5 z v Q Police Expenditures (5) o x Q R Police Expenditures (5) The conswners in (a) are willina to h'ade off a considerable amowlt of styling for some additional performance. Given a will choose a car that The is tme for consumers in (b), (a) (b) 'would be sufficient to allow the firm to make a sensible strategic business decision. In fact, an exercise similar to this was carried out by General Motors in a survey of a large number of automobile buyers. 6 Some of the results were expected. For example, households with children tended to prefer functionality over style and so tended to buy minivans rather than sedans and sporty cars. Rural 110useholds, on the other hand, tended to purchase pickups and allvvheel drives, More interesting was the strong correlation between age and preferences for attributes, Older consumers tended to prefer larger and hea\'ier cars with more safety feahlres and accessories (e.g" po-weI' windows and steer~ ing) , Younger consl;mers preferred greater horsepower and more stylish cars (including sport utility vehicles). & rant programs from the federal government to state and local gO\'ernments serve many purposes. One program might seek to increase school spendina another to redistribute income from relativelv v\'ealtlw states and 0' ,.I ,.I localities to those that are relati\-ely poor. A third might h-y to ensure that individual govermnents provide minimum service levels. 6 The sUr\'ey design and the results are described in 5te\'en Berry, James Le\'insohn, and Ariel Pa~es, "Differentiated Products Demand 5\'stems from a Combination of Micro and Macro Data: The :\ew Car Market," National Bureau of Economic Research Working Paper 6481, March 1998. (a) A nonmatching grant from the federal govemment to a local government acts just like an income increase in h'aditional consumer analysis. The local govenU11ent official moves from A to B, allocating a portion of the grant to police expendihlres and a portion to lower taxes and, therefore, to an increase in private expendihlres, (b) A matching grant acts just like a price decrease in h'aditional col1Swner analysis. The local govermnent official moves from A to C allocating some of the grant to police expendihlres and some to private expendihlres. Relatively more money, however, is on police expenditures than 'would be the case with a nonmatching grant of the same total amOlmt. Which kinds of grant programs are best suited to achie\'e these different objecti\'es The answer depends on the incentive effects that each program generates. By changing the constraints faced by local public officials, a grant program can alter an official's decision about how much a local government should spend, We can use consumer theory to see how two types of grant programs e\'oke different responses from public officials. Suppose that a public official is in charge of the police budget, which is paid for by local taxes. Her preferences reHect 'what she belie\'es should be allocated for police spending and what she feels citizens would prefer to have available for private consumption. Before the introduction of the grant program, the city's budget line is PQ in Figure 3.1-±(a). This budget line represents the total amount of resources a\'ailable for public police spending (shO\vn on the horizontal axis) and priYate spending (on the vertical)7 The preference-maximizing market basket A on indifference curve U j shows that OR is spent on pri\-ate expendihlres and 05 on police expendihlres. Because public expendihlres are paid for by local taxes, these pri\'ate expenditures represent spending after local taxes ha\'e been paid. The first type of grant program, a 11011I1ll7tclzillg grallt, is simply a check from the federal goyernment that the local goyem:ment can spend without restriction. An unconditional grant of this sort expands the community budget line . This sum \\'oltld approximately equal the per capita income of the jurisdiction (say 510,000) times the number of taxpayers (say, 50,000)
84 Part 2 Producers, Consumers, and Competitive Markets corner solution Situation in which the marginal rate of substitution for one good in a chosen market basket is not equal to the slope of the budget line. outward from PQ to TV in Figure 3.1-l:(a), where PT = QV is the dollar amount of the grant The local gm'ernment's response to this int1ux of dollars is to move to a higher indifference cun'e by selecting market basket B, with more of both goods (OU of pri\'ate expenditures and OZ of police expend i hues). But more pri\'ate expenditures means that some of the money for police that came pre\'iously from taxes now comes from government grants. The second type of program is the lIlotelzillg grallt-funds offered as a form of subsidy to local spending. For example, the federal govemment might offer 51 for every $2 that the local gm'emment raises to pay for police. As a result, a matching grant lowers the cost of the publicly provided good. In terms of Figure 3.14(b), the matching grant rotates the budget line ouhvard from PQ to PR. If no local money is spent on police, the budget line is unchanged. However, if the local official decides to spend money on the public sectOl~ the budget increases. In response to the matching grant, the official chooses market basket C rather than A As ,·"ith a nonmatching grant, there is an increase in police expenditures and a tax cut that leads to an increase in pri\'ate consumption. At C OX dollars are allocated to police and OW to private expenditures. Hovvever, the spending effects of the hvo types of grant are different The diagram shows that the matching grant leads to greater police spending than does the nonmatching grant, even vvhen the two programs involve identical govemment expenditures. s - '" Corner Solutions Sometimes consumers buy in extremes, at least within categories of goods. Some people, for example, spend no money on travel and entertainment. Indifference curve analysis can be used to show conditions under which consumers choose not to consume a particular good. In Figure 3.15, a man faced with budget line for snacks AB chooses to purchase only ice cream (IC) and no frozen yogurt (Y). This decision ret1ects what is called a comer solution: \~hen one of the goods is not consumed, the consumption bundle appears at the corner of the graph. At B, which is the point of maximum satisfaction, the MRS of ice cream for frozen yogurt is greater than the slope of the budget line. This inequality suggests that if the consumer had more frozen yogurt to give up, he would gladly trade it for additional ice cream. At this point, howe\'er, our consumer is already consuming all ice cream and no frozen yogurt, and it is impossible to consume negative amounts of frozen yogurt. When I] corner solutioll arises, the consulller's MRS does not necessarily eqlli1! the price mtio. Unlike the condition expressed in equation (3,3), the necessary condition for satisfaction to be maximized when choosing between ice cream and frozen yogurt in a corner solution is gi\'en by the following inequality:9 - we", Frozen Yogurt (cups per month) A B ew & & Ice cream (cups per month) IAlhen the conswner's marginal rate of substitution is not equal to the price ratio for all levels of consumption, a corner solution arises, The conswner maximizes satisfaction by consuming only one of the two goods. Given budget line AB, the highest level of satisfaction is achieved at B on indifference curve U j , where the Iv1RS (of ice cream for frozen yogmt) is greater than the ratio of the price of ice cream to the price of frozen yogurt. This inequality would, of course, be reversed if the corner solution were at point A rather than B. In either case, we can see that the marginal benefit-marginal cost equality that we described in the previous section holds only when positive quantities of all goods are consumed, An important lesson here is that predictions about how much of a product consumers will purchase when faced 'with changing economic conditions depend on the nature of consumer preferences for that product and related products and on the slope of the consumer's budget line. If the MRS of ice cream for frozen yogurt is substantially greater than the price ratio, as in Figure 3.15, then a small decrease in the price of frozen yogurt will not alter the consumer's choice; he will still choose to consume only ice cream. But if the price of frozen yogurt falls far enough, the consumer could quickly choose to consume a lot of frozen yogurt. Chapter 3 Consumer Behavior 85 (3.4) S Note also that point B, which is attained with a non matching grant, is on a higher indifference ClaTe than point C. which is attained with a matching grant The nonmatching grant leads to greater satisfaction for the same le\'el of expenditure. In other \\'ords, there is a trade-off between encouraging a particular change in expenditure and achie\'ing the highest le\'el of satisfaction for a gi\en expenditure. 9 Strict equality could hold if the slope of the budget constraint happened to equal the slope of the indifference cu[\'e-a condition that is unlikely J ane Doe's parents have provided a trust hmd for her college education, Jane, ,·"ho is 18, can receive the entire trust fund on the condition that she spend it only on education. The fund is a welcome gift to Jane but perhaps not as welcome as an unrestricted trust. To see ,'\'hy Jane feels this way, consider Figure 3.16, in which dollars per year spent on education are shown on the horizontal axis and dollars spent on other forms of consumption on the vertical.
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Daniel l. Rubinfeld

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