Daniel l. Rubinfeld

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p 98 Part 2 Producers, Consumers, and Competitive Markets Consumer Behavior 99 1. TI1e theory of consumer choice rests on the assumption that people behave rationally in an attempt to maximize the satisfaction that they can obtain by purchasing a particular combination of goods and services. 2. Consumer choice has two related parts: the study of the consumer's preferences and the analysis of the budget line that constrains the choices that a person can make. 3. Consumers make choices by comparing market baskets or bundles of commodities. Preferences are assumed to be complete (they can compare all possible market baskets) and transith'e (if they prefer basket A to B, and B to C, then they prefer A to C). In addition, economists assume that more of each good is always preferred to less. 4. Indifference curves, which represent all combinations of goods and services that giw the same level of satisfaction, are downward-sloping and camlOt intersect one another. 5. Consumer preferences can be completely described by a set of indifference curves known as an indifference map. An indifference map provides an ordinal ranking of all choices that the consumer might make. 6. The marginal rate of substitution (MRS) of F for C is the maximum amount of C that a person is willing to give up to obtain 1 additional unit of F The MRS diminishes as we move down along an indifference curve. When there is a diminishing MRS, preferences are convex. 7. Budget lines represent all combinations of goods for which consumers expend all their income. Budget lines shift ouhvard in response to an increase in consumer income. When the price of one good (on the horizontal axis) changes while income and the price of the other good do not, budget lines pivot and rotate about a fixed point (on the vertical axis). 8. Consumers maximize satisfaction subject to budget constraints. When a consumer maximizes satisfaction by consuming some of each of two goods, the marginal rate of substitution is equal to the ratio of the of the two goods being purchased, The effect of any CPI adjustments will not be restricted to the expenditure side of the federal budget. Because personal income tax brackets are in.t1ationadjusted, a CPI adjustment decreasing the rate of measured price increase 'would necessitate a smaller upper adjustment in tax brackets and, consequently, would increase federal tax revenues. '"" i& 9. Ivlaximization is sometimes achieved at a corner solution in which one good is not consumed. In such cases, the marginal rate of substitution need not equal the ratio of the prices. 10. The theory of revealed preference shows how the choices that indh'iduals make when prices and income vary can be used to determine their preferences. When an individual chooses basket A even though she could afford B, we know that A is preferred to B. 11. The theory of the consumer can be presented by two different approaches. The indifference curve approach uses the ordinal properties of utility (that is, it allows for the ranking of alternath'es) .. The utility fLmction approach obtains a utility fLmction by attaching a number to each market basket; if basket A is preferred to basket B, A generates more utility than B. 12. \-'lhen risky choices are analyzed or when comparisons must be made among individuals, the cardinal properties of the utility fLmction can be important Usually the utility fLmction will shOlv diminishing marginal utility: As more and more of a good is consumed, the con SL1l1er obtains smaller and smaller increments of utility. 13. When the utility ftllction approach is used and both goods are consumed, utility maximization occurs when the ratio of the marginal utilities of the two goods (which is the marginal rate of substitution) is equal to the ratio of the prices. 14. An ideal cost-of-living index measures the cost of buying, at current prices, a bW1dle of goods that generates the same lewl of utility as was provided by the bundle of goods consumed at base-year prices. The Laspeyres price index, however, represents the cost of buying the bLmdle of goods chosen in the base year at current prices relative to the cost of buying the same bundle at base-year prices. The CPr, like all Laspeyres price indexes, overstates the ideal cost-of-liYing index. Bv contrast, the Paasche index measures the cost at ~urrent-year prices of buying a bundle of goods chosen in the current year divided by the cost of buying the same bundle at base-year prices. It thus understates the ideal cost-of-living index. ... 1. What does transitiuity of preferences mean 2. Suppose that a set of indifference curves was not negati\'eh' sloped. What could you sa\' about the desirabilit): of the two goods' , 3. Explain why two indifference cun'es cannot intersect. 4. Dra\\' a set of indifference cun'es for which the marginal rate of substitution (MRS) is constant. Draw two budget lines with different slopes; show what the satisfaction-maximizing choice will be in each case. What conclusions can you draw 5. Explain why a MRS between two goods must equal the ratio of the price of the goods for the consumer to achie\'e maximum satisfaction .. 6. Explain why consumers are likely to be worse off when a product that they consume is rationed. 7. Upon merging with the West German econom\', East German consumers indicated a preference f~r 1. In this chapter, consumer preferences for \'arious commodities did not change during the analysis. Yet in some situations, preferences do change as consumption occurs. Discuss why and how preferences might change O\'8r time with consumption of these two commodities: a. cigarettes b. dumer for the first time at a restaurant with a special cuisine. 2. Draw the indifference curves for the following indi \'iduals' preferences for two goods: hamburgers and beer. a. Al likes beer but can live without hamburgers. He alwavs prefers more beer no matter hOlY many hamburgers he has. . b. Betty is indifferent between bLmdles of either three beers or two hamburgers. Her preferences do not change as she consumes an\' more of either food. e. Chris eats one hamburger and washes it down with one beer. He will not consume an additional unit of one item without an additional LUlit of the other. d. Doreen loves beer but is allergic to beef. Every time she eats a hamburger she breaks out in hives. 3. The price of tapes is 510 and the price of CDs is 515. Philip has a budget of 5100 and has already purchased 3 tapes. He thus has S70 more to spend on additional tapes and CDs. Draw his budget line. If his l'emau1ing expenditure is made on 1 tape and -1 CDs, show Philip's consumption choice on the budget line. Mercedes-Benz automobiles over Volks\\'agens. However, when they com"erted their savings into deutsche marks, they Hocked to Volkswagen dealerships. How can you explain this apparent paradox 8. Describe the equal marginal principle. Explain \\"hy this principle may not hold if increasing marginal utility is associated with the consumption of one or both goods. 9. What is the difference between ordinal utilit\" and cardinal utility Explain why the assumption ~f cardinal utility is not needed in order to rank consumer choices. 10. The price of computers has fallen substantiall\" over the past two decades Use this drop in price to e"xplain why the Consumer Price Index is likely to owrstate substantially the cost-of-lh'ing index for individuals who use computers intensi\'ely. 4. Debra usually buys a soft drink when she goes to a movie theater, where she has a choice of three sizes. The S-ounce drink costs 5L50, the 12-ounce drink, 52.00, and the 16-ounce drink, S2.25. Describe the budget constraint that Debra faces when deciding hm\' many OLUlces of the dru1k to purchase. (Assume Debra can costlessly dispose of any of the soft drink that she does not want) 5. Suppose Bill views butter and margaru1e as perfectly substitutable for each other. a. Draw a set of indifference cun"es that describes Bill's preferences for butter and margarule. b. Are these uldifference cun'es com'ex Win' c. If butter costs 52 per package and marga;ine only 51, and if Bill has a 520 budget to spend for the month, which butter-margarine market basket will he choose Can you show your ans\\'er graphically 6. Suppose Jones and Smith have decided to allocate 51,000 per year to liquid refreshment in the form of alcoholic or nonalcoholic drinks. Jones and Smith differ substantially in their preferences for these two forms of refreshrnent. Jones prefers alcoholic to nonalcoholic drinks, while Smith prefers the nonalcoholic option. a. Draw a set of indifference cun'es for Jones and a second set for Smith. b. Using the concept of marginal rate of substitution, explain why the two sets of cun'es are different from each other.
100 Part 2 Producers, Consumers, and Competitive Markets c. If both Smith and Jones pay the same prices for their refreslunents, will their marginal rates of substitution of alcoholic for nonalcoholic drinks be the same or different Explain. 7. Consumers in Georgia pay twice as much for avocados as they do for peaches. Howe\-er, avocados and peaches are equally priced in California. If consumers in both states maximize utility, will the marginal rates of substitution of peaches for avocados be the same for consumers in both states If not, which will be higher 8. Anne is a frequent Hyer whose fares are reduced (through coupon giveaways) by 25 percent after she flies 25,000 miles a year and then by 50 percent after she flies 50,000 miles. Can you graph the budget line that Anne faces in making her flight plans for the year 9. Antonio buys 8 new college textbooks during his first year at school at a cost of S50 each. Used books cost only 530 each. When the bookstore announces that there will be a 20-percent price increase in new texts and a 10-percent increase in used texts for the coming year, Antonio's father offers him 580 extra. Is Antonio better off or worse off after the price change 10. Suppose that Samantha and Jason both spend 524 per week on video and movie entertainment When the prices of videos and movies are both 54, they each rent 3 videos and buy 3 movie tickets. FollOWing a video price war and an increase in the cost of movie tickets, the price of \-ideos falls to 52 while the price of mo\"ie tickets increases to 56. Samantha now rents 6 videos and buys 2 movie tickets; Jason, hmyever, buys 1 mo\"ie ticket and rents 9 videos. a. Is Samantha better off or worse off after the price change b. Is Jason better off or vvorse off 11. Connie allocates S200 of her monthly food budget between two goods: meat and potatoes. a. Suppose meat costs S4 per pound and potatoes $2 per pound. Draw Connie's budget constraint. b. Suppose also that her utility function is given by the equation lI(lvI,P) = 2M P. What combination of meat and potatoes should she buy to maximize her utility (Hint: lvleat and potatoes are perfect substitutes.) c. COlmie's supermarket is rLllming a special promotion: If she buys 20 pounds of potatoes (at 52 per pound), she gets the next 10 pounds for free .. This offer applies only to the first 20 pounds she buys, All potatoes in excess of the first 20 pounds (excluding bonus potatoes) are still 52 per pound, Draw her budget constraint. d. When an outbreak of potato rot raises the price of potatoes to 54 per pound, the supermarket ends its promotion. What does Connie's budget constraint look like now What combination of meat and potatoes will maximize her utility 12. The utility that Jane recei\'es by consuming food F and clothing C is giwn by lI(F,C) = FC a. Draw the indifference curve associated with a utility le\'el of 12 and the indifference cun-e associated with a utility level of 24. Are the indifference CUlTes con\-ex b. Suppose that food costs Sl a unit and clothing 53 a unit. Jane has $12 to spend on food and clothing. Graph the budget line that she faces. c. What is the utility-maximizing choice of food and clothing (Hillt.: Solve the problem graphically.) d. What is the marginal rate of substitution of food for clothing when utility is maximized e. Suppose that Jane buys 3 units of food and 3 units of clothing with her 512 budget. Would her marginal rate of substitution of food for clothing be greater or less than 1/3 Explain 13. The utility that Meredith recei\-es by consuming food F and clothing C is giwn by lI(F,C) = FC Suppose that her income in 1990 is 51,200 and that the prices of food and clothing are 51 per unit of each. By the year 2000, howe\-er, the price of food has increased to 52 and clothing to 53. Let 100 represent the cost-of-lh'ing index for 1990. Calculate both the ideal and the Laspeyres cost-of-li\-ing index for Meredith for 2000. (Hint: IVleredith will spend equal amounts on food and clothing .) !!II I !!II I hapter 3 laid the foundation for the theory of consumer demand. We discussed the nature of consumers' preferences and sal-\' how, gi\-erl budget constraints, consumers choose market baskets that maximize utility. From here it's a short step to analyzing demand itself and showing how the demand for a good depends on its price, the prices of other goods, and income. Our analysis of demand proceeds in six steps: 1. We begin by deriving the demand curve for an individual consumer. Because love knuw how changes in price and income affect a person's budget line, ,ve can determine how they affect consumption choice. We will use this information to see hO\o\' the quantity of a good demanded varies in response to price changes as we move along an indiyidual's demand curve. We will also see how this demand curve shifts in response to changes in the individual's income. 2. With this foundation, "love will examine the effect of a price change in more detail. 'When the price of a good goes up, indi\-idual demand for it can change in two ways. First, because it has now become more expensive relative to other goods, consumers 'will buy less of it and more of other goods. Second, the higher price reduces the consumer's purchasing power. This reduction is just like a reduction in income and will lead to a reduction in the consumer's demand. By analyzing these tvvo distinct effects, we will better understand the characteristics of demand. 3. Next, we will see hmv individual demand curves can be ao-o-reo-ated to determine the market demand curve. We 00 0 will also study the characteristics of market demand and see 'why the demands for some kinds of goods differ considerably from the demands for others. 4. We will go on to show how market demand curves can be used to measure the benefits that people receive when they consume products, above and beyond the expenditures they make. This information will be especially important later, when we study the effects of government intervention in a Inarket 5. We then describe the effects of network externalities-i.e., what happens ''''hen a person's demand for a good also
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Daniel l. Rubinfeld

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