Transcript Ch 4 - PPT
Chapter 4 Principles and Preferences McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved. Last Chapter Review During the last chapter, we looked at the basic concepts concerning… Maximizing benefits less costs Thinking on the margin Marginal Benefit vs. Cost Sunk costs and decision-making 3-2 Main Topics Today’s class is the beginning of material that may be new to you. This, and the next 10 chapters involve the principles of economic decision making. Today will deal with decisions by consumers concerning the goods they purchase. Topics covered: Principles of decision-making Consumer preferences Substitution between goods Utility 4-3 Building Blocks of Consumer Theory To start our class, we will first contemplate the food in front of us…. Peperos Chips Coke Which products are the “best”? Which of these products do you like best? Worst? Equally well? How much of each would you like me to give you? 4-4 Building Blocks of Consumer Theory Preferences tell us about a consumer’s likes and dislikes due to personal, emotional or intangible reasons. A consumer is indifferent between two alternatives if she likes (or dislikes) them equally Assumptions of consumer behavior… The Ranking Principle: A consumer can rank, in order of preference, all potentially available alternatives (ties are also possible) The Choice Principle: Among available alternatives, the consumer chooses the one that he ranks the highest 4-5 The Consumer’s Problem A consumer’s economic problem is to allocated limited funds to competing needs and desires over some time period Chooses a consumption bundle The collection of goods that an individual consumes over a given period (hour/day/month/etc) Should reflect preferences over various bundles, not just feelings about any one good in isolation Decision to consume more of one good is a decision to consume less of another 4-6 Principles of Consumer DecisionMaking The Ranking Principle: A consumer can rank, in order of preference, all potentially available alternatives The Choice Principle: Among available alternatives, the consumer chooses the one that he ranks the highest The More-is-better Principle: When one consumption bundle contains more of every good than a second bundle, a consumer prefers the first bundle to the second 4-7 Principles of Consumer DecisionMaking Madeline likes to eat at a restaurant that only serves bread and water. Which bundle is her first choice…second …last? Why? 4-8 Principles of Consumer DecisionMaking What about your preferences between pepero and chips? How would you build a table similar to that of soup/bread? Are there any combinations that you like equally? 4-9 Indifference Curves Use when goods are (or assumed to be) available in any fraction of a unit Represent alternatives graphically or mathematically rather than in a table Starting with any alternative, an indifference curve shows all the other alternatives a consumer likes equally well 4-10 Figure 4.1: Identifying Alternatives and Indifference Curves Which points are liked equally as much as A? Which are not as good? Which are better? WHY? 4-11 Properties of Indifference Curves Thin Do not slope upward Separates bundles that are better from bundles that are worse than those that are on the indifference curve Why? Think about the More is Better Principle 4-12 Families of Indifference Curves Collection of indifference curves that represent the preferences of an individual Do not cross Comparing two bundles, the consumer prefers the one on the indifference curve further from the origin 4-13 Figure 4.3: A Family of Indifference Curves 4-14 Figure 4.4: Indifference Curves Do Not Cross 4-15 Properties of Indifference Curves To reiterate….there are 5 properties of indifference curves. Thin Do not slope upward Separates bundles that are better from bundles that are worse than those that are on the indifference curve Indif. curves from the same family do not cross Comparing any two bundles, the consumer prefers the one on the indifference curve further from the origin 4-16 Formulas for Indifference Curves More complete and precise to describe preferences mathematically For example, can write a formula for a consumer’s indifference curves Formula describes an entire family of indifference curves Each indifference curve represents a particular level of well-being Higher levels of well-being are on indifference curves further from the origin 4-17 Figure 4.6: Plotting Indifference Curves Formula for indifference curves is B = U/S U is well-being, or “utility” (more later in lecture) To find a particular curve, plug in a value for U, then plot the relationship between B and S 4-18 Indifference Curves - Practice See p104, In-Text Exercise. Julie likes Coke and Pepsi. Indifference curve formula is C=U-1.2P Draw some of the indif. Curves. Which bundle does she prefer 1 liter of Coke and no Pepsi Or 1 liter of Pepsi and no Coke? 4-19 Indifference Curves - Practice See p104, In-Text Exercise. Solve for U, thereby making a utility function. Before C=U-1.2P so now U = C + 1.2P Now, we can plug the two bundles into the utility function to compare them. U(C, P) = C + 1.2P U(1, 0) = 1 + 1.2(0) = 1 U(0, 1) = 0 + 1.2(1) = 1.2 Since the bundle consisting of one liter of Pepsi and no Coke provides the greater level of utility, Judy prefers this bundle. Judy gets more “value” or utility from Pepsi than Coke. Hence 6 Cokes = 5 Pepsis 4-20 Goods and Bads A bad is an object, condition or activity that makes a consumer worse off. Here are 2 different indiv. curve sets. Which contains a bad? 4-21 Substitution Between Goods Economic decisions involve trade-offs To determine whether a consumer has made the best choice, we need to know the rate at which she is willing to make trade-offs between different goods Indifference curves provide that information 4-22 Rates of Substitution Consider moving along an indifference curve, from one bundle to another This is the same as subtracting units of one good and compensating the consumer for the loss by adding units of another good Slope of the indifference curve shows how much of the second good is needed to make up for the decrease in the first good 4-23 Figure 4.8: Rates of Substitution Look at move from bundle A to C Consumer loses 1 soup; gains 2 bread Willing to substitute for soup with bread at 2 ounces per pint 4-24 Marginal Rate of Substitution The marginal rate of substitution for X with Y, MRSXY, is the rate at which a consumer must adjust Y to maintain the same level of wellbeing when X changes by a tiny amount, from a given starting point MRSXY Y X Tells us how much Y a consumer needs to compensate for losing a little bit of X Tells us how much Y to take away to compensate for gaining a little bit of X 4-25 Figure 4.9: Marginal Rate of Substitution Marginal Rate of Substitution for soup with bread at bundle A MRSSB=-B/S=-3/2 or -1.5 ounces of bread for 1 pint of soup What about the MRS for bread with soup? 4-26 What Determines Rates of Substitution? Differences in tastes Preferences for one good over another affect the slope of an indifference curve Implications for MRS Starting point on the indifference curve People like variety so most indifference curves get flatter as we move from top left to bottom right Link between slope and MRS implies that MRS declines; the amount of Y required to compensate for a given change in X decreases 4-27 Figure 4.10: Indifference Curves and Consumer Tastes 4-28 Figure 4.11: MRS along an Indifference Curve Demonstrates that people like variety. We will say than an indif. curve has a declining MRS if it becomes flatter as we move along the curve from the NW to the SE 4-29 Formulas for MRS MRS formula tells us the rate at which a consumer will exchange one good for another, given the amounts consumed Every indifference curve formula has an MRS formula that describes the same preferences Indifference curves: B=U/S; MRSSB=B/S 4-30 Importance of MRS Assists in determining whether different people will trade. If trade will result in a mutually beneficial situation, people will make the exchange. This mutually beneficial situation is determined by the peoples’ MRS. 4-31 In-Text Exercise 4.3 Kate (M&M) and Antonio (MD) swapped 8 M&Ms for 5 Milk Duds What is the MRS for each party? If each person believed that 2 M&Ms = 1 Milk Dud, would they still have made the trade? 4-32 In-Text Exercise 4.3 Since Kate gave up eight M&Ms for five Milk Duds, we know that she values Milk Duds more than M&Ms. Her MRS for Milk Duds with M&Ms must be greater or equal to 1.6 (M&Ms / Milk Duds = 8 / 5 = 1.6). This means that Kate believes that one Milk Dud is a perfect substitute for at least 1.6 M&Ms. For example, if she believed that one Milk Dud was worth 2 M&Ms she would have still made this trade, because she’s giving up less than she would be willing to. On the other hand, if she believed one Milk Dud was worth fewer than 1.6 M&Ms, say 1.5, then she would not make this trade because she would be paying more for Milk Duds than she is willing to. Since Antonio willingly gave up five Milk Duds for eight M&Ms, he probably believes that eight M&Ms have a greater value than five Milk Duds or, equivalently, he probably believes that 1.6 M&Ms have a greater value than one Milk Dud. Therefore, Antonio’s MRS for Milk Duds with M&Ms is at most 1.6, but it is most likely less. If his MRS were equal to 1, so that he thought one M&M was the same as one Milk Dud, then he would definitely make this trade with Kate. However, if his MRS were greater than 1.6, say 2, so that he believed that it took two M&Ms to equal one Milk Dud, then Antonio would not accept only eight M&Ms for his five Milk Duds; he would require ten. In summary, Kate’s MRS>= 1.6 while Antonio’s MRS<= 1.6. 4-33 Perfect Substitutes and Complements Some special cases of preferences represent opposites ends of the substitutability spectrum Two products are perfect substitutes if their functions are identical; a consumer is willing to swap one for the other at a fixed rate Two products are perfect complements if they are valuable only when used together in fixed proportions Note that the goods do not have to be exchanged one-for-one! Examples? 4-34 Figure 4.12: Perfect Substitutes 4-35 Figure 4.13: Perfect Complements 4-36 Neutrals Goods are neutral goods if the consumer doesn’t care about it. Ie. Pepperoni and sausage on our pizza. I only care about the amount of sausage. Don’t care about the pepperoni. Bads A bad is an object, condition or activity that makes a consumer worse off. 4-38 Utility Summarizes everything that is known about a consumer’s preferences Utility is a numeric value indicating the consumer’s relative well-being Recall that the consumer’s goal is to benefit from the goods and services she uses Can describe the value a consumer gets from consumption bundles mathematically through a utility function which assigns a utility value to each consumption bundle. U S , B 2S 5S B 4-39 Utility Functions and Indif. Curves Utility functions must assign the same value to all bundles on the same indifference curve Must also give higher utility values to indifference curves further from the origin Can start with information about preferences and derive a utility function Or can begin with a utility function and construct indifference curves Can also think of indifference curves as “contour lines” for different levels of utility 4-40 Figure 4.14: Representing Preferences with a Utility Function 4-41 Deriving Indifference Curves from a Utility Function For each bundle, the utility corresponds to the height of the utility “hill” The indifference curve through A consists of all bundles for which the height of the curve is the same 4-42 Ordinal vs. Cardinal Utility Information about preferences can be ordinal or cardinal Ordinal information allows us to determine only whether one alternative is better than another Cardinal information reveals the intensity of preferences, “How much worse or better?” Difficulty in measuring this kind of utility Utility functions are intended to summarize ordinal information Scale of utility functions is arbitrary; changing scale does not change the underlying preferences 4-43 Marginal Utility To make a link between MRS and utility, need a new concept Marginal utility is the change in a consumer’s utility resulting from the addition of a very small amount of some good, divided by the amount added MU X U X 4-44 Utility Functions and MRS MRS XY MU X MU Y Small change in X, X, causes utility to change by MUXX Small change in Y, Y, causes utility to change by MUYY If we stay on same indifference curve, then –Y/X =MUX/MUY 4-45 Summary Principles of Decision Making Ranking / Choice Principles Consumer Preferences Need to compare Consumption Bundles Consumers prefer more to less Indif. curves are thin and never slope up I.C. that runs through a bundle separates all better alternatives from all other options. I.C. from the same family never cross. For every bad, there is an assoc. good. 4-46 Summary Substitution between goods MRS varies from one consumer to another according to the relative importance the consumer attaches to the goods in question. MRS for X with Y declines as X becomes more plentiful and Y more scarce. Whether people trade depends upon their MRS I.C. for perfect substitutes is a straight line and L-shaped for complements 4-47 Summary Utility Summarizes everything that is known about a consumer’s preferences Can create a utility function from a family of I.C. by assigning the same utility value to all bundles on the same curve. Higher value curves correspond to higher levels of wellbeing. Utility usually used to for ordinal (not cardinal) information By itself, marginal utility doesn’t measure anything meaningful. The ratio though is equal to equiv. MRS 4-48 Problems 1. Binch Cookies vs. Chips What is your MRS between the two? 2. After reading this chapter, a student complains, “What I like and dislike isn't always the same; it depends on my mood.” Is this a problem with consumer preference theory? Why or why not? 4-49 Problems 2. After reading this chapter, a student complains, “What I like and dislike isn’t always the same; it depends on my mood.” Is this a problem with consumer preference theory? Why or why not? No. This is not a problem with consumer preference theory. Consumer preference theory does not require that preferences never change (such as with mood). What it does require is that, at any given time, a consumer can rank all possible alternatives (though possibly with ties). 4-50