Professors Farhoud Kafi 2010 1. Consumer Preference and Behavior What are the consumer opportunity? ...
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Rational Choice
Professors Farhoud Kafi
2010
1
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Consumer Preference and Behavior
What are the consumer opportunity? Array of goods and services they can afford.
What are the consumer preference? Bundles which they actually buy
Can we develop a model that shows how they buy these bundles? Yes, we can develop a utility/attribute
functionWhat would be the ultimate goal?
Maximizing Utility , subject to Budgetary (Income) constraint.
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How the Objective is Achieved• Given the choices among the bundles, consumers will pick each bundle based on the value he/she assigns to that bundle while considering; budget, price, and all other attributes important to his/her choice.
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How to model the consumer choiceWe assume consumer is rational decision
makerWe assume the bundles ranked higher by
consumer are superiorWe assume additional bundles, inevitably will
lead to diminishing marginal satisfaction (DMU)
Based on information received from the consumer, we can map and develop the consumer utility function
Given the constraint, we can then identify the best possible bundle
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Use of indifference map in modeling consumer behavior
We assume consumer has only two bundles to choose
We assume consumer assigns budget to acquire these bundles
We assume money left over provides no marginal benefit to consumer
We assume consumer can express preference We assume more is preferred to lessWe assume substitution has DMR We assume consumer is constraint by the budget
and prices are exogenous to the model
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Consumer preferences can be described with indifference curves.
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The Properties of Indifference CurvesDo not intersectMore is always betterNegatively sloped throughoutSlope: MRS = “Marginal rate of substitution”
Here MRS = CD / Pizza
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The Consumer’s Budget Constraint
Income = 100, Ppizza = $5.00,
PCDs = $10.00
Slope = - Ppizza/ PCDs20
10
Pizza's
CDs
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Consumer in Equilibrium at EMRS = Ppizza/PCDs
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Consumer in disequilibrium at B
Pizzas
CDs
CD0
P0
B
E
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Difference in Preferences
FIGURE A: JIM FIGURE B: JANE
CDs CDs
Pizzas Pizzas
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Different Preferences lead to Different Choices
FIGURE A: JIM FIGURE B: JANE
CD CDs
Pizzas PizzasP1
D1E
E
P1
D1
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Assignment Question 11. Alex’s preferences for bagels and wine can
be isolated and examined. Assume that Alex’s budget is $200. Bagels cost $2.00 each and wine costs $10.00 per liter. Assume that Alex spends all of his income on bagels and wine in order to maximize his total utility.
a) Write the equation for his budget line. What is the slope of the budget line and what does it mean? Draw the budget line. Use the X-axis for bagels and the Y-axis for wine.
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Budget EquationPBQB + PWQW = I
PB = 2PW = 10I = 200
2QB + 10QW = 200
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Graph of the Budget Line
QB
QW
20
20 40 60 80 100
40
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Bagels and Wine (continued)c) Draw Alex’s preferences map and
superimpose the budget line. Label Alex’s utility-maximizing combination of bagels and wine as point “A.” What is meant by the “utility-maximizing combination of bagels and wine?”
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Alex’s Preference Map
QB
QW
20
20 40 60 80 100
40
U1U2
U3
U4
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Rational Consumer (Alex) Choice
QB
QW
20
20 40 60 80 100
40
U1U2
U3
U4
A
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Utility-Maximizing Combination of Bagels and Wine
Slope of Indifference Curve = MRSMRS = - (Wine/Bagels)MRS = - (QW/QB)
Slope of Budget Line = Relative Price Ratio = – (PB/PW)
Utility-maximizing combination is where the slope of the indifference curve is equal to the slope of the budget line.
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Utility-Maximizing Combination of Bagels and Wine
MRS = (PB/PW)
This is also the point where the highest possible indifference curve is just tangent to the budget line.
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Bagels and Wine (continued)c) Sally is currently spending her entire
budget on bagels. She purchases no wine. Draw Sally’s indifference curves and explain her consumption choices in term of marginal utility.
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Sally’s Indifference Curves and Budget Line
QB
QW
20
20 40 60 80 100
40
U1 U2 U3
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Marginal UtilityMU = U/QSally’s Marginal Utility for Wine
MUW = U/QW = 0
MRS = - (QW/QB)
MRS = - (U/QB)/(U/QW)
MRS = - MUB/MUW = UndefinedSally will not give up any bagels to
gain any wine
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Bagels and Wine (continued)d) Consider alternative strategies wine
manufacturers could use to target Sally and consumers like her (i.e. lowering price of wine, advertising, free samples).