Modeling Consumer Choice

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All that Heaven Will Allow Bruce Springsteen
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Princeton The Indifference Curve
http//www.myspace.com/princetonmusic
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Modeling Consumer Choice

• Tastes
• Resources
• Budget constraint
• Income
• Prices
• Objective Assuming taste fixed, how do prices
  and income affect demand?

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Utility satisfaction from the consumption of
goods or services
Jeremy Bentham University College London
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Characterizing Tastes

• Utility Satisfaction from consuming goods
• Jeremy Bentham
• Marginal utility amount of satisfaction obtained
  from the last unit of the good consumed

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Total and Marginal Utility
(a)
Utils
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Total Utility
60
50
40
30
20
10
1
2
3
4
5
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Ice Cream Cones per Week
(b)
Declines as consumption rises
Utils
30
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MUF (?U/?F) willingness to pay
Marginal Utility
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1
2
3
4
5
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Ice Cream Cones per Week
a
a
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How to relate multiple goods
Consider two goods F Food C Clothing MUF
?U/?F marginal utility of food MUC ?U/?C
marginal utility of clothing
How can we characterize tastes for these two
goods?
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Assumption 1 NonsatiationMore is better
clothing
D?
B?
A
C?
E?
food
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Assumption 1 NonsatiationMore is better
clothing
more preferred
?
B
A
C
B preferred to A A preferred to C
less preferred
?
food
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Assumption 2 CompletenessCan rank any two
bundles
clothing
Nonsatiation means that as we go northeast from C
to B, utility increases
B
A
C
food
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Assumption 2 CompletenessCan rank any two
bundles
clothing
On every arc from C to B, there will be a point
indifferent to A
B
X
A
X
C
food
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Indifference CurveAll Combinations of Goods
that yield the same level of utility
clothing
B
X
A
X
C
U0
food
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Ranking Indifference Curves
clothing
B
A
U1
C
U0
U-1
food
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Ranking Indifference Curves
Heaven on Earth
clothing
B
A
U1
C
U0
U-1
food
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Assumption 3 Diminishing Marginal Utility

• As consumption increases, added utility falls
• Insures convex indifference curves

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Diminishing Marginal UtilityAs Clothing
decreases, takes increasing amounts of food to
leave utility unchanged
clothing
Along an indifference curve, As C decreases and
F increases, MUF decreases and MUC increases
?C
?C
?C
U0
food
?F1
?F2
?F0
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Diminishing Marginal UtilityAs Clothing
decreases, takes increasing amounts of food to
leave utility unchanged
clothing
MRS (?C/?F) -slope of indifference curve
(?U/MUC) / (?U/MUF) (MUF/MUC)
?C
?C
?C
U0
food
?F1
?F2
?F0
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Diminishing Marginal UtilityAs Clothing
decreases, takes increasing amounts of food to
leave utility unchanged
clothing
MRS -slope (MUF / MUC)
Along an indifference curve, As C decreases and
F increases, MUF decreases and MUC
increases Slope decreases in absolute value
?C
?C
?C
U0
food
?F1
?F2
?F0
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Application Relationship between risk (or
safety) and expected return in investments
Avg Return
U0
Safety of Investment
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(No Transcript)
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Sources The Economist, World Bank
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In Class Challenge
Average Return

• What would an indifference curve look like in
  risk return space if the individual is risk
  averse?
• What would an indifference curve look like for
  someone who is risk neutral? Risk loving?

Risk