Microeconomics and Finance Solvay Business School 08/09 Julio DAVILA. Solvay Business School Université Libre de Bruxelles
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1 Microeconomics and Finance Solvay Business School 08/09 Julio DAVILA 1
2 Microeconomics and Finance Textbook: Microéconomie, Pindyck & Rubinfeld Prentice Hall, 6th ed. Part 1 : Demand Part 2 : Introduction to finance Part 3 : Supply Part 4 : Competitive equilibrium Part 5 : Non-competitive markets 2
3 Microeconomics and Finance Teaching Assistant: Ritha Sukadi Office hours: by appointment ( Ritha) Slides: 3
4 Consumer behavior Microéconomie, chapter 3 4
5 Consumer behavior Consumer behavior theory explains how the consumer chooses to spend his income in different goods and services 5
6 Consumer behavior The consumer s choice depends on: his preferences They describe how the consumer ranks different bundles of goods or commodities his budget constraint The consumer has limited resources the optimization of his preferences given his budget constraint The consumer seeks to maximize the «utility» he derives from consumption given his resources 6
7 Consumer preferences Assumptions 1. his preferences are complete he is able to rank any two bundles of goods 2. his preferences are transitive if he prefers A to B, and B to C, then he must prefer A to C 3. his preferences are monotone he always prefers more to less 7
8 Consumer preferences Preferences can be represented graphically by means of indifference curves An indifference curve contains all the bundles of goods that satisfy equally the consumer He is indifferent between any of two them 8
9 Indifference curves: example bundles food clothes A B D E G H
10 Indifference curves: example The assumptions on preferences translate into graphical properties of the indifference curves 10
11 Indifference curves: example clothes B H E A is preferred to any bundle in the yellow box, but any bundle in the pink box is preferred to A. 30 A G D food 11
12 Indifference curves: example The indifference curve through A cannot intersect the areas to the NE and SW of point A It must be contained in the areas to the NW and SE of point A Conclusion: indifference curves must be decreasing Otherwise they are not monotone: The consumer would be indifferent to a bundle having less of both goods!!! 12
13 Indifference curves: example clothes H B A E B, A, and D are indifferent E is preferred to any bundle in U 1 Any bundle in U 1 is preferred to H and G 20 G D U food 13
14 Indifference curves Bundles to the NE of an indifference curve are preferred to those on the curve Bundles on the curve are preferred to those to the SW of the indifference curve 14
15 Indifference curves Indifference curves cannot cross Crossings are incompatible with monotonicity 15
16 Indifference curves clothes U 2 U 1 A and B are indifferent A and C are indifferent B and C should be indifferent but B is preferred to C!! A B C U 1 U 2 food 16
17 Indifference curves Through every bundle goes an indifference curve A consequence of preferences being complete 17
18 Indifference curves clothes C B A Through every bundle goes just one indifference curve A is preferred to B, and B to C. U 3 U 2 U 1 food 18
19 Indifference curves The shape of indifference curves conveys the consumer willingness to trade one good for the other good 19
20 Indifference curves clothes 16 A B -1 2 C -1 1 D -1 the number of clothes required to compensate for the loss of one unit of food increases from 1 to 6 E food 20
21 Indifference curves The shape of indifference curves conveys the consumer willingness to trade one good for the other e.g., from A to B, 6 units of clothes for 1 unit of food but from C to D, only 2 units of clothes for 1 unit of food The more clothes one has, the more one is ready to trade clothes for food 21
22 Indifference curves The consumer willingness to trade goods is measured by his marginal rate of substitution (MRS) It provides the amount of a good that he is ready to trade for one more unit of the other good It is given by the slope of the indifference curve 22
23 Marginal rate of substitution clothes A MRS = 6 MRS = Δc Δf 10 B MRS = 2 C D 4 E food 23
24 Marginal rate of substitution Indifference curves are convex The more one consumes of a good, the less one is ready to give up other goods to increase additionally its consumption Consumers usually do prefer balanced bundles 24
25 Marginal rate of substitution clothes 40 The bundles between A and B are preferred to these two 30 A B U 1 food 25
26 Marginal rate of substitution Decreasing marginal rate of substitution The MRS decreases along the indifference curve In the example, the MRS goes down from 6 to 4, then to 2, and finally to 1 26
27 Marginal rate of substitution different shapes for an indifference curve represent different attitudes to substituting one good for another Special cases: Perfect substitutes Perfect complements 27
28 Marginal rate of substitution Perfect substitutes The MRS is constant Example: some may consider orange juice and apple juice perfect substitutes They would always be ready to exchange 1 glass of orange juice for 1 glass of apple juice 28
29 Consumer preferences Orange juice 4 3 Perfect substitutes Apple juice 29
30 Consumer preferences Perfect complements The indifference curbes are L-shaped Example: left and right shoes are used in pairs (additional units of, say, just left shoes leave us indifferent) 30
31 Consumer preferences Left shoes 4 Perfect complements Right shoes 31
32 Consumer preferences Explaining the consumer behavior does not require an index measuring the consumer s satisfaction A ranking suffices, but utility indexes are useful, mainly to represent attitudes towards risk 32
33 Consumer preferences Utility A numerical value representing the level of satisfaction derived from consuming a particular bundle of goods 33
34 Utility Utility function A formula assigning a utility level to each bundle of goods Example 1: given the utility function U(f,c) = f + 2c the bundle (8 units of food, 3 units of clothes) provides a utility 14 = 8 + 2x3 34
35 Utility Example 1 bundles food clothes utility A x3 = 14 B x4 = 14 C x4 = 12 The consumer is indifferent between A and B but prefers both to C 35
36 Utility Example 2 clothes 15 bundle U = f x c A 25 = 2,5 x 10 B 25 = 5 x 5 C 25 = 10 x 2,5 10 A B 5 C U 3 = 100 U 2 = 50 U 1 = 25 food 36
37 Utility Ordinal utility function Ranks bundles from less to more preferred but does not convey any sense of intensity of preferences Cardinal utility function It describes how much more is a bundle preferred to another 37
38 Utility An ordinal utility sufices to explain most individual decisions A cardinal ranking is needed to explain decisions under uncertainty and risk 38
39 The budget constraint Preferences alone do not explain consumers choices The budget constraint limits the consumer s decisions 39
40 The budget constraint The budget line It contains all the bundles of goods whose cost equals the consumer s income or wealth 40
41 The budget line If f is the amount of food purchased c is the amount of clothes, P f is the price for food, P c is the price for clothes then P f f is the expenditure in food, and P c c is the expenditure in clothes P f f + P c c is the total expenditure 41
42 The budget line The equation of the budget line is: P f f + P c c = I It says that the entire income is spent either on food or clothes 42
43 The budget constraint bundles food clothes P f = 1 P c = 2 income I = P f f + P c c A B C D E
44 The budget line clothes I/P c = A B C slope = - Δc Δf D = I/P f E = = - Pf P c food 44
45 The budget line Along the budget line any increase in the consumption of a good implies a decrease in the consumption of the other good The slope the negative of the ratio of the goods prices The slope is the rate at which goods can be substituted between them without changing the cost of the bundle The slope measures also the relative price of one good in terms of the other 45
46 The budget line P f f + P c c = I c = I P c P f f P c 46
47 The budget line The intersection I/P c with the vertical axis is the maximum quantity of clothes c that can be purchased with an income I The interection I/P f with the horizontal axis is the maxmum quantity of food f that can be purchased with an income I 47
48 The budget line clothes I/P c = A B C slope = Δc Δf D = I/P f E = = - Pf P c food 48
49 The budget line Income and prices can change Changes in prices and income shift the budget line Shifts in the budget line change the consumer s choice 49
50 The budget line clothes 80 An increase of income shifts the budget line outwards An decrease of income shifts the budget line inwards 20 0 D 3 I = D 1 I = D 2 I = 160 food 50
51 The budget line Impact of a change in income: An increase in income shifts outwards the budget line (keeping the slope constant) With the additional income one can buy more of both goods 51
52 The budget line Impact of a change in income: A decrease in income shifts inwards the budget line (keeping the slope constant) One cannot buy as much as before with the smaller income 52
53 The budget line clothes A decrease in the price of food to 0,50 makes the budget line pivot outwards around An increase in the price of food to 2 makes the budget line pivot inwards around 40 D 2 D 1 D 3 P f = 2 40 P f = 1 P f = 0, food 53
54 The budget line Impact of changes in prices: If the price of a good increases, the budget line pivots inwards around its crossing with the axis of the other good e.g. if the price of food increases: If the consumer only buys food he cannot buy as much as before (the intersection with the axis of food shifts leftwards) If the consumer only buys clothes he can still by the same amount (the intersection with the axis of clothes stays put) 54
55 The budget line Impact of changes in prices: If the price of a good decreases, the budget line pivots outwards around its crossing with the axis of the other good e.g. if the price of food decreases: If the consumer only buys food he can buy even more than before (the intersection with the axis of food shifts rightwards) If the consumer only buys clothes he can still by the same amount (the intersection with the axis of clothes stays put) 55
56 The budget line Impact of changes in prices: If all prices increase in the same proportion, then the slope does not change The budget line shifts inwards 56
57 The budget line Impact of changes in prices: If all prices decrease in the same proportion, then the slope does not change The budget line shifts outwards 57
58 Consumer s choice Given his preferences and budget constraint, how does the consumer choose a bundle of goods? The consumer chooses the bundle on the budget line that maximizes his utility 58
59 Consumer s choice The consumer s choice: 1. is on the budget line The consumer spends all his income (since his preferences are monotone) 2. gives the consumer his most preferred bundle on the budget line 59
60 Consumer s choice Graphically, the consumer tries to reach the highest indifference curve on his budget line 60
61 Consumer s choice clothes 40 B 30 D D give a higher utility than A, but it is too expensive B and C are affordable, but they are less preferred than A A gives the highest attainable utility A is the consumer s choice 20 A U C U 1 food U 2 61
62 Consumer s choice Graphically, the consumer tries to reach the highest indifference curve on his budget line The highest attainable indifference curve is tangent to the budget line The slope of the budget line is equal to the slope of the indifference curve at the consumer s choice 62
63 Consumer s choice The slope of an indifference curve is: slope IC = MRS the slope of the budget line is: slope BL = Pf Pc 63
64 Consumer s choice therefore, at the consumer s chosen bundle: MRS = Pf Pc 64
65 Consumer s choice Utility is maximized on the budget line when the marginal rate of substitution is equal to the relative price This happens ONLY at the optimal consumption bundle 65
66 Consumer s choice clothes B bundle B does not maximize the utility since the MRS = -(-10/10) = 1 Is bigger than the relative price = 1/2-10c f U food 66
67 Consumer s choice If MRS P f /P c the consumer can increase his utility spending his income differently If MRS > P f /P c He will increase his consumption of food and decrease his consumption of clothes until MRS = P f / P c holds If MRS < P f /P c He will decrease his consumption of food and increase his consumption of clothes until MRS = P f /P c holds 67
68 Consumer s choice clothes B D at B the MRS> P f /P c and the utility increases as more food and less clothes are consumed at C the MRS< P f /P c and the utility increases as less food and more clothes are consumed 20 A U C U 1 food U 2 68
69 Consumer s choice A corner solution happens when the consumer does not buy one of the goods In that case MRS needs not be equal to the relative price P f /P c 69
70 Corner solution clothes A U 1 U 2 U 3 bundle B is a corner solution B food 70
71 Corner solution At bundle B, the MRS of clothes for food is bigger than the slope of the budget line The consumer would like to give up clothes in exchange for additional food But he has no more clothes to exchage 71
72 Corner solution When the optimal choice is located at the border of the budget constraint, the MRS needs not be equal to the relative price In this case: MRS P f P c 72
73 Corner solution When the MRS is much bigger than the the relative price, a small change in the price for clothes will have no impact on the consumer s choice 73
74 Revealed preferences If the consumer s choices before many different prices and incomes are known, then the consumer preferences can be recovered 74
75 Revealed prices clothes D 2 D 1 A D 1 : chooses A instead of B A is revealed preferred to B D 2 : chooses B instead of C B is revealed preferred to C B C food 75
76 Revealed preferences clothes D 1 D 2 All pink bundles are preferred to A. A A is preferred to any yellow bundle B C food 76
77 Revealed preferences As the budget line changes, the consumer s choice changes The more the consumer reveals his choices, the more his preferences can be identified In the limit, the indifference curves can be obtained 77
78 Revealed preferences clothes L 3 L 1 L 3 : C is revealed preferred to A C All pink bundles are Preferred to A L 4 A L 2 A is preferred to any yellow bundle B D L 4 : D reveled preferred to A L 2 : A revealed preferred to B food 78
79 Marginal utility and the consumer s choice Marginal utility mesures the additional satisfaction from the consumption of one more unit of a good How much happier is a consumer due to an additional unit of food? 79
80 Marginal utility - example Let 9 be the marginal utility from increasing the consumption of food from 0 to 1 units from 1 to 2, let the marginal utility be 7 from 2 to 3, let the marginal utility be 5 remark: marginal utility decreases as consumption increases 80
81 Marginal utility Principle decreasing marginal utility: the more a good is consumed, the smaller the marginal utility of an additional unit of the good Total utility increases monotonically nonetheless, since preferences are monotone 81
82 Marginal utility and the consumer s choice Along an indifference curve: The increase in utility from the additional consumption of a good must compensate for the decrease of utility from the smaller consumption of the other good 82
83 Marginal utility and the consumer s choice formally: 0 = MgUf Δf + MgUc Δc Total utility does not change along the indifference curve. The compensation leaves the consumer indifferent. 83
84 Marginal utility and the consumer s choice That is to say: and since then Δc Δf = MgU f MgU c MRS = Δc Δf MRS = MgU f MgU c 84
85 Marginal utility and the consumer s choice When the consumer maximizes his utility: MRS = P f P c Since the MRS equals also the ratio of marginal utilities from consuming f et c MgU f MgU c = P f P c 85
86 Marginal utility and the consumer s choice Condition for the utility maximization: MgU f P f = MgU c P c 86
87 Marginal utility and the consumer s choice Equal marginal utilities principle: utility is maximized only if the marginal utility from spending an additional euro is the same for both goods 87
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