Theory of Consumer Choice and Frontiers of Microeconomics

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Theory of Consumer Choice and Frontiers of Microeconomics

Purpose of Assignment

Week 5 exposes students to subjects that are intended to whet their appetites for further study in economics. Students will use the theory of consumer choice and the impact of the concepts of asymmetric information, political economy, and behavior economics, to describe how consumers make economic decisions.

Assignment Steps

Scenario: You have been asked to assist your organization's marketing department to better understand how consumers make economic decisions.

Write a 1,050-word analysis including the following:

  • The impact the theory of consumer choice has on:
    • Demand curves
    • Higher wages
    • Higher interest rates
  • The role asymmetric information has in many economic transactions.
  • The Condorcet Paradox and Arrow's Impossibility Theorem in the political economy.
  • People are not rational in behavior economics.

Cite a minimum of three peer-reviewed sources not including your textbook.

Format your paper consistent with APA guidelines.

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Page 1 of 43 PRINTED BY: honeybun58@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. CHAPTER 21 The Theory of Consumer Choice https://jigsaw.vitalsource.com/api/v0/books/9781305892811/print?from=43... 5/15/2017 Page 2 of 43 hen you walk into a store, you are confronted with thousands of goods that you might buy. Because your financial resources are limited, however, you cannot buy everything that you want. You therefore consider the prices of the various goods offered for sale and buy a bundle of goods that, given your resources, best suits your needs and desires. W In this chapter, we develop a theory that describes how consumers make decisions about what to buy. Thus far in this book, we have summarized consumers' decisions with the demand curve. As we have seen, the demand curve for a good reflects consumers' willingness to pay for it. When the price of a good rises, consumers are willing to pay for fewer units, so the quantity demanded falls. We now look more deeply at the decisions that lie behind the demand curve. The theory of consumer choice presented in this chapter provides a more https://jigsaw.vitalsource.com/api/v0/books/9781305892811/print?from=43... 5/15/2017 Page 3 of 43 complete understanding of demand, just as the theory of the competitive firm in Chapter 14 provides a more complete understanding of supply. PRINTED BY: honeybun58@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. One of the Ten Principles of Economics discussed in Chapter 1 is that people face trade-offs. The theory of consumer choice examines the trade-offs that people face in their role as consumers. When a consumer buys more of one good, she can afford less of other goods. When she spends more time enjoying leisure and less time working, she has lower income and can afford less consumption. When she spends more of her income in the present and saves less of it, she must accept a lower level of consumption in the future. The theory of consumer choice examines how consumers facing these trade-offs make decisions and how they respond to changes in their environment. After developing the basic theory of consumer choice, we apply it to three questions about household decisions. In particular, we ask: • Do all demand curves slope downward? • How do wages affect labor supply? • How do interest rates affect household saving? At first, these questions might seem unrelated. But as we will see, we can use the theory of consumer choice to address each of them. 21-1 The Budget Constraint: What the Consumer Can Afford Most people would like to increase the quantity or quality of the goods they consume—to take longer vacations, drive fancier cars, or eat at better restaurants. People consume less than they desire because their spending is constrained, or limited, by their income. We begin our study of consumer choice by examining this link between income and spending. To keep things simple, we examine the decision facing a consumer who buys only two goods: pizza and Pepsi. Of course, real people buy thousands of https://jigsaw.vitalsource.com/api/v0/books/9781305892811/print?from=43... 5/15/2017 Page 4 of 43 different kinds of goods. Assuming there are only two goods greatly simplifies the problem without altering the basic insights about consumer choice. We first consider how the consumer's income constrains the amount she spends on pizza and Pepsi. Suppose the consumer has an income of $1,000 per month and she spends her entire income on pizza and Pepsi. The price of a pizza is $10, and the price of a liter of Pepsi is $2. The table in Figure 1 shows some of the many combinations of pizza and Pepsi that the consumer can buy. The first row in the table shows that if the consumer spends all her income on pizza, she can eat 100 pizzas during the month, but she would not be able to buy any Pepsi at all. The second row shows another possible consumption bundle: 90 pizzas and 50 liters of Pepsi. And so on. Each consumption bundle in the table costs exactly $1,000. The graph in Figure 1 illustrates the consumption bundles that the consumer can choose. The vertical axis measures the number of liters of Pepsi, and the horizontal axis measures the number of pizzas. Three points are marked on this figure. At point A, the consumer buys no Pepsi and consumes 100 pizzas. At point B, the consumer buys no pizza and consumes 500 liters of Pepsi. At point C, the consumer buys 50 pizzas and 250 liters of Pepsi. Point C, which is exactly at the middle of the line from A to B, is the point at which the consumer spends an equal amount ($500) on pizza and Pepsi. These are only three of the many combinations of pizza and Pepsi that the consumer can choose. All the points on the line from A to B are possible. This line, called the budget constraint, shows the consumption bundles that the consumer can afford. In this case, it shows the trade-off between pizza and Pepsi that the consumer faces. budget constraint the limit on the consumption bundles that a consumer can afford PRINTED BY: honeybun58@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. FIGURE 1 The Consumer's Budget Constraint The budget constraint shows the various bundles of goods that the consumer can buy for a given income. Here the consumer buys bundles of pizza and https://jigsaw.vitalsource.com/api/v0/books/9781305892811/print?from=43... 5/15/2017 Page 5 of 43 Pepsi. The table and graph show what the consumer can afford if her income is $1,000, the price of pizza is $10, and the price of Pepsi is $2. The slope of the budget constraint measures the rate at which the consumer can trade one good for the other. Recall that the slope between two points is calculated as the change in the vertical distance divided by the change in the horizontal distance (“rise over run”). From point A to point B, the vertical distance is 500 liters, and the horizontal distance is 100 pizzas. Thus, the slope is 5 liters per pizza. (Actually, because the budget constraint slopes downward, the slope is a negative number. But for our purposes we can ignore the minus sign.) Notice that the slope of the budget constraint equals the relative price of the two goods—the price of one good compared to the price of the other. A pizza costs five times as much as a liter of Pepsi, so the opportunity cost of a pizza is 5 liters of Pepsi. The budget constraint's slope of 5 reflects the trade-off the market is offering the consumer: 1 pizza for 5 liters of Pepsi. Quick Quiz Draw the budget constraint for a person with income of $1,000 if the price of Pepsi is $5 and the price of pizza is $10. What is the slope of this budget constraint? 21-2 Preferences: What the Consumer Wants Our goal in this chapter is to see how consumers make choices. The budget constraint is one piece of the analysis: It shows the combinations of goods the https://jigsaw.vitalsource.com/api/v0/books/9781305892811/print?from=43... 5/15/2017 Page 6 of 43 consumer can afford given her income and the prices of the goods. The consumer's PRINTED BY: honeybun58@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. choices, however, depend not only on her budget constraint but also on her preferences regarding the two goods. Therefore, the consumer's preferences are the next piece of our analysis. 21-2a Representing Preferences with Indifference Curves The consumer's preferences allow her to choose among different bundles of pizza and Pepsi. If you offer the consumer two different bundles, she chooses the bundle that best suits her tastes. If the two bundles suit her tastes equally well, we say that the consumer is indifferent between the two bundles. Just as we have represented the consumer's budget constraint graphically, we can also represent her preferences graphically. We do this with indifference curves. An indifference curve shows the various bundles of consumption that make the consumer equally happy. In this case, the indifference curves show the combinations of pizza and Pepsi with which the consumer is equally satisfied. indifference curve a curve that shows consumption bundles that give the consumer the same level of satisfaction Figure 2 shows two of the consumer's many indifference curves. The consumer is indifferent among combinations A, B, and C because they are all on the same curve. Not surprisingly, if the consumer's consumption of pizza is reduced, say, from point A to point B, consumption of Pepsi must increase to keep her equally happy. If consumption of pizza is reduced again, from point B to point C, the amount of Pepsi consumed must increase yet again. The slope at any point on an indifference curve equals the rate at which the consumer is willing to substitute one good for the other. This rate is called the marginal rate of substitution (MRS). In this case, the marginal rate of substitution measures how much Pepsi the consumer requires to be compensated for a one-unit reduction in pizza consumption. Notice that because the indifference curves are not straight lines, the marginal rate of substitution is not the same at all points on a given indifference curve. The rate at which a consumer https://jigsaw.vitalsource.com/api/v0/books/9781305892811/print?from=43... 5/15/2017 Page 7 of 43 is willing to trade one good for the other depends on the amounts of the goods she is already consuming. That is, the rate at which a consumer is willing to trade pizza for Pepsi depends on whether she is hungrier or thirstier, which in turn depends on how much pizza and Pepsi she is consuming. marginal rate of substitution the rate at which a consumer is willing to trade one good for another The consumer is equally happy at all points on any given indifference curve, but she prefers some indifference curves to others. Because she prefers more PRINTED BY: honeybun58@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. consumption to less, higher indifference curves are preferred to lower ones. In Figure 2, any point on curve I2 is preferred to any point on curve I1. FIGURE 2 The Consumer's Preferences The consumer's preferences are represented with indifference curves, which show the combinations of pizza and Pepsi that make the consumer equally satisfied. Because the consumer prefers more of a good, points on a higher indifference curve (I2 here) are preferred to points on a lower indifference curve (I1). The marginal rate of substitution (MRS) shows the rate at which the consumer is willing to trade Pepsi for pizza. It measures the quantity of Pepsi the consumer must be given in exchange for 1 pizza. https://jigsaw.vitalsource.com/api/v0/books/9781305892811/print?from=43... 5/15/2017 Page 8 of 43 A consumer's set of indifference curves gives a complete ranking of the consumer's preferences. That is, we can use the indifference curves to rank any two bundles of goods. For example, the indifference curves tell us that point D is preferred to point A because point D is on a higher indifference curve than point A. (That conclusion may be obvious, however, because point D offers the consumer both more pizza and more Pepsi.) The indifference curves also tell us that point D is preferred to point C because point D is on a higher indifference curve. Even though point D has less Pepsi than point C, it has more than enough extra pizza to make the consumer prefer it. By seeing which point is on the higher indifference curve, we can use the set of indifference curves to rank any combination of pizza and Pepsi. 21-2b Four Properties of Indifference Curves Because indifference curves represent a consumer's preferences, they have certain properties that reflect those preferences. Here we consider four properties that describe most indifference curves: • Property 1: Higher indifference curves are preferred to lower ones. People usually prefer to consume more goods rather than less. This preference for greater quantities is reflected in the indifference curves. As Figure 2 shows, higher indifference curves represent larger quantities of goods than lower indifference curves. Thus, the consumer prefers being on higher indifference curves. • Property 2: Indifference curves are downward sloping. The slope of an indifference curve reflects the rate at which the consumer is willing to substitute one good for the other. In most cases, the consumer likes both goods. Therefore, if the quantity of one good is reduced, the quantity of the other good must increase for the consumer to be equally happy. For this reason, most indifference curves slope downward. • Property 3: Indifference curves do not cross. To see why this is true, suppose that two indifference curves did cross, as in Figure 3. Then, because point A is on the same indifference curve as point B, the two points would make the consumer equally happy. In addition, because point B is on the same https://jigsaw.vitalsource.com/api/v0/books/9781305892811/print?from=43... 5/15/2017 Page 9 of 43 indifference curve as point C, these two points would make the consumer equally happy. But these conclusions imply that points A and C would also PRINTED BY: honeybun58@email.phoenix.edu. Printing is for personal, private use only. No make consumer even without though point prior C has more Violators of both partthe of this book may beequally reproducedhappy or transmitted publisher's permission. will This be prosecuted. goods. contradicts our assumption that the consumer always prefers more of both goods to less. Thus, indifference curves cannot cross. • Property 4: Indifference curves are bowed inward. The slope of an indifference curve is the marginal rate of substitution—the rate at which the consumer is willing to trade off one good for the other. The marginal rate of substitution usually depends on the amount of each good the consumer is currently consuming. In particular, because people are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little, the indifference curves are bowed inward. As an example, consider Figure 4. At point A, because the consumer has a lot of Pepsi and only a little pizza, she is very hungry but not very thirsty. To induce the consumer to give up 1 pizza, she has to be given 6 liters of Pepsi: The marginal rate of substitution is 6 liters per pizza. By contrast, at point B, the consumer has little Pepsi and a lot of pizza, so she is very thirsty but not very hungry. At this point, she would be willing to give up 1 pizza to get 1 liter of Pepsi: The marginal rate of substitution is 1 liter per pizza. Thus, the bowed shape of the indifference curve reflects the consumer's greater willingness to give up a good that she already has in large quantity. FIGURE 3 The Impossibility of Intersecting Indifference Curves A situation like this can never happen. According to these indifference curves, the consumer would be equally satisfied at points A, B, and C, even though point C has more of both goods than point A. https://jigsaw.vitalsource.com/api/v0/books/9781305892811/print?from=43... 5/15/2017 Page 10 of 43 21-2c Two Extreme Examples of Indifference Curves The shape of an indifference curve tells us about the consumer's willingness to trade one good for the other. When the goods are easy to substitute for each other, the indifference curves are less bowed; when the goods are hard to substitute, the indifference curves are very bowed. To see why this is true, let's consider the extreme cases. FIGURE 4 Bowed Indifference Curves Indifference curves are usually bowed inward. This shape implies that the marginal rate of substitution (MRS) depends on the quantity of the two goods the consumer is consuming. At point A, the consumer has little pizza and much Pepsi, so she requires a lot of extra Pepsi to induce her to give up one of the pizzas: The marginal rate of substitution is 6 liters of Pepsi per pizza. At point B, the consumer has much pizza and little Pepsi, so she requires only a little extra Pepsi to induce her to give up one of the pizzas: The marginal rate of substitution is 1 liter of Pepsi per pizza. https://jigsaw.vitalsource.com/api/v0/books/9781305892811/print?from=43... 5/15/2017 Page 11 of 43 Perfect Substitutes Suppose that someone offered you bundles of nickels and dimes. How would you rank the different bundles? PRINTED BY: honeybun58@email.phoenix.edu. Printing is for personal, private use only. No part of this book likely, may be reproduced or transmitted withoutabout publisher's permission. Violators will be Most you would care only theprior total monetary value of each prosecuted. bundle. If so, you would always be willing to trade 2 nickels for 1 dime, regardless of the number of nickels and dimes in the bundle. Your marginal rate of substitution between nickels and dimes would be a fixed number—2. We can represent your preferences over nickels and dimes with the indifference curves in panel (a) of Figure 5. Because the marginal rate of substitution is constant, the indifference curves are straight lines. In this extreme case of straight indifference curves, we say that the two goods are perfect substitutes. perfect substitutes two goods with straight-line indifference curves Perfect Complements Suppose now that someone offered you bundles of shoes. Some of the shoes fit your left foot, others your right foot. How would you rank these different bundles? In this case, you might care only about the number of pairs of shoes. In other words, you would judge a bundle based on the number of pairs you could assemble from it. A bundle of 5 left shoes and 7 right shoes yields only 5 pairs. Getting 1 more right shoe has no value if there is no left shoe to go with it. We can represent your preferences for right and left shoes with the indifference curves in panel (b) of Figure 5. In this case, a bundle with 5 left shoes and 5 right shoes is just as good as a bundle with 5 left shoes and 7 right shoes. It is also just as good as a bundle with 7 left shoes and 5 right shoes. The indifference curves, therefore, are right angles. In this extreme case of right-angle indifference curves, we say that the two goods are perfect complements. perfect complements two goods with right-angle indifference curves In the real world, of course, most goods are neither perfect substitutes (like nickels and dimes) nor perfect complements (like right shoes and left shoes). More typically, the indifference curves are bowed inward, but not so bowed that they become right angles. FIGURE 5 Perfect Substitutes and Perfect Complements When two goods are easily substitutable, such as nickels and dimes, the indifference https://jigsaw.vitalsource.com/api/v0/books/9781305892811/print?from=43... 5/15/2017 Page 12 of 43 curves are straight lines, as shown in panel (a). When two goods are strongly complementary, such as left shoes and right shoes, the indifference curves are right angles, as shown in panel (b). PRINTED BY: honeybun58@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Quick Quiz Draw some indifference curves for pizza and Pepsi. Explain the four properties of these indifference cur ...
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Professor_Markins
School: Boston College

It has been great working with you right from the start to the end. I wish you all the best in your studies.

Running head: CONSUMER CHOICES AND THEIR IMPACT

Consumer Choices and Their Impact
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CONSUMER CHOICES AND THEIR IMPACT

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Consumer Choices and Their Impact
The behavior of consumers and their decision-making process has always been a
particular interest for economists and business owners. These groups spend massive amounts of
time and resources in gathering data on their consumers to help them form policies that will be
geared towards capturing their attention and business. The average businessman can accomplish
a lot in terms of planning and overall consumer care by acquiring and interpreting consumer
data. The data being collected is often that of the market trends that looks at the consumer buying
trends of goods and their alternatives to satiate a need or want. The data are given here often
comes in the form of Supply-Demand curves which forecast the level of demand a product can
get at a certain price level, one of the curves also shows a number of supply producers are
willing and able to put in the market at certain prices. Where the Supply and Demand curves
meet is referred to as the equilibrium price where the optimum demand meets the optimum
supply. Most companies aim for this point due to the many benefits and stability it offers.
Consumer choice making is influenced by many factors and is irregular and at times
impromptu. Its st...

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awesome work thanks

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