Part 2 Chapter 5 Economic Principles summary Lecture 5 week 3

The Standard Economic Model of Consumer Behaviour:

 The law of demand states that as the price of a good increases, demand for
that good will decrease. In reality, this is the consequence of a complicated
decision-making process that involves many trade-offs and other
considerations.

 The Standard Economic Model of Consumer Behaviour asks: “Given the

almost unlimited assortment of goods and services that one can buy, how do
consumers decide what they want to purchase?” The factors in this decision
are:
- Market prices
- Income
- Preferences
 The model yields a number of important insights, including:
- Where does the demand curve come from? Does it always slope
downwards?
- What effect do taxes have on decision making?
- What is the best way for the government to redistribute income?

 The standard economic model assumes that consumers behave:

- Rationally
- More is preferred to less
- Consumers are selfish and do not care about the utility of others
- Consumers seek to maximise their utility
 The term utility refers to some personal measure of satisfaction that is
derived from consuming a certain quantity of a product.
 Utility is an abstract concept and it is measured on an ordinal scale.
 For ordinal scales, the ordering is all that matters. This is opposed to a
cardinal scale where both the ordering and the magnitude matter:
- “Prefer PlayStation over Xbox” is an ordinal ranking.
- “Prefer PlayStation 10 times more than Xbox” is a cardinal ranking

The Budget Constraint:

 Which products and how much should you buy?  Constrained by budget
 How much in combination is constrained by your income.
 A bundle is a combination of goods and services that the consumer might
purchase. For example, 8 of A and 2 of B, or 3 of A and 12 of B. The next will
be to identify which affordable bundle is most preferred.
(Remember we assume consumer prefer more over less)
 Which of the bundles can the consumer afford? Depends on income and price

 Assume that:
- The consumer’s weekly income is: Income=£ 40
- The price of one good A is: P A =£ 5
- The price of one good B is: PB =£ 4

 If the consumer spends all £40 on A, 8 of good A could be purchased.

 If the consumer spends all £40 on B, 10 of good B could be purchased.
 Of course, the consumer could split it up:
- If £20 is spent on A and £20 is spent on B, the consumer can purchase 4
of good A and 5 of good B.

(Good A = Hot Dogs, and good B = Hamburgers)

 The budget constraint (red line) shows all combinations of Hot Dogs and
Hamburgers that can be purchased if all the money is spent.

- Bundle A and C is affordable, Bundle B does not use all the money, and
Bundle D is too expensive given prices and the consumer’s income.
 The slope of the budget constraint measures the rate at which the consumer
can trade one good for another.
If the consumer buys 1 more Hot Dog, how many burgers does he give up?
If the consumer buys 1 more burger, how many hot dogs does he give up?

 The slope of the budget constraint (rise over run) is simply the negative price
ratio. It is the price of the good on the horizontal axis divided by the price of
the good on the vertical axis:
P Ham 4
= =0.8
P Hot 5

 The opportunity cost of consuming one more burger (horizontal axis) is 4/5 of
a hot dog.
 The opportunity cost of consuming one more hot dog (vertical axis) is 5/4 of a
burger.

 Consider change in income: we used to have £40, now we have £60.

- Before you could buy 8 of good A (hot dog), and now you can buy 12.
- Before you could buy 10 of good B (burger), and now you can buy 15.
 The budget line will shift out following an increase in income. The slope
remains the same because the price ratio remains the same.
 Consider the change in price: Good B (burger) goes from £4 to £8, but good
A (hot dog) remains the same.
 The horizontal intercept (which shows the max number of burgers that can be
consumed) will shift from 10 to 5.
 The vertical intercept doesn’t change.
 The price ratio (which determines the slope) will increase from 4/5 to 8/5.
 The consumer’s choice set has become smaller
Example: Transfer in Cash or Transfer in Kind

 Nearly every country in the world transfers some wealth to the poor. Broadly
speaking, there are two ways to provide such transfers.
 First, wealth can be transferred kind. For example:
- Food stamps
- Subsidized housing
- Education vouchers
 Second, wealth can be transferred “in cash”.

Application:
Consumer has £40, price of burger is £4, and price of hot dog is £5.
Consider the following options:
1. The government provides an individual with 5 burgers. At £4 that’s worth £20
2. The government provides and individual with £20 of cash

Both transfers are worth £20, but which individual is better off?

 The first transfer will shift consumer’s budget from red line, to blue line.
 If the consumer spends all of their money on hot dogs, they will have 8 hot
dogs and 5 burgers.
- The 5 burgers are provided by the government for free.
 If the consumer spends all their money on burgers, they will have 15 burgers.
- 10 burgers bought, and 5 provided by government for free.
  The cash transfer provides the consumer with strictly larger choice set.
 For this reason, transfer in cash are generally better than equivalent in kind.
(However, government often give in-kind transfers because we don’t know
where the money will be spent)

Indifference Curves:

 The budget constraint shows all of the affordable bundler, but which of the
affordable bundles will the consumer choose?
- It depends on the consumer’s preferences. Remember, preferences are
represented by utility.
 If Bundle A provides the consumer with higher utility than Bundle B, then
Bundle A is preferred to Bundle B. The consumer will purchase A over B if
both bundles are affordable.
 Its easiest to represent consumer preferences using indifference curves.
 An indifference curve is a curve which shows all bundles that give the
consumer the same level of utility.
 (There should be a Z axis representing the utility level)
 The slope of the indifference curve is related to the marginal rate of
substitution.
 The marginal rate of substitution is the number of hot dogs (goods on vertical
axis) that the consumer is willing to give up to get one more hamburger (good
on horizontal axis) holding utility constant.
 From point A to B the consumer gives up 10 hot dogs to get 4 more burgers.
 From point B to C the consumer gives up 2 hot dogs to get 9 burgers.

 Notice the marginal rate of substitution is not constant.

- When consumers has a lot of hot dogs and few burgers, they are willing to
give up many hot dogs in exchange for one burger.
- When they have many burgers, they are willing to give up many burgers
for one hot dog.
 This is driven by the concept of diminishing marginal utility. (Marginal refers to
an incremental change, remember?)
 Holding constant burgers, each additional hot dog provides less utility than the
last. For example, single hot dog is very valuable to a consumer with only
burgers.
 Important axioms (rules) of consumer preferences.
1. Axiom of Comparison: The consumer is able to compare any two
bundles. The consumer can state that A is preferred to B, B is preferred to
A, or that they are indifferent between the two.
2. Axiom of Transitivity: If Bundle A is preferred to Bundle B and Bundle B
is preferred to Bundle C, the Bundle A must be preferred to Bundle C.
- This means that preferences are logically consistent.

 Based on these axioms, and on the assumptions presented earlier in the

lecture we can summarise 4 properties of indifference curves that reflect
typical rational consumer preferences.
Property 5: The indifference curve cannot be thick enough to have two points within
the line.

The Optimal Choice:

 We still use the same example as previously with hot dogs and hamburger.
The constrains are £40 income, £5 for a hot dog, and £4 for a burger.

 The slope of the budget constraint is given by the price ratio. If the price of a
hot dog is £4 and the price of a hamburger is £5, the price ratio is:

P Ham 4
=
P Hot 5

 The slope of the indifference curve is the marginal rate of substitution, which
is given by the ratio of marginal utilities.

MU Ham
MU Hot

 We now know which bundles the consumer can afford and the consumer’s
preferences. From this, we can identify the optimal bundle that the consumer
will purchase.

 A rational consumer will choose

the affordable bundle that gives
highest utility. This model
assumes the consumer spends all
of their income.
 If we suppose the consumer
chooses to purchase Bundle A (as
depicted), is the consumer’s utility
maximised?
 No, it’s not. Higher indifference curves represent higher levels of utility. The
consumer can be made better off by consuming fewer hot dogs and more
burgers. Looking at Bundle B, it provides the consumer with higher level of
utility than Bundle A (higher indifference curve). The remaining question is if
we can do better?

 Yes, the consumer can choose Bundle C, which maximises utility as it is

tangent with the indifference curve at this point. The consumer maximises
their preferences, income, and price.
 As we’ve said earlier, the slope of the budget constraint is given by the price
ratio and the slope of the indifference curve is given by the marginal rate of
substitution.
 Therefore, at the optimal point, the equation is:
MU Ham P Ham
=
MU Hot PHot

 We can rearrange this into:

MU Ham MU Hot
=
PHam P Hot

MU Ham
is the “bang for your buck” from hamburger consumption. It describes
PHam
the extra utility per £ that can be earned by eating one more burger.

MU Ham MU Hot
If the current consumption bundle is greater than , you are not
PHam PHot
maximising utility.
Burgers give more “bang for buck”, and you can be made better off by
consuming fewer hot dogs and more burgers.
 Only when these expressions are equal it is no longer possible to be
made any better off.

 Given the consumers income and market prices the best bundle is C.
 But what if the income changes. Say we go from £40 to £60.
- Remember, nothing changes in the slope of the budget line because the
price ratio is unchanged.
 The new optimal bundle (Bundle D) once again occurs where the two curves
are tangent.
 But this is only the case when we assume the two goods are normal goods.

 A good is considered normal when the consumer purchases more of it as

income increases and it’s considered inferior if you buy less of it when
income increases.
 If burgers were and inferior good and hot dogs a normal good, the increase in
income would cause the consumer to buy more hot dogs and fewer burgers.

 The income expansion path summarises how a rational consumer responds

to income changes. The income expansion path is a curve which connects all
optimal bundles for different levels of income.

 If both goods are normal, the income expansion path is upward sloping (left
diagram). If one good is inferior, the income expansion path is downward
sloping. The income expansion path is represented by the blue line.
 The Engel curve shows the
relationship between the quantity of a
good consumed and income. It is
similar to the demand curve, except
income is on the vertical axis instead of
price.
(Notice that on the Engel curve, the y-
axis is of income and only relates to 1
good at the time.)

 What would it look like if hamburgers

were an inferior good?

Answer: if hamburger is an inferior

good the Engel curve will be
downward sloping because when
you earn more you will move away
from hamburgers. (Point D more to
the left than Point C, causing a
downward sloping)

 What happens when there is a change in price?

 Assuming that income is £40, and hamburgers drop from £4 to £2 per unit.
Before, the consumer could buy up to 10 burgers. Now they can buy 20.
What is the slope of the new budget constraint?

 The optimal choice is no longer C. After the price change, D is the optimal
choice.

 Similar to the income expansion path, the price consumption curve is a

curve which shows the optimal bundles as the price of one good changes.
 The price consumption curve is depicted as the orange line below:
  It’s very easy to use this to
derive the demand curve.

 To derive the demand

curve, we need to know
how the optimal
consumption of one good
changes as the price
changes. The demand
curve for hamburgers is
depicted to the right, and it
shows the utility-maximising
number of hamburgers for
different prices.
(Notice how this is the
same as the normal
demand curve for one
good.)

Income and Substitution Effect:

 This effect is used to analyse price change in more detail.

 The effect of a price change can be broken down into two separate effects.
These are the income effect and the substitution effect.

Total Effect of Price Change=Income Effect + Substitution Effect

 In the case of normal goods, the income and substitution effect work in the
same direction.
 In the case of inferior goods, the income and substitution effect work in
opposite directions.
 When the price of hamburgers decreases, two things happen that will affect
how many hamburgers you wish to buy.
1. Hamburgers become relatively cheaper. The price ration (burger price
divided by hot dog price) will change. Because hamburger are relatively
cheaper and hot dogs are relatively more expensive, consumers will
naturally substitute towards the cheaper good. That’s the substitution
effect. The optimal bundle changes because the price ratio has changed.
The substitution effect always works in this direction. Consumers always
tend to consume more of the cheaper good.
2. When the price of burgers falls, the consumer’s purchasing power
increases. Some money that was once spent on burgers is now freed up.
It’s as if income has increased. Because the consumer’s purchasing power
has changed, the optimal consumption bundle will also change. This is
called the income effect. The optimal bundle changes because
purchasing power (effective income) had changed. The direction of the
income effect will depend on whether burgers are normal or inferior good.

 If burgers are an inferior good, increase in effective income will cause the
consumer to purchase fewer burgers.
 If burgers are a normal good, the increase in effective income will cause the
consumer to purchase more burgers.
 When combining the two effects after a price decrease, burger consumption
will unambiguously decrease if burgers are a normal good.
- Substitution effect increases burger consumption (decrease if price rise)
- Income effect increases burger consumption (decrease if price rise)
 When combining the two effects after a price decrease, it is not clear what will
happen to burger consumption if burgers are an inferior good.
- Substitution effect increases burger consumption
- Income effect decreases burger consumption
- Total effect depends on which effect is stronger.

 Something strange here is that a price decrease can result in decrease in

quantity demanded. This violates the law of demand (demand curve would
slope upwards)! Goods that violate the
law of demand like this is known as
Giffen goods. Burgers would be
considered a Giffen good this diagram.
That is because the optimal quantity of
burgers has fallen after a decrease in
price.
(While Giffen goods exist in theory,
they are extremely rare in reality and
there is only limited evidence of their
existence).
Examples of Giffen goods are potatoes
during the Irish Potato famine (where
there was a shortage of potatoes), but it’s still doubted be modern
economists.
  Another example is Jensen and Miller paper, studying consumption behaviour
in poor households in China. They provided subsidies for rice and wheat flour,
and as they lowered the price for the households, they found that the
quantity of wheat and rice that was bought actually fell, indicating the
Giffen good states. This was because the price reduction freed up a lot of
income, which was used to purchase more desirable foods.

Are Consumers Rational?

 The standard economic model is a great starting point for understanding

consumer behaviour. Like all models, it relies on several assumptions, among
which are that consumers are fully rational.
Do consumers make well-thought-out and logical consistent decisions that
maximise their utility?
Economists conduct expiriments on rationality often, and in UoE there is an
organisation called “BLUE” (Beahaviour Laboratory at the Uni of Edi).

 It is there and several other places proven that consumers are never fully
rational, and it highly depends on the individual.
 Unlike the assumptions of SEM, humans make systematic and consistent
mistakes in decision making:
- Overconfidence
- Give too much weight to a small number of vivid observations
- They are reluctant to change their minds
- Have natural tendency to look for examples which confirm their existing
views or hypothesis.
- People use rules of thumb – Heuristics
 Anchoring – use a starting point and adjust thereafter. Internal anchor
is that you use assumptions to start guessing. External anchor is
assessing if something is true or false based on external value.
 Availability heuristic – because something can happen, you assume
it will happen. (I.e. terrorist attacks)
 Representativeness heuristic – certain traits judge how likely we
think an occurrence will be even though it is unlikely.
 Persuasion heuristic – if many people like something, more people
will join them.
 Simulation heuristic – you visualise the effect of the product while the
true effect is different.
 Expected utility theory and framing effects – we rank products and
frame them based on how likely it is it will redeem a favourable result.