Consumer Choice

1. Consumer Choice Consumer Behavior

2. Law of Demand Reviewed • Common Sense • High Price discourages customers from buying • Low Price encourages customers to buy • Consumer Behavior is reflected in the Demand Curve

3. The Income Effect • The change in the price of a product will have effects on…. • Consumer’s real income • The quantity demanded of that product • When the price of a good declines, people will have more money to spend • My son’s allowance: $20 per week • He drinks 8 Monsters a week at $2.50 • If price of monsters were to decrease to $2.00 • He would have $4.00 Extra! • He can either purchase more Monsters or other goods

4. Substitution Effect • This is the impact that a change in product’s price has on its relative expensiveness and on the quantity demanded • When price of a product falls, that product is now cheaper relative to other products • If Monster falls from $2.50 to $2.00, it becomes a better buy • Lower price induces my son to substitute Monsters for other caffeinated drinks • He will buy More of it

5. Law of Diminishing Marginal Utility • Mankiw’s Priniciple #3: Rational People Think at the Margin • Margin—an incremental adjustment • What is the benefit of the next item consumed? • What is the cost of the next item consumed? • Utility • Want satisfying power • Marginal Utility is the extra satisfaction that a person derives from an additional consumption of one more item

6. Example: Diminishing Marginal Utiity

8. Vending Machines Soda Machines Newspaper Box

9. Indifference Curve Analysis • Consumer behavior and equilibrium is based on: • Budget Lines • Indifference Curves

10. Budget Line • Technical Constraint • Schedule or curve that shows various combinations of two products a consumer can purchase with specific income

11. Budget Line: Combinations of Monster and Snickers Bars (Income of $20)

12. Budget Line Monsters Snickers

13. Budget Line • Two (2) things can cause the budget line to shift • Income Changes • Increase in income will shift the curve to the left • Price Changes • Decreases in the price of both items will shift the curve to the left • Change in price relative to the other will cause change in slope

14. Indifference Curves • Subjective • An indifference curve shows all the combinations of two products (A and B) that will yield the same total satisfaction or total utility to a consumer

15. Indifference Schedule

16. Indifference Curve Schedule Snickers j Monsters

17. Indifference Curve Characteristics • Convex to origin • Slope at each point measures Marginal Rate of Substitution • Rate at which consumer will substitute one good for the other in order to remain equally satisfied. • As the amount of Monsters increases, its marginal utility decreases • As the amount of Snickers decreases, its marginal utility increases

18. A Group of Indifference Curves

19. Indifference Map • Curves farther from origin indicate higher levels of total utility • Curves closer to origin represent less total utility

20. Indifference Curves and Budget Constraints • The best combination is the point where the indifference curve and the budget line are tangent.

21. Indifference Curves and Budget Constraints

22. Deriving a Demand Curve from the Indifference Curve • Demand is the quantity of a good that a person will buy at various prices.

23. Deriving a Demand Curve from the Indifference Curve • By varying the price of one of the goods while holding the price of other constant, the points of tangency will change. • This gives alternative price/quantity combinations.

24. Deriving a Demand Curve from the Indifference Curve

25. Concluding Remarks • Does everyone think this way? • As Mankiw points out: No • Consumer behavior is a model

26. Revenues and Profits A brief overview

27. Revenue • Total Income from sales

28. Revenue S P D Q REVENUE = PRICE X QUANTITY

29. Costs • Fixed Costs • Incurred no matter what the output is • RENT • VEHICLES • EQUIPMENT • Variable Costs • Costs which vary per with output • LABOR • UTILITIES • FUEL CONSUMPTION

30. TOTAL COSTS • TOTAL COST = FIXED + VARIABLE

31. ACCOUNTING PROFIT • Very Simple • PROFIT = Revenue – Total Cost

32. Economic Profit • Takes into account Explicit Costs (like an accountant) • Also takes into account Implicit Costs • Opportunity Cost

33. Economic Profit vs Accounting Profit Economist Accountant Implicit Costs Economic Profit Accounting Profit Explicit Costs Explicit Costs

34. Opportunity Cost • A firm’s implicit costs are the opportunity costs of using its self-owned, self employed resources. • To the firm, opportunity costs are the money payments that self employed resources could have earned in their best alternative use

35. Economic Profit Example • You are earning $22,000 per year as a salesperson at the Gap • You decide to open up your own store! • You have saved up $20,000 in CDs that were paying 5% per year • Use that $20K as a down-payment/initial investment on your new store • New store’s lease is $5K per year • You hire clerk to help out and give her $18K annually

36. End of Your 1st Year! Looks Good…..right????

37. Your Economic Profit????

38. Economic Profit • Economic Profit is not a cost, because it is a return in excess of the normal profit that is required to retain the entrepreneur • Even if the Economic Profit is zero, the entrepreneur is still covering all explicit and implicit costs, including a normal profit. • In our example, as long as accounting profit is $33,000 or more, you will continue to operate

39. Questions??