A primer on Consumer Choice Finding the optimal choice

1. A primer on • Consumer Choice • Finding the optimal choice Lecture 12

2. Constrained consumer choice • The consumer will want to choose the best bundle within her opportunity set • Nothing lying beyond the budget constraint is reachable • We can always find something better that what lies inside the budget constraint... Lecture 12

3. Figure 4.08a Consumer Maximization Lecture 12

4. Constrained consumer choice • We want to choose a bundle that lies at the tangency of the budget constraint and the indifference curve Lecture 12

5. MRS and MRT • Marginal Rate of Substitution between pizzas and burritos: • telling us how many burritos we are willing to give up for an extra bit of pizza • and the Marginal Rate of Transformation was the ratio of prices, the slope of the budget constraint Lecture 12

6. Interior solution • The MRS = MRT between pizzas and burritos if we have an interior solution • You will make yourself best-off when you choose your bundle by making equal your, subjective, relative valuation of the goods (MRS) and the, objective, relative valuation of the goods made in the market (MRT) Lecture 12

7. Interior solution • To understand this remember that we have decreasing MRS • This means that the more pizzas we have relative to burritos, the less we value pizzas relative to burritos • By sliding along our indifference curves or along our budget constraint we would be changing our MRS • When are we going to stop? Lecture 12

8. Interior solution • Remember the ratio of prices is given (regardless of how much you slide along your indifference curves/budget constraint) • Now imagine you are currently consuming a bundle that makes your MRS pizza-burrito very high • What does it mean? • Well it must mean that according to your own taste you have relative few pizzas if compared to burritos, that makes the MRS high: you would be willing to give away many burritos for a slice of pizza! Lecture 12

9. Interior solution • So perhaps you are going to choose a bundle with more pizza and less burritos, right? • Because you seem to have now too little pizza and too many burritos to be happy, right? Go to hidden slide Go to hidden slide Lecture 12

10. Corner solution • But we can have a corner solution too • This happens when we try to follow our rule of sliding until MRS = MRT but we are stopped by one of the axes • This is because we cannot consume less than 0 pizza nor less than 0 burritos!!! Lecture 12

11. Figure 4.08b Consumer Maximization Lecture 12

12. An example • Steven is indifferent between buying books on-line or in a shop: they are the same price and quality • But then the government taxes books in the shop Lecture 12

13. Solved Problem 4.3 Initially ANY point on I2 will be the best for him After the tax, he will obviously choose to shop only on-line!…as suggested by the new budget constraint L* Lecture 12

14. Figure 4.09a Optimal Bundles on Convex Sections of Indifference Curves Lecture 12

15. Figure 4.09b Optimal Bundles on Convex Sections of Indifference Curves Lecture 12

16. Next • Deriving Demand Curves • The price-consumption curve • The income-consumption curve • The Engel curve • The effects of a price change Lecture 12