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Hall and Lieberman, 3rd edition,


Thomson South-Western, Chapter 5
r  
x ou will learn from this chapter
1. Budget constraint, interpretation
of its slope and components
ë. Marginal utility and the law of
diminishing marginal utility
3. Assumptions economists make
about preferences
4. Utility maximization and the
solution derivation logic
ë
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x ou are constantly making economic decisions
x At the highest level of generality, we are all very
much alike
² Come up against the same constraints
Too little income or wealth
Too little time to enjoy it all
x The theory of individual decision making is
called ´consumer theoryµ

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x rirtually all individuals must face two facts of
economic life
² Have to pay prices for the goods and
services they buy
² Have limited funds to spend
x A consumer·s budget constraint identifies which
   of goods and services the consumer
can afford with a 
budget
x Mathematical expression:
² D D
² Where  is budget, D and D are prices for
good X and good  respectively

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x mraphical representation of a budget constraint:
@   
² The price of one good relative to the price of
another
² Interpretation on the vertical / horizontal intercepts
² The slope of the budget line indicates the spending
trade-off between one good and another
Amount of one good, that must be sacrificed in
order to buy more of another good
If P is the price of the good on the vertical axis,
then the slope of the budget line is ²PX / P
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Õ 
 
 Slope is - Px/Py
0

 

£
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x Max·s entertainment budget:
² m = $150
x Max is making choice to go to a local
rock concert (mood X) or see a movie
(mood ):
² A movie ticket (Px) = $10
² A concert ticket (Py) = $30


w    |    
  
*@  With $150 per month, Max
  
   can afford 15 movies and
no concerts, . . .
15 G
1ë movies and 1 concert or any other
combination the budget line.

Points   the line are

 also affordable.

 
 But  points

 the line.
3

1 ë 3 4 5 *@ 
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a
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x Changes in   
² Increase in income will shift the budget line
upward (and rightward)
² A decrease in income will shift the budget
line downward (and leftward)
² Shifts are parallel
Changes in income do not affect the budget
line·s slope
w 
 |  
 
Õ 
*@   
  
1. An increase in income shifts
30 the budget line rightward,
with no change in slope.

15

5 10 15 *@ 
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10
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x Changes in j 
² In each case, one of the budget
line·s intercepts will change, as
well as its slope
When the price of a good
changes, the budget line rotates
²Both its slope and one of its
intercepts will change

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Õ@
*@    ë. A decrease in the price of   
   rotates the budget line j 

30    j  
j    

15

5 15 *@ 
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w D |    
Õ

*@    3. while a decrease in the price of   
   rotates it  

30   j  
j    

15

5 15 *@ 
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D  

D 
x How can we possibly speak systematically
about people·s preferences?
² People are different
x Despite differences in preferences, can find
some important common denominators
² something true for a wide variety of people
They are focus in our theory of
consumer choice

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x People have preferences
² We assume that you can look at two
alternatives and state either that you prefer
one to the other or entirely indifferent
between the
x Preferences are 

   , or
transitive
x †ational preference: choices can be made and
they are logically consistent
x †ationality is a matter of ÷  you make your
choices, and not what choices you make
² What matters is that you make logically
consistent choices
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x We generally feel that more is better
x The model of consumer choice in this
chapter is designed for preferences that
satisfy the ´more is betterµ condition
² It would have to be modified to take
account of exceptions
The consumer will always choose a point on
the budget line
² †ather than a point below it

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x Theories of consumer decision making
² Marginal utility
² Indifference curve
Both assume that preferences are rational
Both assume that consumer would be better
off with more of any good
Both theories come to same general
conclusions about consumer behavior
² However, to arrive at those conclusions
each theory takes a different road

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    G 
x Utility: a quantitative measure of pleasure
or satisfaction obtained from consuming
goods and services
x Assume that consumers as striving to
maximize their utility
² any decision maker tries to make the
best out of any situation
x Anything that makes the consumer better
off is assumed to raise his utility
² Anything that makes the consumer
worse off will decrease his utility
1a
    
x Marginal utility (MU) of an additional unit
² Change in utility derived from consuming
an additional unit of a good
x The law of diminishing marginal utility, as
defined by Alfred Marshall (1a4ë-1 ë4) states
that
² Marginal utility of a thing to anyone

 with every increase in the
amount of it he / she already has

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  G    

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Number of Total Marginal
cones Utility Utility
0 0 -
1 30 30
ë 50 ë0
3 0 10
4 5 5
5 a 3
 a 0
ë0
w G    
  0
0 —   
50
40 1. The    from
30 one more ice cream cone . . .
ë0
10

1 ë 3 4 5 

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ë. is called the  utility 3. Marginal utility
  of an additional cone. falls as more cones
30
ë0 are consumed.
10
     
1 ë 3 4 5 

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ë1
    G 
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x An individual·s utility-maximizing choice


² What is the best affordable combination of
the two goods?
² Considering both marginal utility values and
the budget constraint
x Central idea:
² Highest possible utility will be point at which
marginal utility per dollar is the same for
both goods
² Otherwise, individual has incentive to deviate,
i.e., chooses alternative combination
ëë
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*@ 
      

     ½
   

15 G
   

 ë  ë
1ë    

   

 ½  
   





1 ë 3 4 5 *@ 
| 
 
  

ë3
    G 
     
x wor any two goods x and y, with prices Px and P,
whenever MUx / Px > MU / P, a consumer is
made better off shifting away from y and toward x
² rice versa
x Leads to an important conclusion
² A utility-maximizing consumer will choose the
point on the budget line where marginal utility
per dollar is the same for both goods (MUX / PX
= MU / P)
² At that point, there is no further gain from
reallocating expenditures in either direction

ë4
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x Utility will be maximized where


    for any pair of
goods x and y
² If this condition is not satisfied, consumer
will be better off consuming more of one and
less of the other good in the pair

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x A rise in income³with no change in price³leads
to a new quantity demanded for  good
² Whether a particular good is normal (quantity
demanded increases) or inferior (quantity
demanded decreases) depends on the
individual·s preferences
As represented by the marginal utilities for
each good, at each point along the budget
line

ë
w   
  
 
30 ë. If his preferences are as given in
*@ 
   ë  the table, he'll choose point 
  
1. When Max's
income rises
to $300, his
budget line G
shifts 15
outward. 1ë  3.But
  marginal
utility numbers could
 lead him to  or 


3 

1 ë 3 4 5   a 10 *@ | 
 
  

ë
| 
D 
x A drop in the price of concerts rotates the
budget line rightward, pivoting around its
vertical intercept
x The consumer will select the combination of
movies and concerts on his budget line that
makes him as well off as possible
² Will be combination at which marginal
utility per dollar spent on both goods is the
same

ëa

  · | 
x Curve showing quantity of a good or
service demanded by a particular
individual at each different price

ë
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1. When the price of concerts is ë. If the price falls to
*@  15 $30, point D is best for Max. $10, Max's budget
   line rotates
   10 rightward, and he
a choose point ù.
  ù

0 3 5  10 15 30
3. And if the price drops

$30  to $5, he chooses point
| 
 .
4. The demand curve shows
the quantity Max chooses
10 ù at each price.
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3  10 *@ | 
 
  
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