Consumer Choice

• Individual tastes or preferences determine the amount of pleasure people derive from the goods and services they consume.

• Consumers face constraints or limits on their choices. • Consumers maximize their pleasure from consumption, subject to the constraints they face. • The properties of consumers’ preferences:

o The completeness property holds that, when facing a choice between any two bundles of goods, Bundles a and b, a consumer can rank them so that one of the following relationships is true: a to b, b to a, and a ~ b.

o The transitivity property eliminates the possibility of certain types of illogical behaviour. For example, if a consumer prefers a to b and b to c, then he must also prefer a to c.

o The more-is-better property states that, all else the same, more of a commodity is better than less of it.

• A good is a commodity for which more is preferred to less, at least at some levels of consumption.

• A bad is something for which less is preferred to more, e.g. pollution. • An indifference curve illustrates the set of all bundles of goods that a consumer views as

being equally desirable. • An indifference map refers to the complete set of indifference curves that summarize a

consumer’s tastes or preferences. • Indifference curve maps must have the following four properties:

1. Bundles on indifference curves farther from the origin are preferred to those on indifference curves closer to the origin.

2. There is an indifference curve through every possible bundle as a consequence of the completeness property: The consumer can compare any bundle to another.

3. Indifference curves cannot cross. That is, a given bundle cannot be on two indifference curves.

4. Indifference curves slope downward—otherwise, the more-is-better property is violated. • The marginal rate of substitution refers to the maximum amount of one good a

consumer will sacrifice to obtain one more unit of another good. • If an indifference curve is concave, the consumer would be willing to sacrifice more of one

good to obtain another, the fewer the former good the consumer has. • Perfect substitutes are goods that a consumer is completely indifferent as to which to

consume. • Perfect complements are goods that a consumer is interested in consuming only in fixed

proportions. • Utility refers to a set of numerical values that reflect the relative rankings of various

bundles of goods. • The utility function shows the relationship between utility values and every possible

bundle of goods. • An ordinal measure is one that tells us the relative ranking of two things but no how much

more one rank is than another. • The marginal utility is defined as the extra utility that a consumer gets from consuming

the last unit of a good. • The MRS is the negative ratio of the marginal utility of one good to the marginal utility of

another good.

• The budget line (or budget constraint) illustrates the bundles of goods that can be bought if the entire budget is spent on those goods at given prices.

• The opportunity set refers to all the bundles of goods a consumer can buy, including all the bundles inside the budget constraint and on the budget constraint.

• The opportunity set increases when the price of one of the goods increases. This is because more of one good can be consume with the same amount of income.

• The slope of the budget line is called the marginal rate of transformation: the trade-off the market imposes on the consumer in terms of the amount of one good the consumer must give up to purchase more of the other good.

• If the consumer’s income increases, the consumer can buy more of all goods. This effect is shown by an outward shift of budget line.

• The optimal bundle—the consumer’s optimum—must lie on the budget constraint and be on an indifference curve that does not cross it.

• There are two solutions to solving the problem: the first is an interior solution, in which the bundle has positive quantities of both goods and lies between the ends of the budget line. The other possibility, called a corner solution, occurs when the optimal bundle is at one end of the budget line, where the budget line forms a corner with one of the axes.

• Interior solution: o The utility of a consumer is maximized at the bundle where the rate at which he is

willing to trade one good to another equals the rate at which he can trade. • Corner solution:

o Some consumers choose to buy only one of the two goods. They so prefer one good to another that they only purchase the preferred good.

o The indifference curve is not tangent to the budget line. • If indifference curves have both concave and convex sections, the optimal bundle lies in a

convex section or at a corner. • Behavioral economics adds insights from psychology and empirical research on human

cognition and emotional biases to the rational economic model. • Children’s lack of transitivity or rationality provides a justification for political and

economic restrictions and protections placed on young people. • The endowment effect states that people place a higher value on a good if they own it

than they do if they are considering buying it. • Economists use the term salience, in the sense of striking or obvious, to describe this idea,

e.g. tax salience is awareness of a tax.