Production and consumption: Consumer preferences and consumer choice

5.2 Consumer preferences and consumer choice

Activity

Principles of Microeconomics: "Chapter 7, Section 3: Indifference Curve Analysis: An Alternative Approach to Understanding Consumer Choice"

• Read this section to learn about indifference analysis. Attempt the "Try It” problems at the end of the section before checking your answers.

MIT OpenCourseWare: Jon Gruber's "Preference and Utility"

• Watch this lecture for an explanation of consumer theory, and especially mathematical representations of consumer preferences.

MIT OpenCourseWare: Jon Gruber's "Labor Supply" MIT OpenCourseWare: Jon Gruber's "Child Labor"

• Watch these two lectures for an explanation of labor analysis.

Consumer theory and indifference curves

Activity

Khan Academy: "Equalizing Marginal Utility per Dollar Spent"

• Watch this video about equalizing marginal utility per dollar spent.

Khan Academy: "Types of Indifference Curves"

• Watch this video about the types of indifference curves.

Khan Academy: "First Degree Price Discrimination"

• Watch this video about first degree price discrimination.

Wolfram Demonstrations Project: "Changes in the Budget Line"

• To use this simulation, you must download and install the Mathematica Viewer from the Wolfram Demonstrations Project. Although this software is free, it is a sizable download. This activity is therefore optional.

It is difficult to map indifference curves because preferences can change from moment to moment, but budget lines are real and tangible. This simulation shows how price changes and income changes affect a budget line. Of course, we are often making purchasing decisions based on more than two goods at a time, but modelling simpler considerations is the first step to modelling more complex decisions.

Once you have downloaded the software to your desktop, open the simulation and click the "reset parameters" box. The two goods in this model are labeled A and B. At the initial settings, the person to whom this budget line belongs can purchase a maximum of four units of good B at $6 per unit. Alternately, the this person could chose to buy only good A., purchasing 6 units at a price of $4 each. Notice that, in either case the total is $24; $24 is the budget this person has to spend on goods A and B. All points on the red line is a possible combination of goods with the $24 budget. For example, purchasing 2 units of good B at $6 each and 3 units of good A at $4 each fits within the budget.

Explore the simulation. Move the income slider to, say, $36. The dotted line that appears is the new budget line. Notice how this new budget line is parallel to the previous budget line at the lower income. Does that make sense? It ought to! The slope of the budget line is determined by the respective prices of goods A and B, not income!

Next, reset the parameters and examine what happens when goods A and B are different prices. Raise and lower both prices separately.

Now, lower both prices. Change the price of good A to $2.66 and the price of good B to $4. Doesn’t the dotted line look like the previous budget line you had for $36? Why might this be? In effect, with general deflation we experience a general wage increase, as we will be able to buy more for the same total price. Yes, the lowering of prices is conceptually equivalent to an increase in income.

Try the opposite last. Reset the values, lower the budget line, and find a level of price for each good such that the budget line approximates the previous one. Take a few more moments to experiment with this simulation.

Utility maximization

The optimal consumer choice in the indifference curve analysis is determined by the tangency condition between the marginal rate of transformation (MRT) and the marginal rate of substitution (MRS).

Activity

Khan Academy: "Optimal Point on Budget Line"

• Watch this video about the optimal point on a budget line.

Elasticity

Activity

Boundless: "Defining price elasticity of demand"

• Read this section about price elasticity.