PPA 723: Managerial Economics: Consumer Choice

PPA 723: Managerial
Economics
Lecture 7:
Consumer Choice
Managerial Economics, Lecture 7: Consumer Choice
Outline
 Consumer Utility Maximization
 Application to Food Stamps

Review: Preferences
 Indifference curve map summarizes
preferences.
 Higher indifference curves indicate higher
utility.
 Marginal utility = extra utility from one
more unit of a good holding constant
consumption of all other goods.
 Slope of an indifference curve = marginal
rate of substitution (MRS) = MUB/MUA.
Review: Budget Constraints

 A consumer's opportunity set increases with
income and decreases with prices.
 A budget constraint shows bundles that a

consumer can buy by spending all of his or her
income at given prices.

 The slope of budget line = marginal rate of
transformation (MRT) = PB/PA = rate at which
Good A can be exchanged for Good B.
Budget Line Meets Indifference Curves

 Households maximize utility subject
to their budget constraint.
 There are two possibilities for the

optimal bundle:
an interior solution: buy some units of all
goods.
a corner solution: buy only one good.
Interior Solution
 The consumer buys some of all goods.
 The optimum bundle is where highest

indifference curve just touches the
budget line—but does not cross it!
 This is a tangency point.

Figure 4.8a Consumer Maximization
B, Burritos Budget line

per semester (a) Interior Solution
g
25 Optimal Bundle
c f
20
B e
10
I3
d a I2
A
I1
0 10 30 50
Z, Pizzas per semester
Tangency Property
 The tangency of the indifference curve
and the budget line implies that:
MU Z pZ
MRS     MRT
MU B pB
MU Z MU B

pZ pB
 The last dollar spent on pizza gives as
much extra utility as that spent on
burritos
Summary: Utility Maximized

 To maximize their well-being subject to their
budget, consumers pick the point where the
highest possible indifference curve hits
budget constraint.
 This indifference curve is tangent to budget

constraint, which implies that MRS = MRT
 The last dollar spent on one good gives as

much extra utility as the last dollar spent on
any other consumed good.
Marginal Conditions
 This rule provides the introduction to a
very different way of thinking:
The best choice requires getting things
right at the margin.
 Consumers maximize their utility when

they cannot gain by fiddling with their
choices at the margin.
No gain from further fiddling is equivalent
to finding the overall utility maximum!
Marginal Conditions and Public Administration

 The use of marginal conditions is a
critical management tool.
As a manager, your best choices will
involve getting the same marginal return
per dollar from all activities or purchases.
 To maximize any objective, make sure

you can’t fiddle any more at the margin.
No gain from further fiddling is equivalent
to finding your overall maximum!
Optimal Bundle: Corner Solution

 The optimal bundle is still at the point
where highest indifference curve
touches budget line.
 But this point is at a “corner” where only

one good is consumed.
 The indifference curve and budget line

are not tangent at the optimal bundle.
Figure 4.8b Consumer Maximization
B, Burritos (b) Corner Solution

per semester
Optimal Bundle
e
25
I3
I2
Budget line
I1
50
Z, Pizzas per semester
Solved Problem: Food Stamps

Are poor people better off receiving food
stamps or a comparable amount of
cash?
Answer
 Cash gives recipients more choice.
 Whether that greater choice matters

depends on the recipients tastes or,
roughly, on how much food they eat.
Figure 4.10 Food Stamps Versus Cash

All other goods
per month
Budget line with cash
Y + 100
f
C e
Y I3
d I2
I1
B
Budget line with
food stamps
A Original
budget line
0 100 Y Y + 100
Food per month
Food Stamps Versus Cash, Continued

All other goods
per month
Budget line with cash
Y + 100
f
C e
Y I3
d I2 Household 1
I1
I 2*
B Household 2
I 1*
A Budget line with

Original food stamps
budget line
0 50 100 150 160 Y Y + 100
Food per month
Cash vs. In-Kind Transfers: Lessons
 Cash and in-kind transfers of Good A are

equivalent unless the in-kind transfer is
large relative to the recipient’s initial
consumption of Good A.
 If the in-kind transfer is large relative to
initial consumption, then
the cash transfer leads to higher utility, and
the in-kind transfer leads to more consumption
of Good A.
A Price Subsidy and an Equal-Cost Cash Grant

Budget Line with
Cash Grant
Tangency Point
Clothing with Cash Grant
Tangency Point
with Price Subsidy
I3
I2 Budget Line with
Price Subsidy
I1
F1 F3 F2
Food
Cost of Both Programs
(in Units of Food)
Cash vs. a Price Subsidy: Lessons
 A cash transfer and an equal-cost price

subsidy have the same income effect, but
the price subsidy also has a price effect.
 It follows that
the cash transfer leads to higher utility, and
the price subsidy leads to more consumption of
the subsidized good.

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PPA 723: Managerial

 Consumer Utility Maximization

 Application to Food Stamps

Review: Budget Constraints

 A budget constraint shows bundles that a

Budget Line Meets Indifference Curves

 There are two possibilities for the

 The optimum bundle is where highest

 This is a tangency point.

Figure 4.8a Consumer Maximization

B, Burritos Budget line

Summary: Utility Maximized

 This indifference curve is tangent to budget

 The last dollar spent on one good gives as

 Consumers maximize their utility when

Marginal Conditions and Public Administration

 To maximize any objective, make sure

Optimal Bundle: Corner Solution

 But this point is at a “corner” where only

 The indifference curve and budget line

Figure 4.8b Consumer Maximization

B, Burritos (b) Corner Solution

Solved Problem: Food Stamps

 Whether that greater choice matters

Figure 4.10 Food Stamps Versus Cash

Food Stamps Versus Cash, Continued

A Budget line with

Cash vs. In-Kind Transfers: Lessons

 Cash and in-kind transfers of Good A are

A Price Subsidy and an Equal-Cost Cash Grant

Cash vs. a Price Subsidy: Lessons

 A cash transfer and an equal-cost price

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