The Theory of Consumer Behavior
Rational Consumer Choice – Chapter 3
Big picture:
• We’re modeling the cost benefit decision of consumers.
• Ultimately where do demand curves come from?
I.
A.
B.
C.
D.
E.
II.
Costs = Budget constraints
Assumptions and variables
Graphically
Algebraically
Changes
Non-linear
Benefits = Preferences
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Rational Consumer Behavior: Budget Constraints describe all the combinations (bundles) of goods you can purchase with a given amount of money
A. Assumptions and variables
1. Assumptions
a. only two goods
b. spend all your money
2. Variables
M = Income
X = one of the goods
Y = the other good
PX = price of X
PY = price of Y
3. Example:
M = Income = $30
X = Tony’s Frozen Pizza
Y = Double Stuff Oreos
PX = price of X = $6/pizza
PY = price of Y = $3/bag
B. Graphically
12
11
10
9
8
7
6
5
4
3
2
1
0
0
1
2
3
4
5
6
7
8
9
10
If I spent all my money on Oreos, how many bags could I buy?
If I spent all my money on Frozen Pizza, how many could I buy?
What is the opportunity cost in terms of Oreos of another Frozen Pizza?
What is the opportunity cost in terms of Frozen Pizza of another bag of
Oreos?
C. Algebraically:
2
D. Changes in the Budget Constraint:
12
11
10
9
Double Stuff
8
7
6
5
BC0
4
3
2
1
0
0
1
2
3
4
5
6
7
8
9
10
Tony's Froz e n Piz z a
M
$30
PX
6
PY
3
increase
in income
$36
6
3
BC2
decrease
in income
$24
6
3
BC3
increase
in price
$30
6
6
BC4
decrease
in price
$30
3
3
BC0
baseline
BC1
Y-intercept
10
Slope
-2
Equation
Y = 10-2X
True or False: If prices double and income doubles at the same time, the budget constraint will not change.
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E. Non-linear budget Constraints
Ex 1: Quantity Discounts - the price/unit becomes less expensive the more you buy
Mary Mary sells silver bell (a flower) seeds. She charges $2/lb for the first
10 lb you buy and $1/lb for every lb you buy thereafter. If your income is
$100, draw your budget constraint for silver bells and everything else. PY =
$1
Ex 2: BMG music club
Buy 1 at regular price, get 10 free
Each additional CD is regular price
PY = $1
Pregular = $15
M = $300
100
90
80
70
Y
Y
60
50
40
30
20
10
0
315
300
285
270
255
240
225
210
195
180
165
150
135
120
105
90
75
60
45
30
15
0
100
90
80
70
60
50
40
30
20
10
0
0
2
4
6
8 10 12 14 16 18 20 22 24 26 28 30
CDs
Silver Bell Seeds (lbs)
M
$100
PXX
X=silver bells
PY*Y
Y
$100
$100
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