class: center, middle, inverse, title-slide # Consumer Theory ## EC 201: Principles of Microeconomics ### Kyle Raze ### Winter 2020 --- class: inverse, middle # Prologue --- # Demand and Supply ## Foundations If goods and time were not scarce, then we would never have to choose among competing alternatives. - .hi-pink[Consumer theory] characterizes .pink[consumers' choices] in a systematic way. - .hi-purple[Producer theory] characterizes .purple[producers' and sellers' choices] in a systematic way. --- # Demand **Q:** What constrains our consumption of goods? -- **A:** Lots of things! - Our income or wealth. - Price of the good. - Legality of consuming the good. - Cost of maintaining the good. - Our health. - Our finite existence. - *etc.* --- # Demand **Q:** If we could measure those constraints for a group of individuals, could we predict the choices of those individuals? -- - **A:** No. To predict behavior, we also need to consider individual tastes or preferences. -- **Q:** Can we measure tastes or preferences? -- - **A:** Not typically. --- # Demand Our inability to measure preferences requires us to make assumptions. - However preferences are defined, they do not change during the course of the investigation. - Preferences are such that individuals strive to reduce the adverse consequences of the constraints they face. Given those assumptions, we can make refutable hypotheses about how individuals respond to *changes* in the constraints they face. --- # Demand .less-right[ ### .pink[Demand Curve] Shows the amount of a good .pink[consumers] are willing and able to purchase at specified prices. .pink[Downward sloping:] P increases .mono[->] Q.sub[D] decreases. ] .more-left[ <img src="03-Consumer_Theory_files/figure-html/market_demand-1.svg" style="display: block; margin: auto;" /> ] --- # Supply .less-right[ ### .purple[Supply Curve] Shows the amount of a good .purple[producers or sellers] are willing and able to sell at specified prices. .purple[Upward sloping:] P increases .mono[->] Q.sub[S] increases. ] .more-left[ <img src="03-Consumer_Theory_files/figure-html/market_supply-1.svg" style="display: block; margin: auto;" /> ] --- # Equilibrium .less-right[ ### Market Clearing Quantity demanded equals quantity supplied: Q.sub[D] .mono[=] Q.sub[S]. No tendency for prices to change. ] .more-left[ <img src="03-Consumer_Theory_files/figure-html/equilibrium-1.svg" style="display: block; margin: auto;" /> ] --- count:false # Equilibrium .less-right[ ### Market Clearing Quantity demanded equals quantity supplied: Q.sub[D] .mono[=] Q.sub[S]. No tendency for prices to change. ] .more-left[ <img src="03-Consumer_Theory_files/figure-html/equilibrium2-1.svg" style="display: block; margin: auto;" /> ] --- # Disequilibrium .less-right[ ### Shortage Quantity demanded exceeds quantity supplied: Q.sub[D] .mono[>] Q.sub[S]. Prices tend to rise. <img src="shortage.png" width="267" style="display: block; margin: auto;" /> ] .more-left[ <img src="03-Consumer_Theory_files/figure-html/shortage1-1.svg" style="display: block; margin: auto;" /> ] --- count: false # Disequilibrium .less-right[ ### Shortage Quantity demanded exceeds quantity supplied: Q.sub[D] .mono[>] Q.sub[S]. Prices tend to rise. <img src="shortage.png" width="267" style="display: block; margin: auto;" /> ] .more-left[ <img src="03-Consumer_Theory_files/figure-html/shortage2-1.svg" style="display: block; margin: auto;" /> ] --- # Disequilibrium .less-right[ ### Surplus Quantity supplied exceeds quantity demanded: Q.sub[S] .mono[>] Q.sub[D]. Prices tend to fall. <img src="surplus.png" width="380" style="display: block; margin: auto;" /> ] .more-left[ <img src="03-Consumer_Theory_files/figure-html/surplus1-1.svg" style="display: block; margin: auto;" /> ] --- count: false # Disequilibrium .less-right[ ### Surplus Quantity supplied exceeds quantity demanded: Q.sub[S] .mono[>] Q.sub[D]. Prices tend to fall. <img src="surplus.png" width="380" style="display: block; margin: auto;" /> ] .more-left[ <img src="03-Consumer_Theory_files/figure-html/surplus2-1.svg" style="display: block; margin: auto;" /> ] --- class: inverse, middle # Consumer Choice --- # Individual Preferences Economists seek to understand the combined actions of individuals. However, the forthcoming behavioral assumptions concern individual preferences. - Why? Because describing the preferences of a group is extraordinarily difficult. --- # Group Preferences **Scenario:** Three officials in the current administration have preferences over three ways to respond to recent US-Iran tensions. - **Official 1:** *bomb them* .mono[>] *impose sanctions* .mono[>] *do nothing* - **Official 2:** *impose sanctions* .mono[>] *do nothing* .mono[>] *bomb them* - **Official 3:** *do nothing* .mono[>] *bomb them* .mono[>] *impose sanctions* -- **Q:** How do we define preferences for this group? - What does "the group" prefer? -- **A:** 🤷 -- - For any course of action, a majority would rather do something else! --- # Behavioral Assumptions Four assumptions buy us the ability to model consumer behavior: 1. People have preferences. 2. People prefer more over less. 3. People are willing to substitute. 4. The marginal value of a good decreases as one consumes more of it. -- **Note:** These assumptions may rule out some realistic behaviors. --- # Valuation The value of a good .mono[=] what you are willing to give up to obtain it. - If you give up .mono[$]30,000-worth of other goods to buy a car, then you value the car at a minimum of .mono[$]30,000. -- We will maintain that an object's value is limited to what people are willing to pay for the right to control the object. --- # Total Value ## Definition 1 > The .pink[maximum] amount of money a consumer is .pink[willing to pay] to acquire a specific quantity of a good. *Example:* The highest price you would pay for 3 pounds of Stumptown coffee. -- ## Definition 2 > The .pink[minimum] amount of money a consumer is .pink[willing to accept] to give up a specific quantity of a good. *Example:* The lowest amount of money for which you would willingly part with 3 pounds of Stumptown coffee. --- # Marginal Value ## Definition 1 > The .pink[maximum] amount of money a consumer is .pink[willing to pay] to acquire one more unit of a good. *Example:* The highest price you would pay for a cup of Stumptown coffee. -- ## Definition 2 > The .pink[minimum] amount of money a consumer is .pink[willing to accept] to give up one more unit of a good. *Example:* The lowest amount of money for which you would willingly part with a cup of Stumptown coffee. --- class: clear-slide **Q:** After running a marathon, how might you value the first glass of water? -- - How might you value the second glass relative to the first? -- **Assumption 4:** Diminishing marginal value. - *All else being equal*, the marginal value of a good decreases as you consume more of it. - Applies to all goods and all individuals. --- # Diminishing Marginal Value .more-left[ <img src="03-Consumer_Theory_files/figure-html/mv-1.svg" style="display: block; margin: auto;" /> ] .less-right[ ### .pink[Marginal Values Schedule] MV .mono[=] Marginal value. q .mono[=] Quantity of a good. q increases .mono[->] MV decreases. ] --- # Optimal Purchase **Q:** How does a consumer decide how much of a good to purchase? **A:** The consumer makes a decision *at the margin*. - Purchase an additional unit if the marginal value of the additional unit exceeds the price. - Do not purchase an additional unit if the price of the additional unit exceeds the marginal value. - Keep purchasing until marginal value equals the price. --- # Optimal Purchase .more-left[ <img src="03-Consumer_Theory_files/figure-html/mv1-1.svg" style="display: block; margin: auto;" /> ] .less-right[ **Q:** How many units does the consumer purchase if the price is .mono[$]4.50? > **A:** ] --- count: false # Optimal Purchase .more-left[ <img src="03-Consumer_Theory_files/figure-html/mv1b-1.svg" style="display: block; margin: auto;" /> ] .less-right[ **Q:** How many units does the consumer purchase if the price is .mono[$]4.50? > **A:** .pink[4 units.] ] --- # Optimal Purchase .more-left[ <img src="03-Consumer_Theory_files/figure-html/mv2-1.svg" style="display: block; margin: auto;" /> ] .less-right[ **Q:** How many units does the consumer purchase if the price is .mono[$]3.00? > **A:** ] --- count: false # Optimal Purchase .more-left[ <img src="03-Consumer_Theory_files/figure-html/mv2b-1.svg" style="display: block; margin: auto;" /> ] .less-right[ **Q:** How many units does the consumer purchase if the price is .mono[$]3.00? > **A:** .pink[6 units.] ] --- # Optimal Purchase .more-left[ <img src="03-Consumer_Theory_files/figure-html/mv3-1.svg" style="display: block; margin: auto;" /> ] .less-right[ **Q:** How many units does the consumer purchase if the price is .mono[$]9.00? > **A:** ] --- count: false # Optimal Purchase .more-left[ <img src="03-Consumer_Theory_files/figure-html/mv3b-1.svg" style="display: block; margin: auto;" /> ] .less-right[ **Q:** How many units does the consumer purchase if the price is .mono[$]9.00? > **A:** .pink[0 units.] ] --- # Optimal Purchase ## Rule > A consumer selects her optimal purchase **q.sup[*]** **s.t.** **MV** .mono[**=**] **P**. -- If the consumer - Stops purchasing where .green[MV .mono[>] P] .mono[==>] she bought .hi-green[too little]. - Stops purchasing where .purple[MV .mono[<] P] .mono[==>] she bought .hi-purple[too much]. - Makes a purchase where .pink[MV .mono[=] P] .mono[==>] she made the .hi-pink[optimal purchase]. -- Do you follow such a rule? - What matters is not that you do, but that you **behave as though you do.** --- # Living Your Best Life .more-left[ <img src="03-Consumer_Theory_files/figure-html/cs-1.svg" style="display: block; margin: auto;" /> ] .less-right[ ### .pink[Consumer Surplus] The total value of the consumer's purchase in excess of the cost of the purchase. Measures the gains to the consumer from the transaction. ] --- # Individual Demand .more-left[ <img src="03-Consumer_Theory_files/figure-html/ind_demand1-1.svg" style="display: block; margin: auto;" /> ] .less-right[ Marginal values schedule .mono[<=>] demand curve! Both show how the quantity demanded changes as the price changes, *holding all other determinants of demand constant*. ] --- # Individual Demand .more-left[ <img src="03-Consumer_Theory_files/figure-html/ind_demand2-1.svg" style="display: block; margin: auto;" /> ] .less-right[ Due to diminishing marginal value, we depict the relationship between P and q.sub[D] as downward sloping. ] --- # The "Law" of Demand ## Definition > *All else being equal*, the quantity demanded of a good falls as its price rises. -- *All else being equal* .mono[=] income, prices of other goods, tastes, quality, age, season, advertising, and other determinants of demand .hi[do not change!] --- class: clear-slide .center[**Increase in Price .mono[->] Decrease in q.sub[D]**] <img src="03-Consumer_Theory_files/figure-html/p_increase-1.svg" style="display: block; margin: auto;" /> --- count: false class: clear-slide .center[**Increase in Price .mono[->] Decrease in q.sub[D]**] <img src="03-Consumer_Theory_files/figure-html/p_increase2-1.svg" style="display: block; margin: auto;" /> --- class: clear-slide .center[**Decrease in Price .mono[->] Increase in q.sub[D]**] <img src="03-Consumer_Theory_files/figure-html/p_decrease-1.svg" style="display: block; margin: auto;" /> --- count: false class: clear-slide .center[**Decrease in Price .mono[->] Increase in q.sub[D]**] <img src="03-Consumer_Theory_files/figure-html/p_decrease2-1.svg" style="display: block; margin: auto;" /> --- # An Important Distinction ## .pink[Demand] > The .pink[schedule of quantities] of a good that a consumer will buy per unit of time at .pink[various prices], everything else held constant. A change in demand .pink[*shifts*] the demand curve. ## .green[Quantity demanded] > The .green[specific quantity] that a consumer will buy per unit of time at a .green[specific price], everything else held constant. A change in price leads to .green[*movement along*] the demand curve. --- class: clear-slide .center[**An Increase in Demand**] <img src="03-Consumer_Theory_files/figure-html/demand_increase-1.svg" style="display: block; margin: auto;" /> --- count: false class: clear-slide .center[**An Increase in Demand**] <img src="03-Consumer_Theory_files/figure-html/demand_increase2-1.svg" style="display: block; margin: auto;" /> --- class: clear-slide .center[**A Decrease in Demand**] <img src="03-Consumer_Theory_files/figure-html/demand_decrease-1.svg" style="display: block; margin: auto;" /> --- count: false class: clear-slide .center[**A Decrease in Demand**] <img src="03-Consumer_Theory_files/figure-html/demand_decrease2-1.svg" style="display: block; margin: auto;" /> --- # The Diamond-Water Paradox **Q:** Why are diamonds, mere frivolities, so much more expensive than water, which is essential to all life? -- What resolves the paradox? - Market prices reflect consumers' marginal values of those goods and not their total values. --- # The Diamond-Water Paradox .less-right[ .pink[TV.sub[Water]] .mono[>] .purple[TV.sub[Diamonds]] .purple[MV.sub[Diamonds]] .mono[>] .pink[MV.sub[Water]] **Q:** Can you think of other similar situations? ] .more-left[ <img src="03-Consumer_Theory_files/figure-html/diamond_water-1.svg" style="display: block; margin: auto;" /> ] --- # Sale Prices **Q:** Why do firms offer "buy one, get one free" or "buy one, get one half off" sales? -- Suppose MV.sub[1] .mono[=] .mono[$]4, MV.sub[2] .mono[=] .mono[$]2, and MV.sub[3] .mono[=] .mono[$]1. If the price of the item is .mono[$]5, how many units would the individual buy? -- - Zero .mono[==>] the firm gets .mono[$]0 in revenue. -- What if the deal was "buy one at .mono[$]5, get a second free?" -- - The individual makes the exchange .mono[==>] the firm gets .mono[$]5 in revenue. -- **A:** Induce consumers who wouldn't otherwise purchase to make a purchase .mono[-->] more revenue. --- # Practice **Q:** Based on the the table below, how many units would a consumer purchase if the price is .mono[$]59? By how much is she better off by purchasing that amount? <table> <thead> <tr> <th style="text-align:center;"> Unit </th> <th style="text-align:center;"> Marginal Value </th> <th style="text-align:center;"> Total Value </th> </tr> </thead> <tbody> <tr> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> 1 </td> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> 90 </td> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> </td> </tr> <tr> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> 2 </td> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> 85 </td> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> </td> </tr> <tr> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> 3 </td> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> </td> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> 235 </td> </tr> <tr> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> 4 </td> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> 55 </td> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> </td> </tr> <tr> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> 5 </td> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> 40 </td> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> </td> </tr> <tr> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> 6 </td> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> </td> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> 360 </td> </tr> <tr> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> 7 </td> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> 20 </td> <td style="text-align:center;color: #272822 !important;line-height: 110%;"> </td> </tr> </tbody> </table> -- **A:** .pink[She purchases 3 units. Her consumer surplus is 235 .mono[-] 3 .mono[×] 59 .mono[=] 58.]