CONSUMER CHOICE: CONSUMER CHOICE CONSUMER CHOICE (Cont’d) CONSUMER CHOICE (Cont’d)APPLICATION: FOOD STAMPS FOOD STAMPS (Cont’d)Revealed PreferencesRevealed Preferences – Two Budget LinesRevealed Preferences – Two Budget LinesRevealed PreferenceRevealed Preferences – Four Budget LinesCONSUMER CHOICE:“Utility Maximization Subject to a Budget Constraint”or“Budget Line Meets Indifference Curves”• Rational consumer approach: highest utility money can buy!Max X,YU(X,Y)subject to: pX*X + pY*Y <• Solution:– Move out to highest indifference curve without breaking the budget– Optimum bundle where an indifference curve is tangent to budget line:MRS = pX/ pYResults presumes both goods are purchasedICONSUMER CHOICERecall that:MRS = - dY /dX = MUX / MUYslope of BL = dY /dX = - pX/pYSubstituting, we get a condition for the optimum bundle:MUX/ MUY= pX/pY• Interpreting the Optimum Condition– Rearrange optimum condition:MUX/ pX= MUY/pY•MUX(1/pX ) gives the utility of last dollar spent on music • Last dollar spent on music increases utility the same amount as the last dollar spent on movies!CONSUMER CHOICE (Cont’d)• Corner Solution– “MRS = price ratio” does not hold anywhere along budget line forpositive quantities (i.e., no “interior solution”)– Caused by indifference curves that are everywhere flatter/steeper than budget line – One good is not purchasedCONSUMER CHOICE (Cont’d)APPLICATION: FOOD STAMPS• Some Background– Food Stamp Act of 1964: vouchers good for food purchases– income, asset, employment “tests”– pre-1979: stamps purchased by household at a discount– post-1979: household receives allotment of stamps (denominated in $s)• The Budget Line– Is household money income–pFand pAare prices of food and all other goods– S is amount of food stamps• Consumer Choice– Utility will e higher with food stamps than without …– But even higher with cash (equal to $S) in place of food stampsIFOOD STAMPS (Cont’d)Revealed Preferences• If we know the choices a consumer has made, we can determine what their preferences are if we have information about a sufficient number of choices that are made when prices and incomes vary.Revealed Preferences –Two Budget LinesRevealed Preferences –Two Budget LinesRevealed Preference• As you continue to change the budget line, individuals can tell you which basket they prefer to others• The more the individual reveals, the more you can discern about their preferences• Eventually you can map out an indifference curveRevealed Preferences –Four Budget
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