5a

Consumer Choice Examples

Optimization and Human Behavior
Handout for Managerial Economics October 21, 2011 Thomas F. Rutherford, Center for Energy Policy and Economics, ETH Zrich
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A Choice Experiment Thomas lives in Ann Arbor where he currently spends 30% of his income on rent. He has an employment offer in Zrich which pays 50% more than he currently earns, but he is hesitant to take the job because rental rates in Zrich are three times higher than in Ann Arbor. Assuming that Thomas has CES preferences with elasticity of substitution ; on purely economic grounds, should he move? As is the case for all interesting questions in economics, the only good answer to this problem is It depends.. Intuition Thomass offer in Zrich does not pay him enough to live exactly the lifestyle that he enjoys in Ann Arbor, as he would need a 60% raise to cover rent and consumption. The elasticity of substitution is key. If it is high, he more willing substitutes consumption of goods and services for housing and thereby lowers his cost of living in Zrich. On the other hand, if the elasticity is low, he is stuck in his ways, and the move is a bad idea. Calibration to a Benchmark Equilibrium We are given information about Thomass choices in Ann Arbor. This information is essentially an observation of a benchmark equilibrium, consisting of the prevailing prices and quantities of goods demand. The benchmark equilibrium data together with assumptions about elasticities are used to evaluate Thomass choices after a discrete change in the economic environment. The steps involved in solving this little textbook model are identical to those typically employed in applied general equilibrium analysis. Graphical Representation

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Preferences The utility function: U (C, H ) = ( C + (1 )H )1/ Exponent is dened by the elasticity of substitution, , as = 1 1/ . The model of consumer choice is: max U (C, H ) s.t. C + pH H = M
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Demand Derivation of demand functions which solve the utility maximization problem involves solving two equations in two unknowns: U / H (1 )H 1 = = pH ; U / C C 1 hence H = C Substituting into the budget constraint, we have: H= and C= 1 + pH M pH +
pH 1

1 pH

(1 ) M p H

+ (1 ) p1 H

M
1 pH

M + (1 ) p1 H
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Calibration It is conventional in applied general equilibrium analysis to employ exogenous elasticities and calibrated value values. If we follow this approach, is then exogenous and is calibrated. Choosing units so that the benchmark price of housing ( p H ) is unity, we have: /M =p H H Substitute into the demand function: 1+ 1

M 1 = = ; H

and then solve for the preference parameter : = (1 )1/ . 1/ + (1 )1/

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Money Metric Utility = (1 )M , Substitute for in U (C, H ), and denoting the base year expenditure on other goods as C we have U (C, H ) = (1 )1/ C + 1/ H
1/

where the is a constant which may take on any positive value without altering the preference ordering. It is convenient to assign this value to the benchmark expenditure, so that utility can be measured in moneymetric units at benchmark prices. Noting that 1/ = 1 , we then can write the utility function as: (C, H ) = M (1 ) C U C

H H

1/

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Indirect Utility Formally, we have: V ( pH , M ) = U (C( pH , M ), M ( pH , M )) = M

+ (1 ) p1 H 1/(1 )

In money-metric terms, we can use benchmark income to normalize the utility function: ( pH , M ) = V M 1/(1 ) (1 + p1 H )

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Demand Functions Calibrated Share Form V ( pH , M ) H =H M V ( pH , M ) C =C M where

pU = 1 + p1 H 1/(1 )
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pU pH pU 1

Should Thomas Move? Thomass welfare level in Zrich can be easily computed in money-metric terms as: ( pH = 3, M = 1.5) = V 1.5 0.7 + 0.3 31
1/(1 )

This expression cannot (to my knowledge) be solved in closed form, however it is easily to solve using Excel. The critical value for is that which equates welfare in Zrich with welfare level in Ann Arbor, i.e. = 1. The numerical value is found to be = 0.441. The general dependence of welfare on the and V can be illustrated in a contour diagram. Dependence of Welfare on Benchmark Shares and Elasticity

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Multivariable Optimization The concept of multivariate optimization is important in managerial economics because many demand and supply relations involve more than two variables. In demand analysis, it is typical to consider the quantity sold as a function of the price of the product itself, the price of other goods, advertising, income, and other factors. In cost analysis, cost is determined by output, input prices, the nature of technology, and so on..

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Optimal Advertising To explore the concepts of multivariate optimization and the optimal level of advertising, consider a hypothetical multivariate product demand function for CSI, Inc., where the demand for product Q is determined by the price charged, P, and the level of advertising, A: Q = 5, 000 10P + 40A + PA 0.8A2 0.5P2 Determine the joint optimal price (P ) and level of advertising (A ) which maximize CSI output. First Order Conditions Begin by calculating partial derivates of demand with respect to price and level of advertising: Q = 10 + A P P Q = 40 + P 1.6A A First order conditions for maximization of demand are: Q =0 P Q =0 A Optimization = Solving Simultaneous Equations Hence, the optimal level of price and advertising solve: 10 + A P 40 + P 1.6A = = 0 0
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Hence, P = 40, A = $5, 000 and the maximal output is Q = 5, 800. Note that in subsequent chapters we will learn that the policies which maximize output may differ from those which maximal prot, depending on how production cost relates to output. Nonlinear Pricing Consider a consumer choice model in which the two goods consist of telecommunication services (x) and all other goods (y). Let the price of other goods is xed at unity. Telecommunication services are somewhat special in that due to economies of scale, these are offered with potentially substantial quantity discounts. Once a subscription fee of f CHF is made, services are offerred at a substantially reduced price. In the absence of the connection fee, px = 1. Telecommunication services made to customers who have paid the connection fee are offered at a price of p x . The consumer is assumed to have the following utility function: max U (x, y) = x y1

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A. Ignoring the subscription plan, solve for the quantity of telecommunication services demanded by the consumer. The standard consumer model is one of budget-constrained utility maximization. Hence, we solve max U (x, y) s.t. px x + y = M . The rst order condition is: U (x, y)/ x px = U (x, y)/ y 1 Hence, x = and y = M px

(1 )M 1
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B. Assuming that the consumer chooses to buy a subscription. Show that she will buy the following quantities: x = M f p x

y = (1 )(M f ) If the consumer buys a subscription, the purchase quantity solves: max U (x, y) s.t. p x x + y = M f . The rst order conditions are identical to the previous case, except that M is replaced by M f and px is replaced by p x .
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C. Holding p xed, what is the critical value of f such that the consumer is indifferent about buying a subscription. The critical value of f is that for which: U (x , y ) = U (x , y ) Substituting for U () we have: Thus, M px

(1 )

M 1

M f p x

(1 )

M f 1

M M f = p p x x f = M 1 p x px

and

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D. Sketch the budget constraint and the optimal choice for a consumer who chooses not to accept the subscription. If a consumer buys a subscription, the maximum amount she can purchase of other goods is M f . The slope of the budget line is p . If the optimal point on the subscription-based budget constraint is associated with a lower indifference curve, then the consumer will not purchase a subscription:

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E. Holding f xed, graphically nd the maximum discount price level which would induce this consumer to purchase additional units of telecommunication services ( p x ). Here we rotate the subscription based budget constraint around the y axis intercept to the point that it is just tangent to the original indifference curve:

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F. Solve for p h ( f ) analytically. As shown above, the price which makes the consumer indifferent between taking a subscription or not is: f 1/ p ( f ) = 1 M
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G. Suppose that the marginal cost of supply for telecom services is 1. What combination of f and p x maximizes rm prot? max ( f ) = f + ( p( f ) 1)x = f + ( p 1)
f

M f p( f )

The rst order for prot maximization is: f d p( f ) d = 1 2 =0 df p df p Applying the basic rules of calculus, we have: d p( f ) df = = Hence: d p( f ) f = 1 + + 2 = 0 p = 1 df p p Basic idea: nonlinear pricing does not provide a means of increasing rm prots in the case of CobbDouglas demand. The optimal subscription rate is zero ( f = 0), and it is optimal to price at marginal cost (p = 1). Cobb-Douglas Calibration Suzy consumes ice cream (x1 ) and soda (x2 ) for lunch every day, and she currently has one ice cream and two sodas per week when they both cost 1 CHF. What Cobb-Douglas utility function is consistent with Suzys choices over ice cream and soda. Write down demand functions which could extrapolate her optimal choices to any expenditure (m) and prices ( p1 and p2 ). A Cobb-Douglas Calibration Exercise: Answer Based current choices, we observe that Suzys budget shares for ice cream and sodas are 1/3 and 2/3, respectively. The Cobb-Douglas utility function which describes her preferences is: U (x1 , x2 ) = x1 x2 and demand functions are x1 = and x2 = Y 3 p1 2Y 3 p2
1/3 2/3
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f M

1/ 1

1 M

p1 M

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Calibration Exercise #2 Suppose that irregardless of relative prices, Suzy always has one soda before and one soda after eating an ice cream. What utility function is consistent with these choices? Write down demand functions which could extrapolate her optimal choices to any expenditure (m) and prices ( p1 and p2 ). Exercise # 2: Solution Perfect complement preferences have the form: U (x1 , x2 ) = min( in which the ratio we have:
a1 a2

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x1 x2 , ) a1 a2

determines the ratio in which goods 1 and 2 are consumed. In the present example, U (x1 , x2 ) = min(x1 , x2 ) 2

and demand functions given by: x1 = and x2 = 2 Y p1 + 2 p2 Y p1 + 2 p2

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Calibration Exercise #3 When Suzy gets to the lunch counter, she always asks about the price of ice cream and the price of soda. If two sodas cost less than one ice cream, she has spends all of her money on soda. Otherwise she buys ice cream. What utility function is consistent with these choices? Write down demand functions which could extrapolate her optimal choices to any expenditure (m) and prices ( p1 and p2 ). Calibration Exercise #3 Solution General perfect substitues preferences have the form: U (x1 , x2 ) = a1 x1 + a2 x2
a1 represents the marginal rate of substitution of good 1 for good 2. The demand functions in which the ratio a 2 for these preferences are given by:

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x1 =

0
M p1

p1 1 when p >a a2 2 otherwise a1 1 when p p2 < a2 otherwise

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x2 =

0
M p2