Consumer Theory Lecture 1

Consumer Theory
A consumer decides how to spend his income or wealth to buy goods with the objective of maximizing his welfare.

Consumer Theory
How do consumers decide what to buy? What determines the (individual, market) demands of goods and services? How do the demands of goods and services depend on good prices, income, etc.?

Consumer Theory
In order to describe the consumers problem we need to specify his: - Preferences - Constraints.

Consumer Theory
The consumers preferences and constraints determine his choice; i.e., the consumption bundle that maximizes the consumers welfare on the set of feasible consumption bundles.

Bundles of goods
List of specific quantities of distinct goods and services Example: Two goods x and y. (x,y) = (quantity good x, quantity good y) e.g. (x,y)=(coffee, shoes) Consumer has to be able to rank all the bundles in order to identify which one he likes the most.

Bundles of goods
Bundle Units of food Units of clothes

B C D E F G

10 20 40 30 10 10

50 30 20 40 20 40

Bundles of goods (graphically)

Clothes (units per week)

50 40 30 20 10 10

B G C D E

20

30

40

Food
(units per week)

Preferences
Let A=(x,y) and B=(x,y) be two bundles. : preference relation; A B (A is preferred or indifferent to B). : strict preference relation;
A B (A is preferred to B) -- A B, but not B A.

~: indifference relation; A ~ B (A is indifferent to B) -- A B and B A.

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Preferences
Examples: Let A=(x,y) and B=(x,y) be two bundles. 1. Pareto: A B if x x and y y. 2. Lexicographic:

A B if x x or [x = x and y y]. 3. Goods and Bads (pollution, waste):

A B if x - y x- y.
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Preferences
4. Perfect substitutes: A B if x+y x+y. 5. Imperfect substitutes: A B if xy xy. 6. Complements: A B if min{x,y} min{x,y}.

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Preferences
I. Three basic axioms: A.1. Preferences are complete if for all bundles A, B: A B, or B A, or both. Consumers can always compare any two bundles.

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Preferences
I. Three basic axioms: A.2. Preferences are transitive if for all bundles A, B, C: A B and B C implies A C.

Consumers preferences do not cycle!

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Preferences
I. Three basic axioms: A.3. Preferences are monotone if for all bundles A=(x,y) and B=(x,y): (x,y) (x,y) implies A B, and (x,y) >> (x,y) implies A B. The more, the better!
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Indifference curves Represent all bundles of goods which give the consumer the same level of satisfaction.

An indifference curve
Clothes (units per week) The bundles B, C, and D give the consumer the same level of satisfaction.

50 40 30 20 10
10

B G C

D F

20

30

40

Food
(units per week)

Indierence Maps
Clothes
(units per week)

All bundles on I2 are preferred to bundles on I1. All bundles on I3 are preferred to bundles on I2

E C F I2 I1
Food
(units per week)

I3

Indifference curves
Implications of A1-A3: A.1: Every bundle is in some indifference curve. A.2: Indifference curves cannot cross. A3: Indifference curves are decreasing.

Preferences
Clothes
Under A.3, the consumer prefers C to F (and every bundle in the blue area), while E (and every bundle in the pink area), are preferred to C.

50 40 30 20 10 10

B G C D E

20

30

40

Food
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Indifference curves cannot cross

Clothes
(units per week)

I2

I1

The more, the better: The consumer should prefer B to D. Transitivity: The consumer should be indifferent between B and D. Contradiction!

C B D
Food
(units per week)

Preferences
II. Other Axioms: A.4. Preferences are continuous: If A B(n) n and {B(n)} If B(n) A n and {B(n)} A.5. Preferences are convex: If A B and 0 < < 1, then [A + (1- )B] B. B, then A B. B, then B A.

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Preferences
The marginal rate of substitution

The marginal rate of sustitution (MRS) is the maximum quantity of good y a consumer is willing to give up in order to get an additional unit of good x; that is, it is the value of a unit of good x measured in units of good y.
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Preferences
Clothes

16 14 12 10 8 6 4 2 1
-6

C MRS = 6

MRS =

-C
F

1 -4

B D
1 -2 1 -1 1

MRS = 2 E G
Food
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Preferences
Apple juice

Perfect substitutes : The MRS is constant.

1 0 1 2 3 4
Orange Juice
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Preferences
Right Shoe

Perfect complements: there is no possibility of substitution.

1 0 1 2 3 4
Left Shoe
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Preferences
The design of new automobiles (I)

The managers of car companies must decide how frequently to introduce new models and how much money to invest in improving performance and/or modifying the design of new automobiles.

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Preferences
The design of new automobiles (I)

The analysis of consumers preferences may help to determine when and how should the car companies change the design of new automobiles. How to determine consumers preferences?

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Preferences
Design

Consumers Preferences (A): High MRS

Consumers value design very little relative to performance.

Performance
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Preferences
Design

Consumers Preferences (B): Low MRS

Consumers value a lot design relative to performance.

Performance
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Preferences
The design of new automobiles (I)

According to a study of the demand of automobiles in the USA, in the last two decades the majority of consumers have shown to sharp preference for design rather than performance.

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Preferences
The design of new automobiles (I)

The growth of the imports of Japanese cars in the from the sixties: 15% of all American automobiles change their design, compare to 23% of imports.

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