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Consumer Theory

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2 .What is Consumer Theory? ‹ Study of how people use their limited means to make purposeful choices. ‹ Assumes that consumers consider the alternatives and choose the one they like best. ‹ Assumes A that th t consumers understand d t d their th i choices (possibilities) and the prices ( (opportunity t it costs) t ) associated i t d with ith each h choice.

Consumer Theory .Why? ‹ Two important reasons: – to understand the foundations of market demand (bake the demand curve from scratch) – to address several interesting consumer theory issues that are best understood using g this model rather than the aggregate gg g demand model 3 .

Two Components of Consumer Demand ‹ Opportunities: – What can the consumer afford? – What Wh t are the th consumption ti possibilities? ibiliti ? – Summarized by the budget constraint ‹ Preferences: – What does the consumer like? – How much does a consumer like a good? – Summarized by the utility function 4 .

income ‹ The budget constraint measures the combinations bi ti of f purchases h th that t a person can afford to make with a given amount of f monetary t income. i 5 .What is a Budget Constraint? ‹A budget constraint shows the consumer’s purchase opportunities as every combination of two goods that can be bought at given prices using a given amount of income.

we say that the consumer is indifferent.Utility and Preferences ‹ Utility is the way economists represent preferences. ‹ If two bundles have the same utility. 6 . ‹ Among A t two bundles. b dl th the one with ith th the higher utility is the preferred bundle.

Indifference Curves ‹ Preferences that satisfy the conditions I have noted above can be represented by indifference curves. ‹ An indifference curve connects all of the bundles that a consumer likes equally equally. 7 . ‹ We will assume only two goods when using indifference curve analysis analysis. ‹ The set of all indifference curves that describe an individual’s preferences are referred to as an indifference curve map map.

Indifference Curve Map Properties ‹ An indifference curve should not slope up.” 8 . ‹ Indifference curves will not be “bowed out. ‹ Better bundles are to the northeast. ‹ Indifference I diff curves can not t cross one another.

Li's Indifference Curves 30 25 20 I2 I1 I0 ‹ Rice 15 10 5 0 0 10 20 ‹ ‹ Wheat 9 .Preferences in Indifference Curves ‹ An indifference curve connects all the bundles that have the same utility. The indifference curve map is FULL of indifference curves. Higher indifference curves indicate more utility (IC2 is preferred to IC1). Lower indifference curves indicate less utility (IC1 is preferred to IC0).

Common to assume the MRS declines as we move down an indifference curve.The Marginal Rate of Substitution ‹ ‹ ‹ The Marginal Rate of Substitution(MRS) tells us how much of one good a person would willingly trade for an incremental unit of the other good and remain indifferent. Li's Indifference Curves 30 25 20 I2 I1 I0 Rice 15 10 5 0 0 10 20 Wheat 10 . The MRS=|slope| of the indifference curve at a bundle.

How Much Wheat and Rice ‹ The optimal amount of wheat and rice to consume is the amount that maximizes utility y subject j to budget g constraint. ‹ In the graph... – Get to the highest g indifference curve p possible – Stay on the budget constraint (b/c more is better) 11 .

All the income has been spent but is not on the highest indifference curve possible.How to Find the Best Combination ‹ The black bundle is best. ‹ The pink bundle is not the best. Rice 20 R* IC2 IC1 IC0 W* 10 Wheat 12 .

How to Find the Best Combination ‹ Utility is maximized when: – the indifference curve is just tangent to the budget line. ‹ Utility is maximized when: – you are on the budget line and – the slope of the indifference curve equals the slope of the budget line ‹ Utility Utilit i is maximized i i d when: h – Income=PRR + PWW 13 .

Income effect: due to the increase in real income associated with a fall in prices (you can buy more with the same nominal income) or the loss of real income associated with a rise in prices (you cannot buy as much as you once did with the same nominal income). more expensive 14 . S b tit ti effect: Substitution ff t due d t to the th change h i in th the relative l ti price of the good.Income and Substitution Effects ‹ ‹ ‹ Economists decompose the effect of a change in price on the quantity demanded into an income and a substitution effect. cheaper goods are substituted for p ones.