Consumer Theory

What is Consumer Theory?

Study

of how people use their limited means to make purposeful choices. 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. Assumes that consumers consider the alternatives and choose the one they like best.
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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

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
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What is a Budget Constraint?

A

budget constraint shows the consumers purchase opportunities as every combination of two goods that can be bought at given prices using a given amount of income. 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
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Utility and Preferences

Utility

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

Indifference Curves
Preferences

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

An

indifference curve should not slope

up. Indifference I diff curves can not t cross one another. Better bundles are to the northeast. Indifference curves will not be bowed out.

Preferences in Indifference Curves

An indifference curve connects all the bundles that have the same utility. Higher indifference curves indicate more utility (IC2 is preferred to IC1). Lower indifference curves indicate less utility (IC1 is preferred to IC0). The indifference curve map is FULL of indifference curves.

Li's Indifference Curves

30 25 20 I2 I1 I0

Rice

15 10 5 0 0 10 20

Wheat

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. The MRS=|slope| of the indifference curve at a bundle. Common to assume the MRS declines as we move down an indifference curve.

Li's Indifference Curves

30 25 20 I2 I1 I0

Rice

15 10 5 0 0 10 20

Wheat

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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)

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How to Find the Best Combination

The

black bundle is best. The pink bundle is not the best. All the income has been spent but is not on the highest indifference curve possible.

Rice

20

R* IC2 IC1 IC0 W* 10 Wheat

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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

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Income and Substitution Effects

Economists decompose the effect of a change in price on the quantity demanded into an income and a substitution effect. 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). 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, cheaper goods are substituted for p ones. more expensive
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