Microeconomics – Consumer Theory

- a formal description of how consumers behave
- predicts consumers' choices in order to determine demand of goods
- evaluates effects of price increases on the well-being of consumers

- preferences: what people like
- budget constraints: what people can afford
- how consumers decide how to make choices: choose randomly vs. behaving in a way that achieves highest possible well-being

- symbol ≽ (A ≽ B means A is preferred to B)
- describes an individual's attitude towards alternatives
- a binary relation on the set of possible alternatives (comparing 2 bundles)

- completeness: if A and B are any 2 situations, an individual can always specify exactly on of the following options: A ≽ B, B ≽ A, A ~ B (indifferent between A and B)
- transitivity: if A is preferred to B, and B is preferred to C, then A is preferred to C, assuming that the individual's choices are internally consistent
- continuity: if A is preferred to B, the situations suitably "close to" A must also be preferred to B; used to analyze individuals responses to relatively small changes in income and prices
- strict monotonicity: more is better, so if A has more than B (A > B), then A ≽ B
- strict convexity: averages are preferred to extremes, mixture is preferred

- indifference curves

- represent all combinations of market baskets hat the person is indifferent to
- a person is equally satisfied with either choice within an indifference curve
- one good is graphed on the x-axis and the other is graphed on the y-axis
- shows the idea that more is better

- describes preferences for all combinations of goods/services
- includes a set of indifference curves
- indifference curves further away from the origin are 'better' due to higher utility

- No
- If we graphed 2 intersecting indifference curves and called the intersection point A and another point on one curve be and another point on the other curve C, we would assume that:
A ~ B and A ~ D but B ≽ D, which violates the axiom of transitivity

- measures how a person trades one good for another (how willing we are to give up one good for the other)
- quantifies the amount of one good a consumer will give up to obtain more of another good
- is equal to the negative of the slope of the indifference curve at any point
- use partial differentiation to find marginal rate of substitution
- changes as good x and good y change
- indifference curves are convex, so as more of one good is consumed, less of the other is willing to be given up

- if the indifference curve is convex, then the combination of (x1+x2), (y1+y2)/2 is preferred to either (x1, y1) or (x2, y2)
- implies that "well-balanced" bundles are preferred to bundles that are heavily weighted toward one commodity

- perfect substitution - MRS of one good for the other is constant
- perfect complements - indifference curves for the goods are right angles, thus MRS = 0 for horizontal and undefined (infinity) for vertical

- formula that assigns a level of utility to individual market baskets
- U(Good X Variable, Good Y Variable)
- along any indifference curve, utility is constant (dU = 0)

- ordinal in nature (have no meaning in terms of intensity; does not define how much more we prefer one good to another)
- records relative desirability of commodity bundles

- consumption of physical commodities
- psychological attitudes (beliefs, ideas)
- general cultural environment (some items are more useful than others)
* Economists generally focus on quantifiable options while holding constant other things that affect utility (ceteris paribus assumption)

- makes no sense to consider how much more utility is gained from A than from B
- impossible to compare utilities between people

- use an indifference curve that contains all combinations of goods that give the same utility

- MRS = ratio of marginal utility of x to marginal utility of y because MUx/MUy = (dU/dx)/(dU/dy)

- the change in utility associated with a small change in the amount of one of the goods consumed holding the quantity of the other good fixed
- dU/dx
- use partial differentiation (differentiate for one variable while others are held constant)

- U(x,y) = (x^a)(y^b)

- U(x,y) = ax + by
- linear indifference curves
- MRS is constant = a/b

- U(x,y) =min(ax, by)
- right angle shaped indifference curve

- a combination of goods that is less than the amount of money a consumer has to spend
- belongs in a budget set (all possible choices for 2 goods that a consumer can buy for the money they have to spend or less)

- different choices of good x and good y can be calculated that use all of the income or money a consumer has to spend
- I (income) = Px (price of good X) X + Py (price of good Y) Y

- changes in INCOME can cause the budget line to shift outward or inward parallel to the original budget line (holding prices constant)
- changes in PRICE can cause the budget line to rotate around an intercept either inward or outward

- the rate at which the two goods can be substituted without changing the amount of money spent
- Px/Py

- consumers choose bundles that have the highest utility that they can afford
- is at the point tangent to the budget line (budget constraint) on the indifference curve
- try to maximize utility subject to the budget constraint

- agents: # consumers
- resources: $
- preferences: axioms of rational choice
- objective: allocate income in 2 goods
- behavioral assumption: consumer is rational & wants to choose bundle of goods that is affordable and maximizes utility
- markets: there is given market price for each good
- individual purchase does not affect price in market

- MRS = (du/dx)/(du/dy) = Px/Py
- MUx/Px = MUy/Py
- if MUx/Px ≠ MUy/Py, MUx/MUy > Px/Py means one should be buying more of good X and less of Y & vice versa

- Particular: solve for precise values for optimal bundles (X, Y)
- General: solve for demand functions X(Px, Py, I) and Y(Px, Py, I)

- budget line

- the budget line remains the same

- move in a parallel way
- due to change in consumer choice

- traces out the utility maximizing market basket for each income level
- Good Y vs. Good X graph

- income-consumption curve has a positive slope
- quantity demanded increases w/ income
- income elasticity of demand is positive

- income-consumption curve has a negative slope
- the quantity demanded decreases w/ income
- the income elasticity of demand is negative

- relate the quantity of the good consumed to income
- normal good = Engel curve slopes upward
- inferior good = Engel curve slopes downward
- Income vs. Good graph

- rotate (slope changes)
- due to change in consumer choice

- traces out the utility maximizing market basket for each price of a good
- connect utility maximizing basket for each price of goods

- MRS falls as we move down and along the demand curve
- Price of Good X vs. Good X graph
- graphs x = x(px, py, I) the relationship of x and px where py, I are FIXED
- as price falls, quantity of X demanded generally rises

- Substitution Effect
- Income Effect

- the change in an item's consumption associated w/ a change in the price of the item, with utility held constant
- when price of an item declines, substitution effect leads to an increase in quantity demanded

- the change in an item's consumption brought about by the increase in purchasing power, with the price of the item held constant
- when a person's income increases, the quantity demanded for the product may increase or decrease depending on the type of good

- F1 to E (substitution effect) is positive
- F1 to F2 (total effect of price change) is positive
- E to F2 (income effect) is positive

- F1 to E (substitution effect) is positive
- F1 to B (total effect of price change) is positive
- E to B (income effect) is negative

- income effect may theoretically be large enough to cause the demand curve for a good to slope upward
- income effect outweighs the substitution effect

- a curve that relates the quantity of a good that all consumers in a market buy to the price of that good
- the sum of all individual demand curves in the market
- obtained by summing the consumers' demand curves
- shifts farther right as more consumers enter the market
- factors that influence demands of many consumers will affect market demand

- measures the percentage change in the quantity demanded resulting from a percent change in price
- using initial vs. final quantities and prices result in different answers (for P/Q)
- Ep = (%ΔQ)/(%ΔP) = (ΔQ/Q)/(ΔP/P)
- Ep = (ΔQ)/(ΔP) x P/Q

- absolute value of Ep is less than 1
- quantity demanded is relatively unresponsive to a change in price
- |%ΔQ| < |%ΔP|
Total expenditure (P x Q) increases when price increases

- absolute value of Ep is greater than 1
- quantity demanded is relatively responsive to a change in price
- |%ΔQ| > |%ΔP|
Total expenditure (P x Q) decreases when price increases

- when price elasticity of demand is constant along the entire demand curve
- demand curve is curved inwards (not linear)

- measures percentage change in the quantity demanded resulting from a percent change in income
- (ΔQ)/(ΔI) x I/Q

- consumers buy goods because it makes them better off
- measures how much better off one is
- difference between the maximum amount a consumer is wiling to pay for a good and the amount actually paid
- can be calculated
- sum of the surplus derived from each one individually