consumer theory_Presentation

consumer theory_Presentation - Consumer Theory What is...

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Unformatted text preview: Consumer Theory What is Consumer Theory? ◆ Study of how people use their limited means to make purposeful choices. ◆ Assumes that consumers understand their choices (possibilities) and the prices (opportunity costs) associated with each choice. ◆ Assumes that consumers consider the alternatives and choose the one they like best. 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 this model rather than the aggregate demand model Two Components of Consumer Demand ◆ Opportunities: – What can the consumer afford? – What are the consumption possibilities? – Summarized by the budget constraint ◆ Preferences: – What does the consumer like? – How much does a consumer like a good? – Summarized by the utility function 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. ◆ The budget constraint measures the combinations of purchases that a person can afford to make with a given amount of monetary income. Li’s Demand for Wheat and Rice ◆ Illustration of consumer theory ◆ Li’s demand for wheat and rice depends upon the prices for these goods, her income, and her preferences. ◆ Suppose we look first at her budget constraint: – Wheat costs $4/lb. – Rice costs $2/lb. – Li has $40 of income. Li’s Budget Constraint ◆ The mathematical expression for Li’s budget constraint is: I = P W W + P R R R = I/P R- (P W / P R )W ◆ I like to refer to the |slope| of the budget line as the ERS= E conomic R ate of S ubstitution ◆ In this case it is P W / P R ◆ For Li: P W =$4 P R =$2 I=$40 ERS=2 Graph of Li’s Budget Constraint ◆ The graph to the right shows a picture of Li’s budget constraint. Li's Budget Constraint 5 10 15 20 5 10 15 20 Wheat Rice ◆ Each blue diamond is a point from the table. ◆ The slope is equal to-2 , as shown on the last slide. Budget Line gymnastics ◆ An increase in income only. ◆ An increase in the price of wheat only. ◆ A decrease in the price of rice only. ◆ Income doubles as do the prices of wheat and rice. ◆ Note: Changes in the price of wheat relative to the price of rice will change the ERS. 10 Preferences ◆ Let R = “at least as good as” – B R B 1 means: B is at least as good as B 1 ◆ Let IN = “indifferent to” – B R B 1 and B 1 R B implies B IN B 1 ◆ Let P = “strictly preferred to” – B R B 1 and not B 1 R B implies B P B 1 11 Preferences ◆ Basic assumptions about an individual’s preferences ( R ) over bundles (B) – more is better : If B has more in it than B 1 then B R B 1 – transitivity: If B R B 1 and B 1 R B 2 then B R B 2 – average bundles are at least as good as extreme bundles: If B IN B 1 and B 2 is an “average” of B and B 1 , then B 2 R B and B 1 12...
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consumer theory_Presentation - Consumer Theory What is...

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