Mod 03 Notes

# Mod 03 Notes - 570.493 Module 3 Lecture Notes Consumer...

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570.493 – Module 3 Lecture Notes Consumer Behavior – cont. Our study of consumer behavior continues with an examination of: Consumer Demand Market Demand Uncertainty Consumer Demand It is clear to most people that price is one of the factors that determines how much of a good will be consumed. Here we use utility theory to explain and describe this relationship. Objective : The objective of this section is to model the consumption of one good by one person as a function of the price of that good. This relationship is known as consumer demand. The following sections show how market demand is derived from consumer demand and explore some characteristics of market demand, including the relationship between quantity demanded and income. Definitions: Demand - The functional relationship between price and quantity demanded Quantity Demanded - The amount of a good consumed at a specified price Notice the difference between the terms, despite the fact that some use them interchangeably. In this course, we will insist on precise use so as to avoid confusion. Graphical Derivation In Module 2 we constructed and plotted a budget constraint and considered the way in which changes in prices or budget would affect the plot. Figure 3-1 is similar to Figure 2-1 with m = 12 and p 1 = 3. However, p 2 is allowed to assume different values. In this figure, p 2 is equal to 6.03, 4, and 2.58. Recall that the intercept on the Good 2 axis is defined as equal to the budget divided by the price of Good 2: in the case of the three different values for price, m/p 2 = 1.99, 3, and 4.65. - 1 -

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570.493 – Module 3 Lecture Notes Figure 3-1 Budget Constraints; P 2 Varies, Fixed Budget It can be seen that the slope of each budget constraint is the ratio of prices for the two goods: the slopes shown in Figure 3-1 are -2.01, -1.33, and -0.86, reading from left to right. (In this case, the slope is defined as the change in Good 1 divided by the change in Good 2. The inverse definition is also acceptable, provided that MRS is defined in a consistent way.) Recall that, because of divisibility, there is an infinite number of budget constraints in good space. Furthermore, an indifference curve passes through each point in good space, so each budget constraint intersects an infinite number of indifference curves. If the indifference curves are sufficiently convex, there will be one and only one indifference curve tangent to each budget constraint. (Recall that indifference curves cannot cross or otherwise touch each other.) Figure 3-2 shows the three budget constraints from Figure 3-1. Here, for each budget constraint, we show an indifference curve which touches the budget constraint at a tangency. Figure 3-2 Utility Maximizing Solutions; P 2 Varies, Fixed Budget As demonstrated in Module 2, each of the tangencies represents a utility maximizing solution; the three solutions differ only because the price of good 2 is different for each one.

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