CH3new07 - Chapter 3 RATIONAL CONSUMER CHOICE Boiling Down...

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Chapter 3 RATIONAL CONSUMER CHOICE Boiling Down Chapter 3 M = PxX + PyY where Px and Py are the prices of goods X and Y, which then are multiplied times the quantities of X and Y that are purchased. Simple algebraic manipulation of the equation shown above leads to the equation that represents the budget line: Y = M/Py- (Px/Py) X Next is the task of representing the preferences of the consumer. It is assumed that 1. consumers can decide between alternative market baskets with even very small changes in composition (completeness). 2. if a consumer prefers A over B and B over C, he also will prefer A over C (transitivity). 3. consumers want more rather than less. When the constraint line and the indifference curve are put on the same graph, showing all possible market baskets, the maximization process becomes one of trying to move out to the highest possible level of pleasure (indifference curve) without exceeding the constraint line In effect, the vertical axis of the graph measures the income remaining to spend on other goods when a specific amount of good X is consumed. The usefulness of these tools in understanding consumer choice and public policy outcomes is far greater than first meets the eye. Chapter Outline 1. Rational consumer choice theory begins with a budget constraint or opportunity set. a. The slope of the constraint shows the relative price ratio of the two goods under consideration. b. The location shows the amount of income that is available. c. One good can be used as a composite good that can represent money spent on goods other than X. 2. Consumer preference patterns are the next building block of consumer theory. a. Consumer preference orderings must be complete, transitive, and more must be preferred to less. b. These qualities lead to indifference curves that are negatively sloped, nonintersecting, and continuous. c. The slope of the indifference curves shows the rate at which the consumer would like to exchange one good for the other. This is called the marginal rate of substitution. d. A diminishing marginal rate of substitution is common and results in an indifference curve that is convex to the origin.
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CHAPTER 3: Rational consumer choice e. Perfect substitutes have straight-line indifference curves and perfect complements have L-shaped curves. 3. Maximizing a consumer's utility requires that the marginal rate of substitution equal the price ratio of the goods. 4. Where the marginal rate of substitution cannot equal the price ratio, a corner solution exists. Important Terms and Concepts rational consumer choice Cash or food stamps economic good composite good flow or stock measurement parallel shifts of budget line budget constraint changing slopes of budget line relative price completeness opportunity set transivity utility indifference curves consumer preference (diminishing) marginal rate of substitution best affordable bundle indifference map multidimensional plane corner solution Cardinal/ordinal utility (appendix) Lagrangian multipliers (appendix) A Case to Consider 1.
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This note was uploaded on 05/25/2008 for the course ECON 73-150 taught by Professor Dubra during the Spring '08 term at Carnegie Mellon.

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CH3new07 - Chapter 3 RATIONAL CONSUMER CHOICE Boiling Down...

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