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Chapter 3 - Consumer Decisions and Utility

Chapter 3 - Consumer Decisions and Utility - Chapter 3...

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Chapter 3 Consumer Decisions and Utility In the last chapter, I described how consumer preferences are captured by means of mathematics in microeconomic theory. What I shall do in this chapter is describe how this construct can be applied in developing a theory of consumer demand, meaning that the decisions that consumers actually make are generally consistent with the underlying theory. In the current chapter, I wish mainly to sketch the ideas broadly. In the next chapter several of the less obvious implications of the theory are developed. It might be worthwhile to state that not all of this is going to sink in for the student, and I suspect that a reason why many students struggle in understanding the material is that there are some conceptual issues to clear up. We will do this once we see how the theory works, but suffice it to say, at the end of this chapter, we will spend a brief moment discussing some interesting questions such as: Do people have utility functions? Do we really need to assume they do? Does anyone actually behave in the way our theory describes them to behave? But before descending into such details, it is important to see how the theory works. 65
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66 CHAPTER 3. CONSUMER DECISIONS AND UTILITY 3.1 Feasibility One could think of chapter 2.1 as an exercise in which we came up with a simple yet flexible way of representing consumer preferences using mathe- matics. Of course, this gets us only half of the way in actually describing a theory as to how people make decisions. To do this, we need to add to our mathematical theory of desirability a theory of feasibility. I would certainly prefer having a Ferrari to having a Volkswagen (however wonderful a car a Volkswagen might be), and I would certainly prefer having two Ferraris to having one Ferrari. So why do I, then, in fact own a Volkswagen? Because I cannot afford a Ferrari, let alone two Ferraris. So, really what we are after in describing consumer behavior is a de- scription of how consumers make the best possible decisions given what is possible, or put another way, by saying consumers maximize their utility given what is feasible or affordable. The primary tool for describing what is feasible for a given consumer is the Budget Constraint . Suppose that a given consumer is confronted with a choice of two goods, x and y , and that a unit of good x costs p x dollars, while a unit of good y costs p y dollars. Given an amount of good x and an amount of good y , the total amount of dollars the consumer spends on the two goods is: Expenditures = p x x + p y y Suppose now that the consumer has a total of I dollars of income available to spend on the two goods. Then, it follows that expenditures cannot be greater than income, or: p x x + p y y I (3.1) You might at this point raise an objection - in the average everyday economy, people routinely spend more money than they have. This is true in a narrow sense, but not true in a broad sense. Consumers are not really spending more than they make in income, they are spending more today , but in turn incurring an obligation to pay back what they have borrowed in the future.
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