consumer theory

# Intermediate Microeconomics: A Modern Approach, Seventh Edition

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1 Consumer Theory

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2 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.
3 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

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4 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
5 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.

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6 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.
7 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

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8 Graph of Li’s Budget Constraint The graph to the right shows a picture of Li’s budget constraint. Li's Budget Constraint 0 5 10 15 20 0 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.
9 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.

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10 Preferences Let R = “at least as good as” – B 0 R B 1 means: B 0 is at least as good as B 1 Let IN = “indifferent to” – B 0 R B 1 and B 1 R B 0 implies B 0 IN B 1 Let P = “strictly preferred to” – B 0 R B 1 and not B 1 R B 0 implies B 0 P B 1
11 Preferences Basic assumptions about an individual’s preferences ( R ) over bundles (B) more is better : If B 0 has more in it than B 1 then B 0 R B 1 transitivity: If B 0 R B 1 and B 1 R B 2 then B 0 R B 2 average bundles are at least as good as extreme bundles: If B 0 IN B 1 and B 2 is an “average” of B 0 and B 1 , then B 2 R B 0 and B 1

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12 Utility and Preferences
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• Summer '07
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