Theory of Consumer Behavior

Theory of Consumer Behavior - Economics 2101 Handout 4:...

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Unformatted text preview: Economics 2101 Handout 4: Theory of Consumer Behavior I. Introduction Consumer Behavior Theory of I. Consumers are rational, seeking to maximize their well-being subject to Introduction constraints on what they feasibly can purchase. By rational, all we mean subject Consumers are rational, seeking to maximize their well-being is that the consumer's actions are consistent with his/her goals. to constraints on what they feasibly can purchase. By rational, all we mean is that the consumer's actions are consistent with his/her goals. In its barest form, we assume that the consumer derives satisfaction from the consumption of goods but that the consumer has a limited budget and can not In its barest form, we assume that the consumer derives satisfaction purchase all heconsumption ofgiven income andthe consumer hasgoods. from the /she would like goods but that the prices paid for a limited budget and can not purchase all he /she would like given income and Mathematically: The consumer is assumed to maximize Utility the prices paid for goods. (Satisfaction) U = Mathematically: The budget constraint: f(X,Y,....) subject to a consumer is assumed to maximize Utility (Satisfaction) UExpenditure on Goodsto ancome. constraint: Expenditure on Goods < = f(X,Y,....) subject < I budget Income. II. Preferences II. Preferences A. Basic Assumptions "Utility" or "Satisfaction" is a function of the consumption of goods: U A. Basic Assumptions = f(X,Y) "Utility" or "Satisfaction" is a function of the consumption of goods: U = f(X,Y) Preference assumptions: 1. Completeness: Given any two bundles of goods (A,B), the Preference assumptions: consumer can rank them and say: (1) A is preferred to B(APB), 1. Completeness: Given any two bundles of goods (A,B), the consumer can (2) B is preferred to A(BPA),or rank them (3) He/she is indifferent between the two (A I B). and say: (1) A is preferred to B (A P B), (2) B or Consiste A (B P A), or 2. Transitivityis preferred toncy: Given any three bundles of goods (3) He/she is indifferent between the two (A I B). (A,B,C), then (1) ifAPBandBPC,thenAPC (2) ifAIBandBIC,thenAIC. 3. Definition of a Good (Non-satiation): More of a good is preferred to less. (Note: could also define a Bad, less is preferred to more e.g., garbage or risk). 4. Diminishing Marginal Rates of Substitution: Along an indifference curve, the marginal rate of substitution of X for Y ( MRSx for y or MRSxy) decreases as X increases. (Alternative way of stating assumption: Indifference curves are convex to the origin.) B. Graphing Preferences Definition of Indifference Curve: An indifference curve shows combinations of good among which a consumer is indifferent. (That is, combinations of goods yielding the same level of utility.) Properties of Indifference Curves. a. Indifference curves have negative slopes. b. Indifference curves do not intersect. c. Indifference curves are everywhere dense. d. Indifference curves have diminishing marginal rates of substitution. (Alternatively, indifference curves are convex to the origin.) Definition of MRSxy: The marginal rate of substitution of X for Y is the amount of Y the consumer is willing to give up to get an additional unit of good X and be equally well off or it is the amount of good Y t the absolute value of the slope of an loss of a unit of X and leave the equalshat would just compensate for the indifference curve. It represents the consumer equally of the consumer to trade one commodity for the other. psychological willingnesswell off. Note: the - slope of indifference curve. value of the slope of an MRSxy = MRSxyequals the absolute indifference curve. It represents the psychological willingness of the consumer to trade one commodity for the other. MRSxy = - slope III. Budget Constraintof indifference curve. I. Assumptions III. Budget Constraint I. Assumptions TThebasic budget constraint is is that expenditure canexceed income: he basic budget constraint that expenditure can not not exceed income: Assuming all Assuming all income is spent,income is spent, . Expenditure on X + Expenditure on = Income Expenditure on X + Expenditure on Y Y = Income II. Graphing the Budget Constraint To graph the budget constraint, we want to find out the combinations of goods the consumer can buy, given his income and the prices of goods. Solve for Y to get: . Expenditure on X + Expenditure on Y = Income II. Graphing Graphing the Budget Constraint II. the Budget Constraint To graph the budget constraint, we want to find out the combinations To graph the budgetconsumer canwant to find out the combinations of of goods the constraint, we buy, given his income and the prices of goods the consumer Solve forgiven his income and the prices of goods. Solve for goods. can buy, Y to get: Y to get: . Intercept: Mntercept: M / - px / py. I / py Slope: py Slope: - px / py. IV. Optimum Choice Optimal consumption is when all budget is spent and the consumer chooses amounts of X and Y, such that MRSxy = px/py. The amount of good Y the consumer is just willing to give up for a unit of X (MRSxy) = The amount of good Y the consumer has to give up for a unit of X (px/py) Marginal benefit of a unit of X = Marginal cost of a unit of X. © Bryan L. Boulier, 2010. All rights reserved. ...
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This note was uploaded on 02/17/2011 for the course ECON 101 taught by Professor Fon during the Spring '06 term at GWU.

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