Chapter1 - Chapter 1 Microeconomics of Consumer Theory The...

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© Sanjay K. Chugh 17 Spring 2008 Chapter 1 Microeconomics of Consumer Theory The two broad categories of decision-makers in an economy are consumers and firms. Each individual in each of these groups makes its decisions in order to achieve some goal – a consumer seeks to maximize some measure of satisfaction from his consumption decisions while a firm seeks to maximize its profits. We first consider the microeconomics of consumer theory and will later turn to a consideration of firms. The two theoretical tools of consumer theory are utility functions and budget constraints. Out of the interaction of a utility function and a budget constraint emerge the choices that a consumer makes. Utility Theory A utility function describes the level of “satisfaction” or “happiness” that a consumer obtains from consuming various goods. A utility function can have any number of arguments, each of which affects the consumer's overall satisfaction level. But it is only when we consider more than one argument can we consider the trade-offs that a consumer faces when making consumption decisions. The nature of these trade-offs can be illustrated with a utility function of two arguments, but is completely generalizable to the case of any arbitrary number of arguments. 1 1 An advantage of considering the case of just two goods is that we can analyze it graphically because, recall, graphing a function of two arguments requires three dimensions, graphing a function of three arguments requires four dimensions, and, in general, graphing a function of n arguments requires n+1 dimensions. Obviously, we cannot visualize anything more than three dimensions.
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© Sanjay K. Chugh 18 Spring 2008 Figure 1. Utility as a function of two goods, c 1 and c 2 . The specific utility function here is the square-root utility function, 12 1 2 (, ) uc c c c ± . Figure 1 illustrates the square-root utility function 1 2 c c ± , where 1 c and 2 c are two different goods. This utility function displays diminishing marginal utility in each of the two goods, which means that, holding consumption of one good constant, increases in consumption of the other good increase total utility at ever-decreasing rates. Graphically, diminishing marginal utility means that the slope of the utility function with respect to each of its arguments in isolation is always decreasing. The notion of diminishing marginal utility seems to describe consumers’ preferences so well that most economic analysis takes it as a fundamental starting point. We will consider diminishing marginal utility a fundamental building block of all our subsequent ideas. Indifference Curves Figure 2 displays the same utility function, with a different emphasis. Each of the solid curves in Figure 2 corresponds to a particular level of utility. This three-dimensional view shows that a given level of utility corresponds to a given height of the function above the cc ² plane.
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Chapter1 - Chapter 1 Microeconomics of Consumer Theory The...

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