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Ch 2 consumer theory basics

Ch 2 consumer theory basics - University of Toronto...

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University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute. 1 ECO 204 C HAPTER 2 Modeling Consumer Choice and Behavior: Preferences and Budget Constraints (this version 2012-2013) Department of Economics (STG), ECO 204, Sayed Ajaz Hussain _________________________________________________________________________________________________ C HAPTER 2 Modeling Consumer Choice and Behavior: Preferences and Budget Constraints 1 Updated: 10/11/2012 Fixed typos are shaded yellow 1. Introduction In ECO 204, we will build intermediate-level “scientific models of economic and financial phenomena ranging from consumer and firm behavior to models of financial portfolios and strategic interaction (game theory). Scientists in both the physical and social sciences use models to understand, explain, and make predictions about reality. For example, the “supply and demand” graph in ECO 100 is a (simple) graphical model of the price and output in competitive markets; a scaled down model aircraft in wind tunnels models actual flight; Brownian motion models the trajectory of commodities prices 2 : Scientists start building models by making simplifying assumptions which subsume, or ignore, many aspects of reality. Modeling the speed and acceleration of objects? Assume there’ s no friction. Modeling how fast something falls towards 1 Thanks: Asad Priyo. For feedback, comments and typos please e-mail [email protected] 2 See this technical note and if you take ECO 404 you will learn how to use Brownian motion to forecast Copper and Zinc prices for a mining company trying to decide if it should bid on a mine.
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University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute. 2 ECO 204 C HAPTER 2 Modeling Consumer Choice and Behavior: Preferences and Budget Constraints (this version 2012-2013) the ground? Assume there is no air resistance. Modeling consumer behavior? A ssume consumers are rational. Modeling firm behavior? A ssume companies choose output to maximize profits; and so on. Scientists are perfectly aware that such assumptions are false: there is friction; there is air resistance to falling bodies; consumers are not always rational; firms don’t always operate to maximize profits 3 . So why do scientists make patently false assumptions? It’s because these greatly facilitate the development of a tractable model. By necessity, we have to assume away many aspects of reality because it s impossible to build a useful model which captures every (or very many) finest-grain details of reality. Having made simplifying assumptions scientists (like ourselves ) build models as follows: For example, suppose we want to understand, explain and predict how much money individuals save (say) each month. In reality, monthly savings depend on many factors such as: disposable income, family size, age, peer effects, expected inflation/deflation etc. A model with every one of these determinants will be unwieldy, cumbersome and thwart our efforts to understand saving. For traction, why not start by understanding, explaining and predicting the link between savings and one of the determinants of savings (say, income)?
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