lecture 3 - consumer theory

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Consumer TheoryLecture 3

Econ 100.2 Introduction to Microeconomic Theory and Policy

Assad Baunto

1st semester, SY 2011-12


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Consumer Theory Lecture 3

Individual demand is based on consumertheory:

amount of goodspurchased

(individual demandcurve)

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Consumer

preferences

Budget

Constraint


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I. Choice

Three ways to depict consumer behaviour:

A.Preferences

B.Indifference curves

C.Utility function

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A. Preferences,

A B

A ~ B

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~


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Properties of preferences:

1.Preferences can be ranked (complete)

2.No circularity of decisions (transitive).

3.More is better (monotonic)

4.Average is better than two indifferent bundles(convex).

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B. Indifference curve

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I.C.

A

B


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Properties of I.C.:

1.Any points on the I.C. curve gives the individualconsumer the same satisfaction. (e.g. pt. A and pt.B). Hence, the term indifference.

2.I.C. is (negatively, or) downward-sloping.

3.The shape of the I.C describes how a consumer iswilling to substitute one good for another good.

Note: the rate at which an individual consumer iswilling to substitute one good (say, broccoli) for

one additional of another good (say, kangkong) isdeclining.

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Marginal Rate of Substitution (MRS)

- how many units of y one is willing to give up in order to get one moreunit of x.

Notes: (i) MRS is declining and (ii) MRS approximates the slope of the I.C. as thesize of the movement along the I.C becomes very small.

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I.C.

y

x

MRS = - y = - MUy

x MUx


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Indifference curves

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I.C1

A

B

I.C2

I.C3C


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For goods that are perfect substitutes, MRS is

constant.

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I.C.


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Goods that are perfect complements are

shaped like right triangles.

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I.C.A

B


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When one good is a bad, then I.C. is upward

sloping

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I.C.


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C. Utility Functions

Utility function assigns a level of utility to each basketof consumption.

Ordinal utility function: ranks the preferences, but doesnot say how much one is preferred to another.

Cardinal utility function: describes the extent to whichone is preferred to another.

Note: our concern is ordinal.

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Cardinal Utility the old school (Bentham and

Jevons)

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U(x)

U

U


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Note: Marginal utility is declining as one consumer

additional unit of good x. Law of diminishingmarginal utility

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MU(x) or U(x)


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II. Budget Constraint

-Individual wants to buy goods given limited income and prices.

Assumption: No savings from income (M) fully spend.

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px .x+ py . y< M

or, y < M px .xpy


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Effect of in income on the budget constraint(B.C.):

-shifts the B.C

Assumption: No savings from income (M) fully spend.

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px .x+ py . y< M

px .x+ py . y< M

px .x+ py . y< M

M < M < M


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Effect of in prices (px, py) on the budget

constraint (B.C.):-rotates the B.C

In this example, the price of good y changes and not the price of good x.

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px .x+ py . y< M

px .x+ py . y< M

px .x+ py . y< M

py < py < py


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III. Optimal Allocation

-maximise your I.C. subject to your budget constraint.

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- px = - MUxpy MUy

qd* for good x

qd* for good y


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Optimal Allocation (cont.)

-As it turns out, when you maximise I.C. subject to your B.C,optimal allocation occurs at a point where the marginalutility of the last peso spent on one good is the same as themarginal utility of the last peso spent on any other good.

Equimarginal principle

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MUy= MUx = = MUi

py px Pi


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IV. Digression: Revealed Preferences

So far, we focused our discussion on how individuals decideoptimal consumption of goods from a utilityfunctions/indifference curves and budget constraint.

What if, we start from

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Utility function/I.C, and Optimal demandor consumptionBudget constraint

Optimal demand, andPreferences

Budget constraint


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V. Substitution Effect and Income Effect

The total impact of a change in the price of a good canbe divided by two effects:

Substitution effect the change in a goodsconsumption associated with a change in the goods

price, while utility is held constant

Income effect the change in a goods consumption

associated with a change in the purchasing power,while the price is held constant.

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case: price of good y declines.

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A CB

BCBC

C

C


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Substitution Effect and Income Effect

Consider decline of price of good y BC rotates to BC optimal allocation from A to C. (total price effect).

Change from A to B is called substitution effect.

Change from B to C is called income effect. (note: increase inreal income results in increase in demand of good x, hence

normal good).

Consider different position of C, say C or C.

Change from B to C or C: increase in real income results indecline in the demand of good x. Hence, inferior good.

If total effect A to C: decrease in price of good x results in thedecline in the demand of good x, the good x is called a Giffengood.

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lecture 3 - consumer theory

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