Consumer Theory

Lecture 4: Consumer Theory
Consumer Theory
Chapter 4
ECON 2106: Managerial Economics
Prof. Colin Mang, 2011
Consumer Theory
Consumers attempt to maximize their own satisfaction (utility)
Assumptions
1. Completeness
Consumers are fully aware of their own preferences For any two bundles A , B , the consumer always knows if they prefer A to B, B to A, or are indifferent between the two
Assumptions
2. More is Better
The Consumer will typically prefer more of all goods to less
3. Diminishing Marginal Utility

As the amount of X the consumer has increases, each additional unit of X becomes less valuable
Assumptions
4. Diminishing Marginal Rate of Substitution
As the amount of X the consumer has declines, the consumer becomes less and less willing to give up more X in exchange for Y
Assumptions
5. Transitivity
For 3 bundles A , B , C , if A is preferred to B and B is preferred to C, then A MUST be preferred to C
Graphing Preferences
We can find all the points that make an individual equally satisfied. i.e. all the bundles of X and Y that yield the same level of utility This collection of points is called an Indifference Curve
ECON 2106: Managerial Economics Prof. Colin Mang, 2011
Indifference Curve Properties

1. As Indifference Curves move outward, utility increases (More is Better) 2. Indifference Curves are always parallel to each other. They NEVER cross (Completeness and Transitivity) 3. The Slope of the Indifference Curve is the rate at which the consumer is willing to substitute between X and Y and still maintain the same level of utility
Indifference Curve Slope

The Rate at which a consumer is willing to switch between X and Y is called the Marginal Rate of Substitution (MRS) The slope of the Indifference Curve is the MRS and tells us exactly how much X a consumer is willing to give up for one more unit of Y Notice that the amount the consumer is willing to give up declines as X 0 (Diminishing MRS)
The Budget Constraint

Individuals do not have unlimited income (although they may have some control over the size of their incomes through education and labour supply choices (take ECON 2007 and find out how)) They must consume within their means

The Opportunity Set, or Budget Set, is all the possible bundles of X and Y that a consumer could afford
M PxX + PyY
Income Amount spent on X Amount spent on Y
Prof. Colin Mang, 2011 ECON 2106: Managerial Economics

If the Consumer spends their entire income on X and Y we get
M = PxX + PyY
a budget line
Change in Income
If Income increases, the budget line shifts outward in a parallel fashion The slope remains the same because the prices have not changed
Change in Price
If the Price of X increases, the budget line rotates inward The maximum amount of Y that can be purchased does not change ( Py is the same); the consumer is only affected if they buy some X The slope has changed because the relative price has changed
Budget Constraint Slope

The slope of the Budget constraint is
Px Py
It is called the price ratio or the Market Rate of Substitution, the ability to convert X to Y in the market
Consumer Equilibrium
The Consumer Equilibrium occurs where the Indifference Curve exactly touches the Budget Constraint
Because the Budget Constraint and Indifference Curve are tangent, they have the same slope
MRS =
Px Py
MRS =
Px Py
The rate at which the consumer is willing to exchange X for Y is exactly the same as the rate at which they are able to exchange X for Y in the market
Deconstructing MRS
The Marginal Rate of Substitution is just the way the consumer trades off the values of the two goods Therefore, the MRS simply represents the relative Marginal Utilities of the two goods
MUx = MRS MUy

Deconstructing MRS
This means that, at the optimum
or
MUx px = p MUy y MUx MUy = px py

Deconstructing MRS
Consumers will balance the utility the get per dollar spent on each good This implies: 1.Consumers will consumer larger quantities of cheap goods and smaller quantities of expensive goods 2.For two goods with the same price, the consumer will buy a greater quantity of the more preferred good
Price Changes and Behaviour

Suppose Px increases
X will decrease for sure If Y decreases, X and Y are complements If Y increases, X and Y are substitutes
Income Changes and Behaviour

Suppose M rises Case 1
Because X increases it is a Normal Good Because Y increases it is a Normal Good
Income Changes and Behaviour

Suppose M rises Case 2
Because X decreases it is an Inferior Good Because Y increases it is a Normal Good Note: At least one good MUST be Normal
Income and Substitution Effects

When looking at Price Changes, we can break down the change in consumption patterns into two effects
1. Substitution Effect 2. Income Effect
Substitution Effect
At the Optimum, the consumers private valuation (the MRS) is the same as the market valuation (the Price Ratio) When one price changes, the consumer will feel compelled to substitute between X and Y until the consumers MRS again equals the market valuation
Income Effect
A change in price will affect the consumers ability to purchase bundles of goods If the price increases, the consumer cannot purchase as much as before (as if their income decreased) If the price decreases, the consumer can purchase more than before (as if their income increased)
Increase in Px
X will decline for sure Substitution Effect compels the consumer to buy less X and more Y in order to adjust to the new market price (they substitute) The Income Effect forces the consumer to consume less X and less Y because old bundles are now unaffordable
Increase in Px
If Y decreases, X and Y are Complements
The Income Effect Dominates
If Y increases, X and Y are Substitutes

The Substitution Effect Dominates
Applications of Indifference Curve Analysis

Buy 1 Get 1 Free (Limit 1 Free per Customer) Gifts vs. Gift Certificates vs. Cash
Special Preferences
Perfect Substitutes
Indifference Curves are straight 450 lines The consumer will only ever by the cheaper good
Special Preferences
Perfect Complements
The Indifference Curves come to a point so that the consumer only cares about consuming the goods together
Special Preferences
Disinterest
A customer does not care about one of the goods The indifference curves are perfectly vertical and the consumer only buys good X
Special Preferences
Colour / Other Features
A customer may prefer some feature of an otherwise generic good
Affecting Consumer Preferences

To affect preferences you need a strong brand
i.e. you must differentiate your product from those of your competitors so that you are not seen as perfect substitutes
Advertising
Can increase the attractiveness of your brand
Develop a Reputation
This takes longer but can cement your brands position in the market
Brand Power $$$

By developing a strong brand, you essentially make the demand curve more inelastic
Consumers are willing to pay more for your product because either
They believe it is of superior quality They are unwilling to risk purchasing another product of unknown quality Your product is a status symbol
The lower the price elasticity, the more you can raise price and still increase profit

Consumer Theory

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Lecture 4: Consumer Theory

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 4: Consumer Theory

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 4: Consumer Theory

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 4: Consumer Theory

3. Diminishing Marginal Utility

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 4: Consumer Theory

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 4: Consumer Theory

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 4: Consumer Theory

Lecture 4: Consumer Theory

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 4: Consumer Theory

Indifference Curve Properties

Lecture 4: Consumer Theory

Indifference Curve Slope

Lecture 4: Consumer Theory

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 4: Consumer Theory

The Budget Constraint

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 4: Consumer Theory

The Budget Constraint

Lecture 4: Consumer Theory

The Budget Constraint

Lecture 4: Consumer Theory

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 4: Consumer Theory

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 4: Consumer Theory

Lecture 4: Consumer Theory

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 4: Consumer Theory

Budget Constraint Slope

Lecture 4: Consumer Theory

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 4: Consumer Theory

Lecture 4: Consumer Theory

Lecture 4: Consumer Theory

MUx = MRS MUy

Lecture 4: Consumer Theory

MUx px = p MUy y MUx MUy = px py

ECON 2106: Managerial Economics

Lecture 4: Consumer Theory

Lecture 4: Consumer Theory

Price Changes and Behaviour

ECON 2106: Managerial Economics