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Consumer Theory
Chapter 4
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
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
M PxX + PyY
Income Amount spent on X Amount spent on Y
Prof. Colin Mang, 2011 ECON 2106: Managerial Economics
M = PxX + PyY
a budget line
ECON 2106: Managerial Economics Prof. Colin Mang, 2011
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
ECON 2106: Managerial Economics Prof. Colin Mang, 2011
Px Py
It is called the price ratio or the Market Rate of Substitution, the ability to convert X to Y in the market
ECON 2106: Managerial Economics Prof. Colin Mang, 2011
Consumer Equilibrium
The Consumer Equilibrium occurs where the Indifference Curve exactly touches the Budget Constraint
Consumer Equilibrium
Because the Budget Constraint and Indifference Curve are tangent, they have the same slope
MRS =
ECON 2106: Managerial Economics
Px Py
Prof. Colin Mang, 2011
Consumer Equilibrium
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
ECON 2106: Managerial Economics Prof. Colin Mang, 2011
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
Deconstructing MRS
This means that, at the optimum
or
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
ECON 2106: Managerial Economics Prof. Colin Mang, 2011
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
ECON 2106: Managerial Economics Prof. Colin Mang, 2011
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)
ECON 2106: Managerial Economics Prof. Colin Mang, 2011
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
ECON 2106: Managerial Economics Prof. Colin Mang, 2011
Increase in Px
If Y decreases, X and Y are Complements
The Income Effect Dominates
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
Advertising
Can increase the attractiveness of your brand
Develop a Reputation
This takes longer but can cement your brands position in the market
ECON 2106: Managerial Economics Prof. Colin Mang, 2011
The lower the price elasticity, the more you can raise price and still increase profit
ECON 2106: Managerial Economics Prof. Colin Mang, 2011