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Todays Discussion
Fundamental Economic Questions revisited What? Consumer Preferences Utility, Total Utility, Marginal Utility and Law of Diminishing Marginal Utility Budget Constraints Consumer Choice/Consumer Equilibrium
Consumer Behaviour
Why people buy goods and services? Primary goal of consumers is maximization of satisfaction from consuming the goods Economists call this satisfaction Utility But how do we measure satisfaction???
Consumer Behaviour
Can satisfaction you derive from consumption of a good be measured in some units of measurement?
There are different opinions! Cardinal and Ordinal Approaches To Cardinal Economists, the motivation to consume goods is to gain utility which is measurable in some numerical value
Consumer Behaviour
There are three steps involved in the study of consumer behavior.
Consumer Behaviour
2)
3) Finally, we will combine consumer preferences and budget constraints to determine consumer choices. What combination of goods will consumers buy to maximize their satisfaction?
Consumer Behaviour
It is assumed that consumers always prefer more of any good to less. That is, consumer is rational. This is called economic rationality. How can we determine the consumers preference?
Utility
Utility is the satisfaction or pleasure derived from consumption of a good or service. Utility received from consumption varies from person to person. It is subjective. Actual measurement of utility is impossible! But to Cardinalists believe it is possible
Utility
Ordinal Versus Cardinal Utility The actual unit of measurement for utility is not important- ordinal school of thought Therefore, an ordinal ranking is sufficient to explain how most individual decisions are made.
Total Utility
Total level of satisfaction derived from
all
Marginal Utility
Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good.
xU MU= xQ
Where x U is change in utility x Q is change in quantity consumed
Budget Constraints
Preferences do not explain all of consumer behavior.
Budget constraints also limit an individuals ability to consume. Suppose you allocate your income for 2 goods, Food and Cloths
Budget Constraints
Market Basket Food (F) Clothing (C) Total Spending Pf = (Rs.100) Pc = (Rs.200) PfF + PcC = Income
A B C D F
0 2 4 6 8
4 3 2 1 0
Budget Line-Graphically
80
Cloths
4 3 New Budget line when income decreases 2 1 0
A B C D
Cloths
4 3 2 1 0 2 4 6 8 16 Food (per week)
A B C D F
0 4 8 12 16
4 3 2 1 0
Cloths
4 3 Due to increase in the price of food 2 1 0 2 4 6 8 Food (per week)
Consumer Choice
How do you allocate our disposable income between the two goods to maximize utility?
Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them.
marginal
Summary
People behave rationally in an attempt to maximize satisfaction from a particular combination of goods and services. Consumer choice has two related parts: the consumers preferences and the budget line. Consumers make choices by comparing bundles of commodities. Consumers maximize satisfaction subject to budget constraints
Topics of Discussion
WHAT? What is behind the Law of Demand? Income Effect Substitution Effect Ordinal Approach to Consumer Behavior Consumer Surplus Types of Demand
What is behind the Law of Demand? Price Any logic from consumer behavior point of view?
Quantity demanded
Why do you purchase less at higher price and more at lower price?
Price changes alter your real income Money Income Vs Real Income A rise in prices decreases purchasing power, and a fall in prices increases purchasing power.
Any other explanation? Suppose the price of a good rises, then you will consume less of that good. Why?
When the price of a good rises, consumers may switch to more affordable substitutes. This is substitution effect. This is second reason behind the law of demand
Ordinal Approach
Economic rationality is assumed Consumers are able to rank their preferences for various combinations of goods A is preferred to combination B or both combinations A and B are equally preferred. If A is preferred to B, then A gives him more utility/satisfaction
Indifference Curve
Ordinal approach use indifference curves to analyze consumer preferences An indifference curve shows all combinations of goods that provide the consumer with the same satisfaction, or the same utility. Numerical measure of utility is not required
Indifference Curve
All combinations on an IC are equally preferred. Total utility is same at all combinations on an IC So consumer is indifferent about which combination to choose.
Properties of IC
IC slope downward
Indifference Map
An indifference map is a graphical representation of a consumers tastes for two goods Each curve in the map reflects a different level of utility Then how we will decide given a consumers indifferent map, how much of each good will be consumed? This is a consumer choice problem
Consumer Choice/Equilibrium
We need to consider the relative prices of the goods and the consumers income
Consumer Equilibrium
The indifference curve indicates what you are willing to buy The budget line shows what you are able to buy Now find out what quantities of each good you are both willing and able to buy.
Consumer Surplus
Consumer surplus = total willingness to pay for a good - the total amount consumers actually do pay. Consumer enjoys consumer surplus if he pays the same amount of money for each unit of good he buys.
CS occurs when people are able to buy a good for less than they would be willing to pay. They enjoy more utility than they had to pay for.
Since it is a measure of the net benefits received by the consumer, government can estimate the loss or increase in consumer welfare due to any policy change.
When the price of a good increases, one Quiz effect of this price increase is that consumers of that good experience a decline in their purchasing power that is like a decline in income. For normal goods, this contributes to the law of demand. What is this effect called? A. The substitution effect. B. The income effect.
Time
TRUE OR FALSE: The law of diminishing marginal utility states that as more and more units of a good or service are consumed, total utility becomes smaller and smaller.
a. True. b. False.
Quiz Time
In a consumer equilibrium, which of the following is true? a. The marginal utility from the last unit of each good
consumed is equal. b. The price of each unit consumed is equal. c. The total utility derived from consuming all the units of each good is equal. d. The marginal utility per rupee spent is equal for the last unit of each good consumed.