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Consumer Theory

This document provides an overview of consumer theory. It discusses that a consumer aims to maximize welfare by choosing a bundle of goods that satisfies preferences given a budget constraint. It defines key concepts like indifference curves, preferences, and the marginal rate of substitution. Preferences are assumed to be complete, transitive, monotone, continuous, and convex. Indifference curves cannot cross and are downward sloping. The marginal rate of substitution measures the rate at which a consumer is willing to trade one good for another while maintaining the same level of utility.

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Asif Hasan Dhiman
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74 views31 pages

Consumer Theory

This document provides an overview of consumer theory. It discusses that a consumer aims to maximize welfare by choosing a bundle of goods that satisfies preferences given a budget constraint. It defines key concepts like indifference curves, preferences, and the marginal rate of substitution. Preferences are assumed to be complete, transitive, monotone, continuous, and convex. Indifference curves cannot cross and are downward sloping. The marginal rate of substitution measures the rate at which a consumer is willing to trade one good for another while maintaining the same level of utility.

Uploaded by

Asif Hasan Dhiman
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Consumer Theory

Lecture 1

Consumer Theory
A consumer decides how to spend
his income or wealth to buy goods
with the objective of maximizing his
welfare.

Consumer Theory
How do consumers decide what to
buy?
What determines the (individual,
market) demands of goods and
services?
How do the demands of goods and
services depend on good prices,
income, etc.?

Consumer Theory
In order to describe the consumer s
problem we need to specify his:
- Preferences
- Constraints.

Consumer Theory
The consumer s preferences and
constraints determine his choice;
i.e.,
the consumption bundle that
maximizes the consumer s welfare
on the set of feasible consumption
bundles.

Bundles of goods
List of specific quantities of distinct goods and
services
Example: Two goods x and y.
(x,y) = (quantity good x, quantity good y)
e.g. (x,y)=(coffee, shoes)
Consumer has to be able to rank all the bundles in
order to identify which one he likes the most.

Bundles of goods
Bundle

Units of food

Units of clothes

10

50

20

30

40

20

30

40

10

20

10

40

Bundles of goods (graphically)


Clothes (units per week)

50

40

E
C

30

20
10
10

20

30

40

Food
(units per week)

Preferences
Let A=(x,y) and B=(x ,y ) be two bundles.
: preference relation;
A B (A is preferred or indifferent to B).
: strict preference relation;
A B (A is preferred to B) -- A B, but not B A.

~: indifference relation;
A ~ B (A is indifferent to B) -- A B and B A.
9

Preferences
Examples: Let A=(x,y) and B=(x ,y ) be two bundles.
1. Pareto:
A B if x x and y y .
2. Lexicographic:

A B if x > x or [x = x and y y ].
3. Goods and Bads (pollution, waste):
A B if x - y x - y .
10

Preferences
4. Perfect substitutes:
A B if x+y x +y .
5. Imperfect substitutes:
A B if xy x y .
6. Complements:
A B if min{x,y} min{x ,y }.

11

Preferences
I. Three basic axioms:
A.1. Preferences are complete if for all
bundles A, B:
A B, or B A, or both.
Consumers can always compare any two
bundles.

12

Preferences
I. Three basic axioms:
A.2. Preferences are transitive if for all
bundles A, B, C:
A B and B C implies A C.

Consumer s preferences do not cycle!

13

Preferences
I. Three basic axioms:
A.3. Preferences are monotone if for all
bundles A=(x,y) and B=(x ,y ):
(x,y) (x ,y ) implies A B,
and
(x,y) >> (x ,y ) implies A B.
The more, the better!
14

Indifference curves
Represent all bundles of goods
which give the consumer the same
level of satisfaction.

An indifference curve
Clothes (units per week)

50
40

The bundles B, C, and D


give the consumer the same
level of satisfaction.

E
C

30

20

10
10

20

30

40

Food
(units per week)

Indierence Maps
Clothes

All bundles on I2 are


preferred to bundles on I1.
All bundles on I3 are
preferred to bundles on I2

(units
per week)

E
C

I3

F
I2
I1

Food
(units per week)

Indifference curves
Implications of A1-A3:
A.1: Every bundle is in some indifference curve.
A.2: Indifference curves cannot cross.
A3: Indifference curves are decreasing.

Preferences
Clothes

50

40

Under A.3, the consumer


prefers C to F (and every
bundle in the blue area),
while E (and every bundle
in the pink area), are
preferred to C.

E
C

30

20
10
10

20

30

40

Food
19

Indifference curves cannot cross


Clothes
(units
per week)

I2

I1

The more, the better: The consumer should


prefer B to D.
Transitivity: The consumer should be
indifferent between B and D. Contradiction!

C
B
D
Food
(units per week)

Preferences
II. Other Axioms:
A.4. Preferences are continuous:
If A B(n) n and {B(n)}

B, then A B.

If B(n) A n and {B(n)}

B, then B A.

A.5. Preferences are convex:


If A B and 0 < < 1, then [A + (1- )B] B.

21

Preferences
The marginal rate of substitution

The marginal rate of sustitution (MRS) is the


maximum quantity of good y a consumer is
willing to give up in order to get an
additional unit of good x; that is, it is the
value of a unit of good x measured in units
of good y.
22

Preferences
Clothes

16
14
12

MRS =

MRS = 6

-C

-6

10

-4

MRS = 2

1
-2

1 -1
1

2
1

Food
23

Preferences
Apple juice

Perfect substitutes : The MRS is


constant.

1
0

Orange Juice
24

Preferences
Right Shoe

Perfect
complements:
there is no
possibility of
substitution.

1
0

Left Shoe
25

Preferences
The design of new automobiles (I)

The managers of car companies must decide


how frequently to introduce new models and
how much money to invest in improving
performance and/or modifying the design of
new automobiles.

26

Preferences
The design of new automobiles (I)

The analysis of consumers preferences may


help to determine when and how should the
car companies change the design of new
automobiles.
How to determine consumers preferences?

27

Preferences
Design

Consumers Preferences (A):


High MRS

Consumers value design


very little relative to
performance.

Performance
28

Preferences
Design

Consumers Preferences (B):


Low MRS
Consumers value a lot
design relative to
performance.

Performance
29

Preferences
The design of new automobiles (I)

According to a study of the demand of


automobiles in the USA, in the last two
decades the majority of consumers have
shown to sharp preference for design rather
than performance.

30

Preferences
The design of new automobiles (I)

The growth of the imports of Japanese cars in the


from the sixties:
15% of all American automobiles change
their design, compare to 23% of imports.

31

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