Consumer Theory: Preferences, Choices, and Utility

Lecture 3: Consumer Theory

Consumer Behavior

1. Consumer Preferences: The fact that a consumer prefers one good to another.

2. Budget Constraints: A consumer has limited resources (income) to consume a restricted quantity of goods.

3. Consumer's Choice: Given their preferences and budget constraints, they will choose the optimal consumption bundle of goods/services to maximize their 'satisfaction'. (Marginal Utility = Marginal Cost)

3 Assumptions about Tastes & Preferences

1. Completeness: Implies that consumers can compare and rank all possible market baskets. A>B, A<B, or A=B

2. Transitivity: If a consumer prefers A>B, and B>C, then they must prefer A>C. (A>B>C)

3. Non-satiation: Consumers are never satisfied; the more, the better.

Utility Function

The utility function assigns a number to each basket to measure the level of satisfaction that a consumer receives from the basket of goods.

Marginal utility is the additional utility one derives from an additional unit of consumption of the goods. (Gradient/Slope of the curve)

, where U is the utility and X is the amount of goods consumed.

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Indifference Curve

Represents the locus of baskets that give a consumer an identical satisfaction/utility level. A consumer is indifferent along all points of the combinations of goods found along the indifference curve.

Marginal Rate of Substitution* (MRS) quantifies the number of units of clothing a consumer is willing to sacrifice to consume one additional unit of food while maintaining their utility at the same level. (MRS, indifference curves are convex to the origin)

MRS is the number of units of Y a consumer is willing to sacrifice for an additional unit of X while maintaining the same utility level.

The MRS is a constant (look at the gradient) for perfect substitutes. This violates the assumption of diminishing marginal returns.

The MRS is 0 for perfect complements. This violates the assumption of diminishing marginal returns and that more is preferred to less.

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Budget Line

It represents all the possible baskets of goods a consumer can buy, given their disposable income and market prices of the goods.

It shows all the combinations of goods for which the total amount of money spent is equal to income.

Budget Line Equation: I=P_f(F)+P_c(C)

Line AG shows the budget associated with an income of $*), price of P_f=$1 and P_c=$2. The slope (measured between B and D) is -10/20 = -0.5.

Hence, the slope measures the cost of buying one additional unit of F in terms of C.

Price changes of the goods will cause the line to rotate about 1 point, and income changes will cause the whole line to shift upwards or downwards.

Decision for Optimal Choice

Found by combining the indifference curve (Utility of goods) and the budget line (Budget Constraints of goods) together. Consumer Equilibrium is the optimal consumption that yields the highest level of satisfaction and is achieved where the curve and line intersect.