Theory of Consumer Behaviour Prof. Ravikesh Srivastava Lecture-7.
Lecture 3 - Consumer Theory
-
Upload
jico-bumagat -
Category
Documents
-
view
222 -
download
0
Transcript of Lecture 3 - Consumer Theory
-
8/4/2019 Lecture 3 - Consumer Theory
1/24
Consumer TheoryLecture 3
Econ 100.2 Introduction to Microeconomic Theory and Policy
Assad Baunto
1st semester, SY 2011-12
-
8/4/2019 Lecture 3 - Consumer Theory
2/24
Consumer Theory Lecture 3
Individual demand is based on consumertheory:
amount of goodspurchased
(individual demandcurve)
2
Consumer
preferences
Budget
Constraint
-
8/4/2019 Lecture 3 - Consumer Theory
3/24
Consumer Theory Lecture 3
I. Choice
Three ways to depict consumer behaviour:
A.Preferences
B.Indifference curves
C.Utility function
3
-
8/4/2019 Lecture 3 - Consumer Theory
4/24
Consumer Theory Lecture 3
A. Preferences,
A B
A ~ B
4
~
-
8/4/2019 Lecture 3 - Consumer Theory
5/24
Consumer Theory Lecture 3
Properties of preferences:
1.Preferences can be ranked (complete)
2.No circularity of decisions (transitive).
3.More is better (monotonic)
4.Average is better than two indifferent bundles(convex).
5
-
8/4/2019 Lecture 3 - Consumer Theory
6/24
Consumer Theory Lecture 3
B. Indifference curve
6
I.C.
A
B
-
8/4/2019 Lecture 3 - Consumer Theory
7/24
Consumer Theory Lecture 3
Properties of I.C.:
1.Any points on the I.C. curve gives the individualconsumer the same satisfaction. (e.g. pt. A and pt.B). Hence, the term indifference.
2.I.C. is (negatively, or) downward-sloping.
3.The shape of the I.C describes how a consumer iswilling to substitute one good for another good.
Note: the rate at which an individual consumer iswilling to substitute one good (say, broccoli) for
one additional of another good (say, kangkong) isdeclining.
7
-
8/4/2019 Lecture 3 - Consumer Theory
8/24
Consumer Theory Lecture 3
Marginal Rate of Substitution (MRS)
- how many units of y one is willing to give up in order to get one moreunit of x.
Notes: (i) MRS is declining and (ii) MRS approximates the slope of the I.C. as thesize of the movement along the I.C becomes very small.
8
I.C.
y
x
MRS = - y = - MUy
x MUx
-
8/4/2019 Lecture 3 - Consumer Theory
9/24
Consumer Theory Lecture 3
Indifference curves
9
I.C1
A
B
I.C2
I.C3C
-
8/4/2019 Lecture 3 - Consumer Theory
10/24
Consumer Theory Lecture 3
For goods that are perfect substitutes, MRS is
constant.
10
I.C.
-
8/4/2019 Lecture 3 - Consumer Theory
11/24
Consumer Theory Lecture 3
Goods that are perfect complements are
shaped like right triangles.
11
I.C.A
B
-
8/4/2019 Lecture 3 - Consumer Theory
12/24
Consumer Theory Lecture 3
When one good is a bad, then I.C. is upward
sloping
12
I.C.
-
8/4/2019 Lecture 3 - Consumer Theory
13/24
Consumer Theory Lecture 3
C. Utility Functions
Utility function assigns a level of utility to each basketof consumption.
Ordinal utility function: ranks the preferences, but doesnot say how much one is preferred to another.
Cardinal utility function: describes the extent to whichone is preferred to another.
Note: our concern is ordinal.
13
-
8/4/2019 Lecture 3 - Consumer Theory
14/24
Consumer Theory Lecture 3
Cardinal Utility the old school (Bentham and
Jevons)
14
U(x)
U
U
-
8/4/2019 Lecture 3 - Consumer Theory
15/24
Consumer Theory Lecture 3
Note: Marginal utility is declining as one consumer
additional unit of good x. Law of diminishingmarginal utility
15
MU(x) or U(x)
-
8/4/2019 Lecture 3 - Consumer Theory
16/24
Consumer Theory Lecture 3
II. Budget Constraint
-Individual wants to buy goods given limited income and prices.
Assumption: No savings from income (M) fully spend.
16
px .x+ py . y< M
or, y < M px .xpy
-
8/4/2019 Lecture 3 - Consumer Theory
17/24
Consumer Theory Lecture 3
Effect of in income on the budget constraint(B.C.):
-shifts the B.C
Assumption: No savings from income (M) fully spend.
17
px .x+ py . y< M
px .x+ py . y< M
px .x+ py . y< M
M < M < M
-
8/4/2019 Lecture 3 - Consumer Theory
18/24
Consumer Theory Lecture 3
Effect of in prices (px, py) on the budget
constraint (B.C.):-rotates the B.C
In this example, the price of good y changes and not the price of good x.
18
px .x+ py . y< M
px .x+ py . y< M
px .x+ py . y< M
py < py < py
-
8/4/2019 Lecture 3 - Consumer Theory
19/24
Consumer Theory Lecture 3
III. Optimal Allocation
-maximise your I.C. subject to your budget constraint.
19
- px = - MUxpy MUy
qd* for good x
qd* for good y
-
8/4/2019 Lecture 3 - Consumer Theory
20/24
Consumer Theory Lecture 3
Optimal Allocation (cont.)
-As it turns out, when you maximise I.C. subject to your B.C,optimal allocation occurs at a point where the marginalutility of the last peso spent on one good is the same as themarginal utility of the last peso spent on any other good.
Equimarginal principle
20
MUy= MUx = = MUi
py px Pi
-
8/4/2019 Lecture 3 - Consumer Theory
21/24
Consumer Theory Lecture 3
IV. Digression: Revealed Preferences
So far, we focused our discussion on how individuals decideoptimal consumption of goods from a utilityfunctions/indifference curves and budget constraint.
What if, we start from
21
Utility function/I.C, and Optimal demandor consumptionBudget constraint
Optimal demand, andPreferences
Budget constraint
-
8/4/2019 Lecture 3 - Consumer Theory
22/24
Consumer Theory Lecture 3
V. Substitution Effect and Income Effect
The total impact of a change in the price of a good canbe divided by two effects:
Substitution effect the change in a goodsconsumption associated with a change in the goods
price, while utility is held constant
Income effect the change in a goods consumption
associated with a change in the purchasing power,while the price is held constant.
22
-
8/4/2019 Lecture 3 - Consumer Theory
23/24
Consumer Theory Lecture 3
case: price of good y declines.
23
A CB
BCBC
C
C
-
8/4/2019 Lecture 3 - Consumer Theory
24/24
Consumer Theory Lecture 3
Substitution Effect and Income Effect
Consider decline of price of good y BC rotates to BC optimal allocation from A to C. (total price effect).
Change from A to B is called substitution effect.
Change from B to C is called income effect. (note: increase inreal income results in increase in demand of good x, hence
normal good).
Consider different position of C, say C or C.
Change from B to C or C: increase in real income results indecline in the demand of good x. Hence, inferior good.
If total effect A to C: decrease in price of good x results in thedecline in the demand of good x, the good x is called a Giffengood.
24