Chapter 5 Flashcards
Why is consumer theory important?
Because consumer spending is the engine of the economy, understanding how consumers may spend their money helps businesses decide where to allocate their resources
Two important elements to understand consumers behavior
Preferences - set what we want –> unlimited
Budget restriction sets the boundary for what we can choose –> limited
DEMAND
Law of demand
people do less of what they want to do as the cost of doing it rises
Reservation price
the highest price you are willing to pay, if its higher you wont buy the goods
Fundamental assumptions for consumers decision making
- People (consumers) make decisions that maximized their own utility (rationality)
- Decisions are made under restrictions. We have a budget constraint that is determined by income and prices. But we also have a time restriction, which determines work and leisure (and the limitation of the day).
What is utility?
A measure of how “satisfied” we are, often referred to as well-being or happiness
A feeling, we use money to put a value on that feeling
Maximize utility
What is a utility function?
A utility function mathematically describes the relationship between consumption and the level of utility
Law of diminishing marginal utility
Tendency for the additional utility gained from consuming an additional unit of a good to diminish as consumption increases beyond some point
Example
Music festival: 1 day higher satisfaction and marginal utility -> 4 day lower marginal utility
Cup of coffee: First better than the third
Go skiing: First day better than the last, even if the last still has utility
the rational spending rule
Spending should be allocated across goods so that the marginal utility per dollar is the same for each good
utility functions with values
Consume different combinations and still reach the same level of utility
what does indifference curves show?
Shows which combinations of two different goods give the same utility
In economics, we used this as a general tool for analyzing and describing peoples choices
what does the slope of an indifference curve show?
And what is this curve called?
The slope shows how many units a good Y an individual is willing to pay to exchange for one unit of good X
Marginal rate of substitution (MRS)
what do the mrs show?
Shows how much of Y we are willing to give up to get one unit more of X, while maintaining utility
Perfect substitutes
The goods are perfectly interchangeable with each other. Note that MRS is constant but does not have to be 1, but it may be the most natural.
An extreme case –> straight line. If the goods are substitute but not perfect, then the indifference curve bends towards the origin,
Example: Different colors of a pencil. A red pencil is as good as a blue pencil.
Perfect complements
Goods that never consumes without the other
If there are no milk to the coffee, you do not drink.
Extreme case. If we get one more of X, the utility is not affected at all!
If the goods are perfect complements, they are always consumed in a given combination. For example, right and left shoe. Note that the combination does not have to be one on one.
