chapter 5 Flashcards
examines how rational individuals make consumption choices when faced with limited resources.
Consumer Theory
Consumer Theory has always has two parts.
(1) What the consumer prefers.
(2) What the consumer can afford.
- Given any consumption bundles (x1, x2), consumer can rank them as to their desirability.
I. Consumer Preferences
the consumer can determine that one of the consumption bundles is strictly better than the other or decide that she is indifferent between the two bundles.
I. Consumer Preferences
>
preferred to
~
indifferent to
at least as good as
> ~
One bundle Is strictly preferred to another if
consumer chooses one bundle over the other
> preferred to
Consumer is indifferent between two bundles
when both bundles satisfies him/her
~ indifferent to
Consumer weakly prefers either of the
bundles which is available upon consumption;
but chooses a bundle when both are present
> ~ at least as good as
The consumer strictly
prefers (X1, X2) to (y1.
> preferred to
Consuming bundle X
satisfies him/her as
he/she would be
satisfied when
consuming bundle Y
~ indifferent to
Bundle X Is at least as
good as Y but X is
chosen either because
it is available or
consumer chooses
such at a certain period
> ~ at least as good as
4 assumptions of rational preferences
- Completeness
- Monotonicity assumption
- Reflexivity
- Transitivity
- A property of preference that implies a bundle of goods can be ranked as preferred, indifferent, or less preferred to one another.
- Completeness
means that you will choose one bundle over the other. (x1, x2) ≻ (y1, y2)
a. Preferred
means that you will gain the same satisfaction with two bundles, other factors being equal. (x1, x2) ~ (y1, y2)
b. Indifferent
- Completeness
a. Preferred
b. Indifferent
- In other words, we assume that people are not paralyzed by indecision—that they can actually state what they prefer.
- Completeness
- This is known as the ‘more is better’ property of preferences.
- Monotonicity assumption
- A bundle with more of one good and no less of the other is preferred or indifferent to as otherwise equivalent bundle.
- Monotonicity assumption
- Monotonicity assumption
- Ex. If bundle A(3, 5) and bundle B(3, 2) are available to the consumer, then he/she will prefer….
bundle A over bundle B as bundle A consists of more units of good 2 than bundle B
- Monotonicity assumption * also called as the
non-satiation assumption
- We assume that any bundle is at least as good as itself.
- Reflexivity
if the consumer thinks that X is at least as good as Y and that Y is at least as good as Z, then the consumer thinks that X is at least as good as Z.
- Transitivity
Advil > Biogesic, Biogesic > Neozep then:
Advil > Neozep
- Transitivity
- Transitivity property exhibit some sort of
internal consistency
- It denotes satisfaction, a subjective pleasure that an individual can derive from consuming a good or service.
utility
The consumer prefers the best bundle of goods that he/she can afford.
- ECONOMIC THEORY OF CONSUMER
states that each successive increments generates less and less additions to total utility.
Law of Diminishing Marginal Utility
- As more goods are consumed, the extra satisfaction or marginal utility receive
decreases
Utility increases at a
decreasing rate.
curve which shows the different combinations of Good X and Good Y which yield the same level of utility.
indifference curve
- It is a curve connecting all combinations of the goods that are equally desirable.
indifference curve
Properties of the indifference curve
- INDIFFERENT CURVES ARE NEGATIVELY SLOPED.
- INDIFFERENT CURVES ARE USUALLY CONVEX TO THE ORIGIN
- INDIFFERENCE CURVES DO NOT INTERSECT
the amount of Good Y that a consumer is willing to give up in exchange for Good X and still lie on the same indifferent curve.
Marginal Rate of Substitution (MRS)
- It is the slope of the indifference curve.
Marginal Rate of Substitution (MRS)
- This manifest that the slope of the indifference curve gets flatter down along the curve.
Diminishing Marginal Rate of Substitution (MRS)
mrsxy formula
change in Qy over change in Qx
or
Qy2 - Qy1 / Qx2 - Qx1
- The indifference curves do not intersect because it will violate the
Transitivity Principle.
The economic theory of the consumer is very simple: economists assume that consumers choose the
best bundle of goods they can afford.
BUDGET SET:
p1x1 + p2x2 = m
Where:
x1= quantity of good 1 consumed
x2= quantity of good 2 consumed
p1= price of good 1
p2= price of good 2
m= budget/ consumers income
shows the different combinations of Good X and Good Y that a consumer can purchase given his income and the prices of goods.
The budget line
all bundles within and along the budget line.
- Affordable Good
slope of the budget line. The amount of good 2 you gave up for good 1. It
- Opportunity Cost
- measures the rate at which the market is willing to “substitute” good 1 for good 2.
- Opportunity Cost
Budget Line Equation
EQ1: p1x1 + p2x2 = m
EQ2: X2=m/p2-p1/p2 (x1)
m/p2 = the vertical intercept
p1/p2 = slope
Changes in the budget line
- Income effect
- Substitution Effect
- Taxes
- Subsidies
- Rationing
- change in purchasing power
- Income effect
- change in income holding prices constant
- Income effect
- A budget line that shifts to the right shows an increase in
income
- change in relative prices
- Substitution Effect
- change in price of x1 holding price of x2 constant
- Substitution Effect
If Good 1 becomes more expensive, the budget line becomes
steeper
If Good 1 becomes more expensive, the budget line becomes steeper.
- INCREASING PRICE
- making the purchasing power of consumers decrease
- Taxes
Tax usually make the budget line __ towards the good where the tax is imposed
steeper
3 Kinds of Tax
i. Lump-sum tax
ii. Quantity tax
iii. Value tax
taking away fixed amount of money regardless of consumption behavior
i. Lump-sum tax
fixed amount for every unit of good consumed
ii. Quantity tax
iii. Value tax - known as
ad valorem tax
amount for every monetary value of good consumed
Value tax or ad valorem tax
TAX ON UNIT.
Quantity Tax
TAX ON THE VALUE (expressed in % term)
Ad Valorem tax
- making the purchasing power of consumers increase
- Subsidies
Subsidies usually make the budget line shift _ towards the good where subsidy is given
outward
3 KINDS OF SUBSIDY
i. Quantity subsidy
ii. Value subsidy
iii. Lump-sum subsidy
fixed amount for every unit of good consumed
i. Quantity subsidy
ii. Value subsidy - known as
ad valorem subsidy,
amount for every monetary value of good consumed
ii. Value subsidy -or ad valorem subsidy
giving fixed amount of money regardless of consumption behavior
iii. Lump-sum subsidy
- making the consumption of a good fixed
- Rationing
We can now rephrase this in terms that sound more professional by saying that “consumers choose the most
preferred bundle from their __________
budget sets.”
A consumer is in equilibrium
when, given his income and the
price of good, he maximizes WHAT?
the
total utility.
, a consumer is in equilibrium when the tangency of _____ and the ______ is
achieved.
budget line, indifference curve is
Utility Maximizing Rule
MUx/Px = MUy/ Py
