Consumer Theory Flashcards
What theory do economists rely on to understand how consumers make decisions
Theory of Consumer Choice
Theory of consumer choice relies on what main three premises
- Consumers have preferences that determine the satisfaction they get from the consumption of goods and services
- Consumers face constraints that limit their choices
- Consumers seek to maximize the level of satisfaction they obtain from consumption given the constraints that they face
Other than theory of consumer choice what other two explanations are there for consumer choice
- random decision making - consumers act blindly and make decisions without any thought
- individuals make systematic decisions (but then what drives systematic decision making)
What do economists presume consumers use to guide them in choosing between goods
- Economists assume that consumers have a set of tastes or preferences that they use to guide them in choosing between goods.
- Theses tastes may differ substantially among individuals due to differences in culture, experience, etc.
The standard model of consumer behavior assumes preferences satisfy what 3 key conditions
- Completeness
- Transitivity
- More is better (Non-satiation)
Describe the condition of completeness when it comes to preferences
This property says that when facing a choice between any two bundles of goods, a consumer can rank them so that one and only one of the following three relationships are true:
- The consumer prefers A to B
- Consumer prefers B to A
- Consumer likes both equally and therefore is indifferent between the two bundles
β> this condition ensures that consumers can rank all possible bundles of goods in term of their desirability
β> Implication: consumers must be able to decide on preferences for all possible options, indecision is not possible (so indifference is allowed, but not indecision)
Describe the condition of Transitivity when it comes to preferences
- Requires that if a consumer strictly prefers A to B, and strictly prefers B to C, then they also strictly prefer A to C
- Also applies to weak preferences and indifference relationships
- Transitivity ensures that individuals are rational in their choice
Describe the condition of more is better when it comes to preferences
- Requires that consumers always prefer more of a good to less of a good.
- This condition is referred to as non satiation
One way to summarize information about consumerβs preferences is to create a
preference map/indifference map
Describe an indifference curve
An indifference curve depicts the set of bundles of goods that a consumer views as being equally desirable. β> points lining the same curve are indifferent to each other
Indifference maps must satisfy what 4 properties
- Bundles on indifference curves farther from the origin are preferred to those on indifference curves closer to the origin (more is better property)
- An indifference curve goes through every possible bundle (completeness assumption, consumer can compare all bundles)
- Indifference curves cannot cross (b/c issue of transitivity would occur)
- Indifference curves slope downward (if they sloped upwards then we would have a clear preference for the higher bundle because it has more of both goods - issue of more is better property when they are supposed to be equivalent on the curve)
What does the slope of an indifference curve reflect
Reflects how willing consumers are to trade one good for another β> known as marginal rate of substitution
Define marginal rate of substitution
The rate at which a consumer is willing to substitute one good for another (= to the slope from one point to another point and then compare those?)
Lets say the y axis is burritos and x axis is pizzas
β> If the marginal rate of substitution is -3 what does that mean exactly
That means the she would be willing to get rid of 3 burritos to get one more pizza (the negative shows that she is willing to give up some of one good to get more of the other good)
What does the curvature of an indifference curve tell you
Curvature tells us how a consumerβs willingness to substitute between goods changes as the relative quantity of each good changes (so does the willingness to substitute increase or decrease etc.)
If the indifference curve is convex shaped, preferences will exhibit
Diminishing marginal rate of substitution 26
If the indifference curve is concave shaped, preferences will exhibit
Increasing marginal rate of substitution
Do most people have concave or convex indifference curves for most pairs of products
Convex
Goods that are perfect substitutes will exhibit what kind of marginal rate of substituion
A constant marginal rate of substitution - they are straight linear lines with a slope of a constant rate
β> perfect substitutes are goods that are essentially equivalent from the consumers point of view
β> ex. coke and pepsi
Goods that are always consumed in fixed proportions are known as what
Perfect compliments - (ex. always getting pie with ice cream scoop)
- They have right angle indifference curves
What are the three types of preferences we have seen then
- The extreme preferences: perfect substitutes, perfect compliments
- in between preference: imperfect substitutes
Our model of consumer behavior assumes that consumers can ________ bundles of goods and services to decide which gives them ___________
compare, greatest satisfaction
Describe the utility from consumption
We can basically summarize the preferences by giving each bundle of goods and services that can be consumed a numerical value that reflects the relative ranking of the bundles
- we can summarize the information contained in the indifference map succinctly using a utility function
The idea of describing preferences with utility comes from
the 19th century with John Stuart Mill and Jeremy Bentham
What does the utility function describe
the level of utility obtained from consuming goods and services (can understand how preferences change as consumption bundles change)
β> U= U(B,T)
U = level of utility obtained from consuming B and T respectively
Given a utility function, if a consumer prefers bundle (B1, T1) to bundle (B2, T2), then which utility value will be greater
U(B1, T1) > U(B2, T2)
Do utility functions exist in the real world
They do not exist in any fundamental sense, they constitute an economic model of consumer behavior
What type of measure is utility
An ordinal measure - it is a relative ranking
Describe an ordinal measure
- Only contains information about relative rankings
like 5 star vs 1 star
(whereas cardinal measures are based on absolute numerical comparison like 10kg vs. 20kg)
Define marginal utility (MU)
Tells us how utility changes as we increase or decrease consumption of one good, holding consumption of all other goods constant
β> the extra utility that a consumer gets from consuming an additional unit of a good is the marginal utility from that good
How do you calculate the marginal utility
MUb = βπ/βπ΅
β> marginal utility for one thing is the change in utility divided by the change in that things quantity?
Marginal rate of substitution vs marginal utility
MRS = tells us the rate at which a consumer is willing to substitute one good for another
MU = tells us how much consumer satisfaction changes if consumption changes by one unit
Show how the marginal rate of substitution can be written in terms of the marginal utilities
MRS = βB/ βZ = -MUZ/MUB
What is the first step in determining consumer choice behavior
Understanding preferences
What is the second step in determining consumer choice behavior
Understanding the constraints consumers face when making decisions
What is the most important constrain that individuals face in the standard theory of consumer choice
the limitations imposed by budget
Define the budget line (budget constraint)
This depicts all possible bundles of goods that can be purchased if the consumerβs ENTIRE budget is spent on those goods at given prices
Define the opportunity set
This is the set of all possible bundles of goods that a consumer can buy, including all the budgets inside the budget constraint and on the budget constraint (the budget line)
The slope of the budget constraint is known as
Marginal rate of transformation (MRT)
Define the marginal rate of transformation
The trade off the market imposes on the consumer in terms of how much of one good the consumer must give up to purchase more of another good
If y-axis is B and x-axis is T what is the MRT
-Pt/Pb (looking at price)
A marginal rate of transformation of -1/2 means what
That you can trade an extra pizza for half a burrito
The third step in determining consumer choice behavior is understanding
how consumers maximize their well-being, subject to the constraints that they face
What is the theory underlying how consumers maximize their well being, subject to the constraints that they face
- Consumers pick the bundle of goods in their opportunity set that gives them the highest level of utility
- intuition: of all the bundle of goods that they can afford to buy consumers choose the bundle that makes them the happiest
So if consumers choose the bundle of goods that make them the happiest, where would there optimal choice be in regards to their indifference curve and their budget line
The choice must lie on an indifference curve that touches the budget line, but does not cross it β> by consuming this bundle there is no incentive to change behavior and substitute
What is an interior solution
where the optimal bundle has positive quantities of all goods and lies between the ends of the budget line.
β> the indifference curve is tangent to the budget line so they will then have the same slope meaning MRS = MRT or MUT/MUB = MUB/PB
What is a corner solution
where the optimal bundle has a quantity of zero for at least one good, meaning the optimal bundle is at one end of the budget line.
Managers often use promotions to induce consumers to purchase more units using deals like buy some get some free
They create kinks in the consumers budget line (budget line does not shift but gets bumps in it). Consumers response to such offers depend on their tastes (the shape of their indifference curves)
For the buy two get one free promotions, what consumers will take advantage of it
The promotion creates a kin in their budget line, if that line still intersects their indifference line, that means there will be an optimal point tangent to a second indifference line and they will take advantage of it
What points are there to remember about designing promotions
- properly exploiting promotions requires knowledge of consumer preferences
- promotions are costly, only use if benefits > costs
A half price promotion causes what to happen to the budget line
a pricing promotion will always rotate the budget line, meaning the consumer chooses a new optimal bundle
What deviations from the theory of consumer choice do we see
Behavioral economics seeks to understand the implications of departures from these assumption using insights from psychology, and empirical research on our cognitive and emotional basis
- there are 3 key findings of transitivity, endowment effects, salience
Describe deviations from theory: transitivity
transitivty fails when it comes to children and novel goods
Describe endowment effects
Standard model assumes that individuals value a good the same regardless of whether or not they own it.
Empirical evidence suggests that most people place a higher value on a good if they own it then they do if they are considering buying it.
Describe salience effects
Standard model assumes that individuals consider all possible information when making a decision.
Empirical evidence suggests that people are more likely to consider information if it is presented in a way that grabs their attention, or if it takes relatively little thought or calculation to understand.
