T1 Theory of consumer choice Flashcards
6 main principles of microeconomics
1) people face trade offs
2) rationalities
3) opportunity costs
4) incentives are important
1) people face trade offs
Resources are scarce so choices have to be made –> by individuals about what to buy and by firms what to produce (choose =sacrifice of another)
> e.g. Governments spending budget on defence spending or hospitals - think about choice as a trade off
e.g. Clean air/water or higher living standards (efficiency or equity/fairness)
2) Rationality
Rational human beings: We have perfect information, we then process this info using algorithms to make objectively correct decisions about what to buy/ for firms, produce. –> implies that decision making is purely considered a cognitive process of calculation and deliberation
> Rational maximisers: Using information efficiently by applying mathematical algorithms to generate behaviour that is objectively determined…
- efficiency in production: Maximise profits, minimise costs
- efficiency in consumption: Maximise utility
3) Opportunity costs
the cost of something is what you give up to get it/ if you make a choice you forgo the other option (e.g. What will it cost to study at Bath for three years?)
4) incentives are important
An incentive is Something that motivates an individual to perform an action. Incentives can influence behaviour
E.g. Lower tax rates may encourage better work ethics.
How do economists allocate resources efficiently
1) TRADE: Can make everyone better off as it allows us to specialise in particular activities
2) MARKETS: Usually a good way to allocate resources. They facilitate trade and exchange of goods and services as well as
Neo Classical economics
neo classical economics treats humans, whether that’s individuals or firms as entirely rational beings
a) unbounded rationality- our rationality knows no bounds
b) homo economics- the rational human being
departures from rationality emerge both in judgements (beliefs) and in choices. The ways in which judgement diverges from rationality are extensive
a) overconfidence and optimism- when making decisions we do nor make realistic appraisals about our chances of success, and have a tendency to overestimate ourselves in many different areas of life
b) loss aversion- tendency for people to experience more pain from losses than pleasure from equivalent gains
examples of divergence from rationality
A) £1000 with certainty
B) 90% odds of £2000 &10% odds of -£1000
people avoid risk when a positive frame is posed but seek risk when a negative frame is posed
why does understanding demand conditions help firms
1) estimate their sales/revenues
2) determines type and quantity of output produced
3) determine the price to charge/effect of price changes on sales/revenue
4) estimate the likely effects of the launch pf new substitute products upon its own sales
what is choice??
choice is a function of preference and budget.
consumers problems are modelled using 2 tools:
1) indifference curves- to analyse preference
2) budget constraint- describes the range of choices affordable to the consumer
budget constraint example and explanation
Lets assume Boozy Jane has an Income (Y) of £20 for her
evening’s drinking. The Price of Beer (Pb )is £2 a pint
and the cocktail price (Pc) is £4.
What is important to Boozy Jane is what her income will buy.
So if Jane spent all her income on beer, she could buy 10 pints
If she spent her £20 on just cocktails she could buy 5 cocktails
(look on moodle to find graph)
Q: what if the price of Janes cocktails falls to £2
A: the budget constraint pivots outwards and Janes affordable set gets bigger THEREFORE the relative price of beer to cocktail is now 10/10=1 (look on moodle for graph)
Q: What happens if Janes income falls to £16?
A: There is an inward parallel shift in a budget constraint (look on moodle for graph)
preferences (the boozy Jane example)
In any given evening, Jane tells us she would be equally as happy (INDIFFERENT) consuming any combinations of beer and cocktails e.g. Jane is equally happy consuming 1 beer with 9 cocktails as she is consuming 8 beers with 1 cocktail.
If we plot these points = AN INDIFFERENCE CURVE.
(look on moodle to find example of the indifference curve)
the curve:
- anywhere along the indifference curve, boozy jane is equally satisfied (CONSTANT UTILITY)
indifference curve definition
A curve which shows all the possible combinations of the two goods that yield the same level of satisfaction
the marginal rate of substitution definition
The MRS is the rate at which a person will give up the good measured on the y axis (for us beer) to get an additional unit of good x (cocktails) and at the same time remain indifferent (i.e. total utility is constant).
(formal definition of the slope of the indifference curve)
the magnitude of the slope of the indifference curve is actually the marginal rate of substitution
