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Topic 5 - Consumer Theory.docx

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Western University
Economics 1021A/B
Arvin Dar

Topic 5: Consumer Theory 1. Introduction 2. The budget constraint/indifference curve approach 2.1. Budget constraint 2.2. Indifference curves 2.3. Equilibrium of consumer 2.4. Derivation of consumer’s demand curve 2.5. Derivation of market demand curve 3. The marginal utility (MU) approach 3.1. Paradox of value 3.2. Total utility (TU), MU and the law of diminishing MU 3.3 Equilibrium of consumer 1. Introduction  If I gave the consumer a set of prices and the income she has decided to set toward the purchase of the goods… what is the consumer’s optimal choice of de goods or services?  You set aside an amount for these goods per week and then the seller confronts you with prices  You want to derive the optimal amount of each commodity to purchase given prices & income  Given prices & income what is the optimal consumption? 2. Budget Constraint/Indifference Curve Approach 2.1 B.C  Sometimes “budget line”  Similar to the budget possibility frontier  You want to spend M dollars on pizza and beer this month (Income set aside/expenditure/budget)  M = PaQa + PbQb is the same as Qa = M/Pa – Pb/Pa X Qb  Good 1: Qa – pizza M/Pa  Good 2: Qb – beer o PaQa + PbQb  expenditure on each good Slope=-Pb/Pa o Before: $100 = $3-Qa + $4Qb o Now: Pa X Qa = M – Pb X Qb o Qa = M/Pa – Pb/Pa X Qb M/Pb Intercept Slope  Regardless of numbers, changing income or the price of either product will have an affect o Income increases:  The slope does not change (-Pb/Pa does not have M)  Both points move up/to the right respectively  Making unattainable points attainable o Price A increases:  The slope changes – moves down A B o Price B increases:  The slope changes – moves left 2.2. Indifference curves  A given indifference curve gives combinations of two commodities that give the consumer the same level of satisfaction/happiness/utility: measured in utils.  Assuming both these commodities are desirable, the curve looks like: o All points give the same satisfaction level (3 pizza & 2 ice tea = 1 pizza & 4 ice tea) o A loss in one commodity can be made up for by more of the other commodity.  Comparing two curves – you want the one with the higher point o (you don’t care where the point is on the same curve) o They cannot cross o Family of indifference curves: a whole bunch of them  Each higher curve must have a higher utility number (100, 110, 120)  Indifference curves are always negative – even if they slope really steeply like:  If a commodity is undesirable like pollution you have a positively sloped curve like: 2.3. Equilibrium of consumer  To see the possibilities, you look at the budget constraint o If the consumer spends all his/her income then you look at the points on the line.  To see your preference, you look at the indifference curve o To see combinations of such that’ll make you… satisfied  Basically, you combine the two graphs into one. Very difficult.  Look at the highest point on the indifference curve while being on the constraint line o “The highest point before you kiss goodbye” Qa 2.4. Derivation of consumer’s demand curve  Recall two goods A and B o Reduce the price of good B Qb o Inverse association – P falls, Q rises Pb 2.5. Derivation of market demand curve  Horizontal summation of individual demand curves  Qb Mr X Ms Y Market Demand Curve (X+Y)  This same equation (X+Y) works the same with a million curves as
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