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Chapter 1

ECO204Y5 Chapter 1: Test 1 Notes

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Department
Economics
Course
ECO204Y5
Professor
Kathleen Wong
Semester
Fall

Description
CHAPTER 3: Consumer Behaviour • Consumer behaviour: the explanation of how consumers allocate incomes to the purchase of different goods and services Consumer Behaviour • How can a consumer with a limited income decide which goods and services to buy? • Three distinct steps in understanding consumer behaviour: 1. Consumer Preferences: • Describe the reasons people might prefer one good to another 2. Budget Constraints: • Consumers have limited incomes which restricts the quantities of goods they can buy 3. Consumer Choices: • given their preferences and limited incomes, consumers choose to buy combinations of goods that maximize their satisfaction • these combinations depend on the prices of various goods • understanding consumer choice will help understand demandi.e., how the quantity of a good that consumers choose to purchase depends on its price 3.1 Consumer Preferences Market Baskets • market basket (or bundle): list with specific quantities of one or more goods o Examples: ▪ various foods items in a grocery cart ▪ quantities of food, clothing, and housing that a consumer buys each month • consumers usually select market baskets that make them as well off as possible • Table 3.1: o The number of food items can be measured in any number of ways: ▪ by total number of containers ▪ by number of packages of each item (e.g., milk, meat, etc.) ▪ by number of pounds or grams o the number of clothing items can be counted in any number of ways: ▪ as total number of pieces ▪ as number of pieces of each type of clothing ▪ as total weight or volume • method of measurement is largely arbitrary, simply describe the items in a market basket in terms of the total number of units of each commodity Some Basic Assumptions about Preferences 1. Completeness: • Preferences are assumed to be complete • Consumers can compare and rank all possible baskets • For any two market baskets A and B, a consumer be will: o Prefer A to B o Prefer B to A o Be equally satisfied with either basket • Preferences ignore costs o Example: a consumer might prefer steak to hamburger but buy hamburger because it is cheap 2. Transitivity: • Preferences are transitive • If a consumer prefers: o Basket A to Basket B o Basket B to Basket C  Basket A to Basket C 3. More is better than less: • Goods are assumed to be desirable • Consumers always prefer more of any good to less • Consumers are never satisfied or satisfies; more is better, even if just a little better • Some goods, such as air pollution, may be undesirable, and consumers will always prefer lessignore these “bads” • These three assumptions form the basis of consumer theory • They do not explain consumer preferences, but they do impose a degree of rationality and reasonableness on them Indifference Curves • Indifference curve: curve representing all combinations of market baskets that provide a consumer with the same level of satisfaction • That person is therefore indifferent among the market baskets represented by the points graphed on the curve • Indifference curves slope downward from left to right • An upward sloping IC would violate the assumption that more of any commodity is preferred to less o Suppose the IC is sloped upward from A to E o because market basket E has more of both food and clothing than market basket A, it must be preferred to A and therefore cannot be on the same IC as A Indifference Maps • indifference map: graph containing a set of indifference curves showing the market baskets among which a consumer is indifferent • indifference curves cannot intercept o violates assumption of transitivity The Shape of Indifference Curves • The fact that indifference curves slope downward follows directly from our assumption that more of a good is better than less • If an indifference curve sloped upward, a consumer would be indifferent between two market baskets even though one of them had more of both food and clothing • shape of an indifference curve describes how a consumer is willing to substitute one good for another • The more of good X and the less good Y a person consumes, the more good X he will give up in order to obtain more good Y The Marginal Rate of Substitution • Marginal rate of substitution (MRS): maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good • The MRS of good X for good Y is the maximum amount of good Y that a person is willing to give up to obtain one additional unit of good X • Suppose the MRS is -3 o The consumer is willing to give up 3 units of good Y to obtain 1 additional unit of good X • Suppose the MRS is -½ o the consumer is willing to give up only ½ units of good Y to obtain 1 unit of good X • the MRS measures the value that the individual places on 1 extra unit of good in terms of another • MRS is the amount of the good on the vertical axis that the consumer is willing to give up in order to obtain 1 extra unit of the good on the horizontal axis • MRS can be written as − Δ𝑌 Δ𝑋 • The MRS at any point is equal in magnitude to the slope of the indifference curve CONVEXITY 4. Diminishing marginal rate of substitution: • IC are usually convex, or bowed inward • Convex means that the slope of the IC increases (i.e., becomes less negative) as we move down along the curve • An indifference curve is convex if MRS diminishes along the curve • consumers generally prefer balanced market baskets to market baskets that contain all of one good and none of another Perfect Substitutes and Perfect Complements • The shape of an indifference curve describes the willingness of a consumer to substitute one good for another • An indifference curve with a different shape implies a different willingness to substitute • Perfect substitutes: two goods for which the MRS of one for the other is constant o Example: one 16-megabyte memory chip is equivalent to two 8- megabyte chips • Perfect complements: two goods for which the MRS is zero or infinite; the ICs are shaped as right angles o Example: left shoes and right shoes BADS • Bads: good for which less is preferred rather than more o Examples: ▪ Air pollution ▪ Asbestos in housing insolation • How do we account for bads in the analysis of consumer preferences? o Redefine the product under study so that consumer tastes are represented as a preference for less of the bad o Turns the bad into a good o Example: preference of air pollution ▪ Can look at preference for clean air, can measure as the degree of reduction in air pollution o With simple adaption, all 4 assumptions of consumer theory hold UTILITY • Utility: numerical score representing the satisfaction that a consumer gets from a given market basket • Utility is a device used to simplify the ranking of market baskets UTILITY FUNCTIONS • Utility function: formula that assigns a level of utility to individual market baskets 3.2 Budget Constraints • Budget constraints: constraints that consumers face as a result of limited incomes The Budget Line • Budget line: all combinations of goods for which the total amount of money spent is equal to income • We are considering only two goods (and ignoring the possibility of saving), out hypothetical consumer will spend her entire income on good X and good Y 𝑃 𝑋 + 𝑃 𝑌 = 𝐼 𝑋 𝑌 𝑌 = ( 𝐼) − (𝑃𝑋)𝑋 𝑃𝑌 𝑃𝑌 • The vertical intercept 𝐼 𝑃 𝑌 o The maximum amount of Y that can be purchased with the income I 𝑃𝑋 • Slope is −( 𝑃𝑌 o The negative of the ratio of the prices of the two goods o Magnitude of the slope tells us the rate at which the two goods can be substituted for each other without changing the total amount of money spent 𝐼 • The horizontal intercept 𝑃𝑋 o How many units of X can be purchased if all income were spent on X The Effects of Changes in Income and Prices INCOME CHANGES • Income alters the vertical intercept of the budget line but does not change the slope (because the price of neither good changed) PRICE CHANGES • When the price of one good changes but the other does not: o When price falls: ▪ The budget line rotates outward o When price rises: ▪ The budget line rotates inward • When the price of both goods change but the ratio is constant: o The slope remains the same o The budget line shifts parallel to the old one • Purchasing power is the ability to generate utility through the purchase of goods and services o Can double either because: ▪ Her income doubles ▪ The prices of all the goods that she buys fall by half • When both prices and the consumer’s income double: o Maximum amount of good X and good Y purchased is unchanged o Will not affect the consumer’s budget line or purchasing power 3.3 Consumer Choice • Consumers choose goods to maximize the satisfaction they can achieve, given the limited budget available to them • The maximizing basket must satisfy two conditions: 1. It must be located on the budget line. • any market basket to the left of and below the budget line leaves some income unallocated—income which, if spent, could increase the consumer’s satisfaction • any market basket to the right of and above the budget line cannot be purchased with available income 2. It must give the consumer the most preferred combination of goods and services. • Satisfaction is maximized at the point where 𝑀𝑅𝑆 = 𝑃𝑋, the marginal rate of 𝑃𝑌 substitution (of X for Y) is equal to the ratio of the prices (of X to Y) • the consumer can obtain maximum satisfaction by adjusting his consumption of goods X and Y so that the MRS equals the price ratio • marginal benefit: benefit from the consumption of one additional unit of a good • marginal cost: cost of one additional unit of a good • marginal benefit is measured by the MRS • marginal cost is measured by the magnitude of the slope of the budget line • If the MRS is less or greater than the price ratio, the consumer’s satisfaction has not been maximized Corner Solutions • Corner solution: situation in which the MRS of one good for another in a chosen market basket is not equal to the slope of the budget line • When a corner solution arises, the consumer’s MRS does not necessarily equal the price ratio 𝑀𝑅𝑆 ≥ 𝑃𝑋 𝑃𝑌 • this inequality would be reversed if the corner solution were at point A rather than B 3.5 Marginal Utility and Consumer Choice • Marginal utility (MU): additional satisfaction obtained from consuming one additional unit of a good • Diminishing marginal utility: principle that as more of a good is consumed, the consumption of additional amounts will yield smaller additions to utility 0 = 𝑀𝑈𝑋∆𝑋 + 𝑀𝑈 (∆𝑌) Δ𝑌 𝑀𝑈 𝑋 −( ) = Δ𝑋 𝑀𝑈 𝑌 −( Δ𝑌 ) 𝑖𝑠 𝑡ℎ𝑒 𝑀𝑅𝑆 𝑜𝑓 𝑋 𝑓𝑜𝑟 𝑌,𝑀𝑅𝑆 = 𝑋 Δ𝑋 𝑀𝑈 𝑌 𝑃 𝑀𝑅𝑆 = 𝑋 𝑃𝑌 𝑀𝑈𝑋 𝑃𝑋 𝑀𝑈 = 𝑃 𝑀𝑈 𝑌 𝑀𝑈𝑌 𝑋 = 𝑌 𝑃𝑋 𝑃𝑌 • utility maximization is achieved when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good o suppose that a person gets more utility from spending an additional dollar on food than on clothing o her utility will be increased by spending more on food. o As long as the marginal utility of spending an extra dollar on food exceeds the marginal utility of spending an extra dollar on clothing, she can increase her utility by shifting her budget toward food and away from clothing o Eventually, the marginal utility of food will decrease (because there is diminishing marginal utility in its consumption) and the marginal utility of clothing will increase (for the same reason) • Equal marginal principal: principle that utility is maximized when the consumer has equalized the marginal utility per dollar of expenditure across all goods SUMMARY 1. The theory of consumer choice rests on the assumption that people behave rationally in an attempt to maximize the satisfaction that they can obtain by purchasing a particular combination of goods and services. 
 2. Consumer choice has two related parts: the study of the consumer’s preferences and the analysis of the budget line that constrains consumer choices. 
 3. Consumers make choices by comparing market baskets or bundles of commodities. Preferences are assumed to be complete (consumers can compare all possible market baskets) and transitive (if they prefer basket A to B, and B to C, then they prefer A to C). In addition, economists assume that more of each good is always preferred to less. 4. Indifference curves, which represent all combinations of goods and services that give the same level of satisfaction, are downward-sloping and cannot intersect one another. 
 5. Consumer preferences can be completely described by a set of indifference curves known as an indifference map. An indifference map provides an ordinal ranking of all choices that the consumer might make. 
 6. The marginal rate of substitution (MRS) of X for Y is the maximum amount of Y that a person is willing to give up to obtain 1 additional unit of X. The MRS diminishes as we move down along an indifference curve. When there is a diminishing MRS, indifference curves are convex. 
 7. Budget lines represent all combinations of goods for which consumers spend all their income. Budget lines shift outward in response to an increase in consumer income. When the price of one good (on the horizontal axis) changes while income and the price of the other good do not, budget lines pivot and rotate about a fixed point (on the vertical axis). 
 8. Consumers maximize satisfaction subject to budget constraints. When a consumer maximizes satisfaction by consuming some of each of two goods, the marginal rate of substitution is equal to the ratio of the prices of the two goods being purchased. 
 9. Maximization is sometimes achieved at a corner solution in which one good is not consumed. In such cases, the marginal rate of substitution need not equal the ratio of the prices. 
 10. The theory of revealed preference shows how the choices that individuals make when prices and income vary can be used to determine their preferences. When an individual chooses basket A even though he or she could afford B, we know that A is preferred to B. 
 11. The theory of the consumer can be presented by two different approaches. The indifference curve approach uses the ordinal properties of utility (that is, it allows for the ranking of alternatives). The utility function approach obtains a utility function by attaching a number to each market basket; if basket A is preferred to basket B, A generates more utility than B. 12. When risky choices are analyzed or when comparisons must be made among individuals, the cardinal properties of the utility function can be important. Usually the utility function will show diminishing marginal utility: As more and more of a good is consumed, the consumer obtains smaller and smaller increments of utility. 1
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