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Week 3 chapter notes

Economics for Management Studies
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Chapter 3 Consumer Behaviour Notes
x theory of consumer behaviour Æ a description of how consumers allocate their incomes among the purchases of different goods
and services to maximize their well-being
Consumer Behaviour
x consumer behaviour is best understood in 3 distinct steps:
1. Consumer Preferences: first step is to find a practical way to describe reasons people might prefer one good over another.
2. Budget Constraints: of course, consumers also consider prices. In Step 2, therefore, the fact that consumers have limited
incomes which restrict the quantities of goods they can buy is taken into consideration.
3. Consumer Choices: given their preferences and limited incomes, consumes choose to buy combinations of goods that
maximize their satisfaction. These combinations will depend on the prices of various goods.
x consumers do not always make purchasing decisions rationally
x sometimes, they buy on impulse, ignoring or not fully accounting for their budget constraints (and going into debt as a result); or
they are unsure about their preferences or are swayed by the consumption decisions of others, or even by changes in mood
x if consumers do behave rationally, it may not be feasible for them to account fully for the multitude of prices and choices seen
x economists have recently been developing models of consumer behaviour that incorporate more realistic assumptions about
rationality and decision making, called behavioural economics and draws heavily from findings in psychology and related areas
3.1 Consumer Preferences
Market Baskets
x market basket (or bundle) Æ list with specific quantities of one or more goods
x a market basket might contain various food items; or quantities of food, clothing, ad housing that a consumer buys each month
x although selections may sometimes be arbitrary, consumers usually select market baskets that make them as well off as possible
Some Basic Assumptions about Preferences
x theory of consumer behaviour begins with 3 basic assumptions about people’s preferences for 1 market basket versus another:
1. Completeness: Preferences are assumed to be complete. In other words, consumers can compare and rank all possible
baskets. Thus, for any 2 market baskets A and B, a consumer will prefer A to B, will prefer B to A, or will be indifferent
between the 2. By indifferent it is meant that a person will be equally satisfied with either basket. Note that these
preferences ignore costs.
2. Transitivity: Preferences are transitive. Transitivity means that if a consumer prefers basket A to basket B and basket B to
basket C, then the consumer also prefers A to C. Transitivity is normally regarded as necessary for consumer consistency.
3. More is better than less: Goods are assumed to be desirable—i.e., to be good. Consequently, consumers also prefer more
of any good to less. In addition, consumers are never satisfied or satiated; more is always better, even if just a little better.
This assumption is made for educational reasons; namely, it simplifies the graphical analysis. Of course, some goods, such
as air pollution, may be undesirable, and consumers will always prefer less.
x these 3 assumptions form the basis of consumer theory
x they do not explain consumer preferences, but they do impose a degree of rationality and reasonableness on them
Indifference Curves
x indifference curve Æ curve signifying all combinations of market baskets that provide consumer with same level of satisfaction
x that person is therefore indifferent among the market baskets represented by the points graphed on the curve
Indifference Maps
x indifference map Æ graph containing set of indifference curves showing market baskets among which consumer is indifferent
x indifference curves cannot intersect
x of course, there are an indefinite number of nonintersecting indifference curves, one for every possible level of satisfaction
x in fact, every possible market basket (each corresponding to a point on the graph) has an indifference curve passing through it
The Marginal Rate of Substitution
x marginal rate of substitution (MRS) Æ the maximum amount of a good that a consumer is willing to give up in order to obtain
one additional unit of another good
x the decline in the MRS reflect an important characteristic of consumer preferences
x there is an additional assumption regarding consumer preferences to the 3 above:
1. Diminishing marginal rate of substitution: Indifference curves are usually convex, or bowed inward. The term convex
means that the slope of the indifference curve increases (i.e., becomes less negative) moving down along the curve. In other
words, an indifference curve is convex if the MRS diminishes along the curve.
x it is reasonable to accept indifference curves to be convex because as more and more of one good is consumed, it is expected that
a consumer will prefer to give up fewer and fewer units of a second good to get additional units of the first one
x another way of describing this principle is to say that consumers generally prefer balanced market baskets to market baskets that
contain all of one good and none of another good
Perfect Substitutes and Perfect Complements
x the shape of an indifference curve describes the willingness of a consumer to substitute one good for another
x perfect substitutes Æ two goods for which the marginal rate of substitution of one for the other is a constant
x indifference curves describing the trade-off between the consumption of the goods are straight lines
x the slope of the indifference curves need not be –1 in the case of perfect substitutes
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