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Chapter 3

Chapter 3 EC260.docx

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Department
Economics
Course Code
EC270
Professor
Karen Huff

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EC260 Chapter 3 – Consumer Behaviour and Rational Choice Week 3 -Market demand for a product is the aggregate of individual demands -Without preference ordering, we are reduced to random choices without an future -Good managers understand that they and take actions to influence consumer choice -This is the idea underlying the use of marketing, pricing, and distributional strategies -In examining how consumers choose, we initially assume a consumer is rational and wishes to maximize his or her well-being -Consumers do not make choices that cause them hard -A rational customer maximizes his or her well-being given the price of goods, personal tastes and preferences for goods, and income -We formally model this behaviour by developing the concepts of utility functions, indifference curves, and budget lines – using them we derive the consumer’s demand curve for products and show how demand shifts when income changes Indifference Curves -We initially assume consumers can purchase only food products and clothing -Indifference curve – contains points representing market bundles among with the consumer is indifferent -We need to understand three things: 1. A consumer has many indifference curves – one thing is certain she will prefer an indifference curve with more bundles of clothing and more food than an indifference curve with less. We assume that consumers are sometimes insatiable 2. Every indifference curve must slope downward to the right, so long as the consumer prefers more of each commodity to less. If one market bundle on an indifference curve has more of one product than a second bundle, it must have less of the other product than the second bundle 3. Indifferent curves cannot intersect - If they did, this would contradict the assumption that more of a product is preferred The Marginal Rate of Substitution -Some consumers place a high value on obtaining an extra unit of a product; others place a low value on obtaining it. -It is useful to measure the relative importance a consumer places on acquiring an additional unit of a particular product -Marginal rate of substitution – the number of units of product Y that must be given up if the consumer, after receiving an extra unit of product X, is to maintain a constant level of satisfaction -The more units of Y that the customer is willing to give up, the more important product X is to the customer -To estimate the marginal rate of substitution, we multiply the slope of the consumer’s indifference curve by -1 The Concept of Utility -Given all the indifference curves of a particular customer, we attach a number, called a utility, to each of the available market bundles -Utility - indicates the level of enjoyment or preference attached by a consumer to a particular market bundle -The higher the utility assigned to a bundle, the higher level of satisfaction the consumer realizes from it -All market bundles on a given indifference curve yield the same amount of satisfaction, they all have EC260 Chapter 3 – Consumer Behaviour and Rational Choice Week 3 the same utility -Market bundles on higher indifference curves have higher utilities than those on lower indifference curves -When we assign utilities to market bundles, it tells us which bundles the consumer refers -Indifference curves are also known as iso-utility curves their slope can be measured {refer to class notes} The Budget Line -Consumers want to maximize their utility -Whether a particular indifference curve is attainable depends on a consumer’s income and product prices -Budget line – shows the market bundles that the consumer can purchase, given the consumer’s income and prevailing market prices -To obtain the equation for a budget line: YP f XP c I Y is the amount of food she buys, X is the amount of clothing she buys, P is the price of food, and P is f c the price of clothing, and I is her income. -A shift occurs in a consumer’s budget line if changes occur in the consumer’s income or product prices -The change in the price of food, alters the slope of the budget line which equals P /P c f The Equilibrium Market Bundle -Equilibrium Market bundle – the market bundle that, among all the items the consumer can purchase, yields the maximum utility -First step: combine the indifference curves with the budget line on the same graph -She must choose a bundle on her budget line -The consumer’s choice boils down to choosing the market bundle on the budget line that is on the highest indifference curve – this is the equilibrium market bundle Maximizing Utility: A Closer Look -When maximizing utility: MRS = P /P c f -The marginal rate of substitution is the ra
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