Consumer Behaviour
Consumer Behaviour Preferences • • • • • • •
Strong preference means that one good is better than the other Weak preference means that one good is at least as good as the other Indifference means that one good is equal to the other A>B means that A is absolutely preferred over B A~B means that A is indifferent to B Preferences are transitive: o If A>B, B>C, then A>B>C Preferences are non-satiated o Consumers prefer more good things than less good things
Indifference Curves • • • •
Shows a set of consumption bundles among which the individual is indifferent Indifference curves cannot intersect Utility numbers cannot be compared between two people The further away from the origin and IC is, the bundle is more preferred
Marginal Rate of Substitution • •
The rate at which a consumer is willing to give up one good for another The slope of the indifference curve at any point is –MRS and declines down the slope ∆𝑦 𝑀𝑈$ 𝑀𝑅𝑆$% = − = ∆𝑥 𝑀𝑈%
Special Cases of Indifference Curves • •
Perfect substitutes will have a linear indifference curve with a constant slope and therefore a constant MRS Perfect complements will have an L shaped indifference curve with a function such as U = min(3x,2y)and the MRS does not exist
Budget Constraints •
• •
With a fixed income in a two good framework, how much of each good can you buy There is no additional utility from having extra money not spent on anything The Marginal Rate of Transformation refers to how much good Y should be given up to get more of good X in the market 𝑃$ 𝑋 + 𝑃% 𝑌 ≤ 1 𝑃$ = 𝑀𝑅𝑇 𝑃%
Optimal Solution: Interior •
•
At the optimum solution, the slope of the indifference curve will equal the slope of the budget constraint 𝑃$ 𝑀𝑅𝑆$% = 𝑃% Thus, if the MRS is greater than the MRT, a consumer should consume more of good x
Optimal Solution: Corner •
•
If MRS is always higher than the price ratio, one unit of X is always preferred to another unit of Y o Indifference curve is always steeper than budget line Corner solution will have all X and no Y or vice versa
Deriving Demand Curves • •
A demand curve can be constructed by analysing different indifferent curves The price consumption curve is a line through all the optimal bundles.
Income Consumption Curve • •
• •
As income rises, the budget constraint shifts to the right Income elasticities will decide where on the new budget constraint the new optimal consumption bundle will be The income consumption curve is a trace of optimal choices as income changes The Engel curve is the relationship between income and consumption of a single good, holding prices constant
X is a normal good
X is an inferior good
Y is an inferior good
Decomposition of a Price Effect • •
•
The price effect is the effect of a price change on a consumer’s demand The income effect is the change in the quantity of a good a consumer demands due to a change in relative income, holding prices constant o Negative for a normal good o Positive for an inferior good o For a giffen good, the income effect is negative and larger than the substitution effect The substitution effect is the change in the quantity of a good that a consumer demands when the good’s price changes, holding other prices and the consumer’s utility constant
•
o Always negative The Slutsky Decomposition is as follows: 𝑇𝑂𝑇𝐴𝐿 𝑃𝑅𝐼𝐶𝐸 𝐸𝐹𝐹𝐸𝐶𝑇 = 𝑆𝑈𝐵𝑆𝑇𝐼𝑇𝑈𝑇𝐼𝑂𝑁 𝐸𝐹𝐹𝐸𝐶𝑇 + 𝐼𝑁𝐶𝑂𝑀𝐸 𝐸𝐹𝐹𝐸𝐶𝑇
Strong preference means that one good is better than the other Weak preference means that one good is at least as good as the other Indifference means that one good is equal to the other A>B means that A is absolutely preferred over B A~B means that A is indifferent to B Preferences are transitive: o If A>B, B>C, then A>B>C Preferences are non-satiated o Consumers prefer more good things than less good things
Indifference Curves • • • •
Shows a set of consumption bundles among which the individual is indifferent Indifference curves cannot intersect Utility numbers cannot be compared between two people The further away from the origin and IC is, the bundle is more preferred
Marginal Rate of Substitution • •
The rate at which a consumer is willing to give up one good for another The slope of the indifference curve at any point is –MRS and declines down the slope ∆𝑦 𝑀𝑈$ 𝑀𝑅𝑆$% = − = ∆𝑥 𝑀𝑈%
Special Cases of Indifference Curves • •
Perfect substitutes will have a linear indifference curve with a constant slope and therefore a constant MRS Perfect complements will have an L shaped indifference curve with a function such as U = min(3x,2y)and the MRS does not exist
Budget Constraints •
• •
With a fixed income in a two good framework, how much of each good can you buy There is no additional utility from having extra money not spent on anything The Marginal Rate of Transformation refers to how much good Y should be given up to get more of good X in the market 𝑃$ 𝑋 + 𝑃% 𝑌 ≤ 1 𝑃$ = 𝑀𝑅𝑇 𝑃%
Optimal Solution: Interior •
•
At the optimum solution, the slope of the indifference curve will equal the slope of the budget constraint 𝑃$ 𝑀𝑅𝑆$% = 𝑃% Thus, if the MRS is greater than the MRT, a consumer should consume more of good x
Optimal Solution: Corner •
•
If MRS is always higher than the price ratio, one unit of X is always preferred to another unit of Y o Indifference curve is always steeper than budget line Corner solution will have all X and no Y or vice versa
Deriving Demand Curves • •
A demand curve can be constructed by analysing different indifferent curves The price consumption curve is a line through all the optimal bundles.
Income Consumption Curve • •
• •
As income rises, the budget constraint shifts to the right Income elasticities will decide where on the new budget constraint the new optimal consumption bundle will be The income consumption curve is a trace of optimal choices as income changes The Engel curve is the relationship between income and consumption of a single good, holding prices constant
X is a normal good
X is an inferior good
Y is an inferior good
Decomposition of a Price Effect • •
•
The price effect is the effect of a price change on a consumer’s demand The income effect is the change in the quantity of a good a consumer demands due to a change in relative income, holding prices constant o Negative for a normal good o Positive for an inferior good o For a giffen good, the income effect is negative and larger than the substitution effect The substitution effect is the change in the quantity of a good that a consumer demands when the good’s price changes, holding other prices and the consumer’s utility constant
•
o Always negative The Slutsky Decomposition is as follows: 𝑇𝑂𝑇𝐴𝐿 𝑃𝑅𝐼𝐶𝐸 𝐸𝐹𝐹𝐸𝐶𝑇 = 𝑆𝑈𝐵𝑆𝑇𝐼𝑇𝑈𝑇𝐼𝑂𝑁 𝐸𝐹𝐹𝐸𝐶𝑇 + 𝐼𝑁𝐶𝑂𝑀𝐸 𝐸𝐹𝐹𝐸𝐶𝑇
