ECON-351: Chapter 5 Notes
ECON-351: Chapter 5 Notes Econ 351
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This 5 page Class Notes was uploaded by Alexander Harutunian on Saturday September 17, 2016. The Class Notes belongs to Econ 351 at University of Southern California taught by Dr. Sena Durguner in Fall 2016. Since its upload, it has received 9 views. For similar materials see Microeconomics for Business in Business at University of Southern California.
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Date Created: 09/17/16
Chapter 5: Consumer Behavior Sections: 5.1, 5.2, 5.3, 5.5 Consumer Behavior See how consumers with limited income allocate their resources across goods and explain how these allocation decisions determine demand for various goods Understanding consumer purchasing decisions will help understand how changes in income and prices affect the demand for goods and why the demand for some is more sensitive than others Consumer behavior is best understood in three steps: 1. Consumer Preferences: find a practical way to describe why people prefer one good to another 2. Budget Constraints: consumers consider prices; take into account that consumers have limited income which restricts how much they can buy 3. Consumer Choices: given consumer preference and budget constraints consumers choose to buy a combination of goods that will maximize their satisfaction Section 5.1: Consumer Preferences Market Baskets Market basket (bundle) list with specific quantities of one or more goods Selections of market baskets may be arbitrary, but often times consumers select the market with which they are as well off as possible To explain theory of consumer behavior, must ask whether consumers prefer one market basket to another The theory assumes consumers’ preferences are consistent and make sense Some Basic Assumptions about Preferences 1. Completeness: Preferences are assumed to be complete; Consumers can compare and rank all possible baskets (including equal ranking); these preferences ignore costs 2. Transitivity: preferences are transitive; If a consumer prefers Basket A to Basket B, and prefers Basket B to Basket C, then he also prefers Basket A to Basket C 3. More is better than less: goods are assumed to be desirable (good) so consumers always prefer more of a good to less; more is always better bc consumers are never satisfied or satiated. Consumers, however, don’t want more of a bad thing, but they want more solutions to those bad things Indifference Curves Graphical representation of consumer preferences Represents all possible combinations of market baskets that provide a consumer with the same level of satisfaction The person is indifferent to all along the line Preferred baskets lie to the right of the line, lesser baskets lie to the left of the line The indifference curves slope downwards because otherwise that would violate the assumption that more of any commodity is preferred to less If it sloped upward then one basket that had more of both goods would theoretically be just as satisfying as one with less of both goods Indifference map: a set of indifference curves to describe a person’s preference for all combinations of goods Indifference curves cannot intersect If they could then one point could theoretically satisfy two curves, which means it would offer two levels of satisfaction Every possible market basket has an indifference curve running through it The Marginal Rate of Substitution Quantifies the amount of one good that a consumer is willing to give up for another “The MRS of food F for clothing C is the maximum amount of clothing that a person is willing to give up to obtain one additional unit of food” MRS measures the value that the individual places on 1 extra unit of a good in terms of another MRS is generally: the amount of the good one the vertical axis that the consumer is willing to give up to obtain one extra unit of the good on the horizontal axis MRS = change of C/ change of F Negative sign is added so that the number is positive (measure the magnitude not vector) Change of C is always negative since the consumer gives up clothing MRS at any point is the magnitude of the slope of the indifference curve at that point Convexity: MRS decreases as you move down the indifference curve Diminishing marginal rate of substitution: indifference curves are usually convex, bowed inwards, because the slope of the curve increases (becomes less negative) The indifference curve is convex if MRS diminishes along the curve Consumers generally prefer balanced market baskets to market baskets that are all of one good Perfect Substitutes and Perfect Complements Perfect substitutes, the consumer is perfectly indifferent to either good Two goods are perfect substitutes when the MRS remains constant (i.e. no diminishing marginal rate of substitution) The indifference curve will be a straight line for perfect substitutes Two goods are perfect complements when the indifference curves for both are shaped as right angles One good will not increase satisfaction unless the complement can be obtained How to account for “bads” things we want less of: redefine the product under study so that consumer tastes are represented as a preference for less of the bad Utility: consumer theory relies only on the assumption that consumers can provide relative rankings for market baskets Utility refers to the numerical score representing the satisfaction that a consumer gets from a market basket Utility is the device used to simplify the ranking of the market baskets Utility functions are formulas that assign a level of utility to each market basket A utility function that generates a ranking of market baskets is called an ordinal function The ranking associated with the ordinal utility function places market baskets in order of most to least preferred It does not, however, indicate by how much one is preferred over another A utility function that describes by how much one market basket is preferred to another is called cardinal utility function All that matters is knowing how consumers rank different baskets Section 5.2 Budget Constraints The Budget Line The budget line indicates all combinations of good X and good Y for which the total amount of money spent is equal to I, income Equation of line: P X + P Y = I x y The slope of the budget line is the negative ratio of the price of the two goods (P /P ) x y The magnitude of the slope shows the rate at which the two goods may be substituted for each other without changing the total amount of money Vertical intercept shows max amount of good Y that can be purchased Horizontal intercept shows max amount of good X that can be purchased The Effects of Changes in Income and Prices Income changes: shift in budget line to right (increased income) or left (decreased income) Price changes: change in price of one good but not the other good, one intercept will remain unchanged since that good’s price is unchanged, the other good will change its intercept; this will result in a different slope for the budget line Change in price of both goods, but not price ratio (slope of budget line): the slope will remain the same, but an increase in price brings the line to the left, and a decrease in price brings the line to the right Purchasing power: a consumer’s ability to generate utility through the purchase of goods and services; it is determined not only by income, but also by prices If income and the prices of both goods is doubled (inflation economy), then the purchasing power remains the same Inflationary conditions will not affect the consumer’s budget line or purchasing power Section 5.3 Consumer Choice We assume consumers decide how much of each good to buy in a rational way They choose goods to maximize the amount of satisfaction they can achieve given their limited income; the maximizing market basket must satisfy two conditions: 1. It must be located on the budget line 2. It must give the consumer the most preferred combination of goods and services The satisfaction maximizing market baskets lies on the highest indifference curve that touches the line Satisfaction is maximized given the point where MRS = P /P x y Satisfaction is maximized when the marginal rate of substitution is equal to the ratio of the prices The consumer can obtain maximum satisfaction by adjusting his consumption of goods X and Y so that MRS = price ratio Satisfaction is maximized when Marginal Benefit = Marginal Cost MB is the benefit associated with consuming one additional unit of a good MC is the cost associated with consuming one additional unit of a good MB is measured by the MRS If the MRS is greater than or less than the price ratio, the consumer’s satisfaction has not been maximized Corner Solutions A corner solution occurs when a consumer chooses to purchase all of one good and none of the other good When one of the goods is not consumed, the consumption bundle is at the corner of the graph When a corner solution arises, the consumer’s MRS does not necessarily equal the price ratio The necessary condition for satisfaction to be maximized when choosing between goods X and Y in a corner solution is given by the equation: MRS≥P /P x y The MB = MC holds true only when positive amounts of both goods are consumed Section 5.5 Marginal Utility and Consumer Choice Marginal utility: 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 (change in good X/change in good Y) = MU /MU MRS = Mx /MUy x y P /P = MU /MU MU /P = MU /P x y x y x x y y Utility is max when the marginal utility per dollar of expenditure is equal for each good Equal marginal principle: principle that utility is maximized when the consumer has equalized the marginal utility per dollar of expenditure across all goods Rationing: in times of war and crises, governments sometimes ration goods rather than allow prices to increase to competitive levels Nonprice rationing is more equitable than relying on market forces; under a market system, higher incomes can outbid lower incomes to obtain goods that are scarce in supply; if products are rationed through a mechanism like the allocation of coupons to households or businesses, everyone will have an equal chance to buy rationed goods
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