Consumer Behavior Theory

• Economics is a social science that studies the production, distribution, and consumption of goods and services
• Microeconomics focuses on the behavior of individual economic agents, such as households and firms, and the markets they participate in

Theory of Consumer Behavior

• Consumer behavior theory studies consumer decisions about purchases, considering preferences and budget limits
• It serves as a basis for understanding consumer demand
• Key concepts: consumer preferences, utility, budget constraints, and optimal consumption choices

Consumer Preferences

• Consumer preferences rank different combinations of goods and services
• Preferences are generally complete, transitive, and non-satiated
  • Completeness means consumers can compare and choose between any two bundles or be indifferent
  • Transitivity means if a consumer prefers A to B and B to C, they prefer A to C
  • Non-satiation suggests consumers prefer more of a good if other goods remain the same (more is better)
• Indifference curves can visually represent preferences

Indifference Curves

• An indifference curve maps bundles of goods yielding equal satisfaction or utility for a consumer
• The consumer is equally satisfied with any combination on a single curve
• Key properties include:
  • Downward slope (due to non-satiation)
  • Curves never intersect (due to transitivity)
  • Higher curves indicate higher utility
  • Typically convex, showing a diminishing marginal rate of substitution

Marginal Rate of Substitution (MRS)

• The marginal rate of substitution (MRS) represents a consumer's willingness to exchange one good for another while maintaining utility
• It equals the absolute value of the indifference curve's slope at a specific point
• MRS decreases along the curve, indicating the consumer is less willing to trade for more of a good they already have

Utility

• Utility is a numerical way to represent consumer preferences
• It quantifies satisfaction from consuming goods and services
• A utility function assigns values to goods bundles that reflect satisfaction levels, where higher numbers mean greater satisfaction
• Utility is ordinal, so only the ranking matters, not the specific numerical value
• Some examples of utility functions include:
  • Cobb-Douglas: U(x,y) = x^a * y^b, where a and b are positive constants
  • Perfect substitutes: U(x,y) = ax + by, where a and b are positive constants
  • Perfect complements: U(x,y) = min(ax, by), where a and b are positive constants

Budget Constraint

• The budget constraint limits consumer choices based on their income and the price of goods and services
• It shows affordable bundles given income and prices
• Typically expressed as: PxX + PyY = I, involving:
  • Px as the price of good X
  • Py as the price of good Y
  • X as the quantity of good X
  • Y as the quantity of good Y
  • I as the consumer’s income
• Its slope, -Px/Py, indicates the relative price of X in terms of Y
• Income changes shift the constraint line, while price changes rotate it

Optimal Consumption Choice

• The optimal choice maximizes utility given budget constraints
• Graphically, this is where the highest possible indifference curve touches the budget constraint
• At this point, the marginal rate of substitution (MRS) equals the price ratio (Px/Py)
• Optimal quantities are mathematically derived from:
  • MRS = Px/Py
  • PxX + PyY = I

Corner Solutions

• A corner solution involves consuming only one good
• This occurs when MRS is always higher or lower than the price ratio
• In this case, MRS = Px/Py does not hold

Income and Substitution Effects

• Price changes alter consumption through income and substitution effects
• The substitution effect is how consumption changes with relative prices, keeping utility constant
  • Consumers buy more of the cheaper good and less of the more expensive one
• The income effect is how consumption shifts with purchasing power changes from the price change
  • Lower prices boost purchasing power; higher prices reduce it
• The total effect combines both substitution and income effects

Normal and Inferior Goods

• A normal good sees increased demand as income rises
• An inferior good sees decreased demand as income rises
• Normal goods have a positive income effect (lower prices, more consumption)
• Inferior goods have a negative income effect (lower prices, less consumption)
• Demand curves usually slope downward because the substitution effect outweighs the income effect

Giffen Goods

• A Giffen good is a rare inferior good where the income effect dominates, leading to an upward-sloping demand curve
• Demand increases as the price increases
• These goods are a large portion of a consumer’s spending with few substitutes

Demand Curves

• A demand curve relates a good's price to the quantity consumers want
• It is based on optimal choices at varying prices, assuming other factors stay constant
• Usually downward sloping, showing the law of demand (higher prices, lower demand)
• Market demand sums all individual demand curves horizontally

Elasticity

• Elasticity measures one variable's responsiveness to another's change
• Price elasticity measures how demand changes with price
  • Calculated as: (% change in quantity demanded) / (% change in price)
• Income elasticity measures how demand changes with income
  • Calculated as: (% change in quantity demanded) / (% change in income)
• Cross-price elasticity shows how demand for one good changes with another's price
  • Calculated as: (% change in quantity demanded of good A) / (% change in price of good B)
  • Positive values indicate substitutes; negative values, complements