Consumer Theory Study Notes

Consumer Theory Study Notes

Utility Maximization

• Utility: Satisfaction or pleasure derived from consuming goods and services.
• Maximization: Consumers seek to allocate their income to maximize total utility.
• Marginal Utility: Additional satisfaction gained from consuming one more unit of a good.

Budget Constraints

• Definition: Limits on consumer spending based on income and prices of goods.
• Equation: Budget Line = Income = P1Q1 + P2Q2 (where P = price, Q = quantity).
• Graphical Representation: A line on a graph showing combinations of goods that can be purchased within a budget.

Indifference Curves

• Definition: Curves representing combinations of two goods that provide the same level of utility.
• Properties:
  • Downward sloping, convex to the origin.
  • Higher curves represent higher utility levels.
  • Cannot intersect: each curve reflects a different utility level.

Demand Functions

• Definition: Mathematical relationships that express the quantity demanded of a good as a function of its price and consumer income.
• Functional Form: Qd = f(P, I) (where Qd = quantity demanded, P = price, I = income).
• Elasticity: Measures responsiveness of quantity demanded to changes in price or income.

Market Equilibrium

• Definition: Point where quantity supplied equals quantity demanded.
• Equilibrium Price: Price at which the market clears, balancing supply and demand.
• Shifts: Changes in supply or demand can cause shifts in the equilibrium price and quantity.

Diamond-Water Paradox

• Concept: Explains the discrepancy in prices between essential goods (water) and non-essentials (diamonds).
• Key Insight: Value is determined by marginal utility and scarcity, not total utility.

Law of Equimarginal Utility

• Principle: Consumers will allocate their resources to equalize marginal utility per unit of currency across all goods.
• Implication: Maximizing total utility requires that the last dollar spent on each good yields the same marginal utility.

Price Effect

• Definition: Change in quantity demanded due to a change in the price of a good.
• Components: Composed of the substitution effect and the income effect.

Income and Substitution Effect

• Substitution Effect: Change in quantity demanded as consumers substitute cheaper goods for more expensive ones.
• Income Effect: Change in quantity demanded due to a change in consumer purchasing power as prices change.

Theory of Revealed Preference

• Concept: Consumers' preferences can be understood by observing their purchasing choices, rather than through stated preferences.
• Implication: If a consumer chooses one bundle of goods over another when both are affordable, the chosen bundle is revealed to be preferred.

Utility Maximization

• Utility represents the satisfaction derived from consuming goods and services.
• Consumers aim to maximize total utility by optimally allocating their income.
• Marginal utility is the extra satisfaction from consuming an additional unit of a good.

Budget Constraints

• Budget constraints limit consumer spending based on income levels and prices of goods.
• The budget line follows the equation: Budget Line = Income = P1Q1 + P2Q2.
• Graphically, the budget line represents combinations of goods purchasable within a set budget.

Indifference Curves

• Indifference curves illustrate combinations of two goods that yield the same utility level.
• These curves slope downward and are convex to the origin.
• Higher indifference curves indicate higher levels of utility and curves cannot intersect.

Demand Functions

• Demand functions mathematically express the quantity demanded as a function of price and income.
• The functional form is represented as Qd = f(P, I).
• Elasticity measures how responsiveness of quantity demanded alters with changes in price or income.

Market Equilibrium

• Market equilibrium occurs when quantity supplied equals quantity demanded.
• The equilibrium price is where the market clears, balancing supply with demand.
• Shifts in supply or demand can affect both equilibrium price and quantity.

Diamond-Water Paradox

• This paradox highlights the price discrepancy between essential goods like water and non-essentials like diamonds.
• Value is determined by marginal utility and scarcity, distinguishing it from total utility.

Law of Equimarginal Utility

• This principle states that consumers equalize marginal utility per dollar spent across all goods.
• To maximize total utility, the last dollar spent on each good should provide the same marginal utility.

Price Effect

• The price effect refers to changes in the quantity demanded triggered by price changes of a good.
• It is comprised of two components: the substitution effect and the income effect.

Income and Substitution Effect

• Substitution effect describes how consumers change their demand in response to price changes, favoring cheaper alternatives.
• Income effect reflects changes in demand due to alterations in consumer purchasing power as prices fluctuate.

Theory of Revealed Preference

• This theory posits that consumer preferences can be inferred from their purchasing decisions rather than self-reported preferences.
• If a consumer selects one bundle of goods over another when both are affordable, the chosen bundle indicates a preference.