Consumer Theory PDF EC4101

EC4101 Wk.08 Lec.01 Consumer Theory (Thursday) Assumptions: People are rational (they’ll always choose the best option). All goods have Utility: The value/satisfaction from consumption. Marginal Utility: The change in utility f...

EC4101 Wk.08 Lec.01 Consumer Theory (Thursday) Assumptions: People are rational (they’ll always choose the best option). All goods have Utility: The value/satisfaction from consumption. Marginal Utility: The change in utility from consuming one additional unit of a good. There is no saving (consumers spend all income). Marginal utility diminishes over time. Diminishing marginal utility: Each additional unit adds less to utility than the previous unit. To find the marginal utility, divide the total utility by the quantity of goods. When it goes negative, it is disutility. Comsumer preference among consumption bundles can be seen by indifference curves: Curves that show consumption bundles that give the consumer the same level of satisfaction. They’re always downward sloping and can never intersect. They are convex to the origin (because of diminishing marginal utility). The further you are from the origin, the higher the utility. Any point on curve A has equally utility. Any point on curve C is better than any point on curve B. The slope at any point on the indifference curve is the Marginal Rate of Substitution: The rate you are willing to trade a good for another (the amount of a new good required to compensate the loss of another good). It is the marginal utility of one good divided by that of another. Two goods with straight-line indifference curves are perfect substitutes. The marginal rate of substitution is fixed. Two goods with right-angle indifference curves are perfect complements. Budget Constraint: Depicts the limit on the consumption bundles that a consumer can afford, this leads people to consume less than they desire. The slope of the budget constraint line equals the relative price of the two goods (the price of one compared to the other). It measures the rate at which a consumer can trade one good for another. A change in income shifts the budget restraint curve. If both prices change by the same relative amount (e.g. doubled), the curve can also shift. A change in the price of one of the goods will cause the budget restraint curve to pivot (the slope changes). If one is becoming relatively more expensive, it will pivot inwards around the one that is not changing. In the pivot above, the price of supplies has decreased, allowing me to purchase 34 units while maintaining a purchasing power of 10 units of food. Consumers need the point of tangency between the budget constraint line and the highest possible indifference curve (the slope of both equals). This is the optimum. At this point, the consumer’s valuation of the two goods is equal to the market’s valuation. Point C is the optimum point of consumption here. With an increase in income, or a decrease in price, your budget constraint can now reach a higher indifference curve. Another way of looking at consumer choice is marginal utility per €. They will attempt to maximise utility per € spent. Compare the MU and the price for the good, then adjust your spending toward the one that gives you more MU per € spent. For example, if the MU of item A is 2, and it costs €.5, and the MU of item B is 1, and it costs €.1, then for each € spent on A, the MU is 4, but for each € spend on B, the MU is 10. So, you’d choose B. The optimum consumption then is where the MU of a product divided by the price equals the MU of another product, divided by its price (subject to budget constraints). References: Notes based on EC4101 Lecture Slides Image 1: www.researchgate.net Image 2: corporatefinanceinstitute.com Image 3: xpaind.com Image 4: econtutorials.com