Rational consumer choice

Positive economics

neoclassical economics assumes optimising agents

Normative economics

economists look for policies most effective at meeting gov goals

what goal to agents maximise, what was this historically known as and changed to

utility

historically happiness and welfare, now preference

how do consumers make choices

by maximising utility

who introduced concept of utility

utilitarian moral philosopher Jeremy Bentham

3 concepts of utility

-wellbeing/welfare (what gov should max)

-happiness (psychological state)

-preference

exceptions of making choices based on utility

-altruism: act to further anothers interest rather than their own

-choices may be driven by how we feel pyschologically: eg long term goals,

the critique of 'happiness is fundamental for what we want for our lives'

criqitued by amartya sen 1980:

-valuation neglect (take into account what people value)

-physical condition neglect (materially poor may be resigned to sitution)

modern approach to utility (who when what)

-john hicks developed consumer theory in 1980s

-utility is ordinal and not interpersonally comparable

what is wrong with modern approach to utility

cardinality required when dealing with uncertainty and functions

Utility function

Ui = U( Xi, Yi)

preference ordering:

describes how consumers rank diff bundles of goods:

1) completeness (can rank all)

2) transitivity (consistent choices)

3) non satiation (more is better)

4) continuity (small changes dont lead to jumps in preferences)

5) convexity (mixtures preferred)

indifference curves are

set of bundles among which the consumer is indifferent, can be upward sloping if one good is a 'bad'

when can indifference curves be circular

when it has a satiation point

properties of indifference curves

-ubiquitous (goes through every possible bundle)

-downward sloping (due to non-satiation)

-cannot cross

-convex to origin

marginal rate of substitution

rate at which a consumer is willing to give up on one good for another (while keeping same utility), equal to absolute value of the slope of indifference curve at that point (magnitude of gradient)

marginal utility

how much utility a small change in goods provides

constraint of non satiation

real income

budget constraint

set of all bundles that exactly exhausts the consumers income at given prices

budget constraint equation

Y = (M/ Py) - (Px/Py)X

from Px X + Py Y = M

effect on budget line if income changes

shifts inward or outward

effect on budget line if price changes

pivots and consumption point changes

effect of qty discount on budget line

non linear budget line

tangency condition

when consumer achieves max utility given their budget, slope of indifference = slope of budget

MRS = Px / Py

what should consumer do if MRS < Px/Py

reduce consumption of X

price consumption curve

shows how choices change when price changes, down sloping

income consumption curve

shows how choices change when income changes, up sloping

engel curve

plots relationship between qty of good consumed and income, drawn from icc focusing on one good