1: Consumer and Producer Theory + Applications

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CONSUMER THEORY

CONSUMER THEORY

What is rational consumer behaviour?

Rational behaviour = foundational idea that individuals (consumers) seek to maximise their overall utility from consumption choices

• Choose their most preferred bundle of goods, from a set of available alternatives, that provides the greatest benefit

How are axioms and rational behaviour linked?

Axioms = assumptions (benchmark for consumer preferences)

Rational/Irrational behaviour = theoretical result

What are the 6 different axioms of consumer preferences?

1. Completeness

2. Reflexivity (consistency)

3. Transitivity

4. Monotonicity (well-behaved preference)

5. Convexity (well-behaved preference)

6. Continuity

Describe:

1 - Completeness

Foundational assumption - states that a rational consumer can always state a definitive preference ordering/ranking between any 2 distinct consumption bundles

• E.g. comparing and ranking Bundle A and Bundle B, i.e. A > B

• Strict or weak preferences permitted

• Indecision NOT permitted

Describe:

2 - Reflexivity

Consistency - any bundle is always at least as good as itself

• "If you gave me exactly the same shopping basket twice, I cannot say that one basket is better than the other"

• Ability to recognise identical bundles & have stable preferences over identical bundles - a consumer must always consider a bundle to be at least as good as an identical bundle

Consumer shouldn’t confuse the outcome of choosing a bundle with the utility they get from their choice

Describe & state the violations for:

3 - Transitivity

Consumers are consistent in their preferences, e.g. if A > B and B > C then A > C

• Crossing indifference curves = violating transitivity:

• Ensuring indifference curves don’t intersect as if it did, it would NOT reflect a consistent ranking of preferences

• Then would create a logical contradiction where the same bundle of goods would simultaneously belong to two different utility levels

• Condorcet paradox:

• When combining a group preference, though each individual preference may be transitive, the overall group preference may not be

• As individually everyone has different preferences, when combined, group preferences can become circular, e.g. the group prefers A over B, B over C, but also C over A

• Results in cyclical aggregate preferences/endless loop - no one group is ‘the best’

Describe:

4 - Monotonicity (non-satiation)

MORE IS BETTER

• If one bundle of goods contains strictly more of everything than another bundle, the consumer will always prefer the larger bundle

• E.g. if Bundle A = 1 biscuit & coke, Bundle B = 2 biscuits & coke > they would prefer Bundle B

PREFER HIGHER INDIFFERENCE CURVES > higher bundles

• The further away from the origin, the higher the utility

Describe:

5 - Convexity

Mixed > extremes

• If a consumer is indifferent between two distinct bundles of goods A and B, they will strictly prefer a balanced combination (a weighted average) of A and B (bundle C) which combines the 2, over either extreme bundle, as it yields a higher overall utility

• The principle of diminishing marginal utility is used to explain convex preferences, as the additional satisfaction gained from consuming more of the same good declines as its quantity increases meaning consumers gain greater satisfaction from diversifying their consumption across different goods rather than consuming increasingly large quantities of just one good

• Diminishing marginal utility helps explain why preferences may be convex; convexity is the actual assumption economists make about how consumers rank bundles

Graphical intuition:

• Drawing a straight line connecting any two points on an indifference curve, all points on that line (representing mixed or averaged bundles) will lie on or above a higher/equal indifference curve

Describe & state the violation for:

6 - Continuity

Indifferent sets are continuous - continuity allows us to move smoothly along an indifference curve

• Small changes in consumption bundles = small changes in preferences > no sudden jumps in consumer preferences

• Continuity allows us to analyse marginal changes (how willing a consumer is to give up one good in order to gain another = MRS) which measures the trade off between goods

• No continuity = no MRS

VIOLATION = discrete goods that aren’t indivisible (broken down):

• Discrete goods can only be consumed in whole units not continuous quantities, e.g. cars - only have a unit (can’t have 0.5 units of a car)

• However, many discrete units of goods can be approximated well with continuity in practice, e.g. burger (though buy 1 unit, can eat half a burger)

Describe an indifference curve

• Everything along an indifference curve (e.g. I₁) is equally preferred to x > statement of indifference

• Everything above I₁ represents increased amounts of x₁ and x₂ so is weakly preferred to x > statement of preference