Week 6: Consumer Theory

Consumer Opportunities

Set of possible goods and services consumers can afford to consume

Consumer Preferences

Determine which goods and services are consumed

Utility

Amount of “happiness” gained from consuming a product

Marginal Utility

Satisfaction gained by consuming one more unit of a product

Total Utility

Cumulative sum of all Marginal Utitlies at a single point

Marginal Utility per Dollar

Amount of satisfaction gained (Marginal Utility) / Price of Product

To maximize utility, look for when…

MUx/Px = MUy/Py (Marginal Utilities Per Dollar equal each other)

Commodity Space

Set of all possible bundles of products a consumer can consume

Indifference Curve

Plots every single bundle that will return the same amount of utility

Marginal Rate of Substitution

Amount of X you’re willing to trade for Y to maintain the same level of satisfaction.

Absolute value of the slope of the indifference curve

MRS = MUx/MUy

Properties of Consumer Preferences

• Completeness - either one bundle is preferred to another or they are indifferent

• More is better

• Diminishing MRS - the more Y you gain in tradeoff for X, the less X you want to give away

• Transitivity - If bundle A is preferred to bundle B, and bundle B is preferred to bundle C, bundle A is preferred to bundle C

Budget Set

Calculated by taking the slope between two extremes of budget spending. Everything on or within it is a feasible bundle.

Consumer Equilibrium

The point of intersection between the budget curve and indifference curve, where the MRS = budget slope curve.

Also can be thought of as when the marginal utilities per dollar are equal.

When not in equilibrium (in disequilibrium)

Consume the more utile good until the marginal utility per dollar for both goods are equal

What is the income effect and how does it change the IC and BC?

Shifts both of them parallel to the original curves. If income increases, budget and possibilities increase, moving the curves outward. Opposite for income decreasing.

What is the substitution effect and how does it change the IC and BC?

Since Qx = M/Px, if Px gets bigger, the line between Qy and Qx gets steeper (rotates inward)

To determine normal and inferior goods:

Compare the goods before and after the income effect. If the income increases and more is bought, it is a normal good. If income increases and less is bought, it is an inferior good.

To go from IC and BC to demand curves…

Look for the change in price and the resulting change in the quantity of the bundle.

To go from individual to market demand…

Sum all of the individuals’ demand at a certain price.