Budget Constraints, Preferences and Utility (Lecture 1)

Consumer theory

Studies how individuals make decisions about what goods and services to purchase

What does the budget constraint do?

Describes the combinations of goods a consumer can afford given their income and the prices of goods

What are the 4 necessary assumptions for the budget constraint?

1. Consumer purchases only two goods

2. Prices are fixed

3. The consumer has a fixed income

4. Borrowing is not allowed

Budget constraint equation

What is the budget set condition?

Includes every combo of goods a consumer CAN afford hence the combo of goods is less than or equal to income

Difference between budget constraint and budget set condition

Constraint focuses on theoretical and therefore consumer spends all their money hence income is equal to the combo of goods

Set condition focuses on what the consumer can acc afford

Budget constraint on a graph

Why does the budget constraint line slope downwards?

Consumer income is limited - if they buy more of good 1 they have to buy less of good 2 to stay within the budget

What does the budget line slope represent?

How many units of good 2 we must give up to purchase one extra unit of good 1

What happens to the budget line if income changes?

There is a parallel shift in the budget constraint - outwards for an increase, inwards for a decrease (as long as there is no change in price)

What happens when a per-unit tax is introduced to the budget constraint?

Consumer pays additional amount of tax for every unity of the taxed good they purchase

What is the new budget constraint after per-unit taxes are introduced?

If good 1 was the taxed good

What does the per-unit tax budget constraint graph show?

Shows how govt policies can affect consumer behaviour by changing what people can afford

What are preferences?

A description of how consumers rank different combos of goods according to how desirable they find them

What type of preference is this?

Weak preference - prefers A or thinks A is just as good as B

What type of preference is this?

Indifference - A is just as good as B

What type of preference is this?

Strict preference - A is definitely preferred over B

What are the 4 assumptions about preferences?

1. Completeness

2. Transitivity

3. Monotonicity

4. Convexity

What is completeness?

A consumers ability to compare any 2 consumption bundles

it assumes you can rank options given

What is transitivity?

Preferences must be logically consistent

What is monotonicity?

The assumption that more is better

What is convexity

when consumers prefer balanced combinations of goods rather than extreme combinations

What are indifference curves used for?

To connect bundles that provide the same level of satisfaction

What does it mean to move to a higher indifference curve?

Means achieving greater satisfaction

What is utility?

A numerical representation of an individuals preferences

What do higher indifference curves represent?

Higher utility

Can numerical utilities and preferences link?

Yes

What is a positive monotonic transformation?

Where numbers representing utility can be changed provided you do not change which bundles the consumer prefers

Give an example of a positive monotonic transformation

• Multiplying by a positive constant

• Adding a constant

• Squaring a utility

What happens to the IC’s when a utility has undergone a positive monotonic transformation?

They are given different labels but they do not move

What does Marginal Utility (MU) measure?

How much utility increases when we consume one more unit of one good whilst holding the other good constant

What is the Marginal Rate of Substitution?

A measure of how much of one good a consumer is willing to give up to obtain more of another good whilst maintaining the same level of utility

What is the formula for the slope of an indifference curve?

What is the Cobb-Douglas utility function?

A type of utility function that represents well-behaved preferences