Ch 04 - ThCB - PowerPoint - PPT

Chapter Overview

Title: Theory of Consumer Behavior

Source: Managerial Economics, Thomas ninth edition, 2008

Consumer Theory

Quote: "Teach a parrot the terms 'supply and demand', and you've got an economist." - Thomas Carlyle

The Consumer's Optimization Problem

The primary goal of individual consumption decisions is to maximize total satisfaction, also referred to as utility, from consuming goods and services. Consumers evaluate their options based on their preferences and available resources.

Constraint: Spending on goods must equal the individual's money income, which is the total income available for consumption. This constraint ensures that consumers cannot spend beyond their means.

Consumer Theory Assumptions

Consumers are assumed to be fully informed about various aspects, including:

• Available products: Knowledge of what goods and services are on the market.

• Prices of products: Awareness of the price tags associated with each product.

• Capacity of products to satisfy needs: Understanding how well a product can meet their personal needs and preferences.

• Their own income: Clarity on their financial limitations and how much they can allocate for consumption.

This comprehensive knowledge requires that consumers can rank all potential consumption bundles based on the satisfaction level they provide.

Properties of Consumer Preferences

1. CompletenessFor any two bundles A and B, the consumer can definitively determine:

   • A is preferred to B

   • B is preferred to A

   • The consumer is indifferent between A and B

2. TransitivityIf a consumer prefers A to B, and B to C, then logically, the consumer must prefer A to C.

3. NonsatiationGenerally, more of a good is preferred to less, indicating that consumers strive for higher quantities of goods to enhance their satisfaction.

Preferences Notation

• Notations:

  • ( x , \succ , y ): x is strictly preferred to y

  • ( x , \sim , y ): x and y are equally preferred.

Utility

• Definition: Utility refers to the benefits that consumers derive from the consumption of goods and services. It is a subjective measure and varies from individual to individual.

• Utility Function: Represents an individual’s utility level derived from consuming different bundles of goods and can be expressed mathematically.

• Ordinal Concept: Utility is understood as an ordinal measure; thus, while U(x) = 6 signifies that x is preferred to y where U(y) = 2, it does not imply x is preferred three times as much as y.

Indifference Curves

• Indifference curves illustrate combinations of goods that provide the same level of satisfaction or utility to the consumer.

• Bundles on the same indifference curve yield equal utility levels, thereby depicting a consumer's preferences graphically.

• Higher indifference curves represent more preferred bundles than lower ones.

Marginal Utility

• Definition: Marginal Utility (MU) is the additional utility gained from consuming one more unit of a good, with other goods held constant.

• Formula: ( MU_x = \frac{\Delta U}{\Delta X} ) which represents the change in utility (U) resulting from a change in the quantity consumed (X).

Marginal Rate of Substitution (MRS)

• The Marginal Rate of Substitution (MRS) measures the rate at which one good can be substituted for another while preserving the same level of utility.

• It is defined as the negative slope of the indifference curve, generally diminishing as a consumer increases the quantity of one good and decreases the quantity of another.

Budget Constraints

• The budget constraint illustrates all possible combinations of goods that consumers can purchase at given prices, based on a fixed money income.

• It forms a boundary that defines the consumer's feasible consumption options.

Economic Rationality

• Decision-makers are presumed to choose their most preferred option from available alternatives to maximize their utility.

• Choice Sets: Identify the range of options available to consumers from which they must select their preferred goods.

Utility Maximization

• The optimal combination of goods that maximizes utility occurs when an indifference curve is tangent to the budget line, representing the most efficient allocation of a consumer's resources.

Demand Relationship

• The individual demand curve connects the utility-maximizing quantities purchased with corresponding market prices, illustrating that the quantity demanded typically varies inversely with price levels.

Market Demand

• The market demand curve is generated from the horizontal summation of individual demand curves within the market, indicating overall consumer preferences.

Changes in Price and Demand

• Alterations in income and prices directly influence the quantity demanded:

  • Substitution Effect: Reflects the change in consumption due to price variations while the consumer remains on the same indifference curve.

  • Income Effect: Represents the change in consumption resulting from a shift in purchasing power as affected by price changes.

Summary

Understanding consumer behavior is a multi-faceted endeavor that involves analyzing preferences, utility maximization, and the intricate dynamics of market demand in relation to price fluctuations and consumer income changes. These concepts form the foundation of consumer theory in economics, encapsulating essential aspects of how individuals make consumption choices in a complex marketplace.