Chapter 4: Consumer Behavior

Consumers Have Preferences

a component of demand theory, which can be represented with a utility function if 3 assumptions are made: 1. complete preferences: consumer can rank their preferences between bundles 2. Transitivity: If A>B and B>C, then A>C 3. Non-Satiation: you can't always get what you want (constrained optimization)

Utility Function

a function that describes a consumer's utility when consuming a bundle; U (x,y)

Budget Constraint

- a curve that describes the entire set of consumption bundles of a consumer can purchase by spending their entire income - m=PxX+PyY - represented by a linear downward slope with everything under the curve as feasible by the consumer's income - the point of optimal bundle is tangent to an indifference curve

Indifference Curve

- the combination of all different bundles of goods that give consumers the same utility - outer curve represents a higher level of utility (more is better) - NEVER cross each other - optimal bundle is reached when tangent to the budget constraint

Marginal Rate of Substitution

- the rate at which a consumer is willing to trade off or substitute exactly 1 unit of good x for more of good y and feel equally well off - represented by an indifference curve - derivative is the budget constraint

Components of Demand Theory

1. Consumers have preferences 2. Consumers have constraints 3. Consumers make systematic choices

Budget Constraint Factors

Income, price, quantity discounts, and quantity limits

Quantity Discount Budget Constraint

causes a kink in the budget constraint curve

Perfect Complements (indifference curve)

consumer cannot increase utility unless a certain amount of good x is matched with good y

Perfect Substitute (indifference curves)

consumer is indifferent to both goods; linear lines (no concavity)

Quantity Limit Budget Constraint

creates a plateau in the budget constraint curve

Decrease in Income (Budget Constraint)

inward shift of the curve

Increase in Income (Budget Constraint)

outward shift of the curve

Marginal Utility

the additional utility a consumer receives from a 1-unit increase in consumption; the derivative of an indifference curve - MUx=du/dx

Consumers Face Constraint

the second component of demand theory dealing with budget constraint with the following assumptions 1. Each good has a fixed price and unlimited availability 2. Consumer has a limited income to spend 3. Consumer cannot borrow or save

Consumers make systematic choices

the third component of demand theory that says consumers optimize their utility subject to a budget constraint

Equal Marginal Principle

when the consumer spends all their income and maximizes their utility, their optimization bundle is the one at which the ratio of their marginal utilities exactly equals the ratio of their prices

Decrease of Price x (Budget Constraint)

x-intercept moves away from origin

Increase of Price x (Budget Constraint)

x-intercept moves toward origin