Magistral 1

7/27/2019 Magistral 1

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Consumer Theory

Lecture 1


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Consumer Theory

A consumerdecides how to spend

his income or wealth to buy goods

with the objective of maximizing hiswelfare.


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Consumer Theory

How do consumers decide what to

buy?

What determines the (individual,market) demands of goods and

services?

How do the demands of goods and

services depend on good prices,

income, etc.?


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Consumer Theory

In order to describe the consumers

problem we need to specify his:

- Preferences

- Constraints.


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Consumer Theory

The consumers preferences and

constraints determine his choice;

i.e.,

the consumption bundle thatmaximizes the consumers welfare

on the set of feasible consumption

bundles.


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Bundles of goods

List of specific quantities of distinct goods andservices

Example: Two goods x andy.(x,y) = (quantity goodx, quantity goody)

e.g. (x,y)=(coffee, shoes)

Consumer has to be able to rank all the bundles inorder to identify which one he likes the most.


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B 10 50

C 20 30

D 40 20

E 30 40

F 10 20

G 10 40

Bundle Units of food Units of clothes

Bundles of goods


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Food(units per week)

10

20

30

40

10 20 30 40

Clothes(units per week)

50

F

C

EG

B

D

Bundles of goods (graphically)


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Preferences

Let A=(x,y) and B=(x,y) be two bundles.

: preference relation;

A B (A is preferred or indifferent to B).

: strict preference relation;

A B (A is preferred to B) -- A B, but not B A.

~: indifference relation;

A ~ B (A is indifferent to B) -- A B and B A.


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Preferences

Examples: Let A=(x,y) and B=(x,y) be two bundles.

1. Pareto:

A B if x x and y y.

2. Lexicographic:

A B if x x or [x = x and y y].

3. Goods and Bads (pollution, waste):

A B if x - y x- y.


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Preferences

4. Perfect substitutes:

A B if x+y x+y.

5. Imperfect substitutes:A B if xy xy.

6. Complements:

A B if min{x,y} min{x,y}.


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Preferences

I. Three basic axioms:

A.1. Preferences are complete if for allbundles A, B:

A B, or B A, or both.

Consumers can always compare any twobundles.


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Preferences


A.2. Preferences are transitive if for allbundles A, B, C:

A B and B C implies A C.

Consumers preferences do not cycle!


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A.3. Preferences are monotone if for all

bundles A=(x,y) and B=(x,y):

(x,y) (x,y) implies A B,

and

(x,y) >> (x,y) implies A B.

The more, the better!

Preferences


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Represent all bundles of goods

which give the consumer the same

level of satisfaction.

Indifference curves


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10

20

30

40

10 20 30 40

Clothes (units per week)

50

The bundles B, C, and Dgive the consumer the samelevel of satisfaction.

F

D

C

EG

B

An indifference curve



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I2

I3


Clothes(units

per week)

I1

E

C

F

All bundles on I2 are

preferred to bundles on I1.All bundles on I3 are

preferred to bundles on I2

Indifference Maps


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Implications of A1-A3:

A.1: Every bundle is in some indifference curve.

A.2: Indifference curves cannot cross.

A3: Indifference curves are decreasing.

Indifference curves


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Under A.3, the consumer

prefers Cto F (and everybundle in the blue area),

while E (and every bundlein the pink area), are

preferred to C.

Food

10

20

30

40

10 20 30 40

Clothes

50

F

C

EG

B

D

Preferences


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I1I2

C

D

B

The more, the better: The consumer shouldprefer B to D.Transitivity: The consumer should be

indifferent between B and D. Contradiction!

Indifference curves cannot cross

Clothes(units

per week)



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Preferences

II. Other Axioms:

A.4. Preferences are continuous:

If A B(n) n and {B(n)} B, then A B.If B(n) A n and {B(n)} B, then B A.

A.5. Preferences are convex:

If A B and 0


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The marginal rate of sustitution (MRS) is the

maximum quantity of goody a consumer iswilling to give up in order to get an

additional unit of goodx; that is, it is the

value of a unit of goodx measured in units

of goody.

The marginal rate of substitution

Preferences


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2 3 4 51

2

4

6

8

10

12

14

16C

B

D

EG

-6

1

1

1

1

-4

-2

-1

MRS= 6

MRS= 2

Preferences

Clothes

Food

MRS = -C F


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Orange Juice

Apple juice

2 3 41

1

2

3

4

0

Perfect substitutes : The MRS is

constant.

Preferences


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Left Shoe

Right Shoe

2 3 41

1

2

3

4

0

Perfect

complements:

there is nopossibility of

substitution.

Preferences


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The managers of car companies must decide

how frequently to introduce new models andhow much money to invest in improving

performance and/or modifying the design of

new automobiles.

Preferences

The design of new automobiles (I)


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The analysis of consumers preferences may

help to determine when and how should thecar companies change the design of newautomobiles.

How to determine consumers preferences?

Preferences



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Consumers value design

very little relative toperformance.

Design

Performance

Consumers Preferences (A):

High MRS

Preferences


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Consumers value a lot

design relative to

performance.

Design

Performance

Preferences

Consumers Preferences (B):Low MRS


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According to a study of the demand of

automobiles in the USA, in the last twodecades the majority of consumers have

shown to sharp preference for design rather

than performance.

Preferences



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The growth of the imports of Japanese cars in the

from the sixties:

15% of all American automobiles change

their design, compare to 23% of imports.

Preferences


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