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TRANSCRIPT
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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
I. Three basic axioms:
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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I. Three basic axioms:
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
Food(units per week)
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I2
I3
Food(units per week)
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)
Food(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
The design of new automobiles (I)
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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
The design of new automobiles (I)
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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
The design of new automobiles (I)