Microeconomics chapter 3 Theory of consumer behavior: description of how consumers allocate incomes among different goods and services

to maximize their well-being. o Consumer preferences: reasons a consumer might prefer one good to another. o Budget constraint: consumers have limited incomes, which restrict the quantities of goods they can buy. o Consumer choices: given their preferences and limited incomes, consumers choose to buy combinations of goods that maximize their satisfaction. Market basket / bundle: list with specific quantities of one or more goods. Basic assumptions about peoples market baskets: o Completeness: consumers can rank and compare all possible baskets. o Transitivity: A > B and B > C then A > C o More is better than less (nonsatiation): Goods are assumed to be desirable. Consequently, consumers always prefer more of a good to less. o Continuity: when consumer prefers x to y, they will also prefer b to y, when b is suitably equivalent or close to x. Indifference curve: curve representing all combinations of market baskets that provide a consumer with the same level of satisfaction. (Downwards sloping; follows directly from our assumption that more is better than less if an indifference curve sloped upward a consumer would be indifferent between two market baskets even though one of them has more of both goods) Indifference map: graph containing a set of indifference curves showing the market baskets among which a consumer is indifferent. Marginal rate of substitution (MRS): maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good. (The value that the consumer places in 1 extra unit of a good in terms of another the amount of the good on the vertical axis that the consumer is willing to give up in order to obtain 1 extra unit of the good on the horizontal axis) Convexity: the MRS falls as we move down the indifference curve. Additional assumption regarding consumer preferences: o Diminishing marginal rate of substitution: indifference curves are convex, (bowed inward) the slope of the indifference curve increases (i.e. becomes less negative) as you move down the indifference curve. An indifference curve is convex if the MRS diminishes along the curve. As more and more of one good is consumed, we can expect that a consumer will prefer to give up fewer and fewer of a second good to get an additional unit of the first one. (Consumers prefer balanced market baskets) Perfect substitutes: two goods for which the marginal rate of substitution of one for the other is constant; the indifference curves are linear shaped. Perfect complements: two goods for which the MRS is zero or infinite; the indifference curves are shaped as right angles.

Bad: good for which less is preferred than more. (Asbestos in housing insulation, air pollution) Utility: numerical score representing the satisfaction that a consumer gets from a given market basket. Utility function: formula that assigns a level of utility to individual market baskets. Ordinal utility function: utility function that generates a ranking of market baskets in order of most to least preferred. (It does not indicate how much one is preferred to another) Cardinal utility function: utility function describing by how much one market is preferred to another. Budget constraint: constraint that consumers face as a result of limited income Budget line: all combinations of goods for which the total amount of money spent is equal to income. (PxX + PyY = I) Slope: ratio of prices is (dY / dX) or (Px/Py) Y-intercept: (I/Py) Income change: changes vertical and horizontal intercept but does not change the slope of a budget line Price change: (of one good) change intercept of that good and slope of budget line. Maximizing market basket must: o Be located on the budget line. o Give the consumer the most preferred combination of goods and services. Maximized satisfaction at: MRS = Px / Py (when the marginal rate of substitution equals the ratio of the prices both of Y to X) Marginal benefit (MRS) is marginal cost (price ratio) Corner solution: situation in which the marginal rate of substitution of one good for another in a chosen market basket is not equal to the slope of the budget line. (MRS does not equal Px / Py and the solution appears in the corner of a graph) Marginal utility: additional satisfaction obtained from consuming one additional unit of a good. Diminishing marginal utility: principle that as more of a good is consumed, the consumption of additional amounts will yield smaller additions to utility. o U(a) U(b) = (dU/dY) * (y y) + (dU/dX) * (x x) o 0 = MUx (dX) + MUy (dY) o (dY / dX) = MUx / MUy o dY / dX = MRS o So, MRS = MUx / MUy Maximizing consumption at: o MUx / MUy = Px / Py o So that marginal utility per dollar of expenditure is the same for each good. Equal marginal principle: principle that utility is maximized when the consumer has equalized the marginal utility per dollar of expenditure per good.