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Ch 4. The Theory of Individual Behavior

Ch 4. The Theory of Individual Behavior. Consumer Behavior. Assume 2 goods exist in the economy. Assume a consumer is able to order his or her preferences for alternative bundles or combinations of goods from best to worst. Consumer Behavior. A > B

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Ch 4. The Theory of Individual Behavior

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  1. Ch 4. The Theory of Individual Behavior

  2. Consumer Behavior • Assume 2 goods exist in the economy. • Assume a consumer is able to order his or her preferences for alternative bundles or combinations of goods from best to worst.

  3. Consumer Behavior • A > B the consumer prefers bundle A to bundle B. • A – B the consumers view the two bundles as equally satisfying. He or she indifferent between bundles A and B.

  4. Consumer Behavior • The preference ordering is assumed to satisfy four basic properties: 1. Completeness. 2. More is better. 3. Diminishing marginal rate of substitution. 4. Transitivity.

  5. Consumer Behavior • Completeness: - for any two bundles, say A and B, either A > B, B > A, A – B.

  6. Consumer Behavior • More is better: - for any two bundles, say A and B, either A > B, B > A, A – B. Figure 4-1 Page 120.

  7. Consumer Behavior • Diminishing marginal rate of substitution: - As a consumer obtains more of good X, the rate at which he or she is willing to substitute good X for good Y decreases.

  8. Consumer Behavior • Transitivity: - For any three bundles, A, B, and C, if A > B and B > C, then A > C. Similarly A – B, and B – C, then A - C

  9. The Budget Constraint • Budget set: The bundles of goods a consumer can afford. Px X + Py Y equals or less M The budget set.

  10. The Budget Constraint • Budget line: The bundles of goods that exhaust a consumer’s income. Px X + Py Y = M The budget line.

  11. Changes In Income • Changes in income shrink or expand opportunities. Figure 4-5 Page 126.

  12. Changes In Prices • Figure 4-6 Page 127.

  13. Consumer Equilibrium • The objective of the consumer is to choose the consumption bundle that maximizes his or her utility, or satisfaction. • Consumer equilibrium: The affordable bundle that yields the greatest satisfaction to the consumer. Figure 4-8 Page 128.

  14. Consumer Equilibrium • Consumer equilibrium: MRS = (Px / Py) MRS = marginal rate of substitution Px = price of good X Py = price of good Y

  15. Comparative Statics(Price Changes and Consumer Behavior) • A change in the price of a good will lead to a change in the equilibrium consumption bundle. Figure 4-9 Page 130. Change in consumer equilibrium due to a decrease in the price of good X (Note: that good Y is a substitute for good X).

  16. Comparative Statics(Price Changes and Consumer Behavior) Figure 4-10 Page 131. When the price of good X falls, the consumption of complementary good Y rises.

  17. Comparative Statics(Income Changes and Consumer Behavior) Figure 4-11 Page 132. An increase in income increases the consumption of normal goods. Figure 4-12 Page 133. An increase in income decreases the equilibrium consumption of good X (an inferior good).

  18. Conceptual and Computational Questions • A consumer has $400 to spend on goods X and Y. The market prices of these two goods are Px = $10 and Py = $40. 1.a. Illustrate the consumer’s opportunity set in a carefully labeled diagram. 1.b. Show how the consumer’s opportunity set changes if income increases by $400. How does the $400 increases in income alter the market rate of substitution between goods X and Y?

  19. Conceptual and Computational Questions • A consumer must divide $250 between the consumption of product X and product Y. The relevant market prices are Px=$5 and Py=$10. 2.a. Write the equation for the consumer’s budget line. 2.b. Illustrate the consumer’s opportunity set in a carefully labeled diagram. 2.c. Show how the consumer’s opportunity set changes when the price of good X increases to $10?

  20. Conceptual and Computational Questions • A consumer is in equilibrium at point A in the accompanying figure (Figure at page 148). The price of good X is $5. 3.a. What is the price of good Y? 3.b. What is the consumer’s income? 3.c. At point A, how many units of good X does the consumer purchase? 3.d. Suppose the budget line changes so that the consumer achieves a new equilibrium at point B. What change in the economic environment led to this new equilibrium? Is the consumer better off or worse off as a result of the price change?

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