Consumer Theory and preferences: a microeconomic application

1. Consumer Theory and preferences:a microeconomic application by Devon Swan Mael-yann Le Capitaine

2. Consumer Theory • Consumer theory is a theory of microeconomics that relates preferences to consumer demand curves. The link between personal preferences, consumption, and the demand curve is one of the most complex relations in economics. Implicitly, economists assume that anything purchased will be consumed, unless the purchase is for a productive activity. • Preferences are the desires by each individual for the consumption of goods and services, and ultimately translate into employment choices based on abilities and the use of the income from employment for purchases of goods and services to be combined with the consumer's time to define consumption activities. • Prominent variables used to explain the rate at which the good is purchased (demanded) are the price per unit of that good, prices of related goods, and wealth of the consumer.

3. Application • Suppose Devon and Mael have decided to allocate $2,000 per year on alcoholic beverage during parties or Travelling. Devon and Mael differ substantially in their preferences for these two forms of leisure. Devon prefers alcoholic beverages, while Mael prefers travelling.

4. Indifference Curve • In microeconomic theory, an indifference curve is a graph showing different units of goods, each measured as to quantity, between which a consumer is indifferent. That is, at each point on the curve, the consumer has no preference for one unit over another. In other words, they are all equally preferred. One can equivalently refer to each point on the indifference curve as rendering the same level of utility (satisfaction) for the consumer. Utility is then a device to represent preferences rather than something from which preferences come. The main use of indifference curves is in the representation of potentially observable demand patterns for individual consumers over commodity units.

5. ApplicationDraw a set of indifference curves for Devon and a second set for Mael Devon Mael Al.Bev Al.Bev Travel. Travel.

6. ApplicationDiscuss why the two sets of curves are different from each other using the concept of marginal rate of substitution. • Let’s look first at Devon, she strongly prefers the alcoholic option. Here she is willing to give up less travelling to get many alcoholic beverages (or conversely would be willing to give up more travelling for just one unit of Alcoholic beverage) and remain just as happy. Thus, her marginal rate of substitution (The rate at which she is willing to give up Alc.bev to travel) is very low. Or, she is willing to give up only a small number of Alc.Bev (it could be less than one) to get one more unit of travel. Mael on the other hand is willing to give up many Alc.Bev to gain one more unit of travelling. Thus, his marginal rate up substitution is high.

7. Marginal Rate of Substitution (MRS) • In economics, the marginal rate of substitution is the rate at which a consumer is ready to give up one good in exchange for another good while maintaining the same level of satisfaction. • Under the standard assumption of neoclassical economics that goods and services are continuously divisible, the marginal rates of substitution will be the same regardless of the direction of exchange, and will correspond to the slope of an indifference curve (more precisely, to the slope multiplied by -1) passing through the consumption unit in question.

8. MRS and Slope of Budget constraint • When consumers maximize utility (preferences) with respect to a budget constraint, the indifference curve is tangent to the budget line, therefore, with m representing slope: Px= Price/unit of X Py= Price/unit of Y • Therefore, when the consumer is choosing his utility maximized market basket on his budget line, MU= Marginal Utility • This important result tells us that utility is maximized when the consumer's budget is allocated so that the marginal utility to price ratio is equal for each good.

9. ApplicationIf Devon and Mael pay the same prices (per year) for their leisure, will their marginal rates of substitution of Alc.Bev or Travelling be the same or different? • Their marginal rates of substitution will be the same. Although the unit that each consumer will be different, the MRS must be the same. We know that each will chose the units that place them on their highest indifference curve given their budget constraint. We also know that for those units or at this point, the slope of the budget constraint is equal to the MRS. Since Devon and Mael pay the same for Alc.Bev and Travelling, their budget constraints must have the same slope and therefore their MRS must be the same.

10. ApplicationNumerical example • Suppose the budget is $2000 per year a unit of alc.bev cost $20 and a unit of travelling cost $500. • So: - Budget = $2000/year - Price of Alc.Bev. = Pa = $20/unit - Price of Trav. = Pt = $500/unit

11. Application Units of Alc. Bev Budget / Pa = $2000/$20 = 100 A Budget Constraint Mael Indifference Curve Devon Indifference Curve Point A and B are the best consumer possibilities for Mael and Devon. B Units of Trav. Budget / Pt = $2000/$500= 4

12. Application • The slope (so the MRS) at point A (Devon) is : Pt/Pa = 500/20 = 25 • The slope (so the MRS) at point B (Mael) is also: Pt/Pa = 500/20 = 25 • So the marginal rate of substitution for Devon and Mael is the same even if there preferences are different.

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