Lecture 3

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Consumer Behaviour

  • allocate incomes (constraints)
  • different goods & services (preferences; price)
  • maximize well-being (satisfaction)

theory of consumer behaviour: Description of how consumers allocate incomes among different goods and services to maximize their well-being.
How do we understand consumer behaviour?

  1. Consumer preferences
    Describes the reasons people might prefer one good to another.
  2. Budget constraints
    Consumers also consider prices. Consumers have limited incomes which restrict the quantities of goods they can buy.
  3. Consumer choices
    Given the preferences and limited incomes, consumers choose to buy combinations of goods that maximize their satisfaction.

Consumer Preferences

Market Baskets

market basket (or bundle): List with specific quantities of one or more goods.

Some Basic Assumptions about Preferences


Preferences are assumed to be complete.
Consumers can compare and rank all possible baskets.

For now, the cost is ignored.


Preferences are transitive.

More is better than less

Goods are assumed to be desirable, i.e., to be good.

Indifference Curves

Curve representing all combinations of market baskets that provide a consumer with the same level of satisfaction..

Indifference Maps

Graph containing a set of indifference curves showing the market baskets among which a consumer is indifferent.

The Marginal Rate of Substitution

MRS = The magnitude of the slope of an indifference curve

Perfect Substitutes and Perfect Complements

  • perfect substitutes: Two goods for which the marginal rate of substitution of one for the other is a constant.
  • perfect complements: Two goods for which the MRS is zero or infinite; the indifference curves are shaped as right angles.

Utility and Utility Functions

  • utility: Numerical score representing the satisfaction that a consumer gets from a given market basket. → Ordinal
  • utility function: Formula that assigns a level of utility to individual market baskets. → Cardinal

Ordinal versus Cardinal Utility

  • ordinal utility function: Utility function that generates a ranking of market baskets in order of most to least preferred.
  • cardinal utility function: Utility function describing by how much one market basket is preferred to another.

Budget Constraints

The Budget Line

  • budget constraints: Constraints that consumers face as a result of limited incomes.
  • budget li:ne: All combinations of goods for which the total amount of money spent is equal to income.

Consumer Choice

The Effects of Changes in Income and Prices

The maximizing market basket must satisfy two conditions:

  1. It must be located on the budget line.
  2. It must give the consumer the most preferred combination of goods and services.

Satisfaction is maximized when the marginal benefit – the benefit associated with the consumption of one additional unit of food – is equal to the marginal cost – the cost of the additional unit of food.

Revealed Preference

Marginal Utility and Consumer Choice

  • marginal utility (M:U) 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.
  • equal marginal principle: \dfrac{MU_F}{MU_C}=\dfrac{P_F}{P_C}

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