Lecture 5

• Course outline


  • Introduction
  • The basic market forces: Supply and demand A
  • The basic market forces: Supply and demand B
  • Quantitative analysis of supply and demand: Elasticities
  • Background to demand: The theory of consumer choice A
  • Background to demand: The theory of consumer choice B
  • Background to supply: The theory of the firm A
  • Background to supply: The theory of the firm B
  • Market structures A: Perfect competition
  • Market structures B: Monopoly and monopolistic competition
  • Market structures C: Oligopoly
  • Introduction to game theory
  • Market failure and the role of the government
  • Exam preparation
• Market demand is the sum of individual demands
• Theory of consumer choice


  Explains and predicts which bundle of goods consumers choose to buy
• The "standard" economic model of consumer choice is a simplification of reality
• The model does not necessarily reflect the actual thought processes of individuals, but it can be used to predict choices
• The model is based on the assumption that individuals make rational decisions
• The model is applicable to any behavior of individuals that involves making trade-offs in the presence of scarce resources
• The model is probably the most fundamental theory of consumer behavior, but not the only one
• Empirical results show that consumers do not always act rationally
• Rational decision


  (in classical economic theory) Consumers are able to consider the outcome of their choices and recognise the net benefits of each one
• Basic structure of the theory of consumer choice

  • Consumer preferences
  • Consumer opportunities
  • Consumer choices
• Indifference curves


  Represent combinations of goods that provide the consumer with the same level of satisfaction
• Budget constraint


  Represents what the consumer can afford to buy
• Consumer equilibrium


  The combination of goods that maximises the consumer's satisfaction given their budget constraint
• Lecture outline


  • The consumer's preference ordering
  • Indifference curves
  • The budget constraint
  • Consumer equilibrium
  • Comparative static analysis
  • Deriving the demand curve
• The analysis assumes there are only two goods in the economy, which can be consumed in any continuous quantity
• Preference ordering


  A ranking of bundles of goods with respect to the consumer's preferences
• Utility


  The satisfaction, benefit, or value derived from the consumption of a certain quantity of a good
• Fundamental assumptions about preference ordering


  • Completeness
  • More is better
  • Diminishing marginal rate of substitution
  • Transitivity
• Completeness


  The consumer has to be able to make a pairwise comparison between all alternative bundles of goods
• More is better


  If a bundle A contains more of one good than a bundle B and no less of the other good, then A is preferred to B
• "Not being able to choose" is not necessarily the same as "being indifferent"
• No rational decision is possible
• If preferences are incomplete, the model cannot be applied
• Axiom of comparison


  The property of completeness
• More is better property

  • If a bundle A contains more of one good than a bundle B and no less of the other good, then A is preferred to B
• The more-is-better property is insufficient to rank other pairs of bundles
• Indifference curve


  Shows which combinations of two goods give a consumer an identical level of utility
• Marginal rate of substitution (MRS)


  The rate at which a consumer is willing to exchange one good for another good while maintaining the same level of utility
• The slope of indifference curves is (usually) not constant: The MRS is diminishing
• Total utility


  The satisfaction a consumer gets from consuming a certain quantity of a good
• Marginal utility


  The added satisfaction a consumer gets from consuming an additional unit of a good
• Total utility is usually increasing when one has more of a good, but marginal utility is usually decreasing
• Indifference map


  A set of indifference curves that graphically models the preference ordering
• Indifference curves that are further away from the origin imply higher levels of utility
• Perfect substitutes


  • Indifference curves are straight lines
• Perfect complements


  • Indifference curves are right angles
• Transitivity


  The consumer has to be "consistent" when making several pairwise comparisons between bundles of goods
• Intransitivity: In the game "rock-paper-scissors", you have an intransitive preference ordering
• If preferences are intransitive, the model cannot be applied