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Theory of consumer behavior
The explanation of how consumers allocate incomes to the purchase of different goods and services
3 steps to understand Consumer Behavior
- 1. Consumer Preferences
- 2. Budget Constraints
- 3. Consumer Choices
What people like, what might prefer one good to another
Consumers also consider price. Their spending on limited incomes which restrict the quantities of goods they can buy
Given their preferences and limited incomes, consumers choose to buy combinations of goods that maximize thier satisfaction
Market Basket (or Bundle)
List with specific quantities of one or more goods
Collection of one or more goods/ Commodities
4 Basic Assumptions about Preferences
- 1. Completeness
- 2. Transitivity
- 3. More is better than less
- 4. Diminishing Marginal Rate of Substitution
Consumers can compare and rank all possible baskets.
Indiffernetly satisfied with either baskets.
if a consumer prefers basket A to basket B and basket B to basket C, then the consumer laso prefer A to C
More is Better than less
More is always better, even if just a little better
Diminishing Marginal Rate of Substitution
Inddifference Curves are usually conves, or bowed inward (downward).
Curve representing all combinations of market baskets that provide a consumer with the same level of satisfaction
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.
- Decrease in Vertical axis
- Increase in Horizontal axis
Two goods for which the marginal rate of Substitution of one for the other is a constant.
e.g. Apple juice or Orange juice
Two goods for which the MRS is zero or infite; the indifference curves are shaped as right angles.
e.g. Right shoes and left shoes
Numerical score representing the satisfaction that a consumer gets from a given market basket
Formula that assigns a level of utility to individual market baskets
Describe relationship between two (which is X and Y) varibles.
- when there is value of X, automatically there is value of Y
Constraints that consumers face as a result of limited incomes
Every consumer has limited income
All combinations of goods for which the total amount of money spent is equal to income
Benefit from the consumption of one additional unit of a good
Cost of one additional unit of a good
Situation in which the marignal rate of substitution of one good for another in a chosen market basket is not equal to the slope of the budget line
Marginal utility (MU)
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 additioanl amounts will yield smaller additions to utility
Equal Marginal Principle
Principle that utility is maximized when the consumer has equalized the marginal utility per dollar of expenditure across all goods