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Ordinal Approach
Topics to be Discussed
Cost-of-Living Indexes
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Consumer Behavior
In Chacterizing consumer Behavior, there are two important but distinct factors to consider: Consumer opportunities (Possible Goods and services consumer can
afford to consume)
Consumer preferences (which of these goods will be consumed). In todays global economy millions of goods are offered for sale, however to focus on essential aspects of individual behavior and to keep things manageable, we assumes that only two goods exist in the economy. X and Y be any two goods i.e. chicken and beef. Assume a consumer is able to order his preferences for alternatives bundles or combinations of goods from best to worst i.e. Bundle A > B (A is preferred to B), A ~ B (indifferent means equally satisfying)
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A consumers preference among consumption bundles may be illustrated with indifference curves.
An indifference curve is a curve that shows consumption bundles that give the consumer the same level of satisfaction. Marginal rate of substitution: The rate at which a consumer is willing to substitute one good for another good and still maintain the same level of satisfaction.
6 5
4 3 2 1 1 2 3 4
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U1
Consumer Preferences
Market Baskets
1.
2. 3. 4.
Consumer Preferences
Clothing
50 40 30 20 10 10
B H A D E
The consumer prefers A to all combinations in the blue box, while all those in the pink box are preferred to A.
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30
40
Food
Consumer Preferences
Clothing
50 H 40
B E A
Combination B,A, & D yield the same satisfaction E is preferred to U1 U1 is preferred to H & G
30
20 10
10
U1
20
30
40
Food
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Higher indifference curves are preferred to lower ones. Indifference curves are downward sloping. Indifference curves do not cross. Indifference curves are bowed inward. IC cannot touch the Horizontal or Vertical Axis
Properties of Indifference Curves Property 1: Higher indifference curves are preferred to lower ones. Consumers usually prefer more of something to less of it. Higher indifference curves represent larger quantities of goods than do lower indifference curves.
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I2
A 0 Indifference curve, I1 Quantity of Pizza
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Points A and B should make the consumer equally happy. Points B and C should make the consumer equally happy. This implies that A and C would make the consumer equally happy. But C has more of both goods compared to A.
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Quantity of Pepsi
C A
Quantity of Pizza
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People are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little. These differences in a consumers marginal substitution rates cause his or her indifference curve to bow inward.
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Quantity of Pepsi
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MRS = 6 A 1
4 3
MRS = 1 1
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The marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up to obtain more of another good.
It is measured by the slope of the indifference curve. Along an indifference curve there is a diminishing marginal rate of substitution. Indifference curves are convex.
Consumer Preferences
Clothing
16 14 12 10
-6
A MRS = 6
MRS C
B
-4
8
6
MRS = 2
4
2 1 2
1 -2 1 -1
E
1
Food
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Consumer Preferences
Perfect Substitutes Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant. Perfect Complements Two goods are perfect complements when the indifference curves for the goods are shaped as right angles.
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Consumer Preferences
Apple Juice (glasses) 4
Perfect Substitutes
1
Orange Juice (glasses)
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Consumer Preferences
Left Shoes
Perfect Complements
Right Shoes
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The budget constraint depicts the limit on the consumption bundles that a consumer can afford. People consume less than they desire because their spending is constrained, or limited, by their income. The budget constraint shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods.
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The Consumers Budget Constraint Any point on the budget constraint line indicates the consumers combination or tradeoff between two goods. For example, if the consumer buys no pizzas, he can afford 500 pints of Pepsi (point B). If he buys no Pepsi, he can afford 100 pizzas (point A).
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A 0 100
Quantity
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The slope of the budget constraint line equals the relative price of the two goods, that is, the price of one good compared to the price of the other. It measures the rate at which the consumer can trade one good for the other.
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Budget Constraints
The Budget Line The slope of the line measures the relative cost of food and clothing. The slope is the negative of the ratio of the prices of the two goods. The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent.
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Consumers want to get the combination of goods on the highest possible indifference curve. However, the consumer must also end up on or below his budget constraint.
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Combining the indifference curve and the budget constraint determines the consumers optimal choice. Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent.
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The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price. At the consumers optimum, the consumers valuation of the two goods equals the markets valuation.
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Optimum B A I3 I2 I1
Budget constraint 0
Quantity of Pizza
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An increase in income shifts the budget constraint outward. The consumer is able to choose a better combination of goods on a higher indifference curve.
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80
60
A decrease in income shifts the budget line inward
L3 (I = $40) L1 (I = $80) L2 (I = $160)
40
20
0
40
80
120
160
Food
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1. An increase in income shifts the budget constraint outward . . . New optimum 3. . . . and Pepsi consumption.
Initial optimum
I2
I1 Quantity of Pizza
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If a consumer buys more of a good when his or her income rises, the good is called a normal good. If a consumer buys less of a good when his or her income rises, the good is called an inferior good.
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Initial optimum
New optimum
I1
I2 Quantity of Pizza
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If the two goods increase (decrease) in price, but the ratio of the two prices is unchanged, the slope will not change.
However, the budget line will shift inward (outward) to a point parallel to the original budget line.
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A fall in the price of any good rotates the budget constraint outward and changes the slope of the budget constraint.
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40
L3
(PF = 2)
40
L1
(PF = 1)
80
L2
120 160
(PF = 1/2)
Food
(units per week)
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New optimum 500 3. . . . and raising Pepsi consumption. Initial budget constraint 0 B
I1 A 100
I2
Quantity of Pizza
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Summary
A consumers budget constraint shows the possible combinations of different goods he can buy given his income and the prices of the goods. The slope of the budget constraint equals the relative price of the goods. The consumers indifference curves represent his preferences.
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Summary
Points on higher indifference curves are preferred to points on lower indifference curves. The slope of an indifference curve at any point is the consumers marginal rate of substitution. The consumer optimizes by choosing the point on his budget constraint that lies on the highest indifference curve.
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Summary
When the price of a good falls, the impact on the consumers choices can be broken down into an income effect and a substitution effect. The income effect is the change in consumption that arises because a lower price makes the consumer better off. The income effect is reflected by the movement from a lower to a higher indifference curve.
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Summary
The substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper. The substitution effect is reflected by a movement along an indifference curve to a point with a different slope.
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