NationMaster - Encyclopedia: Consumer theory

Consumer theory is a theory of economics. It relates preferences (through indifference curves and budget constraints) to consumer demand curves. The models that make up consumer theory are used to represent prospectively observable demand patterns for an individual buyer on the hypothesis of constrained optimization. This article needs additional references or sources for verification. ... Preference (or taste) is a concept, used in the social sciences, particularly economics. ... An indifference curve is a graph showing different bundles of goods, each measured as to quantity, to which a consumer is That is, at each point on the curve, the consumer has no preference for one bundle over another, as they render the same level of satisfaction (utility) for the... A Budget Constraint represents the combinations of goods and services that a consumer can purchase given current prices and his income. ... The supply and demand model describes how prices vary as a result of a balance between product availability at each price (supply) and the desires of those with purchasing power at each price (demand). ... A diagram of the IS/LM model In economics, a model is a theoretical construct that represents economic processes by a set of variables and a set of logical and quantitative relationships between them. ... A mathematical problem is a problem that can be solved with the help of mathematics. ... Look up Hypothesis in Wiktionary, the free dictionary. ...

Indifference curves and budget constraints

For an individual, indifference curves and an assumption of constant prices and a fixed income in a two-good world will give the following diagram. The consumer can choose any point on or below the budget constraint line BC. This line is diagonal since it comes from the equation $xp_X + y p_Y leq mathrm{income}$ . In other words, the amount spent on both goods together is less than or equal to the income of the consumer. The consumer will choose the indifference curve with the highest utility that is within the budget constraint. I3 has all the points outside of their budget constraint so the best that the consumer can do is I2. This will result in them purchasing X* of good X and Y* of good Y. An indifference curve is a graph showing different bundles of goods, each measured as to quantity, to which a consumer is That is, at each point on the curve, the consumer has no preference for one bundle over another, as they render the same level of satisfaction (utility) for the... Income, generally defined, is the money that is received as a result of the normal business activities of an individual or a business. ... In economics, utility is a measure of the relative happiness or satisfaction (gratification) gained. ...

Consumer constraint graph and optimal choice was created by user:jrincayc for the Consumer Theory article. ...

Income effect and price effect deal with how the change in price of a commodity changes the consumption of the good. The theory of consumer choice examines the trade-offs and decisions people make in their role as consumers as prices and their income changes.

Price effects

These curves can be used to predict the effect of changes to the budget constraint. The graphic below shows the effect of a price shift for good Y. If the price of Y increases, the budget constraint will shift from BC2 to BC1. Notice that because the price of X does not change, the consumer can still buy the same amount of X if he or she chooses to buy only good X. On the other hand, if the consumer chooses to buy only good Y, he or she will be able to buy less of good Y because its price has increased.

To maximize the utility with the reduced budget constraint, BC1, the consumer will re-allocate consumption to reach the highest available indifference curve which BC1 is tangent to. As shown on the diagram below, that curve is I1, and therefore the amount of good Y bought will shift from Y2 to Y1, and the amount of good X bought to shift from X2 to X1. The opposite effect will occur if the price of Y decreases causing the shift from BC2 to BC3, and I2 to I3.

If these curves are plotted for many different prices of good Y, a demand curve for good Y can be constructed. The diagram below shows the demand curve for good Y as its price varies. Alternatively, if the price for good Y is fixed and the price for good X is varied, a demand curve for good X can be constructed.

Income effect

Another important item that can change is the income of the consumer. As long as the prices remain constant, changing the income will create a parallel shift of the budget constraint. Increasing the income will shift the budget constraint right since more of both can be bought, and decreasing income will shift it left. Parallel is a term in geometry and in everyday life that refers to a property in Euclidean space of two or more lines or planes, or a combination of these. ...

Depending on the indifference curves the amount of a good bought can either increase, decrease or stay the same when income increases. In the diagram below, good Y is a normal good since the amount purchased increased as the budget constraint shifted from BC1 to the higher income BC2. Good X is an inferior good since the amount bought decreased as the income increases. In consumer theory, an inferior good is a good that decreases in demand when the consumers income rises, unlike normal goods, for which the opposite is observed. ...

$Delta y_1^n$ is the change in the demand for good 1 when we change income from

m'

m

, holding the price of good 1 fixed at

p 1'

Substitution effect

Every price change can be decomposed into an income effect and a substitution effect. The substitution effect is a price change that changes the slope of the budget constraint, but leaves the consumer on the same indifference curve. This effect will always cause the consumer to substitute away from the good that is becoming comparatively more expensive. If the good in question is a normal good, then the income effect will reinforce the substitution effect. If the good is inferior, then the income effect will lessen the substitution effect. If the income effect is opposite and stronger than the substitution effect, the consumer will buy more of the good when it becomes more expensive. An example of this might be a Giffen good. A Giffen good is a product for which a rise in price of this product makes people buy even more of the product. ...

Substitution effect, $Delta y_1^s$ , is the change in the demand for good 1 when the price of good 1 changes to

p 1'

and, at the same time, the money income changes to

m'

Labor-Leisure Tradeoff

Consumer theory can also be used to analyze a consumer's choice between leisure and labor. Leisure is considered one good (often put on the horizontal-axis) and consumption is considered the other good. Since a consumer has a finite and scarce amount of time, she must make a choice between leisure (which earns no income for consumption) and labor (which does earn income for consumption).

The previous model of consumer choice theory is applicable with only slight modifications. First, the total amount of time that an individual has to allocate is known as her time endowment, and is often denoted as T. The amount an individual allocates to labor (denoted L) and leisure (l) is constrained by T such that:

A person's consumption is the amount of labor they choose multiplied by the amount they are paid per hour of labor (their wage, often denoted w). Thus, the amount that a person consumes is:

From this labor-leisure tradeoff model, the substitution and income effects of various changes in price caused by welfare benefits, labor taxation, or tax credits can be analyzed.

See also

A Budget Constraint represents the combinations of goods and services that a consumer can purchase given current prices and his income. ... Convex preferences refer to a property of utility functions commonly represented in an indifference curve as a bulge toward the origin. ... In microeconomics, an indifference curve is a graph showing combinations of two goods to which an economic agent (such as a consumer or firm) is indifferent, that is, it has no preference for one combination over the other. ... Microeconomics is a branch of Economics that studies how individuals, households, and firms make decisions to allocate limited resources,[1] typically in markets where goods or services are being bought and sold. ... Price Points along a Demand curve Price points are prices for which demand is relatively high. ... The supply and demand model describes how prices vary as a result of a balance between product availability at each price (supply) and the desires of those with purchasing power at each price (demand). ... In microeconomics, the utility maximization problem is the problem consumers face: how should I spend my money in order to maximize my utility? Suppose their consumption set has L commodities. ... This is a list of important publications in economics, organized by field. ...

References

John R. Hickss book Value and Capital (1939) is a classic exposition of microeconomic theory. ...

External link

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Topics in microeconomics

Scarcity • Opportunity cost • Supply and demand • Elasticity • Economic surplus • Economic shortage • Aggregate demand • Consumer theory • Production, costs, and pricing • Market form • Welfare economics • Market failure Microeconomics is a branch of Economics that studies how individuals, households, and firms make decisions to allocate limited resources,[1] typically in markets where goods or services are being bought and sold. ... In economics, scarcity is defined as a condition of limited resources, where society does not have sufficient resources to produce enough to fulfill subjective wants. ... In economics, opportunity cost, or economic cost, is the cost of something in terms of an opportunity forgone (and the benefits which could be received from that opportunity), or the most valuable forgone alternative (or highest-valued option forgone), i. ... The supply and demand model describes how prices vary as a result of a balance between product availability at each price (supply) and the desires of those with purchasing power at each price (demand). ... In economics, elasticity is the ratio of the proportional change in one variable with respect to proportional change in another variable. ... The term surplus is used in economics for several related quantities. ... Polish meat shop in the 1980s. ... In economics, aggregate demand is the total demand for goods and services in the economy (Y) during a specific time period. ... This article or section does not cite any references or sources. ... In microeconomics, the main criteria by which one can distinguish between different market forms are: the number and size of producers and consumers in the market, the type of goods and services being traded, and the degree to which information can flow freely. ... Welfare economics is a branch of economics that uses microeconomic techniques to simultaneously determine the allocational efficiency of a macroeconomy and the income distribution associated with it. ... Market failure is a term used by economists to describe the condition where the allocation of goods and services by a market is not efficient. ...

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