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UW-Madison ECON 101 - Consumer Theory

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Consumer Theory (CT)A. Consumer theory1. Goal: to develop a theory that describes how consumers make decisions about what to buyB. Diamond/ Water Paradox: Adam Smith1. Smith wanted to know why diamonds are expensive but not essential and water is inexpensivebut essential?2. For the individual a. Marginal utility- adding total utility from consuming one more unit1. MU= change in total utility/ change in quantity 2. Measure MU as $/ unit= MU= demand curve for individual 3. Law of Diminishing Marginal utility- the more of a goo a consumer has, the less MU an additional unit provides b. Consider 3 possibilities1. P< MU= good is worth purchasing2.P= MU= for the last unit purchased3. P> MU= good isn't worth purchasinga. MU- P> 0= consumer is buying too little of the goodb. MU- P< 0= consumer is buying too much of the good1. Implies that optimality requires that the purchase of an additional dollar's worth of x contributes just as much utility as the last dollar's worth of y that you purc.3. TU water > TU diamondsa. MU water < MU Diamondsb. We need MU water/ P water = MU diamonds/ P diamonds4. Cardinal utility vs Ordinal Utilitya. Cardinal utility- is measurable, quantifiable, and the difference between 2 measurements is numerically significant b. Ordinal utility- consumers can rank various market baskets with regard to the satisfaction they get1. Hypothesis: consumers spend their income in the way that yields the greatest amount of satisfaction or utility 2. Consumers goal: utility maximization 3. Our assumptions:a. Each consumer has a dif. set of preferencesb. each consumer is constrained by their income and $ they pay** given these preferences, each consumer chooses those goods which maximize their satisfaction subject to the constraints of income and prices c. Indifference curves- preferences of each consumer1. On each IC are combinations of the 2 goods that provide the consumer with the same level of satisfaction or utility or where combinations where the consumer is indifferenta. Every point gives the same level of satisfaction if the point is on IC12. Properties of Indifference curvesa. Downward sloping and curved in toward origin 1. consumers like varietya. as you get more of one good you are willing to give upless of the other good b. Each IC represents a different but constant level of satisfaction 1. IC map- mixing bowl analogy2. IC3 has great utility than IC2, and IC2 has more utility than IC13. Utility increases as you move away from the originc. There is an IC for through every pointd. IC never intersect1. implies preferences are transitive for the individuala. no contradictory/ inconsistent preferencese. Slope is not constant1. Slope of IC= marginal rate of substitution (MRS) of good x for good y2. slope of IC= MRSxy= rate at which a person is willing to substitute good y for good x, or the # of units of Y a person is willing to give up in exchange for a unit of xa. MRSxy=change y/change x=-MUx/ MUy=slope of IC<0b. As you move down the IC, the absolute value of MRSxy decreases- the less of good y you have, the smaller will be the amount of good y you will give up in order to get more good xC. Budget line- constraint of income and prices1. Consumer's goal: maximize utility given that income and pricesa. To maximize utility, consumer selects that bundle of goods on the highest IC he can reach= the IC that is just tangent (Touches once) to the budget line2. Income and Substitution effectsa. Income effect- effect on quantity demanded of change in REAL incomeb. Substitution effect- change in quantity demanded of a good that results from a changein its relative price AFTER elimination the effect of real income of this change in price1. labeling will be consistent and potentially different from Krugman/ Wellsc. Income tax rewards people for working less and pushes people from working


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