Lecture 5 Microeconomics

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Lecture 5 Microeconomics

• Budget constraints and
• preferences

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The Economic Model of Behaviour

• Individuals act.
• Incentives determine behaviour.
• Incentives are produced by preferences and
  constraints.
• Preferences and constraints are strictly
  distinguished.
• Individuals pursue their own interests.

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Outline

• Look behind the demand curve and describe what
  consumers are doing.
• Constraints the budget set.
• Objectives preferences.

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Three questions

• How do we describe what the consumer can afford
  to consume?
• How do we describe what the consumer likes to
  consume?
• How do we describe what the consumer actually
  ends up consuming?

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A model of consumer choice
Step 1 Preferences (what consumers want to do)
Step 3 Budget Constraint (what consumers can do)
Step 3 The decision (what consumers actually do)
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Basic assumptions about behaviour

• The consumer selects from the set of affordable
  options, the option that maximises his or her
  objectives.
• The consumer selects the bundle of goods which
  gives him or her the most satisfaction subject to
  what he or she can afford to buy.

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The budget constraint

• One (representative) consumer.
• Two types of goods x and y.
• A bundle of goods (x,y).
• The consumer has a given income m.
• The consumer takes the prices, px and py, of the
  two goods as being out of their control.

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The budget line
Expenditure on good x
Expenditure on good y
Assume that the consumer wants to spend all
income.
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Objective terms of trade
Relative price
Real income
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y
The budget line
m/py
1
-px/py
The budge set.
x
m/px
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Comparative statics

• Increase in consumer income, m
• Increase in the price of good x
• Increase in the price of good y

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An increase in income
y
New budget line (m1)
m1/py
Old budget line (m0)
m0/py
x
m1/px
m0/px
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An increase in the price of good x
y
New budget line
m/py
Old budget line
x
Q
m/p0x
m/p1x
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An increase in the price of good y
y
New budget line
m/p0y
Old budget line
m/p1y
Q
x
m/px
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Question

• Suppose prices of the two goods are 1.
• You can choose between getting
• 10 in addition income
• 10 units of good x for free
• Which option would you choose?

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y
New budget line (m1)
m1
Old budget line (m0)
10
m0
New budget line (m1)
x
m1
m0
10
10
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Preference theory

• The objective is to describe the consumers taste
  or, as economists say, the consumers preference
• and to deduce from that what kind of consumption
  choices she would like to make.

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Preferences Taste
Ranking of alternatives
Utility function
Indifference curve
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Ranking

• For every (relevant) pair of bundles, the
  consumer makes a comparison and conclusions
• Strict preference
• X strictly preferred to Y.
• Weak preference
• X weakly preferred to Y.
• Indifference
• X is as good as Y.

Ranking of the alternative bundles of goods
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Assumption 1 and 2
Completeness.
The consumer can rank (all) bundles of goods
according to his or her preferences.
Reflextivity
A bundle of goods is at least as good as itself.
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Assumption 3
Transitivity
Y
X
Z
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Transitivity in words

• If the consumer prefers X to Y and
• she prefers Y to Z, then
• she prefers X to Z.

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Indifference curves
An indifference curve shows all the consumption
bundles among which the consumer is indifferent.
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(No Transcript)
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Implication of transitivity
Indifference curves cannot cross!
y
A
B
C
x
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Assumption 4
Monotonicity
The consumer prefers more of all goods to less of
all goods.
More is better than less...
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Admissible indifference curve
y
Preferred region
y0
Dominated region
x
xo
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Consequences of assumption 4

• Indifference curves are downwards sloping.
• Commodities that the consumer likes (i.e., goods)
  versus commodities that she dislikes (i.e.,
  bads).
• The consumer is never satisfied.
• Satiation point beer!

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Assumption 5Convexity
The consumer prefers average bundles of goods
to extreme bundles.
Example A bundle with 5 apples and 5 oranges is
preferred to a bundle with 10 apples or 10
oranges only.
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Admissible indifference curve
y
Average bundles
2
1.5
1
x
2
1
1.5
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Summary

• Assumptions 1 to 5, i.e.,
• reflectivity
• completeness
• transitivity
• more is better than less (monotonicity)
• average is better than extreme (convexity)
• produce what is called well-behaved preferences.

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Well-behaved preferences
y
x
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Summing up

• The budge constraint describes what the consumer
  can do.
• The consumers preferences describes what the
  consumer wants to do.

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What is next?

• Alternative way of representing the consumers
  preferences the utility function.
• Optimal consumption choices.