Utility theory and Indifference curves
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Transcript of Utility theory and Indifference curves
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Consumer TheoryConsumer Theory
Utility TheoryUtility Theory
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Consumer TheoryConsumer Theory
A theory of how consumers make A theory of how consumers make choices, assuming they are choices, assuming they are
rational and making what are rational and making what are determined to be the best choices determined to be the best choices
given the parameters. given the parameters.
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Maximizing UtilityMaximizing Utility
Consumer TheoryConsumer Theory
Defining Utility
Indifference CurveIndifference Curve
Parts to learn in this PPT:Parts to learn in this PPT:
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Which do you prefer?Which do you prefer?Consumer TheoryConsumer Theory
1.) You make $80,000 in a world where everyone else makes $50,000.
2.) You make $90,000 in a world where everyone else makes $150,000.
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Which do you prefer?Which do you prefer?Consumer TheoryConsumer Theory
1.) Drive 10 minutes to save $5 on a $15 pen.
2.) Drive 10 minutes to save $5 on a $500 suit
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Consumer TheoryConsumer Theory
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Consumer TheoryConsumer Theory
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Ian is Morpheus from the Matrix, 黑客帝国 He will open you mind
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Maximizing UtilityMaximizing Utility
Consumer TheoryConsumer Theory
Defining Utility
Indifference CurveIndifference Curve
Parts to learn in this PPT:Parts to learn in this PPT:
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Remember it Remember it is solving this is solving this
paradoxparadox
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1.) 1.) Resources are Scarce.Resources are Scarce.
Basic ideas of EconomicsBasic ideas of Economics2.) 2.) Trade - OffsTrade - Offs3.) 3.) Opportunity CostsOpportunity Costs
4.) 4.) Marginal Thinking.Marginal Thinking. - Means an additional one, the measurement from one unit to the next. 最后的东西之一
5.) 5.) Rational ThinkingRational Thinking - People usually exploit - People usually exploit opportunities to make opportunities to make themselves better off.themselves better off.
合理的
And applying And applying all these all these
original ideasoriginal ideas
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UtilityUtility
Consumer TheoryConsumer Theory- - Level of satisfaction a
person receives from the consumption of the good.““Happiness”Happiness”
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UtilityUtilityConsumer TheoryConsumer Theory
TotalTotal UtilityUtility - is the total benefit that a person gets from the
consumption.
- .The key part The key part to realize to realize
- It generally increases as the quantity consumed of a good increases but at a decreasing
rate.
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Consumer Theory Marginal Analysis
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Consumer Theory Marginal Analysis
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Consumer Theory Marginal Analysis Increases at a Increases at a decreasing ratedecreasing rate
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Consumer TheoryConsumer Theory
MarginalMarginal Utility Utility ((MUMU)) - - Additional utility derived from the consumption of one
more unit of a good.
UtilityUtilityTotal UtilityTotal Utility
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Consumer Theory Marginal Analysis
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The marginal utility of the 3rd bottle of
water =
36 units
– 27 units
= 9 units.
Consumer Theory Marginal Analysis
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Consumer Theory Marginal Analysis
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The MU curve The MU curve is the slope of is the slope of the TU curvethe TU curve
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Consumer TheoryConsumer Theory
DiminishingDiminishing MarginalMarginal Utility Utility ((DMUDMU))
- - decline in the marginal utility that person derives
from consuming each additional unit of that
product.
Marginal Utility (MU)Marginal Utility (MU)
UtilityUtilityTotal UtilityTotal Utility
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Example Question:Example Question:Diminishing marginal utility means that
an increase in the consumption of a good leads to
a. a decrease in total utility.b. a decrease in marginal utility.
c. an increase in marginal utility.d. no change in marginal utility.
e. an increase in the consumer's budget.
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Example Question:Example Question:Diminishing marginal utility means that
an increase in the consumption of a good leads to
b. a decrease in marginal utility.
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Example Question:Example Question:
The table above gives Matt's utility from consuming slices of pizza. His marginal
utility from the 3rd slice isa. 27 units.
b. 5 units.c. 9 units.
d. 11 units
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Example Question:Example Question:
The table above gives Matt's utility from consuming slices of pizza. His marginal
utility from the 3rd slice is
b. 5 units.
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Example Question:Example Question:If Raul's marginal utility per dollar spent
on bread is 25 and the marginal utility per dollar spent on butter is 30,
a. Raul should purchase more butter and less bread to increase his total utility.
b. Raul's marginal utility of butter will fall if he buys more butter.
c. Raul's marginal utility of bread will rise if he buys less bread.
d. Only answer A and answer B are correct.e. Answer A, answer B, and answer C are correct.
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Example Question:Example Question:If Raul's marginal utility per dollar spent
on bread is 25 and the marginal utility per dollar spent on butter is 30,
e. Answer A, answer B, and answer C are correct.
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Example Question:Example Question:If a consumer's total utility increases when another unit of a good is consumed, which of the following is true? Marginal utility must bea. negative.b. equal to one.c. positive.d. increasing.e. some amount, but more information is needed to determine if marginal utility is positive, negative, or equal to zero.
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Example Question:Example Question:If a consumer's total utility increases when another unit of a good is consumed, which of the following is true? Marginal utility must be
c.positive.
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Example Question:Example Question:If Joan consumes 1 dinner roll, she has total utility of 15; if she consumes 2, she has total utility of 27; if she consumes 3, she has total utility of 37; and if she consumes 4, she has total utility of 45. What is the marginal utility of the fourth dinner roll consumed?a. 124 units of utilityb. 45 units of utilityc. 11.25 units of utilityd. 8 units of utilitye. 37 units of utility
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Example Question:Example Question:If Joan consumes 1 dinner roll, she has total utility of 15; if she consumes 2, she has total utility of 27; if she consumes 3, she has total utility of 37; and if she consumes 4, she has total utility of 45. What is the marginal utility of the fourth dinner roll consumed?
d. 8 units of utility
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UtilityUtility
Consumer TheoryConsumer Theory- - Level of satisfaction a
person receives from the consumption of a product.
MarginalMarginal UtilityUtility- - Additional utility derived
from the consumption of one more unit of a product.
DiminishingDiminishing MarginalMarginal UtilityUtility
- - decline in the marginal utility that person derives
from consuming each additional unit of that
product.
TotalTotal UtilityUtility - is the total benefit that a person gets from the
consumption.
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Paradox of ValueParadox of ValueConsumer TheoryConsumer Theory
For centuries, philosophers have been puzzled by the fact that water is vital for life but cheap while diamonds are used
only for decoration yet are very expensive.
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These graphs These graphs have the have the answeranswer
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Paradox of ValueParadox of ValueConsumer TheoryConsumer Theory
"The word VALUE, it is to be observed, has two different meanings, and sometimes expresses the utility of some
particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called 'value in use ;' the other, 'value in
exchange.' The things which have the greatest value in use have frequently little or no value in exchange; and on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce any thing;
scarce any thing can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in
exchange for it."
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Paradox of ValueParadox of ValueConsumer TheoryConsumer Theory
"The word VALUE, it is to be observed, has two different meanings, and sometimes expresses the utility of some
particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called 'value in use ;' the other, 'value in
exchange.' The things which have the greatest value in use have frequently little or no value in exchange; and on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce any thing;
scarce any thing can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in
exchange for it."So the translate So the translate in simpler in simpler English…English…
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Paradox of ValueParadox of ValueConsumer TheoryConsumer Theory
"The word VALUE,, has two different meanings,
Value in Use – the utility of itValue in Exchange – the purchasing power of other goods
Sometimes these have almost no relationship with each other.Nothing is more useful than water: but it will buy almost nothing. A diamond, has almost no any value in use to most people; but you can buy a lot of stuff with it.
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Paradox of ValueParadox of ValueConsumer TheoryConsumer Theory
You can solve this puzzle by distinguishing between total utility and marginal utility.
The total utility of water is substantially higher than its marginal
utility and priceThe total utility of diamonds is close
to their marginal utility and price
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Evaluating the Market EquilibriumMarket EQ: P = 30 Q = 15Total surplus = CS + PS
Is the market EQ efficient?
0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
S
D
CS
PS
D
S
Another Another way to way to think think
about itabout it
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0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
D
Water has very high Water has very high total utility total utility but low but low marginal utilitymarginal utility
S0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
D
S
Diamonds Diamonds total utility total utility and and marginal utility marginal utility are closer togetherare closer together
Marginal utility Marginal utility determines the pricedetermines the price
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Paradox of ValueParadox of ValueConsumer TheoryConsumer Theory
You can solve this puzzle by distinguishing between total utility and marginal utility.
Total utility -tells us about relative valueMarginal utility - tells us about
relative priceWhen the high marginal utility of
diamonds is divided by the high price of a diamond,
the result is;a number that equals the low marginal
utility of water divided by the low price of water. The marginal utility per dollar spent
is the same for diamonds as for water.
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Maximizing UtilityMaximizing Utility
Consumer TheoryConsumer Theory
Defining Utility
Indifference CurveIndifference Curve
Parts to learn in this PPT:Parts to learn in this PPT:
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Maximizing Total UtilityMaximizing Total Utility
Consumer ( Consumer ( MU MU )Theory )Theory - The goal of a consumer
is to allocate the available budget in a way that maximizes
total utility.
The by choosing the point on the budget line at which the sum of the
utilities obtained from all goods is as large as
possible.
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Ian has 40 dollars!
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Option one: go to the movies
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Option two: drink many cases of soda
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Eat
Consumer ( Consumer ( MUMU )Theory )Theory
Each row Each row of the table of the table shows a shows a combinatiocombination of movies n of movies and soda and soda that uses that uses all $40.all $40.
Total Budget is $40 dollars a month on
these two goods
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Eat
Consumer ( Consumer ( MUMU )Theory )Theory Total Budget is $40 dollars a month on
these two goods
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Eat
Consumer ( Consumer ( MUMU )Theory )Theory Total Budget is $40 dollars a month on
these two goods
What What combinatiocombinations should ns should be bought be bought to to maximize maximize utility?utility?
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Eat
Consumer ( Consumer ( MUMU )Theory )Theory Total Budget is $40 dollars a month on
these two goodsSure, you Sure, you could add could add up the up the totals, but totals, but that is that is difficult difficult with lots of with lots of items. items. Economists Economists care about care about the the margins!margins!
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Maximizing Total UtilityMaximizing Total Utility
Consumer ( Consumer ( MUMU )Theory )Theory
utility-maximizing rule: :1. Allocate the entire available
budget.2. Make the marginal utility per
dollar equal for all goods.
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Utility-maximizing rule example: :
marginal utility of movies = MUM
marginal utility of soda
= MUS price of movies = PM
price of soda = PS
marginal utility per dollar from seeing movies
= MUM/PM
marginal utility per dollar from soda
= MUS/PS
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Utility-maximizing rule example: :
Total utility is maximized when:
MUM/PM = MUS/PS
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Eat
Consumer ( Consumer ( MUMU )Theory )Theory Total Budget is $40 dollars a month on
these two goods
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Consumer ( Consumer ( MUMU )Theory )Theory
EatTotal Budget is $40 dollars a month on
these two goodsTotal utility is
maximized when:
MUM/PM =
MUS/PS
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Consumer ( Consumer ( MUMU )Theory )Theory
EatTotal Budget is $40 dollars a month on
these two goodsTotal utility is
maximized when:
MUM/PM =
MUS/PS
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Eat
Consumer ( Consumer ( MUMU )Theory )Theory Total Budget is $40 dollars a month on
these two goods
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Maximizing Total UtilityMaximizing Total Utility
Consumer ( Consumer ( MUMU )Theory )Theory
utility-maximizing rule: :1. Allocate the entire available
budget.2. Make the marginal utility per
dollar equal for all goods.
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- - Where is it not possible to switch any expenditure and
increase total utility
Equimarginal PrincipleEquimarginal Principle
equation equation = = ==
MU
P A
A
MU
P B
B
MU
P C
C== …… ==
MU
P N
N
MUMU = Marginal Utility = Marginal Utility
PP = Price = Price
AA, , BB, , CC, , NN = different products = different products
Maximizing Total UtilityMaximizing Total UtilityConsumer ( Consumer ( MUMU )Theory )Theory
So the So the marginal utility marginal utility of each thing of each thing should equalshould equal
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equation equation = =
MU
P A
AThe fun of The fun of
this…this…
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equation equation = = ==
MU
P A
A
MU
P B
B
equals the fun equals the fun of this…of this…
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equation equation = = ==
MU
P A
A
MU
P B
B
MU
P C
C==
equals the fun equals the fun of this…of this…
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equation equation = = ==
MU
P A
A
MU
P B
B
MU
P C
C== …… ==
MU
P N
N
equals the fun equals the fun of this.of this.
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To summarize thus To summarize thus far:far:
Consumer TheoryConsumer Theory
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UtilityUtility
Consumer TheoryConsumer Theory- - Level of satisfaction a
person receives from the consumption of a product.
MarginalMarginal UtilityUtility- - Additional utility derived
from the consumption of one more unit of a product.
DiminishingDiminishing MarginalMarginal UtilityUtility
- - decline in the marginal utility that person derives
from consuming each additional unit of that
product.
TotalTotal UtilityUtility - is the total benefit that a person gets from the
consumption.
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{{
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Maximizing Total UtilityMaximizing Total Utility
Consumer ( Consumer ( MU MU )Theory )Theory - The goal of a consumer
is to allocate the available budget in a way that maximizes
total utility.
The by choosing the point on the budget line at which the sum of the
utilities obtained from all goods is as large as
possible.
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Maximizing Total UtilityMaximizing Total Utility
Consumer ( Consumer ( MUMU )Theory )Theory
utility-maximizing rule: :1. Allocate the entire available
budget.2. Make the marginal utility per
dollar equal for all goods.
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Utility-maximizing rule example: :
Total utility is maximized when:
MUM/PM = MUS/PS
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- - Where is it not possible to switch any expenditure and
increase total utility
Equimarginal PrincipleEquimarginal Principle
equation equation = = ==
MU
P A
A
MU
P B
B
MU
P C
C== …… ==
MU
P N
N
MUMU = Marginal Utility = Marginal Utility
PP = Price = Price
AA, , BB, , CC, , NN = different products = different products
Maximizing Total UtilityMaximizing Total UtilityConsumer ( Consumer ( MUMU )Theory )Theory
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Maximizing UtilityMaximizing Utility
Consumer TheoryConsumer Theory
Defining Utility
Indifference CurveIndifference Curve
Parts to learn in this PPT:Parts to learn in this PPT:
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Indifference CurveIndifference Curve
Consumer Theory Consumer Theory
- shows consumption bundles that give the consumer the same level of satisfaction.
Marginal Rate Marginal Rate of of SubstitutionSubstitution
- the rate at which a consumer
is willing to trade one good for another.
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Indifference CurveIndifference Curve
Consumer Theory Consumer Theory
- shows consumption bundles that give the consumer the same level of satisfaction.
4 qualities of the curve:1.) Indifference curves are downward-sloping.
3.) Indifference curves cannot cross
2.) Higher indifference curves are preferred to lower ones.
4.) Indifference curves are bowed inward
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Indifference CurveIndifference Curve
Consumer Theory Consumer Theory
Quantity of Soda
Quantity of Movies
I1
One of Ian’s indifference curves
B
A
A, B, and all other bundles on I1 make Ian equally happy
- he is indifferent between them.
- doesn’t matter which combine to buy, brings
same satifaction
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Consumer Theory Consumer Theory
Quantity of Soda
Quantity of Movies
I1
One of Ian’s indifference curves
B
A
1.) Indifference curves are downward-
sloping.
If the quantity of soda is reduced,
the quantity of movies must be
increased to keep Ian equally happy.
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Consumer Theory Consumer Theory
Quantity of Soda
Quantity of Movies
One of Ian’s indifference curves
2.) Higher indifference curves are preferred
to lower ones.
I2
Ian prefers every bundle on I2 (like C) to every bundle on I1
(like A). He prefers every
bundle on I1 (like A) to every bundle on I0
(like D).
I1I0
DDC
A
I0I1
I2
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Consumer Theory Consumer Theory
Quantity of Soda
Quantity of Movies
One of Ian’s indifference curves
3.) Indifference curves cannot cross.
D
I1
B
C
I4A
Suppose they did.Ian should prefer B to C, since B has more of both goods.Yet, Ian is indifferent
between B and C:He likes C as much as A
(both are on I4).
He likes A as much as B (both are on I1).
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Consumer Theory Consumer Theory
Quantity of Soda
Quantity of Movies
One of Ian’s indifference curves
4.) Indifference curves are bowed inward.
D
I1
1
1
6
2
A
B
Ian is willing to give up more
movies for soda if he has few
soda (A) than if he has many (B).
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Marginal Rate Marginal Rate of of SubstitutionSubstitution
Consumer Theory Consumer Theory - the rate at which a
consumer is willing to trade one good
for another.
Can view this all Can view this all along the slope of along the slope of
the indifference the indifference curve curve
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Consumer Theory Consumer Theory
Quantity of Soda
Quantity of Movies
One of Ian’s indifference curves
D
I1
1
1
6
2
A
B
MRS = slope of indifference curve
MRS =
MRS =
Marginal Rate Marginal Rate of of SubstitutionSubstitution
Ian’s MRS is the amount of movies he would substitute for
another soda.
MRS falls as you move down along an
indifference curve.
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Marginal Rate Marginal Rate of of SubstitutionSubstitution
Consumer Theory Consumer Theory - the rate at which a
consumer is willing to trade one good
for another.Two extreme examples:
- two goods with straight-line indifference curves (constant
MRS)
Perfect substitutes
((MRSMRS))
- two goods with right-angle indifference curves
Perfect complements
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One Extreme Case: One Extreme Case: Perfect Perfect SubstitutesSubstitutes
Example: nickels & dimes
Consumer is always willing to trade
two nickels (5 cents) for one dime
(10 cents).
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THE THEORY OF CONSUMER CHOICE
Another Extreme Case: Another Extreme Case: Perfect Perfect ComplementsComplements
Example: Left shoes, right shoes
{7 left shoes, 5 right shoes}
is just as good as {5 left shoes, 5
right shoes}
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Less Extreme Cases: Less Extreme Cases: Close Substitutes Close Substitutes and and Close Close ComplementsComplements
Quantity of Coke
Quantity of Pepsi
Indifference curves for close substitutes are not very bowed
Quantity of hot dogs
Quantity of hot
dog buns
Indifference curves for
close complements
are very bowed
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Next is figuring out the budget line to know exactly how much to
buy
Consumer ( Consumer ( MUMU )Theory )Theory
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The EndThe EndThank you Thank you