Preferences, Utility, and Consumer Choice

Under supervision off : Prof. Dr. Somia Done by: Mayar El-Kheshen Shimaa Hamed Kamaly

Commodities: A generic term for both goods and services. y There are four assumptions in our model : a- The consumer can determine which combination of commodities is preferable or which combination yield equal satisfaction b- The consumer is consistent preferences are transitive c- More is preferred to less; and d- The consumer has full knowledge of alternatives. Indifference Curve: A curve along which the level of satisfaction or utility remains unchanged; the locus of points representing combination of two commodities that all yield equal levels of satisfaction. y Indifference curves are negatively sloped, pass through each and every point in the commodity space, and cannot intersect. y If indifference curves were concave to the origin, they would imply specialization rather than diversity in consumption. We use convex to the origin indifference curves because they are consistent with corner solutions. y Any tangent drawn in a convex to the origin indifference curves lies below that curve. y Indifference curves which are convex to the origin have the property of a diminishing marginal rate of substitution of x for y as more of x is consumed, the individual is willing to give up less of y in order to get one more unit of x, i.e., the person s marginal evaluation of x falls. Commodity Space: The X-Y plane, or quadrant, that represents all possible combinations of the two commodities in question.

y A higher indifference curve indicate the consumption of more of both goods in the commodity space or the consumption of enough more of one good to more than compensate for the decreased consumption of the other. Hence, it is preferred to a lower indifference curve. Principals of diversity in consumption: A generalization about none specialize by consuming only one product but diversity their consumption choices and consume more than one. Marginal Rate of Substitution (MRS xy): The number of units of Y that must be given up per unit of X gained in order to maintain a constant level of satisfaction. Diminishing marginal rate of substitution: MRS xy That declines as more of X (and also less of Y) is consumed; a property of convex to the origin in difference curves. Marginal Evaluation: The amount of additional satisfaction that an individual obtains from the consumption of one more unit of a commodity; also called marginal valuation and marginal use value. Cardinal Utility Analysis: The use of cardinal numbers which are quantitatively related to one another in order to measure and compare different levels of utility; such analysis requires the ability to measure utility. y Cardinal utility analysis requires measurement of levels of utility analysis only requires a rank ordering y The shape of a cardinal total utility curve will remain invariant to the origin and to the unit interval used to measure utility; thus, no matter what scale is used, the resultant cardinal utility curve will look the same

Ordinal Utility Analysis: An analysis which uses rankings or orderings of utility levels rather than quantitative numbers on a cardinal scale. Diminishing Marginal Utility: Aproperty of cardinal total utility curves; whenever cardinal tota; utility increases at a steadily decreasing rate, diminishing marginal utility exists and can be interpreted to mean that the marginal utility derived falls as more units if a good are consumed.

Diminishing Marginal Rate of Substitution

y If the cardinal total utility curve is increasing at a steadily decreasing rate, then has the property of diminishing marginal utility; however, it is impossible to prove diminishing marginal utility because we have no way to measure utility Budget constraint: The constraint imposed on consumer decision making by a combination of income and prices. Generally, this is defined as available money income per unit time period and prices in dollars per unit.

All two dimensional budget constraints are generalized into the equation:

Pxx + Pyy = m
Where: -

m = money income allocated to consumption (after

saving and borrowing) Px = the price of a specific good Py = the price of all other goods x = amount purchased of a specific good y = amount purchased of all other goods Budget constraint, where and

The equation can be rearranged to represent the shape of the curve on a graph:

y = (m / Py) (Px / Py)x, where (m / Py) is the y-intercept and ( Px / Py) is the slope,
representing a downward sloping budget line.

The factors that can shift the budget line are a change in income (m), a change in the price of a specific good (Px), or a change in the price of all other goods (Py). y The slope of the budget line is equal the negative of the price of x over the price of y. It represents the feasible rate at which x can be traded for y y The consumer optimum occurs when the highest indifference curve is tangent to the budget line. At this point the marginal rate of substitution is equal to the ratio of the prices of x and y, or MRSxy = Px/Py/MRMSxy.

Marginal rate of market substitution (MRMS): The feasible rate at which the consumer can trade off y and x. This rate is usually given by the relative prices of x and y (= the negative of the slope of the budget line).

Optimization: The individual economic agent s decision-making process which leads to consumer optimum or maximum satisfaction position.

Equilibrium: A property of markets rather than individual decision making in which forces acting upon a system are balanced so that there is no net tendency to change. Corner solution: A solution to optimization or equilibrium problems which lie on either the x or the y axis Interior solution: A solution to either optimization or equilibrium problems which does not lie on either axis Law of equal marginal utilities per dollar A consumer optimum obtain when the marginal utility per dollar spent on a good is the same for all goods consumed y Consumer optimum can also be viewed in marginal utility terms as the combination of commodities which yields equal marginal utility per last dollar spent on each. Otherwise stated, the marginal utility ratio of their prices. y Ignoring utility theory altogether, we might derive convex to the origin indifference curves by using the method of revealed preference which induces properties of consumer tastes from observed behavior.