Applications of consumer theory
This means the substitution effect is the change from Point A to Point B. What matters is whether a bundle produces more than another, less, or the same. This means that both T-shirts and movies are normal goods. Economists think of this approach as analogous to studying gravitation in a vacuum before thinking about the effects of air friction. Preferences are reflexive Means that if A and B are in all respect identical the consumer will consider A to be at least as good as i. But part of the job of studying economics is to learn the language of economics, so bundles it is. Our consumer will, in the end, always spend all of his or her income, although this happens because we adopt a very broad notion of spending. People will substitute away from the good which has increased in price because it is relatively more expensive. The consumer would like more of both, reflected in greater pleasure for greater consumption. Whilst this makes the model less precise, it is generally acknowledged to provide a useful simplification to the calculations involved in consumer choice theory, especially since consumer demand is often examined over a considerable period of time. Since MRS represents the maximum amount of y we are willing to give up in exchange for one unit of x, it also represents how much value our consumer places on x in terms of y. First, the total amount of time that an individual has to allocate is known as his "time endowment", and is often denoted as T.
This assumption is implicit in the last assumption. This also means that if the consumer is indifferent between A and B and is indifferent between B and C she will be indifferent between A and C.
Take, for example, a government tax rebate. Assumptions[ edit ] The behavioral assumption of the consumer theory proposed herein is that all consumers seek to maximize utility. These are relatively strict, allowing for the model to generate more useful hypotheses with regard to consumer behaviour than weaker assumptions, which would allow any empirical data to be explained in terms of stupidity, ignorance, or some other factor, and hence would not be able to generate any predictions about future demand at all.
Both goods cannot be considered inferior in this model, because the model only represents two goods. The income effect is simply what happens when we reverse our thought experiment, and either remove the hypothetical income, or in this case, give it back.
Utility Flow of pleasure or happiness that a person enjoys. Why call it the substitution effect then? This means that if the slope of the indifference curve is steeper than that of the budget line, the consumer will consume more x and less y.
The Final Effect To determine the final effect, we need to bring together the income effect and the substitution effect. Though this exercise is simply to show the effect of a price change while holding purchasing power constant, in reality, this sometimes actually happens!
based on 85 review