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Lectures 3 - 7

Introduction to Microeconomics (L11100). Lectures 3 - 7. Section Two: Consumer Theory. Outline. 2.1 Utility theory and axioms (Lecture 3) 2.2 Indifference curves and budget constraints (Lecture 4) 2.3 Income/Price Changes and Income/Substitution effects (Lecture 5)

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Lectures 3 - 7

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  1. Introduction to Microeconomics (L11100) Lectures 3 - 7 Section Two: Consumer Theory

  2. Outline 2.1 Utility theory and axioms (Lecture 3) 2.2 Indifference curves and budget constraints (Lecture 4) 2.3 Income/Price Changes and Income/Substitution effects (Lecture 5) 2.4 Elasticity (Lecture 6) 2.5 Constrained optimisation of choice (Lecture 7)

  3. 2.1 Utility Theory and Axioms 2.1.1 Utility Defined 2.1.2 Consumption and Utility 2.1.3 Axioms of Consumption

  4. Application • “Italian truffle fetches $200,000 at Macau auction” • Reuters 29th November 2008 • World wide auction of a 1kg Italian white truffle • Bought for $200,000 by “Hong Kong casino mogul Stanley Ho” • Buyers from all over the world bid simultaneously (Rome, London, Abu Dhabi and Macau) • White truffles are very scarce and made more so by climate change (mushrooms are abundant and cheaper!)

  5. 2.1.1 Utility Defined Question: Why do we consume goods and services? Answer: because we want to due to either: Necessity - we have to consume them e.g. food, shelter, water, clothes etc. Desire - we would like to consume them but they are luxuries e.g. televisions, microwaves, holidays etc We gain satisfaction which is called UTILITY Two features: 1. Highly individual 2. Relative measure

  6. 2.1.2 Consumption and Utility How do consumption and utility relate? Episodes of Friends Total Utility 0 0 1 20 38 2 53 3 61 4 65 5 6 55

  7. Total Utility - cumulative satisfaction Marginal Utility - addition to TU from last unit consumed Friends Total Utility Marginal Utility 0 0 0 20 20 1 18 2 38 15 3 53 8 61 4 4 5 65 -10 6 55

  8. TU MU 65 Q 5 Q Principle of Diminishing Marginal Utility

  9. This concept helps us explain two economic features: 1. Barter - exchange of goods (for you to do) 2. Paradox of Value - why do diamonds, which are a luxury, have a higher price than water which is a necessity? Price reflects marginal utility MU(diamonds) > MU (water) Thus, the price of diamonds is higher than the price of water (see ham example)

  10. 2.1.3 Axioms of Consumption Consumption of bundles of goods analysed using Assumptions(Axioms) of consumption Assumption One: Completeness A consumer, when confronted by any two bundles, can tell us which one he/she prefers or whether he/she is indifferent between them Assumption Two: Transitivity Preferences are such that if X is preferred to Y and Y is preferred to Z then X is preferred to Z Assumption Three: Non-satiation More is better!

  11. Good B ? e a Bundles preferred to b b d c Bundles less desirable than b ? Good A

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