Economics - Theory of the Consumer | Economics

Preview (5 of 14 Pages)

100%

Economics - Theory of the Consumer - Page 1 preview image

Loading page ...

Study GuideEconomics–Theory of the Consumer1. Consumer Equilibrium1.1What Is Consumer Equilibrium?When consumers decide how much of different goods and services to buy, their main goal is togetthe maximum possible satisfaction, also calledtotal utility.However, consumers cannot buy everything they want. They face two main limitations:•Limited income (budget)•Prices of goods and servicesTrying to get the highest total utility while staying within these limits is called theconsumer’sproblem.Thesolutionto this problem—where the consumer chooses the best combination ofgoods—is known asconsumer equilibrium.1.2How Is Consumer Equilibrium Determined?To understand this idea clearly, let us start with a simple case.Suppose a consumer buys onlytwo goods:•Good 1•Good 2The consumer:•Knows the prices of both goods•Has a fixed budget•Spends theentire budgeton these two goodsThe consumer reaches equilibrium when thesatisfaction gained from the last rupee spent oneach good is the same.In other words, the consumer distributes spending so that:The marginal utility per rupee spent on Good 1 is equal to the marginal utility per rupee spent onGood 2.

Economics - Theory of the Consumer - Page 2 preview image

Loading page ...

Study Guide1.3Why Must Marginal Utility per Rupee Be Equal?If the marginal utility per rupee fromGood 1is higher than that fromGood 2, the consumer will buymore of Good 1 and less of Good 2.As the consumer buys more units of Good 1:•Thelaw of diminishing marginal utilityapplies•Marginal utility from Good 1 gradually fallsThis process continues until:•The marginal utility per rupee spent on both goods becomes equalAt this point, the consumer is making thebest possible use of income, given prices and budget.1.4An Example of Consumer EquilibriumLet us now understand this with a numerical example.Given:•Price of Good 1 =$2 per unit•Price of Good 2 =$1 per unit•Consumer’s budget =$5Marginal utility (MU) is measured in imaginary units calledutils.More utils meanmore satisfactionfrom consuming a unit of a good.

Economics - Theory of the Consumer - Page 3 preview image

Loading page ...

Study Guide1.5Understanding the TableFrom the table:•The first unit of Good 1 gives24 utils•Price of Good 1 is$2•So, MU per dollar =24 ÷ 2 = 12 utilsSimilarly, MU per dollar is calculated for all units of both goods.Step-by-Step Consumer Decision1.First purchaseoMU per dollar of Good 1 =12 utilsoMU per dollar of Good 2 =9 utilsoGood 1 gives more satisfaction per dollar, so the consumer buys1 unit of Good 1oMoney left = $5 − $2 =$32.Second decisionoMU per dollar of second unit of Good 1 =9 utilsoMU per dollar of first unit of Good 2 =9 utilsoBoth give equal satisfaction, so the consumer buysbothoCost = $2 + $1 =$3

Economics - Theory of the Consumer - Page 4 preview image

Loading page ...

Study Guide3.Budget exhaustedoTotal spending = $5oMU per dollar from both goods is equal1.6Final Equilibrium ChoiceAt equilibrium, the consumer buys:•2 units of Good 1•1 unit of Good 2This combination:•Uses the full budget•Gives maximum total utility•Equalizes marginal utility per dollar spent1.7Consumer Equilibrium with Many GoodsIn real life, consumers usually buymore than two goods.When there areN goods, the rule remains the same:The consumer is in equilibrium when the marginal utility per rupee spent oneach good is equal,subject to the budget constraint.Key Takeaway•Consumers aim tomaximize satisfaction•Income and prices limit choices•Equal marginal utility per rupee spentis the key rule•This rule applies totwo goods or many goods

Economics - Theory of the Consumer - Page 5 preview image

Loading page ...

Study Guide2. Consumer Equilibrium Changes in PricesThe table helps students clearly see how marginal utility per dollar changes when prices change.2.1Understanding Consumer Choices When Prices ChangeConsumers choose how much of different goods to buy so that they get themaximum totalsatisfaction (utility)from their limited income.This choice depends mainly on two things:•Theprices of goods, and•Theconsumer’s budget.When the price of any good changes, the consumer’s best (equilibrium) choice also changes. Let’sunderstand this step by step using a simple example.2.2A Change in the Price of Good 1In our example, the consumer buysGood 1andGood 2.•Theprice of Good 1 increasesfrom$2 to $3 per unit•Theprice of Good 2 stays the sameat$1 per unit•Theconsumer’s budget remains $5•Themarginal utilities of both goods do not changeWhatdoeschange is themarginal utility per dollar spent on Good 1. Since Good 1 is now moreexpensive, each dollar spent on it givesless satisfaction than before.

Preview Mode

This document has 14 pages. Sign in to access the full document!

Report

Economics - Theory of the Consumer

Study Now!

Document Details

Related Documents

Economics - Theory of the Firm

Economics - Perfect Competition

Economics - Monopoly

Economics - Monopolistic Competition and Oligopoly

Economics - Money and Banking

Economics - Labor Market

Economics - Introduction

Economics - GDP, Inflation, and Unemployment

Economics - Fiscal and Monetary Policy

Economics - Demand, Supply, and Elasticity

Company

Explore

Study Tools