Consumer Preferences ordinal theory

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Consumer Preferences - ordinal theory
Budget Constraint
Budget Constraint limits a consumer's ability to
buy unlimited amount of goods and services
Budget Line
Budget Line indicates all combinations of two
commodities for which total money spent equals
total income.
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Consumer Preferences - ordinal theory
Budget Constraint
The consumer divides his income between the
commodities X and Y
I PX . x PY . y
I incomePX price of XPY price of Yx
amount of Xy amount of Y
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Consumer Preferences - ordinal theory
Budget Constraint - example
I 100 USDPbeer 5 USD/can Pfood 10 USD/unit
100 10x 5y
x units of foody cans of beer
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Consumer Preferences - ordinal theory
Budget Constraint slope of budget line
If we sacrifice 2 cans of beer we can buy
additional unit of food
100 10x 5y
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Consumer Preferences - ordinal theory
Market Basket
Collection of one or more commodities
One market basket can be preferred over another
market basket containing a different combination
of goods
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Consumer Preferences - ordinal theory
Budget Constraint change of income and price
Income increases
The price of the good decreases
100 8x 5y
120 10x 5y
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Consumer Preferences - ordinal theory
Budget Constraint change of income and
price Example a) Assume there are two goods
T-shirts and skirts. The price of the T-shirt is
4 and the price of the skirt is 10. The income
is I 200 . -determine the budget constraint.
-determine the slope and the intercepts of the
budget line. -graph the budget area. b) Assume
that income increases to I 300. At the same
time the price of the T-shirt increases to 10.
-determine the equation of the new budget line.
-determine the slope and the intercepts of the
new budget line. -graph the new budget area.
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Consumer Preferences - ordinal theory
Budget Constraint change of income and
price Solution a) The budget constraint is given
by 4x10ylt200. Thus, the budget line is given
by 4x10y200. The intercepts are 50,0 and
0,20. The slope is -Px/Py - 4/10 -0.4 b)
The new budget line is 10x10y300. The
intercepts are 30,0 and 0,30. The slope is -
Px/Py -1

• _______________________________________________
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• This project is co-financed by the European Union

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Consumer Preferences - ordinal theory
Consumer Optimum
Consumers choose a combination of goods that will
maximize the satisfaction they can achieve, given
the limited budget available to them
The maximizing market basket must satisfy two
conditions 1) It must be located on the budget
line 2) It must maximize the utility
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Consumer Preferences - ordinal theory
Consumer Optimum
Slope of indifference curve equals slope of
budget line.
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Consumer Preferences - ordinal theory
Consumer Optimum
Marginal rate of substitution in consumption
Marginal rate of substitution in exchange
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Consumer Preferences - ordinal theory
Consumer Optimum Example See the graph with the
indifference curve and the budget line. The price
of the good X is Px 20 CZK. Determine a)
Income of the consumer. b) Py. c) MRS in the
consumer optimum. d) The the equation of the
budget line.

• I Px X 20 50 1000 CZK
• Py I/4025 CZK
• MRSPx/Py20/250.8
• 20X25Y1000

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Individual Demand
Demand is the amount of a good, which buyers wish
to purchase at each conceivable price
Individual demand is a demand of one consumer for
one good
The curve of individual demand is derived from
indifference analysis
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Individual Demand

• Assumptions
• Constant income
• Constant price of a good Y

Change of the price of good X
Change of the relevant quantity of good X
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Individual Demand
Change the price of good X P0 ? P1 ? P2 Change
the quantity of good X x0 ? x1 ? x2
Change of consumer optimum
PCC Price Consumption Curve
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Individual Demand
Individual demand curve (d) graphs the
relationship between demanded quantity of a good
X and its price P
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Individual Demand
The law of demand The more of a good is
demanded the lower its price
Negative slope of demand curve
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Individual Demand
Income Effect The price of a good X rises
Decrease in real income (real purchasing power)
Decrease in demanded quantity of X
Substitution Effect The price of a good X rises
Increase in relative price of X
Decrease in demanded quantity of X Increase in
demanded quantity of cheaper good
Nominal income is constant !!!!!
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Individual Demand
Change of nominal income I
Increase in nominal income
d1
d
d2
d ? d1
I1 gt I
Decrease in nominal income
d ? d2
I2 lt I
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Individual Demand
Normal Good A good whose consumption increases
with an increase of income
Necessary good low sensitivity of demand to
changes of nominal income (bread, salt)
Luxury good high sensitivity of demand to
changes of nominal income (gold)
Inferior Good A good whose consumption decreases
with an increase of income(cheap salami)
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Individual Demand
Independent Goods No significant sensitivity of
demand for X when price of Y changes
Substitutes Increase in demand for X when price
of Y rises
Complements Decrease in demand for X when price
of Y rises
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Individual Demand
Price elasticity of demand is the percentage
change in quantity demanded divided by the
percentage change in price
The more elastic demand, the more sensitive is
the reaction of a consumer to the change in
price
ePD lt 0
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Individual Demand
How can the consumer react to the change in price
?
Elastic demand
Unit elastic demand
Inelastic demand
Necessary good
Luxury good
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Individual Demand
Example Price elasticity of demand
Specify the range of the demand schedule in which
the demand price is inelastic?
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Individual Demand
Example Price elasticity of demand
Specify the range of the demand schedule in which
the demand price is inelastic?
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Individual Demand
Example Price elasticity of demand

• If a 5 increase in the price of one good results
  in a decrease of 2 in the quantity demanded of
  another good, then it can be concluded that the
  two goods are
• complements
• substitutes
• independent
• normal

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Individual Demand
How can the consumer react to the change in price
?
Perfect inelastic demand
Perfect elastic demand
Drugs, insulin
?
Goods without substitutes
your homework
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Market Demand
Market demand is a sum of all individual demands
for one good
Market demand can be derived graphically as
horizontal summation of individual demand curves.