Understanding Consumer Preferences and Market Behavior
Consumer Preferences: Part of consumer behavior. A consumer compares different groups of items available for purchase through market baskets. A list with specific quantities of goods. It has assumptions about people’s preferences for one market versus another. Completeness: For any two market baskets A and B, a consumer will prefer A to B, will prefer B to A, or be indifferent between both. Transitivity: A consumer prefers A to B, and B to C, then will prefer A to C. More is better than less: Goods are assumed to be desirable. Indifference Curves and Maps: Curves representing all combinations of market baskets that provide a consumer with the same level of satisfaction. Indifference Map: Graph containing a set of indifference curves showing the market baskets among which a consumer is indifferent. Indifference curves can’t intersect due to the law of transitivity. MRS: Maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good. Convexity: Decline in MRS that reflects important characteristics of consumer preferences. In order to understand well, we have to talk about diminishing MRS. An indifference curve is convex if MRS diminishes along the curve. Perfect Substitutes: Two goods are substitutes; an increase in the price of one leads to an increase in the quantity of the other. Perfect Substitutes: When MRS of one for the other is constant. Perfect Complements: Indifference curves for both are shaped as right angles. Utility and Indifference Curves: Numerical scores representing the satisfaction that a consumer gets from a given market basket. Utility function assigns a level of utility to individual market baskets. A utility function can be represented by a set of numerical indifference curves. Ordinal Utility Function: Utility function that generates a ranking of market baskets in order of most to least preferred. Cardinal: Utility function describing by how much one market basket is preferred to another. Budget Constraint: Constraints that consumers face as a result of limited incomes. Budget Line: Describes the combinations of goods that can be purchased given a consumer’s income and prices of the goods. Effects of Changes in Income and Prices: A change in income causes the budget line to shift parallel to the original one, while a change in the price of one good causes the budget line to rotate from one point.
Consumer Choices: We assume that consumers choose goods to maximize the satisfaction they can achieve, due to the limiting budget. This maximization has to satisfy two conditions: it must be located on the budget line and it must give the consumer the most preferred combination of goods and services. Marginal Benefit: Benefit from the consumption of one additional unit of a good. Marginal Cost: Cost of one additional good. Corner Solution: MRS of one good for another in a chosen market basket isn’t equal to the slope of the budget line. Individual Demand: Effective want for something and the willingness and ability to pay for it. Price-Consumption Curve: Curve tracing the utility-maximizing combinations of two goods as the price of one changes. Individual Demand Curve: Curve relating the quantity of a good that a single consumer will buy to its price. It has two properties: the level of utility that can be attained changes as we move along the curve. Diminishing MRS: MRS is a measure of the maximum amount of one good that the consumer is willing to give up in order to obtain units of another good. Income Consumption Curve: Curve tracing the utility-maximizing combinations of two goods as a consumer’s income changes. Normal vs Inferior Goods: Normal goods, consumers want to buy more of them as their incomes increase, while if the quantity demanded falls as income increases, the income elasticity of demand is negative, inferior goods. Engel Curve: Curve relating the quantity of a good consumed to income. Substitution Effect: Change in consumption of a good associated with a change in its price, with the level of utility held constant. Income Effect: Change in consumption of a good resulting from an increase in purchasing power, with relative prices held constant. Giffen Good: A good whose demand curve slopes upward because the (negative) income effect is larger than the substitution effect. Market Demand Curve: Curve relating the quantity of a good that all consumers in a market will buy to its price. Two Points: The market demand curve will shift to the right as more consumers enter the market. The second point refers to the factors that influence the demands of many consumers will also affect market demand.
Elasticity: How sensitive the demand for a good is to changes in other economic variables. Inelastic Demand: Quantity demanded is relatively unresponsive to changes in price, then total expenditure on the product increases when the price increases. Elastic Demand: Total expenditure on the product decreases as the price increases. Unit Elastic: Demand curve with a constant price elasticity. Consumer Surplus: Difference between what a consumer is willing to pay for a good and the amount actually paid, also is the total benefit from the consumption of a product, less the total cost of purchasing it. For the market as a whole, consumer surplus is delimited by the area under the demand curve and above the line of purchase price of the good. Production Technology: Practical way to describe how inputs can be transformed into outputs. Just as consumers get a level of satisfaction from buying different combinations of goods, firms can produce a particular level of output by using different combinations of inputs.
Theory of the Firm: How a firm makes cost-minimizing production decisions and how its cost varies with its output. Production Technology: Production process, turning inputs into outputs. Production Function: Highest output that a firm can produce for every specified combination of inputs. Production Function: Highest output that a firm can produce for every specific combination of inputs (q=f(k,l)). Short Run Production: Period of time in which quantities of one or more production factors can’t be changed. Fixed Input: Production factor that can’t be varied. Long Run: Amount of time needed to make all production inputs variable. Average Product: Output per unit of a particular input. Marginal Product: Additional output produced as an input is increased by one unit. Law of Diminishing Marginal Returns: Principle that as the use of one input increases with other inputs fixed, the resulting additions to output will eventually decrease. Short-Run Cost: FC: Cost that doesn’t vary with the level of output and that can be eliminated only by shutting down. VC: Cost that varies as output varies. TC: Total economic cost of production, consisting of fixed and variable costs. FC: Cost that doesn’t vary with the level of output and that can be eliminated only by shutting down. Marginal Cost: Increase in cost resulting from the production of one extra unit of output. ATC: Firm’s total cost divided by its level of output. AFC: Fixed cost divided by the level of output. AVC: Variable cost divided by the level of output. Isocost Line: Graph showing all possible combinations of labor and capital that can be purchased for a given total cost. Long-Run Cost: Long-run average cost curve: curve relating average cost of production to output when all inputs, including capital, are variable. Short-Run Average Cost Curve: Curve relating average cost of production to output when the level of capital is fixed. Long-Run Marginal Cost Curve: Curve showing the change in long-run total cost as output is increased incrementally by one unit. Economies of Scale: Situation in which output can be doubled for less than a doubling of cost. Diseconomies of Scale: Situation in which a doubling of output requires more than a doubling of cost. Producer Choices: Supply Curve: Relationship between the quantity of a good that producers are willing to sell and the price of the good. The short-run market supply curve shows us the amount of output that the industry will produce in the short run for every possible price. The industry’s output is the sum of quantities supplied by all of its individual firms. Then the market supply curve can be obtained by adding the supply curves of each of these firms. Elasticity of Supply: % change in quantity supplied resulting from a 1% increase in price. The elasticity of market supply measures the sensitivity of industry output to market price. Producer Surplus: Sum over all units produced by a firm of differences between the market price of a good and the marginal cost of production. Equilibrium Point: Supply Curve: Relationship between the quantity of a good that producers are willing to sell and the price of the good. Demand Curve: Relationship between the quantity of a good that consumers are willing to buy and the price of the good. Equilibrium occurs when the two curves intersect at the equilibrium, or market-clearing, price and quantity. At this price, the quantity supplied and quantity demanded are equal. Market Mechanism: Tendency in a free market for price to change until the market clears. Substitutes: Two goods for which an increase in the price of one leads to an increase in the quantity demanded of the other. Complements: Two goods for which an increase in the price of one leads to a decrease in the quantity demanded of the other. Surplus: Situation in which the quantity supplied exceeds the quantity demanded. Shortage: Situation in which the quantity demanded exceeds the quantity supplied. Solving Shortage: Elasticity: % change in one variable resulting from a 1% increase in another. Price Elasticity of Demand: % change in quantity demanded of a good resulting from a 1% increase in its price. Changes in Market Equilibrium: In most markets, both the demand and supply curves shift from time to time. Consumers’ disposable incomes change as the economy grows. The demands for some goods shift with the seasons, with changes in prices of related goods, or with changing tastes. Also, wage rates, prices of raw materials, capital costs change from time to time, and these changes shift the supply curve. The supply and demand curves can be used to trace the effects of these changes.