Chapter 4: The Theory of Individual Behavior
Consumer – an individual who purchases goods and services from firms for the purpose of
consumption.
Two distinct factors to consider while characterizing consumer behavior:
1. Consumer opportunities represent the possible goods and services consumers can
afford.
2. Consumer preferences determine which of the affordable goods will be consumed.
If you would like to make a model of behavior, you should start with a simple model, i.e.
assuming only two goods exist in our economy.
The preference ordering between two goods is assumed to satisfy 4 basic properties;
1. Completeness – Consumer is capable of expressing a preference for, or indifference
among, all bundles. For two bundles A and B: Either A>B, B>A or A~B.
2. More is better – For two bundles A and B: if bundle A has at least as much of every
good as bundle B and more of some good, bundle A is preferred over bundle B.
3. Diminishing marginal rate of substitution – As a consumer obtains more of good A,
the rate at which he or she is willing to substitute good A for good B decreases.
4. Transitivity – The assumption of transitive preferences implies that indifference curves
do not intersect one another. This eliminates the possibility that the consumer is caught in
a perpetual cycle in which he or she never makes a choice. For three bundles A, B and C:
if A>B and B>C, then A>C. Similarly, if A ~ B and B ~ C, then A ~ C.
Indifference curve – A curve that defines the combinations of two or more goods that give a
consumer the same level of satisfaction. Curves farther from the origin imply higher levels of
satisfaction than curves closer to the origin.
Marginal rate of substitution (MRS) – The rate at which a consumer is willing to substitute
one good for another good and still maintain the same level of satisfaction. The marginal rate of
substitution is the slope of the indifference curve.
Constraints – people have a certain limits; legal, time, physical and budget constraints.
Consumer – an individual who purchases goods and services from firms for the purpose of
consumption.
Two distinct factors to consider while characterizing consumer behavior:
1. Consumer opportunities represent the possible goods and services consumers can
afford.
2. Consumer preferences determine which of the affordable goods will be consumed.
If you would like to make a model of behavior, you should start with a simple model, i.e.
assuming only two goods exist in our economy.
The preference ordering between two goods is assumed to satisfy 4 basic properties;
1. Completeness – Consumer is capable of expressing a preference for, or indifference
among, all bundles. For two bundles A and B: Either A>B, B>A or A~B.
2. More is better – For two bundles A and B: if bundle A has at least as much of every
good as bundle B and more of some good, bundle A is preferred over bundle B.
3. Diminishing marginal rate of substitution – As a consumer obtains more of good A,
the rate at which he or she is willing to substitute good A for good B decreases.
4. Transitivity – The assumption of transitive preferences implies that indifference curves
do not intersect one another. This eliminates the possibility that the consumer is caught in
a perpetual cycle in which he or she never makes a choice. For three bundles A, B and C:
if A>B and B>C, then A>C. Similarly, if A ~ B and B ~ C, then A ~ C.
Indifference curve – A curve that defines the combinations of two or more goods that give a
consumer the same level of satisfaction. Curves farther from the origin imply higher levels of
satisfaction than curves closer to the origin.
Marginal rate of substitution (MRS) – The rate at which a consumer is willing to substitute
one good for another good and still maintain the same level of satisfaction. The marginal rate of
substitution is the slope of the indifference curve.
Constraints – people have a certain limits; legal, time, physical and budget constraints.
