Consumer Theory
CONSUMER THEORY I
Consumer theory – deals with how a consumer chooses the best bundle of goods he/she can afford.
BUDGET CONSTRAINT
To know which bundle of goods a consumer can afford, we have to look into the consumer’s budget constraint.
We first assume that there are only two goods, say good x1 and x2. A consumer can choose from bundle A (3, 2) – 3 units of good 1 and 2 units of good 2; bundle B (6, 5) –
6 units of good 1 and 5 units of good, so forth.
Given the price of good 1 (p1), price of good 2 (p2) and income (m), we can represent the consumer’s budget constraint as: p1x1 + p2x2 ≤ m
Where p1x1 is the amount of money the consumer is spending on good 1 and p2x2 is the amount of money spent on good 2. And ≤ m means that total consumption should not exceed income. For simplicity, we will assume that all income is spent on purchasing goods 1 and 2, so p1x1 + p2x2 = m.
The consumer’s affordable consumption bundles are those that don’t cost more than his/her income (m). We call this set of affordable consumption bundles at prices (p1, p2) and income (m) as the consumer’s budget set.
If we assume that good 2 represents all other goods, we call it a composite good. We represent the budget set as p1x1 + p2x2 ≤ m, where p2=1 since the price of one peso is one peso.
Budget Line x2 m/p2
-p1/p2
m/p1
x1
Graphically, we represent the budget set through a budget line. The budget line is a set of bundles that cost exactly m. p1x1 + p2x2 = m
Note: Points along and below the budget line are affordable bundles, which forms the consumer’s budget set. Points beyond the budget line are unaffordable. Those that lie along the budget line exhaust the consumer’s income.
Rearranging the budget line equation, x1 = (m/p1) - (p2/p1)x2
This formula tells us how many units of good 1 a consumer can consume given the price of good 1, price of good 2, consumption of good 2 and income. It also tells us how many units of good 1 a consumer can
Consumer theory – deals with how a consumer chooses the best bundle of goods he/she can afford.
BUDGET CONSTRAINT
To know which bundle of goods a consumer can afford, we have to look into the consumer’s budget constraint.
We first assume that there are only two goods, say good x1 and x2. A consumer can choose from bundle A (3, 2) – 3 units of good 1 and 2 units of good 2; bundle B (6, 5) –
6 units of good 1 and 5 units of good, so forth.
Given the price of good 1 (p1), price of good 2 (p2) and income (m), we can represent the consumer’s budget constraint as: p1x1 + p2x2 ≤ m
Where p1x1 is the amount of money the consumer is spending on good 1 and p2x2 is the amount of money spent on good 2. And ≤ m means that total consumption should not exceed income. For simplicity, we will assume that all income is spent on purchasing goods 1 and 2, so p1x1 + p2x2 = m.
The consumer’s affordable consumption bundles are those that don’t cost more than his/her income (m). We call this set of affordable consumption bundles at prices (p1, p2) and income (m) as the consumer’s budget set.
If we assume that good 2 represents all other goods, we call it a composite good. We represent the budget set as p1x1 + p2x2 ≤ m, where p2=1 since the price of one peso is one peso.
Budget Line x2 m/p2
-p1/p2
m/p1
x1
Graphically, we represent the budget set through a budget line. The budget line is a set of bundles that cost exactly m. p1x1 + p2x2 = m
Note: Points along and below the budget line are affordable bundles, which forms the consumer’s budget set. Points beyond the budget line are unaffordable. Those that lie along the budget line exhaust the consumer’s income.
Rearranging the budget line equation, x1 = (m/p1) - (p2/p1)x2
This formula tells us how many units of good 1 a consumer can consume given the price of good 1, price of good 2, consumption of good 2 and income. It also tells us how many units of good 1 a consumer can