Consumer's behavior
Utility
Utility measures how much satisfaction or happiness you get from consuming something.
Utility = U(x,y)
Indifference curves
MRS - Marginal rate of substitution
MRS represents how much of one good you are willing to trade for another while keeping utility constant
Peculiarities of MRS
Convexity - Person prefers balanced bundles
Diminishing MRS - the more of a good 1 you have, the less good 2 you are willing to give up for an extra good 1
Marginal Utility(MU)
MU - The extra utility from one more unit of something
Calculation of MU - To calculate MU you need to take a derivative of U(x,y) with respect to each variable
MRS formula: MU1/MU2
Indifference curves - are just a graph of all combos of x and y that give the same utility
Key aspects
Key rule - Indifference curves never cross, because that would brake the logic of transitivity
Shape - Indifference curves usually slope downward
Definition - A curve showing all the combinations of two goods that give you the same level of Utility
Higher curves - higher level of Utility
Different types of preferences
Perfect substitutes
Utility function: U(x,y) = ax+by
Indifference curves: straight line as person is ready to trade one good for another at a constant rate
Perfect complements
Utility function: U(x,y) = min(ax,by)
Indifference curves: L-shaped as happiness is only increased if person gets more of both goods
Cobb-Douglas preferences
Utility function: U(x,y) = x^a+y^b
Indifference curve: Smooth, convex curves. They show diminishing MRS - you're willing to trade less of one good for the other as you get more
Utility maximization
Goal - Find the perfect mix of goods that maximizes utility while staying in the budget
Maximize U(x,y) subject to Px*x+Py*y=I
At this moment indifference curve must touch the budget line
MRS = MRT
MUx/MUy=Px/Py
Dual problem of consumer choice
You can not only try to maximize utility, but also to minimize expenditure, while keeping the utility at the same level.
Expenditure function - E(U,Px,Py)
E = total expenditure
U = The target utility level
Px, Py = the prices of the goods
Solutions
Lagrange method
Corner solution
Interior solution
Indirect utility function
Definition - how much utility you get from spending your budget, given certain prices and income
V(Px,Py,I)
Making decisions
Axioms of preferences
Completeness
Any 2 things can be compated
Transitivity
if option 1 is preffered to option 2 and option 2 is preffered to option 3, then option 1 is preffered to option 3
Non-satiation
More is better
Uncertainty and risk
Uncertainty - When person is not sure what is going to happen.
Risk - quantifiable part of uncertainty
Assessing risk - expected utility
Expected utility - weighting each possible outcome by its probability
Expected utility = p1 * U(x1) + p2 * U(x2) + ...+ pn * U(xn)
Attitudes towards risk
Risk averse - people who prefer certainty
Risk loving - people who enjoy taking risks
Risk neutral - those, who rely only on expected value while making decisions
Risk premium
Risk premium - the amount of money that one will pay in order to avoid taking risks.
Risk premium is calculated as a difference between the expected value of the risky option and the amount that someone is willing to accept for certainty
Arrow-Pratt coefficient
This is the way to measure the risk aversion via math. This coefficient tells us how risk averse someone is by looking at the curvature of the utility function. The higher it is, the less risky they are.
Ways of reducing risk
Diversification
Insurance
Only this one is directly related to the topic
Fairness
Fair insurance
The premium that you pay is equal to the expected cost of the risk
Unfair insurace
The premium that you pay is higher than the expected cost of the risk
Hedging
Budget
Definition - The budget constraint shows all the combinations of goods that person can afford with their income and the prices of those goods.
Formula - Px*x + Py*y <= I
Px = price of good x
Py = price of good y
x,y = quantities of the goods
I = income
Budget line
Definition - Budget line is a line which shows combos of goods where you spend all your money
Formula: Px*x+Py*y=I
Slope: -Px/Py
Slope is equal to MRT
MRT
Definition: how much of one good you have to give up to get more of the other
MRT formula: -Px/Py
Change in income or prices
Change in income
More income - Line shifts outward
Less income - Line shifts inward
Change in prices
If Px increases, the line rotates inward
If Py decreases, the line rotates outward
Budget types
Competitive budget: Prices are set by the market
Non-competitive budget: Some might get special offers or advantages
Price changes
Substitution effect
If a good becomes cheeper, you'll tend to buy more of that good and less of other goods that are now relatively more expensive. So, substitution effect is more about relative prices
Normal goods: Price goes down, you buy ,more
Inferior goods: Price goes down, you buy less
Goods
Normal
We buy more when income increases
EI > 0
Inferior
We buy less when income increases
EI < 0
Income effect
If a good becomes cheaper, you fell like you have more free money to spend, so you might buy more of that good or spend money on something else
Normal goods: Price goes down, you buy ,more
Inferior goods: Price goes down, you buy more
Demand
Income elasticity of demand
It measures how much the quantity demanded of a good changes when there's a change in income
EI formula: % change in quantity demanded/% change in income
EI interpretation
EI > 1
Good is income elastic
0<EI<1
Good is income inelastic
EI = 0
Good is income independent
Individual and market demand
Individual - how much a single consumer wants to buy at a specific price
Market demand - the total demand from all the consumers in the market
Types of demand elasticities
PED
Price elasticity of demand
YED
Income elasticity of demand
XED
Cross-price elasticity of demand
Behavioral economics
Behavioral economics focuses on how people actually behave
Main violations of tradicional choice theory:
Bounded rationality
Heuristics
Loss aversion
Framing effects
Anchoring
Time incosistency
Social preferences