Assignment One – ECN5402 Economists Use Economic Theory

Assignment One – ECN5402 Economists use the economic theory of choice

ECN5402 Economists use the economic theory of choice to develop the notion of market demand. The principle assumption upon which the theory of consumer behavior and demand is built is: a consumer attempts to allocate his/her limited money income among available goods and services so as to maximize his/her utility. This process requires an in-depth examination of the ways economists model individual preferences, which are usually referred to by the formal term utility. Spoken words, graphs, and mathematical tools are used to conceptualize utility, which also enable economists to show the various exchanges that individuals are willing to make voluntarily.

Use both mathematical and intuitive analyses to indicate the insights that the concept of utility maximization provides about economic behavior (utility functions). Use the model of utility maximization to investigate how individuals will respond to changes in their circumstances (changes in income and market prices). Use the basic economic theory of consumer choice to determine the location and shape of a demand curve and identify the factors that might cause it to shift to a new position.

This assignment requires a comprehensive analysis of the Theories of Consumer behavior (Choice), the Ordinal Theory of Consumer Choice and the Cardinal Theory of Consumer Choice. Your responses must cover all the different aspects of the Theories of Consumer Behavior stating with the assumptions of the models and end with the derivation of a Marshallian Demand Curve and a Hicksian Demand Curve. The length of your discussions should be an original work and be within fifteen pages long. Please avoid large fonts (more than 12).

Paper For Above instruction

The economic theory of consumer choice is central to understanding how individuals allocate their limited resources among various goods and services to maximize their satisfaction or utility. This theory rests on certain foundational assumptions, including rational behavior, complete preferences, and non-satiation. Consumers are assumed to possess well-defined preferences, which they rank according to their satisfaction levels. The core idea is that consumers aim to reach the highest possible utility given their financial constraints, which makes utility maximization the key principle driving market demand. This paper explores the intuitive and mathematical dimensions of utility, analyzes the models of consumer behavior—the ordinal and cardinal approaches—and derives the demand functions, including the Marshallian and Hicksian demand curves. Additionally, it examines how changes in prices and income affect consumer choices and demand.

The concept of utility functions plays a vital role in modeling consumer preferences. Utility functions assign numerical values to different bundles of goods, capturing the consumer's preferences in a way that allows for mathematical analysis. In the cardinal approach, utility is measured with explicit numbers, implying that the intensity of preferences can be quantified precisely. In contrast, the ordinal approach focuses on the ranking of bundles without assigning specific utility levels, emphasizing the relative preference orderings. Both approaches are instrumental in deriving demand functions and understanding consumer responses to economic changes.

Assumptions of Consumer Choice Models

• Consumers are rational agents aiming to maximize utility.
• Preferences are complete, transitive, and non-satiated.
• Consumers have limited income and face market prices for goods and services.
• Choice sets include all affordable bundles within the budget constraint.

Utility Maximization and Consumer Behavior

Utility maximization involves choosing the most preferred affordable bundle within the budget constraint. Mathematically, it can be expressed as:

Maximize U(x₁, x₂, ..., xₙ) subject to the budget constraint S: p₁x₁ + p₂x₂ + ... + pₙxₙ = I, where pᵢ are prices and I is income.

Graphically, the consumer's optimization occurs at the tangency point between the highest possible indifference curve and the budget line. The slope of the indifference curve (marginal rate of substitution, MRS) equals the slope of the budget line (price ratio) at equilibrium, establishing the condition:

MRS = p₁/p₂.

Response to Changes in Income and Prices

When income increases, the budget constraint shifts outward, allowing consumers to reach higher indifference curves, leading to increased consumption—an expansion along the demand curve. Conversely, a decrease in income shifts the budget constraint inward. Changes in prices alter the slope of the budget line, prompting consumers to re-optimize their choices, which causes movement along the demand curve. These responses underpin the derived demand functions and their slopes.

Derivation of Demand Curves

Marshallian (Ordinary) Demand

The Marshallian demand function describes how consumer demand for a good varies with its price and consumer income, holding preferences constant. It results from solving the utility maximization problem, yielding demand functions x₁*(p₁, p₂, ..., pₙ; I).

Graphically, the Marshallian demand is derived from the tangency condition at the utility-maximizing point, with the demand curve obtained by plotting x₁* against p₁, holding other variables constant.

Hicksian (Compensated) Demand

The Hicksian demand function demonstrates how consumer demand responds to price changes, holding utility constant through compensation. It is derived from minimizing expenditure while maintaining a specified utility level, solving:

Minimize p₁x₁ + p₂x₂ + ... + pₙxₙ subject to U(x₁, x₂, ..., xₙ) = U₀.

The Hicksian demand reflects pure substitution effects, separate from income effects, providing insights into the true response of demand to price changes.

Impact of External Factors on Demand

Demand curves can shift due to changes in consumer preferences, expectations about future prices, income levels, or market conditions affecting preferences and purchasing power. For example, technological improvements or cultural shifts can cause demand to increase independently of price or income changes, shifting the entire demand curve outward.

Conclusion

The theoretical framework of consumer choice, grounded in the principles of utility maximization, provides a comprehensive understanding of demand behavior. Deriving demand curves via the Marshallian and Hicksian approaches offers valuable insights into how prices and income influence consumer behavior. Recognizing the factors that shift demand curves is crucial for policymakers and businesses aiming to anticipate market responses and make informed decisions.

References

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• Mas-Colell, A., Whinston, M. D., & Green, J. R. (1995). Microeconomic Theory. Oxford University Press.
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• Debreu, G. (1959). Theory of Value: An Axiomatic Analysis of Economic Equilibrium. Yale University Press.
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• Hicks, J. R. (1939). Value and Capital: An Inquiry into Some Fundamental Principles of Economic Theory. Oxford University Press.
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• Thaler, R. (1980). Toward a Positive Theory of Consumer Choice. Journal of Economic Behavior & Organization, 1(1), 39-60.
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