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VWalsh: "Introduction Into Contemporary Microeconomics", Layard&Walters "Micro Theory", Smith"Elementary Intro. to Math Economics, Stigler "The Development Of Utility"
The main behavioural assumption made by economists about individuals is that they always do what is best for themselves, they are thus always egoistic and rational. Even when they donate to charity they think that this can give them that amount worth of moral satisfaction. They also hate work and like leisure.
The available purchasing options for a consumer with given income are shown by a budget line.
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It is assumed that the consumer is always buying the combination of goods that lies on that line - he can't afford to be above and being below means he is not using all available resources, thus being irrational.
Assumptions are also made about the tastes of consumers. It is assumed that a consumer can always determine the utility that a good gives to him and compare that to a utility of a different good. Consumer also prefers more to less, thus we can draw indifference curves that represent the combination of goods that yield the same utility.
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Indifference curves are always downward-sloping (more is preferred to less), convex (increasingly more of another good must be supplied to a consumer to make him sacrifice his last units of the first good).
There are infinite numbers of indifference curves and consumers will systematically try to reach the highest possible indifference curve available with current budget.
Transitivity is also assumed. That means if consumer prefers x1 to x2 and x2 to x3 he will prefer x1 to x3. This comes straight from the assumption that indifference curves cannot intersect.
Non-satiation is the assumption that if a bundle of good contains at least as many of different goods than another bundle plus at least one extra, then it is preferred to the second bundle. This means that a consumer will never become satiated with goods.
Diagrammatically :
Consumer being at x will always prefer region B and does not prefer region C, whereas the points in regions A and C may or may not be preferred
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It is assumed that however the small the reduction of the amount of first good obtained, there will always be a possible increase in the other good that can compensate the utility lost. This also means that goods don't come in discreet lumps.
It is also assumed that consumers marginal utility of extra goods purchased falls, this makes indifference curve convex.
The marginal utility must always be positive and the indifference curve must be differentiable i.e. must contain no sudden jumps.
Demand is the amount consumers are willing and able to purchase over a given period of time at different prices. Rational consumers always consume the relative amount of goods at the point where their budget line is just tangential to their indifference curve, i.e. they obtain the maximum possible utility.
Consumer buys a of A and b of B.
Now if we take the other good as being all the rest of the goods, then we can derive the demand curve for a given good, because when the price of this good changes the budget line must pivot. I.e. when the good becomes more expensive, then people cannot buy that much with given income, when this particular good is on the X axis the budget line pivots clockwise. Opposite applies to a good getting more expensive. Below is shown what happens to a good getting more expensive:
Consumer was buying x0 of X and now only x1.
As seen consumer is now on a different utility curve and the amount of the good purchased is less. This will happen to all normal goods - when price raises demand falls. Thus demand can be shown as schedule:
Now if we return to the indifference curve, the move to a new indifference curve can be broken down to 2 steps: income and substitution effect. First is positive for normal goods, i.e. when income rises more goods are demanded and negative for inferior goods (such as bad quality clothes etc.). Income effect arises from the fact that when a good gets more expensive, the purchasing power of a consumer falls, so he has less real income and vice versa. Income effect is usually negligible as most of the goods form a small amount of consumer's income. It can however be large when for example mortgage payments are considered or when a consumer has given budget for something (i.e.. if I can spend £1 on chocolate and I buy Mars and Snickers and the price of Snickers doubles, I will buy less Snickers and more Mars, but I can also afford to buy less chocolate).
Substitution effect is always positive. It determines how sharp is the turn in the curve
Close substitutes Not close substitutes
Below is shown how a fall in price will extend price for normal goods.
Substitution effect pivots budget line, it amounts to x2x0 fall in consumption of good X, whereas income effect causes budget line to decrease, causing further reduction of x1x2.
However there is also a peculiar type of good having negative income effect outweighing substitution effect called Giffen good. They only exist in theory and have upward sloping demand curves.
Demand curves are also upward sloping for many irrational customers that make their decisions according to others (i.e. price of good falls, I will not buy and wait it to fall even further) or who judge the quality of good by its price.
