Stigler spends a long time developing utility theory. He claims that abstract utility with its questionable foundation is a useful tool, because of its predictive power. Though the foundations are not great, the results justify it. Stigler spends the rest of chapter four showing off the power of utility theory.
In order to test the predictive power, we obviously need to make some predictions from our model of utility maximization. Stigler sticks to mostly graphical predictions that involve reaching the highest indifference curve that is still within the consumer's budget. The graphs allow economists to do comparative statics. If one aspect changes, how does that affect the consumer's bundle?
One type of change is variations of income. On a graph, this corresponds to a shift of the budget, illustrated below. Normally, when people are richer they consumer more of a good, hence normal goods. Other times, when a consumer is richer, he consumes less of this good. The classic examples are ramen and potatoes. As college graduates start making money, ramen consumption declines. These are inferior goods.
While not a formal prediction, the outline of utility theory's predictive power is starting to form. This model of normal and inferior goods suggests which types of goods will increase with wealth. Inferior goods convey the idea of "buying because it is cheap." This is simply a definition, but it clarifies the thinking. Continue reading
After developing classical demand theory for individuals, it is natural to try to extend this to many consumers. MWG address three possible questions and solutions, which he calls the econometrician, the positive theorist, and the welfare theorist.
"The econometrician is interested in the degree to which he can impose a simple structure on aggregate demand functions." (pg 105)
The econometrician has some aggregate data on different variables. He is looking for a simple way to analyze it and knows his classical demand theory. Is there a simple way for him to combine these two ideas?
The first and obvious way to look at aggregate demand requires a simple summation of individual demand. Each consumer has a (Walrasian) demand function, which depends on prices and his wealth. Adding them together results will result in an aggregate demand function for each good in the economy-
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Prices provide information and incentives. But how do consumers respond to these price signals? Chapter 3 begins to answer this.
It might seem daunting to understand consumer responses. We are unique and respond differently. However, Stigler claims
"In the response to price and income changes, consumers behave in a tolerably reliable and predictable way. The invariably obey one law as universal as any in social life; they buy less of a thing when its price rises. Their buying propensities are a stable function of prices and income..." (pg 20)
This stable relationship forms price theory.
The Price of the Goods
Prices, usually talked about as dollars or euros, are simply the exchange ratios between two goods or what consumers have to give up for the good. If a hamburger is a dollar and a drink is 50 cents, two drinks exchange for one hamburger. The money facilitates this exchange. When Stigler talks about price, he means exchange ratio between goods.
From this, we know people demand more of a good when the price falls. Fewer other goods are required to obtain it.
However, the demand depends on other factors. It is important to explicitly hold these constant throughout the analysis. The other factors are Continue reading