1.3 Consumer Choice, Price/Income, Income/Substitution Flashcards
What are budget constraints?
The total amount of expenditure from consumers assuming they cant save/borrow, have a fixed amount of money and they are price takers
Usually function is:
p1q1+p2q2 = Y
Rearrange for q2 to calculate all values
What are the properties of a budget constraints slope?
The total amount of expenditure from consumers assuming they cant save/borrow, have a fixed amount of money and they are price takers
Usually function is:
p1q1+p2q2 = Y
Rearrange for q2 to calculate all values
What are the effects of a change in price/income on a budget constraint?
Quite simple, on page 5
What is constrained consumer choice and when is utility maximised?
What does this imply with the relationship between the two curves?
Utility is maximised where the budget constraint meets the indifference curve at the highest point
This is when MRS = MRT
As a result,
-U1/U2 = -P1/P2
So
U1/P1 = U2/P2
This means the amount of U from q1 spent on q1 is equal to extra utility from q2 spent on q2
If U1/P1 > U2/P2 utility can rise if they consume more q1 and less p2 - opposite is true
(example of calculus of this on page 6, not that hard ngl)
What are corner solutions?
If an IC hits the axes
This is possible for perfect substitutes and quasilinear functions
Example of perfect:
U(q1,q2) = q1 + q2, and p1 < p2
MRS = -U1/U2 = -1
However, MRT = -p1/p2 > -1
This is true even if only consumers q1, so the usual rule MRS = MRT is not possible
Consumer bundle moves to where q2 = 0 and q1 = Y/p1
What are composite commodities
In reality, we consume more than 2 types of good so usually compare a good against a composite of all other goods
This is measured in the amount all other goods can be bought in £
The preferences can be depicted as normal using a q1/q2 curve
What are cross price changes
When p1 changes q2 may or may not react
(graphs on page 7)
Substitutes - p1 falls, q1 increases, switch e to new BC2 right
Complements - p1 rises, q1 falls, switch e to new BC2 left
If the price of a complement rises, demand falls.
How does income affect optimal consumption choices
Income and consumption linked through the BCs and ICs
Engel curve is effectively the curve through the optimal consumption choice points at different budget constraints and indifference curves
What are normal and inferior goods
Normal: as incomes rise, consumption also rises (upward sloping)
Inferior goods: as incomes rise, consumption falls (downward sloping)
Goods sometimes may be normal and inferior over different income ranges e.g. fast food
(graphically depicted on page 8)
(also some tekky calculus on page 8 - probably should learn cos it works with all of these)
In general tho, q1* = 0.5 Y/p1 and q2* = 0.5 Y/p2
What is full market demand?
The total demand can be calculated by adding every consumers demand horizontally
Calculus:
Call consumer 1 A and consumer 2 B
q1A = 0.5 YA/p1
q1B = 0.5 YB/p1
Total demand is Q1 = q1a+q1b = (YA+YB)/Y1
Then calculate the inverse demand to get the curve
What are the income and substitution effects?
Substitution effect: substituting other goods for good 1 as the price of 1 rises
- Move up the budget constraint as consume less q1 and more q2
Income effect: as the price of good 1 rises, real incomes fall so spending on all goods change
- Budget constraint shifts in parallel to first one as real income falls
How do income and substitution effects change with the 2 types of good?
Graphed on page 9-10
For normal goods:
When their price increases the substitution and income effect are negative.
When their price decreases the substitution and income effect are positive
For inferior goods:
When prices increase, the income effect is positive (consume more because cheaper), the substitution effect is negative (would rather consume better stuff) - total effect is negative
When prices decrease, the income effect is negative, the substitution effect is positive - total effect positive
What are giffen goods
They are goods that start to slope upwards - original example was potatoes during the Irish famine
When there is a price increase: the income effect is positive, overcompensating the negative substitution effect so consumption rises
When there is a price decrease: income effect is negative, overcompensating the substitution effect so consumption falls
Research shown rice is a given good in China - falling price with subsidy caused a fall in demand for rice (calorie dense). The extremely poor are reliant on this single staple and this staple has very limited substitution options
What are compensated demand curves?
They hold utility constant as a goods price changes - eliminating the income effect so price increases always decrease demand
Constructed by shifting budget constraints to remain on the same indifference curves. This makes the compensated demand curve steeper for normal goods as the income effect is removed
(illustrated page 10)
How do compensated demand curves apply to CPI substitution bias?
CPI measures the changes in cost of living
- Takes average cost of bundle of goods and compares to same bundle in other years
- Weights of goods calculated by expenditure
(Tekky calculus on page 11 idk if its necessary)
