3 - Theory Of Consumer Choice Flashcards
What is a budget constraint and what does it represent?
Answer: It represents the limit on consumption bundles a consumer can afford given their income and prices
What’s the difference between real and nominal income?
Answer: Real income is adjusted for cost of goods/inflation, while nominal income is not adjusted
What does the slope of a budget constraint represent? How do you calculate it?
Answer: The relative prices of goods and the rate at which consumers can trade one good for another
Slope = -P₁/P₂ where P₁ is price of good 1 and P₂ is price of good 2
What do indifference curves represent?
Answer: They show consumption bundles that give consumers the same level of satisfaction (utility)
Name the key properties of indifference curves.
- Higher curves preferred to lower ones → more utility, more goods consumed
- Curves slope downward → as it is a tradeoff
- Curves cannot intersect
- as consumer choices are assumed to be consistent → would not make sense to cross
- Curves are convex (bow inward)
- due to marginal decreasing utility → at extremes, people have less utility with having a lot of one good
Why are indifference curves convex?
Answer: Due to marginal decreasing utility - at extremes, people have less utility with having a lot of one good
What is the Marginal Rate of Substitution (MRS)?
Answer: The rate at which a consumer willingly trades one good for another
Represents slope of indifference curve at any point → slope is NOT linear because of diminishing marginal utility (decreases as you move along the curve)
What are perfect substitutes for indifference curves? Give an example of perfect substitutes.
They have a fixed marginal rate of substitution. straight downward sloping line
€1 and €2 coins
What does a complement indifferent curve look like? What’s an example of complementary goods?
L-shaped indifference curve
Answer: Right and left shoes
When does optimal choice occur in terms of budget constraints?
Answer: When budget constraint touches highest possible indifference curve and MRS equals relative price ratio
What happens to the budget constraint when there is an income effect?
- increase in income → shifts budget constraint outward → movement to different indifference curve (a higher one)
- however, depends on if good is a normal good or inferior good
What is the REMM hypothesis assumption about consumer behavior?
- Homo Oeconomicus [Resource Evaluating Maximizing Man]
- Assumes rational, self-interested behavior
- utility maximizer
- acts according to restrictions and incentives
- the ideal consumer in neo-classical economics
- Assumes fixed preferences and full information
- model explains human behavior → not a normative (realistic) way of how humans should act
Name three types of cognitive biases.
Answer: Framing effects, overconfidence, and hindsight bias
What is prospect theory?
Answer: People evaluate potential gains and losses differently, being more sensitive to losses than equivalent gains
What are the ways to promote sustainable consumer choices?
- Change relative prices
- Tax environmentally harmful goods: Creates substitution effect and negative income effect
- Subsidize green goods: Leads to substitution effect and positive income effects
- Ban harmful goods
- Results in substitution and income effects
- Leads to maximum consumption of remaining affordable alternatives
- Tax income
- Creates strong negative income effect
- No substitution effect
- Unclear impact on relative green vs. harmful consumption
- Change preferences
- Through marketing and campaigning
- Shifts indifference curves
- Can increase green consumption and reduce overall consumption
What is the Low-Cost Hypothesis?
Answer: Moral values predominate in low-cost situations
Name the limitations of the Household Model.
- Saturation effects: Additional consumption doesn’t always increase utility
- Basic needs: Some consumption cannot be substituted and affordability concerns
- Rationality limits: Due to information constraints and cognitive biases
- Transition costs: Non-monetary costs to consumers
- Environmental costs: Not reflected in prices of goods
- Utility measurement challenges
- Policy implementation: Requires understanding of diverse household preferences
What is the main insight of happiness economics?
Answer: Relative income is more important than absolute income in determining happiness
What is real income?
real income: adjusted for the cost of goods/ inflation
What is nominal income?
nominal income → NOT adjusted for the cost of goods/inflation
How do changes affect the budget constraint curve?
- Income changes: parallel shift of constraint line
- Price changes: rotation around axis intercepts
What is diminishing marginal utility?
as consumers get more of one good, they become increasingly willing to give up larger amounts of that good to get an additional unit of the other good
Explain the consumer utility graph
- shape depicts decreasing marginal utility
- the more of good 1 you have, the less utility you get per additional unit
What happens to the budget constraint when there is a price decrease?
a fall in price of any good rotates the budget constraint outward and changes the slope of the budget constraint
What happens to the indifference curve when there is a substitution effect?
- Substitution effects: Movement along same indifference curve
- can happen due to price change
- leads to a different MRS
Explain the New Theory of Consumer Choice
By Lancaster
- Unlike traditional theory where goods directly give satisfaction, Lancaster’s approach focuses on how the characteristics of goods and household uses create utility.
- Instead, they provide utility through their characteristics and household uses (e.g. water services example where people consider things like affordability, availability, quality of water) and also consider non-monetary costs (e.g. time, energy)
Criticisms of REMM
- Bounded Rationality
- people have limited information processing capacity
- often people use satisficing strategies
- Emotions influence people
- biases exist
- Moral Values
- people’s conceptions of good and bad, fair and unfair, etc. affect their decision-making
- people may have altruistic preferences
- people gain utility from behaving altruistically
- there are costs of moral behavior
- opportunity cost → behaving environmentally friendly is often more expensive, time consuming
- exploitation costs → people who behave morally may be exploited by those being selfish (prisoners’ dilemma)
- there are costs to unethical behavior
- legal or social sanctions
