C2: Consumption and Demand Flashcards
In our framework, what is the budget constraint?
budget y = p1q1 + p2q2
What is the indifference curve?
a curve of consumption bundles (q1, q2) which yield equal utility
What is the marginal rate of substitution?
The rate at which good 1 can be substituted for good 2 at constant utility:
MRS_1,2 = dU/dq1 / dU/dq2
also: the slope of indifference curves
What are the properties of preference relations covered in the lecture?
Completeness: all consumption bundles can be compared
Transitivity: bundle a > bundle b, bundle b > bundle c implies bundle a > bundle c (=> indifference curves do not cross!)
Monotonicity: a* > a, b* > b => (a,b) > (a,b) (=> indifference curve is negatively sloped)
Convexity: a, b indifferent => weighted averages of a, b indifferent (=> indifference curve is convex!)
What are perfect substitutes and perfect complements?
Perfect substitutes: individual is willing to substitute two goods at a constant rate (-> linear indifference curves)
Perfect complements: consumption at fixed rates -> orthogonal indifference curves
How can we formulate the optimization problem for optimal consumption?
max_q1,q2 U(q1,q2) s.t. budget constraint
What additional constraint holds for interior solutions of the optimization problem?
price rate = MRS
How can goods be categorized in regards to their consumption under change of income?
more income -> more consumed: normal good
more income -> less consumed: inferior good
What two effects does a price increase yield?
Substitution effect:
if good 1 becomes more expensive, more of good 2 will be consumed
Income effect:
increase in price -> decrease in purchasing power -> more of normal goods consumed, less of inferior goods consumed
How can goods be categorized in regards to their consumption under change of their price?
higher price -> less consumption: ordinary good
higer price -> more consumption: giffen good
What is the law of demand?
The observation that ceteris paribus the market deman for a good increases when its price decreases dQ/dp < 0