Chapter 21 Flashcards
The theory of consumer choice
Budget constraint
The limit on the consumption bundles that a consumer can afford, based on income and prices.
Indifference curve
A curve that shows consumption bundles that give the consumer the same level of satisfaction.
Marginal Rate of Substitution (MRS)
The rate at which a consumer is willing to trade one good for another while maintaining the same level of utility.
Diminishing Marginal utility
As a consumer consumes more of a good, the additional satisfaction from consuming an extra unit declines.
Perfect substitutes
Two goods with a constant marginal rate of substitution, meaning the consumer is always willing to trade one for the other at a constant rate.
Perfect complements
Two goods with right-angle indifference curves, meaning the consumer always consumes the goods in fixed proportions.
Optimal consumption bundle
The point where the budget constraint is tangent to the highest indifference curve, indicating the most preferred combination of goods a consumer can afford.
Income effect
The change in consumption that results from a change in a consumer’s real income or purchasing power.
Leads to increase in consumption of both goods
Substitution effect
The change in consumption that results from a change in relative prices, holding utility constant.
Only one of the good’s consumption increases while the other one’s decreases
Normal goods
Goods for which consumption increases as income increases.
Inferior goods
Goods for which consumption decreases as income increases
Giffen goods
A good for which an increase in price leads to an increase in quantity demanded, due to the strong income effect outweighing the substitution effect.
Utility
A measure of the satisfaction or happiness that a consumer derives from consuming goods and services.
Utility maximization
The process by which consumers choose a consumption bundle that maximizes their utility, subject to their budget constraint.
Properties of indifference curves
Indifference curves are downward sloping, higher curves are preferred to lower ones, they do not cross, and they are bowed inward due to diminishing marginal utility.
