Chapter 21 - Theory of Consumer Choice

Question 1

Theory of Consumer Choice

Answer 1

• economists assume consumers choose the best bundle of goods they value and can afford

Question 2

Budget Constraint

Answer 2

• the limit on the consumption bundles that a consumer can afford
• links income, prices, and spending
• shows the tradeoff between two goods

Income = (P1 Q1) + (P2 Q2)

Question 3

Slope of the Budget Constraint

Answer 3

• equals the relative price of the two goods
• Slope of Budget constraint = -P1/P2
• the rate as which the consumer can trade one good for the other

Question 4

Budget Constraint Graph

Answer 4

• Budget Constraint is a line that shows the tradeoff between one good and another good
• On the line: Just Affordable
• Above the line: Not affordable
• Below the line: Affordable

Question 5

Movements along the Budget Constraint

Answer 5

• Trading one good for another

- calculate via slope p1/p2

Question 6

Shift of Budget Constraint

Answer 6

• Increase in income - shift out

Decrease in income - shift in

Question 7

Rotation of Budget Constraint

Answer 7

• will rotate depending when the price of a good changes without income changing
• when price drops you can buy more and have greater quantity

Question 8

Preferences: Consumer’s Choices

Answer 8

• depend not only on the budget constraint, but also on her preferences regarding the two goods

Question 9

Indifference Curve

Answer 9

• shows the consumption bundles that give the consumer the same level of satisfaction
• all points on the curve are equally preferred
  points on higher curves are more preferred
• are downward sloping, because people preferring having both goods

Question 10

Marginal Rate of Substitution (MRS)

Answer 10

• the rate at which a consumer is willing to trade one good for another
• measured as the slope of the difference curve

Question 11

4 Properties of Indifference Curves

Answer 11

• Higher indifference curves are preferred
• are downward sloping
• indifference curves do not cross
• Curves bow inward; because MRS varies depending on quantity of each good

Question 12

Extreme Indifference Curve: Perfect Substitutes

Answer 12

• two goods with straight-line indifferent goods

- e.g. nickels and dimes; a consumer is always willing to trade two nickels for one dime

Question 13

Extreme Indifference Curve: Perfect Complements

Answer 13

• two goods with right-angle indifference curves

- e.g. right shoes and left shoes (you will always have an equal quantity of both)

Question 14

Less Extreme Curves: Close Substitutes

Answer 14

• curve is not very bowed, consumer will take either good

Question 15

Less Extreme Curves: Close Complements

Answer 15

• Indifference curves for close complements are not very bowed, goods that ‘require’ the other (e.g. hot dogs & buns)

Question 16

Optimization

Answer 16

• consumer would like to end up with the best possible combination of goods (highest indifference curve)
• must also be on their budget constraint

Question 17

The Optimum

Answer 17

• the point on the budget constraint, just touching the highest possible indifference curve
• a shift in income will result in a new optimum
• demand for goods at new optimum; depends on whether normal or inferior

Question 18

Income Effect

Answer 18

• the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve

Question 19

Substitution Effect

Answer 19

• the change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new MRS

Question 20

The Demand Curve and Consumer Consumption

Answer 20

• the demand curve is a summary of the optimal decision arising from her budget constraint and indifference curves