CHAPTER 4 (test 1) Flashcards
What are the 4 assumptions about consumer preferences?
- Completeness and rankability > consumers can compare bundles of goods and rank them based on preference > we will always choose one thing over the other
- For most goods, more is better than less > non-satiation and “free disposal” (can set it aside or donate or trade it)
- Transivity > imposes logical consistency on preferences (ex. A>B, B>C, A must be > C)
- The more a consumer has of a particular good, the less she is willing to give up of something else to get even more of that good > consumers like variety
What is utility? What is a utility function?
utility = a measure of how “satisfied” consumers are > measures happiness or well-being *not a measure of income
utility function = mathematically describes the relationship between what consumers actually consume and their level of well-being > represent consumers preferences (conforms to the 4 preference assumptions)
ex. U = T^0.8 D^0.2
(T = theatre and D = DVD)
*theatres offer more utility than DVDS
What is marginal utility?
The additional utility a consumer receives from an additional unit of a good or service
What are ordinal and cardinal rankings? Which one does utility allow for the ranking of consumption bundles?
Ordinal > implies bundles can be ranked from best to worse
Cardinal > allows a person to determine how much better one bundle is compared to another
*Rules for utility allow for an ORDINAL ranking of consumption bundles
Why?
> we can answer a lot of questions with just an ordinal ranking
> we just care about relative outcomes
> there isn’t any real-world measure of how much more a consumer likes a bundle of goods A to bundle of goods B
ex. U = pizza^10 salad^5
can only say pizza is preferred over salad, we can’t see pizza is doubled over salad
What is an indifference curve?
An indifference curve plots out all of the consumption bundles that provide a consumer with the same level of utility of satisfaction
> a consumer is indifferent between bundles when they derive the same utility level from them
What are the four characteristics of indifference curves (and which consumer preference assumption they stem from)
- They can be drawn
(completeness and rankability) - Curves further from the origin represent higher utility
(more is better) - Curves never cross
(transitivity) - Convex to the origin
(consumers like variety / diminishing marginal utility)
What is the marginal rate of substitution?
Indifference curves describe tradeoffs between goods > the slop of the curve captures this tradeoff
*The slope is the Marginal Rate of Substitution
MRSxy = - (change in Y / change in X)
(although the slope is negative, we can talk about MRS as positive)
*describes the rate at which one is willing to trade off or substitute exactly 1 unit of good X for more of good Y, and be equally well off
What happens to the marginal rate of substitution as you move down a convex indifference curve
As you move down the convex indifference curve, you experience a diminishing marginal rate of substitution > you’re willing to give up less and less of Y good to get one more X good
What is the relationship between the Marginal Rate of Substitution and Marginal Utiltiy?
The MRS between two goods is equal to the inverse of the goods’ marginal utilities:
MRSxy = - (change in Qy/change in Qx) = (MUx/MUy)
What does the steepness of an indifference curve imply about consumer preferences?
Steeper curve simply the consumer is willing to give up a lot of Y to get one unit of X, or could trade 1 unit of X for a lot of good Y
Flatter curves imply the consumer is only willing to give up a little bit of good Y to get a lot of good X, or could trade a lot of good X for one unit of good Y (maybe they get more utility for good Y)
What does the curvature/shape of indifference curves mean?
The shape of indifference curves revels information about the relationship between products
Straight: Straight curves describe goods that are more easily SUBSTITUTABLE for one another
Curvier/more convex to the origin: Describe goods that are more COMPLEMENTARY to one another
What are perfect substitutes and perfect complements?
perfect substitutes: goods that the consumer will trade at a fixed rate and receive the same level of utility (MRS is constant) > indifference curve will be completely straight, and the utility maximizing points will be on either axis (bundles with either one good or the other)
perfect complements: goods that the consumer must consume in a fixed proportion
ex. right and left shoes > indifference curve will be L shaped
> more of both goods = more utility
What is the budget constraint? What is the slope equation?
A curve that describes the entire set of consumption bundles a consumer can purchase when spending all of their income - generally plotted alongside indifference curves
equation:
Income = PxQx + PyQy
To find the slop of the budget constraint, rearrange to solve for Qy
Qy = (income/Py) - (Px/Py)Qx
(Px/Py) = slope
Which two factors affect the slope and position of the budget constraint?
- Changes in income SHIFTS the budget constraint by changing the intercepts
- Change in the price of one good PIVOTS the budget constraint by changing the slope
How does a quantity discount impact the budget constraint?
Sometimes consumers can secure a discounted price if a minimum quantity of a good is purchased (ex. buy two, get the third half off)
* results in a kink in the budget constraint
where is the kink?
if you get a discount after buying 600mb of data, the kink would start where 600mb meets however many of the other good you can get with the leftover money
How does a quantity limit impact the budget constraint?
There may be limits on how much of a good can be purchased –> kink in the opposite direction as a quantity discount >at kink point it just goes straight to the axis/intercept (*the kink point is the axis-intercept)
The concepts of utility and indifference curves describe consumer _________ ; the budget constraint describes which bundles are ________
preferences
feasible
What is meant by consumers facing a constrained optimization problem
Consumers want to maximize utility but they are constrained by their income and market prices
Where can we find what the consumer’s optimal bundle is / where is it on the graph?
Tangency is the key > where the slope of the indifference curve is equal to the slope of the budget constraint
(when the marginal rate of substitution is equal to the price ratio)
mathematically:
MUx/MUy = Px/Py
If two consumers have different preferences for the same 2 goods, how will their MRS compare at their respective optimal bundles?
Their MRS will be the SAME at their optimal bundles because they will face the same ratio of prices!
What is an interior solution? What is a corner solution? what changes at a corner solution and what does this mean?
Interior solution: A utility-maximizing bundle that contains positive quantities of both goods
Corner solution: A utility-maximizing bundle located at the “corner” of the budget constraint where the consumer purchases only one of two goods
* at a corner solution, the MRS will not equal the price ratio (it will be less even though we are still at the utility-maximizing bundle) because the consumer’s marginal utility of one of the goods is so low compared to the good’s price that they are better off not consuming any of that good at all
When would an indifference curve slope upward?
if one of the goods is “bad”
> implies that one of the goods has negative utility, meaning they get less satisfaction from having more of that good > violates the “more is better” assumption
Why is the budget constraint a straight line?
Because we assume a fixed price > the good’s prices don’t change with the number of units purchased
What are the 3 things that impact what a consumer decides what to consume?
- their preferences
- their income
- the good’s prices
