Consumer Choice

Question 1

Consumer theory underlies

Answer 1

the demand curve

Question 2

Producer theory underlies

Answer 2

the supply curve

Question 3

Two key components of utility maximization

Answer 3

Consumer preferences when faced with a choice

Consumer budget constraint – given their resources, what can they afford?

Question 4

What are the three preference assumptions to underlie our model of indifference curves?

Answer 4

Completeness, transitivity, non-satiation

Question 5

Completeness

Answer 5

if you’re comparing two bundles of goods, you prefer one, the other or you’re indifferent (I don’t know isn’t an option)

Question 6

Transitivity

Answer 6

If a is preferred to b, b is preferred to c, then a is preferred to c

Question 7

Non-satiation

Answer 7

“More is better” assumption, you always want more of something ; you might barely prefer a little bit more, but you’ll always want more no matter what

Question 8

Indifference curves

Answer 8

Indifference curves map preferences, allowing us to model how we think a consumer will behave

Specifically, this is the curve that shows all the consumption bundles among which the consumer is indifferent.

Question 9

Properties of indifference curves

Answer 9

Higher is better (further you are from the origin)

Downward sloping

Indifference curves never cross

There is only one indifference curve for any given bundle

Question 10

Utility function

Answer 10

The underlying measure of wellbeing; mathematically represents preferences

Question 11

How can we interpret the number of utils?

Answer 11

This is an ordinal concept (not cardinal); the “number” of utils are meaningless; they just let us rank what makes me happier

Any normal transformation of a utility function will always give us the same answer – the ranks won’t change

Question 12

Marginal utility

Answer 12

The derivative of the utility function with respect to the quantity of goods

Question 13

Diminishing marginal utility

Answer 13

Negative correlation between quantity and incremental happiness; The more of something you get, the less incrementally happy it makes you.

Question 14

What determines the slope of the indifference curve?

Answer 14

The slope measures the rate at which you’re willing to give up one good to get another

Question 15

Marginal rate of substitution

Answer 15

MRS = -ΔY/ΔX = -MUx / MUy

The rate at which you’re willing to trade the y-axis for the x-axis; This is telling you how the marginal utility evolves as you move down the indifference curve.

Question 16

Two fundamental components of consumer theory

Answer 16

The two fundamental components of consumer theory are (1) what the consumer wants, i.e. their preferences, and (2) what the consumer can afford, i.e. their budget constraint.

Question 17

The property “only one indifference curve passes through each bundle” is associated with what assumption about preferences?

Answer 17

Completeness

Question 18

The property “indifference curves farther from the origin are better” is associated with what assumption about preferences?

Answer 18

Non-satiation

Question 19

The property “indifference curves never cross” is associated with what assumption about preferences?

Answer 19

Transitivity

Question 20

The property “indifference curves are downward sloping” is associated with what assumption about preferences?

Answer 20

Non-satiation

Question 21

Are marginal utilities positive, negative, or could they be both?

Answer 21

Marginal utilities are always positive because we always derive additional utility from more of every good.

Question 22

What did we learn from the UK child tax credit reform natural experiment?

Answer 22

When women controlled the money, they spent more money on children’s clothes, and less on alcohol and cigarettes. The fact that women and men spent the money differently either means that one or both were not maximizing family welfare, or that they had different ideas about how to maximize family welfare. The results suggest that money intended for children may not be being spent in their best interest, which suggests a role for the government to intervene on the children’s behalf.

Question 23

Another name for the slope of the indifference curve?

Answer 23

Marginal rate of substitution; MRS is the ration of marginal utilities

MRS = - MUx/MUy = -dU/dx / dU/dy

diminishing as you move along the indifference curve

Question 24

Budget constraint over two goods X and Y is defined as:

Answer 24

I = px * X + py Y

Question 25

Marginal rate of transformation

Represents the slope of…?

Answer 25

slope of the budget constraint
the rate at which you can transform one good into the other in the marketplace

MRT = -px/py

Question 26

What changes the slope of the budget constraint?

Answer 26

shifts in price and income alter the position and slope of the budget constraint

Question 27

How does a consumer choose an optimal bundle?

Answer 27

Defined by the point of tangency between the indifference curve and budget line

MRS = -MUx/MUy = - dU/dx / dU/dy = -px/py = MRT

Question 28

MRS = MRT is equivalent to

Answer 28

equating the marginal cost and benefit of consuming each good

Question 29

What happens if there is a flat indifference curve?

Answer 29

There maybe corner solutions, in which the consumer only consumes one good. In most cases, there is only an interior solution - in which the consumer consumes some of each good

Question 30

How can we use constrained optimization to derive the demand curve?

Answer 30

We can use the constrained optimization problem to derive the demand curve. In other words, as we change prices of goods, we can observe how quantities demanded for those goods change, thereby tracing out the demand curve (the relationship between quantity and price demanded)

Question 31

Engel curve

Answer 31

As you change income, you can trace out the relationship between income and consumption - aka the Engel Curve

Question 32

Income elasticity of demand equation

Answer 32

= dQ/Q / dY/Y

Question 33

Normal goods definition & what is the income elasticity - positive or negative?

Answer 33

Income elasticity is positive, so as income rises, you consume the same or more of these goods

Question 34

Inferior goods

Answer 34

consumption declines when income increases

Question 35

Necessities are…

& what is their income elasticity?

Answer 35

goods with income elasticity < 1; goods where you spend a smaller share of your income on them as income goes up (like food); Not saying that you buy less food as income rises - only that you spend a smaller fraction of your income on food as income rises

Question 36

Luxuries & what is the income elasticity?

Answer 36

goods with income elasticity > 1, goods where you spend a larger share of your income on them as income rises (like cars, jewelry)

Question 37

What two effects does an increase in price have?

Answer 37

It makes the consumer relatively poorer (income effect) and it also make this specific good less attractive relative to alternatives (substitution effect)

Question 38

Substitution effect

Answer 38

The shift in goods consumed from the original point to the optimal point for a budget constraint that has a new slope but is tangent to the old indifference curve.

The substitution effect is always negative, but the income effect can be positive.

Question 39

When will the effect of a price increase be negative or positive?

Answer 39

Accordingly, the overall effect of a price increase on consumption of a good can be negative (for a normal good) or positive, if the good is inferior and the income effect is larger than the substitution effect.

Question 40

Giffen good

Answer 40

A good with a positive own-price elasticity

As the price rises, you’ll consume more of the good (even though it is inferior and you’d typically consume less of the good). I.e. as the price of rice declines, you’ll buy the same amount & use extra money to eat better food vs. the price falling & your demand going up for rice.

Question 41

Explain how labor supply relates to income and substitution effects

Answer 41

leisure (time not spent working) is a consumption good
– the price of that good is the wage since that is the opportunity cost of time not spent working.
– When the wage rate increases, this also has both an income effect and a substitution effect.
∗ Income effect: each worker is now richer, and may want to work less (consume more leisure).
∗ Substitution effect: returns to working are higher, each worker may want to work more.
∗ If the income effect more than offsets the substitution effect, labor supply may go down when income increases.

Question 42

opportunity cost

Answer 42

The value of the next best foregone alternative

Question 43

Opportunity set

Answer 43

the entire area under the curve; all opportunities available to you

Question 44

Normal good

Answer 44

An increase in income, increases demand.

A decrease in income, decreases demand.

Question 45

Inferior good

Answer 45

An increase in income, decreases demand.

A decrease in income, increases demand

Question 46

Income elasticity of demand

Answer 46

eY = % change in quantity demanded / % change in income

Shows the responsiveness of quantity demanded to c change in income, all other things unchanged (including price); reflects a shift in the demand curve at a given price.

Question 47

Price elasticity of demand

Answer 47

Reflects movements along a demand curve in response to a change in price.

eD = % change in quantity demanded / % change in price or [delta Q / Q] / [delta P/P]

Always negative! (Demand has a negative correlation to price)

Question 48

Positive income elasticity of demand means…

Answer 48

income and demand move in the same direction - an increase in income increases demand, and a reduction in income reduces demand (normal good)

Question 49

Negative income elasticity of demand means…

Answer 49

the good is inferior. An increase in income reduces demand for the good.

Question 50

Why are elasticity and slope different?

Answer 50

The slope of a line is the change in the value of the variable on the y-axis divided by the change in the value of the variable on the x-axis between two points.

Elasticity is the ratio of the percentage changes (vs. the values/levels).

Even with a linear demand curve, slope will be constant but the elasticity will change.

Question 51

Normal good, with income elasticity > 1

Answer 51

Luxuries

As your income goes up, you spend a larger share of your budget on these goods.

Question 52

Normal good with income elasticity < 1, > 0

Answer 52

Necessities

As your income goes up, you spend a smaller share of your budget on these goods.

Question 53

Good with income elasticity > 0

Answer 53

Normal

Question 54

Good with income elasticity < 0

Answer 54

Inferior

Question 55

Cross price elasticity equation

Answer 55

eA,B = % change in quantity demand of good A / % change in price of good B

Question 56

Cross price elasticity definition

Answer 56

Defines whether two goods are substitutes, complements, or unrelated. If substitutes - an increase in the price of one will lead to an increase in the demand for the other - the cross-price elasticity of demand is positive. If two goods are complements, an increase in the price of one will lead to a reduction in the demand for the other - the cross-price elasticity of demand is negative. If the two goods are unrelated, a change in the price of one will not affect the demand for the other - the cross-price elasticity of demand is zero