Consumer Choice Flashcards
3 axioms of choice
Comparison
Transitivity
Monotonicity
Transitivity
Ability to be consistent when making preferences
E.g if A>B and B>C, it would also mean A>C
Monotonicity
More is better than less.
Indifference Curve
A curve that passes through all combinations of goods that a consumer enjoys equally (everywhere on the point yields and equal utility)
What is the assumption for anywhere left and under the indifference curve, and right and above?
Left and under-less utility
Right and above-better
Marginal rate of substitution
Slope that tells us how much of good X we would be willing to give up in exchange for one more unit of good Y
How does diminishing marginal utility link to rate of substitution
Starts steeper at a smaller quantity, as we value the first units more so less willing to give them up
Marginal rate of substitution formula
MU of X/MU of Y or MUx/Px=MUy/Py
BuDGET CONSTRAINT
The set of possibles bundles that can be afforded with a fixed amount, no money saved.
Why do we always operate along the budget constraint, not inside or outside
Not inside due to monotonicity, we assume we save none
Not outside as we can’t afford it
The effect following a change in income and how is it shown on a graph and evaluate…
Max quantity of each good that can be consumed falls/increases
Shown by a parallel inward/outward shift as price ratio (slope) hasn’t changed
However… this assumes goods are normal not inferior as if one were inferior, we would consume less of one which is against monotonicity
The effect of a change in price of one good
Max consumption for the one good increases/decreases, while other remains the same
Shown by an extension/shortening in the slope quantity of the one good
What is the rule for inferior goods
There can only be one inferior good, as for monotonicity we want to spend all our money, and if both were inferior, following a change in income will mean less money is spent overall
The effect following a change in income on an inferior good and how is it shown on a graph
Budget constraint shifts out parallel as more can be consumed overall
Consumption for the normal good will increase following the rise in income, however for the inferior good consumption would fall
What do we draw for 2 normal goods following a rise in income
An income expansion path to show the change in consumption as income increases
What happens to good Y when price of good X falls? (both normal) and what does this all depend on
Max consumption for good X increases.
For good Y, consumption may fall, or as they feel richer they may consume more of both goods
This is all determined by the income and substitution effect
If income effect is greater than substitution effect, more of both goods are consumed overall
If substitution effect is greater than income effect, more of one good increases, however consumption of one good falls.
Substitution effect
Substitution effect-change in consumption following change in relative prices of goods
Income effect
Income effect-change in consumption following a change in a consumers purchasing power
Why do we draw a dotted budget constraint
TO SEE NEW PRICES ON THE ORIGINAL INDIFFERENCE CURVE AND SEE THE SUBSTITUTION EFFECT MOST IMPORTANTLY
Price consumption curve
At each price, we find the
consumer’s optimal consumption
point
Joining these gives the price-
consumption curve/demand curve
What does the indifference curve meeting the budget constraint at a point of tangency mean?
MRS=Price ratio.
What is the price ratio
The slope of the budget constraint.
How much of one good we need to give up for an additional unit of the other good
