Consumer Choice and demand decisions Flashcards
What are the Four key elements in consumer choice?
. Consumer’s income (budget)
. Prices of goods
. Consumer preferences/tastes
. The assumption that consumers maximise utility-that they act rationally and try to get the best out of life
What is the budget constraint/line? and what defines it?
Describes the different bundles the consumer can afford when all income is spent.
Defined by consumers income and market price of goods
How is the gradient of the budget line calculated using price?
-Ph/Pv
What are the three assumptions when modelling consumer tastes of preferences?
. The consumer ranks alternative bundles of goods based on the satisfaction/utility they provide
. That consumer prefers more to less (nonsatiation)
. They have tastes satisfying a diminishing marginal rate of substitution
What is the marginal rate of substitution?
The quantity of one good the consumer must sacrifice to increase the quantity of another good by one unit
What is the diminishing marginal rate of substitution?
Holding utility constant, diminishing quantities of one good must be sacrificed to obtain successive equal increases in the quantity of another good.
What is an indifference curve (IC)?
An indifference curve (IC) shows all the consumption bundles that yield the same utility to the consumer
What are the characteristics of an indifference curve?
. ICs slope downwards (given our assumptions)
. their slope gets steadily flatter to the right showing the diminishing marginal rate of substitution
. ICs cannot intersect
. the higher the ic the better ass the consumer prefers more to less
. consumer is indifferent between all points on the curve.
Explain the diminishing marginal rate of substitution on an indifference curve
. Towards the left, the gradient is steep. You are watching a lot of films, and would happily watch one less in return for a good meal.
. Towards the right, the gradient is flatter. You are eating a lot of meals and watching fewer films so would be less happy to watch one less film for another meal and vice versa
Where is the point at which utility is maximised found?
The point at which utility is maximised is found by bringing together the indifference curves (U) and the budget line (BL).
. The choice point is where the budget line is at a tangent to an IC
. Other points on the budget line are affordable but give lower utility
What will a change in income do to the budget line?
A change in the consumer’s income shifts the budget line,
without changing the slope.
The change in the pattern of consumer choice depends on the nature of the two goods
What will a change in income do to the budget line for normal goods?
. line shifts to the right
.The quantity demanded of each good increases
What will a change in income do to the budget line for a normal good and inferior good? e.g meals and films
. budget line shifts to the right
. but choice point shifts to a new utility which gives higher consumption for the normal good but actually less for the inferior good as it is on a different indifference curve
How does the budget line adjust to price changes?
. An increase in the price of one good rotates the budget line about the pint of the other good which hasn’t changed price
. altering its slope.
. which reflects relative prices
The response of a budget line to a price change comprises two effects, what are they?
. The SUBSTITUTION EFFECT
is the adjustment of demand to the change in relative prices
. The INCOME EFFECT
is the adjustment of demand to the change in real income.
Explain the substitution effect?
. a hypothetical budget line HH exists which is parallel to the new budget line and is at a tangent to the old IC
. As it is parallel it reflects the new relative prices from one goods price increase with income adjusted
. As it is on the same IC it has the same utility as befoe the price change but has reduced the demand of the rise in price of ‘meals’
Explain the income effect when the good that has increased price is a normal good?
. A fall in real income will further reduce demand from the point on HH to the new budget line below the old one and will also lead to a fall in demand for the good that hasn’t changed price
Explain the income effect when the good that has increased price is an inferior good?
The income effect is positive.
when real income falls, the consumer demands more of the good than the point on HH but less than the point before the price change
This is because the good that didn’t change price is a normal good and so when income falls you will buy less os that good and more of the inferior good
Explain the income effect when the good that has increased price is an giffen good?
. Extreme inferior good means when there is a drop in real income the quantity demanded of that good is greater than the substitution effect and more than the point before the price change because a price rise further increases the demand of the inferior and less of the normal because it is so vital e.g basic diet of potatoes
What happens to budget lines with transfers in cash and in kind?
. Transfers in cash let the consumers spend the extra income anyway they want
. Tranfers in kind e.g. 4 meal token may limit consumers options
. transfers in cash allow a higher IC and therefore higher utility
What is the market demand curve?
The market demand curve is the horizontal sum of the individual demand curves of each consumer.
If, at a price of £5, consumer 1 demands 11 units, and consumer 2 demands 13 units, then market demand at a price of £5 is?
24 units
