Consumer Theory Flashcards
Preferences
What you want to buy
Indifference Curves
A graphical representation of a consumer’s preferences of one good versus another. Each curve shows all the bundles of goods which keep utility constant.
Utility Function
A mathematical expression that translates bundles of goods into a single valuation of utility. For example U= sqrt(P*C)
Marginal Utility
The change in utility from consumption of an additional unit of a good
Diminishing Marginal Utility
A common assumption in consumer theory, which holds that each additional unit of a good increases utility by less than the previous unit of the good
As you consume more and more ice cream, which of the following is true about the marginal utility of the ice cream and the total utility you get from the ice cream?
Marginal utility drops; Total utility rises
In economics, it is often assumed that as a person consumes more and more of a good, he enjoys each unit less and less. This assumption is known as the principle of:
Diminishing marginal utility
Budget Constraint
A graph that displays all the goods a consumer can purchase given her total resources
Price
How much things cost.
Opportunity cost = Price (What is sacrificed) / Price (What is gained)
On the Budget Constraint graph a change of income is shown by shifting
outwards or inward Slopes are the same
If prices change on the Budget Constraint graph, but the income stays the same
the slope changes
If price increases on the Budget Constraint graph,
then the line rotates inward
If the price decreases on the Budget Constraint graph,
then the line rotates outward
William only buys coffee, which costs $2 per cup, and sweaters, which cost $20 each. What is the opportunity cost of one sweater?
10 cups of coffee
Jaime’s income is $24, and she spends the entire amount on pizza and cookies. The graph below shows her budget constraint, with pizza slices on the vertical axis and cookies on the horizontal axis.
Pizza slices are $3; Cookies are $2 correct
Constrained Optimization
Making the best with what you have, or choosing to maximize something (like utility, or profit) given some constraint (like a budget, or costs and prices)
Marginal Analysis
Whether pruchasing and consuming the next unit of the good makes you btter or worse off
Marginal Benefit
Increase in utility from one more unit ratio of utility
MU/MU
Marginal Cost
Opportunity cost of the next unit
(Also known as the opportunity cost)
Ratio of the prices (Price(Y) /Price (X))
Opportunity Cost
The cost of any action in terms of what you could have done instead
Basically what is lost out on
Can be expressed as the price ratio ex: (Price (Pizza) / Price (Cookies) = 2/1 = 2
Marginal Utility
The change in utility from consumption of an additional unit of a good
(how much benefit is gained/lost from each additional good)
Marginal Benefit
Increase in utility from one more unit of a good
The ratio of the marginal utilities
Marginal Utility (Y) / Marginal Utility (X)
Marginal Cost
The cost of producing an additional unit of a good
The ratio of the prices
Price (Y) / Price (X)
Change in total cost / Change in quantity
If Marginal Benefit is greater than Maginal Cost
Buy more
If Marginal Benefit is less than Marginal Cost
Buy less
If Marginal Benefit is equal to Marginal Cost
Keep the same
Utility is maximized when
Marginal benefit equals Marignal Cost
Andre is at a candy store that only sells Snickers bars at a price of $2 each. The table below shows the total benefit, in dollar value, that Andre gets from consuming different numbers of Snickers bars. How many Snickers bars should Andre buy?
3
Jen is at a restaurant, and the chef offers her a free dessert: peanut butter pie or a chocolate lava cake. She should choose the chocolate lava cake and not the peanut butter pie if…
The marginal utility of the chocolate lava cake is higher than the marginal utility of the peanut butter pie correct. Jen should choose whichever dessert will give her greater utility. If the marginal utility of the chocolate lava cake is higher, the utility she gets from the next unit of this cake is higher than that which she would get from a unit of peanut butter pie. Since the dessert is being offered free of charge, there is no need to consider prices (the marginal costs of these desserts).
Hayleigh is deciding how much to purchase of two goods: bottles or VitaminWater and bottles of Gatorade. The marginal utility of the bottle of VitaminWater is 10, and the marginal utility of the bottle of Gatorade is 20. Which of the following best describes what Hayleigh should buy?
Not enough information. This decision depends not only on the marginal utility of each good, but also on the marginal cost (the price) of each good. Even though VitaminWater has a lower marginal utility, if the price of VitaminWater is also much lower, it may be optimal for Hayleigh to purchase VitaminWater. If the price of VitaminWater is not lower than that of Gatorade, Hayleigh should purchase Gatorade.
Rachel spends her entire daily income on pizza, at $2 per slice, and cookies, at $1 per cookie. For the current mix of pizza and cookies in her bundle, Rachel’s marginal utility for pizza is 20 and her marginal utility for cookies is 15. What should Rachel do to maximize her utility?
Buy more cookies and less pizza, until the marginal utility per dollar is equal for both goods. With the current consumption mix, the marginal benefit of a slice of cookies, expressed as the ratio of the marginal utility of cookies to the marginal utility of pizza, is 15 / 20, or 0.75. The marginal cost of cookies, expressed as the price ratio of cookies to pizza, is 1 / 2, or 0.50. Since the marginal benefit of cookies, 0.75, is greater than the marginal cost, 0.50, Rachel should shift to more cookies and less pizza.
Demand Curve
Shows the relationship between the price of a good and the quantity demanded
Market Demand
The sum of individual demand curves to show the total demand of all the consumers in the market
Individual Demand
The demand that one individual has for a particular good at different prices
Elasticity
Measure of the responsiveness of one variable to changes in another. Mathematically, it’s (% change in one variable) / (% change in another).
Price Elasticity of Demand
Measure of how much quantity demanded changes when the price changes. Mathematically, (% change in Q) / (% change in P)
Cross-Price Elasticity
Measures the responsiveness of the quantity demanded for one good to the change in price of another good. Mathematically, it’s (% change in Q of good X) / (% change in P of good Y)
Mid Point Method
% Change in X = (Change in X) / (Average Value X) x 100
Average Value of X is (Final + Intitial Price / 2)
Suppose that when the price of cookies is $1 and the price of a slice of pizza is $1, market demand for cookies is 2,500 cookies.
When the price of cookies rises to $2, the quantity of cookies demanded in the market falls to 1,500. Using the midpoint method, what is the price elasticity of demand for cookies?
0.75. The price elasticity of demand can be computed by dividing the percent change in quantity demanded by the percent change in price. Percent change is typically computed by dividing the absolute change in the variable by the original value of the variable. The midpoint method computes percent change by dividing the absolute change by the average of the original and final values of the variable. A cookie price change from $1 to $2 is associated with a demand quantity change from 2,500 to 1,500. This corresponds to a price elasticity of demand of:
Again suppose that when the price of cookies is $1 and the price of a slice of pizza is $1, market demand for cookies is 2,500 cookies.
When the price of a slice of pizza rises to $3, the quantity of cookies demanded in the market increases to 7,500. Using the midpoint method, what is the cross-price elasticity of demand between cookies (demand) and pizza (price)?
Explanation
1.00. The cross-price elasticity of demand can be computed by dividing the percent change in quantity demanded of cookies by the percent change in price of pizza. Percent change is typically computed by dividing the absolute change in the variable by the original value of the variable. The midpoint method computes percent change by dividing the absolute change by the average of the original and final values of the variable. A pizza price change from $1 to $3 is associated with a cookie demand quantity change from 2,500 to 7,500. This corresponds to a cross-price elasticity of demand of:
Suppose that the market demand for bottles of Pepsi is as follows:
Point A: (Price of $1; 6,000 units)
Point B: (Price of $2; 4,000 units)
Point C: (Price of $3; 2,000 units)
The absolute value of the price elasticity of demand when moving from Point A to Point B is ____ when compared to the absolute value of price elasticity of demand when moving from Point B to Point C.
Lower. The absolute changes in price and quantity demanded are the same moving from A to B as they are moving from B to C. However, elasticity is not the ratio of the absolute change in quantity demanded to the absolute change in price. Rather, it is a ratio of the percent change in quantity demanded and the percent change in price. Compared to the move from B to C, the move from A to B has a smaller percent change in quantity demanded (same absolute change but larger quantities demanded) and a larger percent change in price (same absolute change but smaller prices), resulting in a lower price elasticity of demand.
Jake is currently maximizing utility by eating 3 cookies and 2 slices of pizza when the prices are $1 per cookie and $3 per slice of pizza. Suppose the price of pizza rises, and Jake is no longer at his optimal point. To get back to the optimum, Jake needs to ______ the marginal utility of pizza by eating ______ slices of pizza.
Increase; Fewer correct
Before the price change, the marginal benefit of pizza must have been equal to its marginal cost since Jake was maximizing his utility. When the price of pizza goes up, the marginal cost of pizza goes up. Now the marginal benefit of pizza is less than its marginal cost. Jake must increase the marginal utility of pizza to get the marginal benefit to equal the marginal cost. Since pizza follows the principle of diminishing marginal utility (consuming more pizza lowers the marginal utility of additional slices), Jake must eat fewer slices of pizza to increase its marginal utility.
Which of the lobster market demand graphs below is most consistent with basic economic principles?
Graph A is the only graph consistent with the law of demand. The law of demand states that as the price of a good increases, the quantity demanded of that good decreases, resulting in a downward-sloping demand curve. This is true for both normal and inferior goods.
Price Elasticity of Demand
Measure of how much quantity demanded changes when the price changes. Mathematically, (% change in Q) / (% change in P)
Substitution Effect
Change in quantity demanded when a good’s price changes, holding income constant
Income Elasticity of Demand
Measures how the quantity demanded responds to a change in income. Mathematically, (% change in Q demanded) / (% change in income)
Income Effect
Change in quantity demanded because of a change in income, holding prices constant
Inferior Goods
Goods you consume more of when your income goes down (or, goods you consume less of when your income goes up).
Normal Goods
Goods you consume less of when your income goes down (or, goods you consume more of when your income goes up).
Directions of Income and Subtition Effects for Price Changes
Subtitution Effect Example
The extent to which a rise in the rpice of a good will lead to a subtitute towards other goods.
Example:
Insulin has a small subtitution effect
Income Effect Example
The extent to which you consume less of a good when its price raises because it has made you effectively poorer
Luxuries have a large income effect
Necessities have a small income effect
Giffen Good
A good which experiences a rise in demand when its price increases
When the price of a good changes, which effect contributes to the change in the quantity demanded of that good?
Income and substitution effects. When the price of a good changes, the change in demand can be decomposed into two effects: the income effect, which captures the way in which the change in price makes a consumer effectively richer or poorer; and the substitution effect, which captures the way in which consumers will substitute away from goods that become more expensive and towards goods that become cheaper.
An increase in consumer income, holding all else constant, will increase demand for _______ but decrease demand for _________.
Normal goods; Inferior goods. Normal goods are those which consumers tend to demand more of as incomes rise. Examples of normal goods may include cars, or jewelry, or steak. Inferior goods are those which consumers tend to demand less of as incomes rise. Examples may include cheap sources of calories like rice or potatoes or ramen noodles. As a consumer gets richer, he might decide he can afford to cut back on his ramen noodle purchases and buy steak instead.
When the price of a good goes up, in what direction does the substitution effect on quantity demanded of that good go?
Down. The substitution effect always goes in the same direction. If the price of a good goes up and everything else is held constant, people substitute away from it. If the price of a good goes down, then the substitution effect causes people to substitute towards it.
Michelle spends all her income on McDonald’s value meals and TV dinners. One day she receives a one-time bonus to her income. Now she buys fewer McDonald’s value meals, but more TV dinners, than before. We can conclude that, for Michelle, McDonald’s value meals are ___________.
An inferior good. Inferior goods are goods for which the income effect causes them to demand less of a good when income rises and nothing else changes. Michelle’s income increased, and the amount of McDonald’s value meals she demanded went down. We can therefore conclude that these are inferior goods.
Suppose that the price of a good rises. When completed, the table below should show the direction of each effect (income and substitution) on the quantity demanded of each type of good (normal and inferior). Choose the answer that correctly completes the table.
1. Down; 2. Up; 3. Down; 4. Down. An increase in the price of a good makes a consumer effectively poorer, since the consumer can no longer afford the same bundle of goods after the price increases. For a normal good, the effectively poorer consumer will demand less of the good. In this case, the income effect causes the quantity demanded of the normal good to go down. For an inferior good, the effectively poorer consumer will demand more of the good. In this case, the income effect causes the quantity demanded of the inferior good to go up.
The substitution effect always pushes in the same direction, regardless of whether the good is normal or inferior. All else equal, increasing the price of a good will cause the consumer to substitute away from that good. In this case, the substitution effect causes the quantity demanded of both normal and inferior goods to go down.
