Consumer theory Flashcards
What are the assumptions of a budget set?
Has an endowment to spend
Chooses a bundle made up of multiple goods
Each good has a constant price
What is the budget set?
I>XPx + YPy
What is the slope of the budget line?
-Px/Py
What is a utility function?
Assigns a number to every choice in a budget set
What is the formula for a utility function?
U(X,Y)=X^a Y^b
What is marginal utility?
It is the additional utility the consumer gets from consuming one more unit
How do you derive the marginal utility on a graph?
We take the partial derivative of X and it is equal to the slope of the tangent of the point
What do the points on the same indifference curve represent?
The consumer gets the same utility from the different points on the same utility curve
Points on a higher indifference curve gives more utility than any other point
Why do indifference curves slope downwards?
Because the consumer likes both goods
What does the slope of the IC show?
It shows the marginal rate of substitution - describes how a consumer is willing to substitute one good for another
What does MRS measure?
The value that the individual places on 1 extra unit of a good in terms of another
What is non-satiation?
When we assume that more is better than less
Why are the indifference curves convex?
We can expect that a consumer will prefer to give up fewer and fewer units of a second good to get additional units of the first one
What are perfect substitutes?
When the MRS of one for the other is a constant
The graph consists of straight lines
What are perfect complements?
When the indifference curves for both goods are shaped as right angles
What are ‘bad’ goods?
Less of the goods is preferred to more - ie. air pollution
How does the utility change when we vary X and Y a little?
We use total derivative
The change in utility is MUx dX+MUy dY=0
Just multiply X and Y by the marginal utility of each one and add them
What happens to the budget line when the income changes?
If the budget doubles, the curve shifts outwards, and if it halves, the curve shifts inwards
Which 2 conditions should the maximizing market basket satisfy?
- It must be located on the budget line
- It must give the consumer the most preferred combination of goods/services
What is the corner solution?
When one of the goods is not consumed, the consumption bundle appears at the corner of the graph
What is revealed preference?
If a consumer chooses one market basket over another, and if the chosen market basket is more expensive than the other, then the consumer must prefer the chosen market basket
What is marginal utility?
Measures the additional satisfaction obtained from consuming one additional unit of good
What does the following equation tell us?
MUf/Pf = MUc/Pc
Tells us that utility maximization is achieved when the budget is allocated so the marginal utility per dollar of expenditure is the same for each good
When does utility maximization occur on a graph with the budget line and the IC?
It is at the point at which an indifference curve is tangent to the budget line
What is the slope of the optimal bundle?
Slope of BL = Slope of IC
Px/Py = MUx/MUy
What does Px/Py show us?
The tradeoff between goods the market is accepting: in exchange for 1 unit of X, the price ratio is the number of units of Y she can get
What does MUx/MUy show us?
The tradeoff between goods that makes the consumers indifferent: in exchange for 1 unit of X, the MRS is the amount of Y she needs to get to be indifferent
What does Px/Py>MUx/MUy show us?
If the consumer gives up a unit of X, the market is willing to give her more Y than she requires to be indifferent - trading away X for Y will increase utility so her current bundle is not optimal
What does Px/Py<MUx/MUy show us?
If the consumer takes an additional unit of X, the market will accept less Y than she would be willing to give up and remain indifferent - trading away Y for X will increase utility so her current bundle is not optimal
What is the optimal bundle’s equation?
Px/Py=MUx/MUy
What does MUy/Py>MUx/Px show us?
A dollar spent on Y gives more utility than a dollar spent on X - improve utility by shifting spending away from X towards Y
What does MUy/Py<MUx/Px show us?
A dollar spent on X gives more utility than a dollar spent on Y - improve utility by shifting spending away from Y towards X
What is the IC graph for when a consumer likes X but dislikes Y?
It is upwards facing - either linear or concave
What is the utility function for goods which have a constant marginal utility?
U(X,Y)= X+Y
Both goods have an MU = 1 so the MRS is constant
What is the IC graph for perfect substitutes?
It is downwards sloping
What is the solution with perfect substitutes?
It is the corner solution - where the consumer chooses X = 0
What is the IC graph for perfect complements?
It looks like right angles and can be represented by the utility function U(X,Y)=min{X,Y}
What is one solution with perfect complements?
When the vertex lies on the budget line
What is another solution with perfect complements?
The price equal to Px+Py so the solution is to buy a quantity of 1/Px+Py
What happens to the budget set when the interest rate falls?
It becomes flatter
What are the effects of the interest rate falling for a borrower?
They become better off since they can borrow for a cheaper amount
What are the effects of the interest rates falling for a saver?
They are worse off since they used to get more money from saving but now they receive less for the same amount
If a person has MRS < 1+r at E, should they borrow or save?
They should save since they value future consumption relatively highly
What is a kinked budget set?
If the interest rate is higher for borrowing than saving, the budget line has a concave kink
What is the substitution effect?
Consumers tend to buy more of the good that has become cheaper and less of the goods which are relatively expensive
What is the income effect?
Because one of the goods is now cheaper, consumers enjoy an increase in the real purchasing power
What is the backward-bending labour supply?
At low wages, we expect people to work more as their wage increases:
- substitution effect dominates
-upward-sloping labour supply
At higher wages, people work less as their wage increases:
- they have enough money
- income effect dominates
- backward-bending labour supply
What is welfare economics?
Allows us to think about distribution/equity
What is the Edgeworth Box?
If trade is beneficial, which trade occurs and which trades will allocate the goods efficiently is shown on the diagram
What is the contract curve?
It’s a swigly line through the Edgeworth box, which shows all allocations from which no mutually beneficial trade can be made
What is the first fundamental theorem of Welfare Economics?
If consumers are price takers and there are no externalities, the market outcome is efficient
What is the second fundamental theorem of Welfare Economics?
If consumers are price takers and there are no externalities, then any efficient outcome can be generated by markets, as long as we make the right pre-market tax/transfers
