Consumer Theory Flashcards
What assumptions are made to give rationality to define a utility function?
Non-satiation Transivity Completeness Continuity Convexity
What does non-satiation mean?
More is preferred to less
What does transivity mean?
if X>Y and Y>Z then X>Z
What does completeness mean?
Consumers will always be able to rank goods -> they will always know what good they prefer
What does continuity mean?
Small changes to a consumer’s bundle will not change their preferences relating to it
What does convexity mean?
An bundle where an average of 2 goods is included is preferred to an extreme bundle (having a lot more of one good than the other)
What shape is the IC for a perfect substitute good and why?
The IC will have a constant gradient -> the IC will be linear. This is because the MRS is constant at all points on the IC
What does this mean about the utility attributed with consuming perfect substitute goods?
Utility comes from the sum of both goods in the bundle in whatever ratio that may be
What is the shape of the IC for a perfect complement good and why?
The IC is L-shaped because utility is conditioned by the quantity of the lowest consumed good in the bundle
What does the Cobb Douglas function show?
It shows the preferences between 2 goods that lie in between the 2 extremes mentioned above
What is the formula for the Cobb Douglas function?
U(x1,x2) = x1^a.x2^(1-a)
What does the Cobb Douglas formula show?
That the substitutability of the 2 goods adds up to 1
How will the size of (a) in the Cobb Douglas determine the shape of the IC?
The higher is a the quicker the IC converges to the x-axis, the lower is a the quicker the IC converges to the y-axis
What is a monotonic transformation and why is it different?
It means that a transformation can be made to a utility function that may create an entirely new utility function, but the preferences of the consumer will remain constant after the transformation
Lagrange method
Check notes -> can’t be put on flash cards
How do revealed preferences help economists?
They reveal the preferences of the consumer, meaning that no assumptions about those preferences have to be made
Diagram of these preferences
Check notes
What is the difference between WARP and SARP?
WARP allows you to make direct comparisons between bundles, stating which one you prefer
SARP allows you to make indirect comparisons between bundles -> leads to transivity (assumptions)
What are homothetic tastes?
This is where consumer preferences depend on the ratio of one good in the bundle to another
What do homothetic tastes mean the IC looks like at all levels of consumption?
It will have the same MRS -> when M increases, the proportional increase in X and Y will be the same
What are quasilinear tastes?
Means that at all levels of consumption and income, the quantity consumed of a good will be constant
What does that mean that IC shifts will look like for Quasilinear tastes?
The IC will only shift vertically -> it can shift out and right but the consumer has no increase in utility by consuming more units of that good than the desired constant amount
What does the Engel curve show?
It shows the relationship between income and the quantity of a good that is consumed. For a normal good it will have a positive gradient, for an inferior good it will be negatively sloped and for a quasilinear good it will be vertical
What is expenditure minimisation?
It is finding the cheapest expenditure, given a new price ratio, where utility will be the same as for the original bundle
What 2 effects come from a price change?
Substitution and income effect
What does the Hicksian Substitution effect attempt to work out?
It tries to find the change in income required to keep utility constant after a price change
What happens to real income in this effect?
It is kept constant
Lagrange working
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What does the Marshallian Demand curve show?
It shows that as the price of x decreases, the consumer will reach a higher IC -> accounts for both the sub and income effect
What is the Marshallian Demand Curve also known as?
The uncompensated demand curve
What does the Slutsky Substitution effect attempt to work out?
What change in income is required to make the original bundle affordable given the new prices
What is the relation of the Slutsky effect and Hicksian effect after a price increase?
The Slutsky effect will be larger
How does the proportion of the Hicksian Effect to the Slutsky effect differ when price decreases?
The Hicksian effect will be larger
What is the respective ratio of the Hicksian and Slutsky Substitution effects?
The difference in the effects will be the same in each case, the roles have just reversed
What does the Compensating Variation work out?
How much money the government (or firm) would have to give consumers after the price change to ensure they remain just as well off
Diagrammatically what is the Compensating Variation showing?
How much money is needed to shift the new budget line out so that it touches the original IC again
What does the Equivalent Variation work out?
How much money needs to be taken away from consumers before the price change
In other words, what is the Equivalent Variation working out?
What are you willing to pay to avoid the price change?
Diagrammatically what is the Equivalent Variation showing?
How much money needs to be taken away to shift the new budget line in to touch the original IC again
What is the key difference between these 2 variations?
The compensating variation happens after the price change, whereas the equivalent variation happens before the price change
Diagrams
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