Consumer Theory and Demand Flashcards
What is the key assumption of Consumer Theory?
consumers are rational economic agents who aim to maximise their own personal satisfaction (utility)
- self interested
- maximise own welfare
What is the fundamental issue of consumer theory?
Consumers have to choose from various goods and services to maximise utility subject to budget (scarce resources available)
What is demand a function of? (PITSC)
Price Income Tastes Substitutes Complements
What is the Budget Constraint?
The financial side of the decision, what we can afford
What do indifference curves show?
The psychology of the consumer’s purchase decision - what they purchase depending on the situation
How is Real Income measured?
Income (Y) / Price (P) - How much they can afford to buy with the prices available
What is Opportunity Cost?
Highest valued alternative that we give up to get something
- generally in terms of goods and services, not money
Why should consumers be indifferent to bundles on an indifference curve?
They are the plotted combinations that all lead to the same level of utility and therefore the same satisfaction
- follows the assumption that consumers are indifferent to each combination
What is the Marginal Rate of Substitution?
The rate at which a person will give up the good measured on the y-axis to get an additional unit of good x-axis and at the same time remain indifferent
How is Marginal Rate of Substitution calculated and what does the answer represent?
Change in y axis/ change in x-axis - e.g. 1.33
Give up 1.33 of y-axis good for one more of x-axis good whilst remaining indifferent
MRS= magnitude/gradient of the slope
What is the Law of Diminishing Marginal Utility?
Diminishing MRS - each additional until of good x-axis contributes less to total utility than the previous good
This gives rise to convex shaped indifference curves
Most benefit by mixing consumption
What is the most favourable indifference curve?
Highest possible that is tangential to the budget constraint - optimal combination that is affordable and maximising welfare in the given environment
What are the two effects of demand?
Substitution effect: as the price of a good falls, consumers will tend to purchase more of their good instead of an alternative good (vice versa)
Income effect: as the price of a good falls a consumer’s real income rises allowing the consumer to buy more units of all goods (lower price, more spending potential)
What are the variations in the nature of the income effect?
Normal goods: expect a big change, both effects work together
Inferior goods: small change, income effect negates some of the substitution effect
How is a market demand graph constructed?
The horizontal summation of individual demand curves
