Consumption Choices Flashcards
Marginal Utility
Additional utility gained from one additional unit of consumption
MU = change in utility / change in Q
Diminishing MU
Additional utility decreases with each unit added
MU per Dollar
Additional utility at a given price
MU/Dollar = MU / Price
Maximizing Utility
Utility-maximizing choice between consumption goods occurs where MU per dollar is the same for both goods
MU1 / P1 = MU2 / P2
Consumer Equilibrium
Ratio of prices from two goods should be equal to the ratio of MU
P1 / P2 = MU1 / MU2
Normal Good
When a rise in income leads to a rise in demand
Inferior Good
When a rise in income leads to a decrease in demand
What happens to a budget constraint when prices rise?
The budget constraint shifts to the left and overall consumption shrinks.
The budget constraint pivots along the axis for the price that remains constant
Income Effect
A higher price means that the buying power of income has been reduced
This happens simultaneously with a substitution effect
Substitution Effect
When a price changes, consumers have an incentive to consume less of the good with a higher price and more of the good with a lower price.
Happens simultaneously with an income effect
Substitution Effect
When a price changes, consumers have an incentive to consume less of the good with a higher price and more of the good with a lower price.
Happens simultaneously with an income effect
How does a decrease in price lead to an increase in purchases of the product? What happens to the budget constraint?
The income effect and substitution effect happen simultaneously.
The decrease in price moves the budget constraint outward (center paribus) and creates an increase in buying power along with an increased demand for that product relative to income remaining the same. The substitution effect says that because the product is now cheaper the consumer will to buy more of the product.
What is a positive income effect?
An increase in income will shift the budget constraint outward and a movement along the budget constraint towards the NORMAL GOOD.
What is a negative income effect?
A decrease in income will shift the budget constraint inward and a movement along the budget constraint towards the INFERIOR GOOD
Labor-Leisure Budget Constraint
A household will choose the combination of labor, leisure, and income that provides the most utility. The result of a change in wage levels can be higher work hours, the same work hours, or lower work hours
How does a rise in wages alter the labor-leisure budget constraint?
A rise in wages causes the labor-leisure constraint to swing upward
Backward-Bending Supply Curve for Labor
Is created with high-wage people.
At the lower portion of the supply curve an increase in wages creates an increase in hours worked.
The middle of the supply curve is almost vertical and an increase in the wages does not increase hours worked
The top of the supply curve then bends backwards towards the y-axis and an increase in wages creates a decrease in hours worked
In the labor-leisure model, what is the price of leisure?
The price of leisure is less hours worked and lower income
Intertemporal Budget Constraint
Explains people’s preferences in relation to current consumption and saving for future consumption over the course of their lives
What is the impact of education on earnings and unemployment rates?
As education rises median income rises and unemployment rates decrease
How will interest rates affect affect the intertemporal budget constraint?
A lower interest rate will make lending cheaper and savings less rewarding creating a flatter intertemporal budget line
A higher interest rate will make lending more expensive and saving more rewarding creating a steeper intertemporal budget line
