ECON101 Unit 7

Question 1

What does budget equation state?

Answer 1

Expenditure = Income

Question 2

What does the budget equation include?

Answer 2

Taking two goods…

Price of x (quantity of x) + Price of y (quantity of y) = Income

Question 3

How do changes in price effect the budget line?

Answer 3

• A rise in the price of a good decreases the affordable quantity of that good
• Increases the slope of the budget line

Question 4

How can the slope of the budget line be determined?

Answer 4

Px/Py = relative price of good x in terms of good y

Also …. opportunity cost of seeing a movie in terms of forgone pop

Question 5

How does a change in income change the budget line?

Answer 5

• slope does not change b/c relative price does not change (slope only shifts)
• Income/Py measures households real income in terms of good/service

Question 6

What is real income?

Answer 6

How much of a good can be purchased if all income was only spent on that one good
Income/ Price of good

Question 7

What is the indifference curve?

Answer 7

A line that shows combinations of goods among which a consumer is indifferent ..they would be satisfied with any combination of goods plotted
- Indifferent about points on the line .. outside of line is preferred inside is not preferred

Question 8

What is the marginal rate of substitution?

Answer 8

Measures the rate at which a person is willing to give up good y to get an additional unit of good x

Question 9

How does the marginal rate of substitution connect with the indifference curve?

Answer 9

The magnitude of the slope of the indifference curve measures the marginal rate of substitution between the two goods

Question 10

What is the slope of the marginal rate of substitution?

Answer 10

Marginal utility of x/ marginal utility of y

Question 11

If the indifference curve is …..(steep.. flat etc)

Answer 11

Steep curve = MRS is high (willing to give up a large quantity to get more x)
Flatter curve = MRS is low (willing to give up a small quantity to get more x)

Question 12

What is the diminishing rate of marginal substitution?

Answer 12

the consumer’s willingness to part with less and less quantity of one good in order to get one more additional unit of another good.

Question 13

How does the indifference curve show the degree of substitutability?

Answer 13

Two ordinary goods/services =
More substitutability = straighter line curve
Less substitutability = more tightly curved
Convex and diminishing rate of substitution

Question 14

What do perfect substitutes and perfect compliments look like when looking at substitutability and the curve?

Answer 14

Perfect substitutes =
consumers are indifferent
substitute at same rate no incentive to choose
MRS is constant + linear

Perfect compliments =
must be consumed in precise combo for satisfaction
ex. right + left shoe (worn as pair)

Question 15

What is the best affordable choice?

Answer 15

• on the budget line
• on the highest attainable indifference curve
• marginal rate of substitution between two goods is equal to their relative price of the two goods

Question 16

What is the price effect?

Answer 16

Effect of a change in the price of a good on the quantity of the good consumed

Question 17

What is the income effect?

Answer 17

Effect of a change in income on the quantity of a good consumed

Question 18

What is the substitution effect?

Answer 18

Effect of a change in price on the quantity bought

Question 19

What do inferior goods do to satisfy the law of demand?

Answer 19

• Income increases = quantity bought decreases
• Negative works against substitution effect
• As long as substitution dominates the demand curve still slopes down

Question 20

What is a giffen good?

Answer 20

Low income, non-luxury product that defies standard economic and consumer demand theory