Exam 3 Flashcards
theory of consumer behavior
description of how consumers allocate incomes among different goods and services to maximize their well-being
steps of consumer behavior
- consumer preferences
- budget constraints
- consumer choices
market basket (bundle)
list with specific quantities of one or more goods
basic assumptions about preferences
- completeness
- transitivity
- more is better than less
- diminishing marginal rate of substitution
indifference curve
curve representing all combinations of market baskets that provide a consumer with the same level of satisfaction
indifference map
graph containing a set of indifference curves showing the market baskets among which a consumer is indifferent
indifference curves cannot intersect, why?
then one of the assumptions of consumer theory is violated (transitivity)
marginal rate of substitution (MRS)
maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good
convex indifference curve
occurs when MRS diminished along an indifference curve
perfect substitutes
two goods for which the MRS of one for the other is a constant (always indifferent between one and the other)
perfect complements
two goods for which the MRS is zero or infinite, the indifference curves are right angles (an additional 1 give no extra satisfaction unless also an extra 1 of the other)
bad
good for which less is preferred rather than more
utility
numerical score representing the satisfaction that a consumer gets from a given market basket
utility function
formula that assigns a level of unity to individual market baskets
ordinal utility function
utility function that generates a ranking of market baskets in order of most to least preferred
cardinal utility function
utility function describing by how much one market basket is preferred to another
budget constraints
constraints that consumers face as a result of limited incomes
budget line
all combinations of goods for which the total amount of money spent is equal to income
I=
PfF+PcC
price of food)x(food quantity) + (price of clothes)x(clothes
effects of income changes on budget line
shifts parallel to original line
income increase- outward shift
income decrease- inward shift
effects of price change on the budget line
budget line rotates around the intercept (point that hits x or y line)
price decrease- rotate outward
price increase- rotate inward
conditions to maximize market basket
- located on the budget line
2. give consumer the most preferred combination of goods/services
satisfaction is maximized at what point (equation)
MRS= Pf/Pc
marginal rate of substitution= price of food/ price of clothes
marginal benefit
benefit from the consumption of oone additional unit of a good, measured by MRS
marginal cost
cost of one additional unit of a good
satisfaction is maximized at what point
when the marginal benefit is equal to the marginal cost
corner solution
situation in which the marginal rate of substitution for one good in a chosen market basket is not equal to the slope of the budget line
how will the consumer maximize their satisfaction in a corner solution
consume only one of the goods
marginal utility (MU)
additional satisfaction obtained from consuming one additional unit of a good
diminishing marginal utility
principle that as more of a good is consumed, the consumption of additional amounts will yield smaller additions to utility
equal marginal principle
principle that utility is maximized when consumer has equalized the marginal utility per dollar of expenditure across all goods
MUf/MUc=
Pc/Pf
cost-of-living index
ratio of the present cost of a typical bundle of consumer goods and services compared with the cost during a base period
ideal cost-of-living index
cost of attaining a given level of utility at current prices relative to the cost of attaining the same utility at base-year prices
price index
represents the cost of buying bundle A at current prices relative to the cost of bundle A at base-year prices, overstates the ideal cost-of-living index
laspeyres price index
amount of money at current year prices that an individual requires to purchase a bundle of goods and services chosen in a base year divided by the cost of purchasing the same bundle at base-year prices
ideal cost-of-living vs laspeyres
laspeyres is greater than the ideal cost-of-living index, it overcompensates for the higher cost-of-living
paasche index
amount of money at current-year prices that an individual requires to purchase a current bundle of goods and services divided by the cost of purchasing the same bundle of goods and services divided by the cost of purchasing the same bundle in a base year
laspeyres vs paasche
laspeyres overstates the ideal cost-of-living, whereas paasche understates because it assumes that the individual will buy the current-year bundle in the base period
fixed-weight index
cost-of-living index in which the quantities of goods and services remain unchanged
chain-weighted price index
cost-of-living index that accounts for changes in quantities of goods and services
price-consumption curve
curve tracing the utility-maximizing combinations of two goods as the price of one changes
individual demand curve
curve relating the quantity of a good that a single consumer will buy to its price
properties of the individual demand curve
- the level of utility that can be attained changes as we move along the curve
- at every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the marginal rate of substitution (MRS) of food for clothing equals the ratio of the prices of food and clothing
income-consumption curve
curve tracing the utility-maximizing combinations of two goods as a consumer’s income changes
engel curve
curve relating the quantity of a good consumed to income
two goods are substitutes if
an increase in the price of one leads to and increase in the quantity demanded of the other
two goods are complements if
an increase in the price of one good leads to a decrease in the quantity demanded of the other
two goods are independent if
a change in the price of one good has no effect on the quantity demanded of the other
effects of a fall in the price of a good
- substitution effect
2. income effect
substitution effect
consumers will tend to buy more of the good that has become cheaper and less of those goods that are now relatively more expensive; change in consumption of a good associated with a change in its price, with the level of utility held constant
income effect
because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power; change in consumption of a good resulting from an increase in purchasing power, with relative prices held constant
total effect=
substitution effect + income effect
something is an inferior good if
the income effect is negative (exception: giffen good)
giffen good
a good whose demand curve slopes upward because the (negative) income effect is larger than the substituion effect
market demand curve
curve relating the quantity of a good that all consumers in a market will buy to its price
fun facts about the market demand curve
- curve will shift to the right as more consumers enter the market
- factors that influence the demands of many consumers will also affect market demand
price elasticity of demand (Ep)=
(change in Q/Q) / (change in P/P)
inelastic demand
the quantity demanded is relatively unresponsive to changes in price; total expenditure on the product increases when the price increases
elastic demand
quantity demanded is responsive to change in price; total expenditure on the product decreases as the price goes up
isoelastic demand curve
demand curve with a constant price elasticity; total expenditure is constant along the demand curve
speculative demand
demand driven not by the direct benefits one obtains from owning or consuming a good but instead by an expectation that the price of the good will increase
consumer surplus
difference between what a consumer is willing to pay for a good and the amount actually paid; the area under the demand curve and above the line representing the purchase price of the good
network externality
when each individual’s demand depends on the purchases of other individuals
positive network externality
the quantity of a good demanded by a typical consumer increases in response to the growth in purchases of other consumers
negative network externality
the quantity demanded of a good by a typical consumer decreases in response to the growth in purchases of other consumers
bandwagon effect
effect of positive network externality in which a consumer wishes to possess a good in part because others do
snob effect
effect of negative network externality in which a consumer wishes to own an exclusive or unique good
