Indifference Analysis (L1-4) Flashcards
3 basic assumptions of indifference analysis and what they mean?
Completeness - one can rank different market baskets according to preference
Monotonicity - ‘more is better’ Ceteris paribus
Transitivity - the consumer has internally consistent preferences
Define indifference curve?
An indifference curve represents all combinations of two goods between which a consumer has no preference
Define utility and unit?
Numerical measure of satisfaction gained from consumption of goods or services (utils)
4 factors that affect utility?
Duration, intensity, certainty/uncertainty, it’s propinquity or remoteness
Define marginal utility?
The additional satisfaction gained from consuming one additional unit of a good (within a given period)
Define total utility?
The sum of all satisfaction gained from the consumption of a number of goods/services (within a given period)
Define indifference map?
An indifference map shows different indifference curves that can be achieved
See ‘mountain of happiness’
Now
4 properties of indifference curves?
Higher curves preferred over lower ones
They never cross
They slope downward
They are convex in shape
(Explain why)
Define marginal rate of substitution?
At any point along an indifference curve, the MRS is the number of units of good Y that have to be sacrificed to acquire on additional unit of good X, without changing TU
What is the change in total utility along an indifference curve?
0
Define diminishing marginal utility, and what it explains?
As one consumes more units of a good, each additional unit gives a lower MU that previous units
This explains the convex shape
What are perfect substitutions in terms of indifference analysis, and how it looks on a graph?
Goods that consumers are willing to trade for one another at a constant rate
Therefore MRS = -1, slope is straight negative line
What are perfect complements in terms of indifference analysis, what does this mean for the MRS, and how it looks on a graph?
Goods that are always consumer together in fixed proportions
A consumer will not substitute between good Y and good X therefore the MRS is undefined
The indifference curves are two lines, paralleled to the axis and meeting at right angles (no extra utility is gained by increasing consumption of X if there’s no increase in consumption of Y)
Two factors that affect the basket of goods a consumer will buy?
Prices of goods
Budget available
What does an increase in income do to the budget line if the goods are normal?
Shifts outwards parallel (vice versa for fall in income)
What happens to the budget line if there’s a fall in the price of good X?
Budget line swings outwards about pivot (y axis)
Vice versa for rise in price of good X
When is maximum utility occurred/optimum consumption point (C)?
When the budget line is tangent to the indifference curve
Graph of one of the goods is not wanted at any price (eg. Cigarettes)?
If good y is not wanted at any price, the OCP will occur when the budget line touches the X axis
OCP for perfect substitutes?
If X and Y are perfect substitutes, but one is cheaper than the other, the OCP will be on the axis of the cheaper good - ie. They will only consume the cheaper good
OCP for perfect complements?
The OCP will always lie at the corner of the highest attainable ‘L’ - budget line will just touch the corner
In what instance will an increase in income shift the budget line inward?
If the goods are inferior
What does the income consumption curve show?
A line showing how an individual’s optimum level of consumption of two goods changes as income changes, Ceteris paribus
(Joins the OCPs as income increases, see graph)
What is an Engel curve?
A line showing the relationship between quantity demanded for a good and the level of income
(See graph for derivation)
What are the axis of an Engel curve?
Y axis - income
X axis - units demanded of a good
What is the real income effect?
As the price of a good increases, the quantity a consumer can buy of it decreases, Ceteris paribus
What is the substitution effect?
As the price of good A increases, the consumer will buy more of good B since good A will become relatively more expensive, and vice versa
Which effects occur when there is an increase in the price of a normal good?
Real income effect
Substitution effect
When a price of one good falls, how do you isolate the substitution effect from the real income effect? What does this show?
After the pivotal swing, imagine the consumer was given more money to move them back to their previous indifference curve. This means no change in real income, so can isolate the substitution effect; this show the substitution effect causes a shift ALONG the indifference curve, while the real income effect causes a shift to a DIFFERENT indifference curve
What does the price-consumption curve show?
It is a line showing how an individual’s optimum level of consumption changes as the price of one of the goods changes, Ceteris paribus
Seen by swinging out budget line and tracing OCPs, normally slightly downward sloping
What is market demand?
The sum of the individual demand curves
Why is the market demand curve kinked?
Because at high prices some individuals would buy no quantity of goods
