Intro to Microecon Flashcards
What is the Theory of consumer behavior?
An explanation of how consumers allocate incomes among different goods and services to maximize their well-being.
3 distinct steps for understanding consumer theory’
Consumer preferences,
Budget constraints and Consumer choices
Consumer preferences
A practical way to describe the reasons people may prefer one good to another. We focus on how to describe consumer preferences grafically and algebriacally.
Budget constraints
Constraints that consumers face as a result of limited incomes.
Consumer choices
Given the consumer preferences and income limitations, choices describe how consumers choose to buy combinations of goods and services for maximizing satisfaction/utility.
Market basket (bundles)
A market basket is a list with specific quantities of one or more goods; (a selected mix of goods and services). The choice of a specific market basket is related to preferences, which are subject to change depending on which mix/combination of goods and services offers the highest satisfaction at that point.
Basic assumptions about preferences
Completeness, Transitivity, More>Less
Assumptions about preferences - completeness?
Preferences are assumed to be complete. In other words,
consumers can compare and rank all possible baskets. Thus, for any two
market baskets A and B, a consumer will prefer A to B, will prefer B to A,
or will be indifferent between the two. By indifferent we mean that a person will be equally satisfied with either basket.
Assumptions about preferences - Transitivity?
(related to consistency!!!)
Preferences are transitive. Transitivity means that if a consumer prefers basket A to basket B and basket B to basket C, then the
consumer also prefers A to C. For example, if a Porsche is preferred to a
Cadillac and a Cadillac to a Chevrolet, then a Porsche is also preferred to
a Chevrolet. Transitivity is normally regarded as necessary for consumer
consistency.
Assumptions about preferences - More>less?
Goods are assumed to be desirable—i.e., to
be good. Consequently, consumers always prefer more of any good to less. In
addition, consumers are never satisfied or satiated; more is always better,
even if just a little better.1
This assumption is made for pedagogic reasons;
namely, it simplifies the graphical analysis. Of course, some goods, such
as air pollution, may be undesirable, and consumers will always prefer
less. We ignore these “bads” in the context of our immediate discussion of
consumer choice because most consumers would not choose to purchase
them.
How can consumer preferences be shown graphically?
Using indifference curves
Indifference curve?
An indifference curve represents all combinations of market baskets that provide a consumer with the same level of satisfaction. That person is therefore indifferent among the market baskets represented by the points graphed on the curve.
(they also describe a trade off between the consumption of different goods)
Law of diminishing marginal utility
The law states that the amount of satisfaction provided by the consumption of every additional unit of a good decreases as we increase the consumption of that good.
Indifference map
Graph
containing a set of indifference
curves showing the market
baskets among which a consumer
is indifferent.
(indifference curves cannot intersect!)
Why can’t indifference curves intersect?
The intersection of indifference curves would violate one of the assumptions of consume theory, as it would mean that the consumer should be indifferent towards any market basket along any of the intersecting curves - this would contradict the assumption that the consumer always prefers having more goods in total.
Shape of all indifference curves?
Downward sloping
(The fact that indifference curves slope
downward follows directly from our assumption that more of a good is better
than less.)
The marginal rate of substitution?
Maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good.
The magnitude of the slope of an indifference curve measures the consumer’s marginal rate of substitution (MRS) between two goods.
What does the shape of an indifference curve describe?
The shape of an indifference
curve describes how a consumer is willing to substitute one good for another.
What does MRS (Marginal Rate of Substitution) measure?
The MRS of food F for clothing C is the maximum amount of clothing that a person is
willing to give up to obtain one additional unit of food. Suppose, for example, the
MRS is 3. This means that the consumer will give up 3 units of clothing to obtain 1 additional unit of food. If the MRS is 1/2, the consumer is willing to give
up only 1/2 unit of clothing. Thus, the MRS measures the value that the individual
places on 1 extra unit of a good in terms of another.
The MRS measures the value that the individual
places on 1 extra unit of a good in terms of another.
What is MRS always equal to? (marginal rate of substitution)
the MRS at any point is equal in magnitude to the slope of the indifference curve
MRS= - (change on Y axis)/(change on X axis)
MRS falls as we move down the indifference curve. Why?
This can be explained by another important assumption regarding consumer preferences (apart from Completeness, Transitivity and More>Less) - Diminishing marginal rate of substitution (the marginal rate of substitution, i.e. the max amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good, decreases as we move down the indifference curve)
Explanation: The willingness to sacrifice N units of one thing to get a unit of another depends on how much of each thing you have to begin with. –> As more and
more of one good is consumed, we can expect that a consumer will prefer to
give up fewer and fewer units of a second good to get additional units of the
first one
How does the diminishing marginal rate of substitution along the indifference curve affect the shape of the curve?
Indifference curves are usually convex, or bowed inward. The term convex means that the slope of the
indifference curve increases (i.e., becomes less negative) as we move down
along the curve. In other words, an indifference curve is convex if the MRS
diminishes along the curve
What kind of market baskets to consumers generally prefer?
consumers generally
prefer balanced market baskets to market baskets that contain all of one good
and none of another
Give an example of when an indifference curve might be non-convex and explain?
With nonconvex preferences, the MRS increases as the amount of the good measured on the
horizontal axis increases along any indifference curve. (i.e., the more you have of good A, the more of good B you are willing to give up in order to secure an additional unit of good A; opposite of the typical, diminishing MRS)
This unlikely possibility might arise if one
or both goods are addictive. For example, the willingness to substitute an addictive drug for other
goods might increase as the use of the addictive drug increased.
Perfect substitutes
Two
goods for which the marginal rate
of substitution of one for the other
is a constant.
- the indifference curve is then a straight line
- e.g. consumer always perceiving two 500g packs of pasta as equivalent to one 1kg pack of pasta, regardless of how much of each he has
Perfect complements
Two
goods for which the MRS is zero
or infinite; the indifference curves
are shaped as right angles.
- for example, left shoe and right shoe
- an additional left shoe will not
increase the consumer’s satisfaction unless she can obtain the matching right shoe. In this
case, the MRS of left shoes for right shoes is zero whenever there are more right shoes than left shoes; the consumer will not give up any left shoes to get additional right
shoes. Correspondingly, the MRS is infinite whenever there are more left shoes
than right because the consumer will give up all but one of her excess left shoes in order
to obtain an additional right shoe
What are ‘bads’?
Good for which less is
preferred rather than more.
How do we account for bads in the analysis of consumer
preferences?
We redefine the product under study so that consumer
tastes are represented as a preference for less of the bad. This reversal turns the
bad into a good. Thus, for example, instead of a preference for air pollution, we
will discuss the preference for clean air, which we can measure as the degree of
reduction in air pollution.
Utility?
Numerical score
representing the satisfaction that
a consumer gets from a given
market basket.
(utility simplifies the ranking of market baskets)
Utility function
Formula
that assigns a level of utility 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 line?
All combinations
of goods for which the total
amount of money spent is equal
to income.
A budget line describes the combinations of goods that can be purchased given the consumer’s income and the prices of the goods.
I = price A x quantity + price B x quantity
Slope of the budget line?
The slope of the budget line is the negative of the ratio of the prices
of the two goods.
-(price of good on x axis/price of good on y axis)
Intercept?
An intercept is where a line on a graph crosses (“intercepts”) the x-axis or the y-axis.
What do the intercepts of the budget line represent?
The vertical intercept represents the maximum amount of
good on y axis that can be purchased with income (if the whole income was spent on it). The horizontal intercept
tells us how many units of the good on x axis can be purchased if all income were spent on F.
Effect of income change on the budget line?
A change in income (with prices unchanged) causes the budget line to shift outwards parallel to the original line. (the intercepts of the line will move, driving this shift)
- the slope stays the same if the price of neither of the goods changed
Effect of price change on the budget line?
A change in the price of one good (with income unchanged) causes the budget line to rotate about one intercept. – the slope is affected
(the slope will be affected only if the change in good price(s) affects the RATIO of the two prices)
It is assumed that consumers make rational choices. Which two conditions must the maximising market basket satisfy (i.e. the market basket they choose)?
- It must be located on the budget line.
- It must give the consumer the most preferred combination of goods and services.
These two conditions reduce the problem of maximizing consumer satisfaction
to one of picking an appropriate point on the budget line.
Marginal cost and benefit?
marginal benefit - Benefit
from the consumption of one
additional unit of a good.
marginal cost - Cost of one
additional unit of a good.
When is consumer satisfaction maximised?
Satisfaction is maximized when the marginal rate of
substitution (of good A for good B) is equal to the ratio of the prices (of good A to good B) –> i.e. marginal benefit is equal to the marginal cost
At the point of max satisfaction, the budget line and the indifference curve are tangent (have one interception)
Why a consumer must choose a combination of goods on a budget line, meaning the indifference curve should be a tangent to the budget line?
When making choices, consumer preferences are constrained by budget (depending on the consumer’s impact). Therefore, the consumer must choose a combination of goods on the budget line (indicating the max he can afford, i.e. the amount he can buy if spending full income) that is a tangent to the indifference curve (the indifference curve containing the amount of services which corresponds to the max amount he can afford)
Economics?
Science about how best limited resources can be utilized
for satisfying unlimited need by individual’s or society’s
own choice.
Macroeconomics?
Branch of economics that deals with aggregate economic variables, such as the level and growth rate of national output, interest rates, unemployment, and inflation.
- The interactions/relationships between actors in microeconomics will be reflected in macroeconomics.
Microeconomics?
Branch of economics that deals with the behavior of individual economic units—consumers, firms, workers, and investors—as well as the markets that these units comprise.
Trade offs in microecon.
In modern market economies, consumers, workers, and firms have much
more flexibility and choice when it comes to allocating scarce resources.
Microeconomics describes the trade-offs that consumers, workers, and firms
face, and shows how these trade-offs are best made.
The idea of making optimal trade-offs is an important theme in microeconomics.
Trade-offs from Consumer perspective
Consumers have limited incomes, which can be spent on a wide
variety of goods and services, or saved for the future. Consumer theory, the subject matter of Chapters 3, 4, and 5 of this book, describes how consumers, based
on their preferences, maximize their well-being by trading off the purchase of
more of some goods for the purchase of less of others. We will also see how consumers decide how much of their incomes to save, thereby trading off current
consumption for future consumption.
Trade offs from worker perspective
Workers also face constraints and make trade-offs. First, people
must decide whether and when to enter the workforce. Because the kinds of
jobs—and corresponding pay scales—available to a worker depend in part on
educational attainment and accumulated skills, one must trade off working
now (and earning an immediate income) for continued education (and the hope
of earning a higher future income). Second, workers face trade-offs in their
choice of employment. For example, while some people choose to work for
large corporations that offer job security but limited potential for advancement,
others prefer to work for small companies where there is more opportunity for advancement but less security. Finally, workers must sometimes decide how
many hours per week they wish to work, thereby trading off labor for leisure.
Trade offs from Firms perspective
Firms also face limits in terms of the kinds of products that they can produce, and the resources available to produce them.
The themes of micro economics?
- Trade offs
- Prices and markets
- Theories and models
- Normative and positive analysis
What are theories in economics?
Theories are developed to explain observed phenomena in terms of a set of basic rules and assumptions. Economic theories are the basis for making predictions.
What are models in economics?
With the application of statistical and econometric techniques, theories can
be used to construct models from which quantitative predictions can be made.
A model is a mathematical representation, based on economic theory, of a firm, a market, or some other entity
Positive analysis?
Analysis
describing relationships of cause
and effect.
- positive questions deal with explanation and prediction. e.g. What will happen with car sales and prices if the government restricts car import?
Normative analysis?
- normative questions deal with what ought to be, e.g. what is best? what is the most profit-maximising combination of products to produce?
Two broad groups of economic units
It is easiest to understand what a market is and how it works by dividing
individual economic units into two broad groups according to function—
buyers and sellers. Buyers include consumers, who purchase goods and services, and firms, which buy labor, capital, and raw materials that they use
to produce goods and services. Sellers include firms, which sell their goods
and services; workers, who sell their labor services; and resource owners,
who rent land or sell mineral resources to firms. Clearly, most people and
most firms act as both buyers and sellers, but we will find it helpful to think
of them as simply buyers when they are buying something and sellers when
they are selling something
A market?
Collection of buyers
and sellers that, through their
actual or potential interactions,
determine the price of a product
or set of products.
Market definition?
Determination of the buyers,
sellers, and range of products that
should be included in a particular
market.
(When defining a market, potential interactions of buyers and sellers can be just as important as actual ones. An example of this is the market for gold. A New Yorker who
wants to buy gold is unlikely to travel to Zurich to do so. Most buyers of gold
in New York will interact only with sellers in New York. But because the cost of
transporting gold is small relative to its value, buyers of gold in New York could
purchase their gold in Zurich if the prices there were significantly lower.)