Micro in Biz Week 2 Flashcards
What does an indifference curve represent in consumer theory?
An indifference curve represents a set of consumption bundles that provide the consumer with the same level of satisfaction.
Why do points A and B on an indifference curve matter?
Points A and B represent consumption bundles that offer the same level of satisfaction to the consumer.
Define the budget constraint in consumer theory.
The budget constraint shows the limit on the consumption bundles a consumer can afford, determined by their income and the prices of goods.
Why cannot consumers consume everything they desire?
Consumers are limited by their income, which constrains their ability to purchase desired goods.
Write and explain the budget equation.
The budget equation is xPx + yPy = M, where: x = quantity of good X, y = quantity of good Y, Px = price of good X, Py = price of good Y, M = consumer’s income.
This equation shows how a consumer allocates their income (M) between two goods (x and y). The total cost of purchasing x units of good x (at price Px) and y units of good y (at price Py) cannot exceed their total income.
What does a point below the budget constraint represent?
A point below the budget constraint represents an affordable consumption bundle where some income remains unspent.
What does a point on the budget constraint represent?
A point on the budget constraint represents a consumption bundle that uses all available income.
How is the slope of the budget constraint calculated, and what does it represent?
The slope is calculated as the ratio of the prices of the two goods, -Px / Py. It represents the relative price of one good compared to the other and the rate at which the consumer can trade them.
How does an increase in income affect the budget constraint?
An increase in income shifts the budget constraint outward (to the right) in a parallel manner, as the relative prices of goods remain unchanged.
How does a decrease in income affect the budget constraint?
A decrease in income shifts the budget constraint inward (to the left) in a parallel manner, without changing the relative prices of goods.
What happens to the budget constraint if the price of one good increases?
The budget constraint pivots inward on the axis of the good that remains unchanged in price.
What happens to the budget constraint if the price of one good decreases?
The budget constraint pivots outward on the axis of the good that remains unchanged in price.
List the key properties of indifference curves.
- Higher indifference curves are preferred to lower ones. 2. Indifference curves are downward sloping. 3. Indifference curves do not cross. 4. Indifference curves are convex. 5. The slope equals the marginal rate of substitution.
What does the slope of the indifference curve represent?
The slope of the indifference curve represents the marginal rate of substitution, which is the rate at which a consumer is willing to trade one good for another while maintaining the same utility level.
How is the consumer’s optimum determined?
The consumer’s optimum is determined at the point where the highest indifference curve is tangent to the budget constraint.
State the mathematical condition for the consumer’s optimum.
At the consumer’s optimum: MRS = Px / Py, meaning the consumer’s valuation equals the market’s valuation of the two goods.
What does the term marginal rate of substitution mean?
The marginal rate of substitution measures the amount of one good a consumer is willing to give up to obtain one more unit of another good while maintaining the same satisfaction level.
Write the mathematical representation of MRS in terms of marginal utilities.
MRS = MUx / MUy, where MUx = change in utility from one more unit of X, and MUy = change in utility from one more unit of Y.
What are the types of utility functions commonly used in consumer theory?
- Perfect substitutes utility function. 2. Perfect complements utility function. 3. Cobb-Douglas utility function.
What is the utility function for perfect substitutes, and what does it imply?
The utility function is U = aX + bY, where a and b are positive constants. It implies that goods X and Y can replace each other at a constant rate.
What is the utility function for perfect complements, and what does it signify?
The utility function is U = min(aX, bY), where a and b are positive constants. It signifies that the goods must be consumed in fixed proportions to provide utility.
What is the Cobb-Douglas utility function, and how does it model preferences?
The utility function is U = Xa Yb, where a and b represent the weights of goods X and Y in the consumer’s preferences. It reflects a balanced preference for both goods based on their exponents.
How does an increase in income shift the consumer’s optimum?
An increase in income shifts the budget constraint outward, allowing the consumer to move to a higher indifference curve and select a new optimum bundle.
What happens to the consumer’s optimum if the price of one good decreases?
A decrease in the price of one good pivots the budget constraint outward, enabling the consumer to achieve a higher level of satisfaction by reaching a new optimum.
What is the optimal consumption bundle, mathematically?
The optimal consumption bundle occurs where MRS = Px / Py, ensuring that the consumer’s subjective rate of substitution matches the market rate.
What is a normal good?
A normal good is one for which the consumer buys more as their income increases, indicated by Delta Qx / Delta M > 0.
What is an inferior good?
An inferior good is one for which the consumer buys less as their income increases, indicated by Delta Qx / Delta M < 0.
Why is the amount of a good a person is consuming at a given point important in determining the marginal rate of substitution (MRS)?
The amount of a good being consumed affects the marginal utility derived from it. If a consumer has a large quantity of good yyy but hardly any of good xxx, they are likely to opt for consuming more of good xxx.
What is the working assumption of standard economic models (SEM) regarding consumers?
The SEM assumes that consumers seek to maximize utility subject to the constraint of a limited income.
What type of problem does consumer optimization represent?
It represents a constrained optimization problem, where utility maximization is limited by income.
How does the budget constraint affect consumer choices?
The budget constraint limits the combination of goods (e.g., cola and pizza) a consumer can afford.
What is the highest indifference curve a consumer can reach?
The highest indifference curve a consumer can reach is the one that just barely touches the budget constraint.
What is the point where the indifference curve and budget constraint touch called?
This point is called the optimum.
Why can a consumer not afford a point like AAA (above the budget constraint)?
The consumer cannot afford point AAA because it lies beyond their budget constraint.
What happens if a consumer chooses a point like BBB (below the optimum)?
Point BBB is on a lower indifference curve, meaning it provides less satisfaction.
Why is point CCC (on the budget constraint but below the highest indifference curve) suboptimal?
At point CCC, the consumer is not in equilibrium because they can reallocate spending to reach a higher indifference curve.
What does reallocating spending to point DDD (on the highest indifference curve) achieve?
Reallocating to DDD allows the consumer to get more utility from cola, as the additional utility from cola outweighs the marginal utility lost from reducing pizza consumption.
What does the consumer’s optimum represent?
The consumer’s optimum is the point on the budget constraint that lies on the highest achievable indifference curve.
What is true about the marginal rate of substitution (MRS) at the optimum?
At the optimum, the MRS equals the relative price of the two goods (MRS=Px/PyMRS = P_x / P_yMRS=Px/Py).
Why does it make sense to buy more cola instead of pizza at point CCC?
At point CCC, the additional utility from cola exceeds the marginal utility of pizza
What rational behavior does the consumer demonstrate by choosing point DDD?
The consumer maximizes their utility by reallocating spending to achieve a higher satisfaction level on the optimal indifference curve.
Why is the consumer’s initial allocation of spending not optimal? (Point C is initial allocation of spending)
The consumer can reallocate spending to reach higher indifference curves until the marginal utility of the last euro spent on cola equals the marginal utility of the last euro spent on pizza.
What does the “optimum” represent in consumer behavior?
The optimum represents the best combination of cola and pizza consumption, given the consumer’s income and behavioral assumptions.
What is the condition for consumer equilibrium (the optimum)?
At the optimum, the slope of the indifference curve equals the slope of the budget constraint. This means the indifference curve is tangent to the budget constraint.
What does the slope of the indifference curve represent?
The slope of the indifference curve represents the marginal rate of substitution, which shows the trade-off rate between cola and pizza that keeps the consumer equally satisfied.
What does the slope of the budget constraint represent?
The slope of the budget constraint represents the relative price of cola and pizza.
What is the mathematical condition for equilibrium in terms of the marginal rate of substitution?
At equilibrium, marginal rate of substitution = P_x / P_y, where P_x and P_y are the prices of cola and pizza.
How is the marginal rate of substitution expressed using marginal utilities?
Marginal rate of substitution = MU_x / MU_y, where MU_x and MU_y are the marginal utilities of cola and pizza.
How can the equilibrium condition be rewritten in terms of marginal utility and price?
The condition becomes MU_x / P_x = MU_y / P_y, meaning the marginal utility of cola divided by its price equals the marginal utility of pizza divided by its price.
What is the relationship between marginal utility per euro and equilibrium?
At equilibrium, MU_x / P_x = MU_y / P_y, meaning the marginal utility per euro spent on good x equals the marginal utility per euro spent on good y.
They are the same formula, they are just re-arranged and they show different persepctives
The Px refers to the price of the good, so if one unit of good x costs $5, then Px = 5
What happens if the consumer is not at equilibrium?
The consumer can increase utility by reallocating spending from the good with lower MU / P to the good with higher MU / P.
How do market prices reflect consumer optimization?
Market prices reflect the value that consumers place on goods, as measured by the marginal rate of substitution at the consumer’s optimum.
What happens to the budget constraint when income increases?
The budget constraint shifts outward in a parallel manner, as the relative prices of the two goods remain unchanged.
How does an increase in income affect the consumer’s spending decisions?
The consumer reallocates income to achieve a better combination of goods, such as more cola and pizza, reaching a new optimum on a higher indifference curve.
Does an increase in income require the consumer to increase consumption of both goods?
No, the logic of the model does not require increased consumption of both goods. The choice depends on preferences and marginal utilities.
What is a normal good?
A good for which consumption increases when income rises is called a normal good.
What is an inferior good?
A good for which consumption decreases when income rises is called an inferior good.
In Figure 4.12, which goods are assumed to be normal?
Both cola and pizza are assumed to be normal goods.
In Figure 4.13, which goods are assumed to be normal and inferior?
Pizza is assumed to be a normal good, while cola is assumed to be an inferior good.
What happens to the budget constraint when the price of cola falls from 2 to 1 per liter?
The budget constraint pivots outward because the consumer can now buy more cola with the same income.
How does the new budget constraint affect cola consumption if income is €1000?
The consumer can now buy 1000 liters of cola instead of 500 liters if they spend their entire income on cola.
What remains unchanged on the budget constraint after the price of cola falls?
The maximum quantity of pizza remains the same at 100 pizzas.
How does the budget constraint’s endpoint for cola consumption shift?
It pivots outward from point B (500 liters) to point C (1000 liters).
What does Figure 4.14 illustrate about changes in price and consumer behavior?
Figure 4.14 shows that when the price of cola falls, the budget constraint pivots outward, allowing the consumer to buy more cola and less pizza, moving from the initial optimum to a new optimum.
Why does the budget constraint’s slope change when the price of cola falls?
The price of cola falls to €1 while the price of pizza remains at €10, making the budget constraint steeper.
What happens to the trade-off between pizza and cola when the price of cola falls?
The consumer can now trade a pizza for 10 liters of cola instead of 5 liters, as cola becomes relatively cheaper.
How does the pivoting budget constraint affect purchases of cola and pizza?
Consumers tend to buy more cola and less pizza, depending on their preferences and the new budget constraint.
What are the income and substitution effects?
The income effect is the change in consumption caused by moving to a higher or lower indifference curve due to a price change. The substitution effect is the change in consumption caused by moving along the same indifference curve to a point with a new marginal rate of substitution.
How does the income effect apply when the price of cola falls?
The consumer is effectively richer because their income can now purchase more cola and pizza than before.
How does the substitution effect apply when the price of cola falls?
Cola becomes relatively cheaper compared to pizza, so the consumer substitutes cola for pizza, buying more cola and less pizza.
What does the income effect mean for consumption of cola?
The consumer is richer and can now buy more cola, such as 300 liters instead of 250 liters, using part of their budget for additional pizza.
How does the income effect impact pizza consumption?
The consumer may choose to buy more pizza with their increased purchasing power.
What causes the substitution effect when cola becomes cheaper?
Cola is now relatively cheaper, so the consumer reallocates spending toward cola and away from pizza.
What happens to pizza consumption during the substitution effect?
Pizza consumption decreases because it becomes relatively more expensive than cola.
How do income and substitution effects act together when the price of cola falls?
Both effects encourage the consumer to buy more cola. The income effect comes from increased purchasing power, while the substitution effect comes from cola being cheaper than pizza.
What is ambiguous about the effect on pizza consumption?
The income and substitution effects act in opposite directions for pizza. Income effect increases pizza consumption, but the substitution effect decreases it.
How does the income effect influence cola consumption?
Cola consumption increases because the consumer is richer and can afford more.
How does the substitution effect influence cola consumption?
Cola consumption increases because it is relatively cheaper.
What is the total effect on cola consumption?
The income and substitution effects act in the same direction, so cola consumption certainly increases.
How does the income effect influence pizza consumption?
Pizza consumption increases because the consumer is richer.
How does the substitution effect influence pizza consumption?
Pizza consumption decreases because it is relatively more expensive than cola.
What is the total effect on pizza consumption?
The total effect is ambiguous because the income and substitution effects work in opposite directions.
What does Figure 4.15 show about decomposing a price change?
It shows how a consumer’s decision can be split into the substitution effect (moving along the initial indifference curve) and the income effect (shifting to a higher indifference curve).
What is the substitution effect in Figure 4.15?
The movement along the initial indifference curve I1, from point A to point B, represents the substitution effect. The consumer is equally happy at both points, but point B reflects the new relative price.
What is the income effect in Figure 4.15?
The shift to a higher indifference curve I2, from point B to point C, represents the income effect, as the consumer adjusts to higher purchasing power.
Why does the slope of the indifference curve I1 at point B equal the slope of I2 at point C?
Both points reflect the same marginal rate of substitution, ensuring consistency in consumer preference.
Why is point B hypothetical in decomposing the effects?
It clarifies the two separate effects—substitution and income—without representing an actual consumer choice.
What does the movement from A to B on indifference curve I1 represent?
It represents the substitution effect, a pure change in the marginal rate of substitution without altering consumer welfare.
What does the movement from B to C represent?
It represents the income effect, a pure change in consumer welfare without changing the marginal rate of substitution.
What was the tax introduced by the UK Chancellor in the March 2016 Budget?
A tax of 24 pence per liter was added to sugary drinks.
What is the demand function for sugary drinks?
D = 10 + Y / (10 * P), where D is demand, Y is income, and P is the price per liter.
What are the initial conditions for sugary drink consumption?
Income is 500 pounds per week, and the initial price of sugary drinks is 3 pounds per liter.
How is initial demand calculated using the demand function?
D = 10 + 500 / (10 * 3); solving gives D = 10 + 16.67, so initial demand is 26.67 liters per week.
What happens to the price of sugary drinks after the tax?
The price rises to 3.25 pounds per liter.
How is demand calculated after the price increase?
D = 10 + 500 / (10 * 3.25); solving gives D = 10 + 15.38, so new demand is 25.38 liters per week.
What is the overall reduction in demand due to the tax?
The reduction in demand is 26.67 - 25.38, which equals 1.29 liters per week.
How is the substitution effect calculated?
Use the adjusted income to maintain purchasing power. Substituting income as 506.67 pounds and price as 3.25, demand is D = 10 + 506.67 / (10 * 3.25), which gives D = 25.6 liters. Substitution effect is 25.6 - 26.67 = -1.07 liters.
How is the income effect calculated?
Income effect is total reduction in demand (1.29) minus substitution effect (-1.07), giving 0.22 liters.
What is the total effect of the tax on sugary drink consumption?
Total demand decreases by 1.29 liters per week.
What is the substitution effect’s contribution to the reduction?
The substitution effect reduces demand by 1.07 liters.
What is the income effect’s contribution to the reduction?
The income effect reduces demand by 0.22 liters.
Draw a budget constraint line and indifference curves for cola and pizza. What happens if the price of pizza rises?
The budget constraint pivots inward on the pizza axis. The consumer moves along the initial indifference curve due to the substitution effect and then shifts to a lower indifference curve due to the income effect.
What is the purpose of the demand curve in consumer theory?
The demand curve shows the quantity demanded of a good for any given price, summarizing the optimal decisions from the budget constraint and indifference curves.
What does Figure 4.16 represent in the context of pizza demand?
It shows the demand for pizza, where successive lower prices of pizza create a series of budget constraints, altering the consumer’s optimum and forming the price-consumption curve.
What is the price-consumption curve?
It is a line showing the consumer optimum for two goods as the price of one of the goods changes, assuming income and the price of the other good are held constant.
How does the price of pizza affect the quantity demanded?
As the price of pizza decreases, the quantity of pizza demanded increases, driven by the income and substitution effects.
How does the lower graph in Figure 4.16 relate to the upper graph?
The lower graph shows the demand curve derived from the price-consumption curve in the upper graph. It plots the relationship between the price of pizza and the quantity of pizza demanded.
How is the demand curve formed using the price-consumption curve?
The price-consumption curve connects the consumer optimum points as the price of pizza changes. These points are then used to plot price versus quantity demanded in the demand curve.
What happens to the consumer optimum when the price of pizza falls?
When the price of pizza falls, the budget constraint pivots outward, allowing the consumer to purchase more pizza and form a new optimum on a higher indifference curve.
What does the upper graph in Figure 4.16 illustrate?
The upper graph shows the price-consumption curve, which maps changes in the consumer’s optimum as the price of pizza decreases.
What does the lower graph in Figure 4.16 illustrate?
The lower graph illustrates the demand curve, plotting the relationship between the price of pizza and the quantity demanded.
How are Q1, Q2, Q3, Q4, and Q5 determined in the graphs?
These quantities represent the consumer’s optimum quantity of pizza at successive prices P1, P2, P3, P4, and P5.
Define price-consumption curve.
The price-consumption curve shows the consumer optimum for two goods as the price of one of the goods changes, while holding income and the price of the other good constant.
How does the substitution effect contribute to the demand curve?
As the price of pizza decreases, the substitution effect encourages the consumer to buy more pizza because it becomes relatively cheaper compared to other goods.
How does the income effect contribute to the demand curve?
As the price of pizza decreases, the consumer’s real purchasing power increases, allowing them to buy more pizza along with other goods.
Why is the demand curve downward-sloping?
The demand curve is downward-sloping because lower prices increase the quantity demanded due to both the substitution and income effects.
What role do indifference curves play in deriving the demand curve?
Indifference curves illustrate the consumer’s preferences and help identify the optimum quantity of pizza at each price level.
What does the law of demand state about the relationship between price and quantity demanded?
The law of demand states that when the price of a good rises, people buy less of it, resulting in a downward-sloping demand curve.
Can demand curves ever slope upwards?
Yes, in rare cases, demand curves can slope upwards, meaning consumers buy more of a good when its price rises.
What type of goods cause an upward-sloping demand curve?
Giffen goods, which are inferior goods with a strong income effect that exceeds the substitution effect, can cause an upward-sloping demand curve.
In the example in Figure 4.17, what are the two goods being considered?
The two goods are meat and potatoes.
How does a rise in the price of potatoes affect the budget constraint?
The budget constraint shifts inward and pivots, reducing the consumer’s ability to purchase potatoes and meat.
What happens to the consumer’s optimum when the price of potatoes rises?
The consumer moves from point C (initial optimum) to point E (new optimum), buying more potatoes and less meat.
Why does a rise in the price of potatoes lead to more potatoes being purchased?
Potatoes are a strongly inferior good in this example. The income effect, which makes the consumer poorer, is so strong that it outweighs the substitution effect.
What happens to the substitution effect when the price of potatoes rises?
The substitution effect encourages the consumer to buy less potatoes and more meat, as potatoes become relatively more expensive.
What is a Giffen good?
A Giffen good is an inferior good for which an increase in price raises the quantity demanded due to the income effect dominating the substitution effect.
Who first proposed the concept of Giffen goods?
The concept was first proposed by British economist Robert Giffen.
What happens in step one when the price of potatoes increases?
The budget constraint rotates inward, reducing the consumer’s ability to purchase potatoes.
What happens in step two if potatoes are a Giffen good?
The consumer responds to the higher price of potatoes by buying less meat and more potatoes.
What do indifference curves I1 and I2 represent in Figure 4.17?
I1 represents the lower indifference curve at the initial budget constraint, and I2 represents the higher indifference curve after the price increase of potatoes.
What is an example of a Giffen good in history?
Some historians suggest that potatoes were a Giffen good during the Irish potato famine of the nineteenth century.
Why might potatoes have been considered a Giffen good during the Irish potato famine?
Potatoes were a staple food, and when prices rose, people had to cut back on luxury items like meat and buy more potatoes to maintain caloric intake.
Is the historical account of potatoes as a Giffen good supported by all economists?
No, some economists argue that the evidence does not support this claim, and that the idea may be a legend.
What are other examples of goods that might exhibit Giffen behavior?
Studies suggest that rice and wheat in parts of China may exhibit Giffen qualities.
What is the role of the income effect in creating a Giffen good?
The income effect makes the consumer poorer, leading them to buy more of the inferior good, which outweighs the substitution effect.
Why is the substitution effect not enough to explain Giffen goods?
The substitution effect encourages buying less of the more expensive good, but in Giffen goods, the income effect is so strong it reverses this behavior.
What is the income expansion path in consumer theory?
The income expansion path connects the consumer’s optimum points as income changes, showing how consumption of two goods changes with income.
How does an increase in income affect consumption of normal goods?
For normal goods, an increase in income leads to an increase in demand for the goods.
What does Figure 4.18 illustrate about normal goods?
Figure 4.18 shows that as income increases, the consumption of both pizza and cola increases, indicating both are normal goods.
Why does the income effect outweigh the substitution effect for normal goods?
For normal goods, the income effect outweighs the substitution effect because an increase in purchasing power—whether from an income rise or a price drop—allows the consumer to buy significantly more of normal goods, making the income effect stronger than the substitution effect.
How are the budget constraints labeled in Figure 4.18?
BC1, BC2, and BC3 represent increasing levels of income.
What are the points A, B, and C on the income expansion path?
Points A, B, and C represent the consumer’s optimum combinations of cola and pizza at different income levels.
What happens to the indifference curves as income increases?
Indifference curves shift outward (I1 to I2 to I3), reflecting higher levels of satisfaction due to increased income.
What happens to pizza demand when it is an inferior good?
Pizza demand decreases as income rises, even though cola demand increases.
What does Figure 4.19 illustrate about inferior goods?
It shows that the income expansion path for pizza bends backward, indicating decreased demand as income rises.
How does the substitution effect influence pizza demand in this case?
The substitution effect for pizza of the income rise is outweighed by the income effect, which leads to reduced pizza consumption.
What happens to cola demand when it is an inferior good?
Cola demand decreases as income rises, even though pizza demand increases.
What does Figure 4.20 illustrate about inferior goods?
It shows that the income expansion path for cola bends backward, indicating decreased demand as income rises.
How does the substitution effect influence cola demand in this case?
The substitution effect of the income rise on cola is outweighed by the income effect, leading to reduced cola consumption.
Define normal goods.
Normal goods are goods for which demand increases as income rises.
Define inferior goods.
Inferior goods are goods for which demand decreases as income rises.
What determines whether a good is normal or inferior?
The classification depends on how demand changes in response to income changes. If demand rises, it is a normal good; if demand falls, it is an inferior good.
What do budget constraints BC1, BC2, and BC3 represent?
They represent increasing levels of income, allowing the consumer to afford more goods.
Why does the income expansion path bend backward for inferior goods?
Because higher income leads to decreased demand for inferior goods as consumers substitute them for better alternatives.
How do indifference curves help determine normal and inferior goods?
Indifference curves show the consumer’s changing satisfaction levels, with outward shifts indicating increased utility from income changes.
What is the Engel Curve?
The Engel Curve shows the relationship between income levels and the demand for a good.
What did Engel observe about the relationship between income and spending?
Engel observed that as income rises, the proportion of income spent on food decreases, while the proportion spent on other goods like leisure increases.
What example is used to explain Engel’s findings?
A family with a combined income of 45000 euros spends 15000 euros (one-third) on food. If income doubles to 90000 euros, spending on food might rise to 20000 euros, reducing the proportion spent on food to 22 percent.
What are the implications of Engel’s findings for businesses?
Businesses selling food will not see revenues rise in proportion to income increases. Conversely, businesses selling leisure goods may benefit more as incomes rise.
How does income elasticity of demand for food change as income rises?
The income elasticity of demand for food becomes more inelastic as income rises.
How does income elasticity of demand for luxuries change as income rises?
The income elasticity of demand for luxuries becomes more elastic as income rises, increasing at a faster rate.
What does Figure 4.21 illustrate about food and luxuries?
The upper graph shows food and luxuries as normal goods, with demand for food increasing at a diminishing rate and demand for luxuries increasing faster.
What does the income-consumption curve represent in the upper graph?
It shows the change in consumer optimum for food and luxuries as income increases, moving from points A to B to C.
What does the Engel Curve represent in the lower graph?
The Engel Curve plots changes in income against changes in the demand for luxuries, highlighting increasing demand with higher incomes.
How is the Engel Curve useful for understanding income effects?
It helps visualize how spending patterns change as income increases, distinguishing between necessities and luxuries.
