Micro - Lecture 8/9 (Constrained Optimisation + Income and Substitution Effects)

Question 1

What is a budget constraint?

Answer 1

Represents combinations of goods affordable at given income and prices.

Question 2

What is the equation and slope for a budget constraint?

Answer 2

Equation: M = PxX + PyY

Slope: -Px / Py

Question 3

What is the optimal choice for constrained optimisation?

Answer 3

The optimal choice occurs where the budget line is tangent to the highest indifference curve.

Condition: MRS = Px / Py

Question 4

What is the income effect?

Answer 4

Change in consumption due to purchasing power changes with constant prices.

Question 5

How are normal and inferior goods effected when the income effect occurs?

Answer 5

Normal Goods: Consumption rises with income.

Inferior Goods: Consumption falls with income.

Question 6

What is the substitution effect?

Answer 6

Change in consumption when relative prices change, holding utility constant. Consumers substitute cheaper alternatives for more expensive ones.

Question 7

What are Giffen goods?

Answer 7

Goods where the income effect dominates the substitution effect, causing demand to rise as price increases.