Microeconomics 1: Introduction and Consumer Theory Flashcards
Introduction What is Microeconomics? 1.1 Consumer choice building blocks: budget constraint, preferences, and utility function; 1.2 Consumer’s optimal choice; 1.3 Consumer demand (includes Slutsky income-substitution decomposition). 1.4 Revealed preferences
Describe & explain what Microeconomics is
Microeconomics is about scarcity.
How can we allocate the world’s limited resources most efficiently?
How do we allocate our limited resources?
Individual ‘agents’ in the economy:
How can a consumer maximise utility? How can a firm maximise profits? What
decisions should an investor make? How individual agents combine and interact
through markets?
Microeconomic issues include: choices, the concept of opportunity cost, rational economic
decision making, and microeconomic objectives - efficiency and equity.
Microeconomics is the study of choices & behaviour of individual decision-
making units (e.g. individual households and firms). Microeconomists also study the
results produced by the interplay of individual decisions
To answer these difficult questions we use abstraction and models .
Microeconomics is about using simple models to get some understanding of
‘real world’ phenomena.
The simpler the model the better, provided that it tells you something useful.
Simplicity is gained through assumptions.
Economic models typically contain mathematical equations and graphs.
Describe the intuition behind a budget constraint line
Economic theory of the consumer is based on the idea that a consumer
chooses: ‘the best bundle of goods that a consumer can afford’.
A consumer’s budget constraint identifies what they can afford to buy.
Among other things, consumer theory is interested in understanding how changes in
the budget constraint change consumption
Describe the notation for budget constraint lines
Please note that:
𝑀 or 𝑚 or 𝑅 stands for income;
𝑥 stands for the amount of good 𝑋;
𝑦 stands for the amount of good 𝑌 (and similarly for other goods);
PX or 𝑝𝑥 stands for the price of good 𝑋 and PY or 𝑝𝑦 stands for the price of good Y
(and similarly for other goods and prices).
Describe the ‘standard consumer’s problem’ and its links with the budget constraint equation
There are two goods 𝑋 and 𝑌;
Good 𝑋 can be purchased at price Px and 𝑌 at price Py;
The consumer has an income of M.
A consumption bundle (𝑥, 𝑦) tells us that the consumer gets 𝑥 units of
good 𝑋 and 𝑦 units of good 𝑌.
Bundle (𝑥, 𝑦) is feasible if, and only if, Pbottom right Xx + Pbottom right Yy =< M
We will call budget line or budget constraint the set of consumption bundles
that cost exactly available income.
Assuming that the consumer spends all of their income, and rearrange:
y = M/Py - Px/Py x
Note: “relative” prices are illustrated by the slope of the budget line
Describe the graph (in a general case) of the budget constraint line
This is graph titled “y = M/Py - Px/Py x” so the line is a straight downward sloping line where y-intercept is “M/Py” (y-axis labelled “y”), labelled “B” (as well) and x-intercept is “M/Px” (x-axis labelled “x”), labelled “A” (as well). Label next to line saying “Budget line slope = -Px/Py”. Area underneath slope is shaded in and labelled “Budget Set”.
Define ‘budget set’
All bundles of 2 products that are affordable at given prices and income
What’s the name for ‘all bundles that are affordable at given prices and income’?
Related to budget constraints
Budget Set
Describe the interpretation of the slope of the budget constraint graph
Slope of the budget line: the opportunity cost
How much of good 𝑦 is the consumer willing to give up in order to have more of
good 𝑥 (with the same income 𝑚)?
pbottom rightx x + pbottom righty y = m (1)
pBottom rightx (x+∆𝑥) + 𝑝bottom right𝑦 (y+∆𝑦) = m(2)
Subtracting (1) from (2):
𝑝bottom right𝑥 ∆𝑥 + 𝑝bottom right𝑦 ∆𝑦 = 0
Or
∆𝑦/∆𝑥 = −𝑝bottom right𝑥/𝑝bottom right𝑦
Slope is negative because
purchasing more of B means
less income for A or vice versa.
Describe the factors that affect the budget constraint’s position
Include description of graphical changes
The slope and position of the budget constraint are a function of two
factors: income and relative prices:
1. Changes in income shift the budget constraint by changing the intercept;
2. Changes in the price of one good pivots the budget line by changing the slope
Comparative statics 1: a change in PY
A change in Py changes the y-intercept and the slope:
Decrease in Py increases the y
intercept (able to buy
more) and increases
the size of the slope (in
absolute value);
Increase in Py decreases the y
intercept (able to
buy less) and
decreases the size of
the slope (in
absolute value)
- x-intercept stays the same regardless
Comparative statics 2: a change in PX
A change in Px changes the x intercept and the slope
Decrease in Px increases the x
intercept (able to buy
more) and decreases
the size of the slope (in
absolute value);
Increase in Px decreases the x
intercept (able to
buy less) and
increases the size of
the slope (in
absolute value)
- y-intercept stays the same regardless
Comparative statics 3: a change in M
A change in M (income) changes the x and y intercept but not the gradient of slope:
An increase in M
increases the x and y
intercept;
A decrease in M
decreases the x and
y intercept
Describe the types of taxes and subsidies and their effects on price. Also describe rationing
Value tax (also known as ad valorem tax): tax on the value (price) of purchased
good or service
If the price of the good is 𝑝, then cost for the consumer will be:
(1 + 𝜏)𝑝 or 𝑝 + 𝜏𝑝
where τ is the value tax.
Quantity tax: per purchased unit
If the price of the good is 𝑝, then cost for the consumer will be 𝑝 + 𝑡
Where 𝑡 is the quantity tax.
Buyers pay a higher price than sellers receive, so we have 𝑃𝑑 = 𝑃𝑠 + 𝑡𝑎𝑥. We can also
express it as 𝑃𝑠 = 𝑃𝑑 − 𝑡𝑎𝑥, where 𝑃𝑑 is the price paid by buyers and 𝑃𝑠 is the price
paid by sellers
Value subsidy: government gives you back a share (%) of purchased good or
service:
(1 − 𝜎)𝑝
where σ is the value subsidy and 𝑝 is the original price of the good.
Quantity subsidy: per purchased unit
𝑝 − 𝑠
Where 𝑠 is the quantity subsidy.
Buyers pay a lower price than sellers receive, so we have 𝑃𝑑 = 𝑃𝑠 − 𝑠𝑢𝑏𝑠𝑖𝑑𝑦. We can
also express it as 𝑃𝑠 = 𝑃𝑑 + 𝑠𝑢𝑏𝑠𝑖𝑑𝑦, where 𝑃𝑑 is the price paid by buyers and 𝑃𝑠 is
the price paid by sellers
Lump-sum tax: government takes away a fixed amount, regardless of the
consumer’s behaviour. The budget line will shift inward, because the income was reduced.
Rationing: maximum level of consumption is fixed. Example: good 𝑥 is rationed so that no more than xbar can be consumed by one
consumer.
Combinations of taxes, subsidies and rationing: Good 𝑥 can be consumed at price 𝑝 below quantity 𝑥bar, and then a tax 𝑡 can be
introduced, so that the cost for the consumer becomes (𝑝 + 𝑡) for any additional unit
Describe the types of subsidies and their effects on price
Value subsidy: government gives you back a share (%) of purchased good or
service:
(1 − 𝜎)𝑝
where σ is the value subsidy and 𝑝 is the original price of the good.
Quantity subsidy: per purchased unit
𝑝 − 𝑠
Where 𝑠 is the quantity subsidy.
Buyers pay a lower price than sellers receive, so we have 𝑃𝑑 = 𝑃𝑠 − 𝑠𝑢𝑏𝑠𝑖𝑑𝑦. We can
also express it as 𝑃𝑠 = 𝑃𝑑 + 𝑠𝑢𝑏𝑠𝑖𝑑𝑦, where 𝑃𝑑 is the price paid by buyers and 𝑃𝑠 is
the price paid by sellers
Describe a budget constraint graph of budget set with
rationing
y-axis labelled “M/Py”, x-axis labelled “M/Px”. Negative straight slope labelled “Budget line”. Vertical line from x-axis to slope labelled, at x-axis, “xbar”. The negative slope is a dotted line from xbar onwards. Area to the left of xbar and underneath slope is shaded and labelled “Budget Set”.
Describe a budget constraint graph of budget set
with taxing consumption greater than xbar
y-axis labelled “M/Py”, x-axis labelled “x”. Negative straight slope labelled “Budget line”. Vertical line from x-axis to slope labelled, at x-axis, “xbar”. Budget line size of slope increases after xbar. At slope before xbar labelled “Slope = -pbottom rightx/pbottom righty”. At slope after xbar labelled “Slope = -(pbottom rightx + t) / pbottom right y”. All of area underneath slope is shaded and labelled “Budget Set”
What is the difference between “budget set” and “budget line”?
The budget set shows all consumption bundles that can be purchased
with a given budget, the budget line shown all consumptions bundles that can be
purchased using all of the revenue.
If the revenue of considered representative consumer doubles, do you expect
the slope of the budget line to change?
No, if prices of goods do not change the slope of the budget line will
not change. The intercepts will change and the budget line will shift
