Module 4: Theory of Consumer Behavior Flashcards
1. Construct the budget constraint and indifference curve. 2. Determine consumer’s optimal choice using the budget constraint and indifference curve. 3. Analyze consumer behavior given the changes in income and prices of commodities
three basic decisions in household choices
- How much of each product, or output, to demand?
- How much labor to supply?
- How much to spend today and how much to save for the future?
Determinants of Household Demand
*product price
* income and wealth levels
* The household’s amount of accumulated wealth
* The prices of other products
* household preference
* The household’s expectations about future income, wealth, and prices
Households are free to choose what they will and will not buy.
Their ultimate choices are governed by their individual ______
preferences and tastes
As long as a household faces a limited budget— and all households ultimately do—the ____________is the value of the other goods and services that could have been purchased with the same amount of money.
real cost of any good or service
The real cost of a good or service is its __________
opportunity cost
________ is determined by relative prices
opportunity cost
Both ____ and ____ affect the size of a household’s opportunity set.
prices and incomes
If a price or a set of prices falls but income stays the same, the opportunity set gets _____ and the household is better off.
bigger
when money income increases and prices go up even more, we say that the household’s _____ has fallen.
“real income”
examines the trade-offs that people face as consumers.
theory of consumer choice
As individuals consume more of a good per time period, their ________ or satisfaction _____, but their ______diminishes.
total utility (TU), increases, marginal utility
The property of a good that enables it to satisfy human wants.
Utility
the extra utility received from consuming one additional unit of the good per unit of time while holding constant the quantity consumed of all other commodities.
Marginal utility (MU)
the arbitrary unit of measure of utility.
Marginal utility (MU)
Each additional unit of a good eventually gives less and less extra utility.
Law of diminishing marginal utility
It means that an individual can attach specific values or numbers of utils from consuming each quantity of a good or basket of goods.
Cardinal utility
this only ranks the utility received from consuming various amounts of a good or baskets of goods.
Ordinal utility
_______ only ranks various consumption bundles, whereas _______provides an actual index or measure of satisfaction.
ordinal utility, cardinal utility
Equating the ratio of the marginal utility of a good to its price for all goods
Utility-Maximizing Rule
A higher price for good increases its demand.
false, decreases
Equation of the Budget Constraint
PxX + PyY = I
Px
price of X
X
quantity of X consumed
PY
the price of Y
Y
quantity of Y consumed
I
household income
When the price of a good decreases, the budget constraint swivels to the _____, ____ the opportunities available and expanding choice.
right, increasing
When there is a rise in income, the budget constraint shifts _____.
outward
When the _____, the budget constraint swivels to the right, increasing the opportunities available and expanding choice.
price of a good decreases
When there is a fall in income, the budget constraint shifts ____.
inward
ASSUMPTIONS FROM INDIFFERENCE CURVE
- We assume that this analysis is restricted to goods that yield positive marginal utility, or, more simply, that “more is better”.
- The marginal rate of substitution is defined as MUx/MUy, or the ratio at which a household is willing to substitute X for Y.
- We assume that consumers have the ability to choose among the combinations of goods and services available.
- We assume that consumer choices are consistent with a simple assumption of rationality.
The _________ is defined as MUx/MUy, or the ratio at which a household is willing to substitute X for Y.
marginal rate of substitution
a curve that shows consumption bundles that give the consumer the same level of satisfaction
INDIFFERENCE CURVE
the rate at which a consumer is willing to trade one good for another
Marginal rate of substitution
The rate at which a consumer is willing to trade one good for the other depends on the amounts of the goods she is already consuming.
Marginal rate of substitution
A consumer’s set of indifference curves gives a complete ranking of the consumer’s preferences
TRUE
FOUR PROPERTIES OF INDIFFERENCE CURVES
- Higher indifference curves are preferred over lower ones.
- Indifference curves are downward-sloping
- Indifference curves cannot cross.
- Indifference curves are bowed inward.
two goods with straight-line indifference curves, constant MRS
Perfect substitutes
two goods with right-angle indifference curves
Perfect complements
a property of indifference curve which people usually prefer to consume more rather than less. This preference for greater quantities is reflected in the indifference curves
- Higher indifference curves are preferred over lower ones.
The slope of an indifference curve reflects the rate at which the consumer is willing to substitute one good for the other.
- Indifference curves are downward sloping
A situation like this can never happen. According to these indifference curves, the consumer would be equally satisfied at points A, B, and C, even though point C has more of both goods than point A.
- Indifference curves cannot cross.
hurley is willing to give more mangos for a fish if he has few fish (A) than if he has many (B).
- Indifference curves are bowed inward.
the point on the budget constraint that touches the highest possible indifference curve.
optimum
At the ______, slope of the indifference curve equals slope of the budget constraint
optimum
another example of “thinking at the margin”
consumer optimization
a good for which an increase in income raises the quantity demanded
normal good
a good for which an increase in income reduces the quantity demanded
inferior good
The fall of the price expands the consumers’ set of buying opportunities, it rotates the budget constraint _______.
outwards
The change in consumption that results when a price change moves the consumer to a higher or lower indifference curve.
INCOME EFFECT
The change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new marginal rate of substitution.
SUBSTITUTION EFFECT
a good for which an increase in price raises the quantity demanded.
Giffen good
If income effect > substitution effect
true
✓ Shows a person’s tradeoff between consumption and leisure.
✓ Depends on how much time she has to divide between leisure and working.
✓ The relative price of an hour of leisure is the amount of consumption she could buy with an hour’s wages.
Budget constraint
✓ Shows “bundles” of consumption and leisure that give her the same level of satisfaction.
Indifference curve
A higher wage makes leisure more expensive relative to consumption. The person chooses less leisure, i.e., increases quantity of labor supplied.
Substitution effect (SE)
With a higher wage, she can afford more of both “goods.” She chooses more leisure, i.e., reduces quantity of labor supplied.
Income effect (IE)
shows the possible combinations of different goods she can buy given her income and the prices of the goods.
budget constraint
The slope of the budget constraint ______ the relative price of the goods.
equals
shows the various bundles of goods that make the consumer equally happy
indifference curve
The consumer ________ by choosing the point on her budget constraint that lies on the highest indifference curve.
optimizes
the change in consumption that arises because a lower price makes the consumer better off.
income effect
the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper.
substitution effect
