ppt 2, 6: consumer choices (cardinal utility and ordinal preferences theory) Flashcards
budget constraint
the limit on the consumption bundles (combinations of products consumed) that a consumer can afford
utility
the capacity of a good to service a want (benefit/satisfaction, basically) -> SUBJECTIVE
marginal utility
an increase in utility when consumption of a good increases by one unit i.e. studying for 1 extra hour increases utility of exam score from 80 to 90, which means the marginal utility of 1 hour is 10
optimal consumption bundle
the consumption bundle that maximizes a consumer’s total utility given his or her budget constraint.
optimal consumption rule
when a consumer maximizes utility, the marginal utility per dollar spent must be the same for all goods and services in the consumption bundle.
MU(c) / P(c) = MU(p)/P(p)
indifference curve
a curve that shows consumption bundles that give the consumer the same level of satisfaction
marginal rate of substitution (MRS)
the rate at which a consumer is willing to trade one good for another
ex. marginal value of fish (in terms of mangos) = price of fish (in terms of mangos, aka the opportunity cost, aka budget constraint)
if P(f) - $4, and P(m) = $1, then the price of fish is 4/1 = $4
why are higher indifference curves preferred to lower ones?
because it represents larger quantities of goods -> consumers usually prefer more of something than less of it
why are indifference curves downward sloping?
slope of an indifference curve reflects the rate at which consumers are willing to substitute one good for the other -> quantity of one good decreasing increases quantity of other good to compensate (negative relationship)
why can’t indifference curves cross? Consider the case of points A, B, and C, where A is on a lower indifference curve and C is on a higher indifference curve, and they intersect at B.
because if A is on the same indifference curve as B, and B is on the same indifference curve as C, that implies the options of consumption bundles A and C would make the consumer equally happy (which is not true, as C for example would have more of both goods)
Why are indifference curves bowed inward?
slope of an indifference curve = MRS
people are mor willing to trade away goods that they have in abundance and less willing to trade away. goods of which they have little
perfect substitutes
two goods with straight-line indifference curves i.e. nickels and dimes
perfect complements
two goods with right-angle indifference curves i.e. left and right shoes
Why is the indifference curve tangent to the budget constraint?
Slope of indifference curve = MRS, and slope of budget constraint = relative price of Pepsi and pizza
Thus, the consumer chooses consumption of the two goods so that the MRS equals the relative price (the optimum point)
What do we mean when we say that the slope of the budget constraint is equal to the relative price of two goods?
we mean that the slope of the budget constraint reflects the opportunity cost of consuming one good in terms of the other.
i.e. if good X is $2 and good Y is $1, the slope is 2/1 = 2. For every unit of good X, the consumer must give up 2 units of good Y.
normal goods
goods for which demand increases when consumer income rises and decreases when consumer income falls ex. jewellery, luxury cars
inferior goods
goods for which demand decreases when consumer income rises and increases when consumer income falls ex. instant noodles, public transport
income effect
change in consumption that results when a price change moves the consumer to a higher or lower indifference curve (usually higher if its normal good, but lower if inferior)
substitution effect
change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new MRS
giffen good
a good for which an increase in the price raises the quantity demanded
usually inferior goods, in which income effect dominates the substitution effect i.e. more expensive potatoes = more potato purchases and less meat as the consumer becomes poorer
Why would a person respond to a higher wage by working less? Analyze this using the income and substitution effects. In which direction do the labour supply curves go?
Substitution: As wage rises, leisure becomes more costly relative to consumption, encouraging a substitution of consumption for leisure -> labour supply curve slopes upwards
Income: Wage rises -> higher indifference curve = better off than before. Assuming consumption and leisure are normal goods, this increase in well-being will want to be used to enjoy both higher consumption and greater leisure -> labour supply curve slopes backwards (work less)
if substitution effect > income effect for X person = work more
if income effect > substitution effect = work less
Under the Ordinal Preferences Theory, why do the units that utility is measured in do not matter?
Theory focuses solely on the ranking of preferences rather than on the specific numerical values assigned to them.
Multiplying the utility by any number, such as 10, keeps the ordering of one combination relative to another
Why can’t you compare utility across people, like saying one person’s utility is higher than another?
Utility is subjective and is based on people’s own individual preferences, experiences, and circumstances. ex. two people might derive same satisfaction from eating pizza, but one person may be able to afford higher quality pizza than the other. OR, one person might like X pizza but another person doesn’t.
ordinal preferences theory
consumers make choices based on their preferences among various options, and these preferences can be ordered in a way that allows us to compare and rank them.
How does the ordinal preferences theory compare and contrast to the cardinal utility theory?
The ordinal preferences theory contrasts with the cardinal utility theory, which assumes that consumers can assign specific numerical values to their preferences. In this case, the units in which utility is measured do matter, since they affect the numerical values assigned to preferences. However, the ordinal preferences theory has the advantage of being more flexible and less vulnerable to problems such as the measurement of utility and the comparability of utilities across different individuals.
law of equi-marginal utility
a rational consumer will allocate their income in such a way that the utility obtained from the last unit of a good or service purchased is the same for all goods and services; consumers will always attempt to maximize total utility
how does the law of equi-marginal utility differ from the law of diminishing marginal utility?
the law of diminishing marginal utility focuses on how the satisfaction from additional units of a good decreases as consumption increases, while the law of equi-marginal utility focuses on how consumers allocate their income across different goods and services to maximize their total utility.
