ppt 2, 6: consumer choices (cardinal utility and ordinal preferences theory)

Question 1

budget constraint

Answer 1

the limit on the consumption bundles (combinations of products consumed) that a consumer can afford

Question 2

utility

Answer 2

the capacity of a good to service a want (benefit/satisfaction, basically) -> SUBJECTIVE

Question 3

marginal utility

Answer 3

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

Question 4

optimal consumption bundle

Answer 4

the consumption bundle that maximizes a consumer’s total utility given his or her budget constraint.

Question 5

optimal consumption rule

Answer 5

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)

Question 6

indifference curve

Answer 6

a curve that shows consumption bundles that give the consumer the same level of satisfaction

Question 7

marginal rate of substitution (MRS)

Answer 7

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

Question 8

why are higher indifference curves preferred to lower ones?

Answer 8

because it represents larger quantities of goods -> consumers usually prefer more of something than less of it

Question 9

why are indifference curves downward sloping?

Answer 9

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)

Question 10

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.

Answer 10

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)

Question 11

Why are indifference curves bowed inward?

Answer 11

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

Question 12

perfect substitutes

Answer 12

two goods with straight-line indifference curves i.e. nickels and dimes

Question 13

perfect complements

Answer 13

two goods with right-angle indifference curves i.e. left and right shoes

Question 14

Why is the indifference curve tangent to the budget constraint?

Answer 14

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)

Question 15

What do we mean when we say that the slope of the budget constraint is equal to the relative price of two goods?

Answer 15

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.

Question 16

normal goods

Answer 16

goods for which demand increases when consumer income rises and decreases when consumer income falls ex. jewellery, luxury cars

Question 17

inferior goods

Answer 17

goods for which demand decreases when consumer income rises and increases when consumer income falls ex. instant noodles, public transport

Question 18

income effect

Answer 18

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)

Question 19

substitution effect

Answer 19

change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new MRS

Question 20

giffen good

Answer 20

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

Question 21

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?

Answer 21

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

Question 22

Under the Ordinal Preferences Theory, why do the units that utility is measured in do not matter?

Answer 22

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

Question 23

Why can’t you compare utility across people, like saying one person’s utility is higher than another?

Answer 23

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.

Question 24

ordinal preferences theory

Answer 24

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.

Question 25

How does the ordinal preferences theory compare and contrast to the cardinal utility theory?

Answer 25

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.

Question 26

law of equi-marginal utility

Answer 26

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

Question 27

how does the law of equi-marginal utility differ from the law of diminishing marginal utility?

Answer 27

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.