Rational Consumer

Question 1

Utility

Answer 1

Value or satisfaction a consumer gets from consuming goods and services

Question 2

Marginal Utility (MU)

Answer 2

Change in total utility from consuming one additional unit of a good or service

Question 3

Law of Diminishing Marginal Utility

Answer 3

As a consumer consumers more units of a good, additional satisfaction (MU) gained from each additional unit decreases

Ex: The more muffins you eat, the less satisfaction, sometimes it can even be negative

Question 4

Utility Maximization

Answer 4

Consumers allocate income to maximize total utility

The last $ you spend on a good should provide the same level of MU

Ex: If I spend $3 on a coke, I should get the same level of utility from that coke

Question 5

Budget Constraint

Answer 5

Representation of the combination of goods and services a consumer can purchase with a given income and set prices.

Ex: Given the prices of apples ($2) and oranges ($3.5), if I have a budget of $17, I can buy 5 ($10) apples and 2 oranges ($7).

Question 6

Optimal Consumption Bundle

Answer 6

Combination of goods and services that maximizes a consumer’s total utility given their budget constraint. MU per dollar needs to be equal for all purchases (MU of A/Price of A = MU of B/P of B.

Ex: I have a budget of $50 to spend on two goods: pizza and burgers. Pizza is worth $10 and burgers are worth $5. My utility (50) from pizza is such that I enjoy my first pizza more than my first burger (30), but each additional pizza gives me slightly less additional value (-10) compared to the burger (-5). After trying out different combos, I discover that 3 pizzas ($30) and 4 burgers ($20) maximizes my utility.

MU of 3rd Pizza (50- 10 - 10)/$10 = 3
MU of 4th burger (30 - 5 - 5 -5)/$5 = 3

Question 7

Income and Substitution Effects

Answer 7

Change in consumption resulting from a change in real income, income effect.
(Tea becomes cheaper so you buy more of it because you feel wealthier)

Change in consumption resulting from a change in relative prices, substitution effect.
(Tea becomes cheaper than coffee so you’re incentivized to get more of it)

Question 8

Normal and Inferior Goods

Answer 8

Normal: Demand increases as income increases

Inferior: Demand decreases as income increases (there are “sexier” alternatives)