Section3 Flashcards
What is utility in consumer demand theory?
The level of satisfaction derived from the consumption of a product.
Can we measure the utility? Can we measure and compare the utility obtained by consuming two goods? Can we compare the utility of two individuals?
What is the difference between cardinal and ordinal utility?
- Cardinal Utility: Belief that utility can be measured numerically. -> Early neo-classical economists
-
Ordinal Utility: Utility cannot be measured but ranked based on preferences. -> Modern consumer theory.
Implications:
➢ The utility values simply define a ranking of preferences rather than an actual cardinal
measurement.
➢ We cannot make interpersonal comparisons of utility.
What is the budget constraint?
The limit on consumption bundles a consumer can afford based on income.
An increase in income means that the consumer can
now buy more of both goods assuming that the
prices of the cola and pizza remain the same.
➢ The result is a shift in the budget constraint to
the right. Because the relative price of the two goods has
not changed, the slope of the budget constraint
remains the same.
Increase in PriceG2 causes the
budget line to pivot inward.
Decrease in PriceG1 causes
the budget constraint to pivot outward.
What does the budget line represent?
The budget line shows all combinations of goods that can be bought with a given income.
2 goods = 2 axes
PriceG1Good1+PriceG2Good2 = Income
Slope = ΔGood2/ΔGood1
What are indifference curves?
Curves that show consumption bundles giving the consumer the same satisfaction.
CONVEX
Four Properties of Indifference Curves
1. Higher indifference curves are preferred to lower ones.
▪ Any bundle lying above and to the right of one indifference curve is preferred to
any bundle on the indifference curve. “More is always better than less.”
2. Indifference curves slope downward from left to right.
▪ An upward sloping curve would violate the assumption that more of any
commodity is preferred to less.
3. Indifference curves do not cross.
4. Indifference curves are bowed inward.
People have consistent preferences that do not change during the period being
analyzed.
What are the key assumptions in consumer demand theory?
(4)
- Buyers are rational
- More is preferred to less
- Buyers maximise utility
- Consumers act in self-interest
What is the marginal rate of substitution (MRS)?
- The rate at which a consumer is willing to trade one good for another
- Equal to the slope of the indifference curve.
➢ A high MRS represents a great importance of the newly obtained good to the
consumer.
What is the income effect?
- Change in consumption due to a price change
- Moving the consumer to a higher or lower indifference curve
I dont understand the first point
What is the substitution effect?
- Change in consumption due to a price change
- Moving the consumer along an indifference curve.
What does the Engel curve show?
A line showing the relationship between income levels and the demand for a good.
Ernst Engel observed that as income rises, the proportion of income spent on food
decreases whereas the proportion of income devoted to other goods such as leisure,
increases.
▪ Engel curve is a line showing the relationship between demand and levels of income.
Utility and Willingness to Pay (WTP)
Utility can be measured in people’s willingness to pay (WTP) for different goods.
▪ How much a consumer is willing to pay for a good is a reflection of the value
that the consumer put on the good.
▪ The demand curve reflects the willingness to pay for a good.
Consumer behavior
Consumer behavior is best understood in three distinct
steps:
1) We will study the budget constraint
▪ Consumers have a limited income
2) Then we will turn to consumer preferences
▪ A description of why and how people prefer one good to
another
3) Finally, we combine consumer preferences and budget
constraint to determine the consumer choices that
maximize the level of satisfaction
➢Derive the demand function using figures
Key Assumptions:
1. Buyers are rational (they do the best they can given their circumstances).
2. More is preferred to less.
3. Buyers seek to maximize their utility.
4. Consumers act in self-interests and do not consider the utility of others.
Perfect Substitutes and Perfect Complements
Perfect Substitutes = \
Perfect Complements = L
Consumer Preferences Represented With a Function
▪ Total utility: the satisfaction gained from the consumption of a good or a bundle of goods.
A utility function U(cola,pizza) is a way to represent a preference order (U(c,p) = cp)
A utility function assigns a number to each bundle of goods so that more preferred bundles
get higher numbers
Numbers have no intrinsic meaning (ordinal approach)
▪ Marginal utility: the additional level of satisfaction obtained from the consumption of an
extra unit of a good.
▪ Diminishing marginal utility: decreasing marginal utility.
The Consumer’s Optimum
Δ𝐶/Δ𝑃 = 𝑀𝑅𝑆𝐶𝑃 = 𝑃rice𝑃izza/𝑃rice𝐶ola
Pizza = good1
Cola = good2
