The theory of consumer choice Flashcards
What is the trade off that people face?
They buy what they want based on what they can afford
What are two things that might influence a trade off?
Budget constraints
Preferences
What do trade offs normally concern?
Consumption bundles of two goods
What does the budget constraint depict?
The limit on the consumption bundles that a consumer can afford
Why do people consume less than they desire?
Because their spending is constrained by their income
What does the budget constraint show?
The various combinations of goods the consumer can afford given their income and the prices of the two goods.
How does an increase in income shift the budget constraint?
It causes it to shift to the right
Why does the slope of the budget constraint remain constant when income changes?
The price of the goods doesn’t change so the slope remains constant.
What does the slope of the budget constraint line equal?
It equals the relative price of the two goods (the price of one good compared to the other)
What does the budget constraint measure the rate of?
The rate at which the consumer can trade one good for the other.
How does a change in the price of one good change the budget constraint? (2)
It will pivot inward or outward on the axis of the good that does not change in price.
It becomes steeper or flatter.
How does a change in the price of both goods influence the budget constraint?
The change in slope is dependent on the relative change in the prices of the two goods.
The budget constraint line pivots twice
What are the four important assumptions about preferences?
Completeness
Non-satiation
Transitivity
Diminishing marginal utility
What is meant by completeness?
People can always tell how they feel about consumption bundles
What is meant by non-satiation?
More is preferred to less
What is meant by transitivity?
A relation between three elements such that if it holds between the first and second and also holds between the second and third, then it must hold between the first and third.
What does diminishing marginal utility mean?
Significance declines as consumption of the good increases.
What is the utility function?
This is a function from consumption bundles to real numbers
What do higher utilities correspond to?
Higher utilities correspond to more preferred bundles.
What can utilities tell us about consumption bundles?
Their ranking
Can utility functions always be found?
Sometimes utility functions are not possible
Give an example of a utility function
U (pizza, cola) = 2 x pizza + 1 x cola
Bundle A (3, 1)= 3 x 2 + 1 x 1 = 7
Bundle B (1, 3)= 2 x 1 + 3 x 1 = 5
Bundle A is preferred to Bundle B
What does an indifference curve show?
Consumption bundles that give the consumer the same level of utility
What does it mean if the bundles are on the same indifference curve?
The consumer is equally happy with the bundles on the indifference curve
What does it mean if the bundles are on different indifference curves?
The consumer has different preferences for the bundles
Where can the marginal rate of substitution be found?
It can be found at any point on the slope of an indifference curve. Find two points and subtract the difference.
What is the marginal rate of substitution?
The rate at which a consumer is willing to trade one good for another
The amount of one good that a consumer requires as compensation to give up one unit of the other good.
What are the 4 properties of indifference curves?
Higher indifference curves are preferred to lower ones
Indifference curves are downward sloping
Indifference curves don’t cross
Indifference curves are bowed inwards
Why are higher indifference curves preferred to lower ones?
Consumers normally prefer more of something than less of it
Higher indifference curves represent larger quantities of goods than lower ones do
Why are indifference curves downward sloping?
A consumer is willing to give up one good only if they get more of another good
If the quantity of one good is reduced, the quantity of another good must increase
Why do indifference curves not cross?
This is due to transitivity and if they crossed it would contradict the idea that higher indifference curves are more preferred
Why are indifference curves bowed inwards?
People are willing to trade away goods they have in abundance.
These differences in a consumer’s marginal substitution rates cause the indifference curve to bow inwards
Define total utility
The satisfaction that consumers gain from consuming a product
Define marginal utility of consumption
The increase in utility that the consumer gets from an additional unit of that good
Define diminishing marginal utility
The tendency for the additional satisfaction from consuming extra units of a good to fall.
What is the marginal rate of substitution equivalent to?
The marginal rate of substitution equals the ratio of marginal utility of one good to the other good.
What type of indifference curve would two perfect substitutes have?
They would have straight-line indifference curves.
Why do perfect substitutes have a fixed number as their marginal rate of substitution?
The indifference curves have a constant slope and therefore a fixed ratio
What type of indifference curve would two perfect complements have?
They would have right-angled indifference curves.
What do the consumers want to get with their bundles?
They want to get the combination of goods on the highest possible indifference curve.
Where along the budget constraint can the consumer end up?
On or below the budget constraint
How can you find the consumer’s optimal choice?
Combine the indifference curve and the budget constraint.
Optimum choice occurs where the highest indifference curve and the budget constraint are at a tangent.
What is the slope of the indifference curve equal to?
The ratio of marginal utility
What is the slope of the budget constraint equal to?
Relative price
What happens at the optimum to the ratio?
The ratio of marginal utility is equal to the relative price.
What do prices reflect?
How people value things on the margin
What happens to the budget constraint if the income increases?
It shifts to the right and outwards
How does an increase in income affect the consumer?
They can choose a better combination of goods on a higher indifference curve.
What type of good is it if a consumer buys more of it when their income rises?
A normal good
What type of good is it if a consumer buys less of it when their income increases?
An inferior good
How can you tell from a budget constraint which is the inferior and normal good after an income increase?
If the consumption rises it is a normal good.
If the consumption decreases then it is an inferior good.
What does a decrease in the price of a good do to the budget constraint?
It makes it pivot, therefore the slope changes
What two effects does price change have on consumption?
Income effect
Substitution effect
What is the income effect?
This is the change in consumption that occurs when a price change moves the consumer to a higher or lower indifference curve
What is the substitution effect?
The change in consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution.
How can a consumer’s demand curve be derived?
From a summary of their optimal decisions that have arisen from their budget constraint and indifference curves
What is the price-consumption curve?
A line showing the consumer optimum for two goods as the price of only one of the goods changes
What type of good causes a demand curve to slope upward?
A Giffen good
What is a Giffen good?
A good where a consumer buys more of it as the price of it increases.
What law do Giffen goods violate?
The law of demand
Why do Giffern goods violate the law of demand?
The income effect dominates the substitution effect
