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ECON102 > Week 4 - Consumer theory > Flashcards

Week 4 - Consumer theory Flashcards

1
Q

Where does the demand curve come from?

A

consumers

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2
Q

Where does the supply curve come from?

A

producers

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3
Q

What are the 3 steps of what bundles of goods makes you best off?

A
  1. Preferences
  2. Budget constraints
  3. Put them together
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4
Q

What is a consumption bundle

A

(basket of goods) is a complete list of quantities for all available goods

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5
Q

What is the notation of a typical consumption bundle?

A

X = (x , x , x )
B C F

Eg A = (2, 5, 1) or A = (2 bananas, 5 coconuts, 1 fish)

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6
Q

What are the x and y axis of the consumption model eg?

A

eg
x = pizza
y = coke

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7
Q

What are the 3 ways of comparing a consumption bundle by any individual (preferences)?

A

If bundle A is strictly preferred to bundle B, then A>B

If bundle A is weakly preferred to bundle B, then A≥ B

If the individual is indifferent between A and B, then A~B

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8
Q

What are the three assumptions about individual preferences?

A
  1. Completeness
  2. Transitivity, Reflexivity
  3. Non-satiation, diminishing marginal utility
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9
Q

What is the completeness assumption?

A

for any pair of available consumption bundles X and Y, the individual can say whether X≥Y or Y≥X (or both)

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10
Q

What is the transivity assumption?

A

for any three consumption bundles, X, Y, Z
X≥Y and Y≥Z imply X≥Z

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11
Q

What is reflexivity?

A

(within transitivity)
for identical consumption bundles, there is no strong preference for either of them X~X

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12
Q

What is the non-satiation assumption?

A

more is better than less (at least more is no worse than less)

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13
Q

What does it mean if the bundle is further away from the axis on the preference graph

A

the ‘better’ they are, prefer those bundles (get more quantity)

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14
Q

What is the utility function?

A

it assigns each consumption bundle an index number of happiness (=total utility)

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15
Q

How can the utility function U(X) be used for any two consumption bundles?

A

for any two consumption bundles, X and Y, the utility function can be used to extract the individual’s preferences as follows:
if U(X) > U(Y) then the individual strictly prefers bundle X to Y
if U(X) = U(Y) then the individual is indifferent between consumption bundles X and Y

the utility function can take a variety of mathematical forms (to compare different assumption models)

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16
Q

What is the ordinal utility?

A

means that only the ranking of utility levels has a meaning - the difference between utility levels is meaningless

U(A) = 20 and U(B) = 40 does not mean that the individual prefers bundle B twice as much as A

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17
Q

What does it mean to be indifferent between X and Y?

A

if you neither prefer X to Y, nor Y to X, you are indifferent between X and Y, and you derive the same utility from both bundles:
U(X) = U(Y)

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18
Q

What shape are indifference curves?

A

always downward sloping

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19
Q

What is an example of axis on an indifference curve?

A

Pizza and coke
eg X1 = (3,4) and X2 = (4,3)
make a rectangle, both have utility of 12

all being utility of 12 means this individual is indifferent to all of these consumption models as they have the same utility

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20
Q

Where does the second indifference curve go when it has a greater utility than the other curve?

A

above, further away the better

higher utility levels lie further outwards (to the origin)

one indifference curve for each utility level

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21
Q

Why cant indifference curves cross example?

A

Eg
A and B on the same indifference curve A~B
B and C on the same indifference curve B~C

By transitivity A~C
But A is on a higher indifference curve than C
So A>C

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22
Q

What is marginal utility?

A

the additional utility generated by an additional unit of the good, holding the quantities of all other goods constant

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23
Q

How do you mathematically calculate the marginal utility of a good?

A

it is the partial derivative of U(x_1,…,x_n) with respect to x

MU_L = ∂U(x_1,…x_n) / ∂x_i

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24
Q

What is the diminishing marginal utility?

A

as an individual consumes more and more of some good, the additional utility gained from an additional unit of consumption decreases

25
Q

What is the marginal rate of substitution?

A

how much of one good a consumer will give up to get a bit more of another good (trade off)

26
Q

What does the marginal rate of substitution measure between any two goods 1 and 2 (MRS_1,2)?

A

measures how many units of good2 the individual is willing to give up (substitute) for 1 additional unit of good1, such that utility remains constant

27
Q

What is the marginal rate of substitution equation?

A

MRS_1,2 = MU_1 / MU_2

28
Q

Eg Q
Suppose that the additional utility Ted gains from an additional slice of pizza is 4. (Marginal utility of pizza is 4). The marginal utility of Coke is 3

How many cokes is Ted willing to give up to get an additional slice of pizza?

A

1 coke is 3 units of utility
1/3 of a coke is 1 unit of utility

1 and 1/3 of a coke is 4 units of utility
If you are giving up 1 and a 1/3 of coke, you will be losing 4 units of utility

So after the trade, gaining one slice of pizza (4 units of utility) and losing 1 and a 1/3 units of coke (4 units of utility), utility levels will be the same

Willing to give 4/3 cokes for 1 pizza slice
Pizza utility = 4 Coke utility = 3
MRS_p,c = MU_p / MU_c

(also the gradient of the indifference curve △y/△x
4/3 coke / 1 pizza)

29
Q

What changes as you move along the indifference curve?

A

the marginal rate of substitution

30
Q

How do we find the slope of the indifference curve?

A

draw a tangent at that point, find gradient
as you consume more and more pizza, coke is going to be more valuable so less willing to give up coke

31
Q

Why is the MRS is typically decreasing?

A

If i have alot of coke, but little pizza, an additional slice of pizza is worth a lot of coke. MRS_p,c is large

If i few cokes, but a lot of pizza, then an additional slice of pizza isnt worth many cokes. MRS_p,c is small

32
Q

What are budget constraints

A

individuals have money, income or a budget to finance consumption, denote this budget as m (assuming no savings), constraint individuals face stopping buying everything you want

33
Q

What is an assumption budget constraints have on individuals?

A

assume the budget/ income an individual has, they want to spend all that money, no savings

34
Q

What is the total expenditure for the consumption bundle?

A

Expenditures for consumption bundle X=(x_1 x_2)
Total expenditure of each consumption bundle depends on the price of each good and number of goods you consume
Total expenditure: E(X) = p1 x x1 + p2 x x2
(^price of good x no. you consume)

Eg p1 = £9 p2= £1 E(3, 4) = 27 + 4 = £31

35
Q

How do individuals make a judgement whether they can afford this consumption bundle?

A

if the amount of money the individual has is greater or equal to the expenditure of the consumption model then you can afford it

so, any consumption plan X is feasible if its expenditure doesnt exceed the budget, ie m≥ E(X)

36
Q

What is the budget set?

A

consists of all feasible consumption plans

consists of all bundles (x_p ; x_c) satisfying the budget constraint
ie m≥ (p_p) x (x_p) + (p_c) x (x_c)

37
Q

What is the budget line?

A

represents all the consumption bundles that exhaust the consumers income (no saving and no borrowing)
ie m= (p_p) x (x_p) + (p_c) x (x_c)
or x_c = (m/p_c) - (p_p/p_c) x (x_p)

38
Q

How do you visualise the budget set?

A

on a graph
number of consumptions of each good on the two axis
budget line is the line on the graph (downward sloping)
budget set is the area under the line

39
Q

Budget set graph example

A

pizza x axis x_p
coke y axis x_c

p_p = £3
p_c = £1
m = £9

Budget set: 3x_p + x_c ≤ 9
or x_c ≤ 9 - 3x_p

Budget line x_c = 9 - 3x_p
(bundles below this line can afford)

40
Q

How do you maximise utility according to the budget line?

A

you want to maximise utility, so the way to do that is to spend all you money (no savings, savings give you no utility)

41
Q

What does the steepness of the budget line tell us?

A

-(p_p / p_c) = -3/1 = -3
relative prices of the two goods determine the slope of the budget constraint

42
Q

What happens to the budget line when there is a change in income/ prices

A

Shift of the budget line

43
Q

Shift of the budget line example income increase

A

Income increases to 12 from 9
x_c ≤ 12 - 3x_p
instead of x_c ≤ 9 - 3x_p

44
Q

Shift of the budget line example price of coke triples to £3

A

x_c ≤ 3 - x_p
instead of x_c ≤ 9 - 3x_p

45
Q

What is the constrained optimisation problem?

A

something you want to maximise -> utility
something that limits how much of the good you can get -> constraint is the budget

46
Q

What is the optimal consumption bundle?

A

the feasible consumption bundle the maximises the consumer’s utility

47
Q

What is the optimal/rational spending rule?

A

if consumption bundle (x_1, x_2) maximises the utility of an individual, given her budget set, then it satisfies the condition

optimal consumer bundle: MRS_1, 2 = p_1 / p_2

^MRS can also be MU_1/ MU_2

if MRS_1,2 > P_1/ P_2 then buy more of good 1 and less of good 2
if MRS_1,2 < P_1 / P_2 then buy more of good 2 and less of good 1

48
Q

What does it mean if you are not at he optimal choice?

A

eg consuming many cokes and not many pizza, so we are willing to trade off alot of cokes to consume additional units of pizza

49
Q

What is income elasticity of demand?

A

the percentage change in Qd associated with a 1% change in consumer income
describes how responsive demand is to income changes

positive for normal goods
negative for inferior goods

50
Q

Budget variation: Eg as income rises, prices unchanged, the consumption of pizza falls why is this

A

the budget line has shifts right from income rising, point B (placed on new line) compared to point A is positioned where there is a reduction in pizza

so pizza is an inferior good, the income elasticity of demand for pizza is negative

51
Q

Applying optimal choice: price variation eg a rise in the price of pizza

A

Line changes where the line crosses the pizza x axis is now closer to 0

marginal utility is reduced and the rise in price of pizza leads to decreased consumption of pizza (substituting away from pizza, substitution effect)

move to a lower indifference curve on the new pizza line, consumption change of pizza as a result of income change, known as income effect

Two effects (substitution + income) gives us the decrease of consumption of pizza as a result of price increase

consumers may consume more/ less burgers, depending on whether these goods are substitutes or complements

as long as the consumer derives utility from both goods, a price increase will lower her utility

but if pizza an inferior good, income and substitution effect will go right instead

52
Q

Is the substitution effect always positive or negative?

A

negative

53
Q

What is the giffen good?

A

the income effect of a inferior good swamp the substitution effect (overwhelms the substitution effect)
(a good people consumer more as the price rises)

54
Q

What is the substitution effect?

A

consumers switching to cheaper products as prices increase

55
Q

When there is an increase in price of a normal good what will the: substitution effect, income effect and total effect be?

A

Substitution effect: -
Income effect: -
Total effect: -

56
Q

When there is an decrease in price of a normal good what will the: substitution effect, income effect and total effect be?

A

Substitution effect: +
Income effect: +
Total effect: +

57
Q

When there is an increase in price of a inferior good what will the: substitution effect, income effect and total effect be?

A

Substitution effect: -
Income effect: +
Total effect: ?

58
Q

When there is an decrease in price of a inferior good what will the: substitution effect, income effect and total effect be?

A

Substitution effect: +
Income effect: -
Total effect: ?

ECON102 (8 decks)

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