Week 4 - Consumer Theory

Question 1

Consumption bundle

Answer 1

A complete list of quantities of available goods that a consumer consumes

Question 2

What factors make a consumption bundle good

Answer 2

preference and budget constraints

Question 3

How are consumption bundles represented

Answer 3

Name = (Qx, Qy, Qz)
E.g., A = (4, 5, 8)

Question 4

Ordering consumption bundles

Answer 4

A > B: bundle A is strictly preferred to bundle B
A ≥ B: bundle A is weakly preferred to bundle B
A ~ B: the individual is indifferent between A and B

Question 5

Assumptions for ordering consumption bundles

Answer 5

Completeness, transitivity, reflexivity, non-satiation.

Question 6

Completeness

Answer 6

Any 2 consumption bundles can be compared - no “I don’t mind” etc.

Question 7

Transitivity

Answer 7

For any 3 consumption bundles, X, Y, Z, If X ≥ Y and Y ≥ Z, this implies that X ≥ Z

Question 8

Reflexivity

Answer 8

For identical consumption bundles there is no preference between them X ~ X

Question 9

Non-sanitation

Answer 9

More is better than less or at least more is not worse than less
E.g., if A has more of at least 1 item compared to B and no less of any others, then A will be preferred to B.

Question 10

Law of demand

Answer 10

As the cost (monetary and non-monetary) of a good/service rises, quantity demanded falls.
Comes from cost benefit principle - higher price will be higher than more consumers reservation price.

Question 11

Utility

Answer 11

A measure of the satisfaction a user receives from consuming a good/service.
A higher utility means more satisfaction.

Question 12

Ordinal utility

Answer 12

Only the ranking of utility matters, not the difference in utility values.
e.g., if U(A) is twice as big as U(B) then A is preferred but does not mean A is preferred twice as much.

Question 13

Cardinal utility

Answer 13

Both the ranking and difference between values of utility matter.

Question 14

Indifference curve

Answer 14

A curve showing all bundles that lead to the same value of utility.
Each value of utility has its own indifference curve.
A curve further away from the origin will have a higher utility.
Indifference curves are downwards sloping and cannot cross.

Question 15

Indifference map

Answer 15

A graph showing multiple different indifference curves.

Question 16

Marginal utility

Answer 16

the additional utility gained by consuming 1 more unit of a good/service, keeping all other quantities of goods constant.

Question 17

Marginal utility formula

Answer 17

ΔUtility / ΔQuantity
Can also be found by doing the partial derivative of the utility function with respect to quantity.

Question 18

Diminishing marginal utility

Answer 18

The marginal utility of a good/service decreases with each unit consumed.

Question 19

Trade-offs

Answer 19

Keeping utility the same, how much of a good is the consumer willing to give up to get more unit of another good.

Question 20

Marginal rate of substation (MRS₁,₂)

Answer 20

The quantity of good 2 that an individual is willing to give up in order to get 1 more unit of good 1.
It is the absolute value of the gradient of an indifference curve.

Question 21

Marginal rate of substitution formula

Answer 21

MRS₁,₂ = MU₁ / MU₂
MU₁ = Marginal utility of good 1
MU₂ = Marginal utility of good 2

Question 22

Diminishing marginal rate of substitution

Answer 22

Marginal rate of substitution is generally decreasing.
This is because as a consumer consumes more of good 1 they are willing to give up less of good 2 to remain at the same utility.

Question 23

Budget (m)

Answer 23

The total amount of money a consumer has to spend on a consumption bundle

Question 24

Expenditure of a consumption bundle

Answer 24

X = (x1, x2)
Expenditure of bundle X ( E(X) ) = (p1 × x1) + (p2 × x2)

Question 25

When is a consumption bundle feasible

Answer 25

m ≥ E(X)

Question 26

Budget set

Answer 26

A set of all feasible consumption bundles

Question 27

Budget line

Answer 27

A set of all consumption bundles that use all of the budget (m)
m = E(x)

Question 28

How income and price effect budget line

Answer 28

Income increases/ decreases: budget line shifts right/ left
Price increases/ decreases: budget line becomes less/more steep

Question 29

Optimal consumption bundle

Answer 29

A feasible consumption bundle (on the budget line) that has the highest utility.

Question 30

Rational spending rule

Answer 30

The optimal consumption bundle occurs when the MRS of 2 goods is the gradient the budget line: MRS₁,₂ = p1/p2
Can also be written as: MU₁ / MU₂ = p1/p2

Question 31

Finding the optimal consumption bundle

Answer 31

If MRS₁,₂ > p1/p2, buy more of good 1 and less of good 2
If MRS₁,₂ < p1/p2, buy less of good 1 and more of good 2