Week 4 - Consumer Theory Flashcards
Consumption bundle
A complete list of quantities of available goods that a consumer consumes
What factors make a consumption bundle good
preference and budget constraints
How are consumption bundles represented
Name = (Qx, Qy, Qz)
E.g., A = (4, 5, 8)
Ordering consumption bundles
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
Assumptions for ordering consumption bundles
Completeness, transitivity, reflexivity, non-satiation.
Completeness
Any 2 consumption bundles can be compared - no “I don’t mind” etc.
Transitivity
For any 3 consumption bundles, X, Y, Z, If X ≥ Y and Y ≥ Z, this implies that X ≥ Z
Reflexivity
For identical consumption bundles there is no preference between them X ~ X
Non-sanitation
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.
Law of demand
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.
Utility
A measure of the satisfaction a user receives from consuming a good/service.
A higher utility means more satisfaction.
Ordinal utility
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.
Cardinal utility
Both the ranking and difference between values of utility matter.
Indifference curve
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.
Indifference map
A graph showing multiple different indifference curves.
Marginal utility
the additional utility gained by consuming 1 more unit of a good/service, keeping all other quantities of goods constant.
Marginal utility formula
ΔUtility / ΔQuantity
Can also be found by doing the partial derivative of the utility function with respect to quantity.
Diminishing marginal utility
The marginal utility of a good/service decreases with each unit consumed.
Trade-offs
Keeping utility the same, how much of a good is the consumer willing to give up to get more unit of another good.
Marginal rate of substation (MRS₁,₂)
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.
Marginal rate of substitution formula
MRS₁,₂ = MU₁ / MU₂
MU₁ = Marginal utility of good 1
MU₂ = Marginal utility of good 2
Diminishing marginal rate of substitution
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.
Budget (m)
The total amount of money a consumer has to spend on a consumption bundle
Expenditure of a consumption bundle
X = (x1, x2)
Expenditure of bundle X ( E(X) ) = (p1 × x1) + (p2 × x2)
When is a consumption bundle feasible
m ≥ E(X)
Budget set
A set of all feasible consumption bundles
Budget line
A set of all consumption bundles that use all of the budget (m)
m = E(x)
How income and price effect budget line
Income increases/ decreases: budget line shifts right/ left
Price increases/ decreases: budget line becomes less/more steep
Optimal consumption bundle
A feasible consumption bundle (on the budget line) that has the highest utility.
Rational spending rule
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
Finding the optimal consumption bundle
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
