CHAPTER 5
ALWAYS DEFINE THE DIRECTION! MRS (marginal rate of substitution of food for clothing) How can this be rewritten and how should each be placed on a graph?
Maximum amount of clothing (vertical axis) that a consumer is willing to give up in order to obtain one additional unit of food (horizontal axis). How much the consumer values food with respect to clothing. A high value of MRS means that the consumer is willing to give up a lot of clothing for one additional unit of food (that is, values food a lot).
To explain the theory of consumer behavior, we will ask whether........
consumers prefer one market basket to another.
When the MRS diminishes along an indifference curve, the curve is....
convex
resume on page 177
convexity
For Convex indifference curve, MRS is: Mixing is:
diminishing good
MRS ____________ as we move down the indifference curve.
falls
For concave indifference curves, the MRS increases or decreases?
increases
for concave indifference curve, MRS is: Mixing is:
increasing bad
Price ratio is how _____________ _______________ good (x) with respect to good (y).
market values
marginal rate of substitution (MRS) definition:
maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good.
An upward sloping indifference curve defined over two goods violates which of the following assumptions from the theory of consumer behavior?
more is preferred to less
Intersecting indifference curves contradicts our assumption that......
more is preferred to less. Transitivity is violated.
For concave indifference curves, the slope is always.......
negative (do more research here)
Utility:
numerical score representing the satisfaction that a consumer gets from a given market basket.
If Px/Py=3, what does this mean in real terms?
one can trade 3 units of good (y) for one unit of good (x) in the market. (think about the - sign, quantity slope formual, and the DMRS down the indifference curve to have this make sense.)
To note:
page 170 (demand consumer choices)
note:
page 173, table 5.1
Therefore, the the budget line and the indifference curve must be.....
tangent
For maximizing utility, unless there is a corner solution, the solution will occur where the highest indifference curve is.... Equivalent to that is the statement:
tangent to the budget constraint the MRS = the price ratio (px/py)
With a budget line, a change in the price of one good (with income unchanged) causes......
the budget line to rotate about one intercept and the slope changes.
Optimal consumption for marginal utility is such that the marginal utility per dollar of expenditure is......
the same across all goods.
The MRS at any point is equal in MAGNITUDE to....... What is the significance of the word magnitude here?
the slope of the indifference curve. magnitude is a positive number and the slope of an indifference curve is negative due to the downward shape of the curve.
What does the MRS measure?
the value that the individual places on 1 extra unit of a good in terms of another.
Some goods, such as air pollution and mold in buildings, may be undesirable, and consumers will always prefer less. How do we deal with this? To discuss.....
to discuss preferences for clean air or removal of mold. We ignore these "bads" in the context of our immediate discussion of consumer choice bc most consumers would not choose to purchase them.
Utility level does not necessarily show you have _______________
twice more satisfaction
Can indifference curves ever have a positive slope?
typical no, but there is an exception: A positive slope would be the case when we have one of the good as Bad i.e a commodity for which lesser is better holds like pollution or something a consumer doesn't like.
Cobb douglas utility function:
u(X,Y) = X^aY^b
Perfect substitutes utility function:
u(X,Y) = aX + bY
perfect complements utility function:
u(X,Y) = min {aX,bY}
The shape of an indifference curve describes how a consumer is......
willing to substitute one good for another.
What if MUx/Px>MUy/Py?
your marginal utility of spending an extra dollar on X is greater than Y. Then, you will shift your budget to consumption of X.
For perfect complements, the marginal rate of substitution of one for the other is either ___________ or ______________
zero infinite
formula for a balanced market basket as a consequence of DMRS:
(y1+y2)/2, (x1+x2)/2
slope of a budget line formula: explain each variable.
-(Px/Py) The slope of the budget constraint is the negative of the PRICE OF THE GOOD on the x axis divided by the PRICE OF THE GOOD of the y axis. NOTICE here that the formula is flipped opposite to what a normal slope formula would be (y/x).
The theory of consumer behavior begins with 4 basic assumptions about people's PREFERENCES for one market basket to another: REMEMBER: preferences ignore costs!!
1. Completeness Preferences are assumed to be complete. Thus a consumer will be indifferent to market baskets or equally satisfied with either basket. 2. Transitivity Preferences are transitive. If a consumer prefers basket A to B, and basket B to C, then the consumer also prefers A to C. 3. More is better than less Goods are assumed to be desirable. To be good!! Consequently, consumers ALWAYS prefer more of any good to less. In addition, consumers are NEVER satisfied or satiated; more is always better, even if just a little better. 4. CONVEXITY, The decline is the MRS reflects our fourth assumption regarding consumer preferences: a diminishing marginal rate of substitution.
consumer behavior is best understood in 3 distinct steps:
1.consumer preferences 2.budget constraints 3.consumer choices
(consumer choice) What if MRS < Px/Py?
In this case, the consumer values good X with respect to good Y relatively less than the market. The consumer is willing to give up one unit of good X for less units of good Y than what he actually receives in the market. The consumer would prefer to consume less good X and more good Y and the reallocation of the budget continues in this manner until the consumer reaches market equilibrium point.
What does IC stand for?
Indifference curve
What is the shape of the indifference curve for perfect complements:
L-shaped
MUx/MUy =
MRS which is also equal to -(change in Y/change in X)
MRS formula:
MRS = -(slope) = -(change in y/change in x) Remember that Y2 - Y1 here can be tricky, usually the lower one is y2. (see slide 8)
the slope/change in utility is calculated as:
MUx/MUy
Can indifference curves cross/intersect? Why?
NO Transitivity is violated bc more is better.
Do the 3 basic assumptions of consumer theory explain consumer preferences?
No, but they do impose a degree of rationality and reasonableness on them.
Budget constraint formula: Explain what each variable means.
PxX + PyY = I The above states that the price of the good on the x-axis times the quantity of the good on the axis plus the price of the good on the y-axis time the quantity of the good on the y-axis has to equal income. NOTE: It's important to remember, that the budget constraint is the set of combinations of beer and pizza that yield an overall spend of all of the available income.
You will make the best consumption choice if you: (2)
Spend your entire budget Buy more of the goods that bring you the most satisfaction per dollar.
perfect substitutes:
Two goods that could be used for the same purpose. These goods may replace each other in use.
budget line Horizontal and vertical intercepts: Write the formulas.
When X=0 (vertical intercept); C=I/Px When Y=0 (horizontal intercept); Y=I/Py see slide 15
What if MUx/Px<MUy/Py?
You will shift you budget to consumption of Y.
a DMRS only applys to what curve?
a CONVEX indifference curve
Perfect complements:
a good that has to be consumed with another good.
For perfect substitutes, the MRS is
constant
the marginal rate of substitution of one for the other is a ______________
constant
for a straight line indifference curve, MRS is Mixing is
constant neutral
budget constraints defined:
constraints that consumers face as a result of limited incomes.
MRS represents what?
consumer preference and his/her willingness to trade good(x) for one additional unit of good(y).
Give a product example that results in a concave indifference curve:
addictive drugs
marginal utility definition:
additional satisfaction obtained from consuming one additional unit of a good. (derivative!!)
Budget line:
all combinations of goods that can be purchased given the consumer's income and the prices of the goods.
Bob view orange juice and apple juice as perfect substitutes. He is _______________ indifferent between a glass of one and a glass of the other.
always
An important consequence of DMRS, is that consumers prefer.......
average (well balanced) bundles over extreme bundles. That is, they prefer balanced market baskets. (see slide 9/18) study more...how do i know when to draw a straight line?
How does a budget line change when income increases or decreases? Does the slope change?
budget line shifts up or down the slope does not change bc the slope is dictated by the PRICE!!!!! (-(px/py)).
When graphing the budget constraint, it's usually easiest to....... How do you figure out where it hits?
figure out where it hits each of the axes first. consider how much of each good could be consumed if all available income was spent on that good. Basically, plug in zero for y if you want to find x and solve the equation.
Utility function defined:
formula that assigns the numerical score ( a level of utility) to individual market baskets.
indifference map
graph containing a set of indifference curves that describes a person's preferences and shows the market baskets among which a consumer is indifferent.
In order to graph a consumer's indifference curve, it helps first to graph..........
his/her individual preferences.
theory of consumer behavior
how consumers allocate incomes among different goods and services to maximize their well-being. Limited income vs unlimited wants
We can show a consumer's preferences graphically with the use of ________________
indifference curves
NOTE:
indifference curves CANNOT intersect Must know page 174/174 (transitivity / more,less)
The utility function provides the same information about preferences that __________________ does. Both order consumer choices in terms of ____________________
indifference map levels of satisfaction
The maximizing market basket (indifference curve) must satisfy two conditions:
it must be located on the budget line must give the consumer the most preferred combination of goods and services.
What is an indifference curve?
it represents all combinations of market baskets that provide a consumer with the same level of satisfaction. That person is therefore indifferent among the market baskets represented by the points graphed on the curve.
Market basket or bundle
list with specific quantities of one or more goods. This is how a consumer might compare different groups of items available for purchase. Think of market basket as a shopping cart that contains various items.
The utility function is simply a way of ______________ different market baskets; the _______________ of the utility difference does not really tells us anything.
ranking magnitude
How do you solve for the maximum utility for perfect complements when the consumer consumes with EQUAL PARTS:
since it is equal parts Q1 must equat Q2 in order to have maximum utility. Therefore set Q1 = Q2 in your budget line equation and solve. ex. 1.) PxQx + PyQy = I 2.) set Qx = Qy 3.) PxQx + PyQx = I, then solve and you have your quantities for both since Qx = Qy.
Indifference curves slope which way? Due to what assumption?
slope downward from left to right due to the assumption that more is better than less.
For maximizing market baskets, the slope of the indifference curve =
slope of the budget line (indifference curve slope)MRS = Px / Py(budget line slope)
(consumer choice) What if MRS > Px/Py?
the consumer values good X with respect to good Y more than the market. For one extra unit of good X, the consumer is willing to give up more units of good Y than what is actually necessary in the market. The consumer would prefer to consume less of good Y and more of good X and the reallocation of the budget continues in this manner until the consumer reaches market equilibrium point.