Consumer Choice- Week 7

Four Properties of Indifference Curves

1. Higher indifference curves are preferred to lower ones. 2. Indifference curves are downward-sloping. 3. Indifference curves do not cross. 4. Indifference curves are bowed inward.

What do a consumer's set of indifference curves show us?

A consumer's set of indifference curves gives a complete ranking of the consumer's preferences - We can use the indifference curves to rank any two bundles

Indifference Curve

A curve that shows consumption bundles that give the consumer the same level of satisfaction

Utility

An abstract measure of the satisfaction or happiness that a consumer receives from a bundle of goods - Economists say that a consumer prefers one bundle of goods to another if one provides more utility than the other.

What causes the budget constraint to shift outward?

An increase in income (The new budget constraint will be parallel to the original because the slopes are still the same)

Why do indifference curves bow inward?

Because people are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little The indifference curves are bowed inward toward the graph's origin The bowed shape of indifference curves reflects the consumer's greater willingness to give up a good that they already has a lot of

How are indiff. curves and utility closely related?

Because the consumer prefers points on higher indifference curves, bundles of goods on higher indifference curves provide higher utility All bundles on an indiff. curve provide the same utility

Consumer Choice Theory

Consumers choose to buy the things that give them the greatest satisfaction, while keeping within their budget

Income and Substitution Effects When the Price of Pepsi Falls

For Pepsi: Income effect- the consumer is richer, so she buys more Pepsi Substitution effect- Pepsi is relatively cheaper, so consumer buys more Pepsi Total effect- The income and substitution effects act in the same direction, so consumer buys more Pepsi. For Pizza: Income effect- The consumer is richer, so she buys more pizza Substitution effect is that pizza is relatively more expensive, so consumer buys less pizza. Total effect- The income and substitution effects act in opposite directions, so the total effect on pizza consumption is ambiguous

Do consumers prefer higher or lower indifference curves?

Higher

Why are higher indifference curves preferred to lower ones?

Higher indifference curves represent larger quantities of goods than lower indifference curves (consumer's consumption of both goods is higher)

Why do indifference curves slope downward?

If the quantity of one good is reduced, the quantity of the other good must increase for the consumer to be equally happy. - The slope reflects the rate at which the consumer is willing to substitute one good for the other

Why can't indifference curves cross?

It will contradict the idea that a higher indifference curve will provide a consumer with a higher level of satisfaction

What is the equation for the MRS at the consumer's optimum?

MRS= Px/Py

What is the marginal utility of one good divided by the marginal utility of the other good equal to?

Marginal Rate of Substitution (the slope of the indiff. curve)

Slope of the Budget Constraint

Measures the rate at which the consumer can trade one good for the other Equals the relative price of two goods

The Indiff. Curve is ________________ to the budget constraint.

Tangent

What happens to the budget constraint and its slope when the price of a good falls?

The budget constraint will shift outward The slope will change. If the price of a good falls, then the slope of the new budget constraint will no longer be the same as the original

How do you know a consumer when a consumer is indifferent among combinations?

The combinations (points on the graph) will all lie along the same curve

What do the points that lie below a consumer's budget constraint tell us?

The consumer can afford that point, but it provides the consumer less satisfaction

What do the points that lie above a consumer's budget constraint tell us?

The consumer can't afford that point

At what point do consumers choose consumption of two goods?

The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price

At the consumer's optimum, what is the relationship between the relative price and marginal rate of substitution?

The consumer's valuation of the two goods (as measured by the marginal rate of substitution) equals the market's valuation (as measured by the relative price)

How do expanded budget constraints affect a consumer's indiff. curve?

The expanded budget constraint allows the consumer to choose a better combination of the two goods- one that's on a higher indifference curve

When two goods are substitutes, what does the indifference curve look like?

The indifference curve is less bowed

When two goods are hard to substitute for one another, what does the indifference curve look like?

The indifference curve is very bowed

What does the indifference curve look like for two goods that are perfect complements?

The indifference curves are right angles

What does the indifference curve look like when the marginal rate of substitution (mrs) is constant?

The indifference curves are straight lines

budget constraint

The limit on the consumption bundles that a consumer can afford Shows the trade-off between two goods that the consumer faces Shows the combinations of goods the consumer can afford given her income and the prices of the goods

What is the slope of the indifference curve?

The marginal rate of substitution between two goods

Marginal Utility

The marginal utility of a good is the increase in utility that the consumer gets from an additional unit of that good

Diminishing Marginal Utility

The more of the good the consumer already has, the lower the marginal utility provided by an extra unit of that good

Optimum

The point at which the indifference curve and the budget constraint touch

Marginal Rate of Substitution (MRS)

The rate at which a consumer is willing to trade one good for another

What is the marginal rate of substitution?

The rate at which the consumer is willing to trade one good for the other

What is the relative price?

The rate at which the market is willing to trade one good for the other

What does the marginal rate of substitution equal at the consumer's optimum?

The ratio of prices

Why does the slope of a budget constraint remain the same when it shifts outward?

The slope of a budget constraint will remain the same after a shift outward if the relative price of the two goods has not chang

What is the slope of the budget constraint?

The slope of the budget constraint is the relative price between two goods

Perfect Compliments

Two goods with right-angle indifference curves

Perfect Substitutes

Two goods with straight-line indifference curves

Normal Good

a good for which an increase in income raises the quantity demanded

Inferior Good

a good for which an increase in income reduces the quantity demanded

Giffen Good

a good for which an increase in the price raises the quantity demanded a good that violates the law of demand

Substitution Effect

the change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new marginal rate of substitution

Income Effect

the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve

Relative Price

the price of one good compared to the price of the other.