9: Possibilities, Preferences and Choices Flashcards
What is the budget equation?
Expenditure = Income
(For two goods)
P1Q1 + P2Q2 = Y(Income)
What is a consumer’s real income in terms of a good? What does this represent in a budget line graph?
Income divided by price of that good
The x and y intercepts
What is the relative price of GOOD1 in terms of GOOD2?
What does this represent in a budget line graph?
Price 1 / Price 2 aka opportunity cost of good 1
Magnitude of the slope of the budget line. (If good 1 is on x-axis)
What is an indifference curve? Preference map?
Line that shows combinations of goods that a consumer equally prefers
Series of indifference curves
What is the marginal rate of substitution? What does MRS represent of the indifference curve?
The rate at which a person is willing to give up good ‘y’ to get an additional unit of good ‘x’ while remaining on the same indifference curve.
The magnitude of the slope of the indifference curve is MRS
What does the indifference curve look like when the two goods are:
- Ordinary goods (normal substitutes)
- Perfect substitutes
- Perfect complements
- Round curves
- Diagonal lines
- Corners
What is condition for a consumer’s best affordable choice?
- On the budget line
- Highest attainable indifference curve
- MRS between two goods = the relative price of those two goods
Price effect: Substitution effect
When the relative price of a good falls, the consumer always substitutes more of that good for other good while remaining on the same indifference curve.
Price affect: Income effect (normal good vs inferior good)
When the market gets more spending power, consumers are able to reach a higher indifference curve.
Normal good: With more income, it reinforces the substitution effect and normal good is bought more
Inferior good: With more income, it works against the substitution effect and inferior good is bought less.
