C2: Consumption and Demand

Question 1

In our framework, what is the budget constraint?

Answer 1

budget y = p1q1 + p2q2

Question 2

What is the indifference curve?

Answer 2

a curve of consumption bundles (q1, q2) which yield equal utility

Question 3

What is the marginal rate of substitution?

Answer 3

The rate at which good 1 can be substituted for good 2 at constant utility:

MRS_1,2 = dU/dq1 / dU/dq2

also: the slope of indifference curves

Question 4

What are the properties of preference relations covered in the lecture?

Answer 4

Completeness: all consumption bundles can be compared
Transitivity: bundle a > bundle b, bundle b > bundle c implies bundle a > bundle c (=> indifference curves do not cross!)
Monotonicity: a* > a, b* > b => (a,b) > (a,b) (=> indifference curve is negatively sloped)
Convexity: a, b indifferent => weighted averages of a, b indifferent (=> indifference curve is convex!)

Question 5

What are perfect substitutes and perfect complements?

Answer 5

Perfect substitutes: individual is willing to substitute two goods at a constant rate (-> linear indifference curves)
Perfect complements: consumption at fixed rates -> orthogonal indifference curves

Question 6

How can we formulate the optimization problem for optimal consumption?

Answer 6

max_q1,q2 U(q1,q2) s.t. budget constraint

Question 7

What additional constraint holds for interior solutions of the optimization problem?

Answer 7

price rate = MRS

Question 8

How can goods be categorized in regards to their consumption under change of income?

Answer 8

more income -> more consumed: normal good

more income -> less consumed: inferior good

Question 9

What two effects does a price increase yield?

Answer 9

Substitution effect:
if good 1 becomes more expensive, more of good 2 will be consumed

Income effect:
increase in price -> decrease in purchasing power -> more of normal goods consumed, less of inferior goods consumed

Question 10

How can goods be categorized in regards to their consumption under change of their price?

Answer 10

higher price -> less consumption: ordinary good

higer price -> more consumption: giffen good

Question 11

What is the law of demand?

Answer 11

The observation that ceteris paribus the market deman for a good increases when its price decreases dQ/dp < 0