Consumer theory underlies
the demand curve
Producer theory underlies
the supply curve
Two key components of utility maximization
Consumer preferences when faced with a choice
Consumer budget constraint – given their resources, what can they afford?
What are the three preference assumptions to underlie our model of indifference curves?
Completeness, transitivity, non-satiation
if you’re comparing two bundles of goods, you prefer one, the other or you’re indifferent (I don’t know isn’t an option)
If a is preferred to b, b is preferred to c, then a is preferred to c
“More is better” assumption, you always want more of something ; you might barely prefer a little bit more, but you’ll always want more no matter what
Indifference curves map preferences, allowing us to model how we think a consumer will behave
Specifically, this is the curve that shows all the consumption bundles among which the consumer is indifferent.
Properties of indifference curves
Higher is better (further you are from the origin)
Indifference curves never cross
There is only one indifference curve for any given bundle
The underlying measure of wellbeing; mathematically represents preferences
How can we interpret the number of utils?
This is an ordinal concept (not cardinal); the “number” of utils are meaningless; they just let us rank what makes me happier
Any normal transformation of a utility function will always give us the same answer – the ranks won’t change
The derivative of the utility function with respect to the quantity of goods
Diminishing marginal utility
Negative correlation between quantity and incremental happiness; The more of something you get, the less incrementally happy it makes you.
What determines the slope of the indifference curve?
The slope measures the rate at which you’re willing to give up one good to get another
Marginal rate of substitution
MRS = -ΔY/ΔX = -MUx / MUy
The rate at which you’re willing to trade the y-axis for the x-axis; This is telling you how the marginal utility evolves as you move down the indifference curve.
Two fundamental components of consumer theory
The two fundamental components of consumer theory are (1) what the consumer wants, i.e. their preferences, and (2) what the consumer can afford, i.e. their budget constraint.
The property “only one indifference curve passes through each bundle” is associated with what assumption about preferences?
The property “indifference curves farther from the origin are better” is associated with what assumption about preferences?
The property “indifference curves never cross” is associated with what assumption about preferences?
The property “indifference curves are downward sloping” is associated with what assumption about preferences?
Are marginal utilities positive, negative, or could they be both?
Marginal utilities are always positive because we always derive additional utility from more of every good.
What did we learn from the UK child tax credit reform natural experiment?
When women controlled the money, they spent more money on children’s clothes, and less on alcohol and cigarettes. The fact that women and men spent the money differently either means that one or both were not maximizing family welfare, or that they had different ideas about how to maximize family welfare. The results suggest that money intended for children may not be being spent in their best interest, which suggests a role for the government to intervene on the children’s behalf.
Another name for the slope of the indifference curve?
Marginal rate of substitution; MRS is the ration of marginal utilities
MRS = - MUx/MUy = -dU/dx / dU/dy
diminishing as you move along the indifference curve
Budget constraint over two goods X and Y is defined as:
I = px * X + py Y
Marginal rate of transformation
Represents the slope of…?
slope of the budget constraint
the rate at which you can transform one good into the other in the marketplace
MRT = -px/py
What changes the slope of the budget constraint?
shifts in price and income alter the position and slope of the budget constraint
How does a consumer choose an optimal bundle?
Defined by the point of tangency between the indifference curve and budget line
MRS = -MUx/MUy = - dU/dx / dU/dy = -px/py = MRT
MRS = MRT is equivalent to
equating the marginal cost and benefit of consuming each good
What happens if there is a flat indifference curve?
There maybe corner solutions, in which the consumer only consumes one good. In most cases, there is only an interior solution - in which the consumer consumes some of each good
How can we use constrained optimization to derive the demand curve?
We can use the constrained optimization problem to derive the demand curve. In other words, as we change prices of goods, we can observe how quantities demanded for those goods change, thereby tracing out the demand curve (the relationship between quantity and price demanded)
As you change income, you can trace out the relationship between income and consumption - aka the Engel Curve
Income elasticity of demand equation
= dQ/Q / dY/Y
Normal goods definition & what is the income elasticity - positive or negative?
Income elasticity is positive, so as income rises, you consume the same or more of these goods
consumption declines when income increases
& what is their income elasticity?
goods with income elasticity < 1; goods where you spend a smaller share of your income on them as income goes up (like food); Not saying that you buy less food as income rises - only that you spend a smaller fraction of your income on food as income rises
Luxuries & what is the income elasticity?
goods with income elasticity > 1, goods where you spend a larger share of your income on them as income rises (like cars, jewelry)
What two effects does an increase in price have?
It makes the consumer relatively poorer (income effect) and it also make this specific good less attractive relative to alternatives (substitution effect)
The shift in goods consumed from the original point to the optimal point for a budget constraint that has a new slope but is tangent to the old indifference curve.
The substitution effect is always negative, but the income effect can be positive.
When will the effect of a price increase be negative or positive?
Accordingly, the overall effect of a price increase on consumption of a good can be negative (for a normal good) or positive, if the good is inferior and the income effect is larger than the substitution effect.
A good with a positive own-price elasticity
As the price rises, you’ll consume more of the good (even though it is inferior and you’d typically consume less of the good). I.e. as the price of rice declines, you’ll buy the same amount & use extra money to eat better food vs. the price falling & your demand going up for rice.
Explain how labor supply relates to income and substitution effects
leisure (time not spent working) is a consumption good
– the price of that good is the wage since that is the opportunity cost of time not spent working.
– When the wage rate increases, this also has both an income effect and a substitution effect.
∗ Income effect: each worker is now richer, and may want to work less (consume more leisure).
∗ Substitution effect: returns to working are higher, each worker may want to work more.
∗ If the income effect more than offsets the substitution effect, labor supply may go down when income increases.
The value of the next best foregone alternative
the entire area under the curve; all opportunities available to you
An increase in income, increases demand.
A decrease in income, decreases demand.
An increase in income, decreases demand.
A decrease in income, increases demand
Income elasticity of demand
eY = % change in quantity demanded / % change in income
Shows the responsiveness of quantity demanded to c change in income, all other things unchanged (including price); reflects a shift in the demand curve at a given price.
Price elasticity of demand
Reflects movements along a demand curve in response to a change in price.
eD = % change in quantity demanded / % change in price or [delta Q / Q] / [delta P/P]
Always negative! (Demand has a negative correlation to price)
Positive income elasticity of demand means…
income and demand move in the same direction - an increase in income increases demand, and a reduction in income reduces demand (normal good)
Negative income elasticity of demand means…
the good is inferior. An increase in income reduces demand for the good.
Why are elasticity and slope different?
The slope of a line is the change in the value of the variable on the y-axis divided by the change in the value of the variable on the x-axis between two points.
Elasticity is the ratio of the percentage changes (vs. the values/levels).
Even with a linear demand curve, slope will be constant but the elasticity will change.
Normal good, with income elasticity > 1
As your income goes up, you spend a larger share of your budget on these goods.
Normal good with income elasticity < 1, > 0
As your income goes up, you spend a smaller share of your budget on these goods.
Good with income elasticity > 0
Good with income elasticity < 0
Cross price elasticity equation
eA,B = % change in quantity demand of good A / % change in price of good B
Cross price elasticity definition
Defines whether two goods are substitutes, complements, or unrelated. If substitutes - an increase in the price of one will lead to an increase in the demand for the other - the cross-price elasticity of demand is positive. If two goods are complements, an increase in the price of one will lead to a reduction in the demand for the other - the cross-price elasticity of demand is negative. If the two goods are unrelated, a change in the price of one will not affect the demand for the other - the cross-price elasticity of demand is zero