Consumer Theory Flashcards
(21 cards)
What is utility?
The satisfaction derived from the consumption of a product.
What is diminishing marginal utility?
Refers to the tendency for the additional satisfaction from consuming extra units of a good to fall.
What is an indifference curve?
A curve that shows the consumption bundles that give the consumer the same level of satisfaction.
(Convex Shape)
What is marginal rate of substitution (MRS)
Represents the slope of the indifference curve at any point.
MRS = -(MUx/MUy)
What are perfect substitutes and complements?
Substitutes: Two goods with straight line indifference curves.
Complements: Two goods with right-angle indifference curves. (MRS = 0)
What is an economic bad?
A good which reduces satisfaction, therefore it has a positive indifference curve slope.
What is a neutral good?
No satisfaction gained from consumption so the indifference curves are vertical.
What is a budget constraint?
The limit on the consumption bundles that a consumer can afford.
What is the budget equation and what is the slope?
xPx + yPy = M
Slope = -Px/Py
How does the budget constraint change with the income effect?
A rise in income causes it to shift to the right.
A fall in income causes it to shift to the left.
How does a change in the price of good change the budget constraint? (substitution effect)
A change in price causes the budget constraint to pivot.
Graphically, where is the consumer’s optimum?
MRS = Px/Py
Slope of the indifference curve = Slope of the budget line
What is a normal good?
A good which a consumer buys more of as their income rises.
(Change in X / Change in M) > 0
What is an inferior good?
A good which a consumer buys more of as their income decreases
(Change in X / Change in M) < 0
What is the substitution effect?
The relative price (opportunity cost) of a good or service rises, people seek substitutes, so the quantity demanded of the good or service decreases.
What is the income effect?
When the price of a good or service rises relative to income, people cannot afford all the things they previously bought.
What is the net effect of a price increase (Normal good) on an indifference curve?
Income effect - Up
Substitution effect - Up
Total effect - Up
What is the net effect of a price increase (Inferior good) on an indifference curve?
Income effect - Up
Substitution effect - Down
Total effect - Down
Income and substitution effect move in opposite ways
What is the order of indifference curve theory?
- Pivot budget line (Substitution effect)
- Shift new budget line to create compensated budget line which touches old indifference curve (Income effect)
How do you derive demand from indifference curves?
As the price of a good increases, the budget constraint swings inwards. Drop a line down from indifference curve diagram to demand and supply diagram.
What are the limitations of indifference curves?
- Consumers may not behave rationally.
- Almost impossible to derive.
- Certain goods will only be purchased now and again
