ECO2101 Consumer Theory (1) Flashcards
(152 cards)
1
Q
What are the four elements of consumer choice?
A
Consumers Income
Prices of goods
Consumer tastes
Rational Maximisation
2
Q
What do the elements of consumer theory: income and prices create?
A
The budget constraint
3
Q
What is the budget constraint?
A
The maximum affordable quantity of one good available to the consumer given the quantity of the other good being consumed. e.g., trade-off
4
Q
How are the intercepts and slope of the budget constraint determined?
A
Intercepts- income divided by price(max of one good)
Slope-determined by relative prices = -p1/p2
5
Q
What is the equation for the budget constraint?
A
m=p1x1+p2x2
where
m=money income
x1,x2 = goods
px,p2= prices
slope = -p1/p2
6
Q
What is the slope of the budget line called?
A
Economic Rate of Substitution (ERS)
ERS = -p1/p2
7
Q
How are different taxes added to the budget constraint?
A
Ad-valorem = p(1+t)
Other taxes = (p+t)
8
Q
What does rationing do to the budget constraint?
A
It puts a cap on consumption so the budget constraint becomes vertical or horizontal (depending on which good has the rationing).
9
Q
Draw a budget constraint with rationing
A
Check PowerPoint
10
Q
Draw a budget constraint with taxation
A
Check PowerPoint
11
Q
What are the assumptions on consumer preferences?
A
Completeness
Transitivity
Reflexivity
Non-Satiation
Continuity
Strict Convexity
12
Q
What is the notation for strictly preferred, weakly preferred and indifferent?
A
Strictly preferred = f
Weakly preferred = f or :
Indifferent = :
13
Q
What does the assumption completeness mean?
A
Consumers can rank alternative bundles according to the satisfaction/utility they provide
14
Q
Why is “completeness” ordinal not cardinal?
A
Consumer only has to say he prefers a to b, not to say by how much
15
Q
What does the assumption transitivity mean?
A
Preferences are assumed to be consistent e.g.
If a f b and b f c, then we would infer that a f c
16
Q
What does transitivity imply?
A
That no bundle can belong to more than one indifference set
17
Q
What does the assumption of reflexivity state?
A
Any bundle is preferred or indifferent.
any bundle is indifferent to itself
18
Q
If Completeness, Transitivity, and Reflexivity are all met what do we say about this bundle?
A
If satisfied, then consumer is said to have a “Weak Preference Ordering” (WPO).
19
Q
What does non-satiation mean?
A
Consumers always prefer more “goods” to less
19
Q
What does continuity mean?
A
Indifference curve set is a continuous line and has no gaps
20
Q
What does strict convexity state?
A
Given any consumption bundle (x1,x2) its better set ( bundles weakly preferred) is strictly convex
21
Q
Show strict convexity on a graph
A
Check PowerPoint
22
Q
What is the Marginal Rate of Substitution?
A
The quantity of good 2 (vertical good) that the consumer must sacrifice to allow an increase in the quantity of Good 1 without changing total utility.
23
Q
What does diminishing Marginal rate of Substitution assume?
A
That the increase in utility from consuming additional units of a good is declining.
24
What does diminishing MRS imply about indifference curves?
It implies that indifference curves are convex to the origin, becoming flatter as we move to the right.
25
What does diminishing MRS imply about the consumers mixture preference in the bundles?
It implies that consumers prefer bundles containing more even mixtures rather then extremes
26
What are some rules for indifference curve analysis?
Any point on the indifference map must lay on an indifference curve.
Indifference curves cannot cross
27
Give examples of bundles with convex, non-convex and concave indifference curves
Convex- consumer prefers averages e.g. bananas, apples
Non-convex- They don't like mixtures of goods brand loyalty e.g. Pepsi/Coke
Concave - consumers prefer extremes and don't like averages e.g. two different holidays
28
Can indifference curves cross?
No
29
Draw and explain what the indifference curves of perfect substitutes look like?
Indifference curves of perfect substitutes are flat
Check Ppt
30
Why are the indifference curves of perfect substitutes flat?
Because the consumer is willing to substitute one good for another across any point of the indifference curve.
31
Draw and explain the shape of perfect complements on an indifference curve?
Perfect compliments are right angled, they are right angles because the consumer gets no extra utility from consuming ine more of the good.
32
Draw and explain the shape of indifference curves for neutral goods?
The indifference curves of Neutral goods (x2 vertical) are a straight vertical line, this is because a neutral goods do not effect a consumers utility. So utility depends entirely on the other good(x1)
33
What is a neutral good?
Something that the consumer doesn't care about, something that doesn't affect utility.
34
What are goods and Bads on indifference curves?
Where one good the consumer likes and one good the consumer doesn't.
35
Draw and explain the shape of goods and Bads indifference curves
They are upwards sloping straight lines, this is because the consumer compensates the bad good with more of the good good.
36
What does Satiated Preferences mean?
A consumer with satiated preferences reaches a point of maximum utility at a specific bundle — called a satiation point. Beyond that, more is not better.
The satiation point (bliss point) is at the centre of the circular indifference curves
37
What do steeper indifference curves imply?
It implies relatively higher demand for the horizontal good.
38
What is the assumption of rational maximisation?
The consumer chooses the affordable bundle that maximises his utility
39
Where is the optimal choice bundle?
Where an indifference curve is tangent to the budget line
Also where MRS and ERS are equal
40
Draw an indifference curve with budget line in equilibrium (MRS=ERS)
Check Ppt
41
Draw an indifference curve with budget line not in equilibrium and show the difference in ERS and MRS
Check ppt
42
If goods are perfect substitutes which will the consumer purchase?
The cheaper one
43
Draw and explain the optimal choice for goods and bads.
The consumer will spend all money on the good he likes and none on the good he dislikes or is neutral towards.
44
What are necessary/sufficient conditions?
P is a necessary condition for Q if Q implies P
P is a sufficient condition for Q if P implies Q
45
When preferences are convex is tangency condition sufficient?
When preferences are convex tangency is sufficient, meaning any point that satisfies the tangency condition will be an optimum
46
Where is the optimal choice with concave preferences?
A boundary choice (touching axis)
Non-convex preferences imply you prefer extremes to averages
47
How do changes in income affect the budget constraint?
Increase in endowment income causes a parallel shift out of the budget constraint.
Opposite for decrease in income.
48
How do changes in prices affect the budget contraint?
An increase in prices causes a pivot inwards of the budget constraint.
Pivot around the good that stays the same price
49
How do price changes affect the optimal choice bundle in two different ways?
Firstly, relative prices change. This is represented by the change in the slope of the budget constraint.
Secondly, there is a change in purchasing power (real income).
50
How is an increase in real income from price changes shown on the budget constraint?
As the line shifts outwards, the area between the new and old line is the increase in consumers real income
51
What is a Giffen good?
A giffen goods are very inferior goods
52
Show how we can tell if a good is giffen or non-giffen following a price increase.
Check ppt
52
What is the income effect?
The adjustment of demand to a change in real income
53
What is the substitution effect?
The adjustment of demand to the change in relative prices.
54
How do we show the substitution and income effects on a graph (explain)?
After shifting the budget constraint, construct a new parallel budget constraint that is on the original indifference curve. The point on this fabricated budget constraint shows the sub effect. Then from this point to the one on the new constraint shows the income effect.
55
Show the income and substitution effect graphically.
Check Ppt
56
What is a Hicks Compensating Variation?
Compensating the consumer for the price change by hypothetically adjusting income after price change until we derive a tangency with the original indifference curve.
57
What is the effect of a fall in the price of a normal good?
Positive substitution and income effect
58
What is the effect of a fall in the price of an inferior good?
Positive substitution effect however a negative income effect.
59
What is an inferior good?
A good for which demand decreases as consumer income increases.
60
Draw a graph showing the income/sub effect on an increase in price of an inferior good
Check Ppt
60
Show the income/sub effect of an increase in price of a giffen good
Check ppt
61
Using necessary/sufficient describe inferior and giffen goods?
Inferiority is a necessary but not sufficient condition for giffeness.
Giffeness implies inferiority.
62
What is Slutsky Compensating Variation (SCV) in money income?
When we vary the consumers money income following a change in price, to permit him to consume his original bundle of goods at new relative prices.
63
Draw a slutsky compensating variation price fall and price rise
Check ppt
64
What is an equivalent variation in money income?
Changing the consumers money income at the original relative price so that he can enjoy a different indifference curve following a price change.
65
Draw a hicks equivalent variation price fall
check ppt
66
Draw a slutsky equivalent variation price rise
check ppt
67
What are the consumers (Marshallian) demand functions?
The optimal amount of each good as a function of prices and income
x1=x1(p1,p2,m)
x2=x2(p1,p2,m)
68
Draw a graph showing an increase in income and also how different areas of the graph with new income indicate whether a good is normal or inferior
check ppt
69
What is an Engel curve?
A curve that maps out the demand for a good as income changes.
70
What is an income offer curve?
It connects optimal bundles as we move the budget line out via an increase in income.
71
Draw an income offer curve
Check ppt
72
What is the slope of the Engel curve?
change(m)/change(x1)
73
What do the income-offer and engel curve look like for perfect substitutes?
check ppt
74
What do the income-offer and engel curve look like for perfect complements?
check ppt
75
expand u(x1,x2) using Cobb-Douglas
check ppt
76
How would you mathematically find the slope of the engel curve?
get an equation for x1 then rearrange for m and find the slope
77
What homothetic preferences?
Homothetic preferences are where the consumers optimal choice scales with income
78
What are examples of homothetic preferences?
Perfect substitutes and perfect compliments
(linear engel curve)
79
What are quasilinear preferences?
All indifference curves are vertically shifted versions of one indifference curve.
utility is linear in good 2 and non-linear in good 1.
Increasing income only changes demand for good 2.
80
What function do quasilinear preferences have u(x1,x2)?
u(x1,x2)=v(x1)+x2
81
What does the Income offer curve and engel curve of quasiliniear preferences look like?
check ppt
82
What is the price offer curve?
The price offer curve plots optimal bundles as we change p1 and hold p2 and m constant.
83
What is the demand curve?
the demand curve plots optimal consumption of good 1 holding price of good 2 and money income constant.
84
Show using graphs how the price offer curve can be used to derive the demand curve
check ppt
85
List whether changes in price of: perfect compliments/substitutes or quasilinear preferences show income or substitution effect
Complements - pure income effect
Substitutes - pure substitution effect
Quasilinear preferences - pure substitution effect
86
What are the axis on the budget constraint for labour?
Vertical - income
Horizontal - time
87
Draw a diagram showing labour market equilibirum
check ppt
88
Draw a diagram showing an increase in unearned income
check ppt
89
What sort of a good is labour?
normal good
(more income means decrease your supple of labour / increase demand for leisure
90
Draw a graph showing an increase in the wage rate
check ppt
91
Explain the substitution and income effect on an increase in wage rate
The income effect from the increase in wage increases demand for leisure
The wage is the opportunity cost of leisure, thus an increase in the wage rate induces a substitution effect away from leisure
92
Draw an increase in wage rate showing the substitution, income and total effects
check ppt
93
If the income effect dominated the substitution effect following an increase in wage rate, what happens to leisure?
Leisure increases
94
What is the usual shape of labour supply curves?
They bend backwards at high wage rates
check ppt
95
Draw a graph showing a stable and unstable equilibrium point on a labour supply graph
Check Ppt
96
Why does the budget constraint for labour start above zero?
Because workers are endowed with M(bar) of non-labour income
97
What is the equation for a workers budget constraint?
pc=M(bar)+wh
which can be expanded too:
pc+wL=pC(bar)+wT
where:
p=price
c=gross demand for the consumption good
h = labour supplied
w=wage rate
C(bar)= M(bar)/p=consumers endowment of consumption
L = gross demand for leisure
98
What does the equation pc+wL=pC(bar)+wT
the left (pc+wL) shows consumers expenditure
the right (pC(bar)+wT) shows the value of his endowment
99
What is endowment and how do we denote it?
The list of resource units with which a consumer starts is his endowment.
it is shown by the vector ω (omega)
100
what does ω=(ω1,ω2)=(10,2) mean?
Consumer is endowed with10 units of good 1 and 2 units of good 2
101
What is the budget constraint for a consumer with endowment (ω1,ω2)?
p1x1+p2x2=p1ω1+p2ω2
102
How does a price change effect a budget constraint with an endowment point?
The endowment point is always on the budget constraint so price changes pivot the constraint around the endowment point.
103
Draw a change in prices with endowment
check ppt
104
What is another way of writing the budget constraint with endowment?
p1(x1-ω1)+p2(x2-ω2)=0
the sum of the values of the consumers net demands is zero
105
Show graphically the consumer selling his endowment units of good 1 to acquire more of good 2
check ppt
106
With x2 on the y axis how will an increase in p2 or decrease in p1 affect the budget constraint?
As the gradient is (p1/p2) an increase in p2/ decrease in p1 will flatten the budget constraint through the initial endowment point
107
What does the price-offer curve contain?
The utility-maximizing gross demands for which the endowment can be exchanged
108
Draw a budget constraint with endowment and the price-offer curve
check ppt
109
How does the Slutsky's decomposition change with endowment?
There will be an additional income effect:
an endowment income effect
110
Construct a graph showing all income and substitution effects following an increase in p2/decrease in p1 with endowment
check ppt
111
What is the future value of $x received today and the present value of $x received tomorrow?
Future value: $(1+r)x
Present value of future $x =
$(1/1+r)x
112
If we receive $x tomorrow and we borrow $z today where $z(1+r) = $x. How much is $z worth today in terms of $x?
$z=$(1/1+r)x
113
What is intertemporal choice?
People making decisions between costs and benefits at different points in time
114
Using intertemporal choice how do we represent income endowment and consumption over time?
income endowment:
y=(y1,y2)
c=(c1,c2)
115
Given an income endowment of y^0=(y1^0,y2^0) what is the maximum period 1 and period 2 income?
Period 1:
ŷ1^0=y1^0+(1/1+r)y2^0
Period 2
ŷ2^0=y2^0+(1+r)y1^0
116
Draw an intertemporal budget constraint and include equations for max period 1 and period 2 income
check ppt
117
What is the equation for consumption in excess of period 2 income y2?
c2=y2+(1+r)(y1-c1)
which =
c2=y2+(1+r)y1-(1+r)c1
intercept = y2+(1+r)y1
slope =-(1+r)
118
What is a rule to apply when using present and future income and consumption?
Present or future value of income and consumption must be equal
c1+c2/(1+r)=y1+y2/(1+r)
119
What does the change in c2 = ?
change c2 = -(1+r)changec1
120
Draw an intertemporal budget constraint where:
(y1-c1)>0
(y2-c2)<0
check ppt
121
How do changes in income endowment and interest rates change the inter-temporal budget constraint?
Changes in income endowment shift constraint parallel
Changes in interest rates pivot the budget constraint around the initial income endowment.
122
Draw a shift outwards on the Intertemporal budget constraint.
check ppt
123
Construct a graph showing an increase in the rate of interest on the intertemporal budget constraint.
check ppt
124
What makes someone a borrower?
(c1-y1)>0
125
Show the effect of a fall in interest rates on a borrower on he intertemporal budget constraint.
check ppt (23)
126
What are the effects of an interest rate fall on borrowers?
Borrower remains borrower
Borrower is better-off
Increases borrowing (c1) normal good
127
Construct a graph showing the effect of an increase in interest rates on a borrower using the intertemporal budget constraint
check ppt (24)
128
Construct a graph showing the effect of an increase in interest rates on savers and show the substitution and endowment income effect
check ppt (24)
E0 to E2 = substitution effect
E2 to E1 = endowment income effect
129
What do the two assumptions of wealth mean?
State 1: Wealth = w1
this^ means good state
State 2: wealth = w2-L
this means bad state L=loss
130
What is the equation for expected wealth?
w(bar)=(1-p)w1+pw2
where p = probability of loss L
131
How else can the expected wealth formula be presented?
w(bar)=(1-p)w1+pw2
w(bar(=(1-p)w1+p(w1-L)
w(bar)=w1-pL
132
What is an individuals maximisation objective?
To maximise expected utility not expected wealth
133
What is an individuals utility function?
u=u(w)
w= wealth
134
What do we assume about utility if wealth increases?
Total utility increases wealth meaning marginal utility is positive
du/dw=u'(w)>0
135
What do we assume about the rate of marginal utility?
Although it is positive, its rate declines (declining in wealth).
This makes the u(w) flatten out for higher wealth
136
What is the equation for expected utility?
u(bar)=(1-p)u(w1)+pu(w2)
137
Draw a risk averseness diagram showing w1,w2 and w(bar)
check ppt 25
138
Show on a diagram how we get a level of expected utility
Check ppt 25
139
What level of wealth does u(bar) have
u(bar)=u(w)
w = an individuals certainty equivalent level of wealth
140
What is the certainty equivalent level of wealth?
certainty equivalent level of wealth is the guaranteed amount of money they would accept instead of taking a risky gamble with uncertain outcomes.
141
What is r^max?
r^max=w1-w(certainty equivalent level of wealth)
r^max is the maximum premium an individual would be prepared to pay for insurance
142
What does 𝜽=(r,L) show?
𝜽 is the insurance contract, the individual pays insurance r and the insurance company contracts to reimburse the individual if he studders state 2 loss L
143
What is an individuals contingent wealth under an insurance contract in state 1 and 2?
State 1:
w1^𝜽=w1-r
State 2:
w2^𝜽=w2-r+L
or
w2^𝜽=w1-L-r
or
w2^𝜽=w1-r
144
What is r^min
The minimum premium an insurance company would accept, it is equal to expected costs
r^min=w1-w(bar)=c(bar)
c(bar)=expected costs
145
What does risk-averse mean?
Individuals are prepared to pay a premium to avoid risk
146
What does risk neutral mean?
Individuals are indifferent to paying a premium and not paying a premium to avoid risk
147
What does risk loving mean?
Individuals are prepared to pay a premium to take risk
148
How is change in marginal utility denoted?
u''(w) (second derivative)
149
