Lecture 2: Budgets and Demand Flashcards
(24 cards)
What is the slope of an indifference curve?
Diminishing marginal rate of substitution
Why is the MRS diminishing?
Preferences are strictly convex
What is the formula for a budget line?
PaA + PaB = M
(Price of a x no. of a) + (price of b x no. of b) = money income
What is the budget set?
The set of affordable bundles (area below the budget line)
What happens to the budget line when prices drop?
It becomes steeper
What happens to the budget line when income changes?
The intercepts change
What is the absolute value of the slope of the budget line?
The radio of prices, relative prices pa/pb (e.g. if a = 10 and b = 5, pa/pb =2)
What makes a bundle affordable?
It falls within the budget set
What is the theory of consumer choice?
Consumers maximise utility subject to budget constraints
What is the best bundle of goods?
The bundle of goods that falls on the highest indifference curve
What happens at x*?
The consumer’s MRS = the exchange rate pa/pb (slope of budget line)
And all income is spent: PaA* + PbB* = M
It is a TANGENCY condition
What is the law of demand?
If price decreases, demand increases.
Change in a*/change in price of a < 0
What happens if the demand of one good goes up when the price of another good goes down?
They are gross complements; goods that you use together.
Change in price of b/change in price of a < 0
What happens if demand for a good decreases when the price decreases?
The Law of Demand fails; they are Giffen Goods.
What happens to the demand for a normal good when money income increases?
It increases
What is an inferior good?
For inferior goods, if money income increases, demand for the good decreases
What are ordinary goods?
Goods that satisfy the law of demand
What is the price effect?
Income effect + substitution effect
What is the substitution effect?
When prices decrease, the slope of the budget line changes
What is the income effect?
If prices go down, the consumer can afford more of the good as real money income increases
Why is the next substitution effect always negative?
Convexity: diminishing marginal rate of substitution
If a good is normal then it is..?
Ordinary
If a good is Giffen then it is..?
Inferior
For an inferior good, what happens to the income and substitution effects?
The net income effect curbs the substitution effect
