Topic 1 Flashcards
(23 cards)
What are the 3 critical assumptions that economists make about the properties of consumers’ preferences?
Completeness, Transitivity and More is better.
Explain the following critical assumption economists make about the properties of consumers’ preferences: Completeness
. This property holds that, when facing a choice between any two bundles of goods, a consumer can rank them so that one (and only one) of the following relationships is true:
• The consumer prefers the first bundle to the second
• The consumer prefers the second to the first
• Or is indifferent between them
This property rules out the possibility that the consumer cannot decide which bundle is better.
Explain the following critical assumption economists make about the properties of consumers’ preferences: Transitivity.
This property holds that consumer’s preferences over bundles is consistent in the sense that, if the consumer weakly prefers bundle z to y and weakly prefers bundle y to x, the consumer also weakly prefers bundle z to x.
Explain the following critical assumption economists make about the properties of consumers’ preferences: More is Better (Satisfaction).
This property holds that (all else being the same) more of a commodity (good) is better than less of it (always wanting more is known as non-satiation).
What is an indifference curve?
The set of all bundles of goods that a consumer views as being equally desirable (The curve will go through points on the indifference map which are equally desirable to the consumer). Indifference curves are assumed to be continuous (no gaps) and do not necessary have to parallel with others.
What is an indifference/preference map?
A complete set of indifference curves that summarise a consumer’s tastes and preferences. All indifference curve maps must have four important properties.
What is marginal rate of substitution (MRS)?
The maximum amount of one good a consumer will sacrifice to obtain one more unit of another good (trade-off). Willingness to trade one good for another is MRofS. MRS = change in A/change in B
What is a utility?
A set of numerical values that reflect the relative rankings of various bundles of goods. Utility is measured in units called utils, which represent the welfare of satisfaction of a consumer from consuming a certain number of goods.
What is the utility function?
The relationship between utility values and every possible bundle of goods. If the utility function is known we can summarise the information in indifference maps succinctly.
What do typical utility functions look like?
- U (utils) on vertical axis
- Z (good – e.g. pizzas per semester)
- Utility function (starts on U axis above 0) typically looks likes square root curve
What is marginal utility?
The extra utility that a consumer gets from consuming the last unit of a good (the extra pleasure someone gets for a good). Thus, marginal utility is the slope of the utility function as we hold the quantity of the other goods constant. E.g.: MUZ = ΔU/ΔZ and MUB = ΔU/ΔB
Marginal utility from consuming the last pizza = change in utility/change in pizzas AND
Utility and marginal rates of substitution:
Marginal rate of substitution (MRS) is the slope of the indifference, but it can also be expressed in terms of marginal utilities.
MRS = ΔB/ΔZ = -MUZ/MUB
Example: if Lisa has 10 burgers and 4 pizzas in a semester and gets 1 more pizza, her utility rises. That extra utility is marginal utility from the last pizza (MUZ). Similarly, if she received one extra burger instead, her marginal utility from the last burger is MUB. Suppose that Lisa trades from one bundle on an indifference curve to another by giving up some burgers to gain more pizza. She gains marginal utility from the extra pizza but loses marginal utility from fewer burgers.
Budget Constraint Equation:
PBB + PZZ = Y
Y = all of a person’s budget/income
PBB – the amount spent on one good (e.g. burgers)
PZZ – the amount spent on another good (e.g. pizzas)
For graphical simplicity, we assume that consumers spend their money on only two goods.
What is the budget line (or budget constraint)?
The bundles of goods that can be bought if the entire budget is spent on those goods ay given prices.
What is the opportunity set?
All the bundles a consumer can buy, including all the bundles inside the budget constraint and on the budget constraint (area between the budget line and axis’).
What is the marginal rate of transformation (MRT)?
The trade-off the market imposes on the consumer in terms of the amount of one good the consumer must give up obtaining more of the other good. The slope of the budget line is called the MRT.
MRT = ΔB/ΔZ = PZ/PB
Effects of a change in price on consumption:
If the price of a good doubles, but the price of another is unchanged, then the budget constraint swings in towards the origin (as seen in figure 4.7, L1 to L2). This then changes the slope of the budget line (MRT). The area between L1 and L2 represents loss.
E.g. burgers on vertical axis and pizzas on horizontal axis – the vertical axis intercept would remain the same, whilst the horizontal axis intercept would move to the left of the axis if the price of pizza doubled whilst the price of burgers remained the same.
Effects of a change in income on consumption:
If the consumer’s income increases, the consumer can buy more of all goods. This results in the budget constraint shifting outwards (away from the origin). Therefore, a change in income only affects the position and not the slope of the budget line.
- The area between L1 and L2 represents gain and results in a larger (shaded) opportunity set.
- If prices of good 1 and good 2 dropped by the same amount, this would look identical to when income doubles.
Why does wellbeing have to be maximised?
Were it not for the budget constraint, consumers who prefer more to less would consume unlimited amounts of all goods. Instead, consumers maximise their wellbeing subject to their budget constraints. Now, we have to determine the bundle of goods that’s maximises wellbeing subject to the budget constraint.
Where does the optimal bundle lie?
On the budget constraint (on an indifference curve that does not cross the budget constraint).
- Although bundles on an indifference curve above the budget constraint are more preferable, they are too expensive.
- Bundles on an indifference curve below the budget constraint are less preferable, as more is better than less.
How may an optimal bundle be achieved?
By the optimal bundle lying on an indifference curve that touches the budget constraint, but does not cross it. This is reached in two ways:
- An interior solution and
- A corner solution
What is an Interior Solution?
This is where the optimal bundle has positive quantities of both goods (the optimal bundle is on the budget line, but not at one end or the other).
- For this indifference curve to touch the budget line but not cross it, it must be tangent to the budget constraint
- L and BL have same slope at the point (optimal bundle) where the touch
o MRS measures the rate in which Lisa is willing to trade burgers for pizza = -MUz/MUB
o MRT measures the rate at which Lisa can trade her money for burgers or pizza in the market = -PZ/PB
- MRS = MRT
o -MUz/MUB = -PZ/PB
o MUZ/PZ=MUB/PB (rearranged)
What is the Corner Solution?
This is where the optimal bundle is at one end or the other of the budget line (it is at a corner with one of the axes).
- This takes place when there are flatter ICs
- ICs still don’t not cross the BL
- The ICs aren’t tangent to the budget line
o They reach tangent point at axis/would cross BL after axis
