Microeconomics Ch.21 Theory of consumer choice

question

The theory of consumer choice examines the trade-offs that people face in their role as consumers

answer

1.People face trade-offs

question

Budget constraint

answer

Limit on consumption bundle that a consumer can afford

question

PxQx+PyQy=M

answer

Budget constraint

question

Slope of budget constraint

answer

Px/Py
Price ratio
rate at which the consumer can trade one good for another

question

Relative price of two goods

answer

Price ratio
Slope of budget constraint

question

BC y-intercept

answer

M/py

question

BC x-intercept

answer

M/Px

question

Utility function

answer

A function that measures happiness.
One's happiness at one point of time

question

Marginal Utility

answer

The EXTRA UTILITY(happiness) that one derives from consuming additional unit of a good/service

question

Law of diminishing marginal utility

answer

for a typical good, utility function increases at a decreasing rate

question

Each additional unit of consumption adds smaller and smaller level of happiness

answer

Law of diminishing marginal utility

question

Satiation

answer

Highest level of utility that can be derived from consuming a particular good

question

ceteris paribus

answer

holding all other factors constant

question

After_____, one derives either zero MU or negative MU from extra unit of consumption of good

answer

Satiation

question

Indifference Curve

answer

Representation of the concept of utility/happiness in the 2-dimensional world of quantities of two good

question

Shows all consumption bundles that give the consumer the same lever of satisfaction or utility

answer

Indifference curve

question

Marginal Rate of Substitution

answer

Slope of an indifference curve
MUx/MUy

question

Rate at which a consumer is willing to trade one good for another and still remain at the same level of satisfaction

answer

Marginal Rate of Substitution

question

MRS of indifference curve is ____ at all points because of law of diminishing marginal utility

answer

not the same

question

4 properties of indifference curves

answer

1. Higher indifference curve is preferred to lower ones
2. Indifference curves are downward sloping
3. Indifference curves do not cross
4. Indifference curves are generally bowed inward

question

More better than less

answer

1. higher indifference curve is preferred to lower ones

question

Slope of indifference curve reflects the rate at which consumer is willing to substitute one good for another

answer

MRS

question

if consumption of one good decreases, consumption of another good must increase in order to keep same lever of happiness thus variables move in opposite direction

answer

. Indifference curves are downward sloping

question

IC1 : pt A to B
IC2 : pt B to C

Happiness:
A=B
B=C
C not equal to A
thus B on IC1 and B on IC2 cannot be equal

answer

3. Indifference curves do not cross

question

following law of diminishing marginal utility---consumer is willing give up a good she already has in large quantity, but won't give up as much when she has small quantity

answer

4. Indifference curves are usually bowed inward

question

2 extreme examples of indifference curve

answer

Perfect substitutes
Perfect complements

question

Shape of an indifference curve tells us about consumer's

answer

willingness to trade one good for another

question

Indifference curves are less bowed when

answer

two goods are easy to substitute for each other

question

Indifference curves are very bowed when

answer

two goods are hard to substitute

question

Perfect substitues

answer

Two goods that are effectively identical and can be substituted for each other
Straight line and fixed slope

question

Perfect complements

answer

Two goods that are consumed together
Right angle IC

question

Two goods with straight line IC with constant MRS (slope)

answer

Perfect Substitutes

question

Two goods with right angle IC

answer

Perfect complements

question

More of the good the consumer already has, the lower the marginal utility provided by an extra unit of that good

answer

Diminishing marginal utility

question

_________between two goods depend on their marginal utilities

answer

MRS

question

Slope of indifference curve=MRS=

answer

MUx(y amt given up for x)/MUy(x amt given up for y)

question

Optimization

answer

Utility maximization

question

Optimum

answer

The point at which the indifference curve and budget line touch

question

Best combination of goods available to the consumer
Point of highest possible indifference curve

answer

Optimum

question

Optimality/Tangency condition

answer

MRS=Price Ratio
MUx/MUy = Px/Py
Point where indifference curve is tangent to the budget line

question

Perfect complement optimization

answer

Point at which BC is touching at one point of the corner

question

Perfect substitute optimization

answer

1. if BC steeper than IC (Px/Py > MRS) = only y-axis good
2. if BC flatter than IC (Px/py < MRS) = only x-axis good
3. if BC and IC have same slope (Px/Py=MRS)=anywhere on BC are good

question

Normal goods

answer

Goods you want more when income increases

question

Increase in income increases demand
Decrease in income decreases demand

answer

Normal goods

question

Inferior goods

answer

Goods you want less when income increases

question

Increase in income decreases demand
Decrease in income increases demand

answer

Inferior goods

question

Parallel shift in BC caused by

answer

Increase/decrease in income

question

Rotate shift in BC caused by

answer

Increase/decrease in price of a good

question

Consumer's optimum moves from initial optimum to new optimum when

answer

There is a change in income / price

question

Income effect

answer

change in consumption that results when a price change moves the consumer to a higher or lower indifference curve

question

Substitution effect

answer

change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new MRS which equals to the new price ratio

question

Consumer moves along the initial IC tangent to intermediate budget line

answer

Substitution effect

question

intermediate budge line

answer

parallel to new budge line and tangent to old IC

question

Consumer shifts to the higher IC

answer

Income effect

question

Price of y falls, consumer feels richer so she buys more y

answer

Income effect

question

Price of y falls, y is relatively cheaper than x so she buys more y

answer

substitution effect

question

Price of y fall, consumer feels richer so she buys more x

answer

Income effect

question

Price of y falls, x is relatively expensive than y so she buys less x

answer

Substitution effect

question

Total effect

answer

Substitution + Income effect

question

Price of y falls, Income and substitution effects act in the same direction for y so consumer buys more y

answer

Total effect

question

Price of y fall, Income and substitution effects act in the opposite direction for x so consumer choice becomes ambiguous.

answer

Total effect

question

For normal goods x and y, price of x falls.
If income effect > substitution effect

answer

Qx increase Qy increase

question

For normal goods x and y, price of x falls.
If income effect < substitution effect

answer

Qx increase Qy decrease

question

Law of demand

answer

when price of good rises, people buy less of it.

question

Goods that defy law of demand

answer

Giffen goods

question

Giffen good

answer

A good for which and increase in price increases the quantity demanded

question

inferior goods for which the income effect dominates the substitution effect resulting in upward sloping demand curve

answer

giffen goods

question

Conditions for giffen good

answer

Inferior good
Lack of close substitution
Large part of consumer's income

question

Price of a y increases, consumer feels poorer, buys less x and more y

answer

Inferior good income effect on giffen good

question

Inferior good income effect on giffen good when price of y increases

answer

increase in demand of y
decrease in demand of x (decrease spend on luxury)

question

Substitution effect on giffen good when price of y increases

answer

decrease in demand for y
increase in demand for x
but Income(inferior good) effect dominates thus
increases demand for y and decreases demand for x

question

Labor leisure trade off

answer

Trade of between leisure(x) and consumption(y)

question

Price of leisure is

answer

wage

question

Budge constraint Labor/leisure trade off

answer

M=PxQx+PyQy
wT=wl+PcQc
wT=wl+wL
y-intercept=wT/Pc
x-intercept=T

question

Wage increases. If substitution effect > income effect

answer

leisure is relatively more expensive than consumption thus consumer works more
positive slope supply-labor curve

question

Wage increases, If income effect > substitution effec

answer

consumer feels richer and works less
negative slope supply-labor curve

question

Life cycle consumption trade-off between periods

answer

Trade-off between consumption today and consumption in future

question

Price of consumption today is

answer

Interest rate

question

Budget constraint Period consumption trade off

answer

PyQy+PxQx=M
P2C2+(1+r)P1C1=M2+(1+r)M1
y-intercept: C2=M2/P2+(1+r)M1/P2
x-intercept: M1/P1
Slope=P1(1+r)/P2

question

Interest rate increases, If SE>IE

answer

Today's consumption becomes relatively more expensive, thus consumer saves more

question

Interest rate increases, IF IE>SE

answer

Consumer feels richer, saves less

1 of 81

question

The theory of consumer choice examines the trade-offs that people face in their role as consumers

answer

1.People face trade-offs

question

Budget constraint

answer

Limit on consumption bundle that a consumer can afford

question

PxQx+PyQy=M

answer

Budget constraint

question

Slope of budget constraint

answer

Px/Py
Price ratio
rate at which the consumer can trade one good for another

question

Relative price of two goods

answer

Price ratio
Slope of budget constraint

question

BC y-intercept

answer

M/py

question

BC x-intercept

answer

M/Px

question

Utility function

answer

A function that measures happiness.
One's happiness at one point of time

question

Marginal Utility

answer

The EXTRA UTILITY(happiness) that one derives from consuming additional unit of a good/service

question

Law of diminishing marginal utility

answer

for a typical good, utility function increases at a decreasing rate

question

Each additional unit of consumption adds smaller and smaller level of happiness

answer

Law of diminishing marginal utility

question

Satiation

answer

Highest level of utility that can be derived from consuming a particular good

question

ceteris paribus

answer

holding all other factors constant

question

After_____, one derives either zero MU or negative MU from extra unit of consumption of good

answer

Satiation

question

Indifference Curve

answer

Representation of the concept of utility/happiness in the 2-dimensional world of quantities of two good

question

Shows all consumption bundles that give the consumer the same lever of satisfaction or utility

answer

Indifference curve

question

Marginal Rate of Substitution

answer

Slope of an indifference curve
MUx/MUy

question

Rate at which a consumer is willing to trade one good for another and still remain at the same level of satisfaction

answer

Marginal Rate of Substitution

question

MRS of indifference curve is ____ at all points because of law of diminishing marginal utility

answer

not the same

question

4 properties of indifference curves

answer

1. Higher indifference curve is preferred to lower ones
2. Indifference curves are downward sloping
3. Indifference curves do not cross
4. Indifference curves are generally bowed inward

question

More better than less

answer

1. higher indifference curve is preferred to lower ones

question

Slope of indifference curve reflects the rate at which consumer is willing to substitute one good for another

answer

MRS

question

if consumption of one good decreases, consumption of another good must increase in order to keep same lever of happiness thus variables move in opposite direction

answer

. Indifference curves are downward sloping

question

IC1 : pt A to B
IC2 : pt B to C

Happiness:
A=B
B=C
C not equal to A
thus B on IC1 and B on IC2 cannot be equal

answer

3. Indifference curves do not cross

question

following law of diminishing marginal utility---consumer is willing give up a good she already has in large quantity, but won't give up as much when she has small quantity

answer

4. Indifference curves are usually bowed inward

question

2 extreme examples of indifference curve

answer

Perfect substitutes
Perfect complements

question

Shape of an indifference curve tells us about consumer's

answer

willingness to trade one good for another

question

Indifference curves are less bowed when

answer

two goods are easy to substitute for each other

question

Indifference curves are very bowed when

answer

two goods are hard to substitute

question

Perfect substitues

answer

Two goods that are effectively identical and can be substituted for each other
Straight line and fixed slope

question

Perfect complements

answer

Two goods that are consumed together
Right angle IC

question

Two goods with straight line IC with constant MRS (slope)

answer

Perfect Substitutes

question

Two goods with right angle IC

answer

Perfect complements

question

More of the good the consumer already has, the lower the marginal utility provided by an extra unit of that good

answer

Diminishing marginal utility

question

_________between two goods depend on their marginal utilities

answer

MRS

question

Slope of indifference curve=MRS=

answer

MUx(y amt given up for x)/MUy(x amt given up for y)

question

Optimization

answer

Utility maximization

question

Optimum

answer

The point at which the indifference curve and budget line touch

question

Best combination of goods available to the consumer
Point of highest possible indifference curve

answer

Optimum

question

Optimality/Tangency condition

answer

MRS=Price Ratio
MUx/MUy = Px/Py
Point where indifference curve is tangent to the budget line

question

Perfect complement optimization

answer

Point at which BC is touching at one point of the corner

question

Perfect substitute optimization

answer

1. if BC steeper than IC (Px/Py > MRS) = only y-axis good
2. if BC flatter than IC (Px/py < MRS) = only x-axis good
3. if BC and IC have same slope (Px/Py=MRS)=anywhere on BC are good

question

Normal goods

answer

Goods you want more when income increases

question

Increase in income increases demand
Decrease in income decreases demand

answer

Normal goods

question

Inferior goods

answer

Goods you want less when income increases

question

Increase in income decreases demand
Decrease in income increases demand

answer

Inferior goods

question

Parallel shift in BC caused by

answer

Increase/decrease in income

question

Rotate shift in BC caused by

answer

Increase/decrease in price of a good

question

Consumer's optimum moves from initial optimum to new optimum when

answer

There is a change in income / price

question

Income effect

answer

change in consumption that results when a price change moves the consumer to a higher or lower indifference curve

question

Substitution effect

answer

change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new MRS which equals to the new price ratio

question

Consumer moves along the initial IC tangent to intermediate budget line

answer

Substitution effect

question

intermediate budge line

answer

parallel to new budge line and tangent to old IC

question

Consumer shifts to the higher IC

answer

Income effect

question

Price of y falls, consumer feels richer so she buys more y

answer

Income effect

question

Price of y falls, y is relatively cheaper than x so she buys more y

answer

substitution effect

question

Price of y fall, consumer feels richer so she buys more x

answer

Income effect

question

Price of y falls, x is relatively expensive than y so she buys less x

answer

Substitution effect

question

Total effect

answer

Substitution + Income effect

question

Price of y falls, Income and substitution effects act in the same direction for y so consumer buys more y

answer

Total effect

question

Price of y fall, Income and substitution effects act in the opposite direction for x so consumer choice becomes ambiguous.

answer

Total effect

question

For normal goods x and y, price of x falls.
If income effect > substitution effect

answer

Qx increase Qy increase

question

For normal goods x and y, price of x falls.
If income effect < substitution effect

answer

Qx increase Qy decrease

question

Law of demand

answer

when price of good rises, people buy less of it.

question

Goods that defy law of demand

answer

Giffen goods

question

Giffen good

answer

A good for which and increase in price increases the quantity demanded

question

inferior goods for which the income effect dominates the substitution effect resulting in upward sloping demand curve

answer

giffen goods

question

Conditions for giffen good

answer

Inferior good
Lack of close substitution
Large part of consumer's income

question

Price of a y increases, consumer feels poorer, buys less x and more y

answer

Inferior good income effect on giffen good

question

Inferior good income effect on giffen good when price of y increases

answer

increase in demand of y
decrease in demand of x (decrease spend on luxury)

question

Substitution effect on giffen good when price of y increases

answer

decrease in demand for y
increase in demand for x
but Income(inferior good) effect dominates thus
increases demand for y and decreases demand for x

question

Labor leisure trade off

answer

Trade of between leisure(x) and consumption(y)

question

Price of leisure is

answer

wage

question

Budge constraint Labor/leisure trade off

answer

M=PxQx+PyQy
wT=wl+PcQc
wT=wl+wL
y-intercept=wT/Pc
x-intercept=T

question

Wage increases. If substitution effect > income effect

answer

leisure is relatively more expensive than consumption thus consumer works more
positive slope supply-labor curve

question

Wage increases, If income effect > substitution effec

answer

consumer feels richer and works less
negative slope supply-labor curve

question

Life cycle consumption trade-off between periods

answer

Trade-off between consumption today and consumption in future

question

Price of consumption today is

answer

Interest rate

question

Budget constraint Period consumption trade off

answer

PyQy+PxQx=M
P2C2+(1+r)P1C1=M2+(1+r)M1
y-intercept: C2=M2/P2+(1+r)M1/P2
x-intercept: M1/P1
Slope=P1(1+r)/P2

question

Interest rate increases, If SE>IE

answer

Today's consumption becomes relatively more expensive, thus consumer saves more

question

Interest rate increases, IF IE>SE

answer

Consumer feels richer, saves less

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