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Econ Final Review.docx

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University of Miami
ECO 211

Econ Final Review Chapter 21 Vocabulary:  Budget constraint- the limit on the consumption bundles that a consumer can afford  Indifference curve- a curve that shows consumption bundles that give the consumer the same level of satisfaction  Marginal rate of substitution- the rate at which a consumer is willing to trade one good for another  Perfect substitutes- two goods with straight-line indifference curves  Perfect complements- two goods with right-angle indifference curves  Normal good- a good for which an increase in income raises the quantity demanded  Inferior good- a good for which an increase in income reduces the quantity demanded  Income effect- the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve  Substitution effect- the change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new marginal rate of substitution  Giffen good - a good for which an increase in the price raises the quantity demanded Budget Constraint Figure The Consumer's Budget Constraint The budget constraint shows the various bundles of goods that the co buy for a given income. Here the consumer buys bundles of pizza and table and graph show what the consumer can afford if his income is $ price of pizza is $10, and the price of Pepsi is $2 Figure 2The Consumer's Preferences The consumer's preferences are represented with indifference curves, which show the combinations of pizza and Pepsi that make the consumer equally satisfied. Because the consumer prefers more of a good, points on a higher indifference curve 2 I here) are preferred to points on a lower indifferenc1 curve ( I ). The marginal rate of substitution ( MRS) shows the rate at which the consumer is willing to trade Pepsi for pizza. It measures the quantity of Pepsi the consumer must be given in exchange for 1 pizza. 4 Properties of Indifference Curves 1. Higher Indifference curves are preferred to lower ones a. People like more of a good rather than less of a good 2. Indifference curves are downward sloping a. It reflects the rate at which the consumer is willing to substitute one good for the other 3. Indifference curves do not cross Figure 3The Impossibility of Intersecting Indifference Curves A situation like this can never happen. According to these indifference curves, the consumer would be equally satisfied at points A, B, and C, even though point C has more of both goods than point A. 4. Indifference curves are bowed inward a. The MRS depends on the amount of each good the consumer is currently consuming b. People are more willing to trade goods they have in abundance and less likely to trade goods that are scarce, hence it bows inward Extreme cases  When the goods are easy to substitute for each other, the indifference curves are less bowed; when the goods are hard to substitute, the indifference curves are very bowed.  Figure 4Bowed Indifference Curves  Indifference curves are usually bowed inward. This shape implies that the marginal rate of substitution ( MRS) depends on the quantity of the two goods the consumer is consuming. At point A, the consumer has little pizza and much Pepsi, so he requires a lot of extra Pepsi to induce him to give up one of the pizzas: The marginal rate of substitution is 6 pints of Pepsi per pizza. At point B, the consumer has much pizza and little Pepsi, so he requires only a little extra Pepsi to induce him to give up one of the pizzas: The marginal rate of substitution is 1 pint of Pepsi per pizza.   Perfect Substitutes and Perfect Complements  When two goods are easily substitutable, such as nickels and dimes, the indifference curves are straight lines, as shown in panel (a). When two goods are strongly complementary, such as left shoes and right shoes, the indifference curves are right angles, as shown in panel (b).  Optimization  the consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.  Figure 6 The Consumer's Optimum  The consumer chooses the point on his budget constraint that lies on the highest indifference curve. At this point, called the optimum, the marginal rate of substitution equals the relative price of the two goods. Here the highest indifference curve the consumer can reach 2s I . The consumer prefers point A, which lies on indifference curv3 I , but the consumer cannot afford this bundle of pizza and Pepsi. By contrast, point B is affordable, but because it lies on a lower indifference curve, the consumer does not prefer it.  Changes In Income  Figure 7 An Increase in Income When the consumer's income rises, the budget constraint shifts out. If both goods are normal goods, the consumer responds to the increase in income by buying more of both of them. Here the consumer buys more pizza and more Pepsi. Figure 8An Inferior Good A good is inferior if the consumer buys less of it when his income rises. Here Pepsi is an inferior good: When the consumer's income increases and the budget constraint shifts outward, the consumer buys more pizza but less Pepsi. Figure 9A Change in Price When the price of Pepsi falls, the consumer's budget constraint shifts outward and changes slope. The consumer moves from the initial optimum to the new optimum, which changes
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