Econ Final Review
Budget constraint- the limit on the consumption bundles that a consumer can
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
Inferior good- a good for which an increase in income reduces the quantity
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
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
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
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).
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