EC120 Chapter Notes - Chapter 21: Budget Constraint, Indifference Curve, Relative Price

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EC120 – CHAPTER 21: THE THEORY OF CONSUMER CHOICE

THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD

• People consume less than they desire because their spending is constrained,

limited by their income

• BUDGET CONSTRAINT (BC): The limit on the consumption bundles that a

consumer can afford

• The slope of the budget constraint measures the rate at which the consumer

can trade one good for the other

• Slope of the BC = relative price of two goods (the price of one good compared

to another)

REPRESENTING PREFERENCES WITH INDIFFERENCE CURVES

• When offered two bundles, the consumer will pick the one that best suits

their tastes

• INDIFFERENCE CURVE (IC): A curve that shows consumption bundles that

give the consumer the same level of satisfaction

• The slope at any point on an IC equals the rate at which the consumer is

willing to substitute one good for the other.

• MARGINAL RATE OF SUBSTITUTION (MRS): The rate at which the consumer

is willing to substitute one good for the other.

• IC’s are not straight lines, therefore the MRS is not the same throughout the

graph

• Higher IC’s are preferred to lower ones, since people prefer more

consumption (Higher curve vs. lower curve)

FOUR PROPERTIES OF IC’S

1. Higher IC’s are preferred to lower ones – People usually prefer more of

something than less of it

2. IC’s are downwards sloping – If the quantity of one good is reduced, the

quantity of the other good must increase for the consumer to be equally

happy

3. IC’s do not cross – If crossed, two points would be on the same line even

though one would provide more of each good and therefore would make the

consumer more happy

4. IC’s are bowed inwards – People are more willing to trade away goods that

they have in abundance and less willing to trade away goods they have little

TWO EXTREME EXAMPLES OF IC’S

• PERFECT SUBSTITUTES: Two goods with straight-line IC’s

o MRS is fixed in this scenario, therefore the IC’s are straight lines

• PERFECT COMPLEMENTS: Two goods with right-angle indifference curves

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Ec120 chapter 21: the theory of consumer choice. The budget constraint: what the consumer can afford. Representing preferences with indifference curves: when offered two bundles, the consumer will pick the one that best suits their tastes. Ic"s are not straight lines, therefore the mrs is not the same throughout the: higher ic"s are preferred to lower ones, since people prefer more. How changes in income affect the consumer"s choices. How changes in price affect the consumer"s choices: a fall in the price of any good shifts the bc outwards, the slope of the bc changes due to the change in relative price. How do wages affect labour supply: a persons wage represents the tradeoff between leisure and consumption, e. g. For every hour of leisure sally gives up, she works one more hour and gains of consumption: same concept as above, except using time instead of goods.

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1.	_____	The satisfaction or benefit that consumers receive from consuming goods or services.
2.	________________ _	A particular combination of specific quantities of goods or services
3.	________________ _	Consumers can rank all conceivable bundles of goods or services
4.	_____	If A is preferred to B, and B is preferred to C, then A is always preferred to C.
5.	_____	Equation showing a consumerâs perception of the total utility forthcoming from consuming each bundle of goods and services.
6.	_____	A set of consumption bundles each and every one of which provides a consumer with exactly the same level of total utility.
7.	_____	The number of units of Y that must be given up for total utility to remain the same when one more unit of X is consumed.
8.	_____	The addition to total utility attributable to consuming one more unit of a good, holding the consumption of all other goods constant.
9.	_____	The line showing all bundles of goods that can be purchased at given prices if the entire income is spent.
10.	_____	The change in the consumption of a good that would result if the consumer remained on the original indifference curve after the price of the good changes.
11.	_____	The change in consumption of goods results strictly from the change in purchasing power after the price of a good changes.
12.	________________ _	The sum of the substitution and income effects.
13.	_____	A good for which quantity demanded varies directly with price, causing an upward sloping demand curve.
14.	_____	A list of prices and the corresponding quantity consumers are willing and able to purchase at each price.

blushwildebeest943

1. Economists use indifference curves to characterize the preferences of a rational consumer. There are some plausible assumptions that lead to a set of âwell-behavedâ (i.e., downward-sloping and strictly convex) indifference curves. Which one of the following is NOT among the assumptions?

a. All goods must be economic âgoods.â

b. Preferences are complete.

c. Preferences are transitive.

d. All goods are normal goods

2. Given the prices of good X and Y, the (negative of the) slope of the budget constraint (i.e., - PX/PY) measures

a. the amount of good Y the consumer is willing to forgo in order to consume one more unit of good X.

b. the ratio of the consumer's income to the price of the X good.

c. the quantity of the Y good that must be forgone in order to purchase one more unit of the X good.

d. the quantity of the X good that must be forgone in order to purchase one more unit of the Y good.

3. Which of the following statements is incorrect for an inferior good?

a. An inferior good may have an upward-sloping demand curve.

b. The income elasticity of demand for an inferior good is negative.

c. An inferior good is an economic âbad.â

d. All of the above.

True or False. If False explain why it's false.

1. If all prices are doubled an money income is the left the same, the budget set does not change because the relative prices do not change.

2. A decrease in income pivots the budget line around the bundle initially consumed.

3. If preferences are well-behaved, then for any commodity bundle (x1,x2), the set of commodity bundles that are worse than (x1,x2) is a convex set.

4. The marginal rate of substitution measures the distance betwee one indifference curve and the next one.

5. If someone has the utility function U= 2min(x, y), then x and y are perfect complements for that person.

6. At the boundary optimum, a consumers indifference curve must be tangent to her budget line.

7. If two goods are substitutes, then an increase in the price of one of them will increase the demand for the other.

8. An Engel curve is a demand curve with the vertical and horizontal axes reversed.

9. An inferior good is less durable than a normal good.

10. When other variables are held fixed, the demand for a Giffen good rises when income increase.

EC120 Chapter Notes - Chapter 21: Budget Constraint, Indifference Curve, Relative Price

EC120 Full Course Notes

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