Review Notes – Consumer Choice •
Simple two good model
Budget constraint p1X1 + p2X2 ≤ M meaning? graphically?
Budget Line p1X1 + p2X2 = M meaning? graphically? intercepts of the BL? slope of the BL? what shifts the BL? opportunity cost of the two goods?
Preferences define consumption bundle, preferred, and indifferent rationality • completeness (what's that?) • transitivity (what's that?) indifference curves • how are points on, and off, an indifference curve related? o two points on the same indifference curve? o a point above and a point on an indifference curve? o a point below and a point on an indifference curve? • what do they look like? • how many are there? • in which direction is the consumer better off? • can indifference curves cross? • what do different examples of indifference curves look like? utility • what does utility measure? • what happens to utility as we move to a higher indifference curve? • assume individuals want to maximize utility given prices, income, and preferences • what is marginal utility? • What is the marginal rate of substitution?
How do consumer’s maximize their utility? Know utility maximization both graphically and mathematically • Graphically – get on highest possible indifference curve • Mathematically – MRS = -p1/p2
how do you derive a demand curve, graphically, from indifference curve analysis? Composite Goods • What are they? • How are they used? Changes in Income • What is the income consumption path? • What happens to D as income changes? •
Price Changes What is a price consumption curve? Income and Substitution Effects • Do Demand curves always have a negative slope? o No – what’s a giffen good? o How likely are giffen goods? • Substitution effect of a price change – as price increases then QD decreases and the reverse. • Income effect of a price change o As the price decreases, then like $$ increases, so change consumption of the good • If the good is normal then what happens? • If the good is inferior then what happens? • You should know how to show the substitution and income effects graphically in each of three situations. Applications • Decision making is made on the margin – example used in class was excise/tax and then a rebate. • Important point = don’t change relative prices unless you wish to change behavior What is market Demand? What is consumer surplus? • Net benefit of consumption = total benefit – total cost. • What is consumer surplus graphically using demand curve? • What is consumer surplus graphically using indifference curves and budget lines?