Chapter 21 Vocab Budget Constraint The consumption bundles a consumer can afford Indifference Curve A curve that shows consumption bundles that gives the consumer the same level of satisfaction Higher indifferent curves are preferred to lower ones Indifference curves are downward sloping most of the time If the quantity of one good is reduced the quantity of the other good must increase for the consumer to be equally as happy Indifference curves do not cross Indifference curves are bowed inwards The slopes of an indifference curve is the marginal rate of the rate at which the consumer is willing to substitution trade off one good for the other People are more willing to trade goods that they have in abundance willing to trade goods of which they have little and less Marginal Rate of Substitution MRS The rate at which a consumer is willing to trade one good for another Perfect Substitutes 2 goods with strait line indifference curves NICKELS AND DIMES Perfect Compliments 2 goods with right angle indifference curves LEFT SHOE AND RIGHT SHOE Income Effect The change in consumption that results when a price change moves the consumer to a higher or lower indifference curve Great news Now that Pepsi is cheaper my income has greater purchasing power I am in effect richer than I was Because I am richer I can buy both more pizza and more Pepsi This is the income effect Work less and save less 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 MRS Now that the price of Pepsi has fallen I get more pints of Pepsi for every pizza that I give up Because pizza is now relatively more expensive I should buy less pizza and more Pepsi This is the substitution effect Work more to save more Giffen Good A good for which an increase in the price raises the quantity demanded VERY RARE Inferior goods for which the income effect dominates the substitution effect therefore they have upward sloping demand curves INFO The slope of the budget constraint measures the rate at which the consumer can trade one good for the other Slope of the budget constraint relative price of the two goods the price of one good compared to the price of the other Budget constraint shows the combinations of goods the consumer can afford given his income and the prices of the good Given 2 different bundles consumers will choose the bundle that best suits his taste The rate at which a consumer is willing to trade one good for the other depends on the amounts of the goods he is already consuming A consumer is indifferent among any point on the same indifferent curve When the goods are easy to substitute for each other the indifference When goods are hard to substitute the indifference curves are very curves are less bowed bowed The consumer choose the consumption of the 2 goods so that the marginal rate of substitution equals the relative price The point at which this indifference curve and the budget constraint touch is called the optimum The consumer would prefer point A but he cannot afford that point because it lies above his budget constraint The consumer can afford point B but that point is on a lower indifference curve and therefore provides the consumer less satisfaction The optimum represents the best combination of pizza and Pepsi available to the consumer Relative price is the rate at which the market is willing to trade 1 good for the other whereas the marginal rate of substitution is the rate at which the consumer is willing to trade 1 good for the other At the consumer s optimum the consumer s valuation of the 2 goods equals the market s valuation As a result of this consumer optimization market prices of different goods reflect the value that consumers place on those goods An increase in income leads to a parallel shift in the budget constraint A fall in the price of any good shifts the demand outward The income effect is the change in consumption that results from the movement to a higher indifference curve The substitution effect is the change in consumption that results from being at a point on an indifference curve with a different marginal rate of substitution
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