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Microeconomics
Chapter 10 - The Rational Consumer (Utility)
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Economics
03/29/2010

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Term
Utility
Definition

the measure of the satisfaction gained from consumption of goods and services

 

think of consumers as using consumption to "produce" utility (like how producers use inputs to produce outputs)

Term
Consumption Bundle
Definition
the set of all goods and srvices an individual consumes
Term
Utility Function
Definition

the relationship between an individual's consumption bundle and the toal amound of utility it generates for that individual

 

a personal matter; two people with different tastes will have different utility functions

Term
What do we measure utility in?
Definition
hypothetical units called utils
Term
How do you maximize total utility?
Definition

by focusing on marginal utility and considering the change in total utility from consuming one more unit of something

 

ex: Cassie likes clams and is at an all you can eat cafe. If the most clams she can eat without feeling sick is 8, then if she's rational she won't eat the 9th clam. Adding that additional clam actually makes Cassie worse off: it would lower her total utility.

When she chooses how many clams to consume, she will make the decision by considering the change in her total utility from consuming one more clam. To maximise total utility she must focus on marginal utility.

Term
Marginal Utility
Definition

the change in total utility from consuming one additional unit

 

represented by a marginal utility curve (constructed by plotting points at the midpoint of the unit intervals)

Term
Principle of Diminishing Marginal Utility
Definition

the additional satisfaction a consumer gets from one more unit of a good or service declines as the amount of that good or service consumed rises

 

the more of a good or service you consume, the closer you are to being satiated (reaching a point @ which more of the good adds nothing to your satisfaction)

Term
Budget Constraint
Definition

the cost of a consumer's consumption bundle must be no more than the consumer's income

 

you can't spend more money than you have

 

consumption bundles are affordable only when they obey this rule

Term
Consumption Possibilities
Definition

all of an individual's affordable consumption bundles

 

 

Term
What determines whether or not a particular consumption bundle is included in a consumer's consumption possibilities?
Definition
the consumer's income and the prices of goods and services
Term
Budget Line
Definition

A graph of one good vs another good showing all consumption bundles available to a consumer when that consumer spends all of their income

 

we do not consider points below the line because as long as the consumer doesn't get satiated (as long as marginal utility from consuming either good is always positive) and they don't get any utility from saving income rather than spending it, then they will always choose to consume a bundle that lies on the budget line

Term
Optimal Consumption Bundle
Definition

the point on the budget line that maximizes a consumer's total utility

 

found at the maximum on the total utility curve

 

also use marginal utility and as a problem of how much to spend on each good, ask whether or not the consumer can make themself better off by spending a little bit more on good X and a little less on good Y or by doing the opposite. question of how to spend the marginal dollar - how to allocate an additional dollar between good X and goo dY in a way that maximizes utility

Term
Marginal Utility per Dollar Spent
Definition

the additional utility from spending one more dollar on a good or service

 

am I better off by spending another dollar and, if so, by how much?

Term
How do you calculate the marginal utility per dollar for a good?
Definition

you must divide the marginal utility of the good by its price in dollars

 

MUx/Px (marginal utility per dollar spent on x)

Term
when does MUx/Px = MUy/Py?
Definition

at the optimal consumption bundle

 

where the two curves cross on a graph of marginal utility per dollar of the two goods over quantity of the goods

Term
If marginal utility per dollar spent on X is high than marginal utility per dollar spent on Y then what should the consumer be comsuming more off and what should they consume less of?
Definition

they should consume less of Y and more of X

 

by spending more on X they can add a large number of utils to their total utility; meanwhile by spending less on Y they will decrease a small number of utils from their total utility because marginal utility per dollar spent is higher for good X than for good Y

Term
Optimal Consumption Rule
Definition

when a consumer maximizes utility in the face of a budget constraint, the marginal utility per dollar spent on each good or service in the consumption bundle is the same.

 

for any two goods x and y, the optimal consumption rule says that at the optimal consumption bundle:

MUx = MUy

 Px       Py  

 

easiest understood when only two goods in use, but applies no matter how many goods or services a consumer buys

 

the marginal utilities per dollar spent for each and every good or service in that bundle are equal

Term
How does a rise in price affect marginal utility and marginal utility per dollar spent?
Definition

it does not change marginal utility

 

it reduces the marginal utility per dollar spent

this gives the consumer incentive to consume less of that good

Term
How does a fall in price affect marginal utility and marginal utility per dollar spent on a good?
Definition

it does not change marginal utility

 

it causes the marginal utility per dollar spent to increase

the consumer can now increase his/her utility by purchasing more of that good and less of other goods

Term
The Subsitution Effect
Definition

relates to the change in the proce of a good

 

leads to a change in the quantity of that good consumed as the consumer substitutes the good that has become relatively cheaper in place of the good that has become relatively more expensive

Term
The Income Effect
Definition

*relates to more expensive goods not subject to the substitution effect*

 

happens when there has been a reduction in a consumer's real income, having an effect beyone the substitution effect on a consumer's consumption bundle

 

this effect is when there is a change in a quantity of a good consumed that results from a change in the overall purchasing power of the consumer due to a change in the price of that good

 

ex: price of housing goes up: a change in the price of a good effectively changes the consumer's income becuase it alters the consumer's purchasing power

 

along with the substitution effect, this is another means by which changes in prices alter consumption choices

 

 

Term
What is "real income"
Definition
in contrast to "money income" or "nominal income", this is the amount of income adjusted to reflect true purchasing power
Term
What types of goods and services does the income effect influence?
Definition

for most goods and services it is not important and has no significant effect on individual consumption

 

when it does matter at all, it usually reinforces the substitution effect

eg. when a price of a good that absorbs a substantial share of income rises, consumers of that good become a bit poorer because their purchasing power falls. this effective reduction in come leads to a reduction in the quantity demanded and reinforces the substitution effect

Term
what goods and services does the substitution effect influence?
Definition

the majority of goods and services

 

most market demand curves slope downward soley because of the substitution effect

Term
what happens with the income and substitution effects in the case of an inferior good?
Definition

they work in opposite directions

 

in this case, the income effect of a price tends to produce an increase in the quantity demanded

 

in this case, the substitution effect tends to produce a decrese in the quantity of any good demanded as its price increases