Economics Consumer Choice and Budget Constraints

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Questions and Answers

What is the real cost of a good or service determined by?

Market equilibrium

Supply and demand

Consumer preferences

Opportunity cost (correct)

How does a decrease in price while income remains the same affect a household's opportunity set?

It eliminates the opportunity set.

It reduces the opportunity set.

It keeps the opportunity set unchanged.

It expands the opportunity set. (correct)

What happens to total utility (TU) as individuals consume more of a good over time?

It decreases.

It fluctuates randomly.

It remains constant.

It increases. (correct)

Which statement about marginal utility (MU) is accurate?

MU diminishes with increasing consumption of a good. Signup and view all the answers

What is likely to occur when both income increases and prices also rise?

The real income of the household falls. Signup and view all the answers

In the context of consumer choice, what term is used to describe the property of a good that satisfies human wants?

Utility Signup and view all the answers

How are budget constraints and opportunity sets related?

Budget constraints restrict the opportunity set. Signup and view all the answers

What is indicated by the term 'opportunity cost'?

The value of forgone alternatives Signup and view all the answers

Which property of indifference curves indicates that consumers prefer bundles located higher on the graph?

Higher indifference curves are preferred over lower ones. Signup and view all the answers

What does the downward slope of an indifference curve represent?

The rate at which a consumer is willing to substitute one good for another. Signup and view all the answers

Indifference curves that cannot cross imply what?

The consumer's preferences are well-defined and consistent. Signup and view all the answers

Which scenario exemplifies perfect complements in indifference curves?

Left shoes and right shoes. Signup and view all the answers

If Hurley spends all his income on fish at a price of $40 per fish, how many fish can he buy with an income of $12,000?

300 fish. Signup and view all the answers

If the marginal rate of substitution (MRS) between two goods equals the ratio of their prices, what does this imply?

The consumer is maximizing their utility. Signup and view all the answers

What type of consumer behavior is demonstrated by a consumer willing to trade two nickels for one dime?

Perfect substitutes. Signup and view all the answers

What is indicated by the fact that indifference curves are bowed inward?

The consumer has diminishing marginal rate of substitution. Signup and view all the answers

What distinguishes cardinal utility from ordinal utility?

Cardinal utility provides specific values while ordinal utility only ranks satisfaction. Signup and view all the answers

In the utility-maximizing rule, what must be true for the consumer to have maximized their utility?

The ratio of marginal utility to price must be equal for all goods. Signup and view all the answers

How does a decrease in the price of good X affect the budget constraint?

It causes the budget constraint to pivot to the right. Signup and view all the answers

What is the formula for the budget constraint?

I = PxX + PyY Signup and view all the answers

What does the marginal utility (MUx) represent in the utility-maximizing rule?

The additional satisfaction from consuming one more unit of good X. Signup and view all the answers

If MUx is less than MUy, what should the consumer do to increase utility?

Consume more of good Y and less of good X. Signup and view all the answers

If the price of good Y increases while income remains unchanged, what happens to the budget constraint?

It shifts leftward, reducing purchasing power. Signup and view all the answers

What characterizes ordinal utility as opposed to cardinal utility?

It focuses on the ranking of preferences without measuring actual satisfaction. Signup and view all the answers

What does the slope of Hurley's budget constraint represent?

The rate at which he can trade fish for mangos Signup and view all the answers

What is the marginal rate of substitution (MRS) at the optimum consumption point?

It is equal to the price of fish divided by the price of mangos Signup and view all the answers

Which of the following describes a normal good?

The quantity demanded increases as income increases Signup and view all the answers

What effect does a decrease in the price of fish primarily have on Hurley's budget constraint?

It rotates the budget constraint outwards Signup and view all the answers

What is the substitution effect in the context of a price change?

A new consumption point along the same indifference curve Signup and view all the answers

How do consumers react to an increase in income regarding inferior goods?

They decrease the quantity of inferior goods Signup and view all the answers

If Hurley prefers B to A, why can't he afford it?

He does not have enough income Signup and view all the answers

What is the consumption level in Period 1 for a young person who earns $100,000 and saves a portion of it?

$100,000 minus total savings Signup and view all the answers

What does a higher indifference curve indicate?

A higher level of satisfaction or utility Signup and view all the answers

How does an increase in the interest rate from 10 to 20 percent affect Period 2 consumption for an individual?

It increases as a result of greater interest earned on savings Signup and view all the answers

What does the slope of the budget constraint represent?

The relative price of the goods Signup and view all the answers

Which statement about an indifference curve is true?

It represents the combinations that give the same satisfaction Signup and view all the answers

What does the income effect refer to in economic terms?

A change in consumption as a result of a lower price making the consumer better off Signup and view all the answers

What happens to consumption patterns when the relative price of a good changes?

The substitution effect triggers greater consumption of the cheaper good Signup and view all the answers

How is consumption in Period 2 dependent on savings from Period 1?

It includes savings from Period 1 plus any interest earned Signup and view all the answers

What represents the optimum choice for a consumer in relation to their budget constraint?

The point on the budget constraint that touches the highest indifference curve Signup and view all the answers

Study Notes

Opportunity Costs

The real cost of a good or service is its opportunity cost
Opportunity cost is determined by relative prices
The real cost of a good is the value of other goods and services that could've been purchased with the same amount of money

Budget Constraints

A household's budget constraint is limited by available income
Prices and income affect the budget constraint
A decrease in prices, keeping income the same, expands the opportunity set and makes the household better off
Real income reduces if money income increases but prices increase more

Theory of Consumer Choice: Utility and Preferences

Theory of consumer choice examines trade-offs faced by consumers
Utility is the property of a good that helps satisfy human needs
Total Utility (TU) is the overall satisfaction from consuming a certain quantity of a good
Marginal Utility (MU) is the extra utility from consuming one additional unit of a good, while holding other commodities constant
The Law of Diminishing Marginal Utility states that each additional unit of a good consumed eventually gives less and less extra utility
Cardinal utility assigns specific numerical values to utility
Ordinal utility ranks the utility received from various amounts of a good

Utility-Maximizing Rule

Consumers maximize utility by equating the ratio of the marginal utility of a good to its price for all goods
The consumer will increase utility by spending more on a good with higher MU relative to price, and less on goods with lower MU relative to price
This rule ensures the consumer's marginal utility per dollar spent is equal across all goods

The Budget Constraint Equation

The budget constraint equation is PxX + PyY = I
- Px is the price of good X
- X is the quantity of good X consumed
- Py is the price of good Y
- Y is the quantity of good Y consumed
- I is household income

Budget Constraint Changes

A decrease in the price of a good shifts the budget constraint outwards, expanding the opportunity set
Changes in income also affect the budget constraint.
Budget constraint shifts outwards with an increase in income, indicating improved purchasing power

Indifference Curves

Indifference curves show combinations of goods giving a consumer equal levels of satisfaction
Higher indifference curves represent greater satisfaction
Indifference curves are typically downward sloping, reflecting tradeoffs between goods to maintain the same utility level
Indifference curves cannot cross, as this would imply a contradiction in preference rankings
Indifference curves are bowed inward, or convex to the origin, reflecting the diminishing marginal rate of substitution (MRS) - the consumer is willing to give up less of one good to gain an additional unit of another good as they have more of the latter
Perfect substitutes have linear indifference curves, implying a constant MRS
Perfect complements have right-angle indifference curves, representing goods that must be consumed in fixed proportions

Consumer Optimization: Attaining the Highest Utility Level

Consumers choose the bundle of goods on the highest indifference curve that they can afford
At the optimum, the slope of the indifference curve equals the slope of the budget constraint
This occurs where MRS = Price Ratio (Px/Py)

Income and Substitution Effects

A decrease in the price of a good has both an income effect and a substitution effect
The Income Effect: The consumer has more purchasing power, leading to increased consumption of both goods if they are normal goods
The Substitution Effect: The price difference makes the good relatively cheaper, encouraging greater consumption of that good

Applications in Intertemporal Consumption

The interest rate acts as the relative price of consumption in period 1 versus consumption in period 2.
A higher interest rate encourages saving and increases the relative price of consumption in the current period.

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Description

This quiz explores key concepts in economics such as opportunity costs, budget constraints, and the theory of consumer choice. Understand how these principles influence consumer decisions and the satisfaction derived from goods and services. Test your knowledge on utility and preferences as well as how income and prices interact.