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Unit 13

Word Meaning
utility satisfaction come from using goods or services
consumption bundle the set of all goods and services an individual consumes
total utility / TU
utility function a function gives to total utility generated by a consumption bundle
marginal utility / MU How each additional good or service adds to the total utility
max TU when MU = 0
=\frac{\Delta TU}{\Delta Q}
diminishing MU Each additional unit of good consumed adds less to TU than the previous one

Constaints on Which Goods to Purchase

  • Consumer's income
  • price of the goods
Word Meaning
budget constraint / BC the limit on the consumption bundles that a consumer can afford
BC for 2 goods X and Y with income N is P_x\times Q_x+P_y\times Q_y=N, the slope is -\frac{P_x}{P_y}
budget set All the possible combinations of goods a consumer can buy along his BC or inside it
optimal consumption bundle the combination of goods that maximizes a consumer's TU given their budget
relative price how much of the Y good a consumer gives up to get one unit of X (opportunity cost of good X in terms of good Y)
=\frac{P_x}{P_y}

Changes to the BC

  • if income ⬆, BC ➡
  • if income ⬇, BC ⬅
  • If P_x ⬇, BC becomes flatter (rotates out on x-axis)
  • if P_x ⬆, BC becomes steeper (rotates in on x-axis)
  • if P_x and P_y both change at the same rate, BC will have a parallel shift
Word Meaning
marginal utility per dollar spent =\frac{MU_x}{P_x} for any good X
TU is maximized when \frac{MU_x}{P_x}=\frac{MU_y}{P_y}
indifference curves / ICs every point on an IC has the same TU as every other point on the same curve
image-20211128170420144
perfect substitutes two goods with straight line indifference curves (always trade off one good for a fixed amount of another good)
perfect complements two goods with right angle indifference curves. e.g. 1 right glove and 1 left glove
image-20211128173700722

Optimum consumption bundle occurs at the point where the highest indifference curve and the budget constraint are tangent, at this point, |MRS|=\frac{MU_x}{MU_y}=\frac{P_X}{P_y}

Word Meaning
marginal rate of substitution / MRS the slope at any point on an indifference curve, the rate at which a consumer is willing to trade one good for another
$
Word Meaning
substitution effect the change in sonsumption that results when a price

Effects of Price Change on Consumption

  • Substitution effect: consumer moves along an IC to a point with a different MRS (still on the same IC)
  • Income effect: consumer moves to a higher or lower IC

image-20211128181533307

Last update: November 30, 2021
Created: November 28, 2021