EC120 Chapter Notes - Chapter 21: Budget Constraint, Indifference Curve, Relative Price
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10/13/15
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EC120 – CHAPTER 21: THE THEORY OF CONSUMER CHOICE
THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD
• People consume less than they desire because their spending is constrained,
limited by their income
• BUDGET CONSTRAINT (BC): The limit on the consumption bundles that a
consumer can afford
• The slope of the budget constraint measures the rate at which the consumer
can trade one good for the other
• Slope of the BC = relative price of two goods (the price of one good compared
to another)
REPRESENTING PREFERENCES WITH INDIFFERENCE CURVES
• When offered two bundles, the consumer will pick the one that best suits
their tastes
• INDIFFERENCE CURVE (IC): A curve that shows consumption bundles that
give the consumer the same level of satisfaction
• The slope at any point on an IC equals the rate at which the consumer is
willing to substitute one good for the other.
• MARGINAL RATE OF SUBSTITUTION (MRS): The rate at which the consumer
is willing to substitute one good for the other.
• IC’s are not straight lines, therefore the MRS is not the same throughout the
graph
• Higher IC’s are preferred to lower ones, since people prefer more
consumption (Higher curve vs. lower curve)
FOUR PROPERTIES OF IC’S
1. Higher IC’s are preferred to lower ones – People usually prefer more of
something than less of it
2. IC’s are downwards sloping – If the quantity of one good is reduced, the
quantity of the other good must increase for the consumer to be equally
happy
3. IC’s do not cross – If crossed, two points would be on the same line even
though one would provide more of each good and therefore would make the
consumer more happy
4. IC’s are bowed inwards – People are more willing to trade away goods that
they have in abundance and less willing to trade away goods they have little
of
TWO EXTREME EXAMPLES OF IC’S
• PERFECT SUBSTITUTES: Two goods with straight-line IC’s
o MRS is fixed in this scenario, therefore the IC’s are straight lines
• PERFECT COMPLEMENTS: Two goods with right-angle indifference curves
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Document Summary
Ec120 chapter 21: the theory of consumer choice. The budget constraint: what the consumer can afford. Representing preferences with indifference curves: when offered two bundles, the consumer will pick the one that best suits their tastes. Ic"s are not straight lines, therefore the mrs is not the same throughout the: higher ic"s are preferred to lower ones, since people prefer more. How changes in income affect the consumer"s choices. How changes in price affect the consumer"s choices: a fall in the price of any good shifts the bc outwards, the slope of the bc changes due to the change in relative price. How do wages affect labour supply: a persons wage represents the tradeoff between leisure and consumption, e. g. For every hour of leisure sally gives up, she works one more hour and gains of consumption: same concept as above, except using time instead of goods.