Microeconomics Chapter 21 free essay sample

Budget constraint: 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 Preferences: What the consumer wants -The budget constraint is one piece of the analysis: it shows what combination of goods the consumer can afford given his income and the prices of the goods -The consumers’ choice, however, depend not only on his budget constraint but also on his preferences regarding the two goods -The consumer’s preferences are the next piece of our analysis Representing Preferences with Indifference Curves Indifference curve: a curve that shows consumption bundles that give the consumer the same level of satisfaction -The slope at any point on an indifference curve equals the rate at which the consumer is willing to substitute one good for the other Marginal rate of substitution: the rate at which a consumer is willing to trade one good for another Because the indifference curve are not straight lines, the marginal rate of substitution is not the same at all points on a given indifference curve -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 -The consumer is equally happy at all points on any given indifference curve, but he prefers some indifference curve to others -A consumer’s set of indifference curves gives a complete ranking of the consumer’s preferences -We can use the indifference curve to rank any two bundles of goods Four propert ies of Indifference curves Property 1: Higher indifference curves are preferred to lower ones. We will write a custom essay sample on Microeconomics Chapter 21 or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page People usually prefer more of something to less of it. This preference of greater quantities is reflected in the indifference curves Property 2: Indifference curves are downward sloping. The slope of an indifference curve reflects the rate at which the consumer is willing to substitute one good for the other, In most cases, the consumer like both goods. Therefore, if the quantity of one good is reduced, the quantity of the other good must increase in order for the consumer to be happy Property 3: Indifference curves do not cross. Contradicts our assumption that the consumer always prefers more of both goods to less. Thus, indifference curves cannot cross. (Refer to example) Property 4: Indifference curves are bowed inward. The slope of an indifference curve is marginal rate of substitution-the rate at which the consumer is willing to tradeoff one good for the other. The MRS usually depends on the amount of each good the consumer is currently consuming. People are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little, the indifference curves are bowed inward Two Extreme Examples of Indifference Curves -The shape of an indifference curve tells us about the consumer’s willingness to trade one good for the other -When the goods are easy to sub. For each other, the indifference curve are less bowed; when the goods are hard to sub, the indifference curves are very bowed Perfect Substitute -Because the marginal rate of substitution is constant, the indifference curves are straight lines In this extreme case of straight indifference curve, we say that they two goods are perfect subs. Perfect Complements The indifference curve, therefore are right angles -In this extreme case of right-angle indifference curves, we say that the two goods are perfect complements -Real world- most goods are neither perfect substitutes nor perfect complements but typically, the indifference curves are bowed inward, but not so bowed as to become right angles Optimization: What the consumer chooses Income effect: when the interest rate rises, he moves to a higher indifference curve. As long as consumption in both periods consists of normal goods, he tends to want to use this increase in well-being to enjoy higher consumption in both periods- income effect induces him to save less -The theory of consumer choice says that an increase in the interest rate could either encourage or discourage savings Conclusion: Do people really think this way? -The theory of consumer choice does not try to present a literal account of how people make decisions -The theory of consumer choice tries to describe this implicit, psychological process in a way that permits explicit, economic analysis -Test of theory is in the application