Week 4

• Marginal Utility

  The additional utility generated by an additional unit of the good, holding the quantities of all other goods constant
• Diminishing Marginal Utility

  As the individual consumes more and more of some good, the additional utility gained from an additional unit of consumption decreases
• Trade-offs

  Holding the utility constant, how much of one good a consumer will give up to get more of another good
• Marginal Rate of Substitution

  • Between any two goods 1 and 2 (MRS(1,2)) measures how many units of good 2 the individual is willing to give up (substitute) for one additional unit of good 1, such that the utility remains constant
  • MRS(1,2) = MU(1)/MU(2)
• MRS and Indifference Curves

  MRS is the (absolute value of the) slope of an indifference curve
• Budget Constraints

  • Individuals have money income or a budget to finance consumption; denote this budget by m (assume no savings)
  • Consumption bundles are costly
  • Expenditures for consumption bundle X=(Xp Xc): E(X) = Pp x Xp + Pc x Xc
  • Definition: any consumption bundle plan X is feasible if its expenditures doesn't exceed the budget
  • Definition: the budget set consists of all feasible consumption plans
• Budget Set

  Consists of all bundles (Xp;Xc) satisfying the budget constraint
• Budget Line

  Consists of all bundles that exhaust the consumer's income
• Optimal Consumption Bundle

  The feasible consumption bundle that maximises the consumer's utility
• Rational Spending Rule

  • If consumption bundle (X1, X2) maximises utility of an individual, given their budget set, then it satisfies condition
  • MRS(1,2) = P1/P2
  • If MRS(1,2) > P1/P2, then buy more of good 1 and less of good 2
  • If MRS(1,2) < P1/P2, then buy more of good 2 and less of good 1
• Applying Optimal Choice: Budget Variation (Normal Goods)

  • If goods A and B are both normal goods, then an increase in income leads the consumer to consume more of both goods
  • The income elasticity of demand is the percentage change in quantity demanded associated with a 1% change in consumer income.
  • Describes how responsive demand is to income changes.
  • Positive for normal goods
  • Negative for inferior goods
• Decomposing a Price Change

  • As long as the consumer derives utility from both goods, a price increase will lower their utility
  • Substitution effect is always negative
  • Income effect could be positive (inferior good) or negative (normal good)