Indifference Curves, Optimization & Income/Substitution Effects

Why are indifference curves downward sloping?

To maintain equal utility more of one desirable good must be offset by less of the other.

What do higher indifference curves represent?

Higher utility because they represent bundles with more preferred combinations of goods.

Can indifference curves cross?

No. Crossing would create contradictory rankings of the same bundles.

Why are indifference curves typically convex to the origin?

Because consumers generally have a diminishing willingness to substitute one good for another.

What is the marginal rate of substitution (MRS)?

The amount of one good a consumer is willing to give up for an additional unit of another while keeping utility constant.

What does the slope of an indifference curve represent?

The negative of the marginal rate of substitution.

What is diminishing MRS?

As a consumer has more of one good they are generally willing to sacrifice less of the other to obtain even more.

How is MRS different from the budget line's slope?

MRS measures the consumer's willingness to trade while the budget slope measures the market's required tradeoff.

How is the consumer's problem solved graphically?

Find the highest indifference curve attainable within the budget constraint.

What is the typical condition for an optimal interior consumption bundle?

The indifference curve is tangent to the budget line so MRS equals the price ratio.

Why is tangency optimal?

The consumer's willingness to trade equals the market tradeoff so reallocating spending cannot increase utility.

What happens if MRS differs from the price ratio?

The consumer can generally increase utility by changing the combination of goods.

Does the optimal bundle always occur at a tangency point?

No. A corner solution can occur when the consumer optimally buys none of one good.

What is the substitution effect?

The change in consumption caused by a change in relative prices while holding utility constant.

What happens through the substitution effect when a good becomes cheaper?

Consumers substitute toward the relatively cheaper good.

What is the income effect?

The change in consumption caused by a price change altering the consumer's purchasing power.

Why does a price decrease increase purchasing power?

The consumer can afford more goods with the same income.

What is a normal good?

A good whose consumption increases when income rises holding prices constant.

What is an inferior good?

A good whose consumption decreases when income rises holding prices constant.

How do substitution and income effects combine for a normal good when its price falls?

Both effects increase consumption of that good.

How do substitution and income effects relate to the demand curve?

A price change changes the optimal quantity demanded through both effects and tracing those choices produces the demand curve.