Background to Demand: The Theory of Consumer Choice

Vocabulary flashcards covering the Standard Economic Model, budget constraints, indifference curves, and the effects of income and price changes on consumer choice.

Standard Economic Model (SEM)

A classical theory of consumer behaviour that assumes rational behaviour, where buyers seek to maximize their utility, act in self-interest, and prefer more to less.

Utility

The satisfaction derived from the consumption of a product, which helps indicate the ranking of consumer preferences.

Opportunity Cost

What was given up in order to make a purchase.

Budget Constraint

The limit on the consumption "bundles" that a consumer can afford, depicting various combinations of goods possible given a consumer's income and the prices of the goods.

Relative Price

The price of one good compared to the price of another, which equals the slope of the budget constraint line and measures the rate of trade-off between two goods.

Indifference Curve

A curve showing various consumption bundles that provide the consumer with the same level of satisfaction.

Marginal Rate of Substitution (MRS)

The slope at any point on an indifference curve, representing the rate at which a consumer is willing to trade one good for another or the amount of one good required as compensation for giving up one unit of another.

Property 1 of Indifference Curves

Higher indifference curves are preferred to lower ones because consumers usually prefer more of a good to less of it.

Property 2 of Indifference Curves

Indifference curves are downward sloping because if the quantity of one good is reduced, the quantity of the other must increase for the consumer to remain equally happy.

Property 4 of Indifference Curves

Indifference curves are bowed inward, reflecting that people are more willing to trade away goods they have in abundance and less willing to trade away goods they have little of.

Total Utility

The total satisfaction that consumers gain from consuming a product.

Marginal Utility of Consumption

The increase in utility that a consumer receives from consuming an additional unit of a good.

Diminishing Marginal Utility

The tendency for the additional satisfaction gained from consuming extra units of a good to fall as more of it is consumed.

Optimum

The point of the consumer's optimal choice where the marginal rate of substitution equals the relative price, and the consumer's valuation of the goods equals the market's valuation.

Inferior Good

A good for which a consumer's consumption falls when their income rises.

Normal Good

A good for which a consumer's consumption increases when their income rises.

Income Effect

The change in consumption resulting from a price change that moves the consumer to a higher or lower indifference curve, making them feel richer or poorer.

Substitution Effect

The change in consumption resulting from a price change that moves the consumer along a single indifference curve to a point with a different marginal rate of substitution, because one good has become relatively cheaper or more expensive.