Optimal Consumption: Income & Substitution Effects

Flashcards covering key concepts from the lecture on optimal consumption, including income and substitution effects, indifference curves, and the budget constraint.

Preferences

Shows the trade-offs between consumption and leisure an individual is willing to make, illustrated with indifference curves. The MRS falls along the indifference curve.

Budget Constraint

Illustrates the limits on consumption and leisure an individual is able to make, illustrated by the MRT (constant in this simple model).

Optimality Condition: MRS = MRT

Utility is maximized when the slope of the indifference curve equals that of the budget constraint.

Constrained Optimization Model

A framework where an agent (individual, firm) aims to maximize something (utility, profit) subject to certain constraints.

Income Effect

The change in consumption (or leisure) due to the change in purchasing power caused by a price change.

Substitution Effect

The change in consumption (or leisure) due to the change in the relative price of goods.

Substitution Effect of a Wage Increase

An increase in the wage rate has increased the opportunity cost of leisure.

Ceteris Paribus

The model employs the assumption that holds all else equal.

Economics

Economics considers human behavior.

Scope of Economics

Economics applies to the study of both market and non market-based exchange of goods and services.

Impact of Increased Energy Costs

Holding all else equal, we expect an increase in energy costs to change a firm’s choice of production technology to move towards a less energy intensive combination of inputs.

Gains from Trade

Specialisation and the gains from trade mean individuals are likely to be better off if they specialise in what they have a comparative advantage in producing.

Microeconomics Topics

Consumer and producer surplus are typical topics of microeconomics.

Features of the Industrial Revolution

An increase in the use of machinery in production and A series of cumulative technological innovations were features of the industrial revolution.

Firm Technology Preference

Assuming two different production technologies produce the same level of output and the firm has a choice between them, A firm would likely prefer the technology on the lower isocost curve.