📚 Topic 2 Flashcards

Constrained Optimisation Model

A model that explains how people make the best possible choice when they face constraints. Consumers choose the option that maximises utility subject to a budget constraint.

Consumer Choice Model

An application of the constrained optimisation model that explains how consumers choose the combination of two goods that maximises utility subject to a budget constraint.

Leisure–Consumption Model

An application of the constrained optimisation model that explains how workers choose the combination of leisure and consumption that maximises utility subject to a time endowment and wage.

Utility

The satisfaction or happiness a consumer receives from consuming goods and services.

Utility Maximisation

The process of choosing the combination of goods that provides the highest attainable level of utility.

Consumer Optimum

The point where the budget constraint is tangent to the highest attainable indifference curve. This is the combination of goods that maximises utility.

Budget Constraint

A line showing all combinations of two goods that a consumer can afford given their income and the prices of the goods.

Budget Constraint (Price Change)

When the price of one good changes, the budget constraint pivots because only one intercept changes.

Budget Constraint (Income Change)

When income changes, the budget constraint shifts in a parallel direction because both intercepts change.

Good X Intercept

The maximum amount of Good X the consumer can purchase if all income is spent on Good X.

Good Y Intercept

The maximum amount of Good Y the consumer can purchase if all income is spent on Good Y.

Indifference Curve

A curve showing all combinations of two goods that provide the consumer with the same level of utility.

Decrease in the Price of Good X

Causes the budget constraint to pivot outwards around the Good Y intercept because the consumer can afford more Good X.

Increase in the Price of Good X

Causes the budget constraint to pivot inwards around the Good Y intercept because the consumer can afford less Good X.

Decrease in the Price of Good Y

Causes the budget constraint to pivot outwards around the Good X intercept.

Increase in the Price of Good Y

Causes the budget constraint to pivot inwards around the Good X intercept.

Income Increase

Causes the budget constraint to shift outwards in a parallel direction, allowing the consumer to reach a higher indifference curve.

Income Decrease

Causes the budget constraint to shift inwards in a parallel direction, reducing the combinations of goods the consumer can afford.

Income Effect

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

Substitution Effect

The change in consumption caused by a change in the relative prices of goods.

Price Decrease

Produces both an income effect and a substitution effect.

Income Change

Produces only an income effect because relative prices do not change.

Relative Price

The price of one good compared with the price of another good.

When Good X Becomes Cheaper

Good X becomes relatively cheaper than Good Y, encouraging consumers to purchase more Good X.

Opportunity Cost (Consumer Choice Model)

The value of the next best alternative that is given up when making a choice.

Opportunity Cost of Good X

The amount of Good Y that must be given up to obtain an additional unit of Good X.

Opportunity Cost of Leisure

The consumption that must be given up by choosing one more hour of leisure instead of working.

Normal Good

A good for which demand increases when income increases and decreases when income decreases.

Inferior Good

A good for which demand decreases when income increases and increases when income decreases.

Time Endowment

The total amount of time available for a worker to divide between leisure and work.

Consumption

Goods and services purchased using income earned from working.

Leisure

Time not spent working.

Wage

The amount of income earned for each hour worked.

Wage Increase

Causes the budget constraint to pivot upwards around the leisure intercept because the worker can earn more consumption for each hour worked.

Income Effect (Leisure–Consumption Model)

A higher wage increases income, allowing the worker to choose more leisure.

Substitution Effect (Leisure–Consumption Model)

A higher wage increases the opportunity cost of leisure, encouraging the worker to substitute leisure for work.

When the Income Effect Dominates

Workers choose more leisure and fewer work hours.

When the Substitution Effect Dominates

Workers choose less leisure and more work hours.

Real Purchasing Power

The quantity of goods and services a consumer can afford with their income.

Consumer Equilibrium

Another term for the consumer optimum where utility is maximised subject to the budget constraint.

Preferences

A consumer's ranking of different combinations of goods according to the utility they provide.

Rational Consumer

A consumer who chooses the combination of goods that maximises utility given their constraints.

Marginal Rate of Substitution (MRS)

The rate at which a consumer is willing to give up one good in exchange for one more unit of another good while maintaining the same level of utility.

MRS

The slope of an indifference curve.

Diminishing Marginal Rate of Substitution

As a consumer consumes more of one good, they are willing to give up less of the other good to obtain additional units of that good.

Marginal Rate of Transformation (MRT)

The rate at which the market allows a consumer to trade one good for another. It is determined by the relative prices of the two goods.

MRT

The slope of the budget constraint.

Consumer Optimum

At the consumer optimum, the consumer reaches the highest attainable indifference curve where the budget constraint is tangent to the indifference curve.

At the consumer optimum:

MRS = MRT

Slope of the Budget Constraint

The slope of the budget constraint is determined by the relative prices of the two goods.

Slope of an Indifference Curve

The slope of the indifference curve represents the consumer's willingness to substitute one good for another while maintaining the same level of utility.

Relative Prices

Relative prices measure the price of one good compared with the price of another good.