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  • In making decisions about spending, we must all face two facts of economic life:

    1. We have to pay for the goods and services we buy 2. We have limited funds to spend. These two facts are summarized by our budget constraint.

    What is budget constraint?

    The different combinations of goods a consumer can afford with a limited budget, at given prices.

    A consumer's ____________ identifies which combinations of goods and services can afford with a limited budget, at given prices.

    Budget constraint

    What is the graphical representation of a budget constraint, showing the maximum affordable quantity of one good for given amounts of another good?

    Budget Line

    On the budget line, one cannot afford any combination ___________ of this line.

    Above and to the right

    The budget line therefore, serves as a border between those combinations that are affordable and those that are not.


    If we divide on money price by another money price, we get what is called a ___________, the price of one good relative to the other.

    Relative price

    The relative price of a concert, the opportunity cost of another concert, and the slope of the budget line all have the same ____________.

    Absolute value

    If Py is the price of the good on the vertical axis and Px is the price of the good on the horizontal axis, then....

    Px/Py= the relative price of good X
    = The opportunity cost of one more unit of good x
    = the absolute value of the slope of the consumer's budget line.

    These "givens"-- the price of the goods and the consumer's income-- are always assumed constant as we move along the budget line.


    An increase in income will shift the budget line upward (and rightward). A decrease in income will shift the budget line downward (and leftward).

    These shifts are parallel: CHanges in income do not affect the budget line's slope.

    When the price of movie falls, the budget line rotates _______; that is, the vertical intercept moves higher.


    When the price of a good changes, the budget line rotates:

    Both its slope and one of ties intercepts will change.

    One common denominator-- and a critical assumption behind consumer theory-- is that people have ______.

    Preferences, More specifically, we assume that you can look at two alternatives and state wither that you prefer one to the other or that you are entirely indifferent detween the two -- you value them equally. Another common denominator is that preferences are logically consistent or transitive.

    Another feature of preferences:

    We generally feel more is better.

    The consumer will always choose a point on the budget line, rather than a point below it.


    What are rational preferences?

    Preferences that satisfy two conditions: 1. Any two alternatives can be compared, and one is preferred or else the two are valued equally, and 2. The comparisons are logically consistent or transitive.

    What is utility?

    A quantitative measure of pleasure or satisfaction obtained from consuming goods and services.

    Marginal utility treats consumers as striving to maximize their utility- a quantitative measure of the consumer's well-being or satisfaction.


    Although utility increase every time one consumes more of a good, the additional ultiity that one derives from each successive cone gets smaller and smaller as one gets more of that good.

    The Marginal Utility Approach

    What is marginal utility?

    The change in total utility an individual obtains from consuming an additional unit of a good or service. Marginial utility is the change in utility an individual enjoys from consuming an additional unit of a good.

    As she eats more and more ice cream cones in a given week, her marginal utility from another cone declines. We call this is _________.

    Law of Diminishing Marginal Utility

    What is the law of diminishing marginal utility?

    As consumption of a good or derive increases, marginal utility decreases.

    Marginal utility is equal to what?

    The change in total utility

    Once the satiation point is reached then what happens?

    The consumer will turn down the product.

    A utility-maximizing consumer will choose the point on the budget line where marginal utility per dollar is the same for both goods (MUx/Px= MUy/Py

    At that point, there is no further gain from reallocating spending in either direction.

    It must be true that MUx/Px= MUy/Py for any pair of goods x and y.

    If this condition is not satisfied, the consumer will be better off consuming more of one and less of the other good in a pair.

    If an increase in income (with prices held constant) increases in the quantity of a good demanded, the good is ______.


    A rise in income-- with no change in prices-- leads a new quantity demanded for each good.

    Whether a particular good is normal or inferior demanded depends on the individual's preferences, as represented by the marginal utilities for each good, at each pint along his budget line.

    If a price decreases, the drop in the price of concerts rotates Max's budget line rightward...

    pivoting around its vertical intercept. What if we drop the budget line further? The budget line rotates further rightward.

    A FALL IN THE PRICE OF CONCERTS increases the quantity demanded---

    showing that Max's responses to price changes obey the law of demand.

    What is the substitution effect?

    As the price of a good falls, the consumer substitutes that good in place of other goods whose prices have not changed.

    The ______ of a price change always moves quantity demanded in the opposite direction to the price change. When the price of a good decrease, the substitution effect works to increase quantity demanded; when price increases, the substation effect works to decrease quantity demanded.

    Substitution effect

    The substitution effect is also important from a theoretical perspective: It is the main factor responsible for the law of demand.


    What is the income effect?

    THe income effect of a price change wrists from a change in purchasing power over both goods. A drop in price increases total purchasing power, while a rise in price decreases total purchasing power. As the price of a good decreases, the consumers' purchasing power increases, causing a change in quantity demanded for the good.

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