Download Price Theory Handout #3

Price Theory Handout #3
Budget constraint: the set of all combinations of good and services the consumer can afford with a given
income and given prices.
General formula for a budget constraint: Pxx + Pyy = I. Or, y = -(Px/Py)x + (I/Py).
Price ratio: one price divided by the other: Px/Py. It is also the slope of the budget constraint (without the
negative sign).
Utility: the pleasure or satisfaction obtained from consuming goods and services.
Cardinal utility: countable utility. We imagine that satisfaction is an actual quantity that can, in theory, be
measured. We call the units of cardinal utility "utils."
Ordinal utility: ranking of bundles. We don’t assume that utility is measurable, but merely that consumers
can compare bundles of goods and say which one is "better."
Ordinalism: the use of ordinal utility instead of cardinal utility in constructing economic models.
Preference Symbols:
A  B means "bundle A is preferred to bundle B."
A  B means "bundle A is at least as good as bundle B."
A ~ B means "A and B are equally good," or "The consumer is indifferent between A and B."
Comparability: given any two bundles, a consumer can say which one is better (or say he's indifferent).
More is better: if one bundle has more of at least one good, and no less of any other goods, then it’s better.
Transitivity: if A is better than B, and B is better than C, then A is better than C. (This concept also works
for the other preference relations and combinations. For example, if A is better than B, and B and C are
equally valued, then A is better than C.)
Indifference curve: a curve that connects all the bundles of goods that provide the same level of utility to a
consumer. Every point on an indifference curve gives the consumer the same utility.
Marginal rate of substitution (MRS): the amount of good y necessary to compensate the consumer for
losing one unit of good x. It is equal to the slope of the line through two points on an indifference curve, or
the slope of a tangent line through a single point on an indifference curve.
Law of diminishing MRS: the MRS decreases as x increases. In other words, an indifference curve
becomes flatter as x increases.
Utility maximization condition (except in unusual cases): MRS = P x/Py
Superior good: a good that a consumer buys more of when his income rises.
Inferior good: a good that a consumer buys less of when his income rises.
Note: The book uses the term "normal" to refer to what I call superior goods. I use the word normal for
something else: any good for which the law of demand holds. All superior goods are normal, and most
inferior goods are normal as well.
Complements: If the optimal consumption of both goods increases in response to a decrease in the price of
just one good, the goods are complements.
Substitutes: If the optimal consumption of one good increases while optimal consumption of the other
decreases in response to a change in the price of the first good, the goods are substitutes.
Substitution effect: when the price of a good falls, the consumer buys more of the good because it’s now
relatively less expensive than the other good; i.e., because the price ratio has changed.
Income effect: when the price of a good falls, the consumer buys more of the good (or less, if the good is
inferior) because his real income has effectively increased. (Real income is income divided by the price
level.)
Total Effect = Substitution Effect + Income Effect
Giffen good: a good that violates the law of demand. All Giffen goods are inferior goods, but some
inferior goods are not Giffen.