5) CH21 The Theory of Consumer Choice

Question 1

What is a budget constraint?

Answer 1

Limit on the consumption bundles that a consumer can afford.

People consume less than what they want because they are limited by the budge constraint.

It shows the various combinations of goods the consumer can afford given the income and the prices.

Question 2

What does indicate a point on the budget line?

Answer 2

It indicates the the consumer’s combination or trade-off between two goods.

Question 3

What does indicate the slope of the budget constraint?

Answer 3

It indicates the relative prices of the 2 goods (price of 1 good compared to the price of the other).

It measures the rate at which the consumer can trade one good for the other.

Question 4

Which element does indicate the preferences among consumption bundles?

And what is it?

Answer 4

The indifference curve:curve that shows consumption bundles that give the consumer the same level of satisfaction.

Question 5

What is the Marginal Rate of Substitution?

Answer 5

It is the the slope at any point of the indifference curve.It is the rate at which a consumer is willing to trade one good for the other.

It is the amount of one good the consumer requires as a compensation to give up one unit of the other good.

Question 6

What are the properties of the indifference curves?

Answer 6

• Higher indifference curves are prefered than lower ones
• They are downward sloping
• They never cross
• They are bowed inward.

Question 7

Why are higher indifference curves prefered to lower ones?

Answer 7

• Consumer usually prefer to have more goods than less.
• Higher indifference curves represent larger quantities of goods.

Question 8

Why are indifference curves downward sloping?

Answer 8

• A consumer is willing to give up one good if he gets more of the other good, in order to remain equally happy.
• If a quantity og 1 good is reduced, the quantity of the other must increase

Question 9

Why do indifference curves never cross?

Answer 9

Points A and B should make the consumer equally happy.

Points B and C should make the consumer equally happy.

This implies that A and C would make the consumer equally happy.

But C has more of both goods compared to A.

Question 10

Why are indifference curves bowed inward?

Answer 10

• People are more willing to give up goods they have in abundance and less willing to trade away goods of which they have little.

Question 11

What are the 2 extreme examples of indifference curves?

Answer 11

• Perfect substitutes
• Perfect complements

Question 12

When are 2 goods perfect substitutes?

Answer 12

They have a straight-line indifference curve.

The MRS is a fixed number.

Question 13

When are 2 goods perfect complements?

Answer 13

Two goods with a right-angle indifference curves are perfect complements.

The 2 goods must be consumed in a proportional way together.

Question 14

What is the best choice for a consumer?

Answer 14

The one on the highest indifference curve that is also in the budget constraint.

Question 15

What is the consumer optimum?

Answer 15

Point where the highest indifference curve and the budget line are tangent.

MRS = relative price

Consumer’s valuation of the 2 goods = market’s valuation

Question 16

What does allow an increase in the income?

Answer 16

The consumer is able to choose a better combination of goods on a higher indifference curve.

Question 17

What is a normal good?

What is an inferior good?

Answer 17

Good that is more buy when the income rises.

Good that is less buy when the income increases.

Question 18

How changes in price affect consumer’s choices?

Answer 18

A fall of price of any good rotates the budget constraint outward and changes the slope of the budget condstraint.

Question 19

What are the 2 effects of a change in price?

Define them

Answer 19

• Income effect: Change in consumption that results when a price change moves the consumer to a higher or a lower indifference curve.
• Substitution effect: Change in consumption that results when the price change moves the consumer along an indifference curve to a point whith a different MRS.

Question 20

Summary of the income and substitution effect:

Answer 20

Question 21

What is the Demand curve?

Answer 21

Summary of the optimal decisions that arise from the consumer’s budget constraint and the indifference curves.

Question 22

Is it always the case that the D curves slope downward?

Answer 22

When a good is a Giffen good, the D slopes upward.

The income effect dominates the substitution effect.

Question 23

How do wages affect labour supply?

Answer 23

If the substitution effect is greater than the income effect for the worker, he/she will works more.

If income effect is greater than the substitution effect, he/she works less.

Question 24

How do interest rates affect household saving?

Answer 24

• If the substitution effect of a higher interest rate is higher than the income effect, households save more.
• If the income effect of a higher interest rate is greater than the substitution effect, households save less.
• Higher interest rate can either encourage or discourage saving.

Question 25

Summary 1:

Answer 25

• A consumer’s budget constraint shows the possible combinations of different goods he can buy given his income and the prices of the goods.
• The slope of the budget constraint equals the relative price of the goods.
• The consumer’s indifference curves represent his preferences.

Question 26

Summary 2:

Answer 26

• Points on higher indifference curves are preferred to points on lower indifference curves.
• The slope of an indifference curve at any point is the consumer’s marginal rate of substitution.
• The consumer optimizes by choosing the point on his budget constraint that lies on the highest indifference curve.

Question 27

Summary 3:

Answer 27

• The substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper.
• The substitution effect is reflected by a movement along an indifference curve to a point with a different slope.

Question 28

Summary 4:

Answer 28

• The theory of consumer choice can explain:
  
  • Why demand curves can potentially slope upward.
  • How wages affect labour supply.
  • How interest rates affect household saving.