Chapter 3 - Consumer behavior

Question 1

What are the 3 distinct steps of understanding consumer behavior?

Answer 1

1) Consumer preferences

2) Budget constraints

3) Consumer choices

Consumer preferences is all about finding a practical way of describing the reasons why consumers prefer some good to another.

Budget constraints tries to understand what consumers do when they face budget constraints. What type of goods are typically the first to be sacrificed whenever the budget is running tight?

Consumer choice is about maximizing satisfaction based on preferences and limited budgets.

Question 2

In regards to consumer preferences, what are the assumptions that we make when trying to decide facts about consumer preferences?

Answer 2

First of all, all of the assumptions consider baskets as units.

1) Completeness. This means that consumers can rank all baskets. Consumers either prefer A to B, B to A or are indifferent. Point is, they can rank the baskets.

2) Transitivity. If a consumer prefer A to B and B to C, then this consumer prefer A to C as well.

3) More is better than less. Consumers are never satisfied. If they can choose, more goods are always in favor of less.

Question 3

What is an “indifference curve”?

Answer 3

An indifference curve is a graphical curve that shows all combinations of baskets that lead to the same level of satisfaction.

Typically consists of a plot of baskets, and a line or more lines that goes though the plot points, indicating that all points that lies on this line is preferred with the same amount, meaning indifference.

Question 4

What is a plot of individual preferences?

Answer 4

At least in 2D, we can plot the different baskets containing combinations of 2 types of goods. On this plot, was can shade a couple of areas based on the “more is better” assumption. The shading generally says that if a basket point on the plot lies above AND to the right of another “basket”, then this basket is preferred, because it contains more of both goods.

This plot does not provide enough information for the indifference curve(s). We need information on rankings to do this.

Question 5

What is an indifference map?

Answer 5

Indifference map is a set of all the indifference curves possible.

Question 6

Can indifference curves intersect?

Answer 6

No

Question 7

Which indifference curve yield the highest satisfaction?

Answer 7

The most inner curve yields the highest satisfaction.

Question 8

Why do indifference curves slope downward and not upward?

Answer 8

If indifference curves were to slope upward, then they would violate the assumption of more is better. if it sloped upward, a consumer would be “indifferent” between to baskets even though one of them would contain more of both products.

Question 9

What is “marginal rate of substitution”?

Answer 9

The marginal rate of substitution is the measure of how much of A some consumer is willing to give up for an extra unit of B. Actually, the maximum number of some good A that a consumer is willing to give up for an additional united of B.

Commonly referred to as MRS.

MRS at any point is the slope of the indifference curve. (Magnitude of the slope of the indifference curve).

Question 10

When discussing MRS, which good (which axis) are we giving up, and which good (which axis) are we looking at an additional unit of?

Answer 10

We are always looking at how many units of the good on the Y-axis we are willing to give up in order to get an additional unit of the good that is on the X-axis.

Question 11

Explain convexity and indifference curves and MRS

Answer 11

As we move along the indifference curve (from left to right) we see that the MRS - Marginal rate of substitution - diminish. The reason for this is because the more of one good we get, the less interested we are in getting even more of it.
For instance, if we can choose between potatoes and beef: If we have extremely many potatoes, we would not really be satisfied trading a large amount of beef to get one additional unit of potato. Therefore, as the number of a certain good grows larger, the less important for us it is to keep growing this set.

Question 12

What is the fourth assumption in regards to consumer preferences?

Answer 12

Diminishing marginal rate of substitution.

Question 13

Define perfect substitutes and their indifference curves

Answer 13

We already know that the indifference curve represent the willingness to give up some of one good to get 1 additional unit of the other.

Therefore, a perfect substitute should have a one-to-one relationship all the way. It doesn’t matter what unit we have. Perhaps two types of bread with minor differences.

The indifference curve will be straight lines of slope -1.

Question 14

Define perfect complements and their indifference curves

Answer 14

Perfect complements are non-tradable. Meaning, we dont give up anything.

The slope will be 0 when there is an unequal number of each good.

Question 15

Define “utility”

Answer 15

Utility is a measure of the satisfaction we get, as a consumer, by some market basket. Therefore, utility is a score we assign to market maskets.

The level of utility is typically assigned by a “utility function”

Question 16

What is the “rule” of the utility function?

Answer 16

if market basket A is preferred to B, then market basket A should be assigned a higher utility score than market basket B.

Question 17

How can you use the utility function to find indifference curves?

Answer 17

We use of the fact that a single indifference curve MUST have the same utility at all points. Therefore, using the utility function to generate a value, we draw the line/curve that associates combinations of goods that generate indifference based on the utility function.

For instance, if u(F, C) = FC, then we could choose F=5 and C=5 which gives utility of 25. (5,5) is the point, and the utility is 25. Then, we would have to figure out all combinations of F and C that gives us this same utility. Some combinations include 2.5 and 10, 10 and 2.5. When we draw the line of all such combinations, we get the indifference curve.

In this way, we use the utility function to create the indifference curve(s).

Question 18

Do the numbers of utility mean anything?

Answer 18

No, they are for convenience only. The utility function is simply a way of ranking different market baskets.

Question 19

Why are budget constraints relevant?

Answer 19

Because people tend to have limited income.

Question 20

What is “the budget line”?

Answer 20

The budget line is a line/curve that illustrates all combinations of two goods that when multiplied by weights gives us the same total value at all points on the line. Therefore, the budget line shows combinations of goods such that the total value is equal to the budget.

Question 21

What are the limitations of the budget line?

Answer 21

The budget line assumes that the entire income is used on consumption.

Also, only 2 types of goods are possible. Not really relevant.

Question 22

Specify the 2d budget line

Answer 22

PcC + PfF = I

Question 23

What would happen to the budget line if income increase?

Answer 23

The prices are still the same, which means that the slope of the line remains the same.

However, the intercept points will change, as they are direct functions of buying power. Therefore, the curve will shift upwards (out in both directions) given an income increase.

Question 24

What would happen to the budget line if prices change?

Answer 24

The slope of the curve is directly dependent on the prices of both goods. Therefore, the slope will change. If both prices change by the same percentage (ex both double) then the slope remains the same. If only one of the prices change, the slope will in fact change.

At the same time, just because the slope remains the same, if both prices increase by the same percentage, the curve would shift inwards. Same applies to the opposite. This is due to the fact that higher prices against the same income leads to fewer goods able to buy.

However, if the income change accordingly, then everything would remain the same.

Question 25

What is the assumption in regards to consumer choice?

Answer 25

That consumers are rational - they seek to maximize satisfaction based on their level of income

Question 26

What are the requirements of the “maximizing market basket”?

Answer 26

1) Must be on the budget line. Physically cannot be above, and if beneath we have income that is not allocated. More is always better.

2) It must give the consumer the most preferred combination of goods and services. Meaning, the outer-most indifference curve that touch the budget line.

Question 27

How do you figure out what basket to choose? How do you figure out consumer choice?

Answer 27

We plot the budget line along with the indifference curves. Then we find the point/basket that happens to be where the budget line is tangent, meaning they touch in only one point, and in this point the budget line is a tangent to the indifference curve.

This point is where marginal benefit equals marginal cost.

We can formalize by saying that MRS = P_a/P_b is the point we’re after.

Question 28

Define corner solutions

Answer 28

A corner solution is when a consumer only consumes one of the products, completely avoiding the other one.

When a corner solutions occurs, we see that the MRS does not necessarily equal the slope of the budget line. Specifically, the MRS is GREATER than the slope of the budget line. This means that IF the consumer happened to have more of the good that he currently doesn’t have any of, he would gladly trade it to get more of the good that he prefer.

Question 29

What determines consumer choice?

Answer 29

Consumer preference combined with their budget constraints

Question 30

What is the “consumer behavior” question?

Answer 30

Consumers have limited income. How do they decide which goods to buy?

This decision create demand. Demand is basically created from the utility that consumers get from certain goods.

When we aggregate all decisions, we get market demand.

Question 31

What is Laspeyres index?

Answer 31

the amount of money at CURRENT-YEAR prices that an individual requires to purchase the bundle of goods and services that was chosen in the base year divided by the cost of purchasing the same bundle at base year prices.

So, Laspeyres considers some bundle of goods and its price in some base year. Then it claculates the price to buy this bundle today. Then it divides this total sum by the price of buying the bundle in the base year.

Question 32

What is Paasche index?

Answer 32

Index for income changes btween 2 periods where we use the quantities in the current year as weights. This means, we multiply current price of good x with the current quantity of good x, and divide this by the product of current quantity of x and the base year price.

Question 33

Define the “ideal” cost of living index

Answer 33

the ideal cost of living index would capture the index measuring the change in cost of attaining a specific level of utility in the current year vs the same utility in base year.

Therefore, we look at some bundle BEFORE the price change. We calculate the number of goods. We calculate the utility of this bundle. Then we figure out what it would cost us, in the current year (after the price change), to attain the same level of utility.