Chapter 6

Question 1

1. Define the budget constraint and explain how to interpret its slope.

Answer 1

Budget constraint
a. Different combinations of goods
b. A consumer can afford with a limited budget
c. At given prices
Budget line
d. Graphical representation of a budget constraint

Question 2

2. Describe how a budget constraint changes in response to a change in income or prices.

Answer 2

• Changes in income
– 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
• Changes in price
– The budget line rotates
– The slope of the budget line changes
– One of the intercepts of the budget line changes

Question 3

Explain and justify the assumptions economists make about preferences in order to develop the theory of consumer choice.

Answer 3

3.
• Rational preferences satisfy two conditions:
1. Any two alternatives can be compared, and one is preferred or else the two are valued equally
2. The comparisons are logically consistent or transitive
• More is better
1. Always choose a point on the budget line, rather than a point below it

Question 4

4. Define utility and marginal utility and state the law of diminishing marginal utility.

Answer 4

• Utility
– Quantitative measure of pleasure/ satisfaction obtained from consuming goods and services
• Marginal utility
– Change in total utility
– From consuming an additional unit of a good or service
• Law of diminishing marginal utility
– As consumption of a good or service increases, marginal utility decreases
• Marginal utility
– Can be zero
• Assumption
– Marginal utility for every good is positive
– ‘More is better’

Question 5

5. Explain how a budget constraint helps us analyze utility maximization.

Answer 5

• Utility maximization
– Consumer will choose the point on the budget line
– Where marginal utility per dollar is the same for both goods: MUx/Px = MUy/Py
– There is no further gain from reallocating expenditures in either direction

Question 6

6. Explain how changes in income affect consumer choices in the case of normal goods and inferior goods.

Answer 6

• A rise in income
– With no change in prices
– A new quantity demanded for each good
– Individual preferences (marginal utility)
• Normal good – quantity demanded increases
• Inferior good – quantity demanded decreases

Question 7

7. Explain how price changes affect consumer behavior and use this information to construct an individual demand curve

Answer 7

•	Change in prices
–	Decrease in the price of one good
•	Other things constant 
•	Rotates the budget line rightward
•	Individual demand curve
–	Quantity of a good a consumer demands at each different price

Question 8

10. Discuss how budget constraints can be used to show the usefulness of consumer theory whenever two alternatives are considered.

Answer 8

•	Extensions of the model
–	Incorporate choices among many goods
–	Recognize saving and borrowing
–	Incorporate uncertainty and imperfect information
–	Behavioral economics

Question 9

8. Describe the substitution and income effects of a price change.

Answer 9

– As the price of a good falls, the consumer substitutes that good in place of other goods whose prices have not changed
– Arises from a change in the relative price of a good
– It moves quantity demanded in the opposite direction to the price change
• Income effect
– As the price of a good decreases, the consumer’s purchasing power increases
• Causing a change in quantity demanded for the good
– Arises from a change in purchasing power over both goods
• Normal goods
– Substitution and income effects work together
– Quantity demanded - moves in the opposite direction of the price
– Always obey the law of demand
• Inferior goods
– Substitution and income effects work against each other
– Substitution effect virtually always dominates
– Virtually always obey the law of demand

Question 10

12. Describe the subfield of economics known as behavioral economics, and discuss the challenge it presents to the basic model of consumer behavior.

Answer 10

• Behavioral economics
– Subfield of economics
– Decision-making patterns that deviate from those predicted by traditional consumer theory
Traditional economic theory: assumes that consumers have rational preferences
Behavioral economics: analyzes decisions that violate rational preferences