Consumer Choice

Question 1

What does a budget line show?

Answer 1

The maximum combination of goods x and y given the limited amount of money the individual has

Question 2

What determines the position of the budget line?

Answer 2

Income and price only

Question 3

What does the indifference curve show?

Answer 3

The maximum combinations of good x and y that an individual can consume while maintaining the same level of utility (satisfaction level)

Question 4

What is the shape of an indifference curve?

Answer 4

Convex viewing from the origin (0 on x and y axis), feels the same satisfaction on all points of the indifference curve

Question 5

What are the assumptions/axioms of consumer theory?

Answer 5

1. Non-satiation: more is preferred, never satisfied, greed trait
2. Completeness: every consumer has complete knowledge of goods under analysis so they know what the good is
   Essential, models won’t hold without it 3. Transitivity: consistency in choice made by consumers, will consume the same good years further and not switch
3. Law of Diminishing Marginal Utility: everyone has the same threshold on how much they can consume

Question 6

What are the implications of the indifference curve assumptions/axioms?

Answer 6

Explains why:
1. Non-satiation: indifference curve can’t turn up towards the end
Proof: the four quadrants
2. Completeness: will always be an indifference curve passing through within the commodity space (graph drawing area)
Proof: without complete knowledge of good(s) under analysis, can’t pinpoint indifference curve within the commodity space
3. Transitivity: indifference curve cannot intersect
Proof: If A is intersecting point of U0 and U1, A indifferent to B at U0 and C at U1, so B should be indifferent to C, yet there is preference of C at U1, making consumer choice inconsistent
4. Law of Diminishing Marginal Utility: indifference curve is convex viewing from the origin
Proof: as x increases, utiltiy of x also goes up, x and U(x) are positively related. As x increases, marginal utility of x (tells speed of utility x is increasing) decreases, as U(x) is increasing at a decreasing/diminishing rate
Proof: point A and B on U0, to consume one more x: from A to B: slope of indifference curve gets flatter, obeying law of diminishing marginal utility. to consume one more y: from B to A: slope of indifference curve gets flatter (from 90 degree tilt to the right to face good y): obeys law of diminishing marginal utility

Question 7

What causes movement along the indifference curve?

Answer 7

Consumer’s preference of good x or y

Question 8

How do we show that utility has increased on the indifference curve?

Answer 8

By shifting the indifference curve parallel outwards and not allow the indifference curve to intersect with one another

Question 9

U(x) = x^2 utility function interpretation?

Answer 9

Utility only derived from consuming x, 0 from y
Vice versa if x substituted by y

Question 10

U(x,y) = (x^2)*y utility function interpretation?

Answer 10

Getting satisfaction level from both good x and y but prefers good x, therefore x satisfaction level increases faster relative to good y
Vice versa for y

Question 11

What does marginal utility show?

Answer 11

Change in total utility when an additional unit of x is being consumed by the consumer

Question 12

What is slope of indifference curve also known as?

Answer 12

Marginal Rate of Subjective Substitution between good x and y (MRS_xy)
Subjective bc subject to preferences

Question 13

What does the Marginal Rate of Subjective Substitution show?

Answer 13

Individual’s willingness to pay for x in terms of y (how much y an individual is willing to give up to consume an additional unit of x

Question 14

Why is the Marginal Rate of Subjective Substitution formula MU(x)/MU(y)?

Answer 14

Because if you draw a graph, put point A and B at U0, from A to B the slope of indifference curve becomes flatter, meaning the willingness to give up y to consume an additional unit of x has gone down

Question 15

What do utility maximising consumers choose?

Answer 15

Consumption bundle where the highest attainable indifference curve is tangent (equal to one another) to the budget line

Slope of BL (market trade-off between goods / market price of good x) = Slope of Indifference Curve (utility trade-off between goods / willingness to pay for good x)

Question 16

What’s the only parameters that can change in utility optimisation?

Answer 16

The market price of good x (Px) and y (Py)

Question 17

What is price effect formula?

Answer 17

Income effect + Substitution effect

Question 18

What does income effect measure?

Answer 18

Whether an individual feels rich/poorer after price change (real income rise or fall)

Question 19

What does substitution effect measure?

Answer 19

Whether an individual will buy more x and less y in correspondence to the price change made (substituting y away for more x)

Question 20

How do you measure real income?

Answer 20

Nominal income / changes in price

Question 21

What is the nature of a normal good in relation to real income and quantity demanded?

Answer 21

Positively related (real income rises, x also rises, vice versa)

Question 22

What is the nature of a inferior good in relation to real income and quantity demanded?

Answer 22

Negatively related (real income rises, x falls instead, vice versa)

Question 23

What is the nature of a giffen good in relation to real income and quantity demanded?

Answer 23

Negatively related (real income rises, x falls instead, vice versa)
Special characteristics
1. must be inferior good
2. must have strong income effect (income effect > substitution effect in opposite direction)

Question 24

What happens to normal good’s x (quantity demanded) when there is a rise in price for x?

Answer 24

Price x rises, x falls (negatively related, downward sloping)
Can be proven wrong via endowment model

Question 25

What happens to inferior good’s x when there’s a rise in price x?

Answer 25

Price x rises, x falls (positively related, downward sloping)

Question 26

Price effect of inferior good

Answer 26

Income effect operates in opposite direction but RARELY dominates substitution effect

Question 27

Price effect of giffen good

Answer 27

Income effect operates in opposite direction and dominates substitution effect (I.E. > S.E.)

Question 28

When income rises and x also rises, the nature of good and engel curve will be…

Answer 28

Normal good, upward sloping respectively

Question 29

When income rises and x falls, the nature of good and engel curve will be…

Answer 29

Inferior good, backward bending respectively

Question 30

What are the important observations once the nature of good’s demand curve has been derived?

Answer 30

1. Demand for inferior good is stepper than demand for normal good
2. Demand for giffen good is upward sloping
3. Giffen good I.E. > S.E.
4. Inferior good I.E. < S.E.

Question 31

Engel curve observation when income rises

Answer 31

Normal good: engel consumes more x and y (hence upward sloping, positvely related to income)
Inferior good: engel consumes less x and y (hence backward sloping from point A to C, negatively related to income)

Question 32

Position depending on relationship of x and y and price elasticity

Answer 32

If x consumed more and y consumed less: gross substitutes (PED > 1)
If x consumed less and y consumed less: complements (PED < 1)
If x consumed more and y remains the same: no relationship (PED = 1)

Question 33

What is the endowment model?

Answer 33

An economic model where an individual is endowed with a certain amount of good x and good y for free, giving the individual a choice to either consume at the endowed bundle or sell away the goods that doesn’t prefer and thus use the income earned from selling the good to buy the other good he prefers, assuming that he has no initial income to begin with

Question 34

What can the endowment model prove?

Answer 34

1. That the demand for a normal good can be upward sloping
2. that when price of a good falls, quantity demand for that good may not rise to result in the individual being better off and can actually become worse off

Question 35

What are the endowment model assumptions

Answer 35

1. Individual is endowed with bundle E where there are x0 units of good x and y0 units of good y. Initial market price for good x and y: Px0 and Py0 respectively
2. Individual is allowed to sell good x and use money to buy good y and vice versa (if individual can’t sell -> can only consume bundle A bc no initial income)
3. Individual prefers good y compared to good x
4. Price of good x FALLS from Px0 to Px1 but price of good y remains the same

Question 36

In reality, when demand for normal good x is upward sloping, what type of good is good x?

Answer 36

Ostentatious good: goods that reflect wealth level
e.g. antiques, supercars, branded clothing