EC2101

Question 1

What are the 3 fundamental assumptions on Preferences, and what do they mean? Which is considered an additional preference out of the 3, that is not always assumed?

Answer 1

Completeness: A consumer has complete preferences if she can compare any two goods or any two baskets

Transitivity: A consumer has transitive preferences if her preferences are internally consistent

Monotonicity: The good is desirable, having more of the good increases utility

Monotonicity is the additional assumption

Question 2

If monotonicity holds for both goods, can the indifference curve shift upwards? Why?

Answer 2

If the indifference curve is upwards sloping, it indicates that more of the good corresponds to the same level of utility, which violates the principle of monotonicity

Question 3

What is the Marginal Rate of Substitution (MRS) of x for y?

Answer 3

It is the consumers’ valuation of a unit of x, measured in terms of units of y. MRS is the rate at which the consumer is willing to give up y, in order to get more of x, maintaining the same level of utility

Question 4

What does it mean to have a diminishing rate of MRS?

Answer 4

Holding the utility level fixed, means that as the consumer consumes more of x, his willingness to give up y in exchange for an additional unit of x falls.

Question 5

What are the different types of consumer preferences?

Answer 5

They are Well-Behaved Preferences, Perfect Complements, Perfect Substitutes

Question 6

What is the marginal utility (MUx)? What does the sign of MUx tell us?

Answer 6

Marginal utility is the rate at which utility changes as the level of consumption of a good change. The sign of MUx tell us whether monotonicity holds

Question 7

What does it mean to have diminishing marginal utility (MUx)?

Answer 7

As the level of consumption of goods increases, the marginal utility decreases

Question 8

What are the characteristics of utility curve, function and MRS for perfect substitutes?

Answer 8

Perfect Substitutes: The indifference curves are linear. The utility function is linear. The MRS is constant.

Question 9

What are the characteristics of utility curve, function and MRS for perfect complements?

Answer 9

Perfect Complements: The indifference curves are L-shaped. The utility function is a “minimum” function. The MRS is zero when horizontal, infinity in the vertical part and undefined at the kink.

Question 10

Why is the MRS for Perfect Substitutes constant?

Answer 10

The marginal rate of substitution for perfect substitutes (x and y) are independent of the quantities of the respective goods. It is dependent on the proportion of each of the good relative to one another

Question 11

Why is the MRSxy for Perfect Complements zero in the horizontal part, and infinity in the vertical part?

Answer 11

At the horizontal part: y is the limiting constraint, and the consumer’s willingness to give up y for x = 0, hence MRSxy = 0.

At the vertical part: Assuming (2,1000), the consumer would be willing to give up a large amount of y to get a perfect complement at a higher indifference curve, hence MRSxy = infinity

Question 12

Is the marginal utility always diminishing for Cobb-Douglas functions?

Answer 12

Not necessarily. We need to find out how marginal utility (MUx/y) changes as the consumption of x/y increases

Question 13

What does the gradient of the budget line represent?

Answer 13

It represents the rate at which the two goods are exchanged in the market; the absolute value of the slope is the relative price of good x

Question 14

For Perfect Complements, how do we know which good is more valuable to the consumer? (eg: U(x,y) = [ 3x , 5y ] )

Answer 14

The good with higher weightage in the function is more valuable. In this example, the consumer wants 5 of x and 3 of y at the same time, less of y is needed in the complement compared to x.

Question 15

For Cobb-Douglas indifference curve, to maximize utility, the consumer should consume at the ______ possible indifference curve that is ______ to the budget line

Answer 15

highest, tangent

Question 16

What is the tangency condition?

Answer 16

The tangency condition is fulfilled when the marginal rate of substitution (MRSxy) equals the rate at which the two goods are exchanged in the market (px/py).

MRSxy = Px/Py

Question 17

What is the equal marginal principle?

Answer 17

The consumer sets the marginal utility per dollar of each good equal to each other, in order to maximise utility.

MUx/Px = MUy/Py
(can be derived from tangency condition)

Question 18

Using the BLTC method, what are the necessary conditions needed to find the optimal choice?

Answer 18

The 2 necessary conditions needed are the tangency condition and the equation of the budget line.

Question 19

Using the Lagrange Multiplier Method, what are the necessary conditions needed to find the optimal choice?

Answer 19

The necessary conditions and steps are:

1. Finding the Lagrangian function, by putting terms of the budget line on one side, and substituting it into the Lagrangian function
2. Differentiate the Lagrangian function partially with respect to x , y and ƛ
3. Make ƛ the subject for 2/3 of the equations, and solve algrbraically to find x , y and ƛ

Question 20

What is the meaning of the Lagrange Multiplier?

Answer 20

It refers to the additional utility from an additional dollar of consumption.

ƛ = MUx/Px = MUy/Py

Question 21

What should be done if the optimal choice calculation yields a negative value for a particular good?

Answer 21

1. Find out which good has a negative value, which becomes the limiting constraint
2. Assume that good’s consumption = 0 , and substitute the value into the budget line equation to find the true optimal choice.

Question 22

What does it mean graphically when a consumer has the optimal choice (9,0)?

Answer 22

Assuming the Cobb-Douglas utility curve, it means that at that point, the gradient of the utility curve is steeper than the gradient of the budget line.

This indicates MRSxy is larger than Px/Py, and also indicates that the consumer should consume less of the good that is already zero, which the consumer is unable to do so.

Question 23

What is the difference between an interior and corner solution?

Answer 23

An interior solution refers to an optimal basket where strictly positive amounts of both goods are consumed

A corner solution refers to an optimal basket where the consumption of at least one good is zero.

The indifference curve for an interior solution is tangent to the budget line, but may not be for a corner solution

The optimal basket for an indifference curve does not lie on the horizontal/vertical axis, while the optimal basket for a corner solution lies either on the horizontal/vertical axis.

Question 24

What is the graphical difference between the effect of a voucher and cash?

Answer 24

The use of a voucher pertains to a single good (x) usually, and shifts the graph forward by the amount of the voucher. The section is represented by a straight horizontal line.

The use of cash can be for both goods, which increases the overall income that the consumer has. Thus, this increases the y-intercept of the graph to indicate the rise in income.

Question 25

What are normal and inferior goods?

Answer 25

A normal good: As income increase, the quantity demanded of the good increases. holding other factors constant An inferior good: As income increase, quantity demanded of the good decreases. holding other factos constant

Question 26

What is the difference between the individual demand curve and demand function?

Answer 26

The individual demand curve is the quantity demanded of the good as a function of the price of the good, holding all other factors fixed. The demand function for a good includes the price of the good (Px), price of other goods (Py), and income (M).

Question 27

What are Ordinary goods?

Answer 27

An ordinary good: Follows the law of demand. When price increase, QD falls, when price decrease, QD rises.

Question 28

What are Giffen and Veblen goods?

Answer 28

Giffen and Veblen Good: When price increase, QD increase, when price decrease, QD falls, holding other factors constant.

Question 29

What is the difference between Giffen and Veblen goods?

Answer 29

For a Giffen good, the increase in demand is directly attributable to the increase in price For a Veblen good, the increase in demand reflects the consumer's preference and utility function, which in turn partially depend on the increase in price

Question 30

What are substitutes and complements?

Answer 30

Substitutes: An increase in the price of one good causes the demand for the other good to increase Complements: An increase in the price of one good causes the demand for the other good to decrease

Question 31

Does the demand for one good depend on the price of other goods for a Cobb-Douglas Utility function?

Answer 31

No it does not.

Question 32

What is the property of a Cobb-Douglas Utility function in terms of the consumer's spending proportion?

Answer 32

By making PxX and PyY the subject respectively with the budget line and utility function equations, it shows that the consumer always spends a fixed proportion of income on each of the good

Question 33

What are the 4 different types of curves related to demand functions, and what are their purposes?

Answer 33

1. Offer Curve: Connects all optimal choices at different prices 2. Individual Demand Curve: This shows the relationship between the price and quantity demanded 3. Income Expansion Path: Connects all optimal choices at different incomes 4. Engel Curve: This shows the relationship between income and quantity demanded.

Question 34

How do we describe the substitution and income effects due to a change in price of a good?

Answer 34

Substitution effect focuses on the relative price of the good changing, due to the price change of the good. Income effect focuses on the change in purchasing power due to the price change of the good. - Assume increase in the price of good, and that good is normal - - Price Increase -> Spend on other goods -> QD for good decreases - - Price Increase -> Purchasing power decreases -> QD for good decreases

Question 35

How do we carry out the Hicksian Decomposition?

Answer 35

1. Change Px/Py and income of the consumer [relative price is changed while purchasing power is constant, by changing consumer income] 2. Change the purchasing power, but hold Px/Py constant [by changing consumer income back to original]

Question 36

How do we carry out the Slutsky Decomposition?

Answer 36

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Question 37

How do we carry out the Kaldor Decomposition?

Answer 37

Opposite of the Hicksian Decomposition

Question 38

What are the graphical representations of the substitution and income effect?

Answer 38

Assuming Hicksian Decomposition, The substitution effect is the difference in quantity demanded, taken from the original and intermediate curves. The income effect is the difference in quantity demanded, taken from the final and intermediate curves.

Question 39

What is the effect of a price change?

Answer 39

Effect of price Change = Substitution Effect + Income Effect

Question 40

What is the direction of the substitution and income effect for a normal and inferior good respectively?

Answer 40

Normal Good: Same direction Inferior Good: Different direction

Question 41

Why are all Giffen goods inferior goods?

Answer 41

As the price decreases, QD decreases, holding other factors constant As the price increases, QD increases, holding other factors constant Price Decrease -> Increase in Purchasing Power -> QD Decreases Price Increase -> Decrease in Purchasing Power -> QD Increases Therefore, since a rise in purchasing power results in a fall in QD of a Giffen good, and vice versa, all Giffen goods are inferior goods.

Question 42

What is the difference between consumer surplus for an individual consumer and for a market?

Answer 42

Individual Consumer: The difference between the consumer's willingness to pay for a good and the cost of purchasing the good Market: The sum of all individual consumers' consumer surplus. It is the area below the demand curve and above the price

Question 43

What is the compensating variation? How is it calculated?

Answer 43

The amount of money (income) that the consumer is willing to give up after the price drop in order to maintain the pre-price drop utility level The compensating variation is calculated by taking the income at the old budget line - intermediate line

Question 44

What is the equivalent variation? How is it calculated?

Answer 44

The amount of money (income) that the consumer would need before the price drop, in order to attain the post-price drop utility level The equivalent variation is calculated by taking the income at the intermediate line - old budget line

Question 45

What are network externalities? What are the different types of network externalities?

Answer 45

Network externalities occur when a consumer's demand for a good depends on how many other consumers are purchasing the good Positive network externalities: A consumer's demand for goods increases with the number of other consumers who buy the good Negative network externalities: A consumer's demand for goods decreases with the number of other consumers who buy the good

Question 46

Describe the snob and bandwagon effect

Answer 46

Bandwagon Effect: Increase in QD of a good as more consumers buy the good Snob Effect: Decrease in QD of a good as more consumers buy the good

Question 47

What is the difference between Partial Equilibrium and General Equilibrium?

Answer 47

Partial Equilibrium: Finding the equilibrium price and quantity in a single market, holding prices in all other markets fixed General Equilibrium: Finding the equilibrium prices and quantities in more than one market simultaneously

Question 48

What are the key characteristics of an exchange economy?

Answer 48

There is no money or income. There is no production The two consumers can trade with each other

Question 49

What does a feasible allocation mean?

Answer 49

An allocation that is feasible is: - - All the quantities are non-negative - - For each good, total consumption = total endowment

Question 50

What does an Edgeworth box show?

Answer 50

An Edgeworth box is used to graphically show all feasible allocations of the two goods. Every point in the box including those on the boundaries represent a feasible allocation

Question 51

What are the conditions for a Pareto dominance?

Answer 51

Assuming P and Q are feasible allocations: - All consumers like P at least as well as Q - At least one consumer likes P better than Q

Question 52

What does it mean when a feasible allocation is Pareto efficient/optimal?

Answer 52

A feasible allocation is Pareto Efficient if there exists no alternative feasible allocation Q such that: - Q gives all consumers at least as much utility as P - Q gives at least one consumer more utility than P

Question 53

How do we know graphically, which points are Pareto efficient?

Answer 53

Assume each consumer has indifference curves that are smooth with diminishing MRS: - The tangency points of any two indifference curves are Pareto efficient

Question 54

Are the points where indifference curves intersect Pareto efficient?

Answer 54

No.

Question 55

What is the contract curve?

Answer 55

The contract curve is the set of all Pareto-efficient allocations

Question 56

How do we mathematically derive the equation of the contract curve?

Answer 56

1. Find the tangency condition and check that the allocation is feasible (2 conditions) 2. Substitute equations for allocation into tangency condition, and express contract curve in terms of X1a and X2a OR X1b and X2b

Question 57

If an allocation is Pareto efficient, there are no Pareto improvements to be had (True/False)

Answer 57

True, there exist no alternative options that both consumers prefer at least to the current option, and there are no options that give at least one consumer more utility than the current option

Question 58

If an allocation is not Pareto efficient, there are Pareto improvements to be had (True/False)

Answer 58

True.

Question 59

What does the budget line in an exchange economy look like?

Answer 59

The budget line/constraint is determined by prices and endowments

Question 60

Why is the budget line for 2 consumers in the Edgeworth box represented on a single line?

Answer 60

This is because every point on the budget line represents a feasible allocation for both consumers Also, both consumers are subjected to the price for both goods in the exchange economy. Hence the gradient of the budget line (P1/P2) is the same for both consumers

Question 61

What is the definition of a competitive equilibrium?

Answer 61

A competitive equilibrium comprises an allocation and a pair of prices such that: Each consumer maximizes her utility given her budget constraint The market for both goods clear - The total amount of good 1 = The endowment allocation for good 1 - The total amount of good 2 = The endowment allocation for good 2

Question 62

Why does the endowment allocation remain on the budget line?

Answer 62

Endowment represents each of the consumer's maximum budget, and will therefore remain on the budget line regardless of price change

Question 63

What are the conditions for finding competitive equilibrium, in the case that we want to find it mathematically?

Answer 63

Conditions Needed: 1. Consumer A: Tangency Condition, Budget Line 2. Consumer B: Tangency Condition, Budget Line 3. Total Amount of Good 1 = The Endowment Allocation of Good 1 4. Total Amount of Good 2 = The Endowment Allocation of Good 2 Steps: 1. Substitute (3) and (4) into tangency condition to find the relation between X1A and X2A. 2. Use relation between X1A and X2A to find P1/P2 3. Substitute P1 , P2 and X1A/X2A into the budget line equation of Consumer A to find terms [Can be done for Consumer B also]

Question 64

What do prices in an exchange economy mean?

Answer 64

All we need to know is the relative price of the two goods (P1/P2). The relative price of the two goods tells us the relative scarcity of the two goods — how the two goods can be exchanged in the market.

Question 65

Does Pareto efficiency depend on prices?

Answer 65

No. Pareto Efficiency does not depend on prices.

Question 66

Does Pareto Efficiency depend on the endowment allocation?

Answer 66

No. Pareto efficiency does not depend on the endowment allocation.

Question 67

Does the competitive equilibrium depend on price?

Answer 67

No. A competitive equilibrium comprises an allocation and a pair of prices such that: - Each consumer maximizes her utility given her budget constraint. - The markets for both goods are clear.

Question 68

Does the competitive equilibrium depend on the endowment allocation?

Answer 68

Yes. A competitive equilibrium depends on the endowment allocation.