The Theory of Individual Behaviour

Question 1

Consumer Behavior

What are consumer opportunities (budget constraints)?
What are consumer preferences (indifference curves)?

Answer 1

What are consumer opportunities (budget constraints)?

• Set of possible goods and services consumers can afford to consume.

What are consumer preferences (indifference curves)?

• Determine which set of goods and services will be consumed.

Question 2

Properties of Consumer Preferences (4)

Answer 2

Completeness:

For any two bundles of goods either:

• 𝐴≻𝐵.
• 𝐵≻𝐴.
• 𝐴∼𝐵.

More is better

• If bundle 𝐴 has at least as much of every good as bundle 𝐵 and more of some good, bundle 𝐴 is preferred to bundle 𝐵.

Diminishing marginal rate of substitution

• As a consumer obtains more of good X, the amount of good Y the individual is willing to give up to obtain another unit of good X decreases.

Transitivity:

For any three bundles, 𝐴, 𝐵, and 𝐶, either:
If 𝐴≻𝐵 and 𝐵≻𝐶, then 𝐴≻𝐶.
If 𝐴∼𝐵 and 𝐵∼𝐶, then 𝐴∼𝐶.

≻ means better than ; ∼ means indifferent

Question 3

Properties of Consumer Preferences

What is an indifference curve? (3)
What is the marginal rate of substitution?

Answer 3

Indifference curve:

• A curve that defines the combinations of two goods that give a consumer the same level of satisfaction.
• Can indifference curves intersect?
  NO
• The higher the better, so in terms of utility,
  III > II > I

Marginal rate of substitution (MRS):

• The rate at which a consumer is willing to substitute one good for another good and still maintain the same level of satisfaction.

Question 4

Properties of Consumer Preferences - Indifference curves

Basic Characteristics (4)

What are perfect substitutes and perfect complements and examples of those?

Answer 4

Basic Characteristics:

• Higher indifference curves are better
• Indifference curves do not intersect
• Indifference curves slope downward
• Indifference curves are convex

Perfect substitutes are products that satisfy the same need.
e.g., car models.

Perfect complements are products consumed together.
e.g., cars and tires

Perfect Substitutes (Straight Lines):

• These occur when the consumer sees two goods as interchangeable at a fixed rate. The indifference curves for debit and credit card limits are straight because a person is indifferent between spending money from either source.

Perfect Complements (L-Shaped Curves):

• These happen when goods are used together in fixed proportions—like bicycle frames and tires. No matter how many extra tires or frames a consumer has, their satisfaction doesn’t increase unless they have a matching pair.

Imperfect Substitutes (Convex Curves):

• These represent cases where goods can substitute for each other but at diminishing rates—like baseball and football tickets. The more of one a consumer has, the less they are willing to trade for more of it.

Question 5

The Budget Constraint

What is it?

Formulas (2)

Basic Characteristics (2)
Market rate of substitution?
Effects of Changing Income and Prices (2)

Answer 5

Budget constraint

• Restriction set by prices and income that limits bundles of goods affordable to consumers.

Basic Characteristics

• Show affordable combinations of X and Y.
• Slope of –PX/PY reflects relative prices, also represents the market rate of substitution.

Market rate of substitution

The rate at which one good may be traded for another in the market; slope of the budget line.

Effects of Changing Income and Prices

• Budget increase (decrease) causes parallel outward (inward) shift.
• Relative price change alters budget slope.

Question 6

The Budget Constraint In Action

Answer 6

The Market Rate of Substitution

Question 7

The Budget Constraint - Effects of Changing Income and Prices

Example

Answer 7

Question 8

The Budget Constraint in Action

Answer 8

Question 9

Consumer Equilibrium

What is it (2)

Formula

Answer 9

• Consumption bundle that is affordable and yields the greatest satisfaction to the consumer.
• Consumption bundle where the rate a consumer choses (marginal rate of substitution - MRS) to trade between goods X and Y equals the rate at which these goods are traded in the market (ratio of prices).

marginal rate of substitution = market rate of substitution

Question 10

Consumer Equilibrium in Action

Picture of graph

Answer 10

The curveis the marginal rate of substitution. (utility)

The Straight line is the market rate of substitution. (budget)

Question 11

Comparative Statics - Price Changes and Consumer Equilibrium

Rule?
Goods X and Y are? (2)

Answer 11

Price increases (decreases) reduce (expand) a consumer’s budget set.
The new consumer equilibrium resulting from a price change depends on consumer preferences:

Goods X and Y are:

• substitutes when an increase (decrease) in the price of X leads to an increase (decrease) in the consumption of Y.
• complements when an increase (decrease) in the price of X leads to a decrease (increase) in the consumption of Y.

Question 12

Price Changes and Consumer - Substitute goods case

Answer 12

Price Changes and Consumer - Complement goods case

Question 13

From Indifference Curves to Individual Demand (picture)

Answer 13

Question 14

From Individual to Market Demand (picture)

Answer 14