Questions for review

Questions for review - Ques%on for review N.B. Ques%ons...

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Unformatted text preview: Ques%on for review N.B. Ques%ons for review 1.  Suppose that unusually hot weather causes the demand curve for ice cream to shi8 to the right. Why will the price of ice cream rise to a new market ­ clearing level? Suppose the supply of ice cream is completely inelas%c in the short run, so the supply curve is ver%cal as shown below. The ini%al equilibrium is at price P1. The unusually hot weather causes the demand curve for ice cream to shi? from D1 to D2, crea%ng short ­run excess demand (i.e., a temporary shortage) at the current price. Consumers will bid against each other for the ice cream, puHng upward pressure on the price, and ice cream sellers will react by raising price. The price of ice cream will rise un%l the quan%ty demanded and the quan%ty supplied are equal, which occurs at price P2. N.B. Ques%ons for review N.B. Ques%ons for review 2. Use supply and demand curves to illustrate how each of the following events would affect the price of buBer and the quanDty of buBer bought and sold: a. An increase in the price of margarine. BuJer and margarine are subs%tute goods for most people. Therefore, an increase in the price of margarine will cause people to increase their consump%on of buJer, thereby shi?ing the demand curve for buJer out from D1 to D2 in Figure 2.2.a. This shi? in demand causes the equilibrium price of buJer to rise from P1 to P2 and the equilibrium quan%ty to increase from Q1 to Q2. N.B. Ques%ons for review b. An increase in the price of milk. Milk is the main ingredient in buJer. An increase in the price of milk increases the cost of producing buJer, which reduces the supply of buJer. The supply curve for buJer shi?s from S1 to S2 in Figure 2.2.b, resul:ng in a higher equilibrium price, P2 and a lower equilibrium quan%ty, Q2, for bu@er. N.B. Ques%ons for review c. A decrease in average income levels. Assuming that buJer is a normal good, a decrease in average income will cause the demand curve for buJer to decrease (i.e., shi? from D1 to D2). This will result in a decline in the equilibrium price from P1 to P2, and a decline in the equilibrium quan:ty from Q1 to Q2. See Figure 2.2.c. N.B. Ques%ons for review 4. Explain the difference between a shi8 in the supply curve and a movement along the supply curve. A movement along the supply curve occurs when the price of the good changes. A shi? of the supply curve is caused by a change in something other than the good’s price that results in a change in the quan%ty supplied at the current price. Some examples are a change in the price of an input, a change in technology that reduces the cost of produc%on and an increase in the number of firms supplying the product. Ques%ons for review 1.  What are the four basic assumpDons about individual preferences? Explain the significance or meaning of each. (1) Preferences are complete: this means that the consumer is able to compare and rank all possible baskets of goods and services. (2) Preferences are transiDve: this means that preferences are consistent, in that if bundle A is preferred to bundle B and bundle B is preferred to bundle C, then bundle A is preferred to bundle C. (3) More is preferred to less: this means that all goods are desirable, and that the consumer always prefers to have more of a good. (4) Diminishing marginal rate of subsDtuDon: this means that indifference curves are convex, and that the slope of the indifference curve increases (becomes less nega%ve) as we move down along the curve. As a consumer moves down along her indifference curve she is willing to give up fewer units of the good on the ver%cal axis in exchange for one more unit of the good on the horizontal axis. This assump%on also means that balanced market baskets are generally preferred to baskets that have a lot of one good and very liJle of the other good. Ques%ons for review 2. Can a set of indifference curves be upward sloping? If so, what would this tell you about the two goods? A set of indifference curves can be upward sloping if we violate assump%on number three; more is preferred to less. When a set of indifference curves is upward sloping, it means one of the goods is a “bad” so that the consumer prefers less of that good rather than more. The posi%ve slope means that the consumer will accept more of the bad only if he also receives more of the other good in return. As we move up along the indifference curve the consumer has more of the good he likes, and also more of the good he does not like. Ques%ons for review 3. Explain why two indifference curves cannot intersect. The figure below shows two indifference curves intersec%ng at point A. We know from the defini%on of an indifference curve that the consumer has the same level of u%lity for every bundle of goods that lies on the given curve. In this case, the consumer is indifferent between bundles A and B because they both lie on indifference curve U1. Similarly, the consumer is indifferent between bundles A and C because they both lie on indifference curve U2. By the transi:vity of preferences this consumer should also be indifferent between C and B. However, we see from the graph that C lies above B, so C must be preferred to B because C contains more of Good Y and the same amount of Good X as does B, and more is preferred to less. But this violates transi/vity, so indifference curves must not intersect. Ques%ons for review . What happens to the marginal rate of subsDtuDon as you move along a convex indifference curve? A linear indifference curve? The MRS measures how much of a good you are willing to give up in exchange for one more unit of the other good, keeping u%lity constant. The MRS diminishes along a convex indifference curve. This occurs because as you move down along the indifference curve, you are willing to give up less and less of the good on the ver%cal axis in exchange for one more unit of the good on the horizontal axis. The MRS is also the nega%ve of the slope of the indifference curve, which decreases (becomes closer to zero) as you move down along the indifference curve. The MRS is constant along a linear indifference curve because the slope does not change. The consumer is always willing to trade the same number of units of one good in exchange for the other. Explain why an MRS between two goods must equal the raDo of the price of the . goods for the consumer to achieve maximum saDsfacDon. The MRS describes the rate at which the consumer is willing to trade one good for another to maintain the same level of sa%sfac%on. The ra%o of prices describes the trade ­off that the consumer is able to make between the same two goods in the market. The tangency of the indifference curve with the budget line represents the point at which the trade ­offs are equal and consumer sa%sfac%on is maximized. If the MRS between two goods is not equal to the ra%o of prices, then the consumer could trade one good for another at market prices to obtain higher levels of sa%sfac%on. For example, if the slope of the budget line (the ra%o of the prices) is −4, the consumer can trade 4 units of Y (the good on the ver%cal axis) for one unit of X (the good on the horizontal axis). If the MRS at the current bundle is 6, then the consumer is willing to trade 6 units of Y for one unit of X. Since the two slopes are not equal the consumer is not maximizing her sa%sfac%on. The consumer is willing to trade 6 but only has to trade 4, so she should make the trade. This trading con%nues un%l the highest level of sa%sfac%on is achieved. As trades are made, the MRS will change and eventually become equal to the price ra%o. Exercises Describe the equal marginal principle. Explain why this principle may not hold if . increasing marginal uDlity is associated with the consumpDon of one or both goods. The equal marginal principle states that to obtain maximum sa%sfac%on the ra%o of the marginal u%lity to price must be equal across all goods. In other words, u%lity maximiza%on is achieved when the budget is allocated so that the marginal u%lity per dollar of expenditure (MU/P) is the same for each good. If the MU/P ra%os are not equal, alloca%ng more dollars to the good with the higher MU/P will increase u%lity. As more dollars are allocated to this good its marginal u%lity will decrease, which causes its MU/P to fall and ul%mately equal that of the other goods. If marginal u%lity is increasing, however, alloca%ng more dollars to the good with the larger MU/P causes MU to increase, and that good’s MU/P just keeps geSng larger and larger. In this case, the consumer should spend all her income on this good, resul%ng in a corner solu%on. With a corner solu%on, the equal marginal principle does not hold. Exercises 2. Draw indifference curves that represent the following individuals’ preferences for hamburgers and so8 drinks. Indicate the direcDon in which the individuals’ saDsfacDon (or uDlity) is increasing. a. Joe has convex preferences and dislikes both hamburgers and so8 drinks. Since Joe dislikes both goods, he prefers less to more, and his sa%sfac%on is increasing in the direc%on of the origin. Convexity of preferences implies his indifference curves will have the normal shape in that they are bowed towards the direc%on of increasing sa%sfac%on. Convexity also implies that given any two bundles between which the Joe is indifferent, any linear combina%on of the two bundles will be in the preferred set, or will leave him at least as well off. This is true of the indifference curves shown in the diagram. Exercises c. Bob loves hamburgers and dislikes so8 drinks. If he is served a so8 drink, he will drink it to be polite. Since Bob will drink the so? drink in order to be polite, it can be thought of as a “bad”. When served another so? drink, he will require more hamburgers at the same %me in order to keep his sa%sfac%on constant. More so? drinks without more hamburgers will worsen his u%lity. More hamburgers and fewer so? drinks will increase his u%lity, so his sa%sfac%on increases as we move upward and to the le?. Exercises d. Molly loves hamburgers and so8 drinks, but insists on consuming exactly one so8 drink for every two hamburgers that she eats. Molly wants to consume the two goods in a fixed propor%on so her indifference curves are L ­shaped. For a fixed amount of one good, she gets no extra sa%sfac%on from having more of the other good. She will only increase her sa%sfac%on if she has more of both goods. Exercises b. Jane loves hamburgers and dislikes so8 drinks. If she is served a so8 drink, she will pour it down the drain rather than drink it. Since Jane can freely dispose of the so? drink if it is given to her, she considers it to be a neutral good. This means she does not care about so? drinks one way or the other. With hamburgers on the ver%cal axis, her indifference curves are horizontal lines. Her sa%sfac%on increases in the upward direc%on. QUESTIONS FOR REVIEW 1.  Explain the difference between each of the following terms: a. a price consumpDon curve and a demand curve The difference between a price consump%on curve (PCC) and a demand curve is that the PCC shows the quan%%es of two goods that a consumer will purchase as the price of one of the goods changes, while a demand curve shows the quan%ty of one good that a consumer will purchase as the price of that good changes. The graph of the PCC plots the quan%ty of one good on the horizontal axis and the quan%ty of the other good on the ver%cal axis. The demand curve plots the quan%ty of the good on the horizontal axis and its price on the ver%cal axis. 4.1 Price Changes Figure 4.1 Effect of Price Changes INDIVIDUAL DEMAND Two important properties: 1. The level of utility changes as we move along the curve. The lower the price, the higher the utility (purchasing power increases). 2. At any point on the demand curve, the consumer is maximizing utility by satisfying the condition that MRS of food for clothing = PF / PC. As the price for food falls, the price ratio and the MRS also fall. Thus MRS varies along the demand curve QUESTIONS FOR REVIEW b.an individual demand curve and a market demand curve An individual demand curve plots the quan%ty demanded by one person at various prices. A market demand curve is the horizontal sum of all the individual demand curves for the product. It plots the total quan%ty demanded by all consumers at various prices. c.an Engel curve and a demand curve An Engel curve shows the quan%ty of one good that will be purchased by a consumer at different income levels. The quan%ty of the good is ploJed on the horizontal axis and the consumer’s income is on the ver%cal axis. A demand curve is like an Engel curve except that it shows the quan%ty that will be purchased at different prices instead of different income levels. 4.1 Income Changes Figure 4.2 Effect of Income Changes INDIVIDUAL DEMAND An increase in income, with the prices of all goods fixed, causes consumers to alter their choice of market baskets. In part (a), the baskets that maximize consumer satisfaction for various incomes (point A, $10; B, $20; D, $30) trace out the income-consumption curve. The shift to the right of the demand curve in response to the increases in income is shown in part (b). (Points E, G, and H correspond to points A, B, and D, respectively.) 4.1 Engel Curves ● Engel curve INDIVIDUAL DEMAND Curve relating the quantity of a good consumed to income. Figure 4.4 Engel Curves Engel curves relate the quantity of a good consumed to income. In (a), food is a normal good and the Engel curve is upward sloping. In (b), however, hamburger is a normal good for income less than $20 per month and an inferior good for income greater than $20 per month. QUESTIONS FOR REVIEW d. an income effect and a subsDtuDon effect Both the subs%tu%on effect and income effect occur because of a change in the price of a good. The subsDtuDon effect is the change in the quan%ty demanded of the good due to the price change (rela%ve prices), holding the consumer’s u%lity constant. The income effect is the change in the quan%ty demanded of the good due to the change in purchasing power brought about by the change in the good’s price. They are beJer off because they can buy the same amount of the good for less money, and thus have money le? for addi%onal purchases. 4.2 Figure 4.6 Income and Substitution Effects: Normal Good INCOME AND SUBSTITUTION EFFECTS A decrease in the price of food has both an income effect and a substitution effect. The consumer is initially at A, on budget line RS. When the price of food falls, consumption increases by F1F2 as the consumer moves to B. The substitution effect F1E (associated with a move from A to D) changes the relative prices of food and clothing but keeps real income (satisfaction) constant. The income effect EF2 (associated with a move from D to B) keeps relative prices constant but increases purchasing power. Food is a normal good because the income effect EF2 is positive. QUESTIONS FOR REVIEW Explain whether the following statements are true or false a.  The marginal rate of subsDtuDon diminishes as an individual moves downward along the demand curve. True. The consumer maximizes his u%lity by choosing the bundle on his budget line where the price ra%o is equal to the MRS. For goods 1 and 2, P1/P2 = MRS. As the price of good 1 falls, the consumer moves downward along the demand curve for good 1, and the price ra%o (P1/P2) becomes smaller. Therefore, MRS must also become smaller, and thus MRS diminishes as an individual moves downward along the demand curve. QUESTIONS FOR REVIEW Explain whether the following statements are true or false b. The level of uDlity increases as an individual moves downward along the demand curve. True. As the price of a good falls, the budget line pivots outward, and the consumer is able to move to a higher indifference curve. c.Engel curves always slope upwards. False. If the good is inferior, then as income increases, quan%ty demanded decreases, and therefore the Engel curve slopes downwards. QUESTIONS FOR REVIEW 4. a. Orange juice and apple juice are known to be perfect subsDtutes. Draw the appropriate price ­consumpDon curve (for a variable price of orange juice) and income ­ consumpDon curve. We know that indifference curves for perfect subs%tutes are straight lines like the line EF in the price ­consump%on curve diagram below. In this case, the consumer always purchases the cheaper of the two goods (assuming a one ­for ­one tradeoff). If the price of orange juice is less than the price of apple juice, the consumer will purchase only orange juice and the price ­consump%on curve will lie along the orange juice axis of the graph (from point F to the right). If the two goods have the same price, the consumer will be indifferent between the two; the price ­ consump%on curve will coincide with the indifference curve (between E and F). QUESTIONS FOR REVIEW Assuming that the price of orange juice is less than the price of apple juice, the consumer will maximize her u%lity by consuming only orange juice. As income varies, only the amount of orange juice varies. Thus, the income ­consump%on curve will be the orange juice axis in the figure below. If apple juice were cheaper, the income ­ consump%on curve would lie on the apple juice axis. QUESTIONS FOR REVIEW Le8 shoes and right shoes are perfect complements. Draw the appropriate price ­ consumpDon and income ­consumpDon curves. For perfect complements, such as right shoes and le? shoes, the indifference curves are L ­shaped. The point of u%lity maximiza%on occurs when the budget constraints, L1and L2 touch the kink of U1 and U2. See the following figure. QUESTIONS FOR REVIEW In the case of perfect complements, the income consump%on curve is also a line through the corners of the L ­shaped indifference curves. See the figure below. ...
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This note was uploaded on 10/19/2010 for the course ECON 303 taught by Professor Cheng during the Fall '07 term at USC.

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