3-Discussion Questions-Solutions

3-Discussion Questions-Solutions - Lecture 3: Consumer...

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Lecture 3: Consumer Theory Suggested questions and exercises (Pindyck and Rubinfeld, Ch. 3). Questions: 4, 6, 9, 10, 11 Exercises: 5, 10, 14, 15, 16 QUESTIONS 4. Jon is always willing to trade one can of coke for one can of sprite, or one can of sprite for one can of coke. a. What can you say about Jon’s marginal rate of substitution? Jon’s marginal rate of substitution can be defined as the number of cans of coke he would be willing to give up in exchange for a can of sprite. Since he is always willing to trade one for one, his MRS is equal to 1. In particular, this means that Jon sees sprite and coke as perfect substitutes. b. Draw a set of indifference curves for Jon. Since Jon is always willing to trade one can of coke for one can of sprite, his indifference curves are linear with a slope of 1. c. Draw two budget lines with different slopes and illustrate the Jon's optimal choice. What conclusion can you draw? Jon’s indifference curves are linear with a slope of –1. Jon’s budget line is also linear, and will have a slope that reflects the ratio of the two prices. If the prices are different this means that the slope of the budget line is different than -1 which implies that there are no points at which the two slopes coincide! So what is the optimal choice by Jon? The only possibility is that either John spends all his money on sprite or all his money on coke (the choice is a corner solution). If Jon’s budget line is steeper than his indifference curves then he will choose to consume only the good on the vertical axis. If Jon’s budget line is flatter than his indiffe rence curves then he will choose to consumer only the good on the horizontal axis. Jon will always choose a corner solution, unless his budget line has the same slope as his indifference curves. In this case any combination of Sprite and Coke that uses up his entire income with maximize his satisfaction. Does this make intuitive sense? Suppose that one can of sprite is cheaper than one can of coke. Since his MRS is 1 this means that buying one less can of sprite and getting one more can of coke would leave him indifferent. However, if the price of coke is less than the price of sprite, by buying one less can of sprite he could buy more than one can of coke. Since this change makes John better off he will keep on doing this until he spends no money on sprite and all his money on coke.
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6. Explain why an MRS between two goods must equal the ratio of the price of the goods for the consumer's optimal choice. The MRS describes the rate at which the consumer is willing to trade one good for another to maintain the same level of utility. The ratio of prices describes the trade-off that the market is willing to make between the same two goods.
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3-Discussion Questions-Solutions - Lecture 3: Consumer...

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