Question for review

Question for review - Ques%on for review Ques%ons for...

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Unformatted text preview: Ques%on for review Ques%ons for review 1.  What are the four basic assump3ons 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 transi3ve: 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 subs3tu3on: 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 liKle 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 subs3tu3on 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 ra3o of the price of the . goods for the consumer to achieve maximum sa3sfac3on. 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 u3lity is associated with the consump3on 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 geKng 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 soL drinks. Indicate the direc3on in which the individuals’ sa3sfac3on (or u3lity) is increasing. a. Joe has convex preferences and dislikes both hamburgers and soL 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 soL drinks. If he is served a soL drink, he will drink it to be polite. Since Bob will drink the soa drink in order to be polite, it can be thought of as a “bad”. When served another soa drink, he will require more hamburgers at the same %me in order to keep his sa%sfac%on constant. More soa drinks without more hamburgers will worsen his u%lity. More hamburgers and fewer soa drinks will increase his u%lity, so his sa%sfac%on increases as we move upward and to the lea. Exercises d. Molly loves hamburgers and soL drinks, but insists on consuming exactly one soL 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 soL drinks. If she is served a soL drink, she will pour it down the drain rather than drink it. Since Jane can freely dispose of the soa drink if it is given to her, she considers it to be a neutral good. This means she does not care about soa 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 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 ploKed 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 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.) INDIVIDUAL DEMAND 4.1 INDIVIDUAL DEMAND Engel Curves ● Engel curve 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 an income effect and a subs3tu3on effect Both the subs%tu%on effect and income effect occur because of a change in the price of a good. The subs3tu3on 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. Subs%tu%on effect is the component of the total effect of a price change that results from the associated change in the rela%ve aKrac%veness of other goods. 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 beKer off because they can buy the same amount of the good for less money, and thus have money lea for addi%onal purchases. Income effect: the component that results from the associated change in real purchasing power. 4.2 INCOME AND SUBSTITUTION EFFECTS Figure 4.6 Income and Substitution Effects: Normal Good 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 subs3tu3on 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 u3lity 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 subs3tutes. Draw the appropriate price ­consump3on curve (for a variable price of orange juice) and income ­ consump3on 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 LeL shoes and right shoes are perfect complements. Draw the appropriate price ­ consump3on and income ­consump3on curves. For perfect complements, such as right shoes and lea 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 12/16/2011 for the course ECON 303 at USC.

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