3 - Theory Of Consumer Choice

Question 1

What is a budget constraint and what does it represent?

Answer 1

Answer: It represents the limit on consumption bundles a consumer can afford given their income and prices

Question 2

What’s the difference between real and nominal income?

Answer 2

Answer: Real income is adjusted for cost of goods/inflation, while nominal income is not adjusted

Question 3

What does the slope of a budget constraint represent? How do you calculate it?

Answer 3

Answer: The relative prices of goods and the rate at which consumers can trade one good for another

Slope = -P₁/P₂ where P₁ is price of good 1 and P₂ is price of good 2

Question 4

What do indifference curves represent?

Answer 4

Answer: They show consumption bundles that give consumers the same level of satisfaction (utility)

Question 5

Name the key properties of indifference curves.

Answer 5

1. Higher curves preferred to lower ones → more utility, more goods consumed
2. Curves slope downward → as it is a tradeoff
3. Curves cannot intersect
   
   1. as consumer choices are assumed to be consistent → would not make sense to cross
4. Curves are convex (bow inward)
   
   1. due to marginal decreasing utility → at extremes, people have less utility with having a lot of one good

Question 6

Why are indifference curves convex?

Answer 6

Answer: Due to marginal decreasing utility - at extremes, people have less utility with having a lot of one good

Question 7

What is the Marginal Rate of Substitution (MRS)?

Answer 7

Answer: The rate at which a consumer willingly trades one good for another

Represents slope of indifference curve at any point → slope is NOT linear because of diminishing marginal utility (decreases as you move along the curve)

Question 8

What are perfect substitutes for indifference curves? Give an example of perfect substitutes.

Answer 8

They have a fixed marginal rate of substitution. straight downward sloping line

€1 and €2 coins

Question 9

What does a complement indifferent curve look like? What’s an example of complementary goods?

Answer 9

L-shaped indifference curve
Answer: Right and left shoes

Question 10

When does optimal choice occur in terms of budget constraints?

Answer 10

Answer: When budget constraint touches highest possible indifference curve and MRS equals relative price ratio

Question 11

What happens to the budget constraint when there is an income effect?

Answer 11

• increase in income → shifts budget constraint outward → movement to different indifference curve (a higher one)
  
  • however, depends on if good is a normal good or inferior good

Question 12

What is the REMM hypothesis assumption about consumer behavior?

Answer 12

• Homo Oeconomicus [Resource Evaluating Maximizing Man]
  
  • Assumes rational, self-interested behavior
  • utility maximizer
  • acts according to restrictions and incentives
  • the ideal consumer in neo-classical economics
  • Assumes fixed preferences and full information
• model explains human behavior → not a normative (realistic) way of how humans should act

Question 13

Name three types of cognitive biases.

Answer 13

Answer: Framing effects, overconfidence, and hindsight bias

Question 14

What is prospect theory?

Answer 14

Answer: People evaluate potential gains and losses differently, being more sensitive to losses than equivalent gains

Question 15

What are the ways to promote sustainable consumer choices?

Answer 15

1. Change relative prices
   
   • Tax environmentally harmful goods: Creates substitution effect and negative income effect
   • Subsidize green goods: Leads to substitution effect and positive income effects
2. Ban harmful goods
   
   • Results in substitution and income effects
   • Leads to maximum consumption of remaining affordable alternatives
3. Tax income
   
   • Creates strong negative income effect
   • No substitution effect
   • Unclear impact on relative green vs. harmful consumption
4. Change preferences
   
   • Through marketing and campaigning
   • Shifts indifference curves
   • Can increase green consumption and reduce overall consumption

Question 16

What is the Low-Cost Hypothesis?

Answer 16

Answer: Moral values predominate in low-cost situations

Question 17

Name the limitations of the Household Model.

Answer 17

• Saturation effects: Additional consumption doesn’t always increase utility
• Basic needs: Some consumption cannot be substituted and affordability concerns
• Rationality limits: Due to information constraints and cognitive biases
• Transition costs: Non-monetary costs to consumers
• Environmental costs: Not reflected in prices of goods
• Utility measurement challenges
• Policy implementation: Requires understanding of diverse household preferences

Question 18

What is the main insight of happiness economics?

Answer 18

Answer: Relative income is more important than absolute income in determining happiness

Question 19

What is real income?

Answer 19

real income: adjusted for the cost of goods/ inflation

Question 20

What is nominal income?

Answer 20

nominal income → NOT adjusted for the cost of goods/inflation

Question 21

How do changes affect the budget constraint curve?

Answer 21

• Income changes: parallel shift of constraint line
• Price changes: rotation around axis intercepts

Question 22

What is diminishing marginal utility?

Answer 22

as consumers get more of one good, they become increasingly willing to give up larger amounts of that good to get an additional unit of the other good

Question 23

Explain the consumer utility graph

Answer 23

• shape depicts decreasing marginal utility
  
  • the more of good 1 you have, the less utility you get per additional unit

Question 24

What happens to the budget constraint when there is a price decrease?

Answer 24

a fall in price of any good rotates the budget constraint outward and changes the slope of the budget constraint

Question 25

What happens to the indifference curve when there is a substitution effect?

Answer 25

• Substitution effects: Movement along same indifference curve
  
  • can happen due to price change
  • leads to a different MRS

Question 26

Explain the New Theory of Consumer Choice

Answer 26

By Lancaster

• Unlike traditional theory where goods directly give satisfaction, Lancaster’s approach focuses on how the characteristics of goods and household uses create utility.
• Instead, they provide utility through their characteristics and household uses (e.g. water services example where people consider things like affordability, availability, quality of water) and also consider non-monetary costs (e.g. time, energy)

Question 27

Criticisms of REMM

Answer 27

1. Bounded Rationality
   
   • people have limited information processing capacity
   • often people use satisficing strategies
2. Emotions influence people
   
   1. biases exist
3. Moral Values
   
   1. people’s conceptions of good and bad, fair and unfair, etc. affect their decision-making
   2. people may have altruistic preferences
      
      1. people gain utility from behaving altruistically
   3. there are costs of moral behavior
      
      1. opportunity cost → behaving environmentally friendly is often more expensive, time consuming
      2. exploitation costs → people who behave morally may be exploited by those being selfish (prisoners’ dilemma)
   4. there are costs to unethical behavior
      
      1. legal or social sanctions