5. Consumer choice and demand decisions

Question 1

The marginal rate of substitution (MRS) between two goods measures the quantity of a good the consumer must sacrifice to increase the quantity of the other good by one unit without changing total utility.

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Question 2

Consumer tastes exhibit a diminishing marginal rate of substitution when, to hold utility constant, diminishing quantities of one good must be sacrificed to obtain
successive equal increases in the quantity of the other good.

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Question 3

An indifference curve shows all the consumption bundles yielding a particular level of utility.

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Question 4

The budget constraint describes the different bundles that the consumer can afford.

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Question 5

The chosen bundle will be the point at which an indifference curve just touches the budget line. The budget line is a tangent to the indifference curve at this
point.

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Question 6

The income expansion path shows how the chosen bundle of goods varies with consumer income levels, keeping constant everything else.
In the case of a normal good, the Engel curve is sloped upward, meaning that as income increases the quantity demanded of that good also increases. In the case of an inferior good, the Engel curve will normally have a backward-bending shape as the demand of an inferior good will decrease as income continues to increase.

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Question 7

The substitution effect of a price change is the adjustment of demand to the relative price change alone.
The income effect of a price change is the adjustment of demand to the change in real income alone.
The line joining all the optimal bundles is called the price–consumption curve.

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Question 8

The market demand curve is the sum of the demand curves of all individuals in a particular market.

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Question 9

A transfer payment is a payment, usually made by the government, for which no corresponding service is provided by the recipient.
A transfer in kind is the gift of a good or service.

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Question 10

Given the budget constraint, the theory of demand assumes a consumer seeks to reach the maximum possible level of utility.

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Question 11

The budget line shows the maximum affordable quantity of one good for each given quantity of the other good. The position of the budget line is determined by income and prices alone. Its slope reflects only relative prices.

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Question 12

Because the consumer prefers more to less, she will always select a point on the budget line. The consumer has a problem of choice. Along the budget line, more of one good can be obtained only by sacrificing some of the other good.

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Question 13

Consumer tastes can be represented by a map of non-intersecting indifference curves. Along each indifference curve, utility is constant. Higher indifference curves are preferred to lower indifference curves. Since the consumer prefers more to less, indifference curves must slope downwards. To preserve a given level of utility, increases in the quantity of one good must be offset by reductions in the quantity of the other good.

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Question 14

Indifference curves exhibit a diminishing marginal rate of substitution. Their slope is flatter as we move along them to the right. To maintain given utility, consumers sacrifice ever-smaller amounts of one good to get successive unit increases in the amount of the other good

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Question 15

Utility-maximizing consumers choose the consumption bundle at which the highest reachable indifference curve is tangent to the budget line. At this point, the market trade-off between goods, the slope of the budget line, just matches the utility trade-off between goods, the slope of the indifference curve.

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Question 16

At constant prices, an increase in income leads to a parallel outward shift in the budget line. If goods are normal, the quantity demanded will increase.

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Question 17

A change in the price of one good rotates the budget line around the point at which none of that good is purchased. Such a price change has an income effect and a substitution effect. The income effect of a price increase is to reduce the quantity demanded for all normal goods. The substitution effect, induced by relative price movements alone, leads consumers to substitute away from the good whose relative price has increased.

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Question 18

In a two-good world, goods must be substitutes. The substitution effect is unambiguous. With many goods, the pure substitution effect of a price increase also reduces demand for goods that are complementary to the good whose price has risen.

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Question 19

A rise in the price of a normal good must lower its quantity demanded. For inferior goods, the income effect operates in the opposite direction but rarely
seems to dominate the substitution effect. Demand curves slope downwards.

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Question 20

The market demand curve is the horizontal sum of individual demand curves, at each price adding together the individual quantities demanded.

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Question 21

Consumers prefer to receive transfers in cash rather than in kind, if the two transfers have the same monetary value. A transfer in kind may restrict the choices a consumer can make

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Question 22

The main ingredients of the theory of consumer choice are:

Answer 22

1. The consumer’s tastes and utility
   Tastes, or preferences, are the driving force behind what a consumer chooses to consume. Some prefer Coca-Cola to orange juice, some prefer beef to chicken, and so on. Utility is what economists call the satisfaction consumers get from consuming goods.
2. The behavioral assumption that consumers are rational
   By rational, we mean that consumers will try to obtain the best they can from their consumption decisions. In particular, of the affordable consumption bundles, a rational consumer picks the bundle that maximizes her own satisfaction.
3. The consumer’s income
   This represents the resource available to the consumer for the consumption activity. A consumer cannot consume more than her available income.
4. The prices at which goods can be bought.

Question 23

The marginal utility of a good is the increase in total utility obtained by consuming one more unit of that good, for given consumption of other goods.
A consumer has diminishing marginal utility from a good if each extra unit consumed, holding constant consumption of other goods, adds successively less
to total utility

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