Budget Lines and Indifference Curve

Question 1

budget line

Answer 1

shows the consumption contraints faced by a consumer

the combinations of 2 goods or services that a consumer can afford to buy

given their limited inccome

and the prices of the goods

Question 2

indifference curve

Answer 2

a curve showing
the combinations of
two goods that give
equal total utility to a
consumer

Question 3

MRS

Answer 3

the slope of an indifference curve

the amount
of one good that a
consumer must give up
in exchange for another
while keeping total
utility constant

. To induce the consumer to give up 1 pizza, she
has to be given 6 liters of Pepsi: The MRS is 6 liters per pizza.

Question 4

consumer equilibrium (for indifference analysis)

Answer 4

the point at which a
consumer maximises
utility at the tangency
between an indifference
curve and the budget
line; this is the highest level of utility a consumer can reach given their budget constraint

it is a particular optimum combination on the highest attainable IC given available budget

Question 5

substitution effect

Answer 5

following a change in relative prices, consumer substitues relatively cheaper good for relatively more expensive one

Question 6

income effect

Answer 6

the way that a change in relative prices of goods affects purchasing power of given level of income, so consumer buys more or less of each good

Question 7

giffen good

Answer 7

a good
for which the income
effect is so strong that
it more than offsets
the substitution effect,
so that the demand
curve becomes upward
sloping

Question 8

assumptions of indifference analysis related to RATIONALITY

Answer 8

1. consumers make rational decisions based on perfect information
2. Consumer aims to maximise utility
3. consumer** knows combos** b/w which there is indifference
4. consumer can rank their level of satisfaction for multiple goods
5. consumer **can compare two goods rationally **
6. The rational consumer behavior remains constant over the IC curve
7. consumers are assumed not to make choices under uncertainty

Question 9

slope of budget line

Answer 9

represents relative prices of goods and hence the opportunity cost of increasing the consumption of one good by 1 unit

e.g. if slope is 5, it means to increase consumption of good X by 1, you must give up 5 of Y

Question 10

calculating the boundaries of the budget line

Answer 10

budget/price of good A, budget/price of good B

Question 11

4 properties of indifference curves

Answer 11

1. Higher IC preferred to lower IC - consumer prefers more to less
2. IC downward sloping - since all combos of goods on IC yield equal utility, decreasing consumption of one requires increasing consumption of the other to maintain same utility
3. ICs don’t cross
4. ICs are convex to origin due to diminishing MRS (DUE TO DMU) ; when they have more of A and less of B, prepared to sacrifice a lot of A for small increase in B

Question 12

Reaching consumer equilibrium

Answer 12

**where BL is tangential to IC **is equilibrium since this is the highest level of utility given budget. The MRS is equal to relative price.

Question 13

increase in income - budget line

Answer 13

parallel shift in or out

Question 14

how does a change in price affect the shape and position of a budget line?

Answer 14

pivotal shift inward/outward

if both prices change, line will shift but gradient depends on relative price changes (if same ratio, parallel shift)

Question 15

effect of income change on consumption - normal good

Answer 15

outward shift of BL allows consumer to reach higher IC

on the higher IC, will be consuming higher quantities of both goods than before

this is because increase in income = increase in purchasing power and rational consumer prefers more to less

Question 16

effect of income change on consumption - one normal, one inferior good

Answer 16

parallel outward shift of BL allows consumer to reach higher IC

on the higher IC, will be consuming higher quantities of normal good and less of the inferior good

this is because increase in income increase demand for normal but decreases demand for inferior

(if income falls, inward shift, lower IC, higher quantities of inferior and lower of normal)

Question 17

change in relative prices - normal goods

Answer 17

since A is now relatively cheaper, consumer gets more units of A for every unit of B given up, so decides to buy less B and more A - substitution effect

fall in the price of A means real income is higher, in effect shifting budget line outwards pivotally

this allows consumer to reach a point on higher IC - income effect

since I and S effects work in same direction for A, the new point on the IC will mean more A is consumed than before

however, since I and S work in opposite direction for B, the total effect on pizza consumption is ambiguous so the final consumption point will be in between the original and the point showing S effect

Question 18

what is needed for a consumer to reach a higher indifference curve?

Answer 18

higher income, either nominal or real

Question 19

explain the effect of advertising/non price/income factors on the indifference curve

Answer 19

• explain original equilibrium
• explain that advertising increases MRP - i.e. willing to give up more of the other for one unit of X
• explain that slope of IC increases and it becomes steeper at the original equilibrium point, thus pivots around the red curve
• after IC changed shape, consumer can actually reach a higher IC with more of X and less of Y
• therefore advertising changes consumer preferences and encourages purchasing more X

Question 20

limitations of IC analysis

Answer 20

• Two-Goods Model Unrealistic
• assumes consumer rationality but many reasons why they don’t act rationally - e.g. social norms
• assumes they can rank their preference
• assumes more is ALWAYS preferred to less - ignores ideas of DMU which are more realistic