Chapter 3 - Consumer Behavior

Question 1

Define the theory of consumer behavior.

Answer 1

This is the description of how consumers allocate incomes among different goods and services to maximize their well-being.

Question 2

How is consumer behavior best understood?

Answer 2

Consumer behavior is best understood in three distinct steps:
1. Consumer Preferences
2. Budget Constraints
3. Consumer Choices

Question 3

Define Completeness.

Answer 3

: Preferences are assumed to be complete. In other words,
consumers can compare and rank all possible baskets. Thus, for any two
market baskets A and B, a consumer will prefer A to B, will prefer B to A, or
will be indifferent between the two. By indifferent we mean that a person will
be equally satisfied with either basket.

Question 4

What is Transitivity?

Answer 4

Preferences are transitive. Transitivity means that if a
consumer prefers basket A to basket B and basket B to basket C, then the
consumer also prefers A to C. Transitivity is normally regarded as
necessary for consumer consistency.

Question 5

What is a indifference curve?

Answer 5

This is a curve representing all combinations of market baskets
that provide a consumer with the same level of satisfaction.

Question 6

Explain an indifference map.

Answer 6

Graph containing a set of indifference curves showing the market baskets among which a consumer is indifferent.

Question 7

Define marginal rate of substitution (MRS).

Answer 7

Maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good.

Question 8

When is a curve defined as convex?

Answer 8

When the MRS diminishes along an indifference curve, the curve is convex.

Question 9

Define perfect substitutes.

Answer 9

Two goods for which the marginal rate of substitution of one for the other is a constant.

Question 10

Define perfect complements.

Answer 10

Two goods for which the MRS is zero or infinite; the indifference curves are shaped as right angles.

Question 11

What are bads?

Answer 11

A bad is a good for which less is preferred rather than more.

Question 12

What is the utility ?

Answer 12

A Numerical score representing the satisfaction that a consumer gets from a given market basket.

Question 13

Provide the meaning of a ordinal utility function.

Answer 13

A Utility function that generates a ranking of market baskets in order of most to least preferred.

Question 14

What is a cardinal utility function

Answer 14

A Utility function describing by how much one market basket is preferred to another.

Question 15

What are budget constraints of an individual?

Answer 15

Constraints that consumers face as a result of limited incomes.

Question 16

What is a budget line?

Answer 16

All combinations of goods for which the total amount of money spent is equal to income.

A budget line describes the combinations of goods that can be purchased given the consumer’s income and the prices of the goods.

Question 17

State the two conditions that the maximizing market basket must satisfy.

Answer 17

1. It must be located on the budget line.
2. It must give the consumer the most preferred combination of goods and
   services.

Question 18

What is marginal utility?

Answer 18

This is the additional satisfaction obtained from consuming one additional unit of a good.

Question 19

Define diminishing marginal utility.

Answer 19

A principle that as more of a good is consumed, the consumption of additional amounts will yield smaller additions to utility.

Question 20

What are the:
- cost-of-living index
- ideal cost-of-living index

Answer 20

The cost-of-living index is a ratio of the present cost of a typical bundle of consumer goods and services compared with the cost during a base period.

The ideal cost-of-living index Cost of attaining a given level of utility at current
prices relative to the cost of attaining the same utility at base-year prices.

Question 21

What is Laspeyres price index?

Answer 21

Amount of money at current year prices that an individual requires to purchase a bundle of goods and services chosen in a base year divided by the cost of purchasing the same bundle at base-year prices.

Question 22

What is the Paasche index?

Answer 22

Amount of money at current-year prices that an individual requires to purchase a current bundle of goods and services divided by the cost of purchasing the same bundle in a base year.

Question 23

Compare the Laspeyres and Paasche indexes.

Answer 23

Just as the Laspeyres index will overstate the ideal cost of living, the Paasche
will understate it because it assumes that the individual will buy the current year
bundle in the base period.

Question 24

What is a fixed-weight index?

Answer 24

A Cost-of-living index in which the quantities of goods and services remain unchanged.

Question 25

Define a chain-weighted price index.

Answer 25

A Cost-of-living index that accounts for changes in quantities of goods and services.