Consumer Choice

Question 1

What assumptions does the model of consumer choice make?

Answer 1

• Consumers are rational and act to maximise their utility
• There is only one consumer
• There are only two goods

Question 2

What constrains utility maximisation?

Answer 2

The consumer’s budget - comprised of income and price

Question 3

Using the budget constraint, how can total income be calculated?

Answer 3

Total income = expenditure on X + expenditure on Y

Question 4

Draw a budget line to show all feasible options.

Answer 4

Question 5

What happens to the budget line if the price of X increases?

Answer 5

It pivots inwards around Y-intercept.

Question 6

What happens to the budget line if the price of Y decreases?

Answer 6

It pivots upwards around the X-intercept

Question 7

What happens to the budget line if income increases?

Answer 7

It shifts outwards

Question 8

What does an indifference curve represent?

Answer 8

Any combination of X and Y that will return an equal level of utility.

Question 9

What are the three axioms of choice?

Answer 9

1. Non-satiation
2. Diminishing marginal rate of substitution
3. Transitivity

Question 10

Describe non-satiation.

Answer 10

More of a good will always be preferred to less

Question 11

Describe diminishing marginal rate of substitution. Explain why this happens. Demonstrate this graphically.

Answer 11

When one has a lot of Y, they can exchange a lot of Y for X and retain the same utility. When one has less Y, more X will be required to compensate for the loss of the next unit of Y.

Change in Y / Change in X decreases

This happens due to a diminishing marginal utility - the more of a good someone has, the less utility they will get from an additional unit.

Question 12

What is transitivity? What does it mean for an indifference map?

Answer 12

A logic argument. If A is preferred to B and B is preferred to C, then A must also be preferred to C.
In the context of indifference analysis, it means that indifference curves cannot cross.

Question 13

Draw an indifference curve for perfect complements.

Answer 13

Question 14

Draw an indifference curve for perfect substitutes.

Answer 14

Question 15

Where is the optimal consumption point on an indifference curve?

Answer 15

Optimum consumption is where the budget line is tangential to the indifference curve.

Question 16

The slope of the indifference curve at the optimal consumption point is…

Answer 16

… equal to the slope of the budget constraint and therefore
- (price of X/price of Y)

Question 17

The slope of the indifference curve is equal to…

Answer 17

… the -(marginal rate of substitution)

Question 18

The slope of the budget constraint is equal to…

Answer 18

… -(price of X / price of Y)

Question 19

Predict the change in consumption of two normal goods when income decreases.

Answer 19

1. Budget line shifts inwards
2. Consumption of Good X decreases
3. Consumption of Good Y decreases
4. Consumer moves to a lower indifference curve

Question 20

Predict the change in consumption of a normal and inferior good when income decreases.

Answer 20

1. Budget line shifts towards origin
2. Consumption of normal good decreases
3. Consumption of inferior good increases

Question 21

Predict the change in consumption of two normal goods when the price of one increases.

Answer 21

1. Budget line pivots inwards about the Y intercept (or downwards about the X intercept)
2. Consumption of one good increases
3. Consumption of the other good decreases

Question 22

How do you separate the income effect from the substitution effect when price changes?

Answer 22

1. Draw a tangent to the original indifference curve that is parallel to the new budget line
2. Mark the point at which the imaginary budget line is tangential to the IC
3. The change from the original optimal consumption point to the new (imaginary) point of tangency is the substitution effect
4. The change from the imaginary point to the new optimal consumption point is the income effect

Question 23

What is the critique of indifference curve theory? Discuss the papers.

Answer 23

A working paper from Komlos (2014).
Komlos argues that due to the endowment effect (where people value goods they own greater than goods they don’t), the indifference curve is actually ‘kinked’ at the point of current consumption. As a result, the budget curve does not always have a unique tangent with the highest indifference curve, and thus consumption will not always change with a change in price.

Question 24

When has indifference curve analysis been used to inform policy?

Answer 24

Coppock (1945) used indifference curve analysis to investigate how individuals consumption of food changed with income, given that some of their income could only be spent on foods (via the US Food Stamp Programme). By using stamps, rather than subsidies or welfare benefits, individuals would be induced to spend their increase in income on food only rather than non-food goods, and therefore shifting their optimal consumption point on the indifference curve. It also removes the substitution effect when the price of food decreases, ensuring individuals spend increases in income on food but inhibits their ability to move to a higher indifference curve

Isserman (1975) also used indifference curve analysis to examine a new food stamp policy, again finding a shifted indifference curve due to the increase in income only being able to be used for food. Again, it was found that food stamps increase food consumption but the increase in income does not allow its shift to a higher indifference curve.

Therefore, if the point of the food stamps is to increase food consumption then food stamps are the optimal policy. If the point is to increase wellbeing to the worse-off, then a cash subsidy is optimal.