Consumer Demand Theory

Question 1

What is the budget constraint?

Answer 1

All possible bundles of goods that the consumer can afford with their income

Question 2

Describe the budget constraint diagram in terms of good X and good Y?

Answer 2

The quantity of good X is along the X-axis, the quantity of good Y is along the Y axis. The BC is downward sloping, with a slope of -(PX/PY)

Question 3

What happens to the budget constraint (good X on X-axis, and good Y on Y-axis) when the price of good X falls?

Answer 3

The budget constraint swivels outwards - so the quantity of good X is higher (line is further along the x-axis), position on Y -axis is unchanged

Question 4

Why do consumers choices lay on the budget constraint?

Answer 4

Consumers can’t afford anything to the right of the BC on the diagram, and wouldn’t consume to the left of the diagram as they are not using their income, and there is an assumption that consumers always prefer more to less

Question 5

What is utility?

Answer 5

The satisfaction that a consumer derives from consuming a particular consumption bundle

Question 6

What are the 3 assumptions CDT makes about utility?

Answer 6

1) Completeness - bundles can be ranked in terms of their utility
2) Transitivity - the utility ranking of bundles is internally consistent
3) Preference for ‘more’ to ‘less’

Question 7

What is the marginal rate of substitution?

Answer 7

MRS= rate at which a consumer can give up some amount of one good in exchange for another good while maintaining the same level of utility.

Question 8

Explain diminishing marginal rate of substitution ?

Answer 8

A consumer who consumes more and more of good X is less willing to give up good Y in order to further increase their consumption of good X

Question 9

What is an indifference curve? What does it look like

Answer 9

Downward sloping curve - it shows combinations of 2 goods that leave the consumer equally well off/satisfied/having the same utility

Question 10

A higher indifference curve (more the the right) has a higher what?

Answer 10

Utility

Question 11

Can indifference curves intersect?

Answer 11

No - this would violate the assumption that the consumer always prefers more to less

Question 12

What is the consumer optimization problem?

Answer 12

The consumer has infinite wants and finite resources - how do they allocate expenditure to maximize their wellbeing?

Question 13

Where is the optimal consumption bundle?

Answer 13

Where the highest possible indifference curve is tangent to the budget constraint - where relative prices (slope of BC) = MRS

Question 14

What happens, using CDT, when there is an increase in income with 2 normal goods? Describe both diagram changes and theory changes

Answer 14

Budget constraint shifts outwards, so move to a higher indifference curve. As normal goods, consumption of both of them rises with income (positive YED).

Question 15

What happens, using CDT, when there is an increase in income with 1 normal goods(Y) and 1 inferior (X)? Describe both diagram changes and theory changes

Answer 15

Budget constraint shifts out, so move to higher indifference curve. Consumption of normal good (on Y-axis) increases, but consumption of inferior good (X) falls. As at higher levels of income people want to diversify purchases

Question 16

Explain the income and substitution effect when good X becomes cheaper?

Answer 16

Income (holding prices constant) - can afford to reach higher well being and so want to consume more of everything (when goods are normal)
Substitution (holding real income constant) - cheaper to get wellbeing from good X so move from good Y to good X

Question 17

How do you derive the market demand curve from the individual consumer demand curve?

Answer 17

Market demand = horizontal sum of the individual demand curve