Consumer Demand Theory

Question 1

What 3 main tools does consumer demand theory have?

Answer 1

income and prices (budget constraint)

tastes and utility (indifference curves)

behavioural assumption (rationality)

Question 2

What is the Budget Constraint line?

Answer 2

all possible bundles / combinations the consumer can afford with their money income

Question 3

Why is the BC line downward sloping?

Answer 3

because it represents the trade off the consumer has to make between consuming 2 goods given their finite income

Question 4

Where are points on the BC line unattainable and why?

Answer 4

any point above the BC line because it is unaffordable with their income

Question 5

Where are points on the BC line attainable and why?

Answer 5

any point below the BC Line bc they can afford it BUT consumer not exhausting their entire income (saving a proportion of it)

Question 6

What does an increase in consumer’s income cause to the BC line?

Answer 6

causes an outward parallel shift

\ –> \

Question 7

What does an increase in income mean?

Answer 7

that the consumer can consume more of both goods but the trade off between the 2 goods remains the same

Question 8

What 2 things change to the BC Line if the price of one of the goods becomes cheaper?

Answer 8

1) relative prices (the slope of the BC line)

2)real incomes (BC shifts outwards)`

Question 9

what happens to the BC line if the price of meals decrease (good on x axis)?

Answer 9

the slope of the BC line becomes flatter

the increase in real income has caused an outward shift (this is represented by swivel + outward shift on graph)

Question 10

Where does the swivel come from?

Answer 10

the reduction in meal prices relative to cinema tickets

(reduction in x axis good relative to y axis good)

Question 11

Where does the outward shift movement come from?

Answer 11

the increase in the consumer’s real income

Question 12

What does the BC tell us?

Answer 12

what the consumer can and can’t afford

doesn’t tell us much with out further assumption eg rationality assumption

Question 13

What does the rationality assumption dictate?

Answer 13

a consumer will always behave in a utility maximising way
–> consumers always prefer more of a good than less
–> consumer has to be ON the BC line, not above or below

Question 14

Why does the rationality assumption rule out points below the BC line?

Answer 14

it tells us that consumers prefer more of a good than less

all bundles on the BC line dominate bundles below because all bundles that lie on BC line represent higher quantities of both goods

Question 15

Why are bundles above BC line ruled out?

Answer 15

bc these are unattainable as the consumer can not afford this

Question 16

What happens if the price of cinema tickets (y axis good) increase?

Answer 16

causes a swivel and inward shift of the BC line along the X axis intercept

the BC changes to a new one
consumer chooses a point on the new line, this point depends on their preferences

Question 17

What is utility?

Answer 17

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

Question 18

What is the Consumer optimisation problem?

Answer 18

the consumer has infinite wants but finite resources so how do they allocate their expenditure to maximise their wellbeing?

Question 19

how do you examine the consumer optimisation problem?

Answer 19

construct a simple model of consumer choice

the model is simple - has 2 goods and the consumer is assumed to not save or borrow any money for the sake of simplicity

Question 20

How would you draw an indifference curve?

Answer 20

just draw a tangent to the consumer BC line

Question 21

What does the point of tangency between the BC line and indifference curve represent?

Answer 21

the optimal consumption bundle

Question 22

What is the optimal consumption bundle?

Answer 22

where the indifference curve is just tangent to consumer BC line

Question 23

What does the non-satiation assumption about tastes allow us to say?

Answer 23

1) consumer will choose a point on the Budget Constraint
2) certain points on the graph will be preferred to others

Question 24

What bundle should the consumer choose?

Answer 24

the bundle of goods on the BC line on the highest possible indifference curve
this is the point where the indifference curve is tangent to BC

Question 25

What consumption bundle does the consumer choose?

Answer 25

where the MRS (MARGINAL RATE OF SUBSTITUTION) is equal to relative prices

Question 26

What is the impact of a change in income for normal goods?

Answer 26

this is NORMAL:
consumption increases when income increases
consumption falls when income falls
eg nike shoes or organic pasta

Question 27

What is the impact of a change in income for inferior goods?

Answer 27

inferior = small
so consumption falls when income increases
consumption increases when income falls
eg cheap groceries

Question 28

How does an increase in income affect the BC line when both of the goods are normal goods?

Answer 28

increase in consumer’s income shifts their BC outputs parallel

outward shift

the consumption of both goods rises with income increase, both goods are normal so have + income elasticity of demand

Question 29

How does an increase in income affect the BC line when one of the goods is inferior and one is normal?

Answer 29

causes a parallel outward shift of BC line

consumption for normal good increases but consumption for inferior good decreases

at higher levels of income, people want to diversify their purchases so but more of the normal good
if normal good is on y axis then tangency point is higher up (closer to y)

Question 30

What are the 2 consequences of a change in price?

Answer 30

1) Income Effect

2) Substitution Effect

Question 31

What is the income effect?

Answer 31

holds prices constant

consumers can afford more so wants to consume more of everything (if both goods are normal)

Question 32

What is the substitution effect?

Answer 32

holds real income constant

its now cheaper for the consumer to get 1 good than another so move consumption from the more expensive good to the cheaper one

Question 33

What happens to the BC line if price decreases?

Answer 33

BC becomes steeper

Question 34

What do you have to do to decompose the move from A to C into an income and substitution effect?

Answer 34

place a hypothetical BC line in diagram so that it is a tangent to the consumer’s old indifference curve AND parallel to the new BC line

Question 35

what is the move from A to B?
(first move)

Answer 35

the pure substitution effect

due only to the change in relative prices of the 2 goods

sub effect happens first bc you need to put subs into the game first

Question 36

What is the move from B to C?
(second move)

Answer 36

the pure income effect
move to new optimal bundle
due only to the change in real income of the consumer

Question 37

What is the pure income effect?
(in terms of movement)

Answer 37

the move to the new optimal bundle

Question 38

How do we get to the substitution effect move?

Answer 38

note the point of tangency between the hypothetical dashed line and the consumer’s old indifference curve

Question 39

What does the increase in the price of the x axis good cause to BC line?

Answer 39

pushes consumer’s BC line inwards and makes it steeper

Question 40

how do you derive the market demand curve from the individual consumer’s demand curve?

Answer 40

the market demand curve is simply the horizontal sum of the individual demand curves

Question 41

how do you work out the market demand?

Answer 41

the sum of units demanded by both consumers at the price

add the 2 demand curves of consumer 1 and consumer 2

Question 42

what do the income and substitution provide important insights into?

Answer 42

the factors that determine the elasticities of demand curves

Question 43

Scenario: individuals face a choice between consumption and hours of leisure, wage rate increases
what is the trade off in this scenario?

Answer 43

work-leisure trade off

the trade off is between hours of leisure and foregone consumption bc the individual could have worked, earned income + bought goods instead of consuming leisure

Question 44

What sort of good is leisure?

Answer 44

a normal good so it has positive income elasticity of demand

Question 45

Scenario: individuals face a choice between consumption and hours of leisure, wage rate increases

what happens graphically?

Answer 45

increase in wage rate moves consumer’s BC line outwards + steeper
optimal consumption bundle point shifts
pure sub effect = first move
pure income effect = second

Question 46

Scenario: individuals face a choice between consumption and hours of leisure, wage rate increases

What is the substitution effect in this situation?

Answer 46

reduces the hours the worker spends on leisure bc the opportunity cost of leisure increased due to increase in wage rate

Question 47

Scenario: individuals face a choice between consumption and hours of leisure, wage rate increases

What is the income effect in this situation?

Answer 47

worker spends more time on leisure bc the wage increase increased the worker’s disposable income, increasing the demand for leisure (as it is a normal good)

Question 48

Scenario: individuals face a choice between consumption and hours of leisure, wage rate increases
Does the income or substitution effect dominate in this situation?

Answer 48

income effect dominates the substitution effect
income effect > sub effect
so overall hours of leisure for worker increase

Question 49

how do you find the old optimal consumption bundle?

Answer 49

find where the old indifference curve was tangent to the old BC line

Question 50

how do you find the new optimal consumption bundle?

Answer 50

find where the new indifference curve is tangent to new BC line