Consumer Theory

Question 1

The theory of consumer choice relies on what three main premises

Answer 1

1. Consumers have preferences that determine the satisfaction they get from the consumption of goods and services
2. Consumer face constraints that limit their choice
3. Consumers seek to maximize the level of satisfaction they obtain from consumption given the constraints that they face

Question 2

So overall what do economists assume about consumers that guides them in choosing between goods

Answer 2

Consumers have a set of tastes or preferences - these can differ among individuals

Question 3

The standard model of consumer behavior assumes preferences satisfy what three key conditions

Answer 3

1. Completeness
2. Transitivity
3. More is Better (Non-satiation)

Question 4

Describe the assumption of completeness in consumer theory

Answer 4

• Requires that for consumers facing choices between any two bundles of goods (A and B), then either
  –> Consumer prefers A to B
  –> Consumer prefers B to A
  –> Consumer is indifferent between A and B
• This ensures that the consumer can rank all possible bundles in terms of their desirability (so consumers must be able to decide on preferences for all possible options - no indecision)

Question 5

Describe the assumption of Transitivity in consumer theory

Answer 5

• Requires that if a consumer prefers A to B, and prefers B to C, then they also prefer A to C
• this ensures that individuals are rational in their choices

Question 6

Describe the assumption of More is better in consumer theory

Answer 6

• Requires that consumers always prefer more of a good to less
• referred to as non satiation

Question 7

What does an indifference curve depict

Answer 7

The sets of bundles that a consumer views as being equally desirable

Question 8

Indifference maps must satisfy what 4 properties

Answer 8

1. Bundles on indifference curves farther from the origin are preferred to those on indifference curves closer to the origin
2. An indifference curve goes through every possible bundle
3. Indifference curves cannot cross
4. Indifference curves slope downward

Question 9

The slope of an indifference curve reflects what

Answer 9

How willing consumers are to trade one good for another (Marginal rate of substitution)

Question 10

Define the marginal rate of substitution

Answer 10

The rate at which consumer is willing to substitute one good for another

Question 11

If an indifference curve is convex what does that tell you

Answer 11

• convex means bowed towards the origin
• preferences exhibit a diminishing marginal rate of substitution

Question 12

If an indifference curve is concave what does that tell you

Answer 12

• concave means bowed outward from the origin
• preferences exhibit an increasing marginal rate of substitution

Question 13

Most people have what type of curvature for their indifference curve

Answer 13

• convex indifferent curves (therefore have diminishing marginal rate of substitution)

Question 14

A constant marginal rate of substitution indicates what

Answer 14

• This means that goods are perfect substitutes

Question 15

Describe perfect compliments

Answer 15

Goods that are always consumed in fixed proportions

Question 16

Describe perfect substitutes

Answer 16

goods that are essentially equivalent from the consumers pov

Question 17

Typically preferences lie between what two choices

Answer 17

between the two extremes of perfect substitutes and perfect compliments –> so goods are imperfect substitutes

Question 18

What does the utility function describe

Answer 18

It describes the level of utility obtained from consuming goods and services

Question 19

Do utility bundles exist in the real world

Answer 19

No, they are just an economical model of consumer behaviour

Question 20

What type of measure is utility

Answer 20

an ordinal measure - helps you with relative ranking

Question 21

Define marginal utility

Answer 21

This is the extra utility that a consumer gets from consuming an additional unit of a good (either x or y)

–> so it tells you how utility changes as we increase or decrease consumption of one good, holding the consumption of all other goods constant

Question 22

What is the most important constraint that individuals face in the theory of consumer choice

Answer 22

the limitations imposed by their budget

Question 23

The budget constraint/budget line represents what

Answer 23

all possible bundles of goods that can be purchased if the consumers entire budget is spent on those goods at given prices

Question 24

What is the opportunity set

Answer 24

the set of all possible bundles of goods that a consumer can buy

Question 25

Describe the Marginal rate of transformation

Answer 25

The trade off the market imposes on the consumer in terms of how much of one good the consumer must give up to purchase more of another good

Question 26

So how do consumers maximize their well being, subject to the constraints that they face

Answer 26

Consumers pick the bundles of goods in their opportunity set that gives them the highest level of utility

Question 27

What is an interior solution (in consumers reaching their optimal bundle)

Answer 27

This is where the optimal bundles has positive quantities of all goods and lies between the ends of the budget line

Question 28

What is a corner solution (in consumers reaching their optimal bundles)

Answer 28

This is where the optimal bundle has a quantity of zero for at least one good, meaning the optimal bundle is at one end of the budget line

Question 29

The optimal choice for a consumer lies where in relation to their budget line and their indifference curve

Answer 29

Where the indifference curve touches the budget line but does not cross it

Question 30

Describe the effect of a buy two get one free promotion

Answer 30

• this creates a kink in the consumers budget constraint - if the new budget line crosses the pre promotion indifference curve then the promotion works

Question 31

deviation: transitivity

Answer 31

• transitivity is where preferring A to B etc. so assuming they make rational choices

–> In Novel goods and Children this fails

Question 32

deviations: endowment effect

Answer 32

standard model assumes that individuals value a good the same regardless of whether or not they own it. But evidence suggests that people place a higher value on a good if they own it than they do if they are considering buying it

Question 33

deviations: salience

Answer 33

• model assumes that individuals consider all possible information when making a decision. Evidence suggests that people are more likely to consider information if it is presented in a way that grabs their attention, or takes little thought to understand