Consumer Theory: Preferences And Utility

Question 1

What is an indifference curve?

Answer 1

A curve with all the bundles of good one and two that the consumer derives the same utility from.

Question 2

Describe the indifference curve of perfect substitutes.

Answer 2

• Linear
• therefore constant MRS as good 1 can be exchange for good 2 at a constant rate e.g 1:1
• An example is volvic water and highland water.

Question 3

Describe the indifference curve of perfect compliments.

Answer 3

• shaped.
• this is because these goods must be consumed in a fixed proportion.
• e.g one coffee two sugars

Question 4

Describe the indifference curve where good Y is a neutral good.

Answer 4

• a neutral good is one where the consumer doesn’t care about
• indifference curves are vertical
• this shows the consumer is only concerned with good x as utility increases as x increases but the consumer is indifferent to any amount of Y.

Question 5

What are the consistency assumptions of consumer theory ?

Answer 5

Completeness- any bundle can be compared
Reflexitivity- any bundle is atleast as good as itself
Transitivity- if bundle a is better then bundle b and bundle b is better than bundle c then bundle a must be better than bundle c.

Question 6

Describe the indifference curves where good Y is the negative good.

Answer 6

• A bad good is one which causes disutility as the consumer does not like it
• The curves have a positive slope
• Utility increases with graphs further to the right

Question 7

Describe indifference curves of satiated preferences.

Answer 7

• There is only one preferred bundle represented by a dot called the bliss point
• Indifference curves a circle shaped around this point, the further the indifference curve from this point the more utility decreases.

Question 8

What three characteristics reflect the behaviour of indifference curves?

Answer 8

-Convexity- Diversity is preferred to extremes, which is why there which is why the marginal rate of substitution is diminishing.
-Continuity- A small change in consumption is also reflected by a small change in utility
Monotonicity- Bundle A is better than bundle B if it has atleast as much of good x or y and more of good x or y. More is better.

Question 9

What is the marginal rate of substitution?

Answer 9

• The rate at which the consumer is willing to exchange good Y for X.
• The amount of good Y the consumer is willing to give up for an additional unit of X

Question 10

What is a utility function?

Answer 10

It is used to describe the preferences of a consumer.
Cardinal utility- where the difference in size of utility between two bundles is important .
Ordinal utility- Magnitude of utility is irrelevant all we care about if which of the two bundles brings the biggest utility.