Indifference Analysis (L1-4)

Question 1

3 basic assumptions of indifference analysis and what they mean?

Answer 1

Completeness - one can rank different market baskets according to preference

Monotonicity - ‘more is better’ Ceteris paribus

Transitivity - the consumer has internally consistent preferences

Question 2

Define indifference curve?

Answer 2

An indifference curve represents all combinations of two goods between which a consumer has no preference

Question 3

Define utility and unit?

Answer 3

Numerical measure of satisfaction gained from consumption of goods or services (utils)

Question 4

4 factors that affect utility?

Answer 4

Duration, intensity, certainty/uncertainty, it’s propinquity or remoteness

Question 5

Define marginal utility?

Answer 5

The additional satisfaction gained from consuming one additional unit of a good (within a given period)

Question 6

Define total utility?

Answer 6

The sum of all satisfaction gained from the consumption of a number of goods/services (within a given period)

Question 7

Define indifference map?

Answer 7

An indifference map shows different indifference curves that can be achieved

Question 8

See ‘mountain of happiness’

Answer 8

Now

Question 9

4 properties of indifference curves?

Answer 9

Higher curves preferred over lower ones
They never cross
They slope downward
They are convex in shape

(Explain why)

Question 10

Define marginal rate of substitution?

Answer 10

At any point along an indifference curve, the MRS is the number of units of good Y that have to be sacrificed to acquire on additional unit of good X, without changing TU

Question 11

What is the change in total utility along an indifference curve?

Answer 11

0

Question 12

Define diminishing marginal utility, and what it explains?

Answer 12

As one consumes more units of a good, each additional unit gives a lower MU that previous units

This explains the convex shape

Question 13

What are perfect substitutions in terms of indifference analysis, and how it looks on a graph?

Answer 13

Goods that consumers are willing to trade for one another at a constant rate

Therefore MRS = -1, slope is straight negative line

Question 14

What are perfect complements in terms of indifference analysis, what does this mean for the MRS, and how it looks on a graph?

Answer 14

Goods that are always consumer together in fixed proportions

A consumer will not substitute between good Y and good X therefore the MRS is undefined

The indifference curves are two lines, paralleled to the axis and meeting at right angles (no extra utility is gained by increasing consumption of X if there’s no increase in consumption of Y)

Question 15

Two factors that affect the basket of goods a consumer will buy?

Answer 15

Prices of goods

Budget available

Question 16

What does an increase in income do to the budget line if the goods are normal?

Answer 16

Shifts outwards parallel (vice versa for fall in income)

Question 17

What happens to the budget line if there’s a fall in the price of good X?

Answer 17

Budget line swings outwards about pivot (y axis)

Vice versa for rise in price of good X

Question 18

When is maximum utility occurred/optimum consumption point (C)?

Answer 18

When the budget line is tangent to the indifference curve

Question 19

Graph of one of the goods is not wanted at any price (eg. Cigarettes)?

Answer 19

If good y is not wanted at any price, the OCP will occur when the budget line touches the X axis

Question 20

OCP for perfect substitutes?

Answer 20

If X and Y are perfect substitutes, but one is cheaper than the other, the OCP will be on the axis of the cheaper good - ie. They will only consume the cheaper good

Question 21

OCP for perfect complements?

Answer 21

The OCP will always lie at the corner of the highest attainable ‘L’ - budget line will just touch the corner

Question 22

In what instance will an increase in income shift the budget line inward?

Answer 22

If the goods are inferior

Question 23

What does the income consumption curve show?

Answer 23

A line showing how an individual’s optimum level of consumption of two goods changes as income changes, Ceteris paribus

(Joins the OCPs as income increases, see graph)

Question 24

What is an Engel curve?

Answer 24

A line showing the relationship between quantity demanded for a good and the level of income

(See graph for derivation)

Question 25

What are the axis of an Engel curve?

Answer 25

Y axis - income

X axis - units demanded of a good

Question 26

What is the real income effect?

Answer 26

As the price of a good increases, the quantity a consumer can buy of it decreases, Ceteris paribus

Question 27

What is the substitution effect?

Answer 27

As the price of good A increases, the consumer will buy more of good B since good A will become relatively more expensive, and vice versa

Question 28

Which effects occur when there is an increase in the price of a normal good?

Answer 28

Real income effect

Substitution effect

Question 29

When a price of one good falls, how do you isolate the substitution effect from the real income effect? What does this show?

Answer 29

After the pivotal swing, imagine the consumer was given more money to move them back to their previous indifference curve. This means no change in real income, so can isolate the substitution effect; this show the substitution effect causes a shift ALONG the indifference curve, while the real income effect causes a shift to a DIFFERENT indifference curve

Question 30

What does the price-consumption curve show?

Answer 30

It is a line showing how an individual’s optimum level of consumption changes as the price of one of the goods changes, Ceteris paribus

Seen by swinging out budget line and tracing OCPs, normally slightly downward sloping

Question 31

What is market demand?

Answer 31

The sum of the individual demand curves

Question 32

Why is the market demand curve kinked?

Answer 32

Because at high prices some individuals would buy no quantity of goods