Lecture 2

Question 1

Preferences

Answer 1

A description of the benefit or cost we associate with each possible outcome

Question 2

Indifference curves

Answer 2

• Show all combinations of goods that give the same utility
• Each curve is associated with a different level of utility (satisfaction)
• IC are usually downward sloping because of trade offs - if 2 combinations of goods are equally preferred the combination that has more of 1 good must have less of the other good
• Slope of IC = Marginal rate of substitution (MRS) = The trade off that a person is willing to make between 2 goods

Question 3

Common properties

Answer 3

• Usually downward sloping due to trade offs
• Higher indifference curves represent higher levels of utility
• Usually smooth and continuous
• Usually becomes flatter as the amount of the horizontal axis consumption increases (diminishing marginal utility)
• Indifference curves for a particular individual do not cross

Question 4

Feasible frontier

Answer 4

• Shows the maximum feasible quantity of one good for a given quantity of the other (constraint)
• Slope of feasible frontier = Marginal rate of transformation (MRT) = the trade off that a person is forced to make in order to get an additional unit

Question 5

Constraints: Opportunity Cost

Answer 5

• The feasible frontier is downward sloping because free time has an opportunity cost (net benefit of the forgone alternative)
• Slope of feasible frontier = MRT = Opportunity Cost

Question 6

Constraints: Budget constraint

Answer 6

• Budget constraint represents all combinations of goods that exactly exhaust an individual’s income
• Budget constraint is a specific type of feasible frontier
• Equation of budget constraint: c = w (24 - t)

Question 7

Optimal choice

Answer 7

• Is the point where the feasible frontier is tangent to the highest possible indifference curve
• At the optimal point (A), MRS = MRT

Question 8

Income effect

Answer 8

• Whenever the feasible set changes there is an income effect
• Larger feasible set (greater total area) = positive income effect (feel richer)
• Smaller feasible set (smaller total area) = negative income effect (feel poorer)

Question 9

Substitution effect

Answer 9

• Whenever the slope of the feasible frontier changes, there is a substitution effect
• Shallower slope = positive substitution effect for horizontal axis good (it becomes relatively less expensive than before)
• Steeper slope = negative substitution effect for horizontal axis good (it becomes relatively more expensive than before)