Lecture 2: Budgets and Demand

Question 1

What is the slope of an indifference curve?

Answer 1

Diminishing marginal rate of substitution

Question 2

Why is the MRS diminishing?

Answer 2

Preferences are strictly convex

Question 3

What is the formula for a budget line?

Answer 3

PaA + PaB = M

(Price of a x no. of a) + (price of b x no. of b) = money income

Question 4

What is the budget set?

Answer 4

The set of affordable bundles (area below the budget line)

Question 5

What happens to the budget line when prices drop?

Answer 5

It becomes steeper

Question 6

What happens to the budget line when income changes?

Answer 6

The intercepts change

Question 7

What is the absolute value of the slope of the budget line?

Answer 7

The radio of prices, relative prices pa/pb (e.g. if a = 10 and b = 5, pa/pb =2)

Question 8

What makes a bundle affordable?

Answer 8

It falls within the budget set

Question 9

What is the theory of consumer choice?

Answer 9

Consumers maximise utility subject to budget constraints

Question 10

What is the best bundle of goods?

Answer 10

The bundle of goods that falls on the highest indifference curve

Question 11

What happens at x*?

Answer 11

The consumer’s MRS = the exchange rate pa/pb (slope of budget line)

And all income is spent: PaA* + PbB* = M

It is a TANGENCY condition

Question 12

What is the law of demand?

Answer 12

If price decreases, demand increases.

Change in a*/change in price of a < 0

Question 13

What happens if the demand of one good goes up when the price of another good goes down?

Answer 13

They are gross complements; goods that you use together.

Change in price of b/change in price of a < 0

Question 14

What happens if demand for a good decreases when the price decreases?

Answer 14

The Law of Demand fails; they are Giffen Goods.

Question 15

What happens to the demand for a normal good when money income increases?

Answer 15

It increases

Question 16

What is an inferior good?

Answer 16

For inferior goods, if money income increases, demand for the good decreases

Question 17

What are ordinary goods?

Answer 17

Goods that satisfy the law of demand

Question 18

What is the price effect?

Answer 18

Income effect + substitution effect

Question 19

What is the substitution effect?

Answer 19

When prices decrease, the slope of the budget line changes

Question 20

What is the income effect?

Answer 20

If prices go down, the consumer can afford more of the good as real money income increases

Question 21

Why is the next substitution effect always negative?

Answer 21

Convexity: diminishing marginal rate of substitution

Question 22

If a good is normal then it is..?

Answer 22

Ordinary

Question 23

If a good is Giffen then it is..?

Answer 23

Inferior

Question 24

For an inferior good, what happens to the income and substitution effects?

Answer 24

The net income effect curbs the substitution effect