Possibilities, Preferences and Choices

Question 1

What are consumption possibilities?

Answer 1

• Choices limited by income and prices

- Budget lines describe the limits to consumption choices

Question 2

What are divisible and indivisible goods?

Answer 2

• Divisible goods can be bought in the quantity desired e.g petrol and electricity
• Indivisible goods must be bought in specific quantities

Question 3

What are affordable and unaffordable quantities?

Answer 3

• Budget lines mark the boundary between the affordable and unaffordable
• Budget constraints change according to changes of the price or income

Question 4

What is the budget equation?

Answer 4

The budget line is described through the budget equation. Expenditure = income. (Y)
Expenditure = (price x quantity of good A) + (price x quantity of good B)

Question 5

What is real income?

Answer 5

Real income is expressed as a quantity of goods that the household can afford to buy e.g Y/Pa - this quantity is the maximum amount of good A you can buy

Question 6

What is relative price?

Answer 6

A relative price is the price of one good divided by the price of another good. The price of good A in terms of good B

Question 7

How does a change in price influence the budget line?

Answer 7

When price changes, so does the budget line. The lower the price of the good measured on the x axis, other things remaining the same, the flatter is the budget line. The higher the price of the good, the steeper is the budget line.

Question 8

How does a change in income influence the budget line?

Answer 8

A change in money income changes real income but does not change the relative price. The budget line shifts, but its slope does not change. An increase in money income increases real income and shifts the budget line right. A decrease in money income decreases real income and shifts the budget line left

Question 9

What is a preference map?

Answer 9

A preference map is based on intuitively appealing idea that people can sort all the possible combinations of goods into three groups: preferred, not preferred and indifferent. A series of indifference curves.

Question 10

What is an indifference curve?

Answer 10

An indifference curve is a line that shows all the combinations of goods and services among which a consumer is indifferent.

Question 11

What is the marginal rate of substitution?

Answer 11

The MRS is the rate at which a person will give up good y to get an additional unit of good x.

Question 12

How is the MRS affected if the indifference curve is steep?

Answer 12

MRS is high. The person is willing to give up a large quantity of good y to get an additional unit of good x while remaining indifferent

Question 13

How is the MRS affected if the indifference curve is flat?

Answer 13

MRS is low. The person is willing to give up a small amount of good Y to get an additional unit of good x while remaining indifferent.

Question 14

What is a diminishing MRS?

Answer 14

A general tendency for a person to be willing to give up less of good y to get one more unit of good x while remaining indifferent as the quantity of good x increases.

Question 15

What are close substitutes?

Answer 15

Close substitutes = may not know the difference.
The different brands of pens are an example of this
When two goods are perfect substitutes, their indifference curves are straight lines that slope downward

Question 16

What are complements?

Answer 16

Some goods do not substitute for one another, these are complements
E.g left shoes cannot substitute right shoes
Indifference curves of perfect complements are L shaped

Question 17

How is the MRS curve influenced by the closeness of substitutes?

Answer 17

The closer the two goods are to perfect substitutes, the closer the MRS is to being constant (straight line) rather than diminishing (a curved line). Indifference curves for poor substitutes are tightly curved

Question 18

How are best affordable choices derived?

Answer 18

The best affordable point is on the budget line. All income is utilised. Reflects preferences.

Question 19

What is the price effect?

Answer 19

When price of a good lowers, the budget line rotates outward and becomes flatter. The consumption of the other good e.g soda is cut while the consumption of the good that has lowered in price e.g movies is increased. Lisa is substituting soda for movies.

Question 20

What is the income effect?

Answer 20

Buying more or less of both goods due to an increase/decrease in income

Question 21

What is the substitution effect?

Answer 21

The effect of a change in price on the quantity bought when the consumer remains indifferent between the original situation and the new one. When relative price of a good falls, the consumer substitutes more of that good for the other good.

Question 22

How does the income effect affect the budget line?

Answer 22

Increasing Lisa’s income by $12 shifts the budget line outward. The slope of the budget line does not change because both prices remain the same. As Lisa’s budget line shifts outward, her consumption possibilities expand and her best affordable point moves. As Lisa’s income increases, she sees more movies.

Question 23

How does the price effect work for inferior goods?

Answer 23

Demand decreases as income increases. Income effect is negative for an inferior good. This means that a lower price does not inevitably lead to an increase in the QD.

Question 24

How does the negative income effect differ from the substitution effect?

Answer 24

The substitution effect of a fall in the price increases the quantity demanded but the negative income effect works in the opposite direction and offsets the substitution effect to some degree.

Question 25

What happens if the negative income effect = the positive substitution effect?

Answer 25

A fall in price leaves the QD unchanged, the demand curve is vertical and demand is perfectly inelastic.

Question 26

What happens if the negative income effect is smaller than the positive substitution effect?

Answer 26

If the negative income effect is smaller than the positive substitution effect, a fall in price increases the quantity bought and the demand curve still slopes downward like that for a normal good. Demand for an inferior good might be less elastic than that for a normal good.

Question 27

What happens if the negative income effect exceeds the positive substitution effect?

Answer 27

A fall in price decreases the quantity bought and the demand curve slopes upward. This case does not appear to occur in the real world.