Session 3

Question 1

What are our assumptions when talking about consumer preferences?

Answer 1

1. Completeness
2. Transitivity
3. More is better than less

Question 2

Explain the assumptions about consumer preferences

Answer 2

Completeness: Preferences are assumed to be complete. In other words, consumers can compare and rank all possible bundles. Thus, for any two market bundles A and B, a consumer will either prefer A to B, prefer B to A, or be indifferent between the two. Indifference means that a person is equally satisfied with either bundle

Transitivity: Preferences are transitive. Transitivity means that if a consumer prefers bundle A to bundle B and bundle B to bundle C, then the consumer also prefers A to C. Transitivity implies consumer consistency in consumer decision-making

More is better than less: Consumers always prefer more of any good to less. In addition, consumers are never satisfied or satiated; more is always better, even if just a little better

Question 3

What does transitivity means with respect to consumer behaviour?

Answer 3

Transitivity means that if a consumer prefers bundle A to bundle B and bundle B to bundle C, then the consumer also prefers A to C. Transitivity implies consumer consistency in consumer decision-making

Question 4

What does the indifference curve show?

Answer 4

The indifference curve shows the bundles of goods that give the same level of utility (satisfaction)

Question 5

Draw an example of indifference curve!

Answer 5

Slide 5

Question 6

What is the definition of the indifference map?

Answer 6

indifference map: a set of indifference curves showing the market bundles between which a consumer is indifferent.

An indifference map is a set of indifference curves that describes a person’s preferences.
Higher indifference curves show higher utility

Any bundle on indifference curve U3, such as A, is preferred to any bundle on curve U2 such as B, which in turn is preferred to any bundle on U1, such as D.

Question 7

Draw an indifference map

Answer 7

Slide 6

Question 8

Higher indifference curves show

Answer 8

higher utility

Question 9

Indifference curves cannot _______

Answer 9

intersect!

Question 10

What is the definition of the marginal rate of substitution in consumption?

Answer 10

marginal rate of substitution: the amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good.

Question 11

What measures the marginal rate of substitution?

Answer 11

The slope of an indifference curve measures the consumer’s marginal rate of substitution (MRS) between two goods.

Question 12

What does the assumption of convexity mean?

Answer 12

Convexity. When the MRS diminishes along an indifference curve, the curve is convex. The assumption of convexity implies that the more of one good the consumer has ( food), the less willing he or she is to give up the other good (clothing) and vice versa

Question 13

What is the budget line?

Answer 13

A budget line describes the combinations of goods that can be purchased given the consumer’s income and the prices of the goods.

Question 14

Draw a budget line!

Answer 14

Slide 10

Question 15

Effects of a Change in Income on the Budget Line

DRAW RELEVANT DIAGRAM!

Answer 15

Slide 11

Income changes A change in income (with prices unchanged) causes the budget line to shift parallel to the original line (L1).
When the income of $80 (on L1) is increased to $160, the budget line shifts outward to L2.
If the income falls to $40, the line shifts inward to L3.

Question 16

Effects of a Change in Price on the Budget Line

DRAW DIAGRAM!

Answer 16

Slide 12

A change in the price of one good (with income unchanged) causes the budget line to rotate
When the price of food falls from $1.00 to $0.50, the budget line rotates outwards from L1 to L2.
However, when the price increases from $1.00 to $2.00, the line rotates inwards from L1 to L3.

Question 17

What does utility maximisation mean?

Answer 17

The consumer aims to achieve maximum satisfaction from consumption (utility maximization).

Question 18

What does consumer choice have to satisfy?

Answer 18

The choice must satisfy two conditions:

1. it must be located on the budget line and
2. it must give the consumer the most preferred combination of goods and services.

Question 19

When does the consumer select a product called A?

DIAGRAM!

Answer 19

Slide 13

The consumer chooses bundle A where the budget line and indifference curve U2 are tangential!

Question 20

Draw diagrams to explain the impact of a price change for normal goods on the indifference and budget curves.

Answer 20

Slide 14

A decrease in the price of food has both an income effect and a substitution effect.

The consumer is initially at A, on budget line RS.
When the price of food falls, consumption increases by F1F2 as the consumer moves to B.
The substitution effect F1E (associated with a move from A to D) changes the relative prices of food and clothing but keeps real income (satisfaction) constant.
The income effect EF2 (associated with a move from D to B) keeps relative prices constant but increases purchasing power.
Food is a normal good because the income effect EF2 is positive.

Question 21

The Impact of a Price Change: Inferior Goods

diagrams

Answer 21

Slide 15

The consumer is initially at A on budget line RS.
With a decrease in the price of food, the consumer moves to B.
The resulting change in food purchased can be broken down into a substitution effect, F1E (associated with a move from A to D), and an income effect, EF2 (associated with a move from D to B).
In this case, food is an inferior good because the income effect is negative.
However, because the substitution effect exceeds the income effect, the decrease in the price of food leads to an increase in the quantity of food demanded.

Question 22

How do you get a market demand curve?

DIAGRAM

Answer 22

By summing up individual demands!

Slide 16

The market demand curve is obtained by summing horizontally individual consumer demand curves, such as DA, DB, and DC.
At each price, the quantity of coffee demanded in the market is the sum of the quantities demanded by each consumer.
At a price of $4, for example, the quantity demanded by the market (11 units) is the sum of the quantity demanded by A (no units), B (4 units), and C (7 units).