Term 1 Week 1: Consumer Theory and Budget Constraints

Question 1

What does standard economic theory assume (3)

Answer 1

-People aim to maximise utility when consuming G/S
-People don’t choose randomly and get their choices correct (this is often false)
-People make different decisions due to differences in circumstances and preferences

Question 2

What is the equation for a budget constraint (2, 1)

Answer 2

-M ≥ Qx x Px + Qy x Py
-Y = (M/Py) - X(Px/Py)

-Anyplace within the budget constraint is the feasible set, but we assume you always end up on the budget constraint

Question 3

How do you draw the budget constraint (4)

Answer 3

-Have good A on the x axis, and good B on the Y axis
-The budget constraint should be a straight line connecting the 2
-The X intercept is M/Pb, with the Y intercept being M/Py
-Where you are on the BC represents what quantity of each good you are consuming

Question 4

What is the slope of the budget constraint (4)

Answer 4

-The price ratio (BC slope) = price of horizontal axis/price of vertical axis
-This tells you how much of good A you need to sacrifice to consume more of good B
-Changes in the slope are known as the marginal rate of transformation (opp. cost of consuming more of one good)
-The slope represents the trade-off the market imposes on the consumer

Question 5

How might the budget constraint diagram change (2)

Answer 5

-A shift is caused by a change in income, and will never change the curve
-A change in the price of X will cause a pivot around the Y axis