1. Briefly explain what an indifference curve is and how it can be graphically derived.

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1 Chapter 2: Consumer Choice Short Answer Questions 1. Briefly explain what an indifference curve is and how it can be graphically derived. Answer: An indifference curve shows the set of consumption bundles among which a consumer is indifferent. It can be generated by connecting bundles which yields that same level of utility to the consumer. As shown below, since the consumer is indifferent between the bundle consisting 4 bowls of pasta and 8.5 baked potatoes and the bundle consisting 7 bowls of pasta and 5 baked potatoes, both bundles lie on the same indifference curve. 2. What is the Marginal Rate of Substitution? What information does it convey? Answer: The marginal rate of substitution is the negative of the slope of an indifference curve. It shows the rate at which the consumer is willing to trade/substitute one good for the other. 3. Explains the concept of perfect substitute, and how it affects the shape of an indifference curve. Answer: When goods can be substitutes for each other at the constant rate, they are called perfect substitutes. Perfect substitutes have a constant marginal rate of substitution, so their indifference curves are straight line. 4. What is a cardinal utility function? Answer: A cardinal utility function is the utility function whose value tells s exactly how much better some consumption bundles are than other bundles.

2 5. Using an appropriate diagram, define and distinguish between affordable (feasible) and non-affordable (non-feasible) bundles. Answer: Assuming that the consumer s budget constraint is represented by B 1 in the figure below. The non-affordable bundles are bundles that lie above B 1. The affordable bundles are bundles that lie on or below B 1 which is shown as the shaded area in the figure. For the next three questions assume an economy in which John can spend his budgets ( M) on purchasing two goods X and Y. Use an appropriate diagram to explain your answer: 6. How will John s budget constraint be affected if his income increases permanently? Answer: Other things being constant, an increase in his income will result in a parallel shift of the budget constraint from B 0 to B 1.

3 7. How will John s budget constraint be affected if the price of good X increases? Answer: The vertical axis represents the amount of good Y and the horizontal axis represents the amount of good X. Other things being constant, an increase in the price of good X his income will result in a shift of the budget constraint from B 1 to B Assuming that John has smooth preferences, graphically define his equilibrium consumption of the two goods. Answer: John s equilibrium consumption occurs at point E (shown below) where his indifference curve is tangent to his budget constraint. At this point, given his budget constraint, his utility from consumption of the two goods is maximised. Y E U1 U2 U3 X 9. Diagrammatically illustrate and explain the concept of corner solution. Answer: The corner solution is an equilibrium bundle which occurs at the corner formed by the budget constraint and the axis and, as a result, the consumption of some

4 commodity is zero. At point e2, the marginal rate of substitution is less than or equal to the price ratio. 10. Can indifference curves cross? Why? (Use graphical explanation.) Answer: No. Intersecting indifference curves would lead to the outcome that bundle b is considered to be indifferent to bundle a and simultaneously preferred to bundle a. This result violates the assumption of transitivity. Essay questions 1. Discuss the assumptions that need to be satisfied for preferences to be smooth. Brief answer: The reader should discuss all fundamental assumptions which include completeness, transitivity and non-satiation assumption. [For a full discussion see chapter 2, p ] 2. Discuss how utility functions can be used to quantify information about consumer taste. Brief answer: The utility function is used to assign numbers to indifference curve. In other word, it shows the total utility associated with each consumption bundle and

5 hence the ranking of consumption bundle. However, it is important to understand than the value of the utility function does not tell us exactly how much better some bundles are than the others. (To complete the answer, the reader should compare the difference between the ordinal and cardinal utility functions.) 3. Explain how the Marginal Rate of Substitution can be used to characterise the equilibrium outcome. Show your calculations. Brief answer: The consumption equilibrium occurs where the indifference curve is tangent with the budget line. Since the slope of indifference curve is the marginal rate of substitution and the slope of budget line is the price ratio, then the consumption equilibrium can be characterised by setting the marginal rate of substitution equals to the price ratio. The full method of calculation can be viewed from chapter 2, p Discuss how quantity discounts can affect the shape of consumers budget constraint. What are the implications for equilibrium consumption? Brief answer: A budget constraint is linear only if the unit price of each good is the same regardless of the number of units purchased. When the price per unit of a commodity depends in the number of units purchased, the budget constraint becomes non-linear because the changes in prices are reflected in the slope of the budget constraint. (The reader should provide an example to support the discussion.) Consequently, we may observe multiple equilibrium consumption. 5. Discuss the concept of composite commodities. How can they be used to generalise the concept of equilibrium in an economy where more than two goods are traded? Brief answer: By using the two-good assumption, we divide the consumer s budget between the two commodities: the first one is the good of interest (DVD) and the second one is a composite of all other goods. To derive a budget constraint, a unit of all others goods is measured as the amount of all other goods that the consumer could buy by spending one unit of money. The indifference curve now represents the consumer s preference between DVDs and all other goods. Given the budget line

6 and indifference curves, we can use the usual methods to find the equilibrium bundle which is shown as point e 1 in the figure.

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