Consumer Theory 2

Question 1

Substitution Effect

Answer 1

When the price of a good rises, it becomes more expensive relative to others- your real income in terms of that good decreases which changes your behaviour. Consumers sub away from more expensive goods towards cheaper alternatives. E.g. if the price of rice goes up, people consume more pasta. The general rule is that consumers reallocate spending to maintain satisfaction at a cheaper price

Question 2

Income Effect

Answer 2

A price change affects real income- the purchasing power of money. When price rises- real income falls and consumers can afford less. This leads to a reduction in demand for most goods

Question 3

Do substitution and income effects matter?

Answer 3

The substitution effect is always negative- when the price of a good rises, people tend to buy less of it and switch to alternatives. Income effect can go in either direction. For most goods, when prices rise and real incomes fall, people buy less which reinforces the substitution effect (negative income effect). For other goods, like basic necessities, people might not cut back as much, or might even buy more of a cheaper alternatives if they feel poor (positive income effect)

Question 4

4 key assumptions about consumer preferences

Answer 4

1. Completeness and rank ability
2. More is better (non-satiation- assuming that the goods are “good goods”)
3. Transitivity
4. Diminishing marginal rate of substitution

Question 5

Completeness and rankability

Answer 5

Consumers can compare any 2 bundles and say which is preferred or if they are equally good

Question 6

More is better

Answer 6

For most goods, more is preferred to less

Question 7

Transitivity

Answer 7

If a is preferred to B and B to C, then A is preferred to C- this keeps preferences logically consistent

Question 8

Diminishing marginal rate of substitution

Answer 8

As a consumer has more of a good, they are less willing to give up other goods to get more of it- this reflects a preference for variety. It shows willingness to substitute as MU

Question 9

Completeness

Answer 9

The assumption that consumers are able to compere consumption possibilities and rank them in terms of which of the options they prefer. At the simplest level (one good vs one good), someone might say “I prefer apples to chocolate”. If they are given an option of 3 apples and 1 chocolate or 2 apples and 4 chocolate, they will choose bundle A as it has more of the preferred good. However not everything is comparable. If things aren’t comparable, it would imply incomplete preferences

Question 10

Non-Satiation

Answer 10

The assumption that more is always better and consumers prefer to consume more than less for most goods. This is often referred to as monotonicity. Consumers who always prefer to consume more of a good (as opposed to less of it) have monotonic preferences. However not everything is always preferred. If I don’t like apples, when I am forced to consume, I will choose the smallest option.