Consumer Theory 3

Question 1

Ordinal vs Cardinal utility

Answer 1

Utility allows economists to describe preferences, but only in a limited way. Utility gives us an ordinal ranking (positional e.g. 1st, 2nd…)- we can say which bundle is preferred but not by how much. A cardinal ranking would mean we can say how much more one bundle is liked- but this isn’t observable or meaningful in real life

Question 2

Why ordinal utility is enough

Answer 2

Most economic questions can be answered using rankings alone e.g. what will the consumer choose. There’s no reliable way to measure or compare utility across people or even across bundles numerically.

Question 3

Indifference curves

Answer 3

Ordinal rankings allow us to compare outcomes based on preferences- we care about what’s better or worse, not by how much. Some consumption bundles are preferred, others are worse. To begin, we look at bundles that provide the same level of satisfaction. A consumer is indifferent between 2 bundles if they provide the same level of utility r satisfaction. An indifference curve shows all such bundles- combination of goods that make the consumer equally satisfied

Question 4

Characteristics of indifference curves

Answer 4

1. They can be drawn- consumers can rank bundles (completeness and rankability)
2. Curves further from the origin represent higher utility- More is better
3. Curves never cross- Preferences are consistent (transitivity). Curves crossing is contradictory there should be indifference
4. Curves are convex to the origin- Shows a consumers preference for variety and balanced bundles

Question 5

Higher curves represent higher utility

Answer 5

Indifference curves further from the origin represent higher levels of utility due to more of both goods making the consumer better off- based on the more is better assumption. Consumers prefer bundles on a higher curve, even though all points on a single curve give the same satisfaction

Question 6

Indifference curves never cross

Answer 6

Cannot intersect as doing so would contradict consistent preferences. If 2 curves crossed, a single bundle would have to provide 2 different levels of satisfaction which is impossible

Question 7

Convexity 1- Indifference curves reflect like for variety

Answer 7

If points A and C lie on the same indifference curve U1, it means the consumer is indifferent between 2 bundles. The average bundle M, located halfway between A and C, combines elements of both goods in more balanced proportions. If M lies on a higher indifference curve U2, the consumer strictly prefers M to A or C. Consumers prefer a mix of goods (balanced bundles) over extremes

Question 8

Convexity 2- Indifference curves reflect willingness to trade

Answer 8

If points A, B and C lie on the same indifference curve- the consumer is equally satisfied at each bundle. Moving from C to B and then B to A, the consumer gives up 1 unit of food each time. However, the amount of additional clothing needed to maintain the same level of satisfaction increases with each step. This reflects the consumer’s diminishing willingness to trade clothing for food as they consume more food

Question 9

The Marginal Rate of Substitution (MRS)

Answer 9

Indifference curves describe trade-offs between goods. The slope of the indifference curve captures this trade off at any point. This is known as the marginal rate of substitution. The MRS tells us how many units of good Y the consumer is willing to give up to obtain 1 more unit of a good X, without changing their overall utility. It is negative as it reflects a trade-off. MRSxy= Change in Y/ Change in X

Question 10

MRS and slope of an indifference curve

Answer 10

We can illustrate the slope of the curve using a tangent at a given point. It is clear that slope of tangent at one point is greater than that another point. This implies the MRS is not constant, but diminishes as we move along the curve, reflecting diminishing willingness to trade. Indifference curves reflect diminishing MRS