Consumer Theory 5

Question 1

Our approach to utility maximisation

Answer 1

We have 2 key ideas- the MRS captures the consumers’ willingness to trade between goods and the budget constraint which reflects the rate at which the market allows for trade, determined by relative prices. When consumers make choices they compare 2 rates. If the rate at which they are willing to give up one good exceeds the rate allowed by the market, they adjust the bundle. They continue adjusting until these 2 rates align. We now have a precise condition for utility maximisation- where preferences and constraints meet. MRS= MUx/MUy= Py/Px

Question 2

Setup

Answer 2

We can use indifference curves and budget constraints to illustrate this. Consumers are engaging in utility maximisation. They want to be as happy or satisfied as possible. Consumers are constrained by their income given market prices, hence their budget constraint. The utility maximising market basket must satisfy 2 conditions- It must be located om the budget line and it must give the consumer their most preferred combination of goods.

Question 3

Illustration of utility maximisation

Answer 3

Bundle E gives the highest level of utility but it is not affordable since it is above the budget line. Bundle D is affordable but the consumer can afford bundles that yield a higher utility. Bundles A, B and C are all affordable, since they lie on the budget line. Out of these, bundle A gives the highest possible utility, therefore the consumer chooses A

Question 4

Mathematics of utility maximisation

Answer 4

We can illustrate the tangency mathematically. Tangency is the key to finding the optimal bundle and occurs where the slope of the indifference curve is equal to the slope of the budget constraint i.e. when the marginal rate of substitution is equal to the price ratio. The slope of indifference curves= MRS= MUx/MUy= Py/Px= slope of the budget constraint. This implies MUx/MUy= Py/Px > MUx/Px= MUy/Py. The consumption bundle that provides the most benefit on a cost adjusted basis. Occurs when marginal utility per dollar spent is equalised across all products (Equimarginal principle).

Question 5

Implications

Answer 5

Even if 2 consumers have different preferences between 2 goods, they will have the same ratio of marginal utilities. This is because they face the same market prices

Question 6

Links between consumer choice and demand

Answer 6

With the consumer choice framework in place, we can now link consumer decisions with individual demand. These links can help us determine why shifts in tastes affect prices, the benefits products offer consumers, how changes in the price of one good affect the demand for other goods, Etc

Question 7

Effect of income changes

Answer 7

Higher income is sometimes associated with higher consumption of goods. For normal goods, higher income is associated with rising consumption. For inferior goods, higher income is associated with falling consumption

Question 8

Illustration of changes in income when both goods are normal

Answer 8

Initially the budget line is BC1 and utility maximising consumption occurs at bundle A. An increase in income induces a parallel, outward shift in the budget constraint from BC1 to BC2. The new optimal consumption bundle at this higher level of income is B. As both goods are normal goods, consumers consumes more of both. However, football tickets compered to movies is more of a luxury good. As a result the responsiveness of demand is higher

Question 9

An increase in the price

Answer 9

An increase in the price of a good causes the budget line to pivot inward, reducing the affordable quantity of a good. The pivot occurs around the intercept of the other good, which remains unchanged
* This is because relative prices change, resulting in a change in consumer’s purchasing power and real income in terms of the goods
* Obviously, if both prices change in the same direction, by the same amount, the slope will remain the same, while real income in terms of both goods will change
* The result will be equivalent to a change in income e.g. if both prices triple, it will be as if income goes down to a third of initial incomes. If both prices halve, it will be as if income is doubled
* The resulting effect on consumer choice will be similar to the effects caused by changes in income
Illustration of price change and derivation of demand
*

Question 10

A decrease in the price

Answer 10

A decrease in the price of a good causes the budget line to pivot outward, increasing the affordable quantity of a good. The pivot occurs around the intercept of the other good, which remains unchanged

Question 11

Why do these budget line pivots happen

Answer 11

This is because relative prices change, resulting in a change in consumer’s purchasing power and real income in terms of the goods. Obviously, if both prices change in the same direction, by the same amount, the slope will remain the same, while real income in terms of both goods will change. The result will be equivalent to a change in income e.g. if both prices triple, it will be as if income goes down to a third of initial incomes. If both prices halve, it will be as if income is doubled. The resulting effect on consumer choice will be similar to the effects caused by changes in income.