Chapter 06 - Consumer Behavior (Appendix)

Chapter 06 Consumer Behavior (Appendix)

QUESTIONS

1.What information is embodied in a budget line? What shifts occur in the budget line when
money income (a) increases and (b) decreases? What shifts occur in the budget line when the
price of the product shown on the vertical axis (c) increases and (d) decreases? LO6

Answer: A budget line shows all the combinations of any two products that a consumer
can purchase, given the prices of the products and the consumer’s income.
As money income (a) increases, the budget line shifts to the right (outward); (b)
decreases, the budget line shifts to the left (inward).
As the price of the product on the horizontal axis (a) increases, the budget line, while
remaining anchored at its original position on the vertical axis, will fan to the left
(inward); (b) decreases, the budget line, while remaining anchored at its original position
on the vertical axis, will fan to the right (outward).

2.What information is contained in an indifference curve? Why are such curves (a) downsloping
and (b) convex to the origin? Why does total utility increase as the consumer moves to indiffer-
ence curves farther from the origin? Why can’t indifference curves intersect? LO6

Answer: Every point on an indifference curve shows some combination of two products
that will give equal utility to a consumer; that is, each combination of the two products
has the same level of total utility. Indifference curves are:
(a) Downsloping because both products yield utility to the consumer. Going down the
curve means more of one commodity is being consumed, thus increasing the
consumer’s total utility. To keep total utility constant, some amount of the other
commodity must be given up to precisely offset the gain in total utility. Thus, the
quantities of the two commodities are inversely related. Any curve showing an
inverse relationship is downsloping.
(b) Convex to the origin because the consumer’s willingness to give up more of one
commodity to get more of another diminishes as more and more of one commodity is
substituted for the other. When the consumer has much of one commodity but little
of the other, the consumer will resist more and more giving up what little still
remains of the first commodity. This resistance is shown by the consumer
demanding a great deal of the abundant commodity in exchange for a small amount
of the scarce commodity. Technically expressed, the marginal rate of substitution
declines as one moves southeast along an indifference curve.

6A-1
Chapter 06 - Consumer Behavior (Appendix)

3. Using Figure 4, explain why the point of tangency of the budget line with an indifference curve
is the consumer’s equilibrium position. Explain why any point where the budget line intersects an
indifference curve is not equilibrium. Explain: “The consumer is in equilibrium where MRS=
PB/PA.” LO6

Answer: The tangency point places the consumer on the highest attainable indifference
curve; it identifies the combination of goods yielding the highest total utility. All
intersection points place the consumer on a lower indifference curve. MRS is the slope
of the indifference curve; PB/PA is the slope of the budge line. Only at the tangency
point are these two slopes equal. If MRS > P B/PA or MRS < PB/PA, adjustments in the
combination of products can be made to increase total utility (get to a higher indifference
curve).

PROBLEMS

1.Assume that the data in the accompanying table give an indifference curve for Mr. Chen. Graph
this curve, putting A on the vertical axis and B on the horizontal axis. Assuming that the prices of
A and B are $1.50 and $1, respectively, and that Mr. Chen has $24 to spend, add his budget line
to your graph. What combination of A and B will Mr. Chen purchase? Does your answer meet the
MRS =PB/PA rule for equilibrium? LO6

6A-2
Chapter 06 - Consumer Behavior (Appendix)

Answer: The budget constraint for Mr. Chen is $24.

Mr. Chen will consume 8 units of A and 12 units of B; yes, equilibrium will satisfy the condition
MRS = PB/PA.

Feedback: Consider the following example. Assume that the data in the accompanying
table give an indifference curve for Mr. Chen. Graph this curve, putting A on the vertical
axis and B on the horizontal axis. Assuming that the prices of A and B are $1.50 and $1,
respectively, and that Mr. Chen has $24 to spend, add his budget line to your graph. What
combination of A and B will Mr. Chen purchase? Does your answer meet the MRS
=PB/PA rule for equilibrium?

The budget constraint for Mr. Chen is as follows.

Graphically,

6A-3
Chapter 06 - Consumer Behavior (Appendix)

The most A units Mr. Chen can consume is 16 (=$24/$1.50, set B units to zero and solve
for A). This is the vertical intercept.

The most B units Mr. Chen can consume is 24 (=$24/$1.00, set A units to zero and solve
for B). This is the horizontal intercept.

To determine the bundle Mr. Chen will (can) consume we check the combinations in the
table above to see which bundle is affordable (satisfies the budget constraint).

Combination 16 units of A and 6 units of B: Substituting these values into the budget
constraint
$1.50x16 + $1.00x6 = $30 > $24 (not affordable) Cannot be optimal bundle.

Combination 12 units of A and 8 units of B: Substituting these values into the budget
constraint
$1.50x12 + $1.00x8 = $26 > $24 (not affordable) Cannot be optimal bundle.

Combination 8 units of A and 12 units of B: Substituting these values into the budget
constraint
$1.50x8 + $1.00x12 = $24 = $24 (affordable) Could be optimal bundle.

Combination 16 units of A and 6 units of B: Substituting these values into the budget
constraint
$1.50x4 + $1.00x24 = $30 > $24 (not affordable) Cannot be optimal bundle.

Since the only bundle that is affordable out of the given choice set is the combination of 8
units of A and 12 units of B, this must be the optimal bundle.

Graphically (see graph above), we know that the equilibrium will satisfy the condition
MRS = PB/PA. This implies that the indifference curve must be tangent to the budget con-
straint at the combination of 8 units of A and 12 units of B (the optimal bundle). Here the
MRS = $1.00/$1.50 = 2/3.

6A-4
Chapter 06 - Consumer Behavior (Appendix)

2. Explain graphically how indifference analysis can be used to derive a demand curve. LO6

Answer:

Feedback: In the top graph appearing below, the initial equilibrium is at X, where the
budget line is tangent to indifference curve I 2. Money income is $12; the price of A is
$1.50 and the price of B is $1.00. Dropping a perpendicular from X in the top diagram to
the bottom diagram, we obtain X’, a point on the demand curve of B. We note that at the
price of $1.00, Q is 7.
We now assume that the price of B rises to $2.00, causing the budget line to fan to the
left (inwards) from its anchor on the vertical (A) axis to Q of 6 on the horizontal (B) axis.
This causes the new budget line to be tangent, at Y, to an indifference curve, I 1, closer to
the origin—one that gives less utility. Dropping a perpendicular line from Y in the top
diagram to the bottom diagram, we obtain Y’, the second point on the demand curve of
B. We note that at the higher price of $2.00, Q is 3.

6A-5
Chapter 06 - Consumer Behavior (Appendix)

We can continue this procedure to obtain more points on the demand curve of B.

6A-6
Chapter 06 - Consumer Behavior (Appendix)

3. ADVANCED ANALYSIS First, graphically illustrate a doubling of income without price

Answer: See graph below. The income elasticity for good B is greater than that of good A.

Feedback: Consider the following example. First, graphically illustrate a doubling of in-
come without price changes in the indifference curve model. Next, on the same graph,
show a situation in which the person whose indifference curves you are drawing buys
considerably more of good B than good A after the income increase. What can you con-
clude about the relative coefficients of the income elasticity of demand for goods A and
B (Chapter 4)?

6A-7
Chapter 06 - Consumer Behavior (Appendix)

A
The income elasticity for good B is greater than that of good A. This must be true
since income doubled and good B consumption increased by more than good A. In fact,
since good B consumption increased more than good A, this implies that spending on
good B more than doubled and is income elastic. The opposite must be true for good A.

6A-8