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Tutorial 6

Uploaded by

Charity Kwok
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Possibilities, Preferences and Choices

Predicting Consumer Choices


Practice Questions

ECON2113 Microeconomics (L1/L7)


Tutorial Six

Jeremy TO

Department of Economics, HKUST

Jeremy TO ECON2113 Microeconomics (L1/L7)


Possibilities, Preferences and Choices
Predicting Consumer Choices
Practice Questions

Consumption Possibilities
A household’s consumption choices are constrained by its
income and the prices of the goods and services available. A
household’s budget line describes the limits to its consumption
choices.
The budget line illustrates a constraint on choices. Any point
on or inside the line can be purchased. Any points outside the
line is unaffordable and cannot be purchased.
Budget constraint: An individual has I dollars to allocate
between good x and good y . If Px is the price of good x and
Py is the price of good y , then the individual is constrained by
I = Px x + Py y
Rearrange the terms to obtain the budget line:
I px
y= − x
py py
Jeremy TO ECON2113 Microeconomics (L1/L7)
Consumption Possibilities - Diagram
Consumption Possibilities - Real Income and Relative Price

A household’s real income is the household’s income


expressed as a quantity of goods the household can afford to
buy.
A relative price is the price of one good divided by the price
of another good.
The magnitude of the slope of the budget line, ppyx , is the
relative price of a good x in terms of a good y .
Question: How does a change in price or a change in income
affect the position of the budget line?
Possibilities, Preferences and Choices
Predicting Consumer Choices
Practice Questions

Preferences and Indifference Curves


A preference map shows how a person ranks various combinations
of goods and services.
Indifference curves are used to illustrate a person’s preference
map. An indifference curve is a line that shows combinations of
goods among which a consumer is indifferent. That is, the bundles
provide the same level of utility.
The slope of indifference curves: The marginal rate of
substitution (MRS) is the rate at which a person will give up good
y to get an additional unit of good x and at the same time
remaining indifferent (remaining on the same indifference curve).
∆U ∆U
∆U = ∆x + ∆y
∆x ∆y ∆U=0 along an indifference curve
∆U
∆y ∆x MUx
MRS = = ∆U
=
∆x ∆y
MUy
Jeremy TO ECON2113 Microeconomics (L1/L7)
Preferences and Indifference Curves - Diagram
Preferences and Indifference Curves

The magnitude of the slope of the indifference curve at any


point measures the marginal rate of substitution between the
goods.
If the indifference curve is steep, the MRS is high; if the
indifference curve is flat, the MRS is small.
The diminishing marginal rate of substitution (DMRS) is
the general tendency for a person to be willing to give up less
of good y to get one unit of good x, and at the same time
remain indifferent, as the quantity of x increases.
Perfect Complements and Perfect Substitutes
Possibilities, Preferences and Choices
Predicting Consumer Choices
Practice Questions

Consumer Equilibrium

The consumer will select his or her best affordable point.


This point is on the budget line, is on the highest attainable
indifference curve, has a marginal rate of substitution between
the two goods equal to the relative price of the two goods.
MUx Px
MRS = =
MUy Py
| {z } |{z}
Slope of indifference curves Slope of budget line

A Change In Price: The price effect shows how a change in


the price of a good affects the quantity consumed of that
good.
A Change In Income: The income effect shows how a
change in income affects the buying plans of consumers.

Jeremy TO ECON2113 Microeconomics (L1/L7)


Possibilities, Preferences and Choices
Predicting Consumer Choices
Practice Questions

Decomposition - Income Effect and Substitution Effect

The substitution effect is the effect of a change in price on


the quantity bought when the consumer (hypothetically)
remains indifferent between the original situation and the new
one.
The income effect is the effect on the quantity bought of a
change in income sufficient to shift the hypothetical budget
line used to measure the substitution effect, so that it is the
same as the actual new budget line.

Jeremy TO ECON2113 Microeconomics (L1/L7)


Decomposition - Diagrams
Possibilities, Preferences and Choices
Predicting Consumer Choices
Practice Questions

Problem 1

Katy has made her best affordable choice of noodles and iced tea.
She spends all of her income on 15 packets of instant noodles at $3
each and 30 cups of iced tea at $2 each. Now the price of a packet
of noodles rises to $3.5 per packet and the price of iced tea falls to
$1.75 a cup.
(1) Will Katy now be able to consume 15 packets of instant
noodles and 30 cups of iced tea?
(2) If Katy changes the quantities she buys, will she buy more
or fewer packets of instant noodles? Explain your answer.

Jeremy TO ECON2113 Microeconomics (L1/L7)


Possibilities, Preferences and Choices
Predicting Consumer Choices
Practice Questions

Problem 2

Sara’s income is $12 a week. The price of popcorn is $3 a bag, and


the price of cola is $1.5 a can. Assume that both are normal goods.

(1) By using the budget line and indifference curves,


graphically demonstrate Sara’s optimal consumption behavior.
(2) Suppose that the price of cola rises to $3 a can. All other
things remain the same. Graphically demonstrate Sara’s
optimal consumption behavior.
(3) Graphically demonstrate the price effect. Especially, you
need to separate the income effect and the substitution effect
clearly.

Jeremy TO ECON2113 Microeconomics (L1/L7)

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