Question

Question 1 a. In the theory of consumer behaviour, several assumptions are made about the nature of preferences. What are these assumptions? llustrate the significance of these assumptions using indifference curves. b. Discuss why the utility is maximised when the marginal utility per additional dollar spent on one good equals the marginal utility per additional dollar spent on the other good. c. Explain the difference between the income effect and the substitution effect of a price decrease. d. Consider the demand for large pizzas (Qdp) is given as: Q2ヤー2,000-40P,P If P = S 10, calculate the point elasticity of demand. ii. What would happen to the total expenditure of consumers on large pizzas if there is a price increase from $10 to S30?

Answer 1

a.

An indifference curve is a graph which shows the combination of goods that give the consumer equal satisfaction. An important property of indifference curve is that it cannot cross each other. The axiom of transitivity is violated if indifference curve intersects. The axiom of transitivity states that consumers are consistent in their preferences.

An indifference curve is a graph which shows the combination of goods that give the consumer equal satisfaction. An important property of indifference curve is that it cannot cross each other. The axiom of transitivity is violated if indifference curve intersects. The axiom of transitivity states that consumers are consistent in their preferences. In the above figure, two indifference curve IC1 and IC2 are shown. These two indifference curves cross each other at point C. The points B and C are on the same indifference curve IC1. Another two points A and C are on the same indifference curve IC2. According to the definition of indifference curves, an indifference curve represents those combinations of two commodities which give equal satisfaction to the consumer. So points B and C should give equal satisfaction and points A and C should also give equal satisfaction. If A is equal to C on IC2 in terms of satisfaction, and B is equal to C on IC1,

In the above figure, two indifference curve IC1 and IC2 are shown.These two indifference curves cross each other at point C. The points B and C are on the same indifference curve IC1. Another two points A and C are on the same indifference curve IC2. According to the definition of indifference curves, an indifference curve represents those combinations of two commodities which give equal satisfaction to the consumer. So points B and C should give equal satisfaction and points A and C should also give equal satisfaction. If A is equal to C on IC2 in terms of satisfaction, and B is equal to C on IC1, it follows that the satisfaction from A will be equivalent to satisfaction from B. But this is an absurd conclusion because point A contains more of Good Y and point B contains less of Good Y. The amount of Good X is equal on both points. So a rational consumer will prefer A to B since it has more of Good Y.

b.

The four basic assumptions of consumer behavior are:

Rationality: the consumers are rational in their choices.

c) Completeness: the two consumption bundles can be compared. Monotonicity: more is always preferred to less of goods.

Transitivity: If there are three bundles and bundle A is preferred to B and B is preferred to C then A must be preferred to C by transitivity.

d)