Tarucan, Jourdanette G.

Learning Assessment 3

Questions:

1. What are the basic assumptions about individual preferences? Explain the significance
or meaning of each.

There are four basic assumptions about individual preferences. These are the following:

 Preferences are complete: this means that the consumer is able to compare and rank all
possible baskets of goods and services.
 Preferences are transitive: this means that preferences are consistent, in the sense that
if bundle A is preferred to bundle B and bundle B is preferred to bundle C, then bundle A
is preferred to bundle C.
 More is preferred to less: this means that all goods are desirable, and that the consumer
always prefers to have more of each good.
 Diminishing marginal rate of substitution: this means that indifference curves are
convex, and that the slope of the indifference curve increases (becomes less negative) as
we move down along the curve. As a consumer moves down along her indifference
curve she is willing to give up fewer units of the good on the vertical axis in exchange for
one more unit of the good on the horizontal axis. This assumption also means that
balanced market baskets are generally preferred to baskets that have a lot of one good
and very little of the other good.

2. Can a set of indifference curves be upward sloping? Explain.

A set of indifference curves can be upward sloping if we violate assumption number three:
more is preferred to less. When a set of indifference curves is upward sloping, it means one of
the goods is a bad so that the consumer prefers less of that good rather than more. The positive
slope means that the consumer will accept more of the bad only if he also receives more of the
other good in return. As we move up along the indifference curve the consumer has more of
the good he likes, and also more of the good he does not like.

3. Explain why two indifference curves cannot intersect.

The figure below shows two indifference curves intersecting at point A. We know from the
definition of an indifference curve that the consumer has the same level of utility for every
bundle of goods that lies on the given curve. In this case, the consumer is indifferent between
bundles A and B because they both lie on indifference curve U1. Similarly, the consumer is
indifferent between bundles A and C because they both lie on indifference curve U2. By the
transitivity of preferences this consumer should also be indifferent between C and B. However,
we see from the graph that C lies above B, so C must be preferred to B because C contains more
of Good Y and the same amount of Good X as does B, and more is preferred to less. But this
violates transitivity, so indifference curves must not intersect.

4. Describe the indifference curves associated with two goods that are perfect substitutes.
What if they are perfect complements?

Two goods are perfect substitutes if the MRS of one for the other is a constant number. In this
case, the slopes of the indifference curves are constant, and the indifference curves are
therefore linear. If two goods are perfect complements, the indifference curves are L-shaped. In
this case the consumer wants to consume the two goods in a fixed proportion, say one unit of
good 1 for every one unit of good 2. If she has more of one good than the other, she does not
get any extra satisfaction from the additional units of the first good.

5. What happens to the marginal rate of substitution as you move along a convex
indifference curve? A linear indifference curve?

The MRS measures how much of a good you are willing to give up in exchange for one more
unit of the other good, keeping utility constant. The MRS diminishes along a convex indifference
curve. This occurs because as you move down along the indifference curve, you are willing to
give up less and less of the good on the vertical axis in exchange for one more unit of the good
on the horizontal axis. The MRS is also the negative of the slope of the indifference curve, which
decreases (becomes closer to zero) as you move down along the indifference curve. The MRS is
constant along a linear indifference curve because the slope does not change. The consumer is
always willing to trade the same number of units of one good in exchange for the other.
Problems:

1. Connie has a monthly income of $200 that she allocates between two goods: meat and
potatoes.

a. Suppose meat costs $4 per pound and potatoes cost $2 per pound. Draw her budget
constraint.

Let M = meat and P = potatoes. Connie’s budget constraint is

$200 = 4 M + 2P, or

M = 50 - 0.5P.

As shown in below, with M on the vertical axis, the vertical intercept is 50. The horizontal
intercept may be found by setting M = 0 and solving for P.

b. Suppose also that her utility function is given by the equation U (M, P) = 2M + P. What
combination of meat and potatoes should she buy to maximize her utility? (Hint: Meat
and potatoes are perfect substitutes.)

Connie’s utility is equal to 100 when she buys 50 pounds of meat and no potatoes or no meat
and 100 pounds of potatoes. The indifference curve for U = 100 coincides with her budget
constraint. Any combination of meat and potatoes along this line will provide her with
maximum utility.

c. Connie’s supermarket has a special promotion. If she buys 20 pounds of potatoes (at $2
per pound), she gets the next 10 pounds for free. This offer applies only to the first 20
pounds she buys. All potatoes in excess of the first 20 pounds (excluding bonus
potatoes) are still $2 per pound. Draw her budget constraint.
With potatoes on the horizontal axis, Connie’s budget constraint has a slope of −1/2 until
Connie has purchased twenty pounds of potatoes. Then her budget line is flat from 20 to 30
pounds of potatoes, because the next ten pounds of potatoes are free, and she does not have
to give up any meat to get these extra potatoes. After 30 pounds of potatoes, the slope of her
budget line becomes −1/2 again until it intercepts the potato axis at 110.

d. An outbreak of potato rot raises the price of potatoes to $4 per pound. The supermarket
ends its promotion. What does her budget constraint look like now? What combination
of meat and potatoes maximizes her utility?

With the price of potatoes at $4, Connie may buy either 50 pounds of meat or 50 pounds of
potatoes, or some combination in between. See Figure 3.11.d. She maximizes utility at U = 100
at point A when she consumes 50 pounds of meat and no potatoes. This is a corner solution.

Meat

100

75

50

25
 2. Jane receives utility from days spent traveling on vacation domestically (D) and days
spent traveling on vacation in a foreign country (F), as given by the utility function U(D,F)
= 10DF. In addition, the price of a day spent traveling domestically is $100, the price of a
day spent traveling in a foreign country is $400, and Jane’s annual travel budget is
$4000.

a. Illustrate the indifference curve associated with a utility of 800 and the indifference
curve associated with a utility of 1200.

The indifference curve with a utility of 800 has the equation 10DF = 800, or D = 80/F. To plot it,
find combinations of D and F that satisfy the equation (such as D = 8 and F = 10). Draw a
smooth curve through the points to plot the indifference curve, which is the lower of the two
on the graph to the right. The indifference curve with a utility of 1200 has the equation 10DF =
1200, or D = 120/F. Find combinations of D and F that satisfy this equation and plot the
indifference curve, which is the upper curve on the graph.

b. Graph Jane’s budget line on the same graph.

Answers for A and B.

c. Can Jane afford any of the bundles that give her a utility of 800? What about a utility
of 1200?

Jane can afford some of the bundles that give her a utility of 800 because part of the U = 800
indifference curve lies below the budget line. She cannot afford any of the bundles that give her
a utility of 1200 as this indifference curve lies entirely above the budget line.
 d. Find Jane’s utility maximizing choice of days spent traveling domestically and days
spent in a foreign country.

The optimal budget is where the ratio of prices is equal to the MRS, and Jane is spending her
entire income. The ratio of prices is P f = 4 / P D, and MRS = MU F / MU D = 10 D / 10 F = D / F.
Setting the two equal and solving for D, we get D = 4F. Substitute this into the budget
constraint, 100D + 400F = 4000, and solve for F. The optimal solution is F = 5 and D = 20. Utility
is 1000 at the optimal bundle, which is on an indifference curve between the two drawn in the
graph above.