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Transcript of © Pilot Publishing Company Ltd. 2005 Chapter 3 Consumer Behaviour I --- The Indifference Curve...
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© Pilot Publishing Company Ltd. 2005
Chapter 3Consumer Behaviour I ---The Indifference Curve
Approach
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• Postulates of Consumer Behaviour• Good, Bad and Neuter• Utility• Indifference Curve • Properties of Indifference Curves of Two Goods• Other Shapes of Indifference Curves• Budget Line • Consumer Equilibrium
Contents:
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• Changes in Consumer Equilibrium in Response to Changes in Constraints• Decomposition of Price Effect into Substitution Effect and Income Effect• Advanced Material 3.1: Postulate of utility maximization• Advanced Material 3.2: Corner solutions
Contents:
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Postulates of Consumer Behaviour
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• A theory has four components - definitions; postulates; test conditions; implications
• Chapter one: basic definitions This chapter: postulates
+ test conditions + implications
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A. An economic agent behaves rationally.
• Significance: Thus, economic investigation is possible and meaningful.
• Meaning: Behaviour of an economic agent has objectives and involves a prudent (審慎的 ) choice among alternative means. In other words, consumer behaviour is not random or arbitrary(隨意的 ). It has patterns and can be explained.
What are the basic postulates of consumer behaviour?
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• Meaning: An economic agent always chooses the option that _________ the achievement of his goals among the options allowed by existing constraints.
B. Postulate of constrained maximization / self-interest / selfishness
Then how does an individual make his choice?
maximizes
• Significance: Without a postulate on economic choice, there is no economics. Without a confirmed postulate on economic choice, economics might not have survived.
Note: This is the most important & most useful postulate in economics.
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Competition Choice
C. Each individual has many wants.
D. To each individual, some goods are scarce.
Scarcity
• Significance: Hence competition and choice are inevitable. They constitute the main content of economics.
• Significance: Hence choice and exchange may arise.
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• Meaning: One is willing to forgo something to get more of the scarce good — substitution, provided that the value got is larger than the cost paid.
E. Scarce goods are substitutable
• Significance: Exchange is possible.
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F. The law of diminishing MRS
• Marginal rate of substitution (MRS): is the maximum amount of good Y that an individual is willing to forgo for an additional unit of good X.
• The law states that MRS or MUV of a good ____________ as more units of the good are obtained, ceteris paribus.
• It is equal to marginal use value (MUV) of good X in terms of good Y.
declines
• Significance: (Both interior and corner solutions are possible.)
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Good, Bad and Neuter
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A good is something desired,
i.e., _________ is preferred to _________. none
(Options: more / less / none / some)
some
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Goods
Free goods Scarce goods (economic goods)
Types of goods:
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(Options: more / less / some / no more )
Free good: Features
its amount available is ______ than its amount desired at zero price,
i.e., ________ is preferred.
something desired
no more
more
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Scarce good (economic good): Features
(Options: more / less / some / none )
something desired
its amount available is _____ than its amount desired at zero price,
i.e., ______ is preferred to _____.
less
more less
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• Depends on situations rather than kinds.
• Any examples?
Distinction between free goods and scarce goods:
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Distinction between free goods and goods free-of-charge:
A free good must be a good free-of-charge. Why?
A good free-of-charge may not be a free good. Why?
• its amount available is more than its amount desired.
• no one desires to have more of it
• no production nor exchange takes place zero-priced.
• a scarce good can also be free-of-charge if someone pays the cost for you. Any examples?
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Is sickness a bad ?
more
(Options: more / less / some / none )
A bad is something undesired,
i.e., _________ is preferred to _________. less
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A neuter (中性物品 ) is something neither desired nor undesired,
i.e., the quantity does not matter.
Any examples?
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Q3.2:Which of the following are free goods? Explain.air pocket money sea water parental care
Q3.3:
Draw a demand and supply diagram to illustrate a free good and a scarce good respectively.
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Utility
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What is utility?
Utility (效用 ) is a number
• arbitrarily assigned to entities to rank them according to one’s preference.
a criterion of maximization to rank options for making choice.
the higher the utility, the more one prefers the entity.
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What is utility?
Utility reflects preference
social welfare
happiness / satisfaction
Why?
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Measurement of utility
Ordinal utility
• only reflects an order
• but the difference between the numbers assigned is meaningless
Cardinal utility
• can also reflect an order
• and the difference between the numbers assigned is meaningful
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Measurement of utility
Which measurement of utility is used in the indifference curve approach?
Ordinal measure of utility
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Indifference Curve
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U=10
An indifference curve (IC, 等優曲線) is a line joining all the points (representing different baskets of goods) giving the same utility to an individual.
Good X
Good Y
0
What is an indifference curve?
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An indifference map (等優曲線圖 ) is a set of ICs showing the _________ of an individual.
What is an indifference map?
U=10U=20
U=30
Good Y
Good X0
preference
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Properties of Indifference Curves of Two Goods
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U=10
Good Y
Good X0
+X
-Y
1. ICs of two goods are negatively sloped Keeping utility constant, along an
IC, a basket with more units of good X must have _____ units of good Y.fewer
negative
(Options: more / fewer / positive / negative)
• Slope of an IC of two goods (= Δ Y/ Δ X)
must be ________.
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If quantities of good X and good Y can be increased or decreased by infinitesimal amounts, the ICs are continuous. Why?
2. Indifference curves are continuous
U=10
Good Y
Good X0
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Along U2: point A = point C = U2
Along U1: point A = point B = U1
• What is the utility of point A, = U1 or U2?
3. Indifference curves can never intersect
U of the intersection point logical contradiction
A
B
C
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U1
U2
U3
Good Y
Good X0
The higher the IC , the higher the utility (U3 > U2 > U1). Why?
The higher the IC , the higher the utility (U3 > U2 > U1). Why?
• If a consumer knows his preference on every basket of commodities, the commodity plane will be fully covered by ICs. Why?
4. Full coverage
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5. Indifference curves of two goods are convex to the origin
U1
Good Y
Good X0
+1X
-Y
As the consumption of good X rises, MRS (the slope) falls. Why?
convex
As the IC becomes flatter & flatter, its shape is _______ to the origin.
The numerical value of the slope of an IC (+1X -?Y) is equal to the MRS. Why?
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Other Shapes of Indifference Curves
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Y (A good)
X (A neuter)
0
U2
U1
U3
U3>U2>U1
1. X is a neuter and Y is a good
Any increase or decrease in the quantity of X makes no difference to the consumer.
Why?
ICs are ___________.horizontal
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What will be the shape of the ICs if (a) X is a good and Y is a neuter?(b) both X and Y are neuters?
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ICs are _________ sloping with a/an _________slope.
2. X is a bad and Y is a good
U3>U2>U1
U1
U2
U3
0
Y (A good)
X (A bad)
Why?
upwardincreasing
+X
+Y
To keep U constant, in a bad (+X) requires in a good (+Y) as a compensation.
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What will be the shape of the ICs if (a) X is a good and Y is a bad?(b) both X and Y are bads?
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3. X is a commodity with a satiation threshold (beyond which X turns from a good to a bad)
0
Good Y
X
U1
U2
U3
U3>U2>U1
X becomes a bad X is a good
ICs are __________.
Why?
U-shaped
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What will be the shape of the ICs if both X and Y are goods with a satiation threshold?
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4. X and Y are perfect substitutes
Good X (pack of 5 kg rice)
Good Y (pack of 8 kg rice)
0 U1 U2 U3
U3>U2>U1
ICs are _________ sloping _______ lines.
Why?
downwardstraight
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5. X and Y are perfect complements
Good Y (left shoes)
Good X (right shoes)0
ICs are __________.
45o U3>U2>U1
U1
U2
U3Why?
right-angled
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Q3.7: Study the indifference maps below and determine if X and Y are goods, bads or neuters.
Y
U1
U2
U3
X
U1 U2 U3
X
Y
(a) U1 < U2 < U3 (b) U1 > U2 > U3
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Budget Line
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It is also called the budget constraint.
What is a budget line?
Budget line (BL) or consumption possibility curve is a boundary showing the largest possible combinations of goods that a consumer can buy in a market, given his money income and market prices of the goods.
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Y
X0
Given I = $100, PX = $20 & PY = $25
The maxi. amount of X one can buy
= ___________$100/$20 = 5
$100/$25 = 4
$20/$25 = 0.8
4
5
+1X
-0.8Y
Derivation of a BL:
To buy 1 more unit of X, one forgoes =____________ unit of Y.
The maxi. amount of Y one can buy
= ___________
The BL is a downward sloping straight line.
The slope of BL = cost of consuming an additional unit of good X in terms of good Y.
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Y
X0
A
C
B
Point A: Expenditure ____ Income
Point B: Expenditure ____ Income
Point C: Expenditure ____ Income
Features: Features:
<=>
(Options: > = < )
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Equation of budget line
X PX + Y PY = I
Expenditure on good X
Expenditure on good Y
Money income of the consumer
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Changes in budget constraints
1. Changes in income When one’s income
increases, the budget line will shift ______ in a parallel manner, and vice versa.
Y
0 X
outward
Why?
in income
in income
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Y
0X
2. Proportionate changes in prices
When prices of both goods rise by the same proportion, the budget line will shift _______ in a parallel manner, and vice versa.
inward
Why?
A proportionate in all money prices
A proportionate in all money prices
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Y
0X
3. Disproportionate changes in prices
A rise in Px
A fall in Px
tilt inward
tilt outward
When PX , the budget line will _________ and become steeper. Why?
When PX , the budget line will __________ and become _______. Why?flatter
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Q3.8: Under the following situations, what would happen to the budget line? Explain with the aid of diagrams. (a) I and PY are constants, but Px increases from P0 to
P1. (b) I and PY are constants, but PX increases as the consumer buys more and more units of the good, i.e., PX and X are positively related. (c) I and PY are constants, but PX decreases as the consumer buys more and more units of the good, i.e., PX and X are negatively related.
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Consumer EquilibriumConsumer Equilibrium
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Optimum (最優點 ) or equilibrium (均衡 ) is the best choice of an economic agent in achieving his objective.
What is a consumer equilibrium?
Optimality conditions (最優性條件 ) or equilibrium conditions (均衡條件 ) are descriptions on thedefining features of the optimum or the equilibrium.
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Interior solution
When a consumer buys both goods X & Y, i.e., the equilibrium is not one of the _________ on the budget line, the equilibrium is called an interior solution (內解點 ).
intercepts
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It is the tangency point, the only point on the budget line reaching the highest IC attainable.
U1
U3
Y
X0
U3>U2>U1
X*
Y*
From observation, the best choice achievable is _____________.
Equilibrium: From observation
E*
U2
E* (X*, Y*)
Why?
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Equilibrium conditions:
U1
U2
U3
Y
X0
U3>U2>U1
E*
X*
Y*
1. The consumer equilibrium must lie ____ the BL.
2. The consumer equilibrium is the ____________ at which the slope of IC equals the slope of BL.
on
tangency point
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Slope of indifference curve Slope of budget line
1.1. =ΔY/ΔX, holding utility constant
=ΔY/ΔX, holding expenditure or income constant
2. 2. = Marginal rate of substitution in consumption, MRSc
= Marginal rate of substitution in exchange, MRSe
Meaning of the slopes
3.3. = The maximum amount of Y one is willing to pay for an additional unit of X
= The actual amount of Y one is required to pay for an additional unit of X in exchange
4. 4. = Cost / Value? of an additional unit of X in terms of Y (=MUV)
= Cost / Value? of consuming an additional unit of X in terms of Y (= Px/Py)
Value Cost
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Buy X
MR
Sc
MR
Se
How is the consumer equilibrium reached?
At point A, MRSc > MRSe (_______ of an additional X > its ________), utility can be raised if the consumer _________ units of X.
U2
U1
Y
X0
A
buys more
(Options: buys more / sells some / value / cost )
valuecost
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Sell X
MR
Se
MRSc
U2
U1
Y
X0
At point B, MRSc < MRSe (value < cost), utility can be raised if the consumer _________ units of X.
B
sells some
(Options: buys some / sells some )
How is the consumer equilibrium reached?
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U2
U1
Y
X0
MRSc = MRSe (value = cost), utility is maximized & the equilibrium is attained.
E*
How is the consumer equilibrium reached?
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Changes in Consumer Equilibrium
in Response to Changes in Constraints
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A. Changes in income
When income with PX and PY unchanged,the BL will shift outward / inward? in a parallel manner.
• The effect of income on the consumption of a consumer can be shown by 2 curves:
1. Income consumption curve2. Engel curve
outward
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Income consumption curve (所得消費曲線 , ICC) is a line joining all the equilibrium (X,Y) of a consumer when one’s income changes, holding PX and PY constant.
ICC
1. Income consumption curve
Y
0 X
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Engel curve (恩格爾曲線 ) is a line showing the consumption of a good at different income levels, holding PX and PY constant.
X
0Income
Engel curve
2. Engel curve
I1 I2 I3
X3
X2
X1
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Y
X
ICC
A. Superior good: Its consumption is positively related to income.
X
Income
Engel curve
X1 X2 X3
X3
X2
X1
I1 I2 I3
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ICC
Y
X
B. Inferior good: Its consumption is negatively related to income.
X
I
Engel curve
X3X2X1
X1
X2
X3
I1 I2 I3
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B. Changes in price
The effect of price on the consumption of a consumer can be shown by 2 curves:
1. Price consumption curve2. Demand curve
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PCC
Price consumption curve ( 價格消費曲線 ) is a line joining all the equilibrium of a consumer when PX changes, holding I & PY constant.
1. Price consumption curve
Y
0 X
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Demand Curve
Px
0 X
Px1
Px2
Px3
Demand curve is a line showing the ________________ of a good of a consumer at different prices.
2. Demand curve
quantity demanded
X1 X2 X3
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Px1
Px3
Px2
Y
0Px
0 X
X
PCCPCC
Demand Curve
X1 X2 X3 X4
If price (Px) & quantity demanded (X) of the good are negatively related.
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Px1
Px2
PCC
Y
0X
Px
0 X
Demand Curve
Giffen paradox
If price (Px) & quantity demanded (X) of a good are _________ related, the good is called a Giffen good.
positively
X1 X2
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Decomposition of the Price Effect into
the Substitution Effect & the Income Effect
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Price effect
Price effect is the overall change in the quantity demanded of a good caused by a change in its price, holding money income constant.
Price effect can be decomposed into ___________ effect and __________ effect. substitution income
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Px One will buy more good X to substitute good Y
S.E.S.E.
L3
X3
E3
Y
0 X
E1
L1
X1
So substitution effect must be negative.
Substitution effect ( 替代效應 ) is the change in the quantity demanded of a good caused by a change in its price, holding utility or real income constant.
New equilibrium
L2
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I.E.
L2
X2
Y
0X
S.E.
E3
E1
L1L3
X3X1
Using the saved income
The saved income will raise the consumption of good X if good X is a superior good.
E2
Income effect ( 所得效應 ) is the change in the quantity demanded of a good as a result of a change in real income caused by a change in its price.
When Px, income is saved. Income is further saved by the S.E. as the consumption of an expensive good is substituted by the consumption of a cheaper good.
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Price effect of different kinds of goods
S.E.
Positive I.E.
Y
0 X
E1
L1 L2L3
E3
E2
2. If good X is a superior good, what will be the income effect?
3. And what will be the price effect?
1. The substitution effect must be negative.
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S.E.
L3 L2
Negative I.E.Y
0 XL1
E1
2. If X is an inferior good
with its -ve I.E. < S.E.,
what will be the price effect?
E3
E2
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S.E.
L1 L3L2
E3
Y
0 X
E1
Negative I.E. 3. If X is an inferior good with its -ve I.E. > S.E., (called Giffen good), what will be the price effect?
E2
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Q3.12:Decompose the price effect into the substitution effect and the income effect, when the price of good X rises.(a) If good X is a superior good
(c) If good X is an inferior good with its substitution effect smaller than its income effect
(b) If good X is an inferior good with its substitution effect greater than its income effect
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Advanced Material 3.1: Postulate of utility maximization If the utility and the cost of each option
can be measured or asserted beforehand• the postulate can generate refutable predictions and it is useful if it is not refuted.
cannot be measured or asserted beforehand
• the postulate cannot generate refutable predictions, then it becomes tautological and useless in explanation and prediction.
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Advanced Material 3.2: Corner solutions
When a consumer buys one good only, i.e., the equilibrium is one of the intercepts on the budget line, the equilibrium is called a corner solution (角隅解 ).
There is a ___________________ in consumption.specialization
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Advanced Material 3.2: Corner solutions
Possible reasons for a corner solution are:
3. MRS is not decreasing.
1. The good is too expensive.
2. The entity is a bad.
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E*
Y (A good)
X (A good but too expensive)
MRSc (= value)
MRSe (= cost)
U1
U3
U2
U3>U2>U1
1. The good is too expensive
>
1X
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Y (A good)
X (A bad)
U1
U3
U2
E*
0
U3>U2>U1
2. The entity is a bad
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Y (A good)
X (A good)
U1
U3
U2
E*
0Increasing MRS
U3>U2>U1
3. MRS is not decreasing
Constant MRS
Y (A good)
X (A good)
U1
U3
U2
E*
0
U3>U2>U1
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Correcting Misconceptions:
1. A free good is a good provided by the government free of charge.
2. A free good is a good without utility and is not preferred.
3. Utility is a measure of individual satisfaction or a measure of social welfare.
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4. Utility of a good must be a positive number and that of a bad must be negative.
5. Postulate of utility maximization is tautological.
6. A straight-line indifference curve denies the postulate of substitution.
Correcting Misconceptions:
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7. A concave indifference map cannot have consumer equilibrium or can have an interior solution.
8. A good with its price and quantity demanded negatively related is a normal good.
9. Holding money income constant is the same as holding real income constant.
Correcting Misconceptions:
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10. Substitution effect is positive for superior good and negative for inferior good.
11. Giffen good has no relation with inferior good.
Correcting Misconceptions:
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Survival Kit in Exam:Question 3.1(a) What is utility? Must the utility of a bad be a negative number?
(b) Michael says, “Anderson fails in HKCEE and he commits suicide. Why? He is maximizing utility. Mary also fails in HKCEE but she does not commit suicide. Why? She is maximizing utility. So, the postulate of utility maximization is tautological.” Do you agree?
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Survival Kit in Exam:Question 3.2Being a member of a club, a consumer can purchase cosmetics at a reduced price. However, he has to pay a membership fee, and after which he has just enough income to purchase the original basket of goods. Does he prefer to be a member? Use an indifference map to illustrate.