Tutorial 2 ECONS

 Marginal utility
 Is the extra satisfaction you get as you consume 1 more unit
 Decreases as we got more and more of a good (because of satiation)

Slope of Budget constraint = MRT = -Px/Py

MRT = Marginal rate of transformation

MAKE SURE TO LABEL AXIS = GOOD Y (AXIS Y) AND GOOD X (AXIS X)

Budget constraint show what you can get with the income (M) amount

X = $10

Y = $5

-Px/Py = -10/5 = -2

Margin rate or transformation tells you the opportunity costs are

Slope of indifference curve (IC) = MRS = -MUx/MUy (MU = marginal utility)

MRS = Marginal rate of substitution

 IC show the utility also shows the different bundles

 Higher curve higher utility

MRS = MRT when the budget constrain touches the indifference curve (best affordable choice)

EXAM QUESTIONS

 In the consumer choice model, we usually represent indifference curves as smooth downward
sloping curves that do not cross. Using an appropriate diagram or diagrams, carefully explain:
 (i) why indifference curves are curves rather than straight lines (Hint: Start by describing two
bundles of goods, one that is high on the indifference curve, and one that is low on the
indifference curve)
 (ii) why indifference curves cannot cross each other.

MUx is high and MUy low = high ratio

MUx is low and MUy high = low ratio

 this will tell us the slope of the curve

 High ratio = steeper curve
 Low ratio = flatter curve

That bundle A has a high rate of substitution therefore telling us the steepness of the indifference
curve. Bundle B has a low rate of substitution therefore telling us how flat the indifference curve is
and that the marginal utility is low. This is the reason why we don’t have a straight line.
 Tutorial 2 ECONS

 Consider a consumer who is currently purchasing x0 units of Good X, when the price of the good
is Px0 and income is M0. Using a diagram of the constrained optimisation model for the
consumer, explain whether a price decrease for Good X will lead the consumer to buy more of
Good X or not

EXPLAIN STEPS TAKE

When price of x decrease the BC stretches out on the X axis. Then you will be able to reach a higher
indifference curve (I1), this will make the consumer purchase bundle B as it gives more utility and
satisfaction.

M/Py1

M/Py

Y1 I1
Y0
I0

M/Px1
X0 X1 M/Px0

 Carefully explain the income and substitution effects associated with a decrease in the price of
Good X.

When the price of x falls mean the price of x will be relatively cheaper the consumer will more of x
and will by less of good Y. This is called the substitution effect.

When the price of good x decreases (real income and purchasing power will increase) there is more
income to spend. This is called the income effect. If good x is inferior there will be less consumption
of x. But if [good x is a normal good there will be more consumption of x.
Tutorial 2 ECONS

 Even though wages have increased substantially over the last two centuries, workers now spend
fewer hours working (and more hours in leisure) than ever before. Using a diagram of the
constrained optimisation model for a worker (and assuming there has been no change in
workers’ time endowment), explain why increases in wages over time have led to an increase in
leisure hours (and a decrease in work hours). Of the income and substitution effects, which is
likely to have caused this change? Explain your answer.

DRAW GRAPH THAT HAS BOTH BUDGET COST LINE AND INDIFFERENCE CURVE. Y AXIS =
CONSUPMTION (INCOME) AND X AXIS LEISURE (TIME CONSTAINT OF 24 HRS)

C0 show how much they are making (income) L0 is the amount of hours of leisure. E (is x axis of
budget constraint) to L0 is the amount of hours working.

When income has increased the new Budget constraint will the Y axis will increase up while x axis
remain the same.

Put new IC then put in new bundle (B)

Bundle B has more leisure time and income. This will mean that there is more time for leisure and
less time working.

The substitution effect shows us that when the income increases that the amount of hours of
working should increase and the time on leisure should decrease.

The income effect tells that when income increases there will an increase to purchasing power.
Meaning less time working and more that leisuring. Because consumers are consuming more leisure
(L0 to L1) that must mean that the income effect is driving this change and the income must be
bigger that the substitution effect.

1) tells that wages has increased as the budget constraint pivoting outwards along the Y axis
2) because of this you are able to reach a higher indifference curve
3) how you consume bundle B and at bundle the amount of leisure increases from L0 to L1
4) what effect is driving it. Substitution effect tells us and what income effect tells us