1. What are the four basic assumptions about individual preferences? Explain the significance or meaning of each.
(1) Preferences are complete: this means that the consumer is able to compare and rank all possible baskets; (2) Preferences are transitive: this means that preferences are consistent, in that if bundle A is preferred to bundle B and bundle B is preferred to bundle C, then we should be able to conclude that bundle A is preferred to bundle C;
(3) More is preferred to less: this means that all goods are desirable, and that the consumer will always prefer to have more of a good;
(4) 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.
2. Can a set of indifference curves be upward sloping? If so, what would this tell you about the two goods?
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” in that the consumer prefers less of the good rather than more of the good. The positive slope means that the consumer will accept more of the bad good only if she also receives more of the other good in return. As we move up along the indifference curve the consumer has more of the good she likes, and also more of the good she does not like.
3. Jon is always willing to trade one can of coke for one can of sprite, or one can of sprite for one can of coke. a. What can you say about Jon’s marginal rate of substitution?
Since Jon is always willing to trade one for one, his MRS is equal to 1.
(1) What can you say about Jon’s indifference curves? Draw.
Since Jon is always willing to trade one can of coke for one can of sprite, his indifference curves are linear with a slope of –1.
(2) Draw two budget lines with different slopes and illustrate the satisfaction-maximizing choice. What conclusion can you draw?
Jon’s indifference curves are linear with a slope of –1. Jon’s budget line is also linear, and will have a slope that reflects the ratio of the two prices. If Jon’s budget line is steeper than his indifference curves then he will choose to consume only the good on the vertical axis. If Jon’s budget line is flatter than his indifference curves then he will choose to consumer only the good on the horizontal axis. Jon will always choose a corner solution, unless his budget line has the same slope as his indifference curves. In this case any combination of Sprite and Coke that uses up his entire income with maximize his satisfaction.