Deck 19: The Logic of Individual Choice: the Foundation of Supply and Demand

Question 1

What is the principle of rational choice?

Answer 1

The principle of rational choice: spend your money on those goods that give you the most marginal utility (MU) per dollar.

Question 2

Define bounded rationality and explain why bounded rationality might be a more realistic assumption for much of human behavior than pure rational choice.

Answer 2

Bounded rationality is rationality based on rules of thumb, such as "you get what you pay for" or "follow the leader." Even though such rules of thumb do not result in utility maximization, they may be more realistic assumptions for much of human behavior because the decision-making demands of pure rational choice are beyond human capability. Rational choice requires the comparison of the ratio of MU to price for different consumption possibilities. This may seem a reasonable procedure when a small number of alternatives are involved. But to engage in pure rational choice when a very large number of alternatives are involved (such as all the different consumption possibilities that might contribute to utility) is not realistically possible. Bounded rationality avoids having to make all these calculations, by following rules of thumb.

Question 3

How does the principle of rational choice also underlie the law of supply (as it applies to the supply of labor)?

Answer 3

The law of supply states that the quantity supplied rises as price rises, other things constant. Consider a consumer faced with two uses for her time: working or engaging in recreation. If she works, she gets $7 per hour. The price of an hour of recreation (its opportunity cost) is also $7. (P_W = P_R = $7) Suppose initially our consumer is in equilibrium maximizing her utility so that MU_W/P_W = MU_R/P_R. Now suppose her boss gives her a raise to $8 per hour (P_W = P_R = $8). She is likely to work more because with $8 per hour, she can buy more stuff and thus get more utility for every hour worked. MUW will increase so that now MU_W/P_W > MU_R/P_R. As a result of this inequality, she will increase her work time and decrease her recreation time until once again she arrives at the time allocation where MU_W/P_W = MU_R/P_R. Thus she increases her quantity supplied of work when the price of work (her wage rate) increases-this is exactly what the law of supply says will happen.

Question 4

What is utility, according to economist's use of the term?

Question 5

How does the principle of diminishing marginal utility underlie the law of demand?

Question 6

What two assumptions underlie economists' theory of rational choice?

Question 7

Economists' formal analysis requires two pieces of information. What are they?

Question 8

The utility maximizing rule states that "if MU_X/P_X = MU_Y/P_Y, then you're maximizing utility." Why is that so? How will the ratio of prices compare to the ratio of marginal utilities when you are maximizing your total satisfaction from a given amount of spending?

Question 9

Suppose that every time you go to the library to study economics you buy yourself soda (S) and candy bars (C) as an incentive to study. Having mastered the material on rational choice you always allocate your study snack budget so that MU_S/P_S = MU_C/P_C. What should you do if one night you discover that the price of a can of soda has increased?

Question 10

What is the utility maximizing rule?

Question 11

Give two explanations of individual choice other than self-interest. Why do economists focus on self-interest?

Question 12

What is the principle of rational choice?

Question 13

What is the principle of diminishing marginal utility?

Question 14

What is an indifference curve? (Appendix)

Question 15

The three major assumptions underlying the economist's theory of choice are (1) decisions can be made costlessly, (2) our preferences are given and not shaped by society, and (3) that individuals maximize utility. Explain why each of those assumptions may not reflect reality. Why may the assumption of "bounded rationality" be more realistic?

Question 16

What does rational behavior mean to an economist?

Question 17

What is a consumer's budget constraint? (Appendix)

Question 18

Who would be categorized as a conspicuous consumer?

Question 19

What is meant by "utility" and how do the concepts of total utility and marginal utility relate to one another? Use these concepts to explain the principle of diminishing marginal utility and give an example.

Question 20

Define total utility and marginal utility and explain the relationship between them. Give an example.

Question 21

Use the principle of rational choice to determine which of the following to choose:
(a) buying the latest album by Kanye West for $10.00 that gives you 60 units of utility, or
(b) buying the Brady Bunch Greatest Hits for $5.00 that gives you 35 units of utility.

Question 22

Consider the following table, which gives utility numbers for "Good X." Marginal in this table represents values between levels of total utility. (a) Fill in the blanks of the table.
(b) Draw a picture illustrating the relationship between Units of Good X (horizontal axis) and Marginal Utility (vertical axis).
(c) What does the picture you drew for part (b) say about a consumer's satisfaction when increasing consumption of Good X?
(d) How is this example different than what we typically expect to find?

Question 23

Assume the utility Janet obtains from consuming apples is given in the table below.
(a) Draw the graphs for Jane's total utility curve and marginal utility curve for apples.
(b) At what point does diminishing marginal utility set in?
(c) What is the maximum satisfaction (total utility) she can obtain from consuming apples?
(d) If Janet is at her level of maximum utility from apple consumption, what will happen to her level of utility if she consumes an additional apple?
(e) If apples were freely given away at zero cost, how many apples would she choose to consume? Note: Marginal utility should be interpreted as between levels of total utility, so that the marginal utility between 0 and 1 apple is 7, and the marginal utility between 1 and 2 apples is 6.

Question 24

You have $5 to spend on any combination of goods A and B. The price of good A is $2 and the price of good B is $1. You have calculated the following utility values for yourself: (a) Fill in the empty columns of the table.
(b) You have purchased 2 units of good A and 1 unit of good B. Are you maximizing your utility? If so, explain why. If not, what combination of goods should you buy?

Question 25

Susan has $10 to spend on soda and candy bars. Soda costs $1 per bottle and candy bars cost $.50 each. Using the grid below: (Appendix) (a) Draw Susan's budget constraint.
(b) Draw Susan's best bundle of soda and candy that she can buy for $10.

Question 26

Describe how the principle of diminishing marginal utility underlies the law of demand.

Question 27

Describe how the principle of rational choice underlies the law of supply. Use labor supply to demonstrate your answer.

Question 28

You have determined that the following utility values can be obtained by reading your Economics book. (a) Compute marginal utility.
(b) Does the example illustrate the principle of diminishing marginal utility? Explain.

Question 29

You have just spent two hours studying microeconomics and this has made you very hungry. You have $10 to spend on a snack and decide to go to Taco Bell. Putting your newly acquired economics knowledge to use, you have developed the following table to assist with your purchase decision: (a) Fill in the missing values in the table above.
(b) If you bought 6 tacos and 2 burritos are you maximizing your utility? Explain.

Question 30

Susan has $10 to spend on soda and candy bars. Soda costs $1 per bottle and candy bars cost $.50 each. Using the grid below: (Appendix) (a) Draw Susan's budget constraint.
(b) Draw a new budget constraint if the price of soda stays at $1 per bottle but the price of candy bars rises to $1 each.
(c) Draw a new budget constraint with the prices at their original levels (soda costs $1 per bottle and candy bars cost $.50 each) but now suppose that on her way to the store to make her purchase Susan loses $5 (she now has only $5 to spend).

Question 31

What is the law of diminishing marginal rate of substitution? (Appendix)

Question 32

Use the principle of rational choice to determine which of the following to choose:
(a) reading one chapter of Aristotle's Metaphysics that will take you three hours and give you 300 units of utility, or
(b) reading a chapter of your Chemistry text that takes 2 1/4 hours and gives you 200 units of utility.

Question 33

What is the marginal rate of substitution? (Appendix)

Question 34

Suppose you are considering volunteering some of your time at the student government car wash fundraiser. You compute your utility schedule as follows: Now suppose you discover the person you've been dying to go out with is going to work for five hours at the car wash.
(a) How will this change your utility schedule?
(b) How will this change your decision to volunteer?
(c) How do your answers to (a) and (b) relate to the law of supply? Explain.

Question 35

Zach has $100 to spend on meals at restaurants and movie theatre tickets. The price of a meal is $10 and the price of a movie ticket is $5. At equilibrium, Zach goes to the movies 10 times and eats in the restaurant 5 times a month. (Appendix)
(a) Draw Zach's budget constraint and an indifference curve showing his equilibrium.
(b) What is the relationship between the marginal utility of a meal in a restaurant and the marginal utility of a movie at the current equilibrium condition?
(c) If the price of a meal drops to $5 a meal, show graphically how equilibrium changes.
(d) If Zach's budget increases to $200 and prices remain constant ($5 a movie and $10 a meal), show graphically how equilibrium changes.

Question 36

Using the equilibrium condition of the principle of rational choice, explain why only Point B on the graph below maximizes utility, and that all other points don't. (Appendix)