Download Study Guide Sample Chapter 2

CHAPTER 2
UTILITY AND CHOICE
LEARNING OBJECTIVES
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Utility measures how satisfied a particular person is.
Marginal rate of substitution represents how a person can substitute goods while
remaining just as well off.
Indifference curves illustrate all the combinations of goods that keep a person just as well
off.
Budget constraints illustrate all the combinations of goods that a person can afford.
Each person seeks to maximize his/her utility subject to his/her budget constraint.
FILL-IN SUMMARY
UTILITY
1. ___________
2. ___________
3. ___________
Economists define utility as the satisfaction a person receives
from the various activities he/she pursues. We shall focus our
attention on two particular activities: the consumption of good X and
the consumption of good Y. We represent the utility of a person by
the following function:
Utility = U(X, Y; other things).
The utility a person receives depends on the quantity of good X
consumed, the quantity of good Y consumed, and "other things." By
using the ____________ paribus assumption that "other things" do not
change, we can simplify the utility function:
Utility = U(X, Y).
Economists use a person's utility function to describe how the person
ranks various ____________ of goods. In our case a bundle of goods
consists of a specific amount of good X and a specific amount of good
Y. If the person prefers a particular bundle of goods, bundle A, to a
second bundle of goods, bundle B, then the utility he/she derives from
A will ____________ the utility derived from B. If the person finds
bundles A and B equally attractive,
29
30  Part 2/Demand
4.
5.
___________
___________
then the utility of A will ____________ the utility of B. Last, if he/she
prefers bundle B to bundle A, the utility of B will ____________ the
utility of A.
ASSUMPTIONS ABOUT UTILITY
Consistency of Preferences
6.
___________
When considering any two bundles A and B, we assume that a
person will either prefer A to B, or prefer B to A, or will find them
equally attractive. If this condition is met, we say that preferences are
complete. Second, we assume that preferences are transitive. Consider
three bundles A, B, and C. If a person prefers A to B and also prefers B
to C, then he/she ____________ A to C.
More Is Better
A person always prefers to consume more of a good.
INDIFFERENCE CURVES
7.
___________
8.
9.
___________
___________
10. ___________
11. ___________
To construct an ____________ curve for a person first choose a
particular level of utility. The indifference curve illustrates all the
different bundles that will provide the person with the specified level
of utility. That is, an indifference curve illustrates all the combinations
of good X and good Y that will provide the person with a particular
level of utility. An indifference curve is a ____________ line of the
utility function. Whenever two bundles lie on the ____________
indifference curve, the person finds them equally attractive. The
person prefers a bundle on the indifference curve to any bundle lying
____________ the curve. he/she prefers any bundle lying above to a
bundle ____________ the indifference curve.
MARGINAL RATE OF SUBSTITUTION (MRS)
12. ____________
13. ____________
A person's marginal rate of ____________ of good X for Y equals
the amount of good Y the person is willing to give up in order to get
one additional unit of good X; it represents the ratio by which the
person is willing to substitute the goods. A person's marginal rate of
substitution depends on the bundle of goods he/she is now
consuming. As the person consumer substitutes more and more X for
Y, his/her marginal rate of substitution ____________. We call this
phenomenon diminishing marginal rate of substitution.
Chapter 2/Utility and Choice  31
INDIFFERENCE CURVES AND THE MARGINAL RATE OF
SUBSTITUTION
14. ___________
The ____________ of a person's indifference curve shows how
the person can substitute the goods while remaining at the same level
of utility. This slope equals the ratio by which the person is willing to
substitute good X for good Y, his/her marginal rate of substitution.
The slope of an person's indifference curve and his/her marginal rate
of substitution represent the same thing.
Figure 2.1: Indifference Curve
THE BUDGET CONSTRAINT
15. ____________
16. ____________
17. ____________
18. ____________
19. ____________
An person's budget constraint illustrates all the bundles that the
person can afford with his fixed amount of ____________. That is, a
person's budget constraint illustrates all the combinations of good X
and good Y that the person can afford. A person cannot afford
bundles that lie ____________ his budget constraint. The
____________-intercept of the budget constraint represents how much
of good Y the person could buy if he/she spent all his income on
good Y. The Y-intercept just equals his income divided by the price of
good Y, I/PY. Similarly, the ____________-intercept equals I/PX. The
slope of the budget constraint is the ____________ of the price ratio,(PX/PY).
32  Part 2/Demand
Figure 2.2: Budget Constraint
UTILITY MAXIMIZATION
20. ___________
21. ___________
22. ___________
23. ___________
24. ___________
25. ___________
Of all the bundles of goods a person can afford, he/she will
choose that bundle which provides him/her with the ____________
utility. On the graph the person will choose that bundle on his/her
budget constraint that maximizes his/her utility. The person's
indifference curve passing through the utility maximizing bundle will
be ____________ to the budget constraint. In this situation, any bundle
that the person prefers will lie ____________ his/her budget
constraint; he/she cannot afford to purchase any bundle that he/she
____________. Note that when the person maximizes his/her utility,
the tangent line of the indifference curve is the ____________
constraint. Thus, the slope of the indifference curve equals the slope
of the budget line; consequently, the marginal rate of ____________
equals the price ratio.
Chapter 2/Utility and Choice  33
Figure 2.3: Utility Maximization
MULTIPLE-CHOICE QUESTIONS
1.
____ A person's utility
a. depends on the quantities of goods he/she consumes.
b. refers to how valuable he/she is to society.
c. is defined to be the satisfaction that he/she receives from the various activities
he/she pursues.
d. refers to how adaptable his job skills are.
e. a and c.
2.
____ To economists a bundle of goods consists of
a. all goods that can be bundled, that is, all goods that can be transported.
b. the goods that persons purchase at a supermarket.
c. only goods that are perishable.
d. specific amounts of all goods that persons consume.
e. a and b.
3.
____ Economists use utility functions to
a. measure how much income a person earns.
b. describe how a person ranks various bundles of goods.
c. describe how firms decide upon the level of production.
d. describe how firms decide upon the inputs to use.
e. c and d.
34  Part 2/Demand
4.
____ When comparing bundles A and B, a person with consistent preferences will
a. prefer A to B only if he/she has transitive preferences.
b. prefer A to B only if he/she can afford to buy A.
c. prefer A to B only if he/she can afford to buy A, but cannot afford to buy B.
d. prefer A to B, prefer B to A, or find A and B equally attractive.
e. prefer B to A only if both can be afforded.
5.
____ If a person who has transitive preferences prefers bundle A to B and prefers
bundle B to C, then he/she prefers A to C
a. only if preferences are consistent.
b. only if A contains more of every good.
c. only if he/she can afford to purchase A.
d. only if he/she can afford to purchase both.
e. always.
6.
____ A person's indifference curve
a. is downward sloping.
b. is upward sloping.
c. is a contour line of the utility function.
d. illustrates all the bundles a person can afford to purchase.
e. a and c.
7.
____ If bundle A lies on a person's indifference curve and bundle B lies on the same
curve the person
a. prefers A to B, if he/she can afford A.
b. prefers B to A, if he/she can afford B.
c. always finds A and B equally attractive.
d. always prefers A to B.
e. always prefers B to A.
8.
____ If bundle A lies on a person's indifference curve and bundle B lies above the
curve, the person
a. prefers A to B, if he/she can afford A.
b. prefers B to A, if he/she can afford B.
c. always finds A and B equally attractive.
d. always prefers A to B.
e. always prefers B to A.
9.
____ If bundle A lies on a person's indifference curve and bundle B lies below the
curve, the person
a. prefers A to B, if he/she can afford A.
b. prefers B to A, if he/she can afford B.
c. always finds A and B equally attractive.
d. always prefers A to B.
e. always prefers B to A.
Chapter 2/Utility and Choice  35
10.
____ A person's marginal rate of substitution of X for Y
a. represents the ratio by which the person is willing to substitute good X for
good Y.
b. depends on the bundle presently consumed.
c. represents the ratio by which the person can trade goods in the marketplace.
d. always equals the price ratio.
e. a and b.
11.
____ Graphically, the marginal rate of substitution is indicated by the slope of the
a. line connecting the origin to the point on the person's indifference curve that
represents the bundle being consumed.
b. indifference curve at the point representing the bundle being consumed.
c. line connecting the origin to the point on the person's utility function that
represents the bundle being consumed.
d. utility function at the point representing the bundle being consumed.
e. b and d.
12.
____ As a person substitutes more and more X for Y, his marginal rate of substitution
of X for Y
a. typically increases.
b. typically decreases.
c. typically remains the same.
d. may increase or remain constant, but cannot decrease.
e. must increase.
13.
____ A person's budget constraint
a. is upward sloping.
b. is a contour line of the utility function.
c. illustrates all the bundles the person can afford to purchase.
d. a and b.
e. a and c.
14.
____ The slope of a person's budget constraint
a. is the negative of the price ratio.
b. represents the ratio by which the person can trade goods in the marketplace.
c. represents the ratio by which the person is willing to substitute good X for
good Y.
d. a and b.
e. a and c.
36  Part 2/Demand
15.
____ The Y-intercept of a person's budget constraint equals
a. his/her income divided by the price of Y.
b. his/her income divided by the price of X.
c. how much Y the person can purchase if he/she buys no X and spends all his
income on good Y.
d. how much X the person can purchase if he/she spends half his/her income on
good X.
e. a and c.
16.
____ When a person maximizes his utility, he/she consumes a bundle of goods that
lies
a. above the budget constraint.
b. below the budget constraint.
c. on the budget constraint.
d. above his utility curve.
e. none of the above.
17.
____ When a person maximizes his utility
a. the indifference curve passing through his bundle must be tangent to the
budget line.
b. his marginal rate of substitution equals the price ratio.
c. his marginal rate of substitution must equal the slope of the utility function.
d. all bundles that he/she prefers must lie above the budget line.
e. a, b, and d.
Answer questions 18 through 21 based on the following information:
 A person has a utility function with MRS=Y/X
 The price of good X is $1.00
 The price of good Y is $2.00
 The person has budgeted $1000 for purchases of X and Y.
18.
____ The equation for the person’s budget line is
a. 1000=X+Y.
b. 1000=2X+2Y.
c. 1000=X+2Y.
d. 1000=2X+Y.
e. 1000=2XY.
19.
____ The tangency condition for utility maximization requires that
a. Y/X=2/1.
b. X/Y=2/1.
c. Y/X=1/2.
d. X/Y=1/2.
e. None of the above.
Chapter 2/Utility and Choice  37
20.
____ When the person maximizes his utility
a. they will consume equal amounts of X and Y.
b. they will consume twice as much X as Y.
c. they will consume twice as much Y as X.
d. they will not consume any Y since it is more expensive.
e. None of the above.
21.
____ If the person has $1000 dollars to spend on X and Y
a. they will consume 500 units of X and 250 units of Y.
b. they will consume 250 units of X and 250 units of Y.
c. they will consume 500 units of X and 500 units of Y.
d. they will consume 250 units of X and 250 units of Y.
e. None of the above.
RUNNING GLOSSARY
1.
___________
Theory of choice: the interaction of preferences and __________ that
causes people to make the choices they do.
2.
___________
__________: the pleasure, satisfaction, or need fulfillment that people
get from their economic activity.
3.
___________
4.
___________
5.
___________
6.
___________
Marginal rate of __________ (MRS): the rate at which a person is
willing to trade one good for another while remaining equally welloff.
7.
___________
__________ curve: all the combinations of goods or services that
provide the same level of utility.
8.
___________
Indifference curve map: a __________ map that shows the utility a
person obtains from all possible consumption options.
9.
___________
__________ constraint: the limit that income places on the
combinations of goods and services that a person can buy.
10. ___________
Ceteris paribus assumption: in economic analysis, holding all
__________ factors constant so that only the factor being studied is
allowed to change.
__________ preferences: the assumption that a person is able to state
which of any two possible options is preferred.
Transitivity of preferences: the property that if A is preferred to B,
and B is preferred to C, then A must be __________ to C.
Composite good: treating expenditures on several different goods
whose relative prices do not change as a __________ good for
convenience in analysis.
38  Part 2/Demand
ANSWERS
FILL-IN SUMMARY
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
ceteris
bundles
exceed
equal
exceed
prefers
indifference
contour
same
below
on
substitution
decreases
slope
income
on
Y
X
negative
20.
21.
22.
23.
24.
25.
most
tangent
above
prefers
budget
substitution
MULTIPLE CHOICE
RUNNING GLOSSARY
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
1. income
2. Utility
3. other
4. Complete
5. preferred
6. substitution
7. Indifference
8. contour
9. Budget
10. Single
c
d
b
d
e
e
c
e
d
e
b
b
c
d
e
c
e
c
c
b
a