Economics 2A
Assignment 1

“Consumers are statistics. Customers are people.” Stanley Marcus (1905 –2002)
In order to explain HOW economic theory determines the choices of the consumer, we need to know WHAT the theory states.
We use the terms baskets or bundles for groups of items, consumer preferences to tell us how the consumer ranks those baskets according to his tastes and we do that by:
1. Assuming the preferences to be complete, and that the consumer can distinguish which basket he prefers, or whether they are indifferent to him.
2. When a customer enjoys basket A better than B, and B better than C we assume that the preferences are transitive and accept that for him A > C.
3. Finally we assume that the customer will always be glad to have more of a product than to have less, and more will raise the utility.

John will be my example to explain the theory. His budget is £100.
He likes two products: wine and cheese.
The price per item is £5 for cheese, and £20 for wine.
The budget line represents the maximum amount of either John can buy. To get the line we divide the budget by the price of the item, in order to get the maximum quantity of each bundle and then connect the points on the graph:
Quantity of wine
Quantity of wine
20
20
5
5

The slope of the line is ∆W/∆C = - (Pw/Pc)
The slope of the line is ∆W/∆C = - (Pw/Pc)

Quantity of cheese
Quantity of cheese

We can represent someone’s preferences with a function that we call utility function. It helps us apply the indifference curve by plotting combinations of baskets on a line that give the same total satisfaction to our customer.
To get the indifference curve we can suppose that John’s utility is u(W,C) = 2W + C
We pick all baskets that give the same utility, plant them on the graph and connect them.
We should also clarify what MRS means. It is the marginal rate of substitution, and it is the rate at which John will be willing to substitute wine for cheese, or the other way around. MRS equals the slope of the indifference curve. If the curve is convex, when we move along it, more cheese will be consumed and less wine. At some point, it will be harder for the consumer to give up another of the little bundles of wine he has to get more cheese.

Quantity of wine
Quantity of wine

5
5
B
B
C
C

4
4
A
A

3
3
Indifference curves
Indifference curves

Quantity of cheese
Quantity of cheese

15
15
5
5
10
10
20
20

Assuming that John is a rational consumer that will not pick a point above his budget line, as he will not be able to afford it, and it will not be below the line because he will have excess cash going to waste, he must pick a point from his budget line. I have drawn three indifference curves, each one gives different satisfaction and each represents different combinations of bundles. John has to pick one that crosses with his budget line.
Picking the basket bundle D ( I’ll skip the letter C – cheese ) would indeed give him maximum satisfaction, it contains more of both items and we already said that more is better. But it is unreachable for John, because it is out of his budget. He will pick either A or B.
The right one is A, it lies on the second indifference curve which gives an overall higher satisfaction than the one to the left, and at that point both the indifference curve and budget line have the same slope. Why? Because at A , he will be spending the same amount of money as with point B, but the slope of the indifference curve, his MRS will equal the price ratio. MRS = Pc / Pw = 5/20 = 1/4
The marginal benefit will be equal to the marginal cost. The marginal benefit is measured by the MRS, and the marginal cost is equal to the slope of the budget line. When both are calculated at point A, they are the same. We also call that tangency condition.
Corner solutions
We talked about the interior solution to the problem. There are, however, other solutions to it. If the consumer prefers to buy in extremes All of those options are, in theory a very broad and good way to understand consumer behavior. But in reality, consumers aren’t certain of their desires. They might make choices which are wrong or driven by emotion. That is why
“Without the element of uncertainty, the bringing off of even the greatest business triumph would be a dull, routine, and eminently unsatisfying affair.”
Jean Paul Getty (December 15, 1892 – June 6, 1976)