A Budget Constraint - Assignment Example

A Budget Constraint 1. A customer will sometimes buy one bundle of goods even if she prefers another for various reasons. The consumer is faced with a budget constraint. The consumer is will choose that bundle which maximizes utility. The diagram below explains this concept. x1 Good B x2 In the diagram above, the budget line x1,x2AB shows the consumer can afford to buy x1 of Good A or x2 of Good B or combinations of Good A and B on the budget line. The customer bundle X because it gives him the highest level of utility and it is the highest indifference curve that he could possibly be on right now because of his budget. Therefore, the customer may prefer a combination that is outside of his budget say on IC3 or outside of his budget, however, right now that preference is unattainable. 2. (a)If interest rate in the UK are forecast to rise during 2011 then individuals would increase there savings and cut back on consumption. There is a positive relationship between the interest rate and savings. This will result in an increase in the amount of funds available for loans. There is a negative relationship between interest rate and borrowing. As interest rate increases the demand for loans decreases, (b) The lender will benefit more from increases in interest rate. According to Varian (1999 p186 - 187): “If a person is a lender and the interest rate rises, he or she will remain a lender. … A borrower is made wore off by an increase in the interest rate. When the interest rate facing a borrower increases and the consumer choose to remain a borrower, he or she is certainly worse off.” The reason is that for the borrower an increase in interest rate simply means he will have to pay more interest in period 2. The substitution effect causes the borrower to borrow less and therefore consume less in period 1. So whatever the borrower does he ends up being worse off. 3. (a) When there are only two firms in an industry there is a duopoly. Assuming that firm which produces at the same constant marginal cost, but with zero fixed cost i.e, they share the same cost conditions then on price this may result in a price war. When firm A reduces price this will illicit a response by Firm B. This response will affect the sales of Firm A which is then forced to respond to prevent this situation which obviously will affect profits. If the Bertrand model (non-cooperative duopoly model) is followed the firms will independently set their prices. Consumers will respond by purchasing from the firm with the lowest price. In this model the firm which offers the lowest price supplies the whole market, assuming there are no switching costs. If both firms’ prices are identical then they both supply the market equally. The firms may collude to set the price of the product. (b) When firms that share the same cost conditions compete by deciding how much to produce, they produce where profits are maximized. Production will also depend on the price of the other firm’s goods. None of the firm’s will want to produce too much to cause a glut on the market. 4. (a) The statement that: “The demand for labour is the MRPL (marginal revenue product of labour)” is true. This is so because the downward sloping portion of the MRPL curve is the demand curve. According to Rittenburg and Tregarthen (2009 p301): “It would seem counterintuitive that firms do not operate in the range of increasing returns which would correspond to the upward sloping portion of the marginal revenue product curve. However, to do so would forego profit-enhancing opportunities.” (b) The statement that: “Wages increase hours of work if leisure is a normal good is true. If the wage rate increase this increases the price of leisure. It is conventional wisdom that a rational consumer will substitute more of other goods for a good whose price has increased. Therefore, since the price of leisure increases with a rise in the hourly wage rate the worker will supply more hours of labour at the higher rate thus reducing the hours available for leisure. According to Rittenburg and Tregarthen (p309): “… the substitution effect is always positive; a higher wage induces a greater quantity of labour supplied.” 5. (a) The statement that: All Giffen goods are inferior goods is true. For a normal good, when the price decreases you will demand more of the good. However, if the good is inferior you may decide to reduce the quantity purchased and purchase some other goods. The reduction in the price of the Giffen good constitutes an income effect. (b) The statement that: “the more of her income a consumer spends on a particular good, the more responsive to changes in its price will be her demand” is true. A consumer would spend more of her income on a normal good. As the price of a normal good increases, demand for the good falls. (c) The statement that: “Lower interest rates leads to savers saving less” is uncertain. Under normal conditions as the interest rate increases the supply of loanable funds increase and as the rate fall, supply decreases. However, this is not always true. It depends on the age of the population. According to Pashigan (p607 to 608): “The supply of loanable funds is greater when there are more relatively old individuals in the economy …. These individuals prefer to save for the future when their earnings will be lower.” (d) The statement that: “Higher rates of income tax are a disincentive to work” is uncertain. The reason is, it depends on the level of the worker’s income. For individuals receiving high salaries, they may refuse to work extra hours because of the higher rates attached to higher income streams. For those earning below a certain level of income they may not be affected by the higher rates. It really depends on whether higher rates apply to all workers or just those earning above a certain level of income. 6. (a) A firm’s production technology is represented by the production function Q = F(K, L) where K is the level of capital and L is the level of labour. If the cost of capital is r, and the cost of labour is w then: The slope of the Isocost Curve = (-TC/r) ÷ (TC/w) = -w/r The isocust curve identifies all combinations of capital and labour the firm can hire for a given total cost. The slope of represents the ratio of the unit costs of capital and labour The slope of the Isoquant curve is the marginal rate of technical substitution of the factors capital and is calculated as:Slope of Isoquant curve = MRTSKL = MPL ÷ MPK It measures the rate at which units of labour are substituted for capital. According to McAffee and Lewis): “An isoquant, which means ‘equal quantity’ is a curve that describes all combinations of inputs that produce the same level of output.” (b) The productivity of capital and the productivity of labour are related in that both are important to the production function. If you employ too many persons to use one machine then productivity of both factors will be affected. In this case the productivity of both will decline. As more units of capital are introduced the productivity of labour increases up to a certain point until diminishing returns set in. 9. If a firm has a production function that takes the form Q = 2KL, where Q is output, K is capital, and L is labour. (a) The average product of labour (APL) measures the output for each worker. The formula is APL = Total Product of Labour Number of workers If the firm is currently using 2 units of capital and 1 unit of labour then: APL = Total Product of Labour = TPL(L,K) = 4 = 4 Number of workers L 1 The average product of capital (APK) measures the output for each unit of capital. The formula is: APK = Total Product of Capital = TPL(K,L) = 4 = 2 Units of Capital L 2 Both scenarios assume that the other factor is held constant. (b) The marginal product of labour (MPL) measures the change in total output that comes with an additional worker produces. The marginal product of labour could be. The formula is: MPL = Total Product of Labour = TPL(L,K) = 4 = 4 Number of workers L 1 The marginal product of capital (MPK) measures the change in total output that results from the utilization of an additional unit of capital MPK = Total Product of Capital = TPK(K,L) = 4 = 2 Units of capital K 2 Both scenarios assume that the other factor is held constant. (c) According to Pashigian p180: “The law of diminishing returns describes the eventual decline in the marginal product of the variable factor as the variable factor increases with the other factors held constant.” Diminishing marginal returns occurs when with each additional product that labour produces the returns decline further and further. The following table demonstrates this: Units of labour Increase in Production Total Production Average Product of Labour 1 10 10 10 2 12 22 11 3 5 27 9 4 1 28 7 When there was only one unit of labour the marginal product is 10. It increases to 12 when the second worker is added but by the third worker is added it declines to 5. Diminishing marginal returns sets in after the second worker. This continues up to the addition of the fourth worker. (d) Increasing returns to scale means that a firm exhibits increasing returns in the short run on the factors of production. The production function exhibits increasing returns to scale up to a certain point, after which diminishing returns sets in. 13. (a) The marginal utility of the 6th sporting event is 2 (30 -28). (b) Of the two type of event this person would purchase theatre outings first. The theatre outing is cheaper on the first two outings and provides more utility than the sporting event. Total utility for the 2 theatre outings is 20 at a cost of £50 compared to 2 sporting events which gives a total utility 18 at a cost of £70 (2 x £35). This person would be experience 2 additional utility for $20 less if 2 theatre outings first. Whether this person chooses 1 event or 2 events the theatre outing is a more beneficial choice. (c) If the available budget for these outings is £155, in order to maximise utility 2 theatre outings would be chosen and 3 sporting event outings. See table below: Outings Number of events Price per event (£) Total Cost (£) Utility Theatre outing 2 25 50 20 Sporting events 3 35 105 28 Total Utility 48 The individual would gain a total utility of 48 if the above combinations. This is where his total utility would be maximized. (d) If money is no object in order to maximize utility the individual would choose each outing up to the point where its marginal utility is greater than zero (0). i.e MU > 0. This point is at 5 sporting events and 2 theatre outings. After the 5th sporting event, the marginal utility of 1 more unit of sporting event is -2. After the 2nd theatre outing, the marginal utility of 1 more unit of theatre outing is -10. Therefore, the individual would enjoy 5 sporting events and 2 theatre outings at a total cost of £190 with a total utility of 50. (e) The basic assumption of preferences that is violated is that ‘more is better’. References McAfee, R. P and Lewis, T. R. Introduction to Economic Analysis. USA: Flat World Knowledge.com. 2009. Web 12 Dec 2010 Pashigian, B. P. Price Theory and Applications. USA: McGraw Hill. 1998. Print Rittenburg, L and Tregarthen, T. Principles of Microeconomics. USA: Flat World Knowledge.com. 2009 Web 11 Dec 2010 Varian, H. R (1999). Intermediate Economics: A modern Approach. 5th ed. California: Norton. 1999. Print Read More