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Microeconomic theory - Essay Example

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Name Date Economics Midterm Exam 1) As long as consumers are concerned with only one good and they do not have to make choice, the life seems simple. However, in real world this rarely happens. Consumers and households are often faced with making choices. They are concerned with the consumption of two or more goods in a manner that yields them maximum utility…
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Microeconomic theory
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Download file to see previous pages The diagram above shows that different levels of goods x and y that would yield the same level of utility for the consumers. Just like the demand curve these curves can be shifted rightward or leftward depending on the changes of consumer’s tastes, willingness and other factors. The shift in the curve towards right would mean that the same combination of goods will now yield consumers more utility than what it was yielding before. Similarly, a leftward shift would mean that the same combination of good would yield less utility to consumer than before. There may be a number of reasons for this. The obvious reasons can be income effect, substitution effect or changes in consumers tasted. In the real world things are more complex than first thought. Consumers cannot buy any combination they like. In fact they are faced with budget constraints depending on their income. The real income is what consumers are actually earning and that is what is included in their purchasing analysis. Real income is derived when the income of consumers is adjusted against inflation. The budget constraints of a consumer are reflected by a budget line. This is drawn on the indifference map. The best combination for consumers is the place when budget line is tangent to the indifference map. In other words, the combination of goods where budget line is tangent to the indifference map is the place where the consumer is yielding the maximum utility. At this place marginal utility of both goods are equal and can be represented by the equation: MUx = MUy In the diagram below, it can be seen that the ideal combination or the maximizing utility combination of goods X and Y what the consumer should purchase given his real income is Qx and Qy. This would yield him maximum utility. 3) The income and substitution effect are important concepts explaining the changes in demand. Income affect occurs when the price of a good rises. Since your income is not rising in response to an increase in price of that good, the consumer feels poorer than before. Since the consumer feels poorer, he buys less of that good in order to compensate for the unexpected increase in price that has not synchronized with the income of the consumer. Similarly, when the price of a good falls, the consumer feels richer than before and his ability to buy more has increase and therefore he buys more of a good. This phenomenon is known as income effect. Similarly, when the changes in prices lead you to shift from one good to the cheaper good, it is known as the substitution effect. For example, if there is restaurant that is selling burgers and pizza. If there is a increase in price of pizza, you are more likely to buy more burgers and eat pizza less often than before. If the price of pizza falls, you shift from consuming burgers, to eat pizza more often. This phenomenon is known as substitution effect. However, there are certain goods that follow the opposite income and substitution effects. These are classified as giffen goods. When the prices of designer handbags rise, there are more people in queue to buy them from the richer segments of the society. The reason behind this is that people consider these expensive goods of higher quality and shift from cheaper goods to these goods. ...Download file to see next pages Read More
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