Choices of Consumers and Households - Essay Example

? Economics Midterm Exam 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. When the different bundles or quantities of two different goods that yield same utility are represented in a graph form, it is known as an indifference map for consumers. The reason why it is called indifference curve is because, the combinations of two different goods are yielding same level of utility and hence consumers are indifferent or do not care about the consumption of these different bundles of goods in different quantities. 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. Hence substitution effect is different for these goods. Similarly, there are inferior goods. When the people income increase or price of certain goods fall, people tend to consume less of these goods. For example, when a poor person become rich he may stop using sugar and start using more healthy sugar alternative because he can now afford to buy them and because he feels sugar has side-effects and not healthy. This is income effect for Giffen goods. Here the demand for a good falls when its price falls. The supply curve of labor and capital can be negatively sloped or backward bend. This can occur if labor and capital has positive expectations about the future. They are expecting economy to flourish in the future and hence they do not want to tie them at low returns at this stage. Since, capital is often employed at a fixed rate for long term; therefore bearers of capital would not want to risk losing high rates of tomorrow, buy supplying their labor at low rates now. Similarly, labor in the economy would also be seeking more labor than work because the government is supplying them with unemployment benefit funds that are greater than what they could earn at job. This would again lead to negative or backward bending supply curves. 4) Compensating variations of income refers to the change in money that would be needed by the consumers in order to reach at the previous levels of utility after the company or the government has decided to change the price of quality of the product. Equivalent variation can be a risk mitigating policy for the consumers. This can be in the form of insurance, derivatives or future covers and a price that the consumer is willing to pay now in order to avoid uncertainty or exposure to prices in the future. Consumer’s surplus is the different between the price that the consumers are willing to pay and what they are actually paying. The firms or government can recoup the benefits of the price cuts by charging higher prices to consumers in order to be in a better position and should tell consumers that the price increase has been brought about by a change in quality or because of the increase in operating or fixed costs of the organization. This can be used to the benefit the customers by not changing the price and improving the quality to increase the customer’s utility from the product. Similarly, government can use the consumer surplus from other services that it is giving to the nation and use it as a excuse for taxation and other services by telling them that the government needed fund to finance certain expenditure. Since, consumers would know that they have surplus in some services they are more likely to happily pay taxes then if they know that the government is doing nothing for them and not helping them in any way. If the consumers know that they have future covers in the form of derivatives or insurance they know that they are safe in the future this can lead to lack of uncertainty and the businesses can keep prices more stable than if they are completely uncertain about the future. 6) a) The competitive industry is one where there is no room for inefficiency. There are firms in that industry that are fighting for larger market share and any complacency or relaxation in the efficiency would mean that the other firms would gain cost advantage and consumers are likely to shift to products where they are more likely to get low cost and this implies loss of customers and market share for inefficient firms. As a result, the firms in this industry try to be more cost efficient in order to maintain their market share because there is cut throat competition in the industry. As a result, the firms in these industries operate at the lowest level of their average cost curve and are working at very low margins in order to maintain good market share. These firms are earning a lot by trading in volume rather than at large margin. Constant-Cost industry is one where the costs are not increasing and are pretty much stable. Hence, the firms cannot increase it consumer prices on the pretext that the cost of supplies or raw material have increased. This means that the prices in these industries are pretty stable and they cannot raise price unless there is a major shift in the cost structure of the industry, because consumers would buy from another place of buy imports if they feel that the industry is using unfair practices to increase prices such as forming a cartel. Increasing cost industry is one where the prices are constantly increasing and the firms have the option to make settlement in consumer prices and there is room for price changes. Here the costs are rising so fast that the consumers would be willing to pay for prices increases even if the price changes are very often. Decreasing cost industry is one where the costs are decreasing because the development of industry there are more firms that are entering and auxiliary businesses setting up that increase the economies of scale for the industry. Hence, the costs in this industry are ever decreasing and companies are benefitting by increasing their sales volume by lowering prices or converting the decrease in costs to their profits. 9) Equilibrium is a point where there is not tendency to change or where demand equals supply. However, in a two sector economy where two different goods can be produced or there can be output from two different sectors, usually a Production Possibility Frontier is used to define the equilibrium in that economy. Suppose an economy is producing two goods i.e. Capital and Consumption goods. In this economy the production possibility function shows that the various combination of output of these two different sectors that can be produced. The most efficient points in the economy i.e the equilibrium point are those that are produced on the curve or at the boundary. Any point that is inside the boundary means that the countries resources are lying idle and any point outside the boundary is impossible unless there is an improvement in technology or there is an increase in the number of resources. The equilibrium points in the above curve is A and B. The different quantities in A and B are reflected in the preference of the consumers towards either of these goods and are based on the demand of the quantities of these goods. If a tangent is drawn at the boundary of this curve between the point A and B. The slope of this tangent would show the marginal rate of transformation or how much of one good the consumers are ready to sacrifice for the production of other. This is known as marginal rate of transformation and is obtained by drawn a line tangential to the points at the original curve. If the marginal rate of transformation is not equal to the marginal rate of substitution then there would be equilibrium problems in the economy and soon the consumers would find a shortage of one goods against another which lead to queues and if the marginal rate of transformation and marginal rate of substitutions are not adjusted then the economy would be faced with a problem of inflation. Works Cited Lipsey, A and M Chrystal. Economics. Oxford: Oxford University Press, 2003.Print Read More