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Solutions for Study Questions #3 - Household Consumption Behaviour

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Econ 101 - Solutions to Study Questions #3 E. Lau PART A - Short Answer 1. Example

Consumer surplus arises because of the law of diminishing marginal utility, and the market charges a single price. In this case the price per good is $2 no matter now many you buy.

As you can see from the above diagram, if you are willing to pay $6 for the first unit of the good, but the price is only $2, so $4 is your consumer surplus. You will accumulate consumer surplus until the point where you are just willing to pay the market price for the good. In this diagram, the value of the consumer surplus on the first four moves is $10.

3.

is the marginal utility of good A divided by the price of good A.

The price of good A can be thought of in terms of money. Therefore, we can rewrite the first equation as where 8 can be thought of as the marginal utility of money ($1.00).

If 8Pa > MUa you will not buy A because you would rather have the money. If 8Pa < MUa you will buy good A because you value it more than the money. In fact, you will buy A up to the point where 8Pa = MUa equilibrium condition. From this we can see that

but, following the above steps, we can apply similar concept to multi-goods, a, b, c, ... n such that:

Solutions for Study Questions #3 - Household Consumption Behaviour

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Therefore, in equilibrium

so

. In simpler language, rational consumers maximize utility not

just by comparing the incremental utility of each goods. They compare the per $ worth of MU they take note of the ratio of MU and the price of each good. 6. Note that at pt a, a consumer with a wage of w* can buy either a or b, either would cost w*, i.e. at pt a , Qy1.Py+Qx1Px=w*. However he is less happy at point a (U1) than pt b(U2). Therefore we know at pt a

| thus the consumer should buy

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