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Consumer equilibrium Marginal Rate of Substituion

QUESTION 1

(a) Using an appropriate diagram, explain clearly why a consumer must be in equilibrium when the marginal rate of substitution is equal to the ratio of the prices of the goods consumed.

(b) Use an appropriate diagram; explain how indifference curve analysis can be used to derive a demand curve.

QUESTION 2

"Developments in the world economy obviously pose a risk to economic performance in the near term. Monetary policy has been eased, in recognition of the changing circumstances, and should prove to have some expansionary influence over the period ahead."

From an address by the Governor of the Reserve Bank of Australia to the Economic Society of Australia, Melbourne, 10 April 2001.

The Governor of the RBA was commenting on the reasons for a change in direction of monetary policy in the early part of 2001 from the contractionary stance taken the previous year (2000). Explain why this change in direction was necessary. USING APPROPRIATE DIAGRAMS, trace the expected impact of contractionary monetary policy on aggregate expenditure, aggregate demand and real GDP, commenting on the implications for economic growth, unemployment, and the balance of payments.

QUESTION 3

(a) Suppose initially a firm is making a profit. With the use of diagrams, explain how long run equilibrium is achieved in:

 Perfect Competition.
 Monopolistic Competition.

(b) Compare the economic welfare of a perfectly competitive industry and a monopoly. Draw the appropriate diagrams and explain how market outcome is different in both industries in regard to output and price.

QUESTION 4

In the late 1990s, Australia's current account deficit (CAD) soared to above 6% of our GDP. In early 2000s, the CAD stands at a very comfortable level of just 2% of GDP. Study the following newspaper cutting (Courier Mail, Sept 3, 2001) on the improving CAD and recent strong economic growth:

Growth rate registers dramatic turnaround

Despite the weakening world economy, our export receipts are continuing to climb. ... Conversely, the sharp resurgence in demand in our economy has yet to have any measurable impact on imports. ... The overwhelming reason for such an extraordinary and unexpected turn of events is the super-competitive level of the Australian dollar. ...

To the extent that there is a real threat to this outcome, it lies with the inherent uncertainty of the level of the Australian dollar. The dollar cannot remain at such a super-competitive level forever ...

Courier Mail, Sept 3 2001.

(a) Refer to the first paragraph of the press cutting. Describe how the events: "weakening world economy" and "sharp resurgence in demand in our economy" relate to trade balance of our economy. What does it mean when the writer said the Australian dollar is at a "super-competitive" level? Now, explain why, despite the internal and external events in 2001, Australia's CAD was improving, rather than worsening in that year.

(b) In the second paragraph, it says the Australian dollar cannot stay at such a "super competitive level". Why? Explain with the use of diagrams.

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QUESTION 1
(a) Using an appropriate diagram, explain clearly why a consumer must be in equilibrium when the marginal rate of substitution is equal to the ratio of the prices of the goods consumed.

To understand the problem we first need to look at what each term means. The marginal rate of substitution is the rate at which an individual is willing to give up one good for other. So, if we consider two goods: say water bottles and chewing gums, the marginal rate of substitution of water bottle is how many chewing gums one is willing to forego to get one slice of chewing gum. The reason pricing is important is very simple in practical terms: you do not want to incur a loss in the transaction.

We now need to put this on a stronger theoretical ground. Suppose you have $100, and you plan to spend it on chewing gums and water bottles. Suppose each chewing gum sells for $2 and each water bottle sells for $4. Also assume that you are consuming 20 chewing gums and 15 water bottles. That way you are consuming all your income. Will you want to consume 25 chewing gums and 15 water bottles? Most people will say yes. But can you afford it? The answer is no, not with your given income. That means to get more of one good, say chewing gum, you will have to give up something of the other. So to get a chewing gum you have to give up half a water bottle. When will you do that? When the benefit from giving up half the water bottle is less than the benefit from the additional chewing gum. But you will not do this in case you lose more by giving up than you gain.

Economists put this condition as the tangency point of the budget line and the indifference curve, and that tangency point is when the marginal rate of substitution, which is nothing but the slope of the indifference curve, is equal to the slope of the budget line, which is the relative price. Look at the following diagram from http://www.webshells.com/college/grid18.jpg:
Here you have three indifference curves, I0, I1 and I2. The most preferred curve is I2, since at any point you consume more of both goods. You can afford I0, but that way you will leave out point C which is affordable (since it is on the budget line), and provides higher utility (since it is outside I0). You can afford I1 at one point, point C, but no other point on I1 is affordable given the budget line. So you would want to be there. The point is determined by the location of tangency of the budget line and the indifference curve I1. Condition of tangency is that the slopes of the two curves should be equal, which in this case means the slope of the indifference curve (the MRS) should be equal to the slope of the budget line (the relative price). Hence, the condition in the problem!

(b) Use an appropriate diagram; explain how indifference curve analysis can be used to derive a demand curve.

To answer this question we again need to decide on some income, some prices and some indifference curves. Consider the following graph from http://www.westga.edu/~aaustin/3411/price2_files/image002.jpg

What we have here are two goods: peanuts and bourbon. The income is given to be $20. The initial price of both peanuts and bourbon is given to be $1 per unit. Thus one can afford, either 20 ounces of peanuts, or 20 ounces of bourbon, or some combination between the two. This is given by the blue colored budget line.

Now, suppose the price of peanuts changes to $2 per ounce. One can now afford either 10 ounces of peanuts, since income is still $20, or 20 ounces of bourbon, or some combination in between. The new budget curve is shown in red.

In the former case you consume at point C on the graph. It has a certain quantity of both goods associated with it. As the price of peanuts rises, you go from point C to point A. What happens is the quantity of peanuts you now consume is lower than earlier: higher price implies lower quantity demanded ...

Solution Summary

Consumer equilibrium marginal rate of substitution is examined.

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