Question

1. a) (6 pts) Write down and carefully explain three assumptions on preferences.
   b) (6 pts) Under these three assumptions, show why indifference curves cannot cross.

Answer 1

a)The consumer demand theory is based on consumer preferences and how they behave. Consumers preferences are based on taste and preferences, culture, income, etc. Consumers make their decisions based on their scarce income which is divided among all the possible goods he/she wishes to consume which gives them a level of satisfaction. The consumer preference theory has 3 assumptions

1. Decisiveness: Given any two commodities or a commodity bundle, the consumer must be able to rank them according to their preferences. This implies taht if there are two commodity bundles say A and B, the consumer must be able to rank which commodity bundle he prefers more. Whether he prefers A over B or B over A, when both gives the same level of satisfaction.

2. Consistency: The consumer must be consistent with his choice of preferences and ranking. This implies that if there are 3 commodity bundles say A, B and C. If the consumer prefers A over B and also B over C, this assumption states that consumer should choose A over C.

3. Convexity: This assumption shows that the consumer consumers more and more of one good and this leads to a decrease in the additional utility. This means that when an additional unit of a particular commodity is consumed, the marginal utility decreases. The assumption of convexity proves that Marginal Utility decreases as the consumption increases

b) Under the above assumptions one of the properties of indifferene curve is that two indifference curves dont intersect with each other. At the pont of tangency the higher curve gives the same amount as the lower curve which is illogical and impossible. This can be explained with the help of a diagram

The above diagram has two indfference curves IC1 and IC2. Both these indifference curves cuts at the point B. The combinations at point B and F gives the consumer same satisfaction as both the points is on the same indifference curve IC2. In the same way the points B and E gives the same level of satisfaction to the consumer as both of them falls on the same indifference curve. This concludes that point F and point E is the same in terms of satisfaction. This is illogical because say combination F has more of good Y and point E has more of good X which will lead to a differentitation in consumer satisfction. Hence we can conclude that indifference curves dont cut or intersect each other.