Question

a) what, according to neoclassical economics does "rationality" mean? are consumers rational by this criterion? cite two example providing evidence of irrational behavior.

b) draw a graph that depicts a budget line representing consumption possibilities between two goods (any goods- 'x' and 'y' is fine)

c) what is utility maximizing 'rule' for the consumer, according to neoclassical theory? equation please but also explain the rationale of it.

d) draw a 'map' of a few indifference curves on your graph in a way that depicts a hypothetical utility maximizing point. why does this point maximize utility?

e) show what happens when the price of one of the goods rises.

Answer 1

1) Rationality of the consumer is an important assumption of neo classical theories. Neo Classicals associate the concept of Rationality with the maximisation of satisfaction. A consumer is rational if all the economic activities of the consumer aim at the maximisation of his satisfaction ( which is mainly indicated by the derivation of maximum utility.)

* Modern economists have severely criticised this rationality assumption of neo Classicals.Lets look at two scenarios where the consumer doesn't act rational.

> Interpretation of utility may be different for different consumers. Some times a consumer will have to buy or consume things based on social pressure , peer pressure and driven by emotions.

1. Someone who buys a new branded laptop eventhough he doesn't need it and it's difficult to for him to afford it. He does it only because his friends have the same laptop ( Bandwagon effect)

2 under emergency situations like corona pandemic people caring for others and donating commodities which they could have used for the maximisation of their own satisfaction.

2)

3) According to neo-classical economists, a consumer maximises his utility when his budget line is tangent to the highest possible indifference curve.

In the form of equations it can be expressed as follows.

MRS xy = px/py

( Here marginal rate of substitution is the slope of indifference curve are price ratio is the slope of budget line which are equal at the tangency point)

Since MRSxy = MUx / MUy ( lts equal to the ratio of marginal utilities derived from X and Y) , we can write the equation as follows.

MUx / MUy = Px/ Py

4) ln the following diagram BL is the budget line. IC 1 ,IC 2 and IC3 are the indifference curves. Consumer maximises his utility when BL is tangent to the highest possible indifference curve 1C2

5) When price of one good increases (for example price of X), he can only consume less of it , so budget line shifts from BL toBL1 . The highest possible indifference curve for BL 1 is IC1. So consumer maximises his utility at the point of intersection of these curves. Since lC1 lies at a lower position compared to IC2 , there is a decline in consumer satisfaction. ( Higher the indifference curve, higher the utility or satisfaction)