Variance & Variability | Why is the variance a better measure of variability than the range?

Why is the variance a better measure of variability than the range?

ANSWER

Range is the difference between the highest possible outcome and the lowest possible outcome. Range ignores all outcomes except the highest and lowest, and it does not consider how likely each outcome is. Variance, on the other hand, is based on all the outcomes and how likely they are to occur. Variance weights the difference of each outcome from the mean outcome by its probability, and thus is a more comprehensive measure of variability than the range.

Risk Averse or Risk Lovers

What does it mean to say that a person is risk averse? 

Why are some people likely to be risk averse while others are risk lovers?

ANSWER

A risk-averse person has a diminishing marginal utility of income and prefers a certain income to a gamble with the same expected income. A risk lover has an increasing marginal utility of income and prefers an uncertain income to a certain income when the expected value of the uncertain income equals the certain income. To some extent, a person’s risk preferences are like preferences for different vegetables. They may be inborn or learned from parents or others, and we cannot easily say why some people are risk averse while others like taking risks. But there are some economic factors that can affect risk preferences. For example, a wealthy person is more likely to take risks than a moderately well-off person, because the wealthy person can better handle losses. Also, people are more likely to take risks when the stakes are low (like office pools around NCAA basketball time) than when stakes are high (like losing a house to fire).

Complementary Good or Substitute Good | Which of the following combinations of goods are complements and which are substitutes?

Which of the following combinations of goods are complements and which are substitutes?
Can they be either in different circumstances? Discuss.

a.  a mathematics class and an economics class

b.  tennis balls and a tennis racket

c.  steak and lobster

d.  a plane trip and a train trip to the same destination

e.  bacon and eggs

ANSWER  

a.  a mathematics class and an economics class

If the math class and the economics class do not conflict in scheduling, then the classes could be either complements or substitutes. Math is important for understanding economics, and economics can motivate mathematics, so the classes could be complements. If the classes conflict or the student has room for only one in his schedule, they are substitutes.

b.  tennis balls and a tennis racket

Tennis balls and a tennis racket are both needed to play tennis, thus they are complements.

c.  steak and lobster

Foods can both complement and substitute for each other. Steak and lobster can be substitutes, as when they are listed as separate items on a menu. However, they can also function as complements because they are often served together.

d.  a plane trip and a train trip to the same destination

Two modes of transportation between the same two points are substitutes for one another.

e.  bacon and eggs

Bacon and eggs are often eaten together and are complementary goods in that case. However, in relation to something else, such as pancakes, bacon and eggs can function as substitutes.

Indifference Curve | Explain why two indifference curves cannot intersect.

Explain why two indifference curves cannot intersect.

ANSWER

The figure below shows two indifference curves intersecting at point A. We know from the definition of an indifference curve that the consumer has the same level of utility for every bundle of goods that lies on the given curve. In this case, the consumer is indifferent between bundles A and B because they both lie on indifference curve U₁. Similarly, the consumer is indifferent between bundles A and C because they both lie on indifference curve U₂. By the transitivity of preferences this consumer should also be indifferent between C and B. However, we see from the graph that C lies above B, so C must be preferred to B because C contains more of Good Y and the same amount of Good X as does B, and more is preferred to less. But this violates transitivity, so indifference curves must not intersect.

Individual Preference | What are the four basic assumptions about individual preferences?

What are the four basic assumptions about individual preferences? 

Explain the significance or meaning of each.

ANSWER

(1) Preferences are complete: this means that the consumer is able to compare and rank all possible baskets of goods and services. 

(2) Preferences are transitive: this means that preferences are consistent, in the sense that if bundle A is preferred to bundle B and bundle B is preferred to bundle C, then bundle A is preferred to bundle C. 

(3) More is preferred to less: this means that all goods are desirable, and that the consumer always prefers to have more of each good. 

(4) Diminishing marginal rate of substitution: this means that indifference curves are convex, and that the slope of the indifference curve increases (becomes less negative) as we move down along the curve. As a consumer moves down along her indifference curve she is willing to give up fewer units of the good on the vertical axis in exchange for one more unit of the good on the horizontal axis. This assumption also means that balanced market baskets are generally preferred to baskets that have a lot of one good and very little of the other good.