Chapter 5 Applying Consumer Theory

Multiple Choice

Figure 5.1 1) Figure 5.1 shows Bobbys indifference map for juice and snacks. Also shown are three budget lines resulting from different prices for snacks assuming he has $20 to spend on these goods. Which of the following points are on Bobbys price-consumption curve? (a) (b) (c) (d) 10 snacks and 20 juices 10 snacks and 0 juices 10 snacks and 5 juices 10 snacks and 15 juices

Answer: D Difficulty: 0 Topic: Deriving Demand Curves Question Status: Revised

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2)

Figure 5.1 shows Bobbys indifference map for juice and snacks. Also shown are three budget lines resulting from different prices for snacks assuming he has $20 to spend on these goods. Which of the following points are on Bobbys demand curve for snacks? (a) (b) (c) (d) p = 2, q = 10 p = 2, q = 13 p = 2, q = 5 p = 1, q = 20

Answer: C Difficulty: 1 Topic: Deriving Demand Curves Question Status: Revised 3) Figure 5.1 shows Bobbys indifference map for juice and snacks. Also shown are three budget lines resulting from different prices for snacks. This information could be used to determine (a) (b) (c) (d) the slope of Bobbys demand curve for juice. the amount by which Bobbys demand curve for juice shifts when his income rises. the amount by which Bobbys demand curve for juice shifts when the price of snacks rises. All of the above.

Answer: C Difficulty: 1 Topic: Deriving Demand Curves Question Status: Revised 4) Figure 5.1 shows Bobbys indifference map for juice and snacks. Also shown are three budget lines resulting from different prices for snacks. As the price of snacks rises, Bobbys utility (a) (b) (c) (d) stays the same. increases. decreases. might change, but there is not enough information to determine.

Answer: C Difficulty: 0 Topic: Deriving Demand Curves Question Status: Revised 5) Figure 5.1 shows Bobbys indifference map for juice and snacks. Also shown are three budget lines resulting from different prices for snacks. Bobbys demand for snacks is (a) (b) (c) (d) unit elastic. elastic. inelastic. perfectly elastic.

Answer: C Difficulty: 2 Topic: Deriving Demand Curves Question Status: Revised

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6)

An individuals demand curve for a good can be derived by measuring the quantities selected as (a) (b) (c) (d) the price of the good changes. the price of substitute goods changes. income changes. all of the above.

Answer: A Difficulty: 0 Topic: Deriving Demand Curves Question Status: New 7) As the price of a good rises, the consumer will experience (a) (b) (c) (d) a desire to consume a different bundle. a decrease in utility. a southwesterly movement on the indifference map. All of the above.

Answer: D Difficulty: 1 Topic: Deriving Demand Curves Question Status: Revised 8) An increase in the price of a good causes (a) (b) (c) (d) a change in the slope of the budget line. an increase in the consumption of that good. a rightward shift of the demand curve for that good. a parallel rightward shift of the budget line.

Answer: A Difficulty: 1 Topic: Deriving Demand Curves Question Status: Revised 9) Suppose a graph is drawn to show a consumers preferences for football tickets and basketball tickets. The quantity of football tickets is measured on the horizontal axis. If the price-consumption curve is horizontal when the price of football tickets changes, then (a) (b) (c) (d) football tickets are an inferior good. the demand for football tickets is perfectly elastic. the demand for football tickets is unit elastic. the demand curve for football tickets will be horizontal.

Answer: C Difficulty: 2 Topic: Deriving Demand Curves Question Status: Revised

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10)

Suppose the quantity of x is measured on the horizontal axis. If the price consumption curve is vertical when the price of x changes, then the demand for x is (a) perfectly elastic. (b) perfectly inelastic. (c) unit elastic. (d) There is not enough information to determine the price elasticity of demand for x. Answer: B Difficulty: 2 Topic: Deriving Demand Curves Question Status: Revised

11)

A movement upward along an upward sloping Engel curve corresponds to (a) upward sloping indifference curves. (b) crossing indifference curves. (c) a rotation in the budget constraint. (d) a parallel shift in the budget constraint. Answer: D Difficulty: 1 Topic: How Changes in Income Shift Demand Curves Question Status: New

Figure 5.2 12) Figure 5.2 shows Larrys indifference map and budget lines for ham and pork. Which of the following statements is TRUE? (a) Pork is an inferior good. (b) Ham is an inferior good. (c) Neither pork nor ham is an inferior good. (d) Both ham and pork are inferior goods. Answer: B Difficulty: 1 Topic: How Changes in Income Shift Demand Curves Question Status: Revised

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13)

Figure 5.2 shows Larrys indifference map and budget lines for ham and pork. Which of the following statements is TRUE? (a) (b) (c) (d) Larrys Engel curve for pork will be upward sloping. Larrys Engel curve for pork will be downward sloping. Larrys Engel curve for pork will be backward bending. Larrys Engel curve for pork cannot be derived from the information provided.

Answer: A Difficulty: 1 Topic: How Changes in Income Shift Demand Curves Question Status: Revised 14) Figure 5.2 shows Larrys indifference map and budget lines for ham and pork. Which of the following statements is TRUE? (a) (b) (c) (d) Larrys demand curve for pork shifts rightward when his income increases. Larrys income elasticity of demand for pork is greater than zero. Pork is a normal good. All of the above.

Answer: D Difficulty: 2 Topic: How Changes in Income Shift Demand Curves Question Status: Revised 15) After Joyce and Larry purchased their first house, they made additional home improvements in response to increases in income. After a while, their income rose so much that they could afford a larger home. Once they realized they would be moving, they reduced the amount of home improvements. Their Engel curve for home improvements on their current home is (a) (b) (c) (d) negatively sloped. flat. positively sloped. backward bending.

Answer: D Difficulty: 2 Topic: How Changes in Income Shift Demand Curves Question Status: Revised 16) Suppose the quantity of x is measured on the horizontal axis. If the income consumption curve is vertical, then the income elasticity of demand for x is (a) (b) (c) (d) 0. 1. 1. There is not enough information to determine the income elasticity of demand for x.

Answer: A Difficulty: 2 Topic: How Changes in Income Shift Demand Curves Question Status: Revised

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17)

An inferior good exhibits (a) (b) (c) (d) a negative income elasticity. a downward sloping Engel curve. a decline in the quantity demanded as income rises. all of the above.

Answer: D Difficulty: 0 Topic: How Changes in Income Shift Demand Curves Question Status: New

Figure 5.3 18) When Johns income was low, he could not afford to dine out and would respond to a pay raise by purchasing more frozen dinners. Now that his income is high, a pay raise causes him to dine out more often and buy fewer frozen dinners. Which graph in Figure 5.3 best represents Johns Engel curve for frozen dinners? (a) (b) (c) (d) Graph A Graph B Graph C Graph D

Answer: A Difficulty: 2 Topic: How Changes in Income Shift Demand Curves Question Status: Revised

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19)

When Johns income was low, he could not afford to dine out and would respond to a pay raise by purchasing more frozen dinners. Now that his income is high, a pay raise causes him to dine out more often and buy fewer frozen dinners. Which graph in Figure 5.3 best represents Johns Engel curve for dining out? (a) Graph A (b) Graph B (c) Graph C (d) Graph D Answer: B Difficulty: 2 Topic: How Changes in Income Shift Demand Curves Question Status: Revised

20)

Even though Marys income is very low, she makes sure that she purchases enough milk for her family to drink. As her income rises, she does buy more milk. Which graph in Figure 5.3 best represents Marys Engel curve for milk? (a) Graph A (b) Graph B (c) Graph C (d) Graph D Answer: C Difficulty: 2 Topic: How Changes in Income Shift Demand Curves Question Status: Revised

21)

When John was in college and his income was low, he drank Red Ribbon beer. As his income increased, he purchased better-quality beer and less Red Ribbon. Which graph in Figure 5.3 best represents Johns Engel curve for Red Ribbon beer? (a) Graph A (b) Graph B (c) Graph C (d) Graph D Answer: D Difficulty: 2 Topic: How Changes in Income Shift Demand Curves Question Status: Revised

22)

Which graph in Figure 5.3 best represents a good that is an inferior good at some income levels, and a normal good at other income levels? (a) Graph A (b) Graph B (c) Graph C (d) Graph D Answer: A Difficulty: 1 Topic: How Changes in Income Shift Demand Curves Question Status: Revised

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23)

Median household income is $50,000 per year. The typical household spends about $125 per year on milk, which has an income elasticity of about 0.07. From this information, we can conclude that (a) (b) (c) (d) milk is a luxury. milk is a Giffen good. the income effect from a change in the price of milk is very large. the income effect from a change in the price of milk is very small.

Answer: D Difficulty: 2 Topic: Effects of a Price Change Question Status: Revised 24) When the price of a good changes, the total effect of the price change on the quantities purchased can be found by comparing the quantities purchased (a) on the old budget line and the new budget line. (b) on the original indifference curve when faced with the original prices and when faced with the new prices. (c) on the new budget line and a hypothetical budget line that is a parallel shift back to the original indifference curve. (d) on the new indifference curve. Answer: A Difficulty: 2 Topic: Effects of a Price Change Question Status: Revised 25) When the price of a good changes, the substitution effect can be found by comparing the equilibrium quantities purchased (a) on the old budget line and the new budget line. (b) on the original indifference curve when faced with the original prices and when faced with the new prices. (c) on the new budget line and a hypothetical budget line that is a shift back to the original indifference curve parallel to the new budget line. (d) on the new indifference curve. Answer: B Difficulty: 2 Topic: Effects of A Price Change Question Status: Revised

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26)

When the price of a good changes, the income effect can be found by comparing the equilibrium quantities purchased (a) on the old budget line and the new budget line. (b) on the original indifference curve when faced with the original prices and when faced with the new prices. (c) on the new budget line and a hypothetical budget line that is a shift back to the original indifference curve parallel to the new budget line. (d) on the new indifference curve. Answer: C Difficulty: 2 Topic: Effects of a Price Change Question Status: New

27)

Suppose that frozen dinners were once a normal good for John, but now frozen dinners are an inferior good for him. Johns demand curve for frozen dinners (a) (b) (c) (d) has become steeper as a result. has become flatter as a result. has not changed as a result. has disappeared as a result.

Answer: A Difficulty: 2 Topic: Effects of a Price Change Question Status: Revised 28) One characteristic of a Giffen good is that it (a) (b) (c) (d) is a luxury good. is an inferior good. has an upward-sloping Engel curve. All of the above.

Answer: B Difficulty: 2 Topic: Effects of a Price Change Question Status: Revised 29) A Giffen good has (a) (b) (c) (d) a positive substitution effect. a negative income effect. a larger income effect than substitution effect. all of the above.

Answer: D Difficulty: 1 Topic: Effects of a Price Change Question Status: New

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30)

If a good is an inferior good, then its (a) (b) (c) (d) demand curve will be upward sloping. income effect reinforces the substitution effect. income elasticity is negative. Engel curve cannot be drawn.

Answer: C Difficulty: 2 Topic: Effects of a Price Change Question Status: Revised 31) Suppose Lisa spends all of her money on books and coffee. When the price of coffee decreases, the (a) (b) (c) (d) substitution effect on coffee is positive, and the income effect on coffee is positive. substitution effect on coffee is ambiguous, and the income effect on coffee is ambiguous. substitution effect on coffee is positive, and the income effect on coffee is ambiguous. substitution effect on coffee is ambiguous, and the income effect on coffee is positive.

Answer: C Difficulty: 1 Topic: Effects of a Price Change Question Status: Revised 32) In the case of a normal good (a) (b) (c) (d) demand curves always slope downward. the income effect and substitution effect are in the same direction. the Engel curve slopes upward. All of the above.

Answer: D Difficulty: 2 Topic: Effects of A Price Change Question Status: Revised

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Figure 5.4 33) Figure 5.4 shows Bobbys indifference map for soda and juice. B1 indicates his original budget line. B2 indicates his budget line resulting from a decrease in the price of soda. What change in quantity best represents his substitution effect? (a) (b) (c) (d) 3 10 15 7

Answer: A Difficulty: 2 Topic: Effects of a Price Change Question Status: Revised 34) Figure 5.4 shows Bobbys indifference map for soda and juice. B1 indicates his original budget line. B2 indicates his budget line resulting from a decrease in the price of soda. What change in quantity best represents his income effect? (a) (b) (c) (d) 3 10 15 7

Answer: D Difficulty: 2 Topic: Effects of a Price Change Question Status: Revised

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35)

Figure 5.4 shows Bobbys indifference map for soda and juice. B1 indicates his original budget line. B2 indicates his budget line resulting from an increase in the price of soda. From the graph, one can conclude that (a) (b) (c) (d) Bobby views soda as an inferior good. Bobbys demand for soda is perfectly inelastic. Bobby views soda as a normal good. the income elasticity of demand for soda is 1.

Answer: C Difficulty: 2 Topic: Effects of a Price Change Question Status: Revised 36) The Slutsky equation shows that, holding the total effect constant, the income effect will be larger for goods that (a) (b) (c) (d) have a smaller substitution effect. make up a larger percentage of a households budget. have perfectly inelastic demand curves. All of the above.

Answer: B Difficulty: 2 Topic: Effects of a Price Change Question Status: Revised 37) Suppose that the interest rate paid to savers increases. As a result, Tom wishes to save less. This suggests that, for Tom, (a) (b) (c) (d) the substitution effect is greater than the income effect. the income effect is greater than the substitution effect. utility maximization is not occurring. future consumption is a luxury.

Answer: B Difficulty: 2 Topic: Effects of a Price Change Question Status: Revised 38) Suppose that the interest rate paid to savers increases. As a result, Tom wishes to save more. This suggests that, for Tom, (a) (b) (c) (d) the substitution effect is greater than the income effect. the income effect is greater than the substitution effect. utility maximization is not occurring. future consumption is a luxury.

Answer: A Difficulty: 2 Topic: Effects of a Price Change Question Status: Revised

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39)

Due to inflation, nominal prices are usually (a) (b) (c) (d) equal to real prices. smaller than real prices. larger than real prices. a constant proportion different from real prices.

Answer: C Difficulty: 1 Topic: Cost-of-Living Adjustments Question Status: New 40) A consumer price index adjustment overcompensates for inflation because it ignores (a) (b) (c) (d) the income effect when relative prices change. the substitution effect when relative prices change. that some goods are inferior. that the substitution effect may offset the income effect.

Answer: B Difficulty: 0 Topic: Cost-of-Living Adjustments Question Status: Revised 41) Employing a fixed-weight index like the Consumer Price Index to adjust a persons salary in response to inflation will overcompensate this person because doing so will allow this person to (a) (b) (c) (d) buy the same bundle of goods as he did before the inflation. achieve a higher level of utility than he did before the inflation. achieve the same level of utility as before the inflation. buy more of all goods.

Answer: B Difficulty: 2 Topic: Cost-of-Living Adjustments Question Status: Revised 42) Under which of the following conditions will there be no substitution bias in the CPI? (a) (b) (c) (d) Indifference curves are convex. Indifference curves are L shaped. Indifference curves are linear. Indifference curves are downward sloping.

Answer: B Difficulty: 2 Topic: Cost-of-Living Adjustments Question Status: Revised

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43)

Under which of the following conditions will there be no substitution bias in the CPI? (a) (b) (c) (d) Lower-priced goods increase in price by a greater percentage than do higher-priced goods. Higher-price goods increase in price by a greater percentage than do lower-priced goods. All goods change in price by the same amount. All goods change in price by the same percentage.

Answer: D Difficulty: 2 Topic: Cost-of-Living Adjustments Question Status: Revised 44) A true cost-of-living adjustment in response to a change in prices would compensate consumers so that they will be able to (a) (b) (c) (d) purchase the same bundle they purchased before prices changed. achieve the same level of utility they did before prices changed. face the same choices they did before prices changed. achieve an increase in utility that is equal to the rate of inflation.

Answer: B Difficulty: 2 Topic: Cost-of-Living Adjustments Question Status: Revised 45) The price of leisure (a) (b) (c) (d) is the same for everyone. depends on the number of hours worked. is measured as foregone earnings. is immeasurable.

Answer: C Difficulty: 1 Topic: Deriving Labor Supply Curves Question Status: New 46) If a person supplies more hours of labor in response to a wage increase, then (a) (b) (c) (d) the substitution effect is greater than the income effect. the income effect is greater than the substitution effect. the income effect equals the substitution effect. the person is not maximizing utility.

Answer: A Difficulty: 1 Topic: Deriving Labor Supply Curves Question Status: Revised

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47)

If a person supplies less hours of labor in response to a wage increase, then (a) (b) (c) (d) the substitution effect is greater than the income effect. the income effect is greater than the substitution effect. the income effect equals the substitution effect. the person is not maximizing utility.

Answer: B Difficulty: 1 Topic: Deriving Labor Supply Curves Question Status: Revised 48) A backward-bending labor supply curve implies that (a) the substitution effect dominates the income effect at higher wage rates but not at lower wage rates. (b) the substitution effect dominates the income effect at lower wage rates but not at higher wage rates. (c) leisure is an inferior good. (d) workers are irrational. Answer: B Difficulty: 1 Topic: Deriving Labor Supply Curves Question Status: Revised 49) If Bobby thinks that leisure is an inferior good, then his labor supply curve (a) (b) (c) (d) is backward bending. is always negatively sloped. is always positively sloped. does not exist.

Answer: C Difficulty: 1 Topic: Deriving Labor Supply Curves Question Status: Revised 50) A tax cut that raises the after-tax wage rate will most likely result in more hours worked if (a) (b) (c) (d) tax rates were low already. the relevant portion of the labor supply curve is upward sloping. the relevant portion of the labor supply curve is downward sloping. workers can be easily fooled.

Answer: B Difficulty: 1 Topic: Deriving Labor Supply Curves Question Status: Revised

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51)

If workers are in the backward-bending section of their labor supply curves, than an increase in the income tax rate will (a) (b) (c) (d) increase the tax revenue and increase the number of hours worked. increase the tax revenue and decrease the number of hours worked. decrease the tax revenue and increase the number of hours worked. decrease the tax revenue and decrease the number of hours worked.

Answer: A Difficulty: 2 Topic: Deriving Labor Supply Curves Question Status: Revised 52) In response to an increase in the wage rate, the substitution effect will cause a person to (a) (b) (c) (d) supply fewer hours of labor. supply more hours of labor. supply the same hours of labor. have a backward bend in her labor supply curve.

Answer: B Difficulty: 1 Topic: Deriving Labor Supply Curves Question Status: Revised 53) In response to an increase in the wage rate, the income effect will cause a person to (a) (b) (c) (d) supply fewer hours of labor. supply more hours of labor. supply the same hours of labor. have a horizontal labor supply curve.

Answer: A Difficulty: 1 Topic: Deriving Labor Supply Curves Question Status: Revised

1)

True/False/Explain
If the price-consumption curve is upward sloping when the price of the good measured on the horizontal axis changes, then the demand curve for that good will be upward sloping. Answer: False. An upward-sloping price-consumption curve indicates that as the price of the good falls, more of both goods will be purchased. So, the demand curve for the good measured on the horizontal axis slopes downward. Difficulty: 1 Topic: Deriving Demand Curves Question Status: Revised

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2)

If a consumer is compensated for the income effect that occurs when the price of a good increases, then his demand curves can never slope upward. Answer: True. The demand curve would only include the substitution effect. Even for Giffen goods, dq/dp is negative holding utility constant. Difficulty: 1 Topic: Effects of a Price Change Question Status: Revised

3)

A good may be inferior at some income levels and normal at others. Answer: True. A consumer may demand more of the good at low income levels and less of the good at higher income levels. Hamburger or macaroni and cheese dinners may be examples of such goods. Difficulty: 1 Topic: Effects of a Price Change Question Status: New

4)

If the Engel curve for a good is upward sloping, the demand curve for that good must be downward sloping. Answer: True. If the Engel curve is upward sloping, the good is normal. As a result, the income effect will reinforce the substitution effect and guarantee a downward-sloping demand curve. Difficulty: 1 Topic: Effects of a Price Change Question Status: Revised

5)

Inflation over time necessarily makes consumers worse off. Answer: False. Wages also increase over time. Workers may earn the price of some goods in less time than in the past. Difficulty: 1 Topic: Cost-of-Living Adjustments Question Status: New

6)

Using the CPI to compensate workers for inflation is appropriate because, in the face of a change in relative prices, people should be allowed to purchase the same bundle as they did before the price changes. Answer: False. This assumes that people would still prefer the original bundle. Because they are facing a new set of relative prices, compensating people so that they could purchase the original bundle will allow them to be able to achieve a higher level of utility than they did before the price changes. Difficulty: 1 Topic: Cost-of-Living Adjustments Question Status: Revised

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7)

A tax cut will unambiguously lower income-tax revenue. Answer: False. It depends on how the quantity of labor supplied responds to the increase in the aftertax wage rate. If the income effect dominates, the quantity of labor supplied falls and so will tax revenue. If the substitution effect dominates, the quantity of labor supplied increases, and income-tax revenue could increase. This is a function of whether the after-tax wage was low already because the tax rate was relatively high. Difficulty: 1 Topic: Deriving Labor Supply Curves Question Status: Revised

Problems

Figure 5.5 1) Suppose Joe earns $1,000 in year 1 and $0 in year 2. Any amount he saves will earn interest at a rate of 10%. Draw Joes budget line. (Hint: He can either consume all $1000 this year or consume nothing this year and have $1,100 next year.) Assuming convex indifference curves, show that an increase in the rate of interest can cause Joes savings to either increase or decrease. Explain in terms of income and substitution effect. Answer: See Figure 5.5. On the graph, his original bundle is e1 so that his savings equal 1000 C1*. A higher interest rate rotates the budget line so that, depending on the shape of his indifference map, he may choose either e2, which means savings increase, or e3, which means savings decrease. One plus the interest rate represents the price of current consumption. A higher interest rate has two effects. The substitution effect means that Joe will save more because current consumption has become more expensive. The income effect says Joe will save less because, with the higher interest rate, lower savings could actually generate more future consumption. Difficulty: 1 Topic: Effects of a Price Change Question Status: Revised

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2)

Explain what the slope of the income consumption curve shows about the income elasticity of demand. Answer: A positive slope of the income consumption curve is associated with a positive income elasticity of demand and a negatively sloped income consumption curve is associated with a negative income elasticity of demand. The income consumption curve represents how consumption changes with an increase in income. An upward sloping income consumption curve represents an increase in consumption as income rises, as does a positive income elasticity. Difficulty: 1 Topic: How Changes in Income Shift Demand Curves Question Status: New

3)

Many manufacturers sell products labeled as having imperfections at a discount at their factory outlets but do not ship these imperfect goods to regular retail outlets. Why? Answer: There is some substitutability between the goods, but imperfects sell for a lower price. Suppose, for example, the good sells for $2, but imperfects sell for $1. Both goods cost the same to ship, say $1. As a result, the relative price of an imperfect at a factory outlet is (1/2) but rises to (2/3) at the retail outlet, where imperfects will not sell because of the higher relative price. Difficulty: 1 Topic: Effects of a Price Change Question Status: Revised

4)

Why cant all goods be inferior? Answer: If all goods were inferior, an increase in income would lead to a decline in the quantity demanded for all goods. This, however, would leave the consumer below the budget line and therefore not achieving the highest utility possible. Difficulty: 1 Topic: How Changes in Income Shift Demand Curves Question Status: Revised

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Figure 5.6 5) Figure 5.6 shows three different Engel curves. Rank them in terms of income elasticity. Answer: Engel curve A implies that a certain level of income is required before any of the good is purchased. Engel curve B implies that the quantity demanded is proportional to income (unit elastic). Engel curve C implies that the good is a necessity since it would be consumed even if income were zero. Thus _A > _B > _C. Difficulty: 2 Topic: How Changes in Income Shift Demand Curves Question Status: Revised 6) When income increases by 1%, the quantity demanded of a good decreases by 2%. What is the income elasticity of the good? Is the good normal or inferior? Why? Answer: The income elasticity is 2. The good is inferior because the income elasticity is negative. Difficulty: 1 Topic: How Changes in Income Shift Demand Curves Question Status: Revised 7) Why would you expect the demand for diamond jewelry to fall faster than plastic, costume jewelry when all incomes fall? Answer: The income elasticities differ for the two goods. Diamond jewelry most likely has a larger income elasticity than costume jewelry. Difficulty: 1 Topic: How Changes in Income Shift Demand Curves Question Status: New

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Figure 5.7 8) Draw budget constraints, indifference curves, and the income consumption curve for a good that has an income elasticity that is perfectly inelastic. Answer: See Figure 5.7. Difficulty: 1 Topic: How Changes in Income Shift Demand Curves Question Status: Revised

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Figure 5.8 9) Draw two graphs, one directly above the other. On the upper graph, label the vertical axis Good X and label the horizontal axis Good Y. On the lower graph, label the vertical axis the Price of good Y and label the horizontal axis Good Y. In the upper graph, show the income and substitution effects of a decrease in the Price of good Y when Y is a Giffen good. Draw the corresponding demand curve for Good Y in the lower graph. Answer: See Figure 5.8. Point A is the original consumption point. The movement from point A to point B is the substitution effect. The movement from point B to point C is the income effect. Difficulty: 2 Topic: Deriving Demand Curves Question Status: Revised

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Figure 5.9 10) Figure 5.9 shows a consumers indifference curves for soda and all other goods. Assuming a budget of $100, derive the consumers demand for soda for prices of $4 and $10 per case of soda. Estimate the price elasticity of demand for soda. Answer: At a price of $4, 15 cases are purchased, At a price of $10, 6 cases are purchased. In both cases, the same total amount, $60, is spent on soda. This implies unit elasticity. Difficulty: 1 Topic: Deriving Demand Curves Question Status: Revised 11) Use the Slutsky equation to show that a Giffen good must be an inferior good, BUT an inferior good need not be a Giffen good. Answer: The Slutsky equation may be written as dQ/dpTotal = dQ/dpsubs _(dQ/dI). For a Giffen good, dQ/dpTotal is positive, which implies that _(dQ/dI) must be positive and large enough to offset dQ/dpsubs, which is always negative. For any inferior good, however, _(dQ/dI) is positive but not necessarily large enough to make dQ/dpTotal positive. Difficulty: 1 Topic: Deriving Demand Curves Question Status: Revised

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12)

Suppose the typical consumer only purchases food and clothing, and her utility can be expressed as U = F*C. Currently, food costs $5 per unit and clothing costs $2 per unit. Her income is $70. If the price of food increases to $6, compare the resulting Laspyres price index with a true cost of living index. Answer: Maximizing utility subject to the initial constraint (5F + 2C = 70) yields C/F = 5/2 or F = 7 and C = 17.5. The Laspyres price index calculates the ratio of the income necessary to achieve the original bundle relative to the original income. In this case [(6*7) + (2*17.5)]/70 = 1.10. The true cost of living index calculates the ratio of the income necessary to achieve the original level of utility relative to the original income. Utility is held constant when C*F = 17.5*7 = 122.5. The consumer is on the new budget line when C/F = 3. Combining yields F = 6.39 and C = 19.17. At the new prices, this requires an income of 76.68 and a resulting cost of living index of 76.68/70 = 1.095. Difficulty: 2 Topic: Cost-of-Living Adjustments Question Status: Revised

Figure 5.10 13) Figure 5.10 shows an indifference map for a persons choices between leisure and consumption. Derive this persons labor supply curve for wage rates of $5, $10, and $15. Answer: This persons labor supply curve is downward sloping. The three coordinates for w,H are approximately (5,14), (10,11), and (15,9). Difficulty: 1 Topic: Deriving Labor Supply Curves Question Status: Revised

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Figure 5.11 14) Draw a graph with Goods Per Day on the vertical axis and Leisure Hours Per Day increasing from left to right on the horizontal axis. Show that a person who works can work fewer hours and increase utility when the wage rate increases. Answer: See Figure 5.11. Difficulty: 1 Topic: Deriving Labor Supply Curves Question Status: Revised 15) Suppose a persons utility for leisure (L) and consumption (Y) can be expressed as U = Y + L0.5. Show what happens to the persons labor supply curve when the income tax is cut from 70 percent to 30 percent. Denote hours worked as H and wage per hour as w. Answer: Since Y = net income, U = w(1 t)H + (24 H)0.5. Maximizing utility with respect to hours worked, H, yields H = 24 (2(1 t)w) 2. Any decrease in t would increase the number of hours worked. Note: this person is a workaholic. Even at a net wage of $1, this person only relaxes for 3/4 of an hour! Difficulty: 1 Topic: Deriving Labor Supply Curves Question Status: Revised 16) Suppose a persons utility for leisure (L) and consumption (Y) can be expressed as U = Y + L0.5. Assuming a wage rate of $10 per hour, show what happens to the persons labor supply curve when the person wins a lottery prize of $100 per day. Answer: Rearranging yields U = (Y* + 10H) + (24 H)0.5. Maximizing utility with respect to H yields H = 23.9975 hours. Note: H is not a function of Y* because the marginal utility of leisure is independent of income. Thus, the persons labor supply curve is not affected by winning the lottery. Difficulty: 2 Topic: Deriving Labor Supply Curves Question Status: Revised

Chapter 5

Applying Consumer Theory

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Suppose a persons utility for leisure (L) and consumption (Y) can be expressed as U = Y * L and this person has no non-labor income. Assuming a wage rate of $10 per hour, show what happens to the persons labor supply when the person wins a lottery prize of $100 per day. Answer: Rearranging yields U = (Y* + 10H) * (24 H) = 24Y* + 240H Y*H 10H2. Maximizing utility with respect to H yields dU/dH = 240 Y* 20H = 0. Before winning the lottery, Y* = 0, so H = 12. After winning the $100 per day lottery, Y* = 100, so H = 7. Winning the lottery reduces this persons quantity of labor supplied by 5 hours when w = $10. Difficulty: 2 Topic: Deriving Labor Supply Curves Question Status: Revised