Consumer Demand: Questions & Answers Q4.1

Chapter 4
CONSUMER DEMAND
QUESTIONS & ANSWERS

Q4.1
"The utility derived from consumption is intangible and unobservable. Therefore,

the utility concept has no practical value.@ Discuss this statement.
Q4.1
ANSWER
The utility derived from consumption is intangible, and therefore unobservable.
However, measurable influence on their purchase decisions. Through their revealed
preferences, consumers convey their evaluation of the value, or worth, of individual
products. While the value derived through consumption is intangible, it leads to
purchase decisions that can be monitored and responded to by firms.
Q4.2
Is an increase in total utility or satisfaction following an increase in income

inconsistent with the law of diminishing marginal utility?
Q4.2
ANSWER
No, the law of diminishing marginal utility states that the marginal utility derived
from consumption will eventually diminish as consumption increases during a given
time period. This means that the addition to total utility per dollar of income will
tend to fall as total income rises. Despite the fact that total utility, or well-being,
tends to rise with income, it is typical that the marginal utility derived per dollar of
income tends to fall as income rises -- as is predicted by the law of diminishing
marginal utility.
Q4.3
Prospective car buyers are sometimes confronted by sales representatives who argue
that they can offer a vehicle that is Ajust as good as a BMW, but at one-half the
price.@ Use the indifference concept to explain why the claims of the sales
representative are not credible.
Q4.3
ANSWER
If two products provide the same amount of satisfaction or utility, the consumer is
said to display indifference between the two. Indifference implies equivalence in the
eyes of the consumer. A consumer can be indifferent between goods and services
Presented by Suong Jian & Liu Yan, MGMT Panel , Guangdong University of Finance.
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Chapter 4
that are distinct in a physical or material sense. Similarly, a consumer can display
distinctly different preferences for goods and services that are similar in a physical or
material sense. What=s important in the case of consumer indifference is that two
products yield the same amount of satisfaction or well-being to the consumer.
This should make consumers skeptical of sales representative who argue that a
cheaper product is Ajust as good as@ a more expensive competitor. First of all,
cheaper substitutes seldom perform at the same high level as competing products
with a deservedly superior reputation. And second, it is important to remember that
when consumers buy a product, they purchase a whole range of attributes associated
with that product. For example, the BMW 760i four-door sedan is a $125,000
vehicle famous among car buffs for its awesome power, comfort, and styling.
Buyers of a BMW 760i four-door sedan not only enjoy the creature comforts of a
fine automobile, some also enjoy the Asnob appeal@ of owning a rare and exclusive
automobile that tells all onlookers that they are successful. While you and I might
think Asnob appeal@ is silly, some consumers have a different opinion, and who are
we to argue with consumer preferences?
Q4.4
Following a price change for Diet Coke, explain how retailers use sales information
to learn if Doritos snack chips represent a complement or substitute for Diet Coke.
Q4.4
ANSWER
Following a price change, companies use sales information to distinguish
complements from substitutes by noting the size and direction of effects on demand
for related products. Demand curves are downward sloping. As a result, when the
price of a product is decreased, sales of that product rise. At the same time, sales of
substitutes fall as customers switch to the now lower-priced alternative. When the
price of a product rises, sales of that product fall but sales of substitute products rise
as customers switch to the substitute=s relative bargain price. There is a positive
correlation between price changes and units sold when two products are substitutes.
Sales of substitutes change in the same direction of the price change for substitute
products.
Conversely, when the price of a product is decreased, sales of that product and
complements both rise. When the price of a product rises, sales of that product fall
as do sales of complementary products. There is an inverse correlation between
price changes and units sold when two products are complements.
Q4.5
Describe the income, substitution, and total effects on consumption following a price
decrease.
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Consumer Demand
Q4.5
ANSWER
The total effect on consumption following a price decrease consists of income and
substitution effects. First, consumers will tend to substitute the now relatively less
expensive products for its substitutes. This involves a movement along a given
indifference curve to a market basket consisting of a less expensive combination of
goods and services that provide the same utility and is called the substitution effect.
In addition, a decrease in the price of a product means that a given budget will allow
a greater total amount of goods and services to be purchased for consumption. As a
result, a price decrease has a secondary effect similar to a inccrease in income.
Q4.6
During the past 40 years the average price of a new single-family home has risen by
a factor of ten, making the cost of housing prohibitive for many Americans. Over the
same time frame, however, the number of units sold per year has more than doubled.
Are these data inconsistent with the idea of a downward-sloping demand curve for
new housing?
Q4.6
ANSWER
No, these data are consistent with a downward-sloping demand curve for new
housing. For most goods and services, the price charged is the most important
determinant of sales. Quantity demanded falls with a price increase, and rises with a
price decrease. In the case of housing, the quantity demanded would have fallen as
prices rose except for the overwhelming influence of rising incomes over time.
Housing is a normal good. Housing demand rises sharply during economic
expansions and contracts during recessions. Over long periods of time, housing
demand rises slowly and steadily as economic growth raises disposable income. It is
vital that students separate out price and income effects when considering the
demand for housing and other products.
Q4.7
What would an upward-sloping demand curve imply about the marginal utility
derived from consumption? Why aren't upward sloping demand curves observed in
the real world?
Q4.7
ANSWER
The law of diminishing marginal utility states that the marginal utility derived will
fall as the consumption of a given product increases during a given time interval.
This gives rise to a downward sloping demand curve for all goods and services. For
a given demand curve to be upward sloping, an increasing marginal utility of
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Chapter 4
consumption would have to be operative. This is counter to human nature. Despite
myths that sometimes arise concerning the pricing of some luxury goods, like
perfume, there is no real-world evidence of upward sloping demand curves.
In this regard, it is worth emphasizing the fact that an upward sloping demand
curve implies that higher prices lead to an increase in quantity demanded. Under
such a wonderful circumstance, firms would have an incentive to charge higher and
higher prices (Ato infinity and beyond!@). Nothing would limit the firms ability to
gain revenues by raising prices. In the real world, higher prices eventually result in
some buyers being priced out of the market and to an eventual downturn in revenues.
Q4.8
How is a price-consumption curve related to a demand curve?
Q4.8
ANSWER
If income and the prices of other goods and services are held constant, a reduction in
the price of a given consumption item causes consumers to choose different market
baskets. The various market baskets that maximize utility at different prices for a
given item trace out the consumer=s price-consumption curve. For example, the
price-consumption curve shows how the optimal consumption of both goods and
services are affected by changing prices for services. A similar price-consumption
curve could be used to illustrate how the optimal consumption of both goods and
services are affected by changing prices for goods. On the other hand, the demand
curve for services shows how the quantity demanded of services rises in a response
to a fall in the price for services. A similar individual demand curve could be used to
illustrate how the quantity demanded of goods rises in a response to a fall in prices
for goods.
Q4.9
Individual consumer demand declines for inferior goods as personal income

increases because consumers replace them with more desirable alternatives. Is an
inverse relation between demand and national income likely for such products?
Q4.9
ANSWER
No, not usually. Theoretically, it is plausible that the aggregate demand for some
goods and services might be counter-cyclical, actually rising during a business
recession and falling during an economic boom. After all, if individual consumers
shift from hamburger to steak as incomes rise, wouldn't it seem reasonable to expect
hamburger demand to rise with a fall in income? The answer seems to be yes and no.
Yes, as incomes rise, demand from high-income individuals declines for Ainferior@
goods like hamburger, bus rides, and blue jeans as these consumers switch to more
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Consumer Demand
desirable substitutes such as porterhouse steak, automobiles, and designer clothing.
However, as incomes rise, other low-income consumers move up the economic
ladder. Perhaps for the first time, they are now able to afford hamburger, bus rides,
and blue jeans. As a result, economy wide demand for so-called inferior goods may
actually rise as income levels increase, albeit at a much slower pace than demand for
other, more desirable products.
Despite a lack of empirical evidence, the possibility of an inverse relation
between aggregate product demand and income has intrigued economists for a
number of years. This interest was originally created by an anomaly called the
Apotato paradox.@ As legend has it, a Victorian economist named Robert Giffen
discovered that the potato crop failure of 1845 so depressed Irish incomes that the
poor had to actually increase their consumption of the now higher-priced potatoes.
Because they had to spend so much on potatoes, a necessary staple, the poor couldn't
afford meat or other substitutes and became even more dependent than before on
potatoes. Thus, potatoes became known as the classic case of the inferior or,
AGiffen,@ good. However, empirical evidence casts serious doubt on the credibility
of such a chain of events. After studying the historical record, economists Gerald
Dwyer and Cotton Lindsay found little support for the notion that the consumption of
potatoes in Ireland increased during this period. So widespread were the effects of
the fungus Phytophthora infestans that it destroyed roughly one-half of the 1845
potato crop in Ireland after inflicting serious damage in America, in England, and on
the Continent. After September 1846 and until harvest time in August of the
following year, few potatoes could be bought at any price. Without imports and with
a decrease in domestic supply, how could potato consumption by the poor possibly
have risen during the Irish potato famine? Moreover, there is no evidence that low
potato prices during good years had a depressing effect on potato consumption by the
poor, as would be necessary to classify potatoes as an inferior good. Therefore, it is
only reasonable to conclude that the increase in potato prices and the decrease in
income caused by the Irish potato famine resulted in a decline in the aggregate
consumption of potatoes. As is typical for goods in general, a positive relation
between potato demand and economy wide income seems to hold. Despite the
legend of the potato paradox, concrete evidence of an inverse relation between
aggregate demand and income remains elusive.
(See: Gerald P. Dwyer, Jr. and Cotton M. Lindsay, ARobert Giffen and the
Irish Potato,@ American Economic Review, March 1984, 188-192.)
Q4.10
Throughout much of the United States, high-wage workers shun public transit and
drive their cars to work. At the same time, these same high-income individuals often
support massive subsidies for public transit. Use the concept of revealed preference
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Chapter 4
to explain the public demand for transportation. Can you explain this somewhat
confusing consumer behavior by high-income individuals?
Q4.10
ANSWER
High-wage workers often shun public transit and drive their cars to work. This stems
from the fact that time in transit is a compelling consideration for such workers.
Getting where they need to go, and getting there on time, matter much more than the
out-of-pocket costs associated with driving to work. For example, Kobe Bryant=s
time is valuable, and he drives to work. His time is much too valuable to be spent
waiting for the bus.
At the same time, it is fascinating to note the almost universal political support
for subsidized mass transit among high-income individuals. While high-income
individuals have a documented revealed preference for driving to work, they prefer
that others, including the less fortunate, take public transit. This makes economic
sense from the standpoint that subsidized mass transit might reduce road and parking
congestion, and thereby make driving to work easier for high-income individuals.
these same high-income individuals often support massive subsidies for public transit.
On the other hand, it is less obvious why high-income individuals might support
woefully underutilized mass transit. Perhaps they view support for such mass transit
as a type of income transfer to the poor and other beneficiaries of mass transit
(government employees, equipment manufacturers, and so on).
SELF-TEST PROBLEMS & SOLUTIONS

STP4.1
Budget Allocation. Consider the following data:

Goods (G)
Services (S)
Units
Total Utility
Units
Total Utility
150
100
275
190
375
270
450
340
500
400
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Consumer Demand
STP4.1
A.
Construct a table showing the marginal utility derived from the consumption of
goods and services. Also show the trend in marginal utility per dollar spent
(the MU/P ratio) if PG = $25 and PS = $20.
B.
If consumption of three units of goods is optimal, what level of services

consumption could also be justified?
C.
If consumption of five units of services is optimal, what level of goods

D.
Calculate the optimal allocation of a $150 budget. Explain.
SOLUTION
A.
GOODS (G)
SERVICES (S)
Units
Total
Utility
Marginal
Utility
MU/PG =
MU/$25
Units
Total
Utility
Marginal
Utility
MU/PS =
MU/$20
--
--
--
--
150
150
6.00
100
100
5.00
275
125
5.00
190
90
4.50
375
100
4.00
270
80
4.00
450
75
3.00
340
70
3.50
500
50
2.00
400
60
3.00
B.
S = 3. When 3 units of goods are purchased, the last unit consumed generates 100
utils of satisfaction at a rate of 4 utils per dollar. Consumption of 3 units of services
could also be justified on the grounds that consumption at that level would also
generate 4 utils per dollar spent on services.
C.
G = 4. When 5 units of services are purchased, the last unit consumed generated 60
utils of satisfaction at a rate of 3 utils per dollar. Consumption of 4 units of goods
could be justified on the grounds that consumption at that level would also generate 3
utils per dollar spent on goods.
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Chapter 4
D.
G = 3 and S = 3.75. The optimal allocation of a $100 budget involves spending

according to the highest marginal utility generated per dollar of expenditure. First,
one unit of goods would be purchased since it results in 6 utils per dollar spent. Then,
one units of services and another unit of goods would be purchased, each yielding 5
utils per dollar. Then , a third unit of both goods and services would be purchased,
thus yielding 4 utils per dollar. With thee units of goods and three units of services,
a total of $75 dollars will have been spent on goods and $60 on services. This totals
$135 in expenditures, and leaves $15 unspent from a $150. budget. Assuming that
partial units can be consumed, $15 is enough to buy an additional 0.75 units of
services.
STP4.2
Individual Demand Curve. Alex P. Keaton is an ardent baseball fan. The following
table shows the relation between the number of games he attends per month during
the season and the total utility he derives from baseball game consumption:
Number of Baseball Games per Month
Total Utility
50
90
120
140
150
A.
Construct a table showing Keaton's marginal utility derived from baseball

game consumption.
B.
At an average ticket price of $25, Keaton can justify attending only one game
per month. Calculate Keaton=s cost per unit of marginal utility derived from
baseball game consumption at this activity level.
C.
If the cost/marginal utility trade-off found in part B represents the most Keaton
is willing to pay for baseball game consumption, calculate the prices at which
he would attend two, three, four, and five games per month.
D.
Plot Keaton's baseball game demand curve.
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Consumer Demand
STP4.2
SOLUTION
A.
Number of Baseball
Games Per Month
Total
Utility
Marginal
Utility
--
50
50
90
40
120
30
140
20
150
10
B.
At one baseball game per month, MU = 50. Thus, at a $25 price per baseball game,
the cost per unit of marginal utility derived from baseball game consumption is
P/MU = $25/50 = $0.50 or 504 per util.
C.
At a maximum acceptable price of 504 per util, Keaton's maximum acceptable price
for baseball game tickets varies according to the following schedule:
D.
Total Utility
Marginal
Utility
MU = U/G
Maximum
Acceptable
price
at 504 per MU
--
--
50
50
$25.00
90
40
20.00
120
30
15.00
140
20
10.00
150
10
5.00
Number
of Games
Per Month
Keaton's baseball ticket demand curve is:

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Chapter 4
PROBLEMS & SOLUTIONS

P4.1
A.
Marginal Utility. Complete the following table, which describes the demand
for services:
Price
Units
Total
Utility
Marginal
Utility
Price/Marginal
Utility
$80
---
---
75
100
70
180
65
240
60
280
55
300
B.
How does an increase in consumption affect marginal utility and the

price/marginal utility ratio?
C.
What is the optimal level of services consumption if the marginal utility derived
from the consumption of goods costs $1 per util?
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Consumer Demand
4.1
SOLUTION
A.
Price
Total
Units
Total
Utility
Marginal
Utility
Price/Marginal
Utility
$75
100
100
$0.75
70
180
80
0.875
65
240
60
1.08
60
280
40
1.50
55
300
20
2.75
B.
The marginal utility derived from goods consumption falls as the number of units
consumed increases. This follows from the law of diminishing marginal utility.
Indeed, marginal utility is falling so rapidly that the P/MU ratio increases as the
number of units consumed expands. Despite falling prices, the marginal cost of
utility derived from services consumption is rising.
C.
S = 2 units of services should be purchased if the marginal cost of utility derived

from the consumption of services is $1 per util. The first unit of services consumed
involves a cost of 754 per util. The second unit of services consumed involves a cost
of 804 per util. Both represent relative bargains. However, a third unit of services
would involve a price-utility tradeoff of $1.08 per util. At a marginal cost of $1 per
util, services consumption would represent the better bargain.
P4.2
Utility Theory. Determine whether each of the following statements is true or false.
Explain why.
A.
According to the theory of consumer behavior, more is always better.
B.
Consumer must understand how much one product is preferred over another in
order to rank-order consumption alternatives.
C.
A market basket is a descriptive statement that relates satisfaction or

well-being to the consumption of goods and services.
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Chapter 4
D.
The nonsatiation principle abstracts from time and place considerations.
E.
Marginal utility measures the consumer's overall level of satisfaction derived

from consumption activities
P4.2
SOLUTION
A.
True. Consumer behavior theory rests upon the Amore is better@ assumption
regarding the utility tied to consumption. All goods and services are desirable in the
sense of being able to satisfy consumer wants. As a result, consumers will always
prefer more to less of any good or service.
B.
False. The consumer=s understanding of ordinal utility makes possible a rank

ordering of preferred goods and services. Notice that knowledge concerning
complete consumer preferences does not necessarily include understanding about
how much one product is preferred over another.
C.
False. A utility function is a descriptive statement that relates satisfaction or

well-being to the consumption of goods and services.
D.
True. At any specific place and time, consumers do become sated. Therefore, the
nonsatiation principle involves a certain amount of abstraction from time and place
considerations. It is best considered within the context of money income where more
money brings additional satisfaction or well-being.
E.
False. Whereas total utility measures the consumer's overall level of satisfaction
derived from consumption activities, marginal utility measures the added satisfaction
derived from a one-unit increase in consumption of a particular good or service,
holding consumption of other goods and services constant.
P4.3
Law of Diminishing Marginal Utility. Indicate whether each of the following

statements is true or false. Explain why.
A.
The law of diminishing marginal utility states that as an individual increases

consumption of a given product within a set period of time, the utility gained
from consumption eventually declines.
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Consumer Demand
B.
When prices are held constant, a diminishing marginal utility for consumption
decreases the cost of each marginal unit of satisfaction.
C.
Marginal utility measures the added satisfaction derived from a one-unit

increase in consumption, holding consumption of other goods and services
constant.
D.
When goods are relatively scarce, the law of diminishing marginal utility
means that the added value of another unit of goods will be small in relation to
the added value of another unit of services.
E.
The law of diminishing marginal utility gives rise to a downward-sloping

demand curve for all goods and services.
P4.3
SOLUTION
A.
False. In general, the law of diminishing marginal utility states that as an individual
increases consumption of a given product within a set period of time, the marginal
utility gained from consumption eventually declines.
B.
False. When prices are held constant, a diminishing marginal utility for consumption
increases the cost of each marginal unit of satisfaction.
C.
True. Whereas total utility measures the consumer's overall level of satisfaction
derived from consumption activities, marginal utility measures the added satisfaction
derived from a one-unit increase in consumption of a particular good or service,
holding consumption of other goods and services constant.
D.
False. When goods are relatively scarce, the law of diminishing marginal utility
means that the added value of another unit of goods will be large in relation to the
added value of another unit of services.
E.
True. This law gives rise to a downward-sloping demand curve for all goods and
services.
P4.4
Indifference Curves. Suggest briefly whether each of the following statements about
indifference curves that show preferences between goods and services is true or false
and defend your answer.
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Chapter 4
A.
Consumers prefer higher indifference curves that represent greater

combinations of goods and services to lower indifference curves that represent
smaller combinations of goods and services.
B.
Indifference curves slope downward because if the quantity of one consumer

product is reduced, the quantity of the other must also decrease to maintain the
same degree of utility.
C.
The slope of an indifference curve shows the rate at which consumers are
willing to tradeoff goods and services.
D.
The fact that indifference curves do not intersect stems from the Amore is
better@ principle.
E.
Indifference curves bend inward (are concave to the origin) because if goods
are relatively abundant, the added value of another unit of goods will be small
in relation to the added value of another unit of services.
P4.4
SOLUTION
A.
True. Consumers prefer more to less, so they prefer higher indifference curves that
represent greater combinations of goods and services to lower indifference curves
that represent smaller combinations of goods and services.
B.
False. Indifference curves slope downward. This stems from the fact that the slope
of an indifference curve shows the tradeoff involved between goods and services.
Because consumers like both goods and services, if the quantity of one is reduced,
the quantity of the other must increase to maintain the same degree of utility. .
C.
True. The slope of an indifference curve shows the rate at which consumers are
willing to tradeoff goods and services. For example, when goods are relatively
scarce, the law of diminishing marginal utility means that the added value of another
unit of goods will be large in relation to the added value of another unit of services.
Conversely, when goods are relatively abundant, the added value of another unit of
goods will be small in relation to the added value of another unit of services.
D.
True. Indifference curves do not intersect. Holding goods constant, an indifference

curve involving a greater amount of services must give greater satisfaction.
Similarly, holding services constant, an indifference curve involving a greater
amount of goods must give greater satisfaction. This stems from the fact that goods
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Consumer Demand
and services both provide consumer benefits, and reflects the Amore is better@
principle.
E.
True. Indifference curves bend inward (are concave to the origin). For example,
when goods are relatively scarce, the law of diminishing marginal utility means that
the added value of another unit of goods will be large in relation to the added value
of another unit of services. Conversely, when goods are relatively abundant, the
added value of another unit of goods will be small in relation to the added value of
another unit of services.
P4.5
Budget Constraints. Holding all else equal, indicate how each of the following
changes would affect a budget constraint that limits consumption of goods (Y) and
services (X). Explain your answer.
A.
Deflation that uniformly drops the price of all goods and services.
B.
Inflation that consistently increases the price of all goods and services.
C.
Technical change that reduces the price of goods, but leaves the price of
services unchanged.
D.
Economic growth that boosts the level of disposable income.
E.
Government-mandated health care coverage for workers that boosts the price
of goods by 3% and increases the price of services by 5%.
P4.5
SOLUTION
A.
Deflation that drops the price of all goods and services results in a parallel rightward
(outward) shift in the budget constraint. Holding income constant, lower prices
make it possible for consumers to buy more goods and services with the same total
amount of spending. This beneficial impact on consumption is similar to that
following an increase in income.
B.
Inflation that increases the price of all goods and services results in a parallel
leftward (inward) shift in the budget constraint. Holding income constant, higher
prices reduce the amount of goods and services that consumers can buy with a fixed
amount of spending. This harmful impact on consumption is similar to that
following a decrease in income.
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Chapter 4
C.
Technical change that reduces the price of goods, but leaves the price of services
unchanged results in an outward rotation of the budget constraint along the goods
(Y) axis. After such a change, the budget line intersects the Y axis at a higher point,
indicating that a greater amount of goods can be purchased with a fixed budget.
The amount of services that can be purchased for a fixed amount is unaffected by
such a change, and the X intercept (services axis) of the budget constraint is
unaffected by such a change.
D.
Economic growth that boosts the level of disposable income results in a parallel
rightward (outward) shift in the budget constraint. Holding prices constant, growing
income makes it possible for consumers to buy more goods and services with the
same total amount of spending. This beneficial impact on consumption is similar to
that following deflation that drops the price of all goods and services.
E.
Government-mandated health care coverage for workers that boosts the price of
goods by 3% and increases the price of services by 5% will have a negative impact
on consumption of both goods and services, but the negative impact will be worse in
the case of services. Following such a change, the relative price of services will rise
relative to the price of goods. The new budget line will move inward 3% along the
X axis reflecting the fact that a fixed budget will only be able to buy 97% of the
previously affordable goods. The new budget line will move inward 5% along the Y
axis reflecting the fact that a fixed budget will only be able to buy 95% of the
previously affordable services. The net effect is similar to a decrease in income
followed by a unilateral increase in the price of services.
P4.6
Budget Allocation. Consider the following data:

Goods (G)
Services (S)
Units
Total Utility
Units
Total Utility
100
70
160
124
210
175
250
220
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Consumer Demand
5
P4.6
275
250
A.
Construct a table showing the marginal utility derived from the consumption
of goods and services. Also show the trend in marginal utility per dollar spent
(the MU/P ratio) if PG = $20 and PS = $15.
B.
If consumption of two units of goods is optimal, what level of services

C.
If consumption of five units of services is optimal, what level of goods

D.
Calculate and explain the optimal allocation of a $100 budget.
SOLUTION
A.
GOODS (G)
SERVICES (S)
Units
Total
Utility
Marginal
Utility
MU/PG =
MU/$20
Units
Total
Utility
Marginal
Utility
MU/PS =
MU/$15
--
--
--
--
100
100
5.00
70
70
4.67
160
60
3.00
124
54
3.60
210
50
2.50
175
51
3.40
250
40
2.00
220
45
3.00
275
25
1.25
250
30
2.00
B.
S = 4. When 2 units of goods are purchased, the last unit consumed generates 60
utils of satisfaction at a rate of 3 utils per dollar. Consumption of 4 units of services
could be justified on the grounds that consumption at that level would also generate
3 utils per dollar spent on services.
C.
G = 4. When 5 units of services are purchased, the last unit consumed generated 30
utils of satisfaction at a rate of 2 utils per dollar. Consumption of 4 units of goods
could be justified on the grounds that consumption at that level would also generate
3 utils per dollar spent on goods.
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Chapter 4
D.
G = 2 and S = 4. The optimal allocation of a $100 budget involves spending

according to the highest marginal utility generated per dollar of expenditure. First,
one unit of goods would be purchased since it results in 5 utils per dollar spent.
Then, three units of services would be purchased. Finally, single additional units of
goods and services would be purchased. In total, $40 dollars would be spent on two
units of goods, and $60 dollars would be spent on four units of services.
P4.7
Individual Demand. Indicate whether each of the following statements is true or

false and support your response.
A.
An individual demand curve shows the relation between price and quantity
demanded, or shifts in demand from one demand curve to another.
B.
The income-consumption curve shows movements along a demand curve as

income changes.
C.
Falling service prices cause increases in the demand for services, and a
reduction in the quantity demanded of goods.
D.
The various market baskets that maximize utility at different prices for a given
item trace out the consumer=s price-consumption curve.
E.
In the case of inferior goods, income-consumption curves and Engle curves

have a negative slope.
P4.7
SOLUTION
A.
False. An individual demand curve shows the relation between price and quantity
demanded, or movement along the demand curve.
B.
False. The income-consumption curve shows shifts in demand from one demand
curve to another as income changes.
C.
False. Falling service prices cause increases in the quantity demanded of services,
and a reduction in demand for goods.
D.
True. The various market baskets that maximize utility at different prices for a
given item trace out the consumer=s price-consumption curve.
- 92 -
Consumer Demand
E.
True. In the case of inferior goods, income-consumption curves and Engle curves
have a negative slope.
P4.8
Individual Demand Curve. Catherine Willows lives on a remote ranch near

Bozeman Montana, and is an avid downhill skier at the Big Sky ski resort during
winter months. Lift tickets are expensive, however, and Willows must watch her
budget carefully. Last season, a daily lift ticket cost $48 and Willows skied two
days per week. Using a 100-unit base for the amount of satisfaction (utility) gained
from skiing one day per week, Willows estimates that the added value gained from
skiing declines according to the following schedule:
Number of Ski Days per Week
Marginal Utility
100
80
60
40
20
A.
If the cost/marginal utility trade-off displayed last season represents the most
Willows is willing to pay for a daily lift ticket, calculate the prices at which
she would be willing to ski one, two, three, four, and five days per week.
B.
Plot Willows= daily lift ticket demand curve.
P4.8
SOLUTION
A.
Last season, a daily lift ticket cost $48 and Willows skied two days per week. With
MU = 80 for skiing two days per week, the implicit cost was 604per util (= $48/80).
At a maximum acceptable price of 604 per util, Willows' maximum acceptable
price varies according to the following schedule:
Number
of days
spent skiing
Marginal
Utility
MU = U/G
Maximum
Acceptable
price
at 604 per MU
- 93 -
Chapter 4
per week
0
--
--
100
$60.00
80
48.00
60
36.00
40
24.00
20
12.00
D.
Willows= lift ticket demand curve is:
P4.9
Consumer Surplus. The Heritage Club at Harbour Town offers elegant

accommodations for discriminating vacationers on Hilton Head Island, South
Carolina. A full list of ocean sports, a swimming pool, golf courses, tennis courts,
an open-air hot tub, and a complete activities program are available. The resort is
located in Sea Pines Plantation, with many activities just a few minutes away. More
than 15 miles of trails for jogging and biking wind throughout the plantation.
Specialty shopping and harbor-front dining are within walking distance.
- 94 -
Consumer Demand
Like many vacation resorts, Heritage Club has discovered the advantages of
offering its services on an annual membership or Atime-sharing@ basis. To
illustrate, assume that an individual vacationer=s weekly demand and marginal
revenue curves can be written:
P = $6,500 - $1,250Q,
MR = TR/Q = $6,500 - $2,500Q,
where P is the price of a single week of vacation time, and Q is the number of weeks
of vacation time purchased during a given year. For simplicity, assume that the
resort=s marginal cost for a week of vacation time is $1,500, and that fixed costs
are nil. This gives the following total and marginal cost relations:
TC
MC =
$1,500Q,
TC/Q = $1,500.
A.
Calculate the profit-maximizing price, output, profit level, and consumer

surplus assuming a per unit price is charged each customer.
B.
Calculate the profit-maximizing price, output and profit level assuming a twopart pricing strategy is adopted for each customer.
C.
Now assume that fixed costs of $4 million per year are incurred, and that 500
time-share customers (Aowners@) are attracted when an optimal two-part
pricing strategy is adopted. Calculate total annual profits.
P4.9
SOLUTION
A.
If a single per unit price is charged, the profit-maximizing price is found by setting
MR = MC, where
MR = MC
$6,500 - $2,500Q = $1,500
2,500Q = 5,000
Q = 2
- 95 -
Chapter 4
At the profit-maximizing quantity of 2, the optimal single unit price is $4,000 and
total profits equal $5,000 per customer because:
P = $6,500 - $1,250(2)
= $4,000
= TR - TC
= $4,000(2) - $1,500(2)
= $5,000 per customer
The value of consumer surplus at a standard per unit price is equal to the region
under the demand curve that lies above the profit-maximizing price of $4,000.
Because the area of such a triangle is one-half the value of the base times the height,
the value of consumer surplus equals:
Consumer Surplus = 2 [2 ($6,500 - $4,000)]
In words, this means that at a single per unit price of $4,000 per week, a typical
individual would choose to use 2 weeks of vacation time at the resort, resulting in
total revenues of $8,000 and total profits of $5,000 per customer for the resort
facility. The fact that consumer surplus equals $2,500 means that the typical
vacationer would have been willing to pay an additional $2,500 for these two weeks
of vacation time. This is an amount above and beyond the $8,000 paid. The
customer received a real bargain.
B.
As an alternative to charging a single-unit price of $4,000 per week, consider the

profits that could be earned using a two-part pricing scheme. To maximize profits,
the resort would choose to charge a per-unit price that equals marginal cost, plus a
fixed fee equal to the amount of consumer surplus received by each consumer at this
price. Remember, the value of consumer surplus is equal to the region under the
demand curve that lies above the per-unit price. When the per-unit price is set equal
to marginal cost, P = $1,500 and Q = 4 because
P = MC
- 96 -
Consumer Demand
$6,500 - $1,250Q = $1,500
Q = 4
P = $6,500 - $1,250(4)
= $1,500
At the per unit price of $1,500 and output level of 4, the value of consumer surplus
equals:
Consumer Surplus = 2 [4 ($6,500 - $1,500)]
Thus, $10,000 is the maximum time-share or annual membership fee that the typical
vacationer would pay to spend 4 weeks at the resort when a modest additional
Ause@ charge of $1,500 per week was paid for each week spent at the resort. It
follows that the profit-maximizing two-part pricing scheme is to charge an annual
time-share or membership fee of $10,000 per year plus weekly fees of $1,500 per
week. Resort revenues of $16,000 [= $10,000 + (4 $1,500)] per customer
represent the full value derived from a typical customer staying 4 weeks per year,
cover marginal costs of $6,000 (= 4 $1,500 ), and result in a $10,000 (= $16,000 $6,000) profit contribution per customer for the resort.
C.
As shown in part B, the profit-maximizing two-part pricing scheme is to charge

each customer an annual time-share (or membership) fee of $10,000 per year plus
Ause fees@ of $1,500 per week. If fixed costs are present, the $10,000 amount per
customer represents profit contribution before fixed costs rather than net profit.
If the number of paying time-share subscribers is 500 per year, and fixed costs
total $4 million per year, then total net profits equal:
= Total revenue - Marginal cost - Fixed cost
= 500 [$10,000 + $1,500(4)] - 500 [$1,500(4)] - $4,000,000
= $1 million per year
- 97 -
Chapter 4
It is interesting to note that time-shares and annual memberships are so profitable
that such marketing arrangements have largely replaced pay-as-you-go resorts at
many popular vacation destinations.
P4.10
Revealed Preference. On weekends during the summer months, Terry rents jetskis
at the beach on an hourly basis. Last week, Terry rented his jet skis for 20 hours
per day at a rate of $50 per hour. This week, rentals fell to 15 hours per day when
Terry raised the price to $55 per hour.
Using these two price-output combinations, the relevant linear demand and
marginal revenue curves can be estimated as:
P = $70 - $1Q and MR = $70 - $2Q
A.
Set MR = 0 and solve for Q to calculate the revenue-maximizing price-output

combination and profit level. How much are these maximum revenues?
B.
If marginal cost is $30 per hour, calculate the profit-maximizing price-output

combination. Also calculate revenues and profits at this profit-maximizing
activity level. (Remember MR = MC at the profit-maximizing activity level.)
P4.10
SOLUTION
A.
To find the revenue-maximizing price-output rental rate, set MR = 0, and solve for
Q. Because
TR = P Q
= ($70 - $1Q)Q
= $70Q - $1Q2
MR =
TR/Q
MR = $70 - $2Q = 0
2Q = 70
Q = 35
At Q = 35,
- 98 -
Consumer Demand
P = $70 - $1(35)
= $35
= TR - TC
= $70Q - $1Q2 - $30Q
= $70(35) - $1(352) - $30(35)
= $175 per day
Total revenue at a price of $35 is:
TR = P Q
= $35 35
= $1,225 per day
(Note: 2TR/Q2 < 0. This is a revenue-maximizing output level because total
revenue is decreasing for output beyond Q > 35 hours.)
B.
To find the profit-maximizing output level analytically, set MR = MC, or set M = 0,

and solve for Q. Because
MR = MC
$70 - $2Q = $30
2Q = 40
Q = 20
At Q = 20,
P = $70 - $1(20)
= $50
- 99 -
Chapter 4
Total revenue at a price of $50 is:

TR = P Q
= $50 20
= $1,000 per day
= TR - TC
= $70Q - $1Q2 - $30Q
= $70(20) - $1(202) - $30(20)
= $400 per day
(Note: 2/Q2 < 0, This is a profit maximum because total profit is falling for Q
> 20.)
CASE STUDY FOR CHAPTER 4
Why is Tracking Consumer Demand so Tough?
Driven by movements in stock prices, the ratio of household wealth to personal income climbed
dramatically in the late-1990s, peaked in early 2000, and then retreated considerably over the
next two years. 1 Economic theory tells us that increases in consumer wealth tend to raise
household spending; decreases in wealth tend to lower household spending. This Awealth
effect@ usually produces a negative correlation between household wealth and the personal
saving rate, defined as the difference between income and spending. Empirical research
suggest that an additional dollar of wealth leads to a permanent rise in the level of household
consumption of about two to five cents, with the adjustment occurring gradually over a period
of one to three years. Such estimates of the wealth effect explained the behavior of consumer
demand and personal saving during the second half of the 1990s fairly well. Assuming that a
dollar of additional wealth leads to an increase in consumption of three cents, one would
1
For a discussion of the wealth effect and how it makes tracking changes in consumer
demand difficult, see the Economic Report of the President (2004), 88-102.
(http://www.gpoaccess.gov/eop/)
- 100 -
Consumer Demand
predict that the enormous rise in wealth during the late 1990s would have caused the saving
rate to decline by about 4 percentage points. It did. However, the expected wealth effect failed
to materialize following the stock market crash of 2000-02. Based on experience, the stock
market crash should have caused a sharp drop in consumer demand and a rebound in the
personal saving rate of more than 2 percentage points. In fact, the personal saving rate has not
risen materially (see Figure 4.13).
Figure 4.13 here
Economists still don=t know why consumer demand has been so strong, and savings
rates so weak, at the start of the new millennium. The government=s recent failure to
accurately predict wealth effects tied to the stock market crash of 2000-02 adds to a long list of
problems encountered in measuring and predicting changes in consumer demand. To illustrate,
consider a simple but very tough to answer question: How much have consumer prices risen or
fallen lately? When prices rise, there is the hard-to-decipher problem of sorting out payments
for quality improvements versus simply higher prices. Think about how much more you are
paying for monthly long-distance telephone service and you=ll see what economists mean when
they complain about adjusting for quality improvements. Chances are that your monthly longdistance bill is higher today than it was five years ago, but your use of telephone services has
changed dramatically over time.
Fifteen years ago, commercial and personal use of FAX services skyrocketed as lawyers
and business people sent clients and suppliers documents via FAX. While FAX services may be
more expensive than traditional Asnail mail,@ how does one value the benefits achieved in
terms of more timely service? Over the next few years, use of telecommunications networks to
send information over the Internet is bound to soar. When measuring price changes for
household telecommunications services, how does one adjust Internet service provider (ISP)
charges for the value added by faster and more reliable service? Using high-speed broadband,
it becomes possible to send and receive video clips and movie rentals. Illegal file sharing of
music downloads also becomes quick and easy. How do you measure the quality, price and
value of these legal and illegal services? When telephone service is delivered by traditional
cable television companies, how do you adjust the amount of your phone bill for the added
benefit of Apay per view@ movies, or the added convenience of having phone and cable bills
combined? Even measuring the cost of traditional voice telephone service becomes difficult
when local and long-distance services are combined and offered for a fixed charge per month
by a single provider, as they will be in the years ahead. Every year, voice phone service
customers make more frequent and longer phone conversations. The monthly bill paid by
consumers continues to rise, but the cost per minute has fallen precipitously for decades. Is the
cost of voice telephone service going up or down?
How about the cost of a personal computer? While the average price paid by
consumers for a desktop PC has fallen from roughly $3,000 to under $1,000 during the last
decade, computer costs fell even faster than you think. Dramatic improvements in computing
power and ease of use makes comparing computer hardware and software prices over time
- 101 -
Chapter 4
difficult, at best. The fact is that your desktop computer is several times more powerful and
easier to use than a room full of computers in the 1970s.
Problems judging the pace of productivity growth and price changes for telephone
service and personal computers are only two examples of the many difficulties confronted by
government statisticians. The basic problem is that admittedly imperfect government-provided
estimates increasingly involve errors and bias. Government statisticians are slow to recognize
the effects of new technology and better products. Efforts to reduce the burden of paperwork on
business have also made it more difficult to gather detailed data in a timely fashion. With help
from leading manufacturers, the BLS revised its methods for calculating computer price indexes
by taking into account increases in computing speed. As a result, computer prices adjusted for
quality changes are plunging at a double-digit rate per year. In most other areas, the task of
adjusting price indexes for changes in product quality is woefully inadequate. These
measurement problems are compounded by the fact that the rapidly expanding service sector
has created almost all of the economy's new jobs, and productivity measurement in services is
treacherously difficult. Without accurate measures of product quality and worker productivity,
tracking changes in consumer demand and consumer prices is impossible.
A.
Can you think of reasons why consumer demand remained unusually strong
following the stock market crash of 2000-02?
B.
In addition to consumers, what other important contributors add to national savings

and the pool of resources available for investment?
C.
Why is the amount of national savings and the pool of resources available for
investment important to consumers?
D.
Free economic information is available on the Internet from the Statistical Abstract
of the United States (http://www.census.gov/statab/www/) and the Economic Report
of the President (http://www.gpoaccess.gov/eop/). Unfortunately, this important
information is often reported with a lag of one to two years or more. What can be
done to speed the delivery of government statistics that better measure changes in
consumer demand and consumer prices?
CASE STUDY SOLUTION

A.
According to the Economic Report of the President (2004), a potential explanation

for the unusually strong consumer demand in the period following the stock market
crash of 2000-02 is that households raised consumption in anticipation of a strong
improvement in the labor market that would bolster income. Unusually strong
consumer demand may also have been fueled by a wave of low-cost home mortgage
- 102 -
Consumer Demand
refinancing stemming from a combination of historically low interest rates and
technological advances that have made such transactions easier. Another possibility
is that the availability of low-interest-rate loans on cars and other big ticket items
spurred households to replace cars and other durable goods earlier than they
otherwise might have.
B.
It is important to recognize that consumer saving is only one contributor to the

amount of total saving in the overall economy. Corporations also save in the form
of retained earningsCthe difference between after-tax profits and dividends. While
retained earnings as a share of GDP fell during the late-1990s, they rose following
the crash of 2000-02. This uptick in corporate saving has the potential to replace
some of the lost consumer savings during the post-crash period. National saving is
the sum of private saving by households and corporations plus government saving.
Government saving is equal to the Federal budget surplus plus the state and local
government budget surpluses. National saving rose as a fraction of (GDP) during
the 1990s, but has fallen sharply since 2000. As a fraction of GDP, national savings
now stands at the low end of its range since World War II. Although both
government saving and private saving are above historic lows, the fact that they are
both low at the same time has led to the low level of national saving.
C.
National saving is important because it represents the portion of our country=s

current income that is being set aside for investment in new capital. In particular,
national saving plus the net capital inflow from abroad equals domestic investment.
Greater saving and investment today boost future national income, add to economic
growth, and bolster future consumption possibilities. To increase national saving, it
is necessary to restrain government spending, increase the propensity of
corporations to retain earnings for future investment, and raise household savings.
D.
To better measure trends in consumer demand, consumer prices, and productivity

growth, rapid advances in information technology must be efficiently utilized. To
better measure consumer price changes, electronic scanning information must be
utilized. Price and production indexes must also reflect quality adjustments for new
products and technologies. Surveys of changes in employment must also be refined.
In some instances, government spending on data gathering and analysis needs to
be increased. Americans and their government simply need to know what's really
happening in the economy.
If the federal and state governments prove incapable of providing high quality
statistical information in a timely manner, better imitation of private-sector data
gathering and analysis methods may not be sufficient. In that case, it may become
necessary to consider an outsourcing of some data gathering and data analysis
- 103 -
Chapter 4
responsibilities to the private sector. For example, the Bureau of Labor Statistics
already outsources responsibility for monitoring Leading Economic Indicators to the
Conference Board. The Conference Board is a premier business membership and
research network worldwide that links executives from different companies,
industries and countries. The Conference Board has become a leader in helping top
executives build strong professional relationships, expand their business knowledge,
and find solutions to a wide range of business problems. Founded in 1916, the
Board's twofold purpose is to improve the business enterprise system and to enhance
the contribution of business to society. A not-for-profit, non-advocacy organization,
The Conference Board's membership includes more than 2,900 companies and other
organizations in 65 countries.
The BLS-Conference Board partnership may form the basis for other
beneficial public sector-private sector alliances with the potential to speed delivery
of high-quality statistical information to the public.
- 104 -

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Chapter 4

QUESTIONS & ANSWERS

"The utility derived from consumption is intangible and unobservable. Therefore,

Is an increase in total utility or satisfaction following an increase in income

How is a price-consumption curve related to a demand curve?

Individual consumer demand declines for inferior goods as personal income

SELF-TEST PROBLEMS & SOLUTIONS

Budget Allocation. Consider the following data:

If consumption of three units of goods is optimal, what level of services

If consumption of five units of services is optimal, what level of goods

Calculate the optimal allocation of a $150 budget. Explain.

G = 3 and S = 3.75. The optimal allocation of a $100 budget involves spending

Construct a table showing Keaton's marginal utility derived from baseball

Plot Keaton's baseball game demand curve.

Keaton's baseball ticket demand curve is:

PROBLEMS & SOLUTIONS

How does an increase in consumption affect marginal utility and the

S = 2 units of services should be purchased if the marginal cost of utility derived

According to the theory of consumer behavior, more is always better.

A market basket is a descriptive statement that relates satisfaction or

The nonsatiation principle abstracts from time and place considerations.

Marginal utility measures the consumer's overall level of satisfaction derived

False. The consumer=s understanding of ordinal utility makes possible a rank

False. A utility function is a descriptive statement that relates satisfaction or

Law of Diminishing Marginal Utility. Indicate whether each of the following

The law of diminishing marginal utility states that as an individual increases

Marginal utility measures the added satisfaction derived from a one-unit

The law of diminishing marginal utility gives rise to a downward-sloping

Consumers prefer higher indifference curves that represent greater

Indifference curves slope downward because if the quantity of one consumer

True. Indifference curves do not intersect. Holding goods constant, an indifference

Economic growth that boosts the level of disposable income.

Budget Allocation. Consider the following data:

If consumption of two units of goods is optimal, what level of services

If consumption of five units of services is optimal, what level of goods

Calculate and explain the optimal allocation of a $100 budget.

G = 2 and S = 4. The optimal allocation of a $100 budget involves spending

Individual Demand. Indicate whether each of the following statements is true or

The income-consumption curve shows movements along a demand curve as

In the case of inferior goods, income-consumption curves and Engle curves

Individual Demand Curve. Catherine Willows lives on a remote ranch near

Plot Willows= daily lift ticket demand curve.

Willows= lift ticket demand curve is:

Consumer Surplus. The Heritage Club at Harbour Town offers elegant

Calculate the profit-maximizing price, output, profit level, and consumer

As an alternative to charging a single-unit price of $4,000 per week, consider the

As shown in part B, the profit-maximizing two-part pricing scheme is to charge

Set MR = 0 and solve for Q to calculate the revenue-maximizing price-output

If marginal cost is $30 per hour, calculate the profit-maximizing price-output

To find the profit-maximizing output level analytically, set MR = MC, or set M = 0,

Total revenue at a price of $50 is:

In addition to consumers, what other important contributors add to national savings

CASE STUDY SOLUTION

According to the Economic Report of the President (2004), a potential explanation

It is important to recognize that consumer saving is only one contributor to the

National saving is important because it represents the portion of our country=s

To better measure trends in consumer demand, consumer prices, and productivity

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