ANSWERS to Even-Numbered ONLINE Review Questions

CHAPTER 5

CONSUMER CHOICE

ANSWERS TO EVEN-NUMBERED ONLINE REVIEW QUESTIONS 2. A change in income will shift the budget line in a parallel fashion—increases in income shift the budget line outward and away from the origin, decreases shift it inward and nearer the origin. Changes in income alone do not affect the budget line’s slope. A change in one or both prices will rotate the budget line and change its slope. For example, a decrease in the price of the good measured on the horizontal axis will cause a rotation of the budget line around its vertical axis intercept; the rotation will result in a horizontal intercept farther to the right. 4. [Using the Marginal Utility Approach] The law of diminishing marginal utility states that marginal utility declines as more of a good is consumed. It is a reasonable assumption for most goods: The more of a good one consumes, the less additional satisfaction is derived from each additional unit. There are, indeed, exceptions to the law. One example might be found among collectors. As the collection becomes more complete, the marginal utility of additional paintings might actually increase. Marginal utility would be negative for any good that a consumer dislikes. An additional unit consumed in this case would decrease utility. One example is garbage. 6. The statement makes an error. Rationality does not mean that individuals make choices that are “sensible” to others. Preferences are called rational if (1) they satisfy the logical consistency requirement detailed in question 5, and if (2) the consumer can compare any two combinations of goods and state either that he/she is indifferent between them or that he/she prefers one of them.

8. A change in the price of one good relative to another gives rise to the substitution effect—the tendency of consumers to substitute more of the good made relatively cheaper by the price decline for the good that is now relatively more expensive. Hence, the substitution effect always works to increase the quantity demanded of a good whose price has decreased. In this sense, the substitution effect is always consistent with the law of demand. The income effect is the change in quantity demanded that arises because of the change in purchasing power caused by a price change. For example, if the price of a good declines, a given income will “go farther”—as if the consumer has more income. Any given price change sets in motion both income and substitution effects. If a good is normal, these effects reinforce each other to increase quantity demanded, in the case of a price decrease, or decrease quantity demanded when price increases. When a good is inferior, the income and substitution effects work in opposite

51 52 Even-Numbered Answers for Economics (Microeconomics): Principles and Applications, 4e directions. The question then becomes, Which effect is stronger? If the substitution effect dominates, the law of demand will still hold; but if the income effect is stronger, a price increase will actually cause quantity demanded to increase, in violation of the law of demand. 10. The market demand curve for a particular good is found as the horizontal sum of the demand curves of all consumers in the market for the good. Each individual demand is found by varying the price of the good and observing how the optimal quantity of a good changes as the consumer’s budget line rotates outward or inward.

EVEN-NUMBERED PROBLEM SET

2. [Using the Marginal Utility Approach] No, he is not maximizing utility. For each dollar spent on novels, Parvez gets 5 units of utility; for each dollar’s worth of CDs, only 4. He should spend less of his budget on CDs and more on novels. As he does so, the marginal utility of CDs will rise and the marginal utility of novels will fall, until the ratio of marginal utility to price is the same for both goods. 4. a. Recall that the market demand curve is simply the horizontal sum (summed over quantities at each price) of the individual demand curves. In this case, then, the market demand schedule is:

P ric e

$ 5 .0 0

$ 4 .0 0

$ 3 .0 0 D

$ 2 .0 0

$ 1 .0 0

3 5 7 9 Q u an tity

Price Qty. Demanded $5.00 3 $4.50 5 $4.00 7 $3.50 9 b. The three consumers have different demand schedules because they have different preferences for the cereal. Chapter 5 Consumer Choice 53

6. An increase in income always decreases demand for an inferior good. Hence, the demand curve would behave as below, with new (post-income increase) demand shown by D2.

P r i c e

D 2 Q u a n t i t y Q 2 Q 1

8. False. The price increase generates both income and substitution effects. With an inferior good, both effects work against each other. While it is possible for the income effect to dominate (a case that would, indeed, violate the law of demand), this would be extremely rare. More commonly, the substitution effect dominates, so the good would obey the law of demand.

54 Even-Numbered Answers for Economics (Microeconomics): Principles and Applications, 4e 10. [Using the Indifference Curve Approach] a.

c. Chapter 5 Consumer Choice 55

12. [Using the Marginal Utility Approach] Income = $300 per month| Concerts at $30 each Movies at $10 each (1) (2) (3) (4) (5) (6) Number of Marginal Marginal Number of Marginal Marginal Concerts per Utility from Utility per Movies Utility Utility per Month Last Dollar Spent per Month from Last Dollar Concert on Last Movie Spent on Concert Last Movie 1 450 15 27 150 15 2 390 13 24 175 17.5 3 300 10 21 200 20 4 225 7.5 18 225 22.5 5 180 6 15 250 25 6 150 5 12 275 27.5 7 90 3 9 300 30 8 75 2.5 6 325 32.5 9 60 2 3 350 35 Max’s utility maximizing combination is 1 concert and 27 movies. This corresponds to point H” in Figure 5. 14. [Using the Indifference Curve Approach] a.

The original equilibrium is at point A.

b. The new budget line is BL2. The new tangency must occur at a point where Rafaella is consuming MORE THAN 4 pounds of chicken, and LESS than 10 eggs, for instance, at point B. 56 Even-Numbered Answers for Economics (Microeconomics): Principles and Applications, 4e 16. Income = $150 per month Concerts at $5 each Movies at $10 each Number of Marginal Marginal Number of Marginal Marginal concerts per utility from utility per movies per utility from utility per month last concert dollar spent month last movie dollar spent on last on last concert movie 3 600 120 4 450 90 5 360 72 6 300 60 7 180 36 8 150 30 12 100 10 9 100 20 11 120 12 10 67.5 13.50 10 135 13.50 From this table, the marginal utility per dollar spent on last concert is equal to the marginal utility per dollar spend on the last movie when Max consumes 10 concerts and 10 movies per month. This does, indeed, demonstrate that point K on Figure 6 is optimal.