Microeconomics 7th Edition Perloff Test Bank 1

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Microeconomics, 7e (Perloff)
Chapter 5 Applying Consumer Theory
5.1 Deriving Demand Curves
1) The above figure shows Bobby's 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 Bobby's price-consumption curve?
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Copyright © 2015 Pearson Education, Inc.
A) 10 snacks and 20 juices
B) 10 snacks and 0 juices
C) 10 snacks and 5 juices
D) 10 snacks and 15 juices
Answer: D
Section: Deriving Demand Curves
Question Status: Old
AACSB: Analytic thinking
lines resulting from different prices for snacks assuming he has $20 to spend on these goods. Which of the
following points are on Bobby's demand curve for snacks?
A) p = 2, q = 10
B) p = 2, q = 13
C) p = 2, q = 5
D) p = 1, q = 20
Answer: C
lines resulting from different prices for snacks. This information could be used to determine
A) the slope of Bobby's demand curve for juice.
B) the amount by which Bobby's demand curve for juice shifts when his income rises.
C) the amount by which Bobby's demand curve for juice shifts when the price of snacks rises.
D) All of the above.
Answer: C
lines resulting from different prices for snacks. As the price of snacks rises, Bobby's utility
A) stays the same.
B) increases.
C) decreases.
D) might change, but there is not enough information to determine.
Answer: C
lines resulting from different prices for snacks. Bobby's demand for snacks is
A) unit elastic.
B) elastic.
C) inelastic.
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D) perfectly elastic.
Answer: C
lines resulting from different prices for snacks. As the price of snacks rises, the price for juice
A) stays the same.
B) increases.
C) decreases
D) might change, but there is not enough information to determine.
Answer: A
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7) An individual's demand curve for a good can be derived by measuring the quantities selected as
A) the price of the good changes.
B) the price of substitute goods changes.
C) income changes.
Answer: A
8) As the price of a good rises, the consumer will experience

A) a desire to consume a different bundle.
B) a decrease in utility.
C) a southern or western movement on the indifference map.
Answer: D
9) An increase in the price of a good causes

A) a change in the slope of the budget line.
B) an increase in the consumption of that good.
C) a rightward shift of the demand curve for that good.
D) a parallel rightward shift of the budget line.
Answer: A
10) Suppose a graph is drawn to show a consumer's 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) football tickets are an inferior good.
B) the demand for football tickets is perfectly elastic.
C) the demand for football tickets is unit elastic.
D) the demand curve for football tickets will be horizontal.
Answer: C
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11) A demand curve for a Giffen good would be
A) upward sloping.
B) downward sloping.
C) horizontal.
D) vertical.
Answer: A
Question Status: Revised
12) 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
13) Sandy derives utility from consuming "all other goods," g, and clean air (measured by particulate
matter removed per m3), a, as measured by the utility function U(g,a) = g0.6a0.4. The price of "all other
goods" is $20 and the price of clean air (abatement) equals $10. Brian is the only other consumer in the
market for clean air and demands 10 units of clean air. What is the market demand for clean air?
A) Total market demand is 14 units of clean air.
B) Total market demand is 12 units of clean air.
C) Total market demand is 10 units of clean air.
D) Total market demand is 16 units of clean air.
Answer: A
Question Status: New
14) Ten individuals have $100 and identical preferences for picnics, p, and kayak trips, k, where
U(p, k) = k0.5p0.5. The price of picnics is $5 and the price per kayak trip is $ 10. What is the
shortage/surplus in the market when the supply of picnics totals 120?
A) There is a surplus of 20.
B) There is a shortage of 20.
C) The market is in equilibrium. Therefore, there is no surplus/shortage.
D) There is not enough information to answer this question.
Answer: A
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15) Three individuals have $1000 and identical preferences for gum, g, and cigarettes, s, as measured by
the utility function U(g,s) = 10g0.9a0.1. The price of gum is $9 and the price of cigarettes is $12. What is
the market surplus/shortage at a price of $12 when the supply of cigarettes is 5?
A) There will be a shortage of 3 cigarettes.
B) There will be a surplus of 3 cigarettes.
C) There will be a shortage of 2/3 cigarettes.
D) There will be a surplus of 2/3 cigarettes.
Answer: A
16) What is the slope of the price consumption curve for two goods, x and y, when preferences are
measured by the utility function U(x,y) = x0.5y0.5, the price of good y is $10, income equals $100, and the
price of good x increases from $5 to $10?
A) Slope equals zero.
B) Slope is infinite.
C) Slope is - .
D) Slope is .
Answer: A
For the following, please answer "True" or "False" and explain why.
17) 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.
6
18) 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 the above figure. 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.
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19) The above figure shows a consumer's indifference curves for soda and all other goods. Assuming a
budget of $100, derive the consumer's 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.
5.2 How Changes in Income Shift Demand Curves
1) 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
Section: How Changes in Income Shift Demand Curves
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2) When deriving an Engel curve, the prices of both goods
A) are held constant.
B) increase by the same percentage as income.
C) decrease by the same percentage as income.
D) can either decrease, increase or stay the same.
Answer: A
3) The above figure shows Larry's 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
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A) Larry's Engel curve for pork will be upward sloping.
B) Larry's Engel curve for pork will be downward sloping.
C) Larry's Engel curve for pork will be backward bending.
D) Larry's Engel curve for pork cannot be derived from the information provided.
Answer: A
A) Larry's demand curve for pork shifts rightward when his income increases.
B) Larry's income elasticity of demand for pork is greater than zero.
C) Pork is a normal good.
Answer: D
6) 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) negatively sloped.
B) flat.
C) positively sloped.
D) backward bending.
Answer: D
7) 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) 0.
B) 1.
C) -1.
D) There is not enough information to determine the income elasticity of demand for x.
Answer: A
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8) An inferior good exhibits
A) a negative income elasticity.
B) a downward sloping Engel curve.
C) a decline in the quantity demanded as income rises.
Answer: D
9) When John's 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 the above figure best represents John's Engel curve
for frozen dinners?
A) Graph A
B) Graph B
C) Graph C
D) Graph D
Answer: A
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10) When John's 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 the above figure best represents John's Engel curve
for dining out?
A) Graph A
B) Graph B
C) Graph C
D) Graph D
Answer: B
11) Both Sally and Sam receive a 10% raise in a single year. Sally increases her demand for ground beef
whereas Sam decreases his demand for ground beef.
A) This is impossible.
B) This is only possible if Sally considers ground beef an inferior good, and Sam views it as a normal
good.
C) This is only possible if Sally has lower income than Sam.
D) This is only possible if Sally considers ground beef a normal good and Sam views it as an inferior
good.
Answer: D
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12) Even though Mary's 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 the above figure best
represents Mary's Engel curve for milk?
A) Graph A
B) Graph B
C) Graph C
D) Graph D
Answer: C
13) 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 the above figure best
represents John's Engel curve for "Red Ribbon" beer?
A) Graph A
B) Graph B
C) Graph C
D) Graph D
Answer: A
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14) Which graph in the above figure 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
15) If consumer income and prices increase by the same percentage,

A) the consumer will buy more of both goods.
B) the consumer will buy more of both goods if they are both normal goods.
C) the consumer will buy less of both goods if they are both inferior goods.
D) the consumer's utility maximizing bundle stays the same.
Answer: D
16) An individual derives utility from consuming "all other goods," g, and clean air (measured by the
reduction in particulate matter per m3), a, as measured by the utility function U(g,a) = g0.6a0.4. The price
of consumer goods equals $20 and the price of clean air (abatement) equals $10. What is the slope of the
Engel curve when income increases from $100 to $200?
A) The slope is 25.
B) The slope is -25.
C) The slope is zero.
D) The slope is infinite.
Answer: A
Section: Government Actions that Reduce Market Power
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17) An individual derives utility from games, g (y-axis), and toy airplanes, a (x-axis), described by the
utility function U(g,a) = g0.6a0.4. The price per game is $20 and the price of toy airplanes is $10. Using the
slope of the income consumption curve (ICC), determine whether games and toy airplanes are normal or
inferior goods when income increases from $100 to $200.
A) Both goods are normal goods with an ICC slope of .
B) Both goods are normal goods with an ICC slope of .
C) Both goods are inferior goods with an ICC slope of - .
D) Both goods are inferior goods with an ICC slope of - .
Answer: A
18) An increase in income (all else equal) will ALWAYS lead to a parallel shift of the budget line.
Answer: True. Since prices are unchanged the relative prices of the goods stays the same and thus the
slope of the budget line.
19) 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.
20) Why can't 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.
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21) The above figure 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 in terms of income elasticity.
22) 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.
23) 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.
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24) Draw budget constraints, indifference curves, and the income consumption curve for a good that has
an income elasticity that is perfectly inelastic.
Answer:
See the above figure.

5.3 Effects of a Price Change
1) 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) milk is a luxury.
B) milk is a Giffen good.
C) the income effect from a change in the price of milk is very large.
D) the income effect from a change in the price of milk is very small.
Answer: D
Section: Effects of a Price Change
2) 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
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3) 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
4) The substitution effect can be measured holding ________ constant.

A) income
B) utility
C) the price of one good
D) the price of all goods
Answer: B
5) Suppose that frozen dinners were once a normal good for John, but now frozen dinners are an inferior
good for him. John's demand curve for frozen dinners
A) has become steeper as a result.
B) has become flatter as a result.
C) has not changed as a result.
D) has disappeared as a result.
Answer: A
6) One characteristic of a Giffen good is that it

A) is a luxury good.
B) is an inferior good.
C) has an upward-sloping Engel curve.
Answer: B
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7) A Giffen good has
A) a positive substitution effect.
B) a negative income effect.
C) a larger income effect than substitution effect.
Answer: D
8) If a good is an inferior good, then its

A) demand curve will be upward sloping.
B) income effect reinforces the substitution effect.
C) income elasticity is negative.
D) Engel curve cannot be drawn.
Answer: C
9) Suppose Lisa spends all of her money on books and coffee. When the price of coffee decreases, the
A) substitution effect on coffee is positive, and the income effect on coffee is positive.
B) substitution effect on coffee is ambiguous, and the income effect on coffee is ambiguous.
C) substitution effect on coffee is positive, and the income effect on coffee is ambiguous.
D) substitution effect on coffee is ambiguous, and the income effect on coffee is positive.
Answer: C
10) In the case of a normal good,

A) demand curves always slope downward.
B) the income effect and substitution effect are in the same direction.
C) the Engel curve slopes upward.
Answer: D
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11) The above figure shows Bobby's 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) 3
B) 10
C) 15
D) 7
Answer: A
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) 3
B) 10
C) 15
D) 7
Answer: D
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line. B2 indicates his budget line resulting from an increase in the price of soda. From the graph, one can
conclude that
A) Bobby views soda as an inferior good.
B) Bobby's demand for soda is perfectly inelastic.
C) Bobby views soda as a normal good.
D) the income elasticity of demand for soda is 1.
Answer: C
14) When measuring the substitution effect, one uses the change along
A) the old indifference curve.
B) the new indifference curve.
C) either the old or the new indifference curve.
D) the budget constraint.
Answer: A
15) The Slutsky equation shows that, holding the total effect constant, the income effect will be larger for
goods that
A) have a smaller substitution effect.
B) make up a larger percentage of a household's budget.
C) have perfectly inelastic demand curves.
Answer: A
16) Suppose that the interest rate paid to savers increases. As a result, Tom wishes to save less. This
suggests that, for Tom,
A) the substitution effect is greater than the income effect.
B) the income effect is greater than the substitution effect.
C) utility maximization is not occurring.
D) future consumption is a luxury.
Answer: B
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17) Suppose that the interest rate paid to savers increases. As a result, Tom wishes to save more. This
suggests that, for Tom,
C) utility maximization is not occurring.
D) future consumption is a luxury.
Answer: A
18) What is the primary difference between the substitution and the income effect of a price change?
A) The substitution effect holds income constant and the income effect holds utility constant.
B) The substitution effect is always positive and the income effect is always negative.
C) The substitution effect holds utility constant and the income effect holds prices constant.
D) The substitution effect is always negative and the income effect is always positive.
Answer: A
19) What is the benefit of understanding the income and the substitution effects?
A) The income effect might run in the opposite direction of the substitution effect.
B) The income effect always runs in the opposite direction of the substitution effect.
C) The income and substitution effects just offset each other, which explains a lot.
D) The income and substitution effects are proportional to each other.
Answer: A
20) For an inferior good, if the income effect more than offsets the substitution effect, we call that good
A) a Giffen good.
B) a normal good.
C) an inferior good.
D) a neutral good.
Answer: A
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21) The Affordable Care Act is intended to reduce the price of health care. A decrease in the price of
health care may
A) increase the number of doctors office visits if office visits are considered an inferior good and the
substitution effect dominates the income effect.
B) decrease the number of doctors office visits if office visits are considered an inferior good and the
substitution effect dominates the income effect.
C) increase the number of doctors office visits if office visits are a normal good.
D) Both A and C.
Answer: D
22) If a good is considered a normal good, the demand curve will shift ________ when income increases
because ________.
A) right; the income and substitution effects move in the same direction.
B) right; the income and substitution effects move in the opposite direction.
C) left; the income and substitution effects move in the same direction.
D) left; the income and substitution effects move in the opposite direction.
Answer: A
23) 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.
24) 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.
25) 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.
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26) 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 Joe's 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 Joe's savings to either increase or decrease. Explain in terms of income and
substitution effect.
Answer:
See the above figure. 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.
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27) 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.
5.4 Cost-of-Living Adjustments
1) Due to inflation, nominal prices are usually

A) equal to real prices.
B) smaller than real prices.
C) larger than real prices.
D) a constant proportion different from real prices.
Answer: C
Section: Cost-of-Living Adjustments
2) A Consumer Price Index (CPI) adjustment overcompensates for inflation because it ignores
A) the income effect when relative prices change.
B) the substitution effect when relative prices change.
C) that some goods are inferior.
D) that the substitution effect may offset the income effect.
Answer: B
3) Employing a fixed-weight index like the Consumer Price Index to adjust a person's salary in response
to inflation will overcompensate this person because doing so will allow this person to
A) buy the same bundle of goods as he did before the inflation.
B) achieve a higher level of utility than he did before the inflation.
C) achieve the same level of utility as before the inflation.
D) buy more of all goods.
Answer: B
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4) Under which of the following conditions will there be no substitution bias in the CPI?
A) Indifference curves are convex.
B) Indifference curves are L-shaped.
C) Indifference curves are linear.
D) Indifference curves are downward sloping.
Answer: B
5) Under which of the following conditions will there be no substitution bias in the CPI?
A) Lower-priced goods increase in price by a greater percentage than do higher-priced goods.
B) Higher-price goods increase in price by a greater percentage than do lower-priced goods.
C) All goods change in price by the same amount.
D) All goods change in price by the same percentage.
Answer: D
6) A true cost-of-living adjustment (COLA) in response to a change in prices would compensate

consumers so that they would be able to
A) purchase the same bundle they purchased before prices changed.
B) achieve the same level of utility they did before prices changed.
C) face the same choices they did before prices changed.
D) achieve an increase in utility that is equal to the rate of inflation.
Answer: B
7) Richard receives government transfer payments and currently consumes 5 guns and 6 goose livers.
Assume the price of guns decreases by 10% and the price of goose liver increases by 20%. The
government raises Richard's transfer payments so he can still afford 5 guns and 6 goose livers. Does this
constitute a true cost-of-living adjustment (COLA)?
A) No. Richard is overcompensated.
B) No. Richard is undercompensated.
C) Yes. The payment just achieves the right level of compensation.
D) Not enough information.
Answer: A
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8) Before an uneven rise in prices Allan consumed 5 bread and 6 juice. After the price increase and with
an increased welfare payment from the government Allan consumes 4 bread and 7 juice. Does the
government payment represent a true cost-of-living adjustment (COLA)?
A) Yes, if the two consumption bundles lie on the same indifference curve.
B) Yes, if the second bundle yields more utility than the first.
C) No, the first bundle is clearly preferred.
D) Not enough information.
Answer: A
9) The Consumer Price Index (CPI) measures inflation for every individual.
A) True, the weights used in calculating the CPI are adjusted for every individual in the country.
B) True, people all face the same prices and therefore face the same inflation.
C) False, the CPI uses weights based on how much each product represents in the typical household
budget.
D) False, the CPI doesn't measure inflation.
Answer: C
10) Using a Laspeyres index to calculate the Consumer Price Index (CPI)
A) weights quantities with current prices.
B) weights prices with base-year quantities.
C) weights quantities with base-year prices.
D) weights prices with current year quantities.
Answer: B
11) Using a Paasche index to calculate the Consumer Price Index (CPI)
A) weights quantities with current prices.
B) weights prices with base-year quantities.
C) weights quantities with base-year prices.
D) weights prices with current year quantities.
Answer: D
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12) What is one way to adjust the CPI for substitution bias?
A) Use the Paasche index.
B) Use the Laspeyres index.
C) Multiply the Paasche Index and the Laspeyres index.
D) Take the geometric mean of the Paasche index and the Laspeyres index.
Answer: A
13) The Fisher index

A) uses the arithmetic mean of the Paasche index and the Laspeyres index.
B) uses the standard deviation of the Paasche index and the Laspeyres index.
C) uses the geometric mean of the Paasche index and the Laspeyres index.
D) uses the harmonic mean of the Paasche index and the Laspeyres index.
Answer: C
14) Which of the following is the geometric mean of 4 and 9?

A) 6.5
B) 6
C) 36
D) 3.6
Answer: B
15) 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.
16) 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.
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17) 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 Laspeyres 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 Laspeyres 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.
5.5 Deriving Labor Supply Curves
1) The price of leisure

A) is the same for everyone.
B) depends on the number of hours worked.
C) is measured as foregone earnings.
D) is immeasurable.
Answer: C
Section: Deriving Labor Supply Curves
2) If a person supplies more hours of labor in response to a wage increase, then

C) the income effect equals the substitution effect.
D) the person is not maximizing utility.
Answer: A
3) If a person supplies fewer hours of labor in response to a wage increase, then

C) the income effect equals the substitution effect.
D) the person is not maximizing utility.
Answer: B
29
4) Empirical studies have found that the labor supply curves for most parts of the population are
A) backward-bending.
B) upward-sloping.
C) downward-sloping.
D) nearly vertical.
Answer: D
5) 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
6) If Bobby thinks that leisure is an inferior good, then his labor supply curve
A) is backward bending.
B) is always negatively sloped.
C) is always positively sloped.
D) does not exist.
Answer: C
7) A tax cut that raises the after-tax wage rate will most likely result in more hours worked if
A) tax rates were low already.
B) the relevant portion of the labor supply curve is upward sloping.
C) the relevant portion of the labor supply curve is downward sloping.
D) workers can be easily fooled.
Answer: B
30
8) If workers are in the backward-bending section of their labor supply curves, than an increase in the
income tax rate will
A) increase the tax revenue and increase the number of hours worked.
B) increase the tax revenue and decrease the number of hours worked.
C) decrease the tax revenue and increase the number of hours worked.
D) decrease the tax revenue and decrease the number of hours worked.
Answer: A
9) In response to an increase in the wage rate, the substitution effect will cause a person to
A) supply fewer hours of labor.
B) supply more hours of labor.
C) supply the same hours of labor.
D) have a backward bend in her labor supply curve.
Answer: B
10) In response to an increase in the wage rate, the income effect will usually cause a person to
A) supply fewer hours of labor.
B) supply more hours of labor.
C) supply the same hours of labor.
D) have a horizontal labor supply curve.
Answer: A
11) What might explain a professional baseball player having lower production the year after signing a
multi-million dollar contract?
A) the substitution effect
B) the endowment effect
C) bounded rationality
D) the income effect
Answer: D
31
12) Newspaper accounts of the U.S. labor market often point out that many people are working more
hours than their parents did. What might explain this phenomenon?
A) the substitution effect
B) the endowment effect
C) bounded rationality
D) the income effect
Answer: A
13) Consider two lottery winners, Tino who is 65 years old and Sasha who is 32 years old. Which of these
two would be expected to have the larger income effect, all else equal?
A) Sasha
B) Tino
C) Both would have no income effect.
D) Both would have equal income effects.
Answer: B
14) Wealthy people will tend to have vertical labor supply curves
A) only if their income effect just offsets their substitution effect.
B) only if their income effect is greater than their substitution effect.
C) only if their income effect is less than their substitution effect.
D) only if they don't have an income effect.
Answer: A
Question Status: Revised
15) Recent data has shown that income and volunteer time are positively related. Assuming that
volunteer time is included in leisure time, what could explain this observation?
A) Higher income individuals view leisure as a normal good such that the income effect dominates the
substitution effect.
B) Higher income individuals view leisure as a normal good such that the substitution effect dominates
the income effect.
C) Higher income individuals view leisure as an inferior good such that the income and substitution
effects both increase leisure time.
D) Both A and C.
Answer: A
32
16) 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 after-tax
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.
17) An increase in unearned income always creates a disincentive to work.

Answer: False. The effect on labor supply will also depend on the individual's preferences towards work
(leisure).
18) 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 the above figure.

33
19) Suppose a person's utility for leisure (L) and consumption (Y) can be expressed as U = Y + L0.5. Show
what happens to the person's 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: Let t = income tax rate. 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!
20) Suppose a person's utility for leisure (L) and consumption (Y) can be expressed as U = Y + L 0.5.
Assuming a wage rate of $10 per hour, show what happens to the person's 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 person's labor supply curve is not affected by winning the lottery.
21) Suppose a person's 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
person's 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 person's quantity of
labor supplied by 5 hours when w = $10.
34

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5.1 Deriving Demand Curves

8) As the price of a good rises, the consumer will experience

9) An increase in the price of a good causes

5.2 How Changes in Income Shift Demand Curves

1) A movement upward along an upward sloping Engel curve corresponds to

15) If consumer income and prices increase by the same percentage,

B) Both goods are normal goods with an ICC slope of .

C) Both goods are inferior goods with an ICC slope of - .

D) Both goods are inferior goods with an ICC slope of - .

20) Why can't all goods be inferior?

See the above figure.

5.3 Effects of a Price Change

4) The substitution effect can be measured holding ________ constant.

6) One characteristic of a Giffen good is that it

8) If a good is an inferior good, then its

10) In the case of a normal good,

5.4 Cost-of-Living Adjustments

1) Due to inflation, nominal prices are usually

6) A true cost-of-living adjustment (COLA) in response to a change in prices would compensate

13) The Fisher index

14) Which of the following is the geometric mean of 4 and 9?

15) Inflation over time necessarily makes consumers worse off.

5.5 Deriving Labor Supply Curves

1) The price of leisure

2) If a person supplies more hours of labor in response to a wage increase, then

3) If a person supplies fewer hours of labor in response to a wage increase, then

5) A backward-bending labor supply curve implies that

16) A tax cut will unambiguously lower income-tax revenue.

17) An increase in unearned income always creates a disincentive to work.

See the above figure.

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