Microeconomics Theory and Applications 12th Edition Browning Test Bank 1

Test Bank for Microeconomics Theory and
Applications 12th Edition Browning Zupan

1118758870 9781118758878
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Title: Microeconomics: Theory and Application, 12e
Chapter Number: 5
Question Type: Multiple Choice
1. In an attempt to encourage the use of solar energy, the government pays a part of the price of
solar panels to the producer and allows consumers to buy as many panels as they wish at the
subsidized price. This is an example of a(n) _____.
a. excise subsidy
b. fixed-quantity subsidy
c. voucher program
d. lump-sum transfer
Answer: A
Difficulty Level: Easy

Section Reference: Excise Subsidies, Health Care, and Consumer Welfare
Learning Objective: Determine how an excise subsidy affects consumer welfare and why it
results in a deadweight loss.
2. The U.S. government in effect subsidizes health care of workers by:
a. relaxing health care regulations.

b. having lower tax rates on wages and salaries.
c. not taxing health care benefits.
d. reducing taxes on firms and small businesses.
Answer: C

3. An excise subsidy given on each unit of X consumed will:
a. reduce consumption of X and lower total expenditures on X.

b. shift the budget line inward in a parallel manner.
c. place the consumer on a higher indifference curve.
d. cause the consumer to increase consumption of non-subsidized goods.
Answer: C
Difficulty Level: Medium

4. Which of the following is true of an excise subsidy?
a. An excise subsidy has both an income and a substitution effect which causes the consumption
of the subsidized good to rise.
b. An excise subsidy has a substitution effect since the subsidy artificially lowers the price of the
subsidized good causing the consumer to increase consumption of the good, but no income
effect.
c. An excise subsidy increases consumption of a good by the same quantity as does a cash
transfer but at a lower cost to the government.
d. An excise subsidy has an income effect since the subsidy increases the consumer’s income but
no substitution effect.
Answer: A

5. If an equal-cost lump-sum transfer were substituted for a per unit excise subsidy on good X:
a. the consumption of X under the excise subsidy would be higher and the consumer would be on
a higher indifference curve.
b. the consumption of X under the excise subsidy would be higher, but the consumer would be
on the same indifference curve.
c. the consumption of X under the lump-sum transfer would be higher and the consumer would
be on a higher indifference curve.
d. the consumption of X under the lump-sum transfer could be higher, but the cost of the transfer
would be higher.
Answer: C

6. Which of the following is true of an excise subsidy?
a. An excise subsidy has a positive substitution effect but negative income effect on the
consumption of the subsidized good.
b. An excise subsidy increases consumption of the subsidized good more than a cash transfer of
equal-cost.
c. An excise subsidy leaves the well-being of the subsidy recipient unchanged.
d. An excise subsidy causes consumption of nonsubsidized goods to increase.
Answer: B

7. Compared to an equal-cost cash grant, an excise subsidy on clothing results in the purchase
of:
a. more clothing and more of other goods.
b. less clothing and more of other goods.
c. more clothing and less of other goods.
d. less clothing and less of other goods.
Answer: C

8. Figure 5-1 shows the preferences of a consumer for food and other goods. He is initially in
equilibrium at point A where the budget line MN is tangent to the indifference curve.
. In Figure 5-1, the total outlay on food before the excise subsidy is given by _____.
a. KC
b. 0G
c. 0H
d. 0J
Answer: B

In Figure 5-1, the total outlay on other goods before the excise subsidy is given by _____.
a. 0M
b. 0N
c. 0E
d. 0G
Answer: C

In Figure 5-1, the total cost incurred by the government on the lump-sum transfer is given by
_____.
a. CE’
b. BF
c. CH
d. BJ
Answer: A

11. The effect of substituting an equal-cost lump-sum grant for an excise subsidy is to:
a. increase the consumption of the subsidized good and increase the consumption of other goods.
b. decrease the consumption of the subsidized good and increase the consumption of other goods.
c. decrease the consumption of the subsidized good and decrease the consumption of other
goods.
d. increase the consumption of the subsidized good and decrease the consumption of other goods.
Answer: B

12. Comparing the original budget line with the budget line for an excise subsidy and a cash
grant:
a. the budget line for a cash grant shifts such that it is tangent to the same indifference curve so
that the well-being of the consumer is the same.
b. the slope of the budget line for a cash grant is positive.
c. the budget line for a cash grant is parallel to the original budget line.
d. the budget line for an excise subsidy shifts such that it is tangent to the same indifference
curve so that the well-being of the consumer is the same.
Answer: C

13. Unlike an equivalent-sized cash transfer, an excise subsidy on good X:
a. has an income effect.

b. leaves the consumer better off.
c. has a substitution effect.
d. increases consumption of composite goods.
Answer: C

14. An excise subsidy given on clothing will encourage consumers to purchase:
a. more clothing due to the substitution effect.

b. less clothing due to the income effect.
c. more clothing and less of other goods.
d. less clothing since clothing is an inferior good.
Answer: A

15. Given a choice between an equal-cost cash grant and an excise subsidy, a consumer will:
a. prefer an excise subsidy.

b. prefer an excise subsidy if the good is a normal good.
c. be indifferent between an excise subsidy and a cash grant.
d. be worse off with an excise subsidy.
Answer: D

16. Which of the following is a consequence of subsidizing consumers using a per-unit excise
subsidy for the purchase of some good or service as opposed to a lump-sum payment of an equal
amount?
a. Consumers will not necessarily be better off according to their own preferences.
b. The deadweight loss from over-consumption of the good or service is avoided.
c. Consumers will move to a higher indifference curve.
d. Consumers’ purchase decisions will be based on their true valuation of the good.
Answer: A

17. Being a member of the government-sponsored MediSave scheme entitles employees to a

lump-sum payment in cash towards medical expenses. This scheme would:
a. increase employment.
b. make workers better off.
c. not change workers’ welfare.
d. cause average wages to fall.
Answer: B

18. Figure 5-2 shows the quantity demanded of a good at various prices. Refer to Figure 5-2.
The deadweight loss of an excise subsidy that lowers the price from P1 to P2 is area _____.
a. P1ACP2
b. P1BCP2
c. ADC
d. ABC
Answer: D

19. Figure 5-2 shows the quantity demanded of a good at various prices. Based on Figure 5-2,
the welfare cost of an excise tax (that raises price from P2 to P1) is the area _____.
a. P1ACP2
b. P1BCP2
c. ADC
d. ABC
Answer: C

20. The welfare effect of an excise subsidy indicates that:
a. the consumer is better off than without the subsidy.

b. the consumer is indifferent between an excise subsidy and a cash grant.
c. excise subsidies should not be used by the government.
d. government officials know what is better for low-income families than the families
themselves.
Answer: A

21. In which of the following cases can a subsidy possibly harm its recipients?
a. When consumption of the subsidized good is mandatory

b. When the subsidy is fully funded by the government
c. When the subsidy is targeted at low-income groups
d. When the good that is subsidized is a luxury good
Answer: A

Section Reference: Subsidizing Health Insurance: ObamaCare
Learning objective: Examine how the public provision of a certain quantity of a good such as
education may lead to less consumption of the good.
22. A fixed-quantity subsidy differs from food stamps in that:
a. the fixed-quantity provides a minimum quantity that can be supplemented by additional

consumer purchases while additional quantities cannot be purchased with food stamps.
b. the fixed-quantity subsidy increases consumer welfare more than food stamps.
c. the fixed-quantity subsidy cannot be supplemented by additional purchases while the
consumer can purchase additional quantities with food stamps.
d. the fixed-quantity subsidy cannot move consumers to a higher indifference curve unlike food
stamps.
Answer: C

23. A subsidy can actually cause the consumption of subsidized goods to fall if:
a. the consumer has concave indifference curves.

b. the government prohibits resale of the good.
c. the price of other goods also falls.
d. the subsidized quantity of the good is fixed.
Answer: D

Section Reference: Public Schools and the Voucher Proposal
Learning Objective: Analyze how a voucher program would affect the quantity of educational
services chosen by parents for their children.
24. Figure 5-3 shows a family’s preferences for housing and other goods. Refer to Figure 5-3.
Suppose the government offered public housing that provided exactly B0 units of housing
services to a low-income family. The public housing unit:
a. is provided by the government at a cost of $TB.

b. allows the family to reach a higher indifference curve but causes the family to consume more
housing than an equal-sized cash transfer.
c. increases the level of housing consumption by the same amount as an equal-sized cash
transfer.
d. causes the family to consume less housing than before the fixed-quantity subsidy.
Answer: D

25. Figure 5-4 shows a family’s preferences for public and private healthcare. Refer to Figure 5-
4. Suppose the government offers a fixed quantity subsidy of healthcare valued at $B0. The new
budget line becomes _____.
a. MAS
b. MATN
c. MN
d. AS
Answer: B

26. Suppose the government provides $1,400 worth of educational services for all children.
Assume that public schooling cannot be supplemented with private tutoring. What would be the
cost of schooling for a family that desires educational services worth $1,700?
a. $0
b. $300
c. $1,700
d. Cannot be determined without more information
Answer: C

27. Which of the following statements is true?
a. Consumers are better off with a fixed-quantity subsidy than an equal-cost voucher system.
b. Voucher systems will not increase the quantity consumed of the subsidized good.
c. With a fixed-quantity subsidy consumers will consume more of other goods.
d. Fixed-quantity subsidies and voucher systems can both place the consumer on a higher
indifference curve.
Answer: D

28. A family's preferences toward schooling, before and after a fixed-quantity subsidy, are
shown in Figure 5-5. Prior to the subsidy, the family is in equilibrium at point J. Assume that
public schooling cannot be supplemented with private tutoring. Refer to Figure 5-5. After the
fixed-quantity subsidy has been introduced, the family consumes:
a. its optimum level of other goods.

b. less than its optimum quantity of schooling.
c. more than its optimum quantity of schooling.
d. less than its optimum quantity of other goods.
Answer: B
public schooling cannot be supplemented with private tutoring. Refer to Figure 5-5. The fixed-
quantity subsidy reduces schooling by _____.
a. G0
b. B0
c. BG
d. H0
Answer: C

public schooling cannot be supplemented with private tutoring. Refer to Figure 5-5. Public
schooling provided in the amount of B0 causes the family to increase consumption of other
goods by _____.
a. MC
b. MH
c. M0
d. CH
Answer: B

public schooling cannot be supplemented with private tutoring. Refer to Figure 5-5. Public
schooling provided in the amount of B0 causes the family to consume _____ of other goods.
a. MC
b. MH
c. M0
d. CH
Answer: C

public schooling cannot be supplemented with private tutoring. Refer to Figure 5-5. Suppose the
government offers education vouchers of value $B0 instead of a fixed-quantity subsidy. The
budget line will become _____.
a. MATN
b. AS
c. MN
d. MAS
Answer: D

33. Assume an indifference map with other goods on the vertical axis and health on the
horizontal axis. The government provides families with $400 vouchers that can be redeemed for
healthcare services at any hospital, public or private. The budget line for a family that avails this
voucher scheme will:
a. be negatively sloped.
b. be positively sloped up to $400 and then have a zero slope.
c. have a zero slope up to $400 and then have a negative slope.
d. be a straight line with an infinite slope.
Answer: C

34. Suppose a local government decides to increase taxes on its residents and use that money to
provide meals to each individual in the community. The scheme provides each individual with a
small frozen dinner. Compared to a voucher system that allows individuals to purchase meals at
a private restaurant, the frozen dinner scheme:
a. will decrease both quantity and quality of meals consumed.

b. will not affect the quality or quantity of meals.
c. will give individuals greater variety and choice of meals.
d. will increase both quantity and quality of meals consumed.
Answer: B

35. Compared to a system of providing education free of cost at government schools, a voucher
program that provides the means for parents to send their school-age children to private schools
at government expense:
a. will allow families to consume a higher quantity and better quality of education.
b. will lower the quality of education provided.
c. will not affect the quantity and quality of education.
d. will result in a lower quantity of education consumed.
Answer: A

36. All-you-can-eat restaurants charge a fixed price that permits unlimited access to prepared
food. Suppose food consumption is on the horizontal axis and all other goods on the vertical axis.
If the restaurant charges $10 per meal while the price of all other goods is $20, restaurant patrons
will consume to a point on their indifference curve where their marginal rate of substitution of
food for all other goods is equal to _____.
a. 2
b. 1/2
c. 10
d. 0
Answer: D

Section Reference: Paying for Garbage
Learning Objective: Explore the impact of per-bag charges versus a fixed annual fee on the amount
of trash generated by a community, recycling, and household welfare.
37. One of the possible explanations for why more trash is generated in cities is that _____.
a. cities have a low population density.

b. trash collection services in cities are expensive.
c. trash disposal is an inferior good
d. most city dwellers do not have to pay per unit of trash generated
Answer: D

38. An increase in the price per unit for trash disposal from zero to a positive quantity causes the
budget line to change from:
a. a vertical line to a horizontal line.

b. having a zero slope to a negative slope.
c. having a negative slope to a positive slope.
d. a horizontal line to a vertical line.
Answer: B

39. Which of the following policies would work best towards reducing traffic jams?
a. Relaxation of government restrictions on the number of cars being produced and sold
b. A reduction in interest rates on car loans
c. The imposition of a marginal fee to use certain roads during peak traffic hours
d. A levy of a fixed annual payment by car owners as traffic congestion fees
Answer: C
Difficulty Level: Hard

40. Which of the following groups are better off under an annual fee system of garbage
disposal?
a. Households that generate the average amount of trash

b. Households that generate less than the average amount of trash
c. All households that opt for the annual fee system
d. Households that generate more than the average amount of trash
Answer: D

Learning Objective: Explore the impact of per-bag charges versus a fixed annual fee on the
amount of trash generated by a community, recycling, and household welfare.
41. Consider a two-year period where a consumer has an income of $10,000 in year 1 and
$8,000 in year 2. The consumer can borrow or lend at a rate of 10 percent. If the consumer
decides to save $1,000 in year 1, it means:
a. his consumption will be equal in both years.

b. he will have a higher consumption in year 2 than in year 1.
c. he considers consumption in year 1 as an inferior good.
d. the cost of future consumption will increase.
Answer: B

Section Reference: The Consumer’s Choice to Save or Borrow
Learning Objective: Develop an intertemporal model that illuminates the consumer’s choice to
save or borrow and shows how changes in the consumer’s endowment and the interest rate affect
that choice.
42. An individual who is considering consumption between two time periods (year 1 and year 2)
has an endowment of $20,000 in year 1 and $15,000 in year 2. If the interest rate is 5 percent,
what is the maximum approximate amount that can be spent on consumption in year 1?
a. $35,000
b. $20,000
c. $35,750
d. $34,250
Answer: D

that choice.
43. Consider the income and consumption of an individual between two time periods. If
consumption in period 2 (C2) is on the horizontal axis, consumption in period 1 (C1) is on the
vertical axis, and the interest rate is 11 percent, the slope of the budget constraint must be _____.
a. 0.11
b. 0.9
c. 1.11
d. 11
Answer: B

that choice.
44. Other things remaining the same, in the intertemporal consumer choice model a change in
the endowment point:
a. produces a parallel shift in the consumer’s budget line.

b. alters the relative cost of future and present consumption.
c. pivots the budget line.
d. reduces the cost of current consumption.
Answer: A
that choice.
45. A reduction in an individual’s future income will cause:

a. consumption to fall in both time periods because consumption in both years are normal goods.
b. a fall in consumption in the future period but not the current period since the price of future
consumption relative to current consumption did not change.
c. consumption to fall in the future period and rise in the current period as the consumer
substitutes more current consumption for the future consumption.
d. an increase in current consumption if interest rates are high enough to induce consumption.
Answer: A

that choice.
46. In a two-year period, suppose Gloria has $10,000 in income in year 1 and $4,300 in income
in year 2. In order to maintain her optimal consumption of $8,000 in year 1 and $6,500 in year 2,
she can borrow or lend at a rate of 10 percent. If Gloria's income stream changes such that she
earns $3,000 in Year 1 and $12,000 in Year 2, the budget line will:
a. shift out away from the origin.

b. pivot about the endowment point.
c. pivot about the intercept on the axis representing year 2 income.
d. remain unchanged.
Answer: D

that choice.
47. Suppose consumption in year 2 (C2) is on the horizontal axis and consumption in year 1 (C1)
is on the vertical axis. An increase in the interest rate:
a. makes borrowers better off and lenders worse off.
b. causes more people to shift their consumption from year 2 to year 1.
c. causes the budget line to rotate outward along the horizontal axis.
d. will reduce savings in year 2.
Answer: C

that choice.
48. In the intertemporal consumer choice model, an increase in _____ will alter the slope of the
budget line.
a. saving
b. the interest rate
c. future income
d. borrowing
Answer: B

that choice.
49. An individual is considering consumption in two periods. He has decided to borrow $1,000
in period 1, given his endowment and the interest rate. Other things remaining the same, if the
interest rate increases, he will:
a. borrow less than $1,000.

b. continue to borrow $1,000.
c. borrow more than $1,000.
d. borrow more or less depending upon whether or not the substitution effect of the change is
greater than the income effect.
Answer: A

that choice.
50. Consider an individual for whom consumption in two periods is a normal good. Other things
remaining the same, if the interest rate increases, then:
a. he is worse off.
b. he is better off.
c. he will spend more in each period.
d. he will choose to save more.
Answer: B

that choice.
51. Fred is considering consumption between two periods and is earning an income of $1,000 in
both periods. If the interest rate is 8 percent, Fred borrows $500, but if the interest rate rises to 18
percent, Fred saves $500. Is this behavior economically reasonable?
a. No, Fred would borrow less because of the higher interest rate but would still borrow a
positive amount.
b. No, Fred might not borrow at all, but would not start saving. If Fred wanted to save he would
have saved at the lower interest rate too.
c. Yes, the change in interest rates will cause his endowment point to shift, allowing him to
become a saver.
d. Yes, the higher interest rate will raise the cost of current consumption, inducing him to cut
back current consumption. He could cut back so much that he becomes a saver.
Answer: D

that choice.
52. In a two-year period, if a higher interest rate causes consumption in year 1 to rise:
a. the income effect associated with the higher interest rate is greater than the substitution effect.
b. the substitution effect associated with the higher interest rate is greater than the income effect.
c. the income effect of the higher interest rate is negative.
d. the substitution effect of the higher interest rate is positive.
Answer: A

that choice.
53. When comparing T-bills and stocks, a risk-averse investor may choose to invest in T-bills
although stocks give higher average returns because _____.
a. investing in stocks involves a long term commitment

b. investing in stocks involves a higher degree of risk
c. stocks are less liquid than T-bills
d. stocks cannot be bought and sold in a secondary market
Answer: B

Section Reference: Investor Choice
Learning Objective: Understand how the theory of consumer choice can explain what types of
financial assets an individual intent on saving for the future should invest in, or purchase.
54. Brenda starts a business for $150,000 that gives her a 50% chance of losing and a 50%
chance of gaining an expected annual return of $75,000. John is content with a job that pays him
$75,000 per year with near certainty; there is only about a 1% chance of losing his job each year.
Suppose risk is on the horizontal axis and return on the vertical axis, Brenda’s indifference curve
for risk and return:
a. is flatter than John’s.

b. is steeper than John’s.
c. has the same slope as John’s.
d. is horizontal.
Answer: A

55. Suppose Microsoft stock will provide either a return of 10 or 20 percent over the next year
and that the probability of the former outcome is 0.25 while the probability of the latter is 0.75.
The expected return on Microsoft stock over the next year is thus _____%.
a. 15
b. 12.5
c. 17.5
d. 20
Answer: C

56. Suppose Microsoft stock will provide either a return of 10 or 20 percent over the next year
and that the probability of the former outcome is 0.25 while the probability of the latter is 0.75. If
the utility an investor derives from a 10 percent return on Microsoft stock is 200 and the utility
the investor derives from a 20 percent return is 400, the investor's expected utility from holding
Microsoft stock is _____.
a. 300
b. 350
c. 250
d. 400
Answer: B

57. Expected return is defined as _____.
a. the summed value of each possible rate of return discounted for inflation
b. the average probability of profit on a fair investment
c. the expected probability of high returns on an investment
d. the summed value of each possible rate of return weighted by its probability
Answer: D

58. The expected utility from an investment is defined as _____.
a. the summed value of each possible utility weighted by its probability

b. the expected returns from an investment weighted by its risk.
c. the expected probability of high returns on an investment
d. the summed value of each possible rate of return discounted for inflation
Answer: A

59. For a risk-averse individual, with return on the X-axis and total utility on the Y-axis, the
slope of the total utility curve:
a. increases at an increasing rate.

b. has a constant slope.
c. increases at a decreasing rate.
d. is always negative.
Answer: C

60. For a risk-loving individual, with return on the X-axis and total utility on the Y-axis, the
slope of the total utility curve:

d. decreases at an increasing rate.
Answer: A

61. For a risk-neutral individual, with return on the X-axis and total utility on the Y-axis, slope
of the total utility curve:

d. decreases at an increasing rate.
Answer: B

62. A risk-averse individual _____.
a. prefers a sure return to an uncertain prospect generating the same expected return
b. is indifferent between a sure return and an uncertain prospect generating the same expected
return
c. will forgo a sure return in favor of an uncertain prospect generating the same expected return
d. will avoid all risky investments no matter what the return
Answer: A

63. A risk-neutral individual _____.
a. prefers a sure return to an uncertain prospect generating the same expected return
b. is indifferent between a sure return and an uncertain prospect generating the same expected
return
c. will forgo a sure return in favor of an uncertain prospect generating the same expected return
d. will avoid all risky investments no matter what the return
Answer: B

64. A risk-averse individual who owns a $200,000 house and faces the prospect that the house
will burn down with the probability 0.05 in any given year will be willing to pay how much of an
annual premium to fully insure against such a loss?
a. $5,000
b. More than $10,000
c. No more than $5,000
d. Either more or less than $10,000 depending on whether housing is a normal or inferior good
for the individual
Answer: B

65. Which of the following leads to the diversification of risk?
a. Investing in assets that give the highest possible returns

b. Investing in safe assets that may give low returns
c. Investing in multiple assets rather than a single asset
d. Investing in assets that are highly risky but give high returns
Answer: C

66. Walter works for a large firm that produces software and has a capitalized value of $10
billion. This firm pays its employees, in part, with the company’s stock, compensating Walter an
additional thirty percent of his $50,000 annual salary worth of the company’s stock. Which of
the following is true?
a. This compensation scheme reduces the level of risk in his portfolio since he is employed at the
same company.
b. This compensation scheme provides Walter a good means of minimizing financial risk since
he can hold stock in his company rather than money in the bank.
c. To reduce his exposure to risk Walter should purchase more stock in his company if he
believes more people will buy computers in the future.
d. To minimize risk Walter should sell the stock in his company and buy other assets to diversify
his financial holdings.
Answer: D

67. Consider Figure 5-6. The family shown faces the budget line A1BFZ. Health insurance is
measured in $100 units and other goods in $1 units. A health insurance plan is introduced which
would provide this family $15,000 worth of insurance for $4,000. The new budget constraint the
family will face is:
Other Goods Figure 5-6
$61,000 = A
$50,000 = A1
B A’
$46,000 = A2
$35,000 = A3 F
0 H1 H2 Z Z’ Health Insurance
(40) (150)
a. AA’Z’
b. AA1BA’Z’
c. A1BA’Z’
d. A1A2BA’Z’
Answer: C

Section Reference: Subsidizing Health Insurance: ObamaCare
Learning objective: Examine how the public provision of a certain quantity of a good such as
education may lead to less consumption of the good.
Question Type: Essay
68. Show and explain why substituting an unrestricted cash transfer for an excise subsidy of equal
cost to the government must lead to less consumption of the subsidized good and more
consumption of other goods.
Answer: Let the initial budget line be AZ. An excise subsidy for food will decrease the slope of
the budget line because it lowers the price of food.
Let the new budget line be AY. The optimal (utility-maximizing) consumption bundle under the
excise subsidy is (FC, Oc.. The subsidy costs the government the dollar value of distance CJ because
this is the distance between the subsidized (AY) and unsubsidized (AZ) budget lines at the optimal
level of food consumption (the subsidized good). In other words, if the consumer had to pay the
original (unsubsidized) price, he or she would have distance JFC left to spend on other goods after
buying FC units of food. But with the subsidy, the consumer has distance CFC left to spend on other
goods after buying FC units of food (at the lower subsidized price). The difference, distance CJ, is
the part the government pays for the consumer.
The budget line for an equal-cost lump sum transfer must therefore pass through point C since
point C is distance CJ above budget line AZ. Budget line GH is always distance CJ above line
AZ; they are parallel. The lump sum grant of distance GA (equal to distance CJ) must lead to less
consumption of the food and more consumption of other goods because the lump sum budget line
(GH) is not tangent to, but intersects indifference curve U2. This can be seen above by noting that
point OF is above point OC on the Y-axis and point FF is to the left of point FC on the X-axis. In
other words, both the excise and lump sum subsidies have income effects which tend to increase
consumption of food, only the excise subsidy has a substitution which tends to increase further the
consumption of food which is made relatively less expensive by the excise subsidy.

69. The government of Lilliput wants to ensure food security for all its citizens. Explain how each
of these policies will affect the consumption of food and other goods using indifference curves.
a) Providing each Lilliputian with a food voucher for $50
b) Transferring $50 in cash to each Lilliputian's bank account
c) Subsidizing the price of food with a per-unit subsidy
d) Providing $50 worth of food per head free of cost at government-run food agencies. (Assume
that an individual cannot supplement this quantity with any extra food)
Answer:
a)
For a consumer who was initially at point A with a negatively sloped budget line, a voucher for
$50 changes the budget line such that it has a slope of zero up to the quantity that can be purchased
for $50. For quantities greater than $50, the budget line is negatively sloped, as shown in bold in
the figure. The consumer who was earlier at point A, can now choose to consume only food (at
point A’’) or more of food and other goods at A’. He moves up to a higher indifference curve.
b)
With cash transfer the budget line shifts from MN to M’N’. Due to the income effect of the cash
transfer, consumers are able to increase their purchases of both goods and can consume more of
food or other goods or both according to their preferences. However, the consumer will definitely
move to a higher indifference curve.
c)
A per unit excise subsidy on food decreases the price of food and the budget line rotates about the
vertical axis. Due to the income and substitution effects of an excise subsidy the consumption of
the subsidized good increases.
d)
The budget line for a fixed-quantity subsidy is shown in bold in the figure. Up to $50 worth of
food can be consumed at no extra cost to the consumer. If the consumer wishes to consume more
than $50 worth of food, he will have to forego the subsidized quantity entirely and consume only
along the RZ portion of the budget line, paying the full cost of the food. The fixed-quantity subsidy
does not benefit a consumer who does not wish to avail of the food supplied by the government.

Section Reference 01: Public Schools and the Voucher Proposal
Section Reference 02: Excise Subsidies, Health Care, and Consumer Welfare
Learning Objective 01: Analyze how a voucher program would affect the quantity of educational
Learning Objective 02: Determine how an excise subsidy affects consumer welfare and why it
70. Answer the following:
a) Sarah drives 6 miles to work every day. Liam takes the same route but has to drive for a total of
11 miles. With the objective of reducing traffic jams, the government decides to impose a tax on
drivers. How would an annual fixed payment of $500 as congestion charges affect Sarah and Liam?
Explain your answer using indifference curves and a common budget line for Liam and Sarah.
b) What if the government decided to impose a fee of $1 per mile driven?
Answer:
a) Irrespective of the number of miles they drive per day, both Sarah and Liam have to pay the
same $500 as congestion charges. This implies that their per-mile price of a mile is zero; once they
pay $500, they can drive as many miles as they wish at zero cost. Their common budget line is
vertical with a slope of 0. They would continue to drive the same number of miles as they have no
gains from reducing or increasing the number of miles they drive per day.
b) As a result of the per-unit fee, the slope of the budget line changes from zero to a negative slope
reflecting the increase in per-unit cost to $1. Both Sarah and Liam reduce the number of miles they
drive, perhaps by carpooling or using public transport. Sarah moves to a higher indifference curve
whereas Liam moves to a lower indifference curve. Since Sarah drives less than the average
number of miles (8.5 miles) she is better off on a per-unit fee system.
71. Fun-day, a theme park, recently changed its ticket pricing plan from Plan 1 to Plan 2. How
would you explain the sudden increase in the number of people at the theme park?
Plan 1 Plan 2
Children Adults Children Adults
Fixed
0 0 $20 $40
admission fee
Per-ride fee $2 $5 0 0
Answer: Assume that there are two adults with budget constraints of $40 each. Plan 1 offers
different prices for different rides. The budget line facing both adults is the same straight line with
a slope of –5. The number of rides that the adult chooses will depend on his or her preferences but
will be limited by the budget constraint.
Plan 2 offers a flat admission free and an unlimited number of rides; after paying the fee visitors
can enjoy an unlimited number of rides. This implies that their budget constraint is vertical with a
zero slope. The price per ride becomes zero so visitors tend to enjoy more rides than they would
on a per-unit pricing plan, assuming that the number of rides is a normal good and that the number
of rides each adult enjoys is not affected by congestion and queues.
The case for children can be explained analogously.

a) Doug is 51 years old. He owns a Laundromat and plans to retire at the age of 60. Pete is 21 years
old. He just started working at an investment bank. The figure shows the preferences for future
and present consumption for an individual. Other things unchanged, who is more likely to be at
point N on the budget line and why?
b) The government passes a new regulation on bank bonuses; the tax rate on bonuses has been
hiked to 55%. How would this affect Pete, whose annual bonus forms a substantial portion of his
compensation?
a) The endowment point N on the budget line is indicative of a low level of present income and a
higher level of future income. This is a pattern observed in younger workers and students and so
is most likely to be Pete’s consumption pattern.
b) A hike in the tax rate on bonuses would reduce the income available for Pete to spend in the
future. The reduction in future income will lead to an inward parallel shift of Pete’s budget line,
reducing his consumption both in the present and the future.

that choice.
73. In the model of inter-temporal choice, will a person who initially consumes exactly their
income in each period have more or less current consumption after a decrease in the interest rate?
Answer: The graph below represents a consumer, facing interest rate ‘r’, who consumes exactly
her income in both the periods.
Since the person initially consumes exactly their income in each period, the original utility-
maximizing indifference curve, U1, must be tangent to the original budget line, AB, at the
endowment point, N. A decrease in the interest rate causes the budget line to rotate about point N.
The new budget line is CE and this person will necessarily have more current consumption and
less future consumption.

74. Phil and Jane, and their son Dylan, have $10,000 in savings which they would like to invest.
Phil wants to use the money to open a diner although he has only a 30% chance of getting the same
returns as Jane who prefers investing the money in Treasury bills. Jane prefers to invest in T-bills
since they are less risky. Their son, Dylan, is indifferent between the diner and Treasury bills as
long as he gets a new car. How would you represent their preferences towards risk and return on
an indifference map?
Answer: Phil prefers an uncertain outcome to a certain prospect that gives the same outcome; Phil
is risk-loving. Jane prefers a certain outcome to an uncertain outcome that gives the same returns;
Jane is risk-averse. Dylan does care one way or the other about the risk or returns from a diner or
T-bills; he is risk-neutral.
The indifference curves are positively sloped because risk is considered an economic “bad”.
Jane’s indifference curves are steeper than Phil’s. This is because for a given increase in risk, Jane
needs to be compensated with a greater return to remain at the same level of utility.
Phil has flatter indifference curves because he needs a smaller return for an increase in risk.
Dylan is risk-neutral; he is indifferent to the amount of risk as long as he gets a higher return.

75. Describe the relationship among total utility, marginal utility, and preferences toward risk.
Answer: Marginal utility is the slope (or derivative) of the total utility curve. With respect to
investors, marginal utility is the change in total utility for a one unit change in return. A risk-averse
investor’s total utility curve has a positive and diminishing slope. Therefore, a risk-averse
investor’s marginal utility curve has a negative slope. Similarly, a risk-neutral investor has a total
utility curve with a positive but constant slope. Therefore, a risk-neutral investor’s marginal utility
curve has a zero slope, i.e., it is flat. Finally, a risk-loving investor’s total utility curve has a positive
and increasing slope indicating that the marginal utility curve has a positive slope.

a) How is insurance similar to an individual’s diversified portfolio?
b) Explain why holding a diverse portfolio of assets is important to minimizing the risk of an
investment portfolio.
c) Given the importance of diversifying all of your financial assets, is it a good idea to own stock
in the company for which you work, even if you own stock in other sectors? Explain why or why
not.
d) A home is the most valuable asset for a majority of U.S. residents. Why do we not see more
diversification in real estate ownership against loss of value due to market fluctuations?
Answer:
a) Insurance companies assume risks of different individuals and diversify that risk across
individuals and across geographic regions.
Suppose there is a risk-averse individual who has a one in one-hundred chance of his house
catching fire each year and causing $100,000 in damage. What this means is that once every
hundred years this individual can expect his house to catch fire and consequently have to pay
$100,000 in repair costs. His expected loss is $1,000 per year, which he could simply put aside
and after 99 years his house catches fire and he uses the money he’s put aside, plus an additional
$1,000 for the 100th year, and repairs his home.
Unfortunately, he doesn’t know in which of the 100 years his home will catch fire, or if it will
catch fire at all, or even more than once. If it happens during his first year of saving up to pay the
cost of a fire, he has to greatly curtail his consumption of other goods to pay for the damages. In
this case, this individual, because he is risk-averse, would have been willing to pay more than
$1,000 each year to have someone else assume the cost of damage should his house catch fire.
The solution is to purchase insurance against the damage. What this means is that an insurance
firm accepts $1,000 from each of 100 homeowners, each with the same expected loss as the
individual above. When one of the one hundred homes catches fire, the insurance company uses
the $100,000 it has collected to repair the damage to the unlucky homeowner. Given that our
homeowner, because he is risk-averse, is willing to pay more than the expected loss of $1,000 to
insure against damages, the insurance company charges a fee of $1,000 per homeowner, plus an
additional amount to cover its operating expenses, and it assumes the risk for the 100 homeowners.
Because the insurance company insures people in different geographic regions, and to cover a
variety of calamities, it is diversifying its expected loss. A case in point is an insurance company
that insures against hurricane damages along the coast of Florida, but does not sell other insurance
to individuals in, say, sunny California. By failing to diversify its holdings of insurance policies,
the company benefits greatly if hurricanes never happen, but is financially devastated should one
come through and wreak heavy damages to homes the company has insured.
b) If stock and bond prices follow a random walk, which is the prevailing wisdom, then their prices
are consequently unpredictable. The goal is to have a holding of financial assets that in the
aggregate do not vary significantly from their long-run growth. So it is better to own stock in both
the picnic basket company as well as the umbrella company because it if there is an unexpectedly
long duration of rain, your holdings in the picnic basket company fall, but those in the umbrella
company rise. Conversely, if there is an unexpected drought, then the opposite is true. In the long
run, your holdings average, say, 7%, and by holding a portfolio of diverse assets, the value of your
portfolio at any point in time does not vary by much more than that.
c) Given your human capital is your most important asset, you should not invest your money where
you have invested your human capital. If your company goes bankrupt, you not only lost your job,
you’ve also lost your savings. If you work for suppose the picnic basket company, you must own
stocks in the umbrella company. If your portfolio is already well diversified, then the risk of
holding stock in the company for which your work is likely to be reduced.
d) One explanation is that if you were to diversify your home’s ownership with, say, twenty other
homeowners by each owning 1/20th of 20 different homes in different regions, then there is less of
an incentive to care for the property. If I could benefit $100 by allowing $1,000 damage to go
unabated to the home in which I am living, but of which I only own twenty percent, then my cost
of allowing $1,000 worth of damage to occur is only $50. Since the $100 benefit from neglect is
greater than the $50 cost, we can expect to see more neglect.
There is also a problem with transferring ownership of shared homes, which has been experienced
with timeshares. Timeshares are a program where a company manages the tenancy of (mostly)
condominiums jointly owned by many people.


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Question Type: Multiple Choice

Difficulty Level: Easy

2. The U.S. government in effect subsidizes health care of workers by:

a. relaxing health care regulations.

Difficulty Level: Easy

3. An excise subsidy given on each unit of X consumed will:

a. reduce consumption of X and lower total expenditures on X.

Difficulty Level: Medium

4. Which of the following is true of an excise subsidy?

Difficulty Level: Medium

Difficulty Level: Medium

6. Which of the following is true of an excise subsidy?

Difficulty Level: Easy

Difficulty Level: Medium

Difficulty Level: Easy

Difficulty Level: Easy

Difficulty Level: Easy

Difficulty Level: Easy

Difficulty Level: Medium

13. Unlike an equivalent-sized cash transfer, an excise subsidy on good X:

a. has an income effect.

Difficulty Level: Medium

14. An excise subsidy given on clothing will encourage consumers to purchase:

a. more clothing due to the substitution effect.

Difficulty Level: Easy

a. prefer an excise subsidy.

Difficulty Level: Medium

Difficulty Level: Medium

17. Being a member of the government-sponsored MediSave scheme entitles employees to a

Difficulty Level: Medium

Difficulty Level: Easy

Difficulty Level: Easy

20. The welfare effect of an excise subsidy indicates that:

a. the consumer is better off than without the subsidy.

Difficulty Level: Medium

a. When consumption of the subsidized good is mandatory

Difficulty Level: Easy

22. A fixed-quantity subsidy differs from food stamps in that:

a. the fixed-quantity provides a minimum quantity that can be supplemented by additional

Difficulty Level: Medium

a. the consumer has concave indifference curves.

Difficulty Level: Medium

a. is provided by the government at a cost of $TB.

Difficulty Level: Medium

Difficulty Level: Easy

Difficulty Level: Medium

Difficulty Level: Medium

a. its optimum level of other goods.

Difficulty Level: Medium

Difficulty Level: Medium

Difficulty Level: Medium

Difficulty Level: Medium

Difficulty Level: Medium