Macroeconomics, 11e (Parkin)

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POSSIBILITES,
PREFERENCES,
C h a p t e r
9 AND CHOICES

Answers to the Review Quizzes

Page 204
1. What does a household’s budget line show?
The budget line plots combinations of goods that require all a
household’s income and describes the limits to its consumption
choices.
2. How does the relative price and a household’s real income
influence its budget line?
The magnitude of the slope of the budget line equals the relative
price of the good or service measured on the horizontal axis. A fall
in the price of the good measured on the horizontal (vertical) axis
decreases that good’s relative price and decreases (increases) the
slope of the budget line. A household’s real income is the
household’s income expressed as a quantity of goods the household
can afford to buy. An increase (decrease) in household income causes
a parallel shift of the budget line rightward (leftward). The slope
of the budget line does not change when income changes.
3. If a household has an income of $40 and buys only bus rides at $2
each and magazines at $4 each, what is the equation of the
household’s budget line?
The budget equation states that a household’s spending must equal
its income. The budget equation is derived for two goods, bus rides
and magazines. The amount spent on bus rides is (Pbus ride)×(Qbus
ride), the amount spent on magazines is (Pmagazine)×(Qmagazine), and
the consumer’s income is y. We know that (Pmagazine)×(Qmagazine) +

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(Pbus ride)×(Qbus ride) = y. Rearrange this equality by subtracting

the amount spent on bus rides from both sides to give
(Pmagazine)×(Qmagazine) = y – (Pbus ride)×(Qbus ride). Finally, divide
both sides by the price of magazine to give the budget equation
Qmagazine = y/Pmagazine – (Pbus ride /Pmagazine)×(Qbus ride).
Substituting in our values, y = $40, P bus ride = $2 and P magazine =
$4, gives Qmagazine = $40/$4 – ($2/$4)×(Qbus ride) which is equal to
Qmagazine = 10 – 0.5 Qbus ride

4. If the price of one good changes, what happens to the relative

price and the slope of the household’s budget line?
A relative price is the price of one good divided by the price of
another good. For example, the magnitude of the slope of the budget
line (Pmovie/Psoda) is the relative price of a movie in terms of
soda. This relative price shows how many sodas must be forgone to
see an additional movie. A fall in the price of the good on the
horizontal (vertical) axis increases the total affordable quantity
of that good, decreases its relative price, and decreases
(increases) the magnitude of the slope of the budget line.
5. If a household’s money income changes and prices do not change,
what happens to the household’s real income and budget line?
A household’s real income is the household’s income expressed as a
quantity of goods the household can afford to buy. For example, the
vertical intercept for a budget line measuring soda on the vertical
axis is (y/Psoda), which is the consumer’s real income in terms of
sodas. A change in a household’s money income changes the
household’s real income in terms of both goods and causes a parallel
shift of the budget line. If a household’s money income increases,
its budget line shifts rightward and if a household’s money income
decreases, its budget line shifts leftward.

Page 208
1. What is an indifference curve and how does a preference map show
preferences?
An indifference curve shows those combinations of goods for which a
consumer is indifferent. The consumer has the same level of
satisfaction for any combination on a given indifference curve. The
family of indifference curves is the preference map. This map shows
the person’s preferences because it shows how the person ranks each
combination of goods. In particular, the person prefers combinations
on higher indifference curves to combinations on lower indifference
curves.
2. Why does an indifference curve slope downward and why is it bowed
toward the origin?
The downward slope of an indifference curve illustrates the tradeoff
between two goods while maintaining the same level of total
satisfaction. Since the consumer is indifferent among all points on
an indifference curve, when moving along it any increase in

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 POSSIBILITIES, PREFERENCES, AND CHOICES 145

satisfaction from gaining one good must be matched by an equal

decrease in satisfaction from a loss in the other good. An
indifference curve is bowed toward the origin because the more of
good x that is consumed the less you are willing to give up of good
y to get more of good x and remain indifferent.
3. What do we call the magnitude of the slope of an indifference
curve?
The magnitude of the slope of an indifference curve is called the
marginal rate of substitution (MRS). The MRS measures the rate at
which the consumer gives up one good to get more of another good,
while remaining on the same indifference curve (keeping the consumer
indifferent about the changes). The bowed-in shape of the
indifference curve is due to the assumption of diminishing MRS.
4. What is the key assumption about a consumer’s marginal rate of
substitution?
The key assumption about the marginal rate of substitution is that
it is diminishing as a consumer moves down an indifference curve,
creating the bowed-in shape.

Page 213
1. When a consumer chooses the combination of goods and services to
buy, what is she or he trying to achieve?
The consumer is trying to achieve the highest level of well being
possible.
2. Explain the conditions that are met when a consumer has found the
best affordable combination of goods to buy. (Use the terms
budget line, marginal rate of substitution, and relative price in
your explanation.)
At the optimal consumption choice, the consumer’s consumption bundle
is
1) on the budget line,
2) on the highest attainable indifference curve,
3) such that the slope of the budget line, which is the relative
price of the two goods, equals the slope of the indifference
curve, which is the MRS.
3. If the price of a normal good falls, what happens to the quantity
demanded of that good?
If the price of a normal good falls, the quantity demanded of that
good increases because the substitution effect and the income effect
both bring an increase in the quantity demanded.
4. Into what two effects can we divide the effect of a price change?
A price change can be divided into a substitution effect and an
income effect. The substitution effect is the effect of a change in
price on the quantity bought when the consumer remains indifferent
between the original situation and the new situation. The income
effect is the effect of a change in income sufficient to get the

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146 CHAPTER 9

consumer to the highest indifference curve that is affordable on the

new budget line reflecting the price change.
5. For a normal good, does the income effect reinforce the
substitution effect or does it partly offset the substitution
effect?
For a normal good the substitution effect and the income effect
reinforce each other, and a decrease (increase) in the price of a
good will always result in an increase (decrease) in the quantity of
the good demanded.

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Answers to the Study Plan Problems and Applications

Use the following information to work Problems 1 to 4.
Sara’s income is $12 a week. The price of popcorn is $3 a bag, and
the price of a smoothie is $3.
1. Calculate Sara’s real income in terms of smoothies. Calculate her
real income in terms of popcorn.
Sara’s real income is 4 smoothies. Sara’s real income in terms of
smoothies is equal to her money income divided by the price of a
smoothie. Sara’s money income is $12, and the price of a smoothie is
$3. Sara’s real income is $12 divided by $3 a smoothie, which is 4
smoothies.
Sara’s real income is 4 bags of popcorn. Sara’s real income in terms
of popcorn is equal to her money income divided by the price of a
bag of popcorn, which is $12 divided by $3 a bag or 4 bags of
popcorn.
2. What is the relative price of smoothies in terms of popcorn? What
is the opportunity cost of a smoothie?
The relative price of a smoothie is 1 bag of popcorn per smoothie.
The relative price of a smoothie is the price of a smoothie divided
by the price of a bag of popcorn. The price of a smoothie is $3 and
the price of popcorn is $3 a bag, so the relative price of a
smoothie is $3 divided by $3 a bag, which equals 1 bag of popcorn
per smoothie.
The opportunity cost of a smoothie is 1 bag of popcorn. The
opportunity cost of a smoothie is the quantity of popcorn that must
be forgone to get a smoothie. The price of a smoothie is $3 and the
price of popcorn is $3 a bag, so to buy one smoothie Sara must forgo
1 bag of popcorn.
3. Calculate the equation for Sara’s budget line (with bags of
popcorn on the left side).
The equation that describes Sara’s budget line is QP = 4 – QS. Call
the price of popcorn PP and the quantity of popcorn QP, the price of
a smoothie PS and the quantity of smoothies QS, and income y. Sara’s
budget equation is PPQP + PSQS = y. If we substitute $3 for the price
of popcorn, $3 for the price of a smoothie, and $12 for the income,
the budget equation becomes $3QP + $3QS = $12. Dividing both sides by
$3 and subtracting QS from both sides gives QP = 4 – QS.
4. Draw a graph of Sara’s budget line with the quantity of smoothies
on the x-axis. What is the slope
of Sara’s budget line? What
determines its value?
To draw a graph of the budget
line, plot the quantity of
smoothies on the x-axis and the
quantity of popcorn on the y-
axis. The budget line is a
straight line from 4 bags of

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popcorn on the y-axis to 4 smoothies on the x-axis.

The slope of the budget line, when smoothies are plotted on the x-
axis, is minus 1. The magnitude of the slope is equal to the
relative price of a smoothie. The slope of the budget line is “rise
over run.” If the quantity of smoothies decreases from 4 to 0, the
quantity of popcorn increases from 0 to 4. The rise is 4 and the run
is 4. Therefore the slope equals 4/4, which is 1.

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Use the following information to work Problems 5 to 8.

Sara’s income falls from $12 to $9 a week, while the price of popcorn
is unchanged at $3 a bag and the price of a smoothie is unchanged at
$3.
5. What is the effect of the fall in Sara’s income on her real
income in terms of smoothies?
Sara’s real income falls from 4 smoothies to 3 smoothies. Sara’s
real income in terms of smoothies is equal to her money income
divided by the price of a smoothie. Sara’s money income is now $9
and the price of a smoothie is $3. Sara’s real income is now $9
divided by $3 a smoothie, which is 3 smoothies.
6. What is the effect of the fall in Sara’s income on her real
income in terms of popcorn?
Sara’s real income falls from 4 bags of popcorn to 3 bags of
popcorn. Sara’s real income in terms of popcorn is equal to her
money income divided by the price of a bag of popcorn. Sara’s money
income is now $9 and the price of a bag of popcorn is $3. Sara’s
real income is now $9 divided by $3 a bag, which is 3 bags of
popcorn.
7. What is the effect of the fall in Sara’s income on the relative
price of a smoothie in terms of popcorn?
The relative price of a smoothie is 1 bag of popcorn per smoothie,
the same relative price as before her income fell. The relative
price does not depend on Sara’s income. Instead the relative price
of a smoothie is the price of a smoothie divided by the price of a
bag of popcorn. The price of a smoothie is $3 and the price of
popcorn is $3 a bag, so the relative price of a smoothie is $3
divided by $3 a bag. The relative price equals 1 bag per smoothie.
8. What is the slope of Sara’s new budget line if it is drawn with
smoothies on the x-axis?
The slope of the budget line, when smoothies are plotted on the x-
axis is minus 1, the same slope as before her fall in income. The
magnitude of the slope of the budget line is equal to the relative
price of a smoothie. The relative price does not change when Sara’s
income decreases so the slope of the budget line does not change.
Use the following information to work Problems 9 and 10.
Sara’s income is $12 a week. The price of popcorn rises from $3 to $6
a bag, and the price of a smoothie is unchanged at $3.
9. What is the effect of the rise in the price of popcorn on Sara’s
real income in terms of smoothies and her real income in terms of
popcorn?
The rise in the price of a bag of popcorn has no effect on Sara’s
real income in terms of smoothies. Sara’s real income in terms of
smoothies remains 4 smoothies. Sara’s real income in terms of
popcorn falls to 2 bags of popcorn. Sara’s real income in terms of
popcorn is equal to her money income divided by the price of a bag
of popcorn. Sara’s money income is $12 and the price of a bag of

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popcorn is now $6. Sara’s real income is now $12 divided by $6 a

bag, which is 2 bags of popcorn.
10. What is the effect of the rise in the price of popcorn on the
relative price of a smoothie in terms of popcorn? What is the
slope of Sara’s new budget line if it is drawn with smoothies on
the x-axis?
The relative price of a smoothie falls to 1/2 bag of popcorn per
smoothie. The relative price of a smoothie is the price of a
smoothie divided by the price of a bag of popcorn. The price of a
smoothie is $3 and the price of popcorn is $6 a bag, so the relative
price of a smoothie is $3 divided by $6 a bag, which equals 1/2 bag
of popcorn per smoothie. The rise in the price of a bag of popcorn
lowers the relative price of a smoothie in terms of popcorn.
The slope of the budget line, when smoothies are plotted on the x-
axis is minus 1/2. The magnitude of the slope is equal to the
relative price of a smoothie. The relative price has fallen so the
magnitude of the slope of the budget line has fallen.
11. Draw figures that show your indifference curves for the following
pairs of goods. For each pair, are the goods perfect substitutes,
perfect complements, substitutes, complements, or unrelated?
 Right gloves and left gloves
Figure 9.2A is to the right. Right
gloves/left gloves are perfect
complements. Because these are perfect
complements, the indifference curves are
right angles.

 Coca-Cola and Pepsi

Figure 9.2B is to the right. These are,
for most students, almost perfect
substitutes. The indifference curves
should either be linear (for perfect
substitutes, as shown in Figure 9.2B) or
nearly linear.

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 Tylenol and acetaminophen (the generic

form of Tylenol)
Figure 9.2C is to the right. These pills
are, for most people, very close
substitutes but for most consumers they
are not perfect substitutes.

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 Desktop computers and laptop computers

Figure 9.2D is to the right. These are
substitutes, though not perfect
substitutes. The indifference curves are
bowed inward toward the origin as in
Figure 9.2C.

 Strawberries and ice cream

Figure 9.2E is to the right. These are
probably complements for many students,
though not perfect complements. The
indifference curves are not right
angles, as they would be for perfect
complements, but instead are bowed
inward toward the origin.

12. Discuss the shape of the indifference curve for each of the
following pairs of goods. Explain the relationship between the
shape of the indifference curve and the marginal rate of
substitution as the quantities of the two goods change.
 Orange juice and smoothies
Orange juice and smoothies are substitutes. They are not perfect
substitutes, so the indifference curves are bowed in toward the
origin. The marginal rate of substitution falls moving down along an
indifference curve.
 Baseballs and baseball bats
These are complements but probably not perfect complements. The
indifference curves should be significantly bowed inward. (If a
student says these goods are perfect complements, the indifference
curves should be right angles, such as those in Figure 9.2A.) If the
indifference curves are not right angles, then the marginal rate of

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 POSSIBILITIES, PREFERENCES, AND CHOICES 153

substitution falls rapidly moving down along an indifference curve.

(If the goods are perfect complements, the marginal rate of
substitution does not change moving down along the indifference
curve except when moving around the 90 degree point where it goes
from infinity to zero.)
 Left running shoe and right running shoe
These are perfect complements so the indifference curves are right
angles, as shown in Figure 9.2A. The marginal rate of substitution
does not change moving down along the indifference curve except when
moving around the 90 degree point where it goes from infinity to
zero.
 Eyeglasses and contact lenses
The indifference curves should either be linear (for perfect
substitutes, as shown in Figure 9.2B) or nearly linear as in Figure
9.2C. If the indifference curves are linear, then the marginal rate
of substitution does not change moving down along the indifference
curve; if the indifference curves are nearly linear, then the
marginal rate of substitution falls slightly moving down along an
indifference curve.
Use the following news clip to work Problems 13 and 14.
The Year in Medicine
Sudafed, used by allergy sufferers, contains as the active ingredient
pseudoephedrine, which is widely used to make home-made
methamphetamine. Allergy sufferers looking to buy Sudafed must now
show photo ID and sign a logbook. The most common alternative,
phenylephrine, isn’t as effective as pseudoephedrine.
Source: Time, December 4, 2006
13. Sketch an indifference curve for Sudafed and phenylephrine that
is consistent with this news
clip. On your graph, identify
combinations that allergy
sufferers prefer, do not prefer,
and are indifferent among.
Figure 9.3 has an indifference
curve, I. Figure 9.3 shows the
preferred, not preferred, and
indifferent points. The preferred
points are all points to the
right of the indifference curve;
the not preferred points are all
points to the left of the
indifference curve; and, the
indifferent points are all points
on the indifference curve.

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154 CHAPTER 9

14. Explain how the marginal rate of substitution changes as an

allergy sufferer increases the consumption of Sudafed.
The indifference curve shows that Sudafed and phenylephrine are
substitutes, so the marginal rate of substitution falls moving
downward along the indifference curve.

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 POSSIBILITIES, PREFERENCES, AND CHOICES 155

15. Gas Prices to Stunt Memorial Day Travel

With high gas prices, 12% of the people surveyed say that they
have cancelled their Memorial Day road trip and 11% will take a
trip near home. That may save consumers some money, but it will
also likely hurt service stations, which will sell less gas and
fewer snacks and hurt roadside hotels, which will have fewer
rooms used and serve fewer meals.
Source: Market Watch, May 22, 2008
Describe the degree of substitutability between gasoline and
other Memorial Day trip-related goods and services and sketch a
consumer’s preference map that illustrates your description.
Memorial Day trip-related goods
and gasoline are complements but
not perfect complements. Figure
9.4 shows the indifference curves
between Memorial Day trips and
gasoline. Because these are
comple-ments, the indifference
curves are tightly curved.
16. Use the news clip in Problem 15
to work this question.
a. Sketch a consumer’s preference
map between gasoline and other
Memorial Day trip-related goods
and services. Draw a consumer’s
budget line prior to the rise in
the price of gasoline and mark
the consumer’s best affordable
point.
Figure 9.5 shows the preference
map and the budget line, BL0. The best affordable point is 3 trips
and 30 trip-related goods and services.
b. On your graph, show how the best affordable point changes when
the price of gasoline rises.
Gasoline is a complement of
Memorial Day trips; that is, it
is necessary to buy gasoline to
take Memorial Day road trips.
When the price of gasoline rises,
Figure 9.5 shows that the budget
line rotates inward from BL0 to
BL1. The best affordable point
changes from 3 trips and 30
gallons of gasoline to 2 trips
and 20 gallons of gasoline.

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Use the following information to work Problems 17 and 18.

Pam has made her best affordable choice of cookies and granola bars.
She spends all of her weekly income on 30 cookies at $1 each and 5
granola bars at $2 each. Next week, she expects the price of a cookie
to fall to 50¢ and the price of a granola bar to rise to $5.
17. a. Will Pam be able to buy and want to buy 30 cookies and 5
granola bars next week?
Pam can still buy 30 cookies and 5 granola bars. When Pam buys 30
cookies at $1 each and 5 granola bars at $2 each, she spends $40 a
week. Now that the price of a cookie is 50 cents and the price of a
granola bar is $5, 30 cookies and 5 granola bars will cost $40. So
Pam can still buy 30 cookies and 5 granola bars. But Pam will not
want to buy 30 cookies and 5 granola bars because the marginal rate
of substitution does not equal the relative price of the goods. Pam
will move to a point on the highest indifference curve possible
where the marginal rate of substitution equals the relative price.
b. Which situation does Pam prefer: cookies at $1 and granola bars
at $2 or cookies at 50¢ and granola bars at $5?
Pam prefers cookies at 50 cents each and granola bars at $5 each
because she can get onto a higher indifference curve than when
cookies are $1 each and granola bars are $2 each. To see why Pam can
move to a higher indifference curve, note that the new budget line
and the old budget line both pass through the point 30 cookies and 5
granola bars. If granola bars are plotted on the x-axis, the
marginal rate of substitution at this point on Pam’s indifference
curve is equal to the relative price of a granola bar at the
original prices, which is 2. The new relative price of a granola bar
is $5/50 cents, which is 10. That is, the budget line is steeper
than the indifference curve at 30 cookies and 5 granola bars. So
Pam’s new equilibrium combination of cookies and granola bars must
be on an indifference curve at a point steeper than the initial
indifference curve. Because the new budget line is steeper and
passes through the initial equilibrium combination, the new best
affordable point must lie above the initial equilibrium point so it
must be on a higher indifference curve.
18. a. If Pam changes how she spends her weekly income, will she buy
more or fewer cookies and more or fewer granola bars?
Pam will buy more cookies and fewer granola bars. The new budget
line and the old budget line pass through the point at 30 cookies
and 5 granola bars. If granola bars are plotted on the x-axis, the

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marginal rate of substitution at this point on Pam’s indifference

curve is equal to the relative price of a granola bar at the
original prices, which is 2. The new relative price of a granola bar
is $5/50 cents, which is 10. That is, the budget line is steeper
than the indifference curve at 30 cookies and 5 granola bars. Pam
will buy more cookies and fewer granola bars.
b. When the prices change next week, will there be an income
effect, a substitution effect, or both at work?
There will be a substitution effect and an income effect. A
substitution effect arises when the relative price changes and the
consumer moves along the same indifference curve to a new point
where the marginal rate of substitution equals the new relative
price. An income effect arises when the consumer moves from one
indifference curve to another, keeping the relative price constant.
Use the following information to work Problems 19 and 20.
Boom Time For “Gently Used” Clothes
Most retailers are blaming the economy for their poor sales, but one
store chain that sells used name-brand children’s clothes, toys, and
furniture is boldly declaring that an economic downturn can actually
be a boon for its business. Last year, the company took in $20
million in sales, up 5% from the previous year. Sales are already up
5% this year.
Source: CNN, April 17, 2008
19. a. According to news clip, is used clothing a normal good or an
inferior good?
According to the article, the demand for used clothing increases
when the economy is in a downturn and incomes are falling. Because
the demand increases when income decreases, used clothing is an
inferior good.
b. If the price of used clothing falls and income remains the same,
explain how the quantity of used clothing bought changes.
If the price of used clothing falls and income remains the same, the
quantity of used clothing purchased increases.
c. If the price of used clothing falls and income remains the same,
describe the substitution effect and the income effect that
occur.
The price fall creates both a substitution effect and an income
effect. The substitution effect leads to an increase in the quantity
of used clothing demanded. The price decrease increases consumers’
real incomes. Because used clothing is an inferior good, the income
effect leads to a decrease in the
quantity of used clothing
purchased. The substitution
effect is larger so that the
quantity of used clothing
purchased increases.
20. a. Use a graph to illustrate a
family’s indifference curves for

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