Solutions for End of Chapter Questions

Chapter 5

Easy

1 True or False: On a given indifference curve the marginal rate of substitution is always
decreasing.
1 True. Consumer tastes exhibit a diminishing marginal rate of substitution when, to keep utility
constant, diminishing quantities of one good must be sacrificed to obtain successive equal
increases in the quantity of the other.

A-head: 5.1 Demand by a single consumer

Learning Objective: The concept of diminishing marginal rate of substitution, How to represent
tastes as indifference curves
Type: Conceptual Understanding

2 Common fallacies Why are these statements wrong? (a) Since consumers do not know about
indifference curves or budget lines, they cannot choose the point on the budget line tangent to
the highest possible indifference curve. (b) Inflation must reduce demand since prices are higher
and goods are more expensive.
2 (a) Indifference curves and budget lines are an attempt to explain scientifically what people do
instinctively. (b) The budget line shows relative prices and, unless relative prices change at
different rates as a result of the inflation, the budget line is unaffected.

A-head: 5.1 Demand by a single consumer

Learning Objective: How indifference curves and budget lines explain consumer choice
Type: Conceptual Understanding

3 Suppose films are normal goods but transport is an inferior good. How do the quantities
demanded for the two goods change when income increases?
3 When income increases, the budget line shifts to the right. As the budget line moves to the right
the demand for films will rise relative to the demand for transport.

A-head: 5.2 Adjustment to income changes

Learning Objective: How consumer income affects quantity demanded
Type: Application

4 The own-price elasticity of demand for food is negative. The demand for food is inelastic. A
higher food price increases spending on food. Higher food prices imply less is spent on all other
goods. The quantity demanded of each of these other goods falls. Discuss each statement. Are
they all correct?
4 The first three statements are correct, but the fourth may not be. For other goods, there is a
substitution effect towards them (unless, like cutlery, they are complements of food). An
increase in the price of food will lower the consumer’s real income. But since the demand for
food is inelastic, the substitution effect may not be very strong, and the demand for normal
goods can go either way. Demand for inferior goods must, in theory, rise, though the rise may be
imperceptible.

A-head: 5.3 Adjustment to price changes

Learning Objective: How a price change affects quantity demanded
Type: Application
5 Suppose Glaswegians have a given income and like weekend trips to the Highlands, a three-hour
drive. (a) If the price of petrol doubles, what is the effect on the demand for trips to the
Highlands? Discuss both income and substitution effects. (b) What happens to the demand for
Highland hotel rooms?
5 (a) Both the income and substitution effects reduce demand.
(b) The demand curve shifts down and equilibrium price and quantity fall.

A-head: 5.3 Adjustment to price changes

Learning Objective: Income and substitution effects
Type: Graphing

Medium

6 Frank’s utility function for two goods, X and Y, is given by U  XY . Find Frank’s indifference
curves, when utility is 10, 20 and 30. Plot these indifference curves. How should Frank compare
the following two bundles: ( X  1, Y  10 ) and ( X  5, Y  2 )?
6

The graph shows that Frank should regard the two bundles as of equal utility as they are on the
same indifference curve.

A-head: 5.1 Demand by a single consumer

Learning Objective: How indifference curves and budget lines explain consumer choice
Type: Graphing

7 Suppose Frank has an income of £50, the unit price of X is p X  £2 and the unit price of Y is
pY  £1. Write down the budget constraint for Frank. Knowing that the marginal rate of
X
MRS 
substitution (in absolute value) between X and Y is Y , find the optimal bundle that
Frank should consume. (Hint: at the optimal bundle the absolute value of the MRS must be equal
 to the absolute value of the slope of the budget constraint. Moreover, the budget constraint must
be satisfied. You need to solve a system of two equations in two variables, X and Y).
7 The budget constraint shows that Frank can buy 25 units of X or 50 units of Y (the maximum of
each possible with an income of £50). The optimum bundle is 20X and 10Y (a ratio of 2:1).

A-head: 5.1 Demand by a single consumer

Learning Objective: How to derive a budget line
Type: Calculation

8 Suppose you have 5 coconuts and 5 fish. You can get extra fish by sacrificing 2 coconuts for each
extra fish, or get extra coconuts by sacrificing 1 extra fish for each extra coconut. (a) Draw your
budget line. (b) Draw an indifference map. (c) Where is it likely that you will choose to be? (d)
Suppose there is a small change in the number of fish you can swap for an extra coconut – is your
behaviour likely to change?
8

(a) The budget line is kinked at the point A (5 coconuts and 5 fish). Above this point the negative
slope is flatter, and below it the negative slope is steeper.
(b) As no information is given about marginal rates of substitution, draw any indifference map.
(c) Since the point A (5,5) is the furthest from the origin, it is at this point where the budget line
will touch the highest indifference curve. So this is the combination which will convey the highest
level of utility.
(d) A small change in the slope will still mean that A, the kinked point, is the furthest from the
origin, and thus behaviour will be unchanged.

A-head: 5.1 Demand by a single consumer

Learning Objective: How to represent tastes as indifference curves, How to derive a budget line,
How indifference curves and budget lines explain consumer choice
Type: Graphing

9 Refer to the graph in Figure 5.12 (page 97) to answer the question. The graph shows the income
consumption path for goods X and Y, and the Engel curve for good X
(a) What does the backward bending income consumption path imply about good Y?
(b) Given the Engel curve in the graph, identify the nature of good X.
9 (a) The income consumption path slopes upwards till point a, and as income increases from M1 to
M2, it bends backwards. This implies that as the income of the consumer increases, more of good
Y is consumed and less of good X is consumed. Therefore, good Y is a normal good.

(b) The Engel curve shows that at low income levels, the demand of good X increases as income
increases. As income continues to increase good X becomes an inferior good and the
consumption of that good starts to decrease.

A-head: 5.2 Adjustment to income changes

Learning Objective: How consumer income affects quantity demanded
Type: Conceptual Understanding

10 You can invest in a safe asset, in a risky asset, or in both. The safe asset has a guaranteed return
of 3% a year. The risky asset has an expected return of 4% but it could be as much as 8% or as
little as 0%. You decide to have some of your wealth in each asset. Now the expected return on
the risky asset rises to 5%; it could be as high as 9% or as low as 1%. Given the increase in the
expected return on the risky asset, do you invest more of your wealth in the risky asset?
10 Amazingly, it is not certain that you will invest more in the risky asset when its expected return
rises. The reason is substitution and income effects. With a higher relative expected return than
before, the substitution effect leads you towards demanding more of the risky asset. But do not
forget the income effect. To the extent that you were tempted to invest in the risky asset to
improve your target income, when the expected return on this asset improves you do not have to
risk so much to get any particular target income. That is the income effect. In this case, it makes
you demand less of the risky asset. Whether or not you end up investing more in the risky asset
depends on the relative strength of the income and substitution effects, which pull in opposite
directions in this case.

A-head: 5.3 Adjustment to price changes

Learning Objective: Income and substitution effects
Type: Application

11 Suppose Carl cannot tell the difference between a pack of British and a pack of Danish bacon. In a
graph with British bacon on the vertical axis plot some of Carl’s indifference curves for British and
Danish bacon. Suppose Carl has an income of £20. The price of Danish bacon is £2 per pack, while
the price of British bacon is £4 per pack. In the same graph where you drew the indifference
curves, draw Carl’s budget constraint and show his optimal bundle choice.
11 The optimal bundle choice is 2 packs of British bacon and 6 packs of Danish bacon.
A-head: 5.1 Demand by a single consumer, 5.5 Complements and substitutes
Learning Objective: How indifference curves and budget lines explain consumer choice
Type: Graphing

Hard

12 Essay question. Consumer choice theory assumes that consumers are rational but we observe a
person behaving differently in apparently similar situations. Is it realistic to think that we
account for rational behaviour in every situation?
12 This question involves the methodology used by economists and the disagreements that arise
from different approaches to economic subject matter. The physical scientist is able to carry out
controlled experiments under laboratory conditions. As a result, conclusions can be arrived at
with a fair degree of certainly. By contrast the subject matter of economics is people, and
people’s behaviour changes. A person considered to be rational may save one year and dissave
the following year. A person may develop a work ethic but it may erode over time.

If taxes are increased a person may decide to work more hours in order to maintain a target
income after tax. Eventually the same person may decide to work less because the incentive to
work longer hours has diminished. People learn from experience and so behaviour changes over
time. An atom of nitrogen will always behave like and atom of nitrogen but people will often
change their actions even when faced with similar situations.

Therefore economists find it difficult to devise general laws of human behaviour. An economic
“law” or tendency that seems to be valid in one country or in one time period may seem
inadequate elsewhere or at other times.

Economic theory, in attempting to explain and interpret economic behaviour, depends on the
assumption of ceteris paribus, or other things remaining the same.
Hypotheses or predictions that appeared to have been valid previously may not be valid at
another time because in real life other things do not remain the same.

Much theorizing in economics is based on deduction, which is the process of logical reasoning
from a given proposition. For example, it may be held that producers of goods will always act so
as to obtain the greatest possible monetary return. However, this hypothesis may be found
 wanting when observing producers who act contrary to this pursuit of maximum profit.

Economists, realizing the limitations of abstract reasoning, use a second method of analysis
known as the inductive or empirical method. This is recourse to evidence or facts with the
intention of arriving at conclusions form known events in real life. However, this approach does
not necessarily validate a theory. Facts do not speak for themselves: they have to be
interpreted. Unfortunately evidence can be selective and will often reflect the purpose of the
investigation and the values and attitudes of the investigator. Its adherents consider positive
economics value-free, but it is debatable whether this can be accepted at face value. As J.K
Galbraith, one of the greatest economists of the 20th Century, claimed in his autobiography “A
Life in our Time” (1981)

Economics professors often seek outside income and one obvious place…is the big corporation….
When an economist argues for lower taxes on the affluent, people should be right in believing
that he is speaking out of economic perception or compassion and not because he has been
bought.

A perceptive approach adopts the view that there are various ways of analysing an economic
problem and a particular approach will reflect the views of an individual economist. The concept
of “rational economic man” originated with classical economics; its development by neo-
classicists was nurtured by supply-side economists who emerged in the 1970s and 1980s. The
ideas of these economists underpin the economic theories and models associated with
consumer demand. It is assumed that consumers can decide whether they prefer A to B or B to A
or are indifferent between them. Also that if A is preferred to B and B to C then A will be
preferred to C

It is assumed that consumers aim to maximize satisfaction even though this may be difficult to
quantify. That “a person behaving differently in apparently similar situations” invalidates
economic theorizing is short-term reasoning as what may appear to be irrationality is merely the
result of learning and the acquisition of new information in the long run. As indicated earlier,
solid modern approaches to economic reasoning and analysis are aware of their limitations in
searching for economic “truths”.

A-head: 5.1 Demand by a single consumer

Learning Objective: The relationship between utility and tastes for a consumer
Type: Conceptual Understanding

13 A consumer’s income is £50. Food costs £5 per unit and films cost £2 per unit. (a) Draw the
budget line. Pick a point e as the chosen initial consumption bundle. (b) The price of food falls
to £2.50. Draw the new budget line. If both the goods are normal, what happens to
consumption? (c) The price of films also falls to £1. Draw the new budget line and show the
chosen point e’’. (d) How does e’’ differ from e? Why?
13 (a) The budget line shows that the consumer can buy either 10 units of food or 25 films.
(b) The fall in food prices has both income and substitution effects:
The substitution effect of a price change is the adjustment of demand to the relative price change
alone.
The income effect of the price change is the adjustment of demand to the change in real income
alone.
For films the income effect raises demand and the substitution effect reduces it. The consumer
can now buy 20 units of food or 25 films.

(c) When the price of films falls, demand for films extends and the demand for food could rise or
fall. The fall in the price of food allows more food to be consumed with the same demand for
films (e to e’).
 Putting the two price cuts together between e and e”, there is no substitution effect as relative
prices are the same.
(d) Since both goods are normal e” is north-east of e since real income is higher.

A-head: 5.3 Adjustment to price changes

Learning Objective: Income and substitution effects
Type: Graphing

14 Consider a consumer who consumes only two goods, peas and beans. He has an income of £10,
the price of beans is 20p per kg (=£0.2) while the price of peas is 40p per kg (=£0.4).
(a) Suppose that the consumer consumes 30 kg of beans. Assuming that the consumer wants to
spend all his income, how many kg of peas is he going to consume?
(b) Assume that the price of peas falls from 40p to 20p. Assume that the consumer still
consumes 30 kg of beans, find the new quantity of peas.
(c) After the decrease in the price of peas to 20p, assume that the consumer is just as well off as
he was in (a) if he has an income of £7.60. However, with that income and the new price of peas
he would have consumed 20 kg of beans. Find the quantity of peas he would have consumed in
this case.
(d) Find the substitution effect on consumption of peas due to the decrease in the price of peas
in (c)
(e) Find the income effect on consumption of peas due to the decrease in income in (c)

14 (a) The consumer will consume 10 kg of peas.

(b) The consumer will consume 20 kg of peas.
(c) The consumer will consume 18 kg of peas.
(d) The difference between (c) and (a) is 8 kg of peas, an increase as a result of the substitution
effect.
(e)The difference between the solution in (b) and the solution in (c) is 2 kg of peas, a decrease as
a result of the income effect.

A-head: 5.3 Adjustment to price changes

Learning Objective: Income and substitution effects
Type: Calculation