Universidad Carlos III de Madrid – Department of Economics

Principles of Economics - Course 2020-2021 - Problem Set 2

Conceptual Questions

Write down a short and concise answer. When you are asked to solve the question in
class, explain the concept clearly and give examples or pieces of evidence.

1. In “An Essay on the Nature and Significance of Economic Science”, published in

1932, Lionel Robbins wrote: ‘Economics is the science that studies human behaviour as a
relationship between given ends and scarce means which have alternative uses.’ Although
this is the best-known definition of Economics, do you think that economists are concerned
only with the allocation of scarce resources, given their alternative uses? Can we say that
labour is a scarce resource if 15% of the labour force is unemployment? – Economics isn’t
only concerned with ‘scarce means which have alternative uses’, but also how these create
relationships between people and goods, people and people, or humans and the
environment. The fact that the statement was made while the rate of unemployment was
that high, shows that economics doesn’t always know how to use quite well its scarce
means; however, the studying of these is a crucial part of this science, as it provides us
with all the important relationships that have been previously mentioned. (We usually
consider that if something has a price, in a way, it’s scarce  for example, we pay a
wage, which makes it a scarce resource; unemployment cannot always be due to scarcity
of resources, however  factors such as human capacity, personal traits and fields where
job is more or less needed, could influence the unemployment);

2. Do our models of scarcity and choice provide a plausible explanation for the
observed trends in working hours during the twentieth century? What other factors, not
included in our model, might be important in explaining what has happened? Remember
that our model tells us that people’s best (utility-maximizing) choice is the level of
working hours at which the slope of the feasible frontier is equal to the slope of the
indifference curve. Keep also in mind that an increase in wages leads to both an income
effect and a substitution effect. Which one dominates depends on the budget constraint and
preferences. – The models do provide a plausible explanation about the trends in working
hours. More factors to be added are the wars, the mentality of nations from different
countries, the labour situation with women, child labour, etc.

3. Indicate ways in which you (as student) can improve the technology of your
production function; that is, you can transform a certain number of study hours into more
learning and thus higher grades. What role do you think your preferences play in allocating
your scarce resource (time) to alternative uses? – Concentration (listening to music while
studying, keep phone away); working in the morning (more productive and energized);
regular rests. My preferences are well-balanced between studying for high grades and
sparing enough time for myself.

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 Problems

1. In the diagram below, IC1 is an indifference curve that depicts the preferences of a
student. It shows all the possible combinations of grade obtained and free time enjoyed that
give the same level of utility. As you can see, point A is on the indifference curve. The
combination of grade and free time at point B is not on IC1.

1) Does combination at point B give higher or lower utility than combination at point
A? How do you know? – If we draw the IC2, which B forms part of, at the point where IC1
and IC2 give equal hours of free time, B provides a better grade. Therefore, B is the more
utile option. We put point D, which has the same leisure time as B, but B gives us a
bigger grade for the same leisure and since A and D are on the same indifference
curve, they’re equal  A = D and B>D, so B>A;
2) Draw a sketch of the diagram, and add another indifference curve, IC2, that goes
through B and crosses IC1. Label the point at which IC2 and IC1 cross as point C. – It’s
not possible.
3) Combinations B and C are both on IC2. What does that imply about their levels of
utility? – They’re of equal satisfaction to the student.
4) Combinations C and A are both on IC1. What does that imply about their levels of
utility? – They’re of equal satisfaction to the student.
5) According to your answers to (3) and (4), how do the levels of utility at
combinations A and B compare? If A=C and B=C, then A=B, but this contradicts the
answer in point 1.
6) Now compare your answers to (1) and (5). Explain how you know that two
indifference curves that belong to the same map of indifference curves (they represent the
same preferences) never cross. – If they cross, they’ll be contradictory, because there
cannot be a point on a higher-utility indifference curve which also forms part of a lower-
utility indifference curve.

.C

D
.

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 2. Suppose that the points indicated in the following figure (Figure 3.23 of the text)
reflect the choices of free time and consumption made by a typical worker in each of the
five countries considered. You can find the data in
https://core-econ.org/the-economy/book/text/03.html#310-explaining-our-working-hours-
differences-between-countries. We take the wage (disposable income per hour worked),
free time per day, and consumption per day to plot Figure 3.23 using our model. Notice
that the wage is necessary to calculate the slope of the budget constrain for each country.

1) Is it possible that people in Turkey and the US have the same preferences? If so,
how will a wage rise in Turkey affect consumption and free time? What does this imply
about the income and substitution effects? – Judging by the indifference curves (which
most probably wouldn’t cross), we could say that people in Turkey and in the United States
could have similar preferences. Therefore, a wage-rise in Turkey would make the line
steeper, which would probably encourage them to have less free time and win more, just
the effect we can observe with the United States.  substitution effect dominates;
C = w(24-L), where L is leisure and (24-L) are working hours; C = consumption
C = 24w – Lw
-Lw is the slope, and since its minus something, we see why it’s decreasing.
Having the same preferences means that if they have the same wage, they would spend
the same hours of working. If the countries have the same preferences, their indifferent
curves wouldn’t cross. So, if the indifferent curves are similar, it’s possible that their
preferences are the same.

2) Suppose that people in Turkey and South Korea have the same preferences. In that
case, what can you say about the income and substitution effects of a wage increase? – If
Turkey and South Korea have the same preference, a wage-rise would definitely cause a
greater substitution effect than an income effect  people will work way more than they
would spend free time.
3) If wages in South Korea increased, would you expect consumption there to be
higher or lower than in the Netherlands? Why?  They currently have the same
consumption level, but we can see the priorities of people form South Korea are clearly

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directed towards sparing part of their free time for earning more goods. Having that in
mind, we could suppose that were there to be an increase in the wages, people from South
Korea would go for earning more, than for having more rest.
INDIFFERENCE LINES ARE ALWAYS DECREASING AND NEVER
INCREASING!

Other Questions

1. You work 40 hours per week for a wage of 20 euros an hour. Your free hours are
defined as the number of hours per week not spent working: (24 hours x 7 days) – 40 hours
= 128 hours per week. Suppose now that your wage rate increases from 20 euros to 25
euros. However, you are perfectly happy keeping your current level of consumption, that
is, you don’t want it to change. How many hours will you be working after the wage rise?
In a graph, explain your behavior using our model of time allocation between work and
free time. Consider the income and substitution effects to make sense of your answer.

Solution:
40 hours per week/ 20 euros per hour
Rest: 128 hours per week.
Wage increase: 25  25 euro
The initial income is 40 hours x 20 euros per hour = 800 euros
Since we don’t want to earn more, the new equation would look like:
800 euros = 25 euros per hour x “x hours”  x hours = 800/25 = 32 hours weekly  the
income effect absorbs all the additional money and turns them into more free time;

How to draw indifference curves?

2. Consider indifference curves for the consumption of two goods, milk and
chocolate. The indifference curves are drawn with the number of chocolate bars on the
horizontal axis and pints of milk on the vertical axis. Suppose consumer A has a flatter
indifference curve than consumer B. Under these conditions, we can conclude that:

a. Consumer A likes chocolate more than consumer B.

b. The price of milk relative to the price of chocolates is higher for consumer A than
for consumer B.
c. The indifference curves of the two consumers cannot cross.
d. If in the starting point the two individuals have the same quantity of chocolate bars,
we can assert that consumer A is willing to swap one bar of chocolate for a smaller amount
of milk than consumer B.

3. The following diagram is the

feasible set of a student. It shows
combinations of her final grade and hours
of free time per day. We can study her
behavior by discussing what happens at
points A, B, C, D, E and F, which in

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principle are choices she can make given her preferences. Notice that given her
preferences, she can only maximize utility at a single point on the feasible frontier. Moving
between two points on the same feasible frontier (accepting the opportunity cost it entails)
can only take place if there is a change in preferences. Keeping all these considerations in
mind, only one of the following is correct:

a. If she has to choose between B, C and F, she will choose to be at point B because
she can get a higher grade for the same hours of free time compared to F, and compared to
C she gets more of both goods.
b. If she is at D, she can gain a lot by moving to B.
c. If she compares A and C, no matter what her preferences are, she will choose C
because she enjoys a lot more of free time and still gets a good mark.
d. Going from A to E (one additional hour of free time) costs her 3 points in her mark
(the opportunity cost). However, going from C to F costs her 7 points. Whether she is at A
or C depends on her preferences.  here, we should take into account the fact that the
higher the mark, the more expensive it is (in terms of time) to make it higher; therefore, it
is up to her whether she would choose to sacrifice this time to make the grade a little
higher, but it also depends on the current grade and whether she’s satisfied with it
(preferences).