Browning & Zupan / Microeconomics: Theory & Applications, 12e Solutions Manual

Solution Manual for Microeconomics Theory and

Applications 12th Edition Browning Zupan
1118758870 9781118758878
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Chapter 5 Using Consumer Choice Theory

Solutions

5.1 In the figure below, AZ is the budget line without a government subsidy. The budget line
with the subsidy is ABZ’. The portion AB is on the original budget line because the first visit is
not subsidized by the health plan. On visits over one, the University of Arizona pays half, so the
budget line becomes flatter. Tony’s new optimal point is E’ and he consumes two visits to the
dentist. The total cost of dental visits is AJ, but Tony pays only AK and the University of
Arizona pays KJ.

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Browning & Zupan / Microeconomics: Theory & Applications, 12e Solutions Manual

5.2 Answer in text.

5.3 In the figure below, AZ is the budget line if there is no tax and AZ’ is the budget line with
the excise tax of twenty cents per six-pack. Let E be the optimal point with the excise tax. Since
three six-packs of Diet Coke are consumed per day, the total tax bill is sixty cents. If the
government instead charges a lump-sum tax of sixty cents, the budget line will be different. It
will be parallel to AZ and intersect point E. It intersects E because it reflects a sixty cent tax
when three six-packs are purchased. That is, the distance AZ equals sixty cents. The new budget
line (A"Z") must intersect the indifference curve tangent at E, so the student can achieve a higher
level of utility with the lump-sum tax than an equivalent excise tax.

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Browning & Zupan / Microeconomics: Theory & Applications, 12e Solutions Manual

5.4 Free public schools can result in consumption of less schooling because of the discrete nature
of the choice. The consumers cannot augment the quantity of schooling provided by the
government, so there are large differences in wealth when the consumer chooses public schools
instead of private schools. In the figure below, the budget line with no subsidy is AZ, while the
budget line when schools are provided by the government is AA’RZ. If the consumer could
augment the quantity of education, the budget line would be AA’Z’. The differences between
budget line AA’RZ and AA’Z’ is due to the all-or-nothing characteristic of the choice with free
public schools. For the indifference curves depicted below, consumption of schooling decreases
from E1 to E2 with government provision of schooling.

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Browning & Zupan / Microeconomics: Theory & Applications, 12e Solutions Manual

5.5 No. The tax payments are unrelated to the decision to use public or private schools since they
have to be paid regardless if the family uses public schools or not. In fact, people with no
children still pay the tax.

5.6 In the figure below, the normal budget line is AZ, and the budget line with the all-you-can-
eat situation is AA’Z. By giving up $15 of other goods, the effective price of food (for the meal)
is zero. Hence, the budget line becomes horizontal at this point (A’), and the consumer eats food
until the marginal utility of food equals zero, that is, the indifference curve is horizontal and
tangent to the budget line at optimal point E’.

5.7 Yes, if the person’s indifference curve was tangent to AZ to the right of 2000 units, but the
indifference curve intersected budget line A’Z’. In the figure below, this situation applies with
indifference curve U1. Moving to A’Z’ generates a move from E to E’.

5.8 The estimate indicates that the increase in consumer surplus (such as PEBP’ in Figure 5.2) is
only 75 percent as large as the total amount of money (PCBP’) spent by the subsidizers, or gift
givers.

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Browning & Zupan / Microeconomics: Theory & Applications, 12e Solutions Manual

5.9 Point N is Beth’s endowment point.

5.10 In the figure below, the budget line Anna faces is AZ. The most she can consume in year
two is $17.5 million, because the interest rate of 25 percent on $6 million of savings will
generate interest of $1.5 million. The maximum consumption possible in year one is $14 million,
since the most Anna can borrow is $8 million. (She would then repay $10 million in the second
year with an interest rate of 25 percent.). The optimal point stated in the question is E, where
Anna consumes $7 million in year one by borrowing $1 million. She will have to pay back $1.25
million in year two, which means she will be able to consume $8.75 million in year two. EF
measures the amount borrowed, NF the amount paid back, consumption in year one is equal to
GE and in year two is FH.

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Browning & Zupan / Microeconomics: Theory & Applications, 12e Solutions Manual

5.11 Answer in text.

5.12 The present cost of future consumption is the amount of consumption that must be reduced
today to obtain $1 of consumption in the future. If the interest rate is ten percent, a lender must
give up $0.909 today to get the $1 a year from now. If the interest rate increases to 20 percent,
the lender must give up $0.833 today. That is, the lender has to give up less current consumption
for a dollars worth of future consumption as the interest rate increases.
The higher interest rate also raises the future cost of present consumption. To consume an
extra dollar today, the borrower must pay back the dollar plus interest a year from now. If the
interest rate is 40 percent, the dollar today costs $1.10 in dollars next year. An increase in the
interest rate to 20 percent increases the cost of a dollar today to $1.20 dollars next year.

5.13 In the figure below, the original budget line is AZ, which passes through the endowment
point N. The consumer saves in the first year, so the optimal point must lie on AZ to the right of
N (point E). An increase in the interest rate rotates the budget line around N to A'Z', which
intersects the original indifference curve. The consumer’s new optimal point is E", showing
increased consumption in both periods.
The substitution effect is found by shifting budget line A'Z' back until it is tangent to the
original indifference curve. This is point E', which shows the consumer increasing second-period
consumption and reducing first-period consumption. The substitution effect reduces consumption
in the first period and increase consumption in the second year because the relative cost of future
consumption relative to current consumption has fallen. However, the saver also will have more
income in the second period. The income effect is to encourage more consumption in both
periods. The movement from E' to E" measures the income effect. The consumer consumes more
in the first period, which implies the income effect of an increase in the interest rate is to reduce
the level of savings.

5.14 The figure on the left below shows indifference curves for a risk-neutral investor, and the
figure on the right shows indifference curves for a risk-loving investor. For the latter, risk is a
good so the indifference curves are convex to the origin.

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Browning & Zupan / Microeconomics: Theory & Applications, 12e Solutions Manual

5.15 Differences in expected future incomes likely account for the phenomenon. Since the
average expected future income is greater for law school than doctoral students, this should
translate into relatively greater consumption in both periods (today and tomorrow) by law
students in a two-period intertemporal model provided that consumption in both periods is a
normal good.

5.16 $1,000

5.17 As we saw with the application on trash recycling, where there is a flat fee and the per-unit
price of usage is zero, total usage increases. The average user will be better off if a per-unit
charge system is adopted (see Figure 5.4). Not all users, however, will be better off under a per-
unit charge system (see Figure 5.5).

5.18 By paying a premium in return for the promise that the insurer will provide compensation
for losses due to an accident/illness, a rock or movie star effectively exchanges a gamble for a
sure return. And, risk-averse rock or movie stars will prefer some such sure return, ensured
through a premium, over a gamble on their singing/acting talents remaining unimpaired. An
insurance company will, in all likelihood, be willing to pay such coverage if there is the ability to
pool a large enough number of similar risks and thereby be able to predict reasonably well (that
is, with very low variance) the total expected payments it will have to make on the rock/movie
star policies that it writes.

5.19 Uncertain. Even risk averse individuals may opt not to buy the flight insurance if its cost is
sufficiently high. See the answer to the previous question for more details.

5.20 There may be significant nonpecuniary benefits associated with gambling that go beyond
the associated monetary payoffs. The thrill associated with gambling, for example, may be
sufficiently high to explain the tremendous number of dollars Americans devote to the activity
each year.

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