Solution Manual for Macroeconomics Canadian 15th

Edition Ragan 013391044X 9780133910445

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Part Three

Consumers and Producers

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This Part of the book explores the building blocks of microeconomics—the theory of consumer
demand and the theory of production and cost. We have sought to deal with more than just the
theoretical framework, and we have tried to make the book suitable to a wide variety of tastes. In the
past, some users have criticized us for being too theoretical, and others have criticized us for being
not theoretical enough. We hope the balance we have achieved is about right.

***

Opinions differ greatly among instructors on the amount of demand theory they wish to teach. We
have tried to accommodate both those who prefer to teach indifference curve analysis at this level
and those who prefer not to. Chapter 6 develops the theory of consumer demand using the marginal
utility approach. Though some instructors dislike using this approach (with some justification), it
does have its advantages. In particular, the discussion of marginal utility eases the presentation of
consumer surplus as well as the important distinction between total and marginal utility (such as in
the diamond-water paradox). For those instructors who prefer to use only the approach of budget
lines and indifference curves, the Appendix to Chapter 6 provides a self-contained treatment. Indeed,
these instructors can simply replace the first section of the chapter with the appendix.

Chapter 7 presents the theory of the firm in the short run, when one factor is fixed (usually
capital) and the others are variable (labour being the most prominent). We begin with a brief

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discussion of firms as agents of production. We then discuss the meaning of costs, opportunity costs,
and economic profits. We also examine the difference between the various “runs” over which firms
make decisions. Profit maximization as a motivation is at the core of this chapter.

Chapter 8 discusses the choices made by firms in the long run and the very long run. Unlike
most other texts, we distinguish the period of time over which all factors are variable but technology
is fixed (the long run) from the period of time over which technology is permitted to change (the
very long run). We feel that this approach makes it easier for the student to think clearly about firms’
choices in response to factor-price changes (long-run decisions) and firms’ choices in response to
changes in technology (very long-run decisions). The Appendix to Chapter 8, analogous to that in
Chapter 6, develops the theory of cost and production and long-run substitution between labour and
capital using isoquant analysis.

***

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 ______________________________

Chapter 6: Consumer Behaviour

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This chapter is designed to cover the minimum amount of the theory of consumer behaviour needed
to read the rest of the book. The chapter is designed to be sufficient for instructors who do not want
to teach the intricacies of indifference curves to first-year students. Others may then exercise their
preference for indifference analysis by assigning the chapter’s Appendix.

***

In the first section of the chapter, we develop the theory of consumer behaviour using the marginal
utility approach. After a discussion of total utility and marginal utility, we derive the
utility-maximizing condition that the ratio of marginal utility to price be constant across all goods.
We then use that condition to derive a downward-sloping demand curve. One common pitfall for
students is to think that utility is maximized when the marginal utility for each good is equated, but
the key point, of course, is that the marginal utility per dollar spent on each good should be equated.
It is worth spending the necessary time in class to make sure that students appreciate this distinction.

The second section contains a detailed but intuitive discussion of income and substitution
effects as a way of thinking about the negative slope of demand curves. Figure 6-3 is especially
effective at helping students understand how these different effects operate when a product’s price
changes. Though the formal treatment with indifference curves (in the Appendix) is more precise,
this intuitive discussion should be enough to allow students to use the concepts as they continue their
study of microeconomics.

The third and final section develops the idea of consumer surplus, and builds on the brief
discussion from Chapter 5. We not only develop the main idea (which is key to some of our later
discussions of allocative efficiency), but also apply this concept to an explanation of the paradox of
value (the diamond-water paradox). This is a short section, but it deserves careful attention because
the insights are of great practical importance. We find that students who have attended courses that
just take them through the equivalent of the first section of Chapter 6 tend to be critical of demand
theory as being “too theoretical”. However, students who have understood the material in this final
section tend to have some appreciation for the practical value of demand theory.

The Appendix to this chapter offers a self-contained treatment of budget lines and
indifference curves. For those instructors who prefer to use only the approach of budget lines and
indifference curves in developing basic consumer theory, the Appendix can be used in place of the
first section in the chapter. In this way you can avoid entirely the approach to consumer theory based
on the idea of diminishing marginal utility. You can then proceed from the Appendix to the second
section to emphasize the intuition behind the income and substitution effects, and then to the final
section to appreciate some applications of the core consumer theory.

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 Chapter 6: Consumer Behaviour

Answers to Study Exercises

Question 1

a) utility (or satisfaction); diminishes

b) marginal utility; equalized

c) MUA/pA = MUB/pB

d) quantity demanded; negatively sloped

Question 2

a) The appropriate diagrams for (a) and (c) are shown below. Note that the horizontal scales for
both diagrams are the same but the vertical scales are different. Note also that marginal utility is
plotted between the integer values for the number of avocados consumed because marginal
utility measures the change in utility from consuming one more avocado.

b) The marginal utility is the change in utility divided by the change in the number of units
consumed. The marginal utilities are given in the following table:
Change in Marginal
Consumption Utility
0th to 1st 100
1st to 2nd 85
2nd to 3rd 60
3rd to 4th 40
4th to 5th 30
5th to 6th 20
6th to 7th 10
7th to 8th 5

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c) The graph of marginal utility is shown above.

d) Brett likes avocados, and each extra avocado increases his total utility. But after some point
(and perhaps right away, as in this case), each successive avocado adds less to his total utility (or
satisfaction) than the previous one. That is, the utility that Brett gains from each extra avocado
falls. Most of us experience this phenomenon regularly, whether it be with cold beverages on a
sunny day, pieces of pizza, or meals at a nice restaurant.

Question 3

The key point here is to recognize that utility maximization requires that the marginal utility per
dollar spent on each good should be equated across both goods. If this equality does not hold, then
the pattern of expenditure can be changed in such a way as to increase total utility. Recall also that,
in the presence of declining marginal utility, an increase in the marginal utility from consuming
some product requires a reduction in the number of units of that product consumed. The table
below shows the computation of MU/p for each good and states whether consumption of X or Y
should be changed.

Case MUX/pX MUY/pY Change pattern of consumption?

A 2/10 3/5 Need to raise MUX/pX relative to MUY/pY.
Consume less of X and more of Y.
B 4/12 2/4 Need to raise MUX/pX relative to MUY/pY.
Consume less of X and more of Y.
C 1/3 2/6 MUX/pX equals MUY/pY.
Do not change pattern of consumption.
D 2/4 2/4 MUX/pX equals MUY/pY.
Do not change pattern of consumption.
E 4/3 3/4 Need to reduce MUX/pX relative to MUY/pY.
Consume more of X and less of Y.

Question 4
In each case Luc is assumed to be maximizing his utility, so MU/P is equated across restaurant
meals and “all other goods”.

a) The MU of consuming restaurant meals is 100, so MU/P is 5. Since the price of all other goods
is $10, the MU from consuming those goods must be 50.

b) The MU from consuming all other goods is 40, so MU/P is 4. Since the price of restaurant meals
is $20, the MU from consuming restaurant meals must be 80.

c) The MU of consuming restaurant meals is 56, so MU/P is 56/20 = 2.8. Since the price of all
other goods is $10, the MU from consuming those goods must be 28.

d) The MU from consuming all other goods is 122, so MU/P is 12.2. Since the price of restaurant
meals is $20, the MU from consuming restaurant meals must be 244.

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 Chapter 6: Consumer Behaviour

Question 5

a) From the figure, it is clear that total utility when consumption is 500 units is 75. At 600 units it
is approximately 77.5. At 700 units it also appears to be 77.5.
b) Determining the value of marginal utility at any given level of consumption requires knowledge
of the slope of the function for total utility. In order to know precisely the slope of the function at
any given point, we would have to compute the slope of a tangent line at that point. But even
without doing this we can tell that the function is steeper when consumption is 100 units than when
consumption is 200 units or 500 units. So we can know for certain that marginal utility is higher
when consumption is 100 than it is when consumption is 200, which is higher than when
consumption is 500 units. The function clearly displays diminishing marginal utility.
c) Diminishing marginal utility is shown by the fact that the slope of the function declines as the
level of consumption increases.
d) From the figure, it appears that total utility reaches a maximum when consumption reaches 600
units per period. So every extra unit of consumption beyond this point apparently does not increase
utility at all – this is the situation of marginal utility being equal to zero. This situation is often
referred to one of satiation, and is thought to be quite rare in reality.

Question 6

a) In order to maximize utility, the ratio of MU to p must be equal across all products. For each
shopping trip shown, the MU/p ratios are 0.5 for both products. So Sally is maximizing her utility
on each trip.
b) As the price of shoes declines, Sally is purchasing more shoes and this is what reduces her MU
of her consumption of shoes. (The extra utility obtained from a pair of shoes declines as the number
of pairs increases.)
c) Since the price of everything else is being held constant across the five shopping trips, it is clear
that the only exogenous variable changing is the price of shoes. Thus, we can trace out Sally’s
demand curve for shoes from the information given in the table (drawn under the ceteris paribus
assumption). As the price of shoes falls from $250 to $50 (with other prices being held constant),
Sally’s shoe purchases rise. Thus, we know that Sally’s demand curve for shoes is downward
sloping.

Question 7

a) Good X has a downward-sloping demand curve. The substitution effect of the price increase
reduces consumption, as does the income effect (which means that consumption declines and real
income falls). So Good X is a normal good.
b) Good Y has a downward-sloping demand curve. The substitution effect of the price increase
reduces consumption. But the income effect is to increase consumption as real income falls (due
to the price increase). So Good Y is an inferior good.

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c) For Good X, the income effect and substitution effects are working in the same direction
(consumption falls as price rises). For Good Y, the two effects are working in the opposite
direction: the price rise leads to a reduction in consumption with the substitution effect, but an
increase in consumption for the income effect.

d) In order to be a Giffen good, the demand curve must be upward-sloping. This requires that the
income effect be opposite to and larger than the substitution effect. So, if Q1 were to the right of
Q0, Good Y would be a Giffen good.

Question 8

a) Since salt is a very small element in most people’s consumption bundle, the income effect is likely
to be very small, such that a 10% increase in price should have very little effect on the quantity
demanded. Also, note that there are few good substitutes for salt, so demand tends to be relatively
inelastic.
b) Blue jeans are relatively expensive purchases, and due to swings in fashion may not be that
durable. Therefore, one might expect the income effect to be reasonably large, such that an increase
in price is likely to elicit a reasonably large change in consumption. This is compounded by the fact
that many people might view a large class of clothing as good substitutes for blue jeans, thus making
the demand for jeans relatively elastic.
c) Even the total of all fruits and vegetables makes up a relatively small portion of the average
consumer’s consumption bundle. This implies a small income effect and, for this reason, demand is
likely to be quite inelastic. In addition, there are not many good substitutes to “all fruits and
vegetables”, another reason demand is likely to be inelastic.
d) While gasoline consumes a significant portion of many people’s income, implying a large income
effect, there are few viable substitutes. Consequently, gasoline may exhibit significant response to
price increases, but smaller than one might expect from the pure income effect.
e) Mini-vans are extremely large purchases and should possess very large income effects. Further,
as a consumer durable, mini-vans may be repaired instead of replaced. Consequently, quantity
demanded for mini-vans should exhibit very large responses to changes in price. Working in the
same direction, large sedans and sport utility vehicles are, for many consumers, reasonably good
substitutes for mini-vans, making demand even more elastic.
f) The income effect from a change in rent for apartments is probably bigger than for most products
since rent makes up a large portion of most people’s budget, and is an expense that recurs monthly.
g) Luxury cars are expensive and will constitute a significant portion of the consumer’s income,
except for very rich consumers. The income effect is therefore likely to be significant, making
demand relatively elastic. However, available substitutes are limited, especially if the luxury car is
purchased to confer status and prestige, rather than just being a means of comfortable transportation.
In the final analysis, it is probably best to segment the groups of consumers between the very rich
and the not so rich. Demand among the first group is probably very inelastic; demand among the
second group is probably quite elastic.

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 Chapter 6: Consumer Behaviour

h) Most electronic equipment (TVs, laptops, tablets, smart phones, etc.) are durable goods – they last
for a year or two, and sometimes much longer. This durability means that we do not buy them on a
regular basis, and the price of the product gets “spread out” over the life of the product. So the
average monthly expenditure on electronic products is fairly small as a fraction of total monthly
expenditures, making the income effect from a price change relatively small.

i) A one-week, all-inclusive vacation to Cuba might cost anywhere between $700 and $5000
depending on where you live and the quality of the resort that you visit. For most people, this amount
represents a significant share of monthly income, and so a 10% price increase is likely to have a
significant effect on quantity demanded. On the other hand, these vacations are typically taken only
every few years, and so the price of the vacation is a much smaller share of the total income over the
larger period.

j) The fee for a one-day car rental is a relatively small share of most people’s monthly income. And
since most people rent a car only occasionally, a 10% price increase is unlikely to have a large effect
on car rentals. However, for people who rent cars frequently, the income effect from a price increase
will be larger.

Question 9

For most products, the substitution effect of a price change is always in the direction of increasing
quantity demanded when the price falls (or reducing quantity demanded when the price rises). (In
the extreme case where products are viewed by the consumer as being perfect complements,
sometimes called Leontief preferences, the substitution effect is precisely zero.)

The direction of the income effect depends on whether the good is normal or inferior. For a normal
good, the income effect of a reduction in price is to increase real purchasing power and to increase
quantity demanded; for an inferior good, the income effect of a reduction in price is to increase
real purchasing power but to reduce quantity demanded. (The quantity demanded for inferior
goods increases when income falls.)

Putting the substitution and income effects together, we have:

Normal goods: Income and substitution effects work in the same direction

Inferior goods: Income and substitution effects work in the opposite direction.

This is why, as shown in Figure 6-2, the demand curve for a product will only be upward sloping
in the rare case where that product is “strongly inferior”, meaning that the income effect outweighs
the substitution effect. This is the case of a Giffen good.

Question 10

a) The sum of Rupert’s willingness to pay for the first five pizzas is 18 + 16 + 13 + 9 + 4 = $60.
Thus Rupert would be willing to pay $60 per week for these five pizzas — this is the total value
that Rupert places on five weekly pizzas.

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b) Rupert will purchase pizzas until his willingness to pay for the next pizza is less than the market
price. At a price of $10 per pizza, Rupert will buy three pizzas per week.

c) The total value that Rupert places on the three pizzas is 18 + 16 + 13 = $47. The amount Rupert
must spend to buy them is $10 per pizza times three pizzas, or $30. Thus Rupert’s consumer
surplus is $17.

Question 11

a) Consumer surplus at price p0 is given by the triangle defined by points BCD.

b) The new equilibrium price is p1 and quantity is Q1. Consumer surplus is now given by the triangle
ACE.

c) On the original Q0 units, the lower price means more consumer surplus, given by the rectangle
ABDF.

d) The triangle FDE is the new consumer surplus earned on the new (Q1-Q0) units.

Question 12

This is a good question to emphasize the difference between total and marginal value and to clarify
how changes in market price are related to changes in either total or marginal value.

a) The rightward shift of the demand curve reflects the fact that consumers now place more total
value on this item (or, more precisely, more value for any given quantity). Thus, for any given
quantity of the product, the area under the demand curve has increased.

b) In equilibrium, the marginal value of X has not changed, even though the total value has. The
reason is that, in this case, the supply curve is perfectly elastic, and so the equilibrium market price
is unaffected by the increase in demand. So consumers still consume X until the marginal value is
equal to the market price, but the latter is unchanged and thus so is the former.

c) The total value that consumers place on a given quantity of Y is unchanged—the demand curve
for Y has not moved.

d) The increase in supply drives down the price. The reduction in price leads consumers to
consume more of Y until the marginal value is just equal to the price. But since the price has fallen,
the marginal value of Y has also fallen, even though there has been no change in preferences (the
demand curve hasn’t moved at all).

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 Chapter 6: Consumer Behaviour

Question 13

a) The demand and supply curves are plotted in the diagram below. To compute the equilibrium
price and quantity algebraically, we must solve the system of equations. Equate the prices in the
demand and supply functions to get

30 – 4Q* = 6 + 2 Q*  24 = 6 Q*  Q* = 4
Substitute this value of Q* back into either the demand or supply curve to solve for p*. Using the
demand curve to do so, we get

p* = 30 – (4  4) = 14

b) The total value that consumers place on Q* units of the good is shown by the area under the
demand curve up to Q = 4 units. This is shown by areas A + B + C.

c) The value that consumers place on an additional unit of the good—the marginal value—is shown
by the equilibrium market price, p* = 14. Given the market price, consumers consume the good
until the last unit delivers utility equal in value to the market price.

d) The new supply curve is p = 2 + 2QS. The new equilibrium quantity, Q** is found by

30 – 4Q** = 2 + 2Q**  28 = 6Q**  Q** = 4.67

and p** = 30 – (4  4.67) = 11.33

As the supply curve shifts, price falls and consumers increase their quantity demanded of the
product. Consumers’ marginal value of the good has now fallen and is equal to the new equilibrium
market price.

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e) Consumers have not changed the total value they place on any given amount of the good, but
their marginal value has fallen. As the equilibrium price falls, consumers consume more of the
product, thus diminishing the marginal value of the product.

Question 14
This is a great example of how understanding the concept of marginal value can help us to understand
some facts from our everyday experience. For most people, the value of a second morning
newspaper, given that they have one already, is very close to zero. There is no value in reading two,
and the product cannot usefully be stored until later. Thus, newspaper publishers use simple vending
machines that allow individuals to take several papers even though they pay for only one because
they guess (correctly, in most cases) that most people will take only one newspaper.

For candy and soft drinks, however, the marginal value of an extra unit is quite
high⎯because both products are easily storable so that even if you don’t want a second chocolate
bar or soft drink right away, you may well want it in a few hours or a few days. In this case, many
individuals might be tempted to take extra units that they have not paid for; the solution to this
problem is that the candy and soft-drink companies use vending machines that allow buyers to only
remove one unit at a time.

Question 15
This is a good question to drive home the important difference between marginal and total value,
applied to a very important product to Canadians.

a) Given a downward-sloping demand for medical and hospital services, the unlimited
government-provision at a zero price suggests that consumers will use the services until their
marginal value is driven to zero.

b) Even if the marginal value of medical services is driven to zero, the total value of the consumed
services will be quite high. Consumers will simply use these services up to the point where price
(zero) equals marginal benefit. If the government then restricts supply (for whatever reason), the
total value of services to consumers will fall but the marginal value will rise. This simply reflects
the fact that consumers will move up the demand curve. If the government maintains the zero price
even when they restrict the supply, there will be excess demand for hospital and medical services.
This leads to long queues, waiting lists, and perhaps even a black market in health-care services.

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Question 16

Consider two simple demand-and-supply diagrams, one for the market for cardiac surgeons and one
for NHL hockey stars. The demand curves may well be the same for these two types of workers,
although each of them would be challenging to compute with any precision. But the real difference
is on the supply side. Cardiac surgeons need to go through expensive training for many years in order
to earn their credentials and qualify for their positions. This extensive training explains why they are
in short supply relative to many other doctors, and also relative to many other occupations. But
relative to NHL hockey stars, the cardiac surgeons have a large supply; the very special set of skills
possessed by the very best NHL players makes them extremely rare, and the result is that they can
command much higher salaries than even the very best specialist surgeons. In terms of the diagrams,
the supply curve for the NHL stars is to the left of the supply curve for the cardiac surgeons.

In terms of the “value” question, the higher salary for NHL hockey players suggests that
society values them more at the margin than it values surgeons. But the total value placed on the
two different sets of workers depends on the position of the demand curves.

*****

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________________________________________

Appendix to Chapter 6: Indifference Curves

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Answers to Appendix Study Exercises

Question 1

a) The appropriate scale diagram is shown below.

b) Bundles c and i are on the same indifference curve, marked I1 in the figure. Bundles d, g and h are
also on the same indifference curve (marked I2), but each is preferred to either c or i. Thus I2 lies
above and to the right of I1. Bundle e is Katie’s favourite bundle of those shown, and so the
indifference curve through this bundle (I3) must lie above and to the right of I2.

c) Katie clearly prefers bundle e to bundle g. How about comparing bundle f to bundle g? We know
that Katie is indifferent between bundles d and g. Also, we can be sure that she prefers d to f, for the
simple reason that d and f have the same amount of magazines but d has more ice cream cones. But
this immediately means that she also prefers g to f. Thus, Katie’s ranking is: e is preferred to g, and
g is preferred to f.

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Question 2

a) The cost of each bundle is shown in the following table. Since Katie has $36 per month, she can
afford only bundles a, c, f, g, and i. She cannot afford bundles b, d, e, and h.

Cost ($)
36
a
b 40
c 36
d 38
e 40
f 34
g 36
h 44
i 36

b) If Katie spends her entire $36 on ice cream cones, she can afford to buy 9 cones. This is the vertical
intercept of the budget line shown below. If she spends her entire $36 on magazines, she can afford
to buy 6 magazines. This is the horizontal intercept of the budget line. The (absolute value of the)
slope of the budget line is equal to the “rise over the run”, which in this case is equal to 9/6, which
is 1.5. This slope is equal to the relative price of magazines to ice cream cones (= 6/4 = 1.5).

c) Recall that Katie can only afford bundles a, c, f, g, and i. Which one will she choose? Recall from
Question 1 that Katie prefers bundle g to bundle f, and she also prefers g to both c and i. So Katie
definitely won’t choose c, f, or i. This leaves only bundle a. But from the figure of the indifference
curves above, it is also clear that bundle g is on a higher indifference curve than bundle a, so she
won’t choose bundle a. Thus Katie’s utility-maximizing choice is bundle g.

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Question 3

a) For the budget line given by Line 1, point A shows the tangency between the budget line and the
indifference curve—this shows the highest level of utility that Debra can achieve.

b) If the price of Coronas declined, then the maximum available amount of Coronas (with a given
money income) would increase. This amount of Coronas is the horizontal intercept of the budget
line.

c) Point B shows the hypothetical consumption bundle that Debra would choose if the price of
Coronas declined and her money income was reduced so that she could just achieve her original
level of utility. The movement from A to B is the substitution effect of the reduction in the price of
Coronas. It shows that the substitution effect of a decline in the price of a product is unambiguously
to increase the consumption of that product and decrease the consumption of the other product.

d) Point C is the new consumption bundle that Debra chooses after the actual reduction in the price
of Coronas. If Coronas are a normal good, then an increase in real income must lead Debra to increase
her consumption of Coronas. This implies that point C must lie to the right of point B (the movement
from B to C being the pure income effect of the price change). The diagram as drawn does indeed
satisfy this restriction.

e) If Coronas were an inferior good, then the increase in real income shown by the shift of the budget
line from the dashed line to line 2 would lead Debra to reduce her consumption of Coronas⎯that is,
her new consumption point would lie to the left of point B.

Question 4

This is a good question for emphasizing which factors lie behind the shape of an indifference curve
(in the common situation where both items are “goods”). The key point is that the more substitutable
are the two items in terms of providing utility, the flatter (less curved) is the indifference curve. Thus,
with items that are close substitutes, even small changes in relative prices will lead to large changes
in the utility-maximizing bundle—that is, there are large substitution effects.

Coke and chips are complements, and so we would expect the indifference curves to be quite
curved—in the extreme case of perfect complements, they would be L-shaped. For Coke and Pepsi,
however, we expect the indifference curves to be rather flat since (for most people) Coke and Pepsi
are close substitutes.

*****

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