Microeconomics 8th Edition Perloff Solutions Manual

Microeconomics 8th Edition Perloff Solutions Manual
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Chapter 5
Applying Consumer Theory
Chapter Outline
Challenge: Per-Hour Versus Lump-Sum Childcare Subsidies
5.1 Deriving Demand Curves
Indifference Curves and a Rotating Budget Line
Price-Consumption Curve
Application: Smoking Versus Eating and Phoning
The Demand Curve Corresponds to the Price-Consumption Curve
Solved Problem 5.1
5.2 How Changes in Income Shift Demand Curves
Effects of a Rise in Income
Solved Problem 5.2
Consumer Theory and Income Elasticities
Income Elasticities
Income-Consumption Curves and Income Elasticities
Some Goods Must Be Normal
Application: Fast-Food Engel Curve
5.3 Effects of a Price Change
Income and Substitution Effects with a Normal Good
Solved Problem 5.3
Solved Problem 5.4
Income and Substitution Effects with an Inferior Good
Solved Problem 5.5
*Compensating Variation and Equivalent Variation
Application: What’s Your Smart Phone Worth to You?
5.4 Cost-of-Living Adjustments
Inflation Indexes
Real Versus Nominal Prices
Calculating Inflation Indexes
Effects of Inflation Adjustments
CPI Adjustment
Application: Paying Employees to Relocate
*True Cost-of-Living Adjustment
Size of the CPI Substitution Bias
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Chapter 5 Applying Consumer Theory 67
5.5 Deriving Labor Supply Curves

Labor-Leisure Choice
Income and Substitution Effects
Solved Problem 5.6
Shape of the Labor Supply Curve
Application: Working After Winning the Lottery
Income Tax Rates and Labor Supply
Teaching Tips
This chapter contains a great deal of important material and requires several classes to cover effectively.
I find that covering the price consumption curve, Engel curve, and the derivation of demand curves usually
takes me about one 70-minute period. The material is not intuitively difficult, but students need to be clear
about these concepts in order to have the substitution and income effect material make sense. You may want
to spread the presentation of the substitution and income effects over more than one period because students
will benefit from having some time to process the first run-through, as well as refer back to the book.
The Challenge is a good way to introduce the topics covered. You might discuss why a family might make
different decisions when they are given a lump sum subsidy versus a per-hour subsidy. Then as you go
through the material in the chapter, you can refer back to the childcare Challenge. It is also a slightly
different approach to the income tax rates section, with the per-hour subsidy being a negative tax on
childcare.
When presenting the substitution and income effects, try to set up the presentation such that the class can
take good quality notes on the graphs. When students come in for help on this material, you might go through
their notes with them. What you are likely to discover is that hurriedly drawn indifference curves and freehand
wobbly budget constraints have led to a graph that looks almost nothing like the one you put on the board.
They may have the imaginary budget line drawn so that it intersects the original point of tangency, which
leaves them with no substitution effect. To minimize this problem, in addition to reminding them to bring in
a protractor and colored pencils with which to take notes, I do the following: The first time I demonstrate the
separation of the total effect into the two component effects, I replicate an example that is in the text (such as
the live music and music tracks example in Figure 5.4). I tell the class that I am doing this but ask them to
take notes as they normally would rather than just watch me and look at the book. This way, if they make
errors in note taking, they can refer to the text to see the correct graph. The other thing that can be helpful
is to supply them with pre-drawn indifference curves because this is where most of the trouble occurs. For
example, if they draw their curves much differently than yours when you are demonstrating the separation of
income and substitution effects for an inferior good, theirs may not turn out to be inferior. Another
possibility is to give the class coordinates of points that make up the needed indifference curves. It may be
useful to assign a number of substitution and income effect questions as homework, some with supplied
graphs and some where students draw their own graphs. I find that the more practice that students get
drawing the graphs, the more comfortable they become.
The section on CPI and inflation indexes is an important tool for students to understand. News articles
often compare prices across years without accounting for inflation. Where the inflation figures come from,
the different indexes that can be used and the CPI substitution bias are important concepts that can easily
be applied outside of class.
The inclusion of the labor supply curve and the labor-leisure trade-off in this chapter is another good way
to make the point of the importance of the substitution and income effects. Solved Problem 5.6, about
Enrico’s scholarship, is a good place to start a class discussion. You might ask students to think about their
own work decisions and how they depend on the support they receive from their parents or from other
sources. The effect of income taxes on labor supply is also a good discussion topic. The text describes the

68 Perloff • Microeconomics, Eighth Edition
attempts by the Kennedy, Reagan, and George W. Bush administrations to increase both work effort and tax
receipts by decreasing marginal tax rates at the highest levels. If there is time, you might point out the
normative nature of “fair” marginal tax rates and that, while a primary issue for individuals is fairness,
another important aspect of the setting of tax rates is how they may affect work effort and thus revenues. It
may be the case that in order to construct tax proportions that the majority feels are fair, rates would have
to be higher than another scheme judged to be almost as fair but with lower rates and greater work effort.
The inverted-U curve in text Figure 5.10 is useful when discussing optimal tax rates. The fact that the
United States is far below the peak of the curve and the economic implications with respect to efficiency
and redistribution may be worth discussing. It would never be optimal to tax beyond the peak of the
curvebecause that would further distort the economy without increasing tax revenues. You might ask
students where on the curve would be optimal, and what other factors, such as economic growth and
redistribution, determine that choice.
As an extension of this section, you may want to discuss in class or assign as homework Question 7 in the
following Additional Problems section. This question requires the students to construct a piece-wise linear
budget line due to changes in the marginal tax rate as hours worked increases.
Additional Applications
Rats Treat Quinine Solution as a Giffen Good1
Economists have long sought empirical confirmation of the Giffen good phenomenon—the occurrence of
a negative income effect so large that it overwhelms the substitution effect, creating a positively sloped
demand curve. Battalio, Kagel, and Kogut (1991) used a novel experimental procedure to demonstrate
that, within a certain income range, the Giffen phenomenon can occur at the individual level.
The authors began by providing six rats with the opportunity to consume liquid in the form of root beer,
a quinine solution (0.1 gram per liter), and water. The rats strongly preferred root beer to water and water
to quinine solution. Given these preferences, root beer was chosen as the normal good and quinine was
intended to serve as the Giffen good. In the experiment, the rats could “purchase” each liquid by pressing
on a wall-mounted lever (one for root beer, one for quinine) in their cage. Income was controlled by fixing
the number of presses that would produce liquid. The rats could allocate their total presses across the two
levers in whatever proportion they chose.
The authors first searched for an income range in which quinine was strongly inferior (a necessary condition
for producing the Giffen phenomenon). They then imposed income-constant price changes at these income
levels to demonstrate the Giffen effect. The quinine price was changed by altering the amount received
per lever press. As the price went up, less quinine was received per press.
Of the six rats tested, three produced a Giffen response, and three did not. Not surprisingly, the Giffen-
response-producing rats were the same three that had treated quinine as a strongly inferior good in the
income range that was tested. The other three rats, for whom quinine was not strongly inferior, did not
exhibit the Giffen phenomenon.
The authors concluded that the Giffen good is observed rarely for two reasons. First, it is difficult empirically
to generate (or to observe in human experience) the “initial conditions of strong inferiority that the theory
calls for.” Further, when the responses were averaged across rats to produce a market effect, the effect was
not significantly different from zero. Thus, although some individuals did exhibit the Giffen phenomenon
in a specific income range, the heterogeneity of preferences and income levels across individuals makes
the observation of the Giffen phenomenon at the market level extremely unlikely.
1
Raymond Battalio, John H. Kagel, and Carl A. Kogut, “Experimental Confirmation of the Existence of a Giffen Good,”
American Economic Review, 81(4) September 1991:961–70.

1. The authors were able to demonstrate this result only at very low income levels. Why would this be
so?
2. Does this experiment reinforce or weaken the theory of choice?
Job Sharing May Help Workers to Maximize Utility

The model of labor supply presented in the chapter assumes that workers are free to choose the number of
hours that they work. However, in many occupations, employers typically do not offer part-time work, and
workers are constrained to full-time work. For workers who would choose to work any number of hours
per week other than 40, this alters their utility-maximizing hours choice and so reduces utility. For those
workers with a high preference for income who would like to work more than 40 hours per week, they
may be able to increase their income by working part-time at a second job. However, for those employees
who would like to work less than 40 hours per week, they could face the choice of working more than
they would like, or not at all. Job sharing is a relatively recent labor market innovation that can provide
a solution. In job sharing, two employees work as partners and share a single full-time position. The
employees receive the benefit of knowing that they have full-time coverage (and maybe even better than
full-time coverage if one partner can cover for the other during vacations and sick time), while the
employees receive the benefit of being able to choose fewer hours of labor market participation and can
devote more time to either leisure or work in the home. Partners may be spouses (as sometimes occurs in
academia when spouses with similar training share a single position) or completely unrelated individuals
who have significant at-home responsibilities that make full-time work undesirable. Employers have
responded to the increased demand for shared jobs. USA Today reports that as many as 28% of firms offer
job sharing. Those interested in sharing a job can even use Internet search services specifically designed to
match partners.2
1. Use a graph similar to Figure 5.8 in the text to show an individual who is constrained to working
40 hours per week but would prefer to work less (i.e., her utility would be higher if she could choose
another point on the budget line with about half as many hours of work).
2. Show how the individual in the graph would benefit from job sharing. It may help to assume that
there are two individuals with the same taste for market work.
Discussion Questions
1. What kind of experiment could a firm conduct to determine the demand curve it faces?
2. Suppose the government wants to discourage consumption of some good (such as cigarettes or
liquor). How effective will specific taxes and lump sum taxes (a pure reduction in income) be in
reducing consumption? What type of information do you need to answer this question?
3. How can the firm use the information contained in an Engel Curve and government forecasts of
income to predict future demand?
4. Are you aware of any Giffen goods? What types of goods might these be?
5. Should the government try to pick the marginal tax rate to maximize government revenue?
6. Think of several goods that, at your current income level, you would consider normal, others that you
would consider inferior. Try to determine the defining characteristics of normal and inferior goods by
evaluating your list. What do the two groups have in common? How are they different from each other?
2
Jerry Langdon, “Job Sharing Programs on the Upswing,” at http://www.usatoday.com/careers/news/2001-01-26-jobsharing.htm,
and “Job Share Partner Search,” at http://www.womans-work.com/job_share_search.htm. Accessed 1/1/03.

7. In the United States, Social Security is tied to the CPI-W, a consumer price index for urban and wage
earners. What are the advantages of this index over the more general CPI? How does the welfare of
Social Security recipients depend on the distribution of price changes across the goods in the basket?
Additional Questions and Problems

1. Suppose the government wants to increase the ability of families to pay for college education. Would
a $500 income tax rebate differ from a $500 tax credit for tuition reimbursement? Explain.
2. True, False, or Uncertain; explain your answer. When income rises and the price of x falls, the
consumer will always buy more units of x.
3. Suppose that a consumer’s annual demand for office visits is described by the equation Q = 8 – 0.1p.
If office visits cost $30, and the consumer has no health insurance (i.e., the consumer pays full price),
how many office visits will she make? What is the elasticity of demand for office visits at this point?
Suppose a health insurance plan is instituted that pays for one-third of each office visit. How would
this affect the quantity and the demand elasticity at the new equilibrium?
4. A consumer faces prices for hot dogs and hamburgers of $1 each. Consumption of the two commodities
at various weekly income levels are shown below.
a. Use the information to sketch the income consumption curve on a graph.
b. Draw the Engel curves for hot dogs and hamburgers.
Income Hot Dogs Hamburgers

$10 3 7
15 6 9
20 10 10
c. What is the income elasticity of hot dogs for this consumer as income increases from $10 to $15?
5. Draw a graph with arcade games on the horizontal axis and newspapers on the vertical axis. Joe has
$10 per week to allocate between these commodities. The price of newspapers is $0.50. At the initial
price for arcade games of $0.25, Joe purchases 10 newspapers and plays 20 games. When the price of
games increases to $0.50, Joe purchases 8 newspapers and plays 12 games. When the price of games
increases again to $0.75, Joe buys 5 papers and plays 10 games.
a. Use this information to draw the utility maximizing points on a graph.
b. Draw the price-consumption curve.
c. Draw the individual demand curve for arcade games.
d. Use the information given to calculate Joe’s elasticity of demand for arcade games between
$0.25 and $0.50, and between $0.50 and $0.75.

Chaapter 5 Applyiing Consumer Thheory 71
6. Sarah
S allocatees her incomee of $5.00 bettween the connsumption of donuts and cooffee. Her tasstes and
preferences
p arre indicated by
b the indifferrence curves sshown in Figuure 5.1. The pprice of donuuts is
$0.50
$ each. In
nitially, the prrice of coffee is $1.00 per cup. Subsequuently, the priice of coffee ffalls to
$0.50
$ per cup
p. On the follo owing graph, show the inittial utility-maaximizing possition, the new w utility-
maximizing
m position,
p and separate
s the in
ncome and suubstitution efffects. For Sarrah, is coffee a normal
or
o inferior goood?
Figure
F 5.1
7. What
W would the t value of thhe substitution
n effect be foor two goods tthat are perfect complemennts? Use a
graph
g to demo
onstrate your answer.
8. What
W happenss to the magn nitude of the overcompensa
o ation due to thhe use of the CPI in Figuree 5.5 of
the
t text if onee views food and
a clothing asa perfect com
mplements?
9. Draw
D a graph
h showing the utility-maxim mizing labor aand leisure chhoices for the typical lotterry winner
described
d in the “Working After Winnin ng the Lotteryy” applicationn (the individdual who winss $55,200
and
a decreasess earnings by $1,877/yr). What
W does thiss change in w work effort inddicate about tthe
standard
s assummption that working
w reducces an individdual’s utility llevel? (Assum
me the individdual’s
annual
a incomme was $16,10 00 prior to winnning the lotttery.)
10. The
T basic labo or supply moddel presented in this chapteer assumes thaat wage incomme is untaxed. Suppose
instead
i that a set of margin
nal tax rates was
w imposed ssuch that at a wage of $10//hour, the firsst 5 hours
o labor were untaxed, the next 10 hours of labor werre taxed at a 220% rate, andd all labor theereafter
of
was
w taxed at a 50% rate. Sh how on a grap ph how this w would affect tthe budget linne. How mighht this alter
work
w effort?
11. The
T welfare program
p was designed
d to help
h low-incom me families. T
The benefit frrom this proggram is
calculated
c as the fixed perccentage of thee maximum bbenefit minus family incom me. Explain w why this
design
d may caause an undessirable labor supply
s effect..
12. The
T conventio onal welfare program
p was replaced by tthe Earned Inncome Tax Crredit program m in 1997.
Under
U w program, the benefit is caalculated as a fixed percenttage of earninggs of low-incoome
the new
families.
f Expllain why this new design helps
h to encouurage labor suupply.
13. Suppose
S Nick
k’s salary is tiied to an inflaation index baased on the avverage prices of food and cclothing,
with
w equal weeights on each h. This year th he index (andd thus Nick’s salary) increaased by 4%. DDetermine
the
t effect on Nick’s
N optimaal consumptio on bundle andd welfare if thhe following ooccur:
a.
a The pricees of both food and clothin
ng increased bby 4%.
© 20
018 Pearson Educcation, Inc.
722 Perloff • Microeconomics,
M Eighth Edition
b. The price
p of food increased
i by more than thee price of clotthing, and Nick spent mosst of his salaryy
on food.
c. The price
p of food increased
i by more than thee price of clotthing, and Nick spent mosst of his salaryy
on clo
othing.
Answ
wers to Ad
dditional Question
ns and Prroblems
1. Yes. A $5 500 reduction n in income taaxes would rep present a puree income effeect, providingg families withh
additionall disposable income that co ould be spentt on anything (including, bbut not necessarily, collegee).
A $500 taax credit for tuuition reimbuursement wou uld be a price change and sso would invoolve both a
substitutio
on and an inccome effect bu y be received if the family spent at leastt $500 on
ut would only
tuition. All w the tax ccut as they woould with the tuition tax
A families wiill be as well or better off with
credit (seee Chapter 4). However, thee demand for college educcation would bbe greater witth the tax
credit thann with the tax
x cut.
22. False. In order

o to makee predictions using econom mic theory, it is best to chaange only one parameter att
a time. In nd price falls. If the good i s inferior, thee effects will bbe in oppositee
n this case, inccome rises, an
directionss.
33. If the connsumer has no o health insuraance, she willl make five offfice visits peer year, and thhe elasticity
of demand is –0.6. If ana insurance plan
p covers on ne-third of thee cost of an ooffice visit, thee consumer’ss
quantity will
w increase anda price senssitivity will decrease.
d By ssubstituting 0.667p into thee demand
equation, we can see th hat the elasticcity will fall, as
a the consum mer now reducces visits by 00.0667
when pricce increases byb $1, rather than 0.1. The result is the ssame as if the price were $20 per
visit insteead of $30. Th
he new equilib brium quantitty is six visitss per year, andd the elasticitty falls to
–0.33 [= –0.0667(20/6
– 6)].
44. a. See Figure

F 5.2.
b. See Figures
F 5.3 annd 5.4.
c. ξ = (3
3/5)(10/3) = 2.
2
Figure 5.2
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n Education, Inc.
Figure
F 5.3
Figure
F 5.4
5. a.
a See Figurre 5.5.
b.
b See Figurre 5.5.
c.
c See Figurre 5.6.
d.
d ε1 = (8/–00.25)(0.25/200) = –0.4.
ε2 = (2/–00.25)(0.50/122) = –0.3.
Figure
F 5.5
© 20
M Eighth Edition
Figure 5.6
66. To separaate the incomee and substituttion effects, drraw the imagiinary budget lline I*. In this case, becausee
the incom
me effect partlly offsets the substitution effect,
e coffee is an inferior good. See Fiigure 5.7.
Figure 5.7
© 2018 Pearson
n Education, Inc.
7. Because
B the in
ndifference cu
urves are L-shaped, the suubstitution efffect is zero. W When the imagginary
budget
b line is drawn tangennt to the origiinal indifferennce curve, it ppasses througgh the same pooint as the
original
o tangeency (e1). Thu
us, there is on
nly an income effect. See F Figure 5.8.
Figure
F 5.8
8. If
I the consummer views food d and clothing g as perfect ccomplements, there is no bias. Indifferennce curves
will
w have the characteristicc “L” shape. Restoring
R Klaaas’s purchasiing power to the original bbundle
does
d unity to increaase his utility because he does not beneffit by substituuting away
not creatte an opportu
from
f clothing
g toward food d.
© 20
M Eighth Edition
99. See Figurre 5.9. The ind

dividual’s buddget constrainnt (wage line)) shifts upwarrd to reflect aan increase in
nonlabor income. The slope of the constraint
c doees not changee because laboor income is sstill earned
me wage rate. As described
at the sam d in the examp ple, the indiviidual works oonly fewer hours (hours
o H2) but doess not retire completely. Earrned income ffalls to $14,223.
worked faall from H1 to
Figure 5.9
This supp
ports the assum mption that wo orking reducees an individuaal’s utility levvel because thhe individual
receives positive
p utility
y from leisuree, and when to otal income inncreases theyy demand morre leisure andd
supply lesss labor. How wever, they do o not stop worrking altogethher even thouugh their incom me level
without working
w is greeater than theiir income wass previously. This is becauuse the marginnal benefit
from theirr hourly wagee is greater thhan the margin nal utility from
m the 24th hoour of leisure..
© 2018 Pearson
n Education, Inc.
10. When
W the marrginal taxes arre imposed, th he budget connstraint becom mes nonlinear. Beginning att zero
hours
h of laborr (24 hours off leisure) untill labor supplyy is equal to ffive hours, thee slope of the budget
line
l is –w, thee wage rate. Thereafter
T the after-tax ratee drops to $8, reducing thee slope of the budget
line,
l shown ass line segmen nt TR in Figurre 5.10. This rrate is in effecct from the 6tth through thee 15th
hour
h worked. Thereafter th he net wage faalls to $5 per hour, again cchanging the sslope (segmennt RP).
The
T dashed line shows the wage line wiithout the tax.. The effect oof the tax is too reduce the pprice of
leisure
l but alsso to reduce th
he ability to bu
uy leisure. Deepending on w whether the inncome effect oor the
substitution
s efffect is domin
nant, the indivvidual may w work more or lless. In Figuree 5.10, the inddifference
curves
c shown n result in the individual red
ducing work efffort from H1 to H2 and incrreasing leisuree
(substitution
( effect
e dominannt).
Figure
F 5.10
11. Under
U the weelfare programm’s benefit caalculation form mula for low--income famillies, the moree they
work,
w the lesss benefit they would receiv ve from the goovernment. HHence, this proogram generaates
a negative sub bstitution effeect that discouurages peoplee’s labor suppply. In fact, foor people earnning
minimum
m wage, the maxim mum benefit theyt could geet from welfarre is comparabble to havingg a full-
time
t minimum m-wage job. Hence,
H the inccome effect oof working is close to zero for many peoople,
further
f reinforcing the substitution effecct.
12. Under
U the Earrned Income Tax Credit prrogram, peop le get earningg subsidies, w which is a fixeed
percentage
p off their earning
gs. This progrram essentiallly raises theirr after-tax wagge rate. If, forr low-
income
i families, the incomme effect dom
minates the subbstitution effeect, this new pprogram design might
help
h to encou urage people’ss labor supplyy.
13. a.
a If food an
nd clothing in
ncrease by thee same amounnt, Nick’s buddget constrainnt does not chhange, and
his optim
mal bundle remmains the sam
me. Thus, theree is no welfarre effect.
b.
b If the pricce of food inccreases by mo
ore than the prrice of clothinng, the slope of Nick’s buddget
constraintt will change. Nick will su
ubstitute from
m food to clothhing, but becaause he was sppending
most of his
h money on food, his welfare will likelly decrease (lleft-hand grapph).
c.
c If the pricce of food inccreases by mo
ore than the prrice of clothinng, the slope of Nick’s buddget
constraintt will change (become steeeper). Nick w will substitute from food to clothing, butt because
he was sp pending most of his money y on clothing, his welfare w will increase ((right-hand grraph).
© 20
M Eighth Edition
The reed line is the new

n budget liine with the change
c in pricces, and the inncrease in inccome.
The blue line is Nicck’s original budget
b line.
Clothing
g Clothing
Foo
od Food
Answe
ers to Tex
xtbook Questions
Q s
1.1 Downnward-slopin
ng and horizo
ontal price-cconsumptionn curves are iillustrated inn the figure
below
w.
1..2 As Mimi moves fro om E1 to E2 onn her demand d curve (in thee bottom grapph of Figure 55.1 in the
chapteer), her utility increases. Th
his is exempliified by e2 beiing on a highher indifferencce curve than
e1 in th
he top diagram m of Figure 5.1. This illusttrates that utillity (or well-bbeing) increasses as we
move down
d along a demand curv ve because thhe good’s pricce decreases.
1..3. Let’s say

s Olivia likees one scoop of ice cream with each pieece of pie, eacch piece of piie costs $8, a
scoop of ice cream is $2, and Oliivia’s pie andd ice cream buudget is $60. In the top pannel of the
follow
wing figure, we can plot herr indifferencee curve (a 90- degree angle)) where it inteersects the
budgett line to allow
w for 6 pieces of pie with icce cream. As the price of ppie declines, tthe new budget
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n Education, Inc.
curve will intersect new

w, higher indiffference curvves. Panel (b) shows the ressulting demannd curve
for pie.
1.4 The deman nd curve for manufactured

m d diamonds deepends in partt on whether tthe price of
manufactuured diamondss is greater orr less than thee price of reall diamonds. Iff the price of real
diamonds is less than th
he price of maanufactured ddiamonds, thee quantity dem manded of
manufactuured diamondss is zero. If th
he price of maanufactured ddiamonds is leess than the prrice of real
diamonds, then consum mers purchased d all manufacctured diamonnds, and thus q1 = Y/p1, whhere M and
N are the price
p and quan
ntity demandeed of manufaactured diamoonds, respectivvely.
1.5 In the prev
vious problemm, consumers would simplyy purchase alll manufactureed diamonds or all real
diamonds, depending on t lowest priice. Because tthe marginal utility of bothh types of
n which had the
diamonds is decreasing, but they still enter the utiility function additively annd symmetricaally,
consumerss will still purrchase all of th
he cheapest ddiamond formm but will simp
mply receive leess utility
than they would
w have in n the previouss problem.
1.6 In poorer countries,
c smo
okers are giviing up cigaretttes to buy ceell phones. Ass cell phones hhave
recently beecome affordaable in many poorer counttries, the pricee ratio of cell phones to tobbacco has
fallen subsstantially.
According g to Labonne and
a Chase (20 011), in 20033, before cell pphones were common, 42% % of
households in the Philipppine villagess they studiedd used tobaccoo, and 2% of total village iincome
was spent on tobacco. After
A the pricee of cell phonnes fell, from 2003 to 20066, ownership oof the
phones quaadrupled. As consumers sp pent more on mobile phonnes, tobacco uuse fell by onee-third in
households in which at least one mem mber had smooked (so that consumptionn fell by one-ffifth for
the entire population).
p
Assume th o cell phones on budget linne L1 is p1. Thhen the price of cell phonees
hat the price of
decreases to
t p2, pivoting l to L2.
g the budget line
The price-consumption curve is the line
l through tthe optimal buundles that ann individual wwould
consume at
a different priices. Use the information iin the price-coonsumption ccurve to draw
w the
© 20
demand curve. Corresponding to each price on the vertical axis, record on the horizontal axis the
quantity demanded from the price-consumption curve, as illustrated.
1.7 Marginal rate of substitution (MRS) is the maximum amount of one good a consumer will
sacrifice to obtain one more unit of another good. The marginal rate of substitution of burritos for
pizza equals
0.25 Z −0.75 B 0.75 B
MRS = − 0.75 − 0.25
=− .
0.75 Z B 3Z
Marginal rate of transformation (MRT) is the trade-off the market imposes on the consumer in
terms of the amount of one good the consumer must give up to obtain more of the other good.
Because the budget constraint is
pZZ + pBB = Y,
the slope of the budget line, which equals the marginal rate of transformation, MRT, is
pZ
MRT= − .
pB

Lisa optim
mizes utility su
uch that
MRS = MR
RT
B p
= Z
3Z p B
3 pZ Z
B= .
pB
Substitutin
ng this into th
he budget consstraint,
pZZ + pBB = Y,
pZZ + 3pzZ = Y
4pZZ = Y
0.25Y
Z= .
pZ
2.1 Using the same values as
a in the soluttion to Probleem 1.3, we caan plot the efffect an increasse in
income to $120 or $180
0 has on demaand for pie, ass shown in thhe following ffigure, derivinng the
Engel curv
ve.
© 20
M Eighth Edition
2..2 The figgure will be similar

s to panel (a) and pan
nel (c) of Figuure 5.2 (in thee chapter), buut relabel the
verticaal “wine” axiss as “other go
oods” (or “funn”) in the paneel (a) figure aand the horizoontal “beer”
axis ass “bequests” in
i both panel (a) and (c) figgures. The Enngel curve wiill be steeper.
2..3 Because the two commodities arre perfect com mplements, th e indifferencee curves havee right angles..
Thus, the
t income co onsumption curve
c will be a straight linee that passes tthrough the pooint where thhe
indiffeerence curves just touch thee budget liness. See panel ((a) in the folloowing figure. In order for
Hugo to t buy one more doughnutt per week, hiis budget musst rise enoughh to purchase both another
doughn her cup of cofffee. The Engel curve is alsso linear; see panel (b).
nut and anoth
2..4 An opeera performan nce must be a normal good d for Don beccause he viewws the only othher good he
buys as
a an inferior good.
g To show w this result in
i a graph, drraw a figure similar to Figuure 5.3 (in thee
chapteer), but relabel the vertical “housing” ax xis as “opera pperformancess.” Don’s equilibrium will
he upper-left quadrant at a point like a in
be in th i Figure 5.3..
2..5 The co
onsumer’s bud
dget constrain
nt is
p1q1 + p2 q2 + " + pn qn = Y ,
where Y is income and

a pi is the price
p and qi is the quantity of good i. Differentiating with respect tto
Y, we find
f that
dp1 dq dq ddY
p1 " + pn n =
+ p2 2 +" = 1.
dY dY dY ddY
Multip
plying and div
viding each teerm by qi Y, we
w rewrite thiss last equationn as
p1q1 dq1 Y p2 q2 dq2 Y p q dq Y
+ +"+ n n n = 1,
Y dY q1 Y dY q2 Y dY qn
or
ω1η1 + ω2η2 + " + ωnη n = 1,,
where η1 the incom f each good i, equals (dqqi / dY )(Y /qi ),, and the buddget share of
me elasticity for
good i is ωi = pi qi /Y . That is, th
he weighted su
um of the incoome elasticitiies equals 1. F
For this
equatio
on to hold, at least one of thet goods mu ust have a positive income elasticity; hennce, not all thhe
goods can be inferio or.
2..6 An Enngel curve sho

ows the relatio
onship betweeen the quantitty demanded of a single goood and
income, holding priices constant. It this examp
ple, it shows cconsumption of good X whhen income iss
Y1, Y2, and Y3.
© 2018 Pearson
n Education, Inc.
A good is called a normal good if as much or more of it is demanded as income rises. A good is
called an inferior good if less of it is demanded as income rises. If less of a good is consumed with
income initially but then more of a good is consumed with income at higher income levels, then
the good is an inferior good for low-income levels but a normal good for higher income levels.
3.1 a. The substitution effect causes her to buy more clothing. The convexity of indifference curves
assures that the substitution effect will always be positive for a price decrease.
b. The income effect could be either positive or negative depending on whether clothing is a normal
or inferior good for Cora. If clothing is a normal good, the income effect would be positive; if
clothing is an inferior good, the income effect would be negative.

3.2 See the following figure. The marginal rate of substitution is B/C.
The marginal condition is B/C = 1/2.

B = C/2.
Substituting into the budget constraint yields:
2B + C = 120
2C = 120
C* = 60,
B* = 30.
When the price changes due to the tax, the new marginal condition is
B = C/3.
Substituting into the new budget constraint yields:
3B + C = 120
2C = 120
C* = 60,
B* = 20.
3.3 Eggs and toast are perfect complements. U = min(2Qt, 3Qe). If the price of eggs increases but we
compensate Cori to make her just as “happy” as she was before (which means her utility is the
same as before), her consumption of eggs will still be the same as shown in the following figure.
There is only an income effect but no substitution effect because eggs and toast are perfect
complements; Cori will not substitute toast with eggs even though the price of eggs increases.

3.4 The income effect reinforces the substitution effect for normal goods. It partially offsets the
substitution effect for inferior goods. When the income effect more than offsets the substitution
effect, it is known as a Giffen good.
3.5 Assume for simplicity that the price of a can of Coke increases such that it becomes twice the
price of a can of Pepsi.
The substitution effect is the change in the quantity of a good that a consumer demands when a
good’s price changes, holding other prices and the consumer’s utility constant. Because Coke and
Pepsi are perfect substitutes for Mahdu (and the price of Coke increases from being less than the
price of Pepsi to being greater than the price of Pepsi), Mahdu substitutes from consuming only
Coke to consuming only Pepsi, so the substitution effect is C1 fewer cans of Coke (from e1 to e2,
which contains no Coke and only cans of Pepsi). The income effect is the change in the quantity of
a good a consumer demands because of a change in income, holding prices constant. The income
effect is zero cans of Coke. The total effect is the substitution effect plus the income effect. Thus,
the total effect is equal to the size of the substitution effect.
3.6 Let PH = price of high-quality oranges and PL = price of low-quality oranges in New York. We
expect PH > PL. We have to add the transportation costs, c, (which are the same for high- and low-
quality oranges) to get the prices in California. Now it is easy to check that: (PH /PL) < [(PH +
c)/(PL + c)].
Therefore, considering the transportation costs, the high-quality oranges are relatively cheaper in
California than in New York. Therefore, the demand for high-quality oranges should be higher in
California compared to in New York.

M Eighth Edition
3..7 In the graph, Lf is thhe budget linee at the factorry store, and L 0 is the consttraint at the ooutlet store. A
At
the facctory store, thee consumer maximum
m occuurs at ef on inddifference currve I f. Supposse that we
increasse the income of a consumeer who shops at the outlet sstore to Y*, soo that the resullting budget
line L** is tangent to the indifferennce curve I.f. The consumeer would buy bundle e*. Thhat is, the purre
substittution effect (the movemen e causes thee consumer too buy relativelly more firsts.
nt from ef to e*)
The tootal effect (thee movement from
f ef to e0) reflects
r both tthe substitutioon effect (firssts are now
relatively less expen nsive) and thee income effeect (the consuumer is worse off after paying for
shippin ng).
3..8 It is im
mpossible for either ice cream or fudge sauce
s to be a Giffen good. dq/dp is negaative for bothh
members of a perfectly complem mentary pairin
ng.
3..9 Equivaalent variation
n is the amou
unt of income that, if taken from a consuumer, would llower utility
by the same amount as a price inncrease. This measure
m is thhe same or equuivalent harm
m as that of the
price increase.
mizing utility aat bundle e1 oon budget linee L1. Then thee
dividual is iniitially maxim
In the figure, the ind
o good X increases, pivotiing the budgeet line to L2. T
price of The consumerr maximizes uutility at the
new prrices at bundlle e2.
Line L3 is parallel to
o L1 and just tangent
t to I2. Equivalent
E vaariation is equual to the verttical distance
1 3
betweeen budget linees L and L .
The to
otal effect is frrom X1 to X2. The substituttion effect is ffrom X3 to X2. The incomee effect is from
m
X1 to X3.
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n Education, Inc.
4.1 The attractive feature of the Big Mac Index as an indicator of price indexes is its uniform
composition. The component ingredients of the Big Mac are the same across a long period of time
and among most countries, allowing an “apple-to-apple” comparison. For cross-country
comparisons, we should assume that other factors such as taxes, tariffs, and service costs are the
same for all countries. We also should assume that consumers in each country consume the same
proportion of Big Macs (or their ingredients) as other goods.
4.2 He is better off. If he were to buy all new books, the increase in income would just cover the price
increase. However, if he buys all used books, he will spend only $24 more than if he bought all
used books at the old prices. Thus, any combination of books that includes one or more used
books leaves him with leftover or extra income.
4.3 See the following figure. Ann will buy more books and less ice cream this year, and her utility will
be better off this year on I 2 than on I 1. This is because the price of books rose by less than the
price of ice cream. So, Ann can gain higher utility by consuming more books and less ice cream.

4.4 See the following figure. Alix is equally well off at e2 compared to e1. Even if coffee becomes
relatively cheaper, Alix will not raise her utility by consuming more coffee because cream and
coffee are prefect complements.
The CPI accurately reflects the true cost of living because Alix does not substitute between the
goods as the relative prices change.
4.5 The figure shows Klaas maximizing utility along budget line L1 at bundle e1 in year 1. Then, in
year 2, the price of food increases by more than the price of clothing, but Klaas is given a cost-of-
living adjustment such that he is able to attain his original consumption bundle (bundle e1) in
year 2.
A budget line (or budget constraint) shows the bundles of goods that can be bought if the entire
budget is spent on those goods at given prices. The new budget line (L2) will pass through Bundle
e1, where Klaas maximizes utility in year 2. However, it will be steeper than the original budget
line to illustrate the price of food is relatively more expensive and the price of clothing is
relatively less expensive in year 2. An indifference curve shows the set of all bundles of goods that
a consumer views as being equally desirable. Bundle e2 will be on an indifference curve that is just
tangent to the new budget line.
Klaas is given enough additional income such that he has the option of continuing to consume
Bundle e1. Therefore, Klaas should be no worse off in year 2. However, because relative prices are
different in year 2, Klaas can substitute toward the cheaper good, increasing his utility.
4.6 Answers will vary depending on the date at which the price of French fries is checked.

5.1 From Appendix 5B, we know that, when N is leisure and Y is income:
MU N
MRS = − = −w = MRT .
MUY
We also know that if the utility function is U(Y, N) is Cobb-Douglas such that:
U = Y α N 1− a = ( wH )α (24 − H )1− a
where H is the number of hours worked. Differentiating the utility function with respect to H and
setting it to zero, we find that H = 24α and dH
dw
= 0. Therefore, a wage change will have no effect
on the number of hours worked with this utility function.
5.2 Leisure is not a Giffen good. When the wage increases, it increases the opportunity cost of the
individual. If leisure is a normal good, the individual will purchase more of it as wages rise, just as
he or she may purchase more of other commodities. When the income effect dominates, it
generates a backward-bending labor supply curve at high wages. If leisure is inferior, the income
and substitution effects reinforce one another, and leisure falls as the wage increases.
5.3 See the following figure. Bessie is unambiguously worse off. Because her original optimal bundle
lies in the dashed section in the figure, now she has to choose the corner solution as her optimal
bundle.
5.4 See the following figure. Whether he decides to work additional hours, given the overtime
premium, depends on his taste for income versus leisure. Roy may or may not choose to work
more hours.

5.5 Jerome’s budget line is kinked at eight hours of work. At that point, the slope of the budget line
increases from –w to –w*. See the figure below.
Jerome will obviously pick the higher paying job for his first eight hours. How many total hours
he works will depend on the shape of his indifference curve.
5.6 If the higher paying job had no restriction on hours, as long as the lower paying job provided no
utility other than income he would not work there, and his budget line would be linear, with slope
–w.
5.7 Suppose we have leisure (L) on the horizontal axis and earned income (Y ) on the vertical axis. The
budget constraint is curved and the absolute value of its slope becomes smaller as L increases.
Therefore, the opportunity cost of leisure becomes smaller and smaller because you have more
leisure. Let’s denote the slope of the indifference curve by MRS. Thus, the optimum choice is
where |MRS| = aH, the wage rate. Bill’s tastes determine the MRS, and thus determine the point
on the budget constraint at which his indifference curve will be tangent.
5.8 a. Budget before lottery win:

Y = w(24 - L) + Y*,
where Y * is unearned income.
Budget after lottery win:
Y = w(24 - L) + Y* + 1000.
Thus, the budget shifts up parallel to itself.
b. The income effect is zero.
c. After the wage increase, the budget constraint becomes steeper and rotates up clockwise. As
the wage increases, leisure becomes relatively more expensive. The income effect of the price
increase is zero; however, the substitution effect will still exist and makes the person want to
work more and have less leisure.

5.9 See the following figure. The effect of the poll tax is dependent on whether leisure is normal or
inferior. If leisure is a normal good, both the noble man and the peasant had to work more hours
with the poll tax than when there was no poll tax (see panel (a)). If leisure is an inferior good, they
worked less hours with the poll tax than without the poll tax (see panel (b)). Whether a noble man
or a peasant worked more hours depends on the shape of the indifference curves. For example, in
panel (a), the noble man worked more hours than the peasant, while in panel (b), the peasant
worked more hours than the noble man.
5.10 Under progressive income taxes, the marginal tax is higher than the average tax.
5.11 a. A progressive tax is a tax structure in which the average tax is rising. Assume the marginal tax
rate is constant and equal to a . Then the tax revenue is equal to
T = 0, if Y < 10,000,
T = a (Y – 10,000), if Y ≥ 10,000.
Then the average tax is T/Y = a (Y – 10,000)/Y = a + (10,000a )/Y. As Y increases, (10,000a)/Y
decreases and as a result the average tax will increase. Thus, even though the marginal tax rate
is constant, the average tax is still increasing.
b. Whether the labor supply curve slopes upward or bends backward depends on the income
elasticity of leisure. If a worker always views leisure as an inferior good, then he will work
more hours as his income increases. Therefore, production is stimulated by the flat tax where
the marginal tax rate does not increase with income. If a worker views leisure as inferior at low
wages but a normal good at higher wage rates, then his labor supply curve might bend
backward.
5.12 See the following figure. Individuals with a high preference for leisure (with indifference curve IB)
will accept the welfare payment. Those with a greater preference for income than leisure (with
indifference curve IA) are likely to turn down the payment.
5.13 a. See the following figure. Assume all goods have a unit price. George will work more hours
under a lump-sum tax than under a per-hour tax. A per-hour tax reduces the effective wage,

but a lump-sum tax does not; therefore, when a lump-sum tax is used, the price for leisure is
higher. Hence, George will consume less leisure but work more hours under a lump-sum tax.
b. The income tax is likely to reduce George’s hours of work more. An income tax reduces the
effective wage. However, an inheritance tax is similar to a lump-sum tax, which does not
reduce the effective wage. Therefore, the price of leisure is lower when an income tax is used
and George will consume more leisure but work less.
5.14 As the marginal tax rate on income increases, people substitute away from work due to the pure
substitution effect. However, the income effect can be either positive or negative, so the net effect
of a tax increase is ambiguous. Also, because wage rates differ across countries, the initial level of
income differs, again adding to the theoretical ambiguity. If we know that people work less as the
marginal tax rate increases, we can infer that the substitution effect and the income effect go in the
same direction or the substitution effect is larger. However, Prescott’s (2004) evidence alone about
hours worked and marginal tax rates does not allow us to draw such an inference because U.S. and
European workers may have different tastes and face different wages.
5.15 Kiki will change her consumption bundle once she moves, substituting toward goods that are
cheaper in the new country. Thus, as in Figure 5.5, Kiki will be better off.
6.1 See the following figure. Doreen’s budget constraint with the education voucher is kinked,
intercepting the vertical axis at c, while $5,000 cash would cause the constraint to intercept at a.
Given that Doreen would prefer cash to a voucher, with cash she would choose to consume
education at some point under the $5,000 value, say e2. With the voucher, Doreen would consume
the $5,000 worth of education and less of other goods, at e1. We can measure the cash value of the
education voucher to Doreen as the difference in the amount of other goods she would purchase
with cash versus with the voucher—b-c.

6.2 The government could give a smaller lump-sum subsidy that shifts the LLS curve down so that it is
parallel to the original curve but tangent to indifference curve I2. This tangency point is to the left
of e2, so the parents would consume fewer hours of childcare than with the original lump-sum
payment.
6.3 Parents who do not receive subsidies prefer that poor parents receive lump-sum payments rather
than a subsidized hourly rate for childcare. If the supply curve for day-care services is upward
sloping, by shifting the demand curve farther to the right, the price subsidy raises the price of day
care for these other parents.
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5.5 Deriving Labor Supply Curves

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2. Does this experiment reinforce or weaken the theory of choice?

Job Sharing May Help Workers to Maximize Utility

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 Additional Questions and Problems

Income Hot Dogs Hamburgers

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22. False. In order

44. a. See Figure

99. See Figurre 5.9. The ind

The reed line is the new

1..3. Let’s say

curve will intersect new

1.4 The deman nd curve for manufactured

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2..2 The figgure will be similar

where Y is income and

2..6 An Enngel curve sho

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The marginal condition is B/C = 1/2.

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5.8 a. Budget before lottery win:

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Chapter 5 Applying Consumer Theory 93

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