Microeconomics An Intuitive Approach With Calculus 1st Edition Nechyba Test Bank

Microeconomics An Intuitive Approach
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Microeconomics: An Intuitive Approach (with and without Calculus)
Chapter 7
TRUE/FALSE
1. Quasilinear goods are borderline goods between the set of normal and the set of inferior goods.
ANS: T
A quasilinear good is a good whose consumption remains unchanged with changes in income ---
whereas an inferior good is a good whose consumption moves in the direction opposite to income and
a normal good is a good whose consumption moves in the same direction as income.
PTS: 1 DIF: A-Section material
2. Every necessity is a normal good, but not all normal goods are necessities.
ANS: F
Necessities can be normal or inferior.
3. Every luxury good is a normal good but not every normal good is a luxury.
ANS: T
Luxuries are goods whose consumption increases with income by a bigger percentage than income ---
so they are normal goods (whose consumption moves in the same direction as income). But a good
whose consumption increases with income at a rate less than income is still a normal good without
being a luxury good.
4. Every Giffen good is a necessity but not every interior good is a necessity.
ANS: F
All inferior goods --- including Giffen goods --- are goods whose consumption moves in the opposite
direction from income. Necessities are goods whose consumption increases by less than the percentage
increase in income, which is the case if consumption decreases with increases in income.
5. All homothetic goods are normal goods.
ANS: T
Homothetic goods are goods whose consumption changes at the same rate (and in the same direction)
as income --- which makes them normal goods.
6. All quasilinear goods are necessities.
ANS: T
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
34
Consumption of quasilinear goods does not depend on income --- which means that, as income
increases, consumption does not change. Necessities are goods whose consumption increases by less
than the percentage increase in income, which is true if consumption does not change at all with
income.
7. Goods with small substitution effects tend to be normal goods.
ANS: F
The definition of normal goods relates to income effects, not substitution effects. Normal goods can
have large or small substitution effects.
8. A change in the price of one good cannot leave utility unchanged unless the price change is
accompanies by a change in income.
ANS: F
There are several types of counterexamples to this. For instance, it a consumer consumes at a corner
solution and the price of the good that is not consumed increases, the consumer’s utility is unchanged.
Or, if a consumer consumes at an interior solution, an increase in the price of one good could be
accompanied by a decrease in the price of the other good such that the consumer’s utility remains
unchanged.
9. Except for the case of Giffen goods, the substitution effect always tells us that a consumer will
consume less (or at least no more) of a good whose price has increased.
ANS: F
The statement is true --- except that it applies to Giffen goods as well.
10. The price of peaches goes up and I observe you buying more strawberries. This implies strawberries
must be a normal good.
ANS: F
When the price of peaches goes up, the substitution effect (from A to B) clearly suggests the purchase
of more strawberries. But the optimal final bundle could be bundle C, which would make strawberries
an inferior good.
35
11. The price of peaches goes up and I observe you buying more strawberries. This implies that
strawberries must be an inferior good.
ANS: F
Below is a case where strawberries are a normal good.
12. The price of peaches goes up and I observe you buying fewer strawberries. This implies strawberries
must be a normal good.
ANS: T
In the graph below, the substitution effect (from A to B) tells us that more strawberries should be
consumed. If strawberry consumption decreases from the original A when we get to the final budget,
the final bundle C lies below A --- implying it also lies below B. Thus, as income falls (from the
dashed compensated to the final budget), strawberry consumption falls, making strawberries a normal
good.
36
13. Bottles of Coca-Cola and equally-sized bottles of Pepsi Cola are perfect substitutes for a consumer, but
a bottle of Coke costs 10 cents less than bottles of Pepsi. The income effect of a 15 cent increase in the
price of Pepsi will be for the consumer to drink less cola.
ANS: F
The consumer is at a corners solution -- consuming only Coke -- before the price of Pepsi increases.
The increase in the price of Pepsi therefore has not impact on the consumer.
14. Bag of chips and bottles of salsa are perfect complements for consumer who eats only chips and salsa,
but a bottle of salsa costs $1 more than a bag of chips. The income effect of a 50 cent increase in the
price of a bag of chips will be fore the consumer to eat fewer chips and less salsa.
ANS: T
When two goods are perfect complements (in a 2-good model), both are normal goods.
MULTIPLE CHOICE
1. The price of peaches goes up and I observe you buying fewer strawberries. Which of the following is
consistent with this observation:
a. Strawberries are inferior and peaches are normal.
b. Strawberries are normal and peaches are inferior.
c. Both strawberries and peaches are inferior.
d. Both (a) and (b).
e. Both (a) and (c).
f. Both (b) and (c).
g. All of the above.
ANS: F
37
Since the substitution effect (from A to B) tells us to buy more strawberries, and since we end up
buying fewer than at A, the final bundle lies below B and thus involves a decrease in strawberry
consumption as income falls (from the dashed compensated to the final budget). Thus, strawberries
must be normal and thus (a) can’t be true. Peaches, on the other hand, could be normal (as when the
final optimal bundle is C) or inferior (as when the final optimal bundle is D).
2. You and I both have homothetic tastes. When the price of peaches goes up, you buy more strawberries
and I buy fewer. Which of the following must be true.
a. Peaches are more substitutable with strawberries for me than they are for you.
b. Peaches are more substitutable with strawberries for you than they are for me.
c. Strawberries are normal goods for you and inferior goods for me.
d. Strawberries are normal goods for me and inferior goods for you.
g. Both (a) and (d)
h. Both (b) and (d)
ANS: B
When tastes are homothetic, all goods are normal. Thus, (c) and (d) must be false. The two graphs
below then illustrate (b).
38
3. At most museums, you can either buy a year-long membership that gives you free access to the
museum any time, or you can pay a daily fee every time you visit. (Assume for purposes of this
exercise that everyone can in principle afford the year-long membership.)
a. Those who choose to pay the daily fees all place the same value on their marginal museum
visit.
b. We cannot tell how much value anyone places on the marginal museum visit because we
cannot compare utility across individuals.
c. If someone is indifferent between the two options, she will go to the museum at least as
much if she chooses the year-long membership than if she does not.
d. Both (a) and (c) are true.
e. Both (b) and (c) are true.
ANS: D
39
The consumer chooses between two budgets --the solid budget (with daily fees) and the dashed budget
(with one lump sum fee and then no fee per visit). Those who choose the solid budget (i.e. the daily
fees) will all optimize at a point like A -- a point where their MRS is equal to the (negative) price of a
daily entrance fee. Thus, they all place the same value on the marginal museum visit -- and (a) is true.
Answer (b) is therefore false -- we can often tell what the marginal value is that someone places on a
good, because the marginal value is equal to the price. Finally, if someone is indifferent between the
two options, the graph below shows that she will visit less frequently under the daily fee.
4. Wholesale clubs charge a fixed monthly fee but then offer goods at discount prices. For purposes of
this question, suppose a wholesale club and a supermarket offer the same composite grocery item, with
the supermarket charging no fixed fee but a higher price for the item. (Assume no corner solutions.)
a. Anyone shopping at the wholesale club places less value on the marginal item bought than
anyone shopping at the supermarket.
b. Anyone indifferent between the two stores buys more (or at least no less) if she chooses
the wholesale club.
c. We cannot predict how much value different individuals place on the marginal item in
each store because we cannot measure utility objectively.
d. Both (a) and (b) are true.
e. Both (b) and (c) are true.
ANS: D
Since there are no corner solution, we know that those in the wholesale club as well as those in the
supermarket will by the composite item until their MRS is equal to the negative price -- but the price is
higher in the supermarket. Thus, those choosing to shop in the supermarket place a higher value on the
marginal item bought. We can make these comparisons even though we cannot measure utility
objectively -- because we know what the MRS is at the margin for those at interior solutions.
Furthermore, anyone indifferent between the stores must shop less at the supermarket because of the
substitution effect.
5. Suppose the government spends the same for a particular consumer under two different policies: One
subsidizes the price of good x while the other is a lump sum subsidy. Which of the following is true.
a. Compared to the lump sum subsidy, the consumer will purchase more x under the price
subsidy if and only if x is a normal good.
b. Compared to the lump sum subsidy, the consumer will purchase less of x under the price
subsidy if x is an inferior good.
40
c. Compared to the lump sum subsidy, the consumer will purchase less of x under the price
subsidy if x is a Giffen good.
d. The consumer will spend the same on x under the two policy if and only if her indifference
curves are kinked.
g. All of the above.
h. None of the above.
ANS: D
The solid lines in the graphs below are the budget constraints under the two policies. If the government
spends the same amount, it must be that A is optimal under the price subsidy -- which implies the
indifference curve crosses the lump-sum subsidy budget in a way that implies the optimal bundle
under the lump sum subsidy B lies to the left of A regardless of what kind of good x is (so long as there
is some curvature at A). If there is a kink at A (as in the second graph), the two policies can result in
the same choice.
PROBLEM
1. Currently. the price of consuming housing is lowered by the fact that home mortgage interest is tax
deductible. Suppose the government proposed to eliminate this implicit subsidy of your housing
consumption, raising the price from to . At the same time, the government lowers the tax on
other consumption, lowering the price from to .
a. Write down your original budget constraint assuming the consumer has income I.
b. Suppose the utility function captures your tastes, and suppose ,
, , and . Write out the utility maximization problem for this consumer prior to
any policy change.
c. How much housing and other goods will this consumer consume prior to any policy change?
d. How much would this consumer be willing to pay to get the policy change implemented?
ANS:
a.
41
b.
c.
d. We first have to solve for the bundle the consumer would consume if she paid the maximum amount
she is willing to pay to get the policy change implemented. The maximum she is willing to pay is an
amount that will leave her with the same utility that she had before the policy --- and that utility is
. At the post-policy prices, the expenditure necessary to reach this
utility level is determined by solving
.
This gives us the bundle At the post-policy prices, this bundle costs
--- which implies that the consumer is willing to pay as much as
to get the policy implemented. (Without rounding errors, this amount comes out
to be $2523.26.)
PTS: 1 DIF: B-Section material
2. Suppose your tastes are defined by the utility function .
a. Suppose your income is $1,000, the price of is 1 and the price of is . Set up your utility
maximization problem.
b. Derive the quantity of you will consume.
c. What happens to your consumption of if increases?
d. Now suppose that your and my tastes are captured by the utility function
, with the parameter different for you than it is for me. When
increases, you consume more than before and I consume less. What range of is consistent with
your behavior, and what range is consistent with mine? Use your answer to (b) to explain.
ANS:
a.
b.
c. It remains the same.
d. Cobb-Douglas tastes are CES tastes with elasticity of substitution equal to 1. The elasticity of
substitution in the CES function is given by , with Cobb-Douglas tastes therefore having
.If , the elasticity of substitution is less than 1, and if , the elasticity of substitution is
greater than 1. The graphs below illustrate two scenarios --- the first with a high elasticity of
substitution and the second with a low elasticity of substitution. In both cases, tastes are homothetic (as
they are for CES preferences). A high elasticity of substitution implies that consumption increases
with an increase in , and a low elasticity of substitution implies that consumption decreases with
an increase in . In part (c), we found that Cobb-Douglas tastes fall at the border of these scenarios,
which implies that divides the two cases. For you, therefore lies between 0 and , while for
me lies between 0 and -1.
42
3. Suppose you collect stamps and coins for the sheer fun of it. Currently, your collection contains both.
For purposes of this problem, suppose that stamps all sell for one price and coins all sell for another,
and both are normal goods.
a. Begin by illustrating your current budget constraint (with stamps on the horizontal and coins on the
vertical) as well as the bundle A you currently own. Assume that you have done the best you can given
your circumstances.
b. The stamp industry has recently marketed its product as a safe way of investing and insuring against
inflation. As a result, the price of stamps has been driven up since you chose your current bundle.
Show how this changes your budget constraint given that you can buy and sell both stamps and coins -
-- and assuming you have no additional funds to spend on your collections.
c. Are you happy about the stamp industry’s marketing campaign? In what way will you adjust your
collection?
d. After a while (and after you have made your desired adjustments), it turns out that the marketing
campaign only produced a temporary “bubble” in the stamp market --- and prices fall back to what
they were before. Are you happy when the bubble bursts? Will you have more or fewer coins and
stamps than you had before the marketing campaign started?
43
e. True or False: For collectors that collect to satisfy their passion (rather than as an investment
strategy), volatility in prices is good.
ANS:
a.
b. This changes the budget to the dashed budget in the second graph.
c. A portion of the new dashed budget lies above the original indifference curve --- implying that there
are now bundles available that are preferred to the original bundle A. So you are happy about the
marketing campaign. All of these bundles have more coins and fewer stamps --- so you will end up
selling stamps and buying coins.
d. When the bubble bursts, we are at bundle B --- and the new budget now passes through B with a
shallower slope. Again, new bundles emerge that lie above the indifference curve that contains B ---
implying you are happy about the bubble bursting. All of the potentially more preferred bundles
contain more stamps and fewer shirts. Since we know stamps and coins are both normal goods, we
know that bundle C where you end up will have more stamps and more coins than you had at A. (This
is because the original and final budgets both have the same slope.)
44
e. This is true --- price fluctuations open up new bundles that are preferred, as items that have become
relatively more expensive are sold to purchase items that have become relatively cheaper,
4. Your drink budget is entirely split between bottled water and fancy liqueurs, and your tastes are
quasilinear in bottled water. In an attempt to get people to drink more water, the government
introduces a subsidy that lowers the price of bottled water.
a. In a graph with bottled water on the horizontal and fancy liqueurs on the vertical axis, illustrate your
before-subsidy budget and your optimal bundle A.
b. As a result of the water subsidy, I notice you consume more fancy liqueur. Illustrate this in your
graph using income and substitution effects.
c. You and I are good friends, in part because I confided in you some time ago that I, too, have tastes
that are quasilinear in water. (Nothing bonds like quasilinearity!) But, after the subsidy is introduced,
you observe that I, unlike you, have reduced my consumption of fancy liqueurs. Your other friends
claim that this is proof that our friendship is based on a fiction --- that I cannot possibly also have
quasilinear tastes. Illustrate in a graph why your friends are wrong.
d. If we both have quasilinear tastes, can you explain what the fundamental difference in our tastes is
that accounts for the difference in behavior?
ANS:
a. This is illustrated in the first graph with the steeper solid budget and the optimal bundle A that lies
on that budget.
b. The substitution effect takes you from A to B, and the income effect takes you vertically up to C
(from B) because of the quasilinearity of bottled water. Since C is higher than A, we have illustrated
the case of you consuming more liqueurs as a result of the lower price for bottled water.
45
c. Below we illustrate the same graph as above except that the substitution effect is bigger. As a result,
C ends up below A --- illustrating a case where bottled water is still quasilinear but my consumption of
liqueurs falls when the price of bottled water falls.
d. The fundamental difference in our tastes is the degree of substitutability of water for liqueur at the
original bundle A. The two are relatively complementary for you --- resulting in a small substitution
effect, while they are relatively substitutable for me, resulting in larger substitution effect.
5. Suppose a relatively low income family has a monthly budget of $1,000 to allocate between food and a
non-food composite good. In this problem, assume food is aggregated into a “composite food” good
that is modeled on the horizontal axis, and the non-food composite good is denominated in “dollars of
other consumption”. The price of food is $10 per unit. Suppose further that this family’s tastes exhibit
kinks in indifference curves, with one such indifference curve graphed below.
46
a. Draw the family’s budget constraint and label the optimal consumption bundle.
b. Due to unexpected droughts, the price of food rises to $20. A cash subsidy S that leaves our family
with the same level of happiness as it enjoyed prior to the price increase is proposed. How much would
this subsidy cost for this family?
c. An alternative proposal suggests a price subsidy s that lowers the price of food for this family from
$20 to ($20-s), with s set sufficiently high to allow the family to reach its original utility level.
d. Yet a third proposal suggests a price subsidy that leaves in tact the new price of $20 for the first 20
units of food bought by the family but then lowers the price for this family to $(20-s’) while also
making the family just as happy as it was before. How high does s’ have to be to accomplish this?
e. If cost is all you care about, how would you rank these three policies? What if you care about food
consumption for this family and believe a policy is better if it results in more food consumption?
ANS:
a. The budget, illustrated below, is “tangent” at B -- making B the optimal consumption bundle.
47
b. This would change the slope of the budget from -10 to -20 -- which is steeper than the portion of the
indifference curve that connects A and B. Bundle A will therefore be the optimum under the cash
subsidy -- and the family will need $1,400 to reach A at the new price. Thus, S=$400.
c. For the family to reach its original indifference curve, the price of food would have to go back to
$10 for the family -- with B again optimal. Thus, s=10.
d. This is pictured in the last panel -- where the least cost way of reaching the original indifference curve
now implies getting the family to bundle C. The slope of the dashed line is -5 -- implying that s’=15.
e. The cash subsidy program costs $400; the straight subsidy costs $500; and the modified subsidy (in
part d) is $900. If all you care about is cost, you would prefer the cash subsidy to the straight subsidy
to the modified subsidy. If, however, you care about how much food the family eats -- and you think
more is better, the preference ordering over the three policies would be reversed.
48
6. Suppose the only two goods you care about in the world are French wine (x) and Cuban cigars (y) and
your utility function is given by u(x,y)=xy. You have no income, and the only thing in the world you
possess is a large box you have just inherited from your rich uncle who passed away last week (of liver
and lung cancer.) You open the box, and much to your liking, you find it contains 9 bottles of fine
French wine and 3 boxes of exquisite Cuban cigars. Currently, the wine sells for $1 per bottle, and the
cigars sell for $9 per box. Just as you receive the inheritance, you read the headline: "President Lifts
Embargo - Price of Cuban Cigars Falls to $4 per Box!"
a. Determine the income (or wealth) and substitution effects of a decrease of the price of cigars from 9
to 4. (Assume fractions of bottles and cigars can be bought.)
b. Are cigars a normal or inferior good for you?
c. How much would you have been willing to pay the President in order not to lift the embargo?
ANS:
a. Cobb-Douglas tastes with equal exponents result in demand functions of .
Income in our case is based on the value of the endowment -- which is 36 before the price change
and 21 afterwards. Thus, to total change in the consumption bundle is from an initial (18,2) to a
final .
To isolate the substitution effect, we need to start by finding the utility level before the price change
--- which is 18(2)=36. We then solve
to get the bundle (12,3).
The substitution effect therefore takes us from (18,2) to (12,3) while the wealth effect takes us from
(12,3) to (11.5, 2.625).
b. Cigars are normal goods. It may appear like the income effect is negative, but that’s because the
budget is endogenous -- Cobb-Douglas tastes are always over normal goods.
c. If embargo is lifted, utility will be (11.5)(2.625)=30.1875. If prices remained at the pre-embargo

levels and you had just enough income E to reach this utility level, it would have to be that
(because you would be consuming according to the demand functions in (a)
with the price of wine at 1 and the price of cigars at 9). Solving this equation, we get ---
while the initial value of your endowment is 36. Thus, you would be willing to pay approximately
$3 to avoid the lifting of the embargo.
49

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PTS: 1 DIF: A-Section material

PTS: 1 DIF: A-Section material

PTS: 1 DIF: A-Section material

PTS: 1 DIF: A-Section material

5. All homothetic goods are normal goods.

PTS: 1 DIF: A-Section material

6. All quasilinear goods are necessities.

PTS: 1 DIF: A-Section material

7. Goods with small substitution effects tend to be normal goods.

PTS: 1 DIF: A-Section material

PTS: 1 DIF: A-Section material

PTS: 1 DIF: A-Section material

PTS: 1 DIF: A-Section material

PTS: 1 DIF: A-Section material

PTS: 1 DIF: A-Section material

PTS: 1 DIF: A-Section material

PTS: 1 DIF: A-Section material

PTS: 1 DIF: A-Section material

PTS: 1 DIF: A-Section material

PTS: 1 DIF: B-Section material

2. Suppose your tastes are defined by the utility function .

PTS: 1 DIF: A-Section material

PTS: 1 DIF: A-Section material

PTS: 1 DIF: A-Section material

to get the bundle (12,3).

c. If embargo is lifted, utility will be (11.5)(2.625)=30.1875. If prices remained at the pre-embargo

PTS: 1 DIF: B-Section material

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