Macroeconomics Canada in the Global

Environment Canadian 9th Edition

Parkin Solutions Manual
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 POSSIBILITES,
C h a p t e r
9 PREFERENCES,
AND CHOICES

Answers to the Review Quizzes

Page 204
1. What does a household’s budget line show?
The budget line describes the limits to its consumption choices.
2. How does the relative price and a household’s real income influence its budget
line?
The magnitude of the slope of the budget line equals the relative price of the good or service
measured on the horizontal axis. A fall in the price of the good measured on the horizontal
axis decreases that good’s relative price and decreases the slope of the budget line. A fall in
the price of the good measured on the vertical axis decreases that good’s relative price and
increases the slope of the budget line. A household’s real income is the household’s income
expressed as a quantity of goods the household can afford to buy. An increase in household
income shifts the budget line rightward. A decrease in household income shifts the budget
line leftward. The slope of the budget line does not change when income changes.
3. If a household has an income of $40 and buys only bus rides at $2 each and
magazines at $4 each, what is the equation of the household’s budget line?
The budget equation states that a household’s spending must equal its income. The budget
equation is derived for two goods, bus rides and magazines. The amount spent on bus rides
is (Pbus ride)×(Qbus ride), the amount spent on magazines is (Pmagazine)×(Qmagazine), and
the consumer’s income is y. We know that (Pmagazine)×(Qmagazine) + (Pbus ride)×(Qbus ride)
= y. Rearrange this equality by subtracting the amount spent on bus rides from both sides to
give (Pmagazine)×(Qmagazine) = y – (Pbus ride)×(Qbus ride). Finally, divide both sides by the
price of magazine to give the budget equation Qmagazine = y/Pmagazine – (Pbus ride
/Pmagazine)×(Qbus ride). Substituting in the values, y = $40, P bus ride = $2 and P magazine =
$4, gives Qmagazine = $40/$4 – ($2/$4)×(Qbus ride), which gives Qmagazine = 10 – 0.5 Qbus
ride.

4. If the price of one good changes, what happens to the relative price and the slope
of the household’s budget line?
A relative price is the price of one good divided by the price of another good. For example,
the magnitude of the slope of the budget line (Pmovie/Ppopcorn) is the relative price of a
movie in terms of popcorn. This relative price shows how much popcorn must be forgone to
see an additional movie. A fall in the price of the good on the horizontal axis increases the
total affordable quantity of that good, decreases its relative price, and decreases the
magnitude of the slope of the budget line. A fall in the price of the good on the vertical axis
increases the total affordable quantity of that good, decreases its relative price, and
increases the magnitude of the slope of the budget line.

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122 CHAPTER 9

5. If a household’s money income changes and prices do not change, what happens
to the household’s real income and budget line?
A household’s real income is the household’s income expressed as a quantity of goods the
household can afford to buy. For example, the vertical intercept for a budget line measuring
movies on the vertical axis is (y/Pmovie), which is the consumer’s real income in terms of
movies. A change in a household’s money income changes the household’s real income in
terms of both goods and causes a parallel shift of the budget line. If a household’s money
income increases, its budget line shifts rightward and if a household’s money income
decreases, its budget line shifts leftward.

Page 208
1. What is an indifference curve and how does a preference map show preferences?
An indifference curve is a line that shows combinations of goods among which a consumer is
indifferent. The family of indifference curves is the preference map. This map shows the
person’s preferences because it shows how the person ranks each combination of goods. In
particular, the person prefers combinations on higher indifference curves to combinations on
lower indifference curves.
2. Why does an indifference curve slope downward and why is it bowed toward the
origin?
The downward slope of an indifference curve illustrates the tradeoff between two goods while
maintaining the same level of total satisfaction. Since the consumer is indifferent among all
points on an indifference curve, when moving along it any increase in satisfaction from
gaining one good must be matched by an equal decrease in satisfaction from a loss in the
other good. An indifference curve is bowed toward the origin because the more of good x that
is consumed the less you are willing to give up of good y to get more of good x and remain
indifferent.
3. What do we call the magnitude of the slope of an indifference curve?
The magnitude of the slope of an indifference curve is called the marginal rate of substitution
(MRS). The marginal rate of substitution is the rate at which a person will give up good y (the
good measured on the y-axis) to get an additional unit of good x (the good measured on the
x-axis) while remaining indifferent (remaining on the same indifference curve).
4. What is the key assumption about a consumer’s marginal rate of substitution?
Diminishing marginal rate of substitution is the key assumption about preferences. A
diminishing marginal rate of substitution is a general tendency for a person to be willing to
give up less of good y to get one more unit of good x, while at the same time remaining
indifferent as the quantity of x increases.

Page 213
1. When a consumer chooses the combination of goods and services to buy, what is
she or he trying to achieve?
The consumer is trying to achieve the best affordable choice—the highest level of well being
possible.

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 POSSIBILITIES, PREFERENCES, AND CHOICES 123

2. Explain the conditions that are met when a consumer has found the best
affordable combination of goods to buy. (Use the terms budget line, marginal rate
of substitution, and relative price in your explanation.)
At the best affordable combination of goods to buy, the consumer is
1) on the budget line,
2) on the highest attainable indifference curve,
3) has a marginal rate of substitution equal to the relative price of the two goods.
3. If the price of a normal good falls, what happens to the quantity demanded of that
good?
If the price of a normal good falls, the quantity demanded of that good increases because the
substitution effect and the income effect both bring an increase in the quantity demanded.
4. Into what two effects can we divide the effect of a price change?
A price change can be divided into a substitution effect and an income effect. The
substitution effect is the effect of a change in price on the quantity bought when the
consumer (hypothetically) remains indifferent between the original situation and the new
situation. The income effect is the effect of a change in income sufficient to get the consumer
to the highest indifference curve that is affordable on the new budget line reflecting the price
change.
5. For a normal good, does the income effect reinforce the substitution effect or
does it partly offset the substitution effect?
For a normal good the substitution effect and the income effect reinforce each other.

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124 CHAPTER 9

Answers to the Study Plan Problems and Applications

Use the following information to work Problems 1 and 2.
Sara’s income is $12 a week. The price of popcorn is $3 a bag, and the price of a
smoothie is $3.
1. Calculate Sara’s real income in terms of smoothies. Calculate her real income in
terms of popcorn. What is the relative price of smoothies in terms of popcorn?
What is the opportunity cost of a smoothie?
Sara’s real income is 4 smoothies. Sara’s real income in terms of smoothies is equal to her
money income divided by the price of a smoothie. Sara’s money income is $12, and the price
of a smoothie is $3. Sara’s real income is $12 divided by $3 a smoothie, which is 4
smoothies.
Sara’s real income is 4 bags of popcorn. Sara’s real income in terms of popcorn is equal to
her money income divided by the price of a bag of popcorn, which is $12 divided by $3 a
bag, which is 4 bags of popcorn.
The relative price of a smoothie is 1 bag of popcorn per smoothie. The relative price of a
smoothie is the price of a smoothie divided by the price of a bag of popcorn. The price of a
smoothie is $3 and the price of popcorn is $3 a bag, so the relative price of a smoothie is $3
divided by $3 a bag, which equals 1 bag of popcorn per smoothie.
The opportunity cost of a smoothie is 1 bag of popcorn. The opportunity cost of a smoothie is
the quantity of popcorn that must be forgone to get a smoothie. The price of a smoothie is $3
and the price of popcorn is $3 a bag, so to buy one smoothie Sara must forgo 1 bag of
popcorn.
2. Calculate the equation for Sara’s budget line (with bags of popcorn on the left
side). Draw a graph of Sara’s budget line with the quantity of smoothies on the x-
axis. What is the slope of Sara’s budget line? What determines its value?
The equation that describes Sara’s budget line is QP = 4 – QS. Call the price of popcorn PP
and the quantity of popcorn QP, the price of a smoothie PS and the quantity of smoothies QS,
and income y. Sara’s budget equation is PPQP + PSQS = y. If we substitute $3 for the price of
popcorn, $3 for the price of a smoothie, and
$12 for the income, the budget equation
becomes $3QP + $3QS = $12. Dividing both
sides by $3 and subtracting QS from both sides
gives QP = 4 – QS.
To draw a graph of the budget line, plot the
quantity of smoothies on the x-axis and the
quantity of popcorn on the y-axis. The budget
line is a straight line from 4 bags of popcorn on
the y-axis to 4 smoothies on the x-axis.
The slope of the budget line is minus 1. The
magnitude of the slope is equal to the relative
price of a smoothie. The slope of the budget
line is “rise over run.” If the quantity of
smoothies increases from 0 to 4, the quantity of
popcorn decreases from 4 to 0. The rise is -4
and the run is 4. Therefore the slope equals
-4/4, which is -1.

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 POSSIBILITIES, PREFERENCES, AND CHOICES 125

Use the following data to work Problems 3 and 4.

Sara’s income falls from $12 to $9 a week, while the price of popcorn is unchanged at
$3 a bag and the price of a smoothie is unchanged at $3.
3. What is the effect of the fall in Sara’s income on her real income in terms of (a)
smoothies and (b) popcorn?
a. Sara’s real income falls from 4 smoothies to 3 smoothies. Sara’s real income in terms of
smoothies is equal to her money income divided by the price of a smoothie. Sara’s money
income is now $9 and the price of a smoothie is $3. Sara’s real income is now $9 divided by $3
a smoothie, which is 3 smoothies.
b. Sara’s real income falls from 4 bags of popcorn to 3 bags of popcorn. Sara’s real income in
terms of popcorn is equal to her money income divided by the price of a bag of popcorn. Sara’s
money income is now $9 and the price of a bag of popcorn is $3. Sara’s real income is now $9
divided by $3 a bag, which is 3 bags of popcorn.
4. What is the effect of the fall in Sara’s income on the relative price of a smoothie in
terms of popcorn? What is the slope of Sara’s new budget line if it is drawn with
smoothies on the x-axis?
The relative price of a smoothie is 1 bag of popcorn per smoothie, the same relative price as
before her income fell. The relative price does not depend on Sara’s income. The relative
price of a smoothie is the price of a smoothie divided by the price of a bag of popcorn. The
price of a smoothie is $3 and the price of popcorn is $3 a bag, so the relative price of a
smoothie is $3 divided by $3 a bag. The relative price equals 1 bag of popcorn per smoothie.
The slope of the budget line, when smoothies are plotted on the x-axis is minus 1, the same
slope as before her fall in income. The magnitude of the slope of the budget line is equal to
the relative price of a smoothie. The relative price does not change when Sara’s income
decreases so the slope of the budget line does not change.
5. Sara’s income is $12 a week. The price of popcorn rises from $3 to $6 a bag, and
the price of a smoothie is unchanged at $3. Explain how Sara’s budget line
changes with smoothies on the x-axis.
The budget line rotates inward around the unchanged x-axis intercept. The magnitude of the
slope of the budget line is equal to the relative price of a smoothie. The relative price of a
smoothie is the price of a smoothie divided
by the price of a bag of popcorn. The rise in
the price of a bag of popcorn lowers the
relative price of a smoothie in terms of
popcorn. The relative price has fallen so the
magnitude of the slope of the budget line has
fallen.
6. Draw figures that show your indifference
curves for the following pairs of goods.
For each pair, are the goods perfect
substitutes, perfect complements,
substitutes, complements, or unrelated?
 Right gloves and left gloves
Figure 9.2A is to the right. Right gloves and
left gloves are perfect complements.
Because these are perfect complements, the
indifference curves are right angles.

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126 CHAPTER 9

 Coca-Cola and Pepsi

Figure 9.2B is to the right. Coca-Cola and Pepsi
are almost perfect substitutes. The indifference
curves should either be linear (for perfect
substitutes, as shown in Figure 9.2B) or nearly
linear.

 Desktop computers and laptop computers

Figure 9.2C is to the right. Desktop computers
and laptop computers are substitutes, though
not perfect substitutes. The indifference curves
are bowed inward toward the origin.

 Strawberries and ice cream

Figure 9.2D is to the right. Strawberries and ice
cream are complements, though not perfect
complements. The indifference curves are not
right angles, as they would be for perfect
complements, but instead are bowed inward
toward the origin.

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 POSSIBILITIES, PREFERENCES, AND CHOICES 127

7. Discuss the shape of the indifference curve for each of the following pairs of
goods. Explain the relationship between the shape of the indifference curve and
the marginal rate of substitution as the quantities of the two goods change.
 Orange juice and smoothies
Orange juice and smoothies are substitutes. They are not perfect substitutes, so the
indifference curves are bowed in toward the origin. The marginal rate of substitution falls moving
down along an indifference curve.
 Baseballs and baseball bats
These are complements but probably not perfect complements. The indifference curves
should be significantly bowed inward. The marginal rate of substitution falls rapidly when
moving from the vertical portion of the indifference curve to the horizontal portion of the
indifference curve.
 Left running shoe and right running shoe
These are perfect complements so the indifference curves are right angles. The marginal
rate of substitution does not change moving down along the indifference curve except when
moving around the 90 degree point where the MRS changes from infinity to zero.
 Eyeglasses and contact lenses
The indifference curves should either be linear for perfect substitutes, or nearly linear for
substitutes. If the indifference curves are linear, then the marginal rate of substitution does
not change moving down along the indifference curve; if the indifference curves are nearly
linear, then the marginal rate of substitution falls slightly moving down along an indifference
curve.
Use the following data to work Problems 8 and 9.
Pam has made her best affordable choice of cookies and granola bars. She spends all
of her weekly income on 30 cookies at $1 each and 5 granola bars at $2 each. Next
week, she expects the price of a cookie to fall to 50¢ and the price of a granola bar to
rise to $5.
8. a. Will Pam be able to buy and want to buy 30 cookies and 5 granola bars next
week?
Pam can still buy 30 cookies and 5 granola bars. When Pam buys 30 cookies at $1 each and
5 granola bars at $2 each, she spends $40 a week. When the price of a cookie is 50 cents
and the price of a granola bar is $5, 30 cookies and 5 granola bars will cost $40. So Pam can
still buy 30 cookies and 5 granola bars. But Pam will not want to buy 30 cookies and 5
granola bars because the marginal rate of substitution does not equal the relative price of the
goods. Pam will move to a point on the highest indifference curve possible where the
marginal rate of substitution equals the relative price.
b. Which situation does Pam prefer: cookies at $1 and granola bars at $2 or
cookies at 50¢ and granola bars at $5?
Pam prefers cookies at 50 cents each and granola bars at $5 each because she can move
onto a higher indifference curve than when cookies are $1 each and granola bars are $2
each. To see why Pam can move to a higher indifference curve, note that the new budget
line and the old budget line both pass through the point 30 cookies and 5 granola bars. If
granola bars are plotted on the x-axis, the marginal rate of substitution at this point on Pam’s
indifference curve is equal to the relative price of a granola bar at the original prices, which is
2. The new relative price of a granola bar is $5/50 cents, which is 10. That is, the budget line
is steeper than the indifference curve at 30 cookies and 5 granola bars. So Pam’s new
equilibrium combination of cookies and granola bars must be on an indifference curve at a
point steeper than the initial indifference curve. Because the new budget line is steeper and

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128 CHAPTER 9

passes through the initial equilibrium combination, the new best affordable point must lie
above the initial equilibrium point so it must be on a higher indifference curve.
9. a. If Pam changes how she spends her weekly income, will she buy more or fewer
cookies and more or fewer granola bars?
Pam will buy more cookies and fewer granola bars. The new budget line and the old budget
line pass through the point at 30 cookies and 5 granola bars. If granola bars are plotted on
the x-axis, the marginal rate of substitution at this point on Pam’s indifference curve is equal
to the relative price of a granola bar at the original prices, which is 2. The new relative price
of a granola bar is $5/50 cents, which is 10. That is, the budget line is steeper than the
indifference curve at 30 cookies and 5 granola bars. Pam will buy more cookies and fewer
granola bars.
b. When the prices change next week, will there be an income effect, a substitution
effect, or both at work?
There will be a substitution effect and an income effect. A substitution effect arises when the
relative price changes and the consumer moves along the same indifference curve to a new
point where the marginal rate of substitution equals the new relative price. An income effect
arises when the consumer moves from one indifference curve to another, keeping the
relative price constant.
Use the following information to work Problems 10 and 11.
Boom Time For “Gently Used” Clothes
Most retailers are blaming the economy for their poor sales, but one store chain that
sells used name-brand children’s clothes, toys, and furniture is boldly declaring that an
economic downturn can actually be a boon for its business. Last year, the company
took in $20 million in sales, up 5% from the previous year.
Source: CNN, April 17, 2008
10. a. According to news clip, is used clothing a normal good or an inferior good? If
the price of used clothing falls and income remains the same, explain how the
quantity of used clothing bought changes.
According to the article, the demand for used clothing increases when the economy is in a
downturn and incomes are falling. Because demand increases when income decreases,
used clothing is an inferior good. If the price of used clothing falls and income remains the
same, the quantity of used clothing purchased increases.
b. Describe the substitution effect and the income effect that occur.
The price fall creates both a substitution effect and an income effect. The substitution effect
leads to an increase in the quantity of used clothing demanded. The price decrease
increases consumers’ real incomes. Because used clothing is an inferior good, the income
effect leads to a decrease in the quantity of used clothing purchased. The substitution effect
is larger so that the quantity of used clothing purchased increases.

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 POSSIBILITIES, PREFERENCES, AND CHOICES 129

11. Use a graph of a family’s indifference

curves for used clothing and other
goods. Then draw two budget lines to
show the effect of a fall in income on the
quantity of used clothing purchased.
In Figure 9.3, the fall in income shifts the
budget line from BL1 to BL2. The quantity of
used clothing purchased increases, in the
figure from 4 items per month to 5 items per
month.

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130 CHAPTER 9

Answers to Additional Problems and Applications

Use the following data to work Problems 12 to 15.
Marc has a budget of $20 a month to spend on root beer and DVDs. The price of root
beer is $5 a bottle, and the price of a DVD is $10.
12. What is the relative price of root beer in terms of DVDs and what is the
opportunity cost of a bottle of root beer?
The relative price of root beer is 1/2 DVD. The relative price of root beer is the price of root
beer divided by the price of a DVD. The price of root beer is $5 a bottle and the price of a
DVD is $10, so the relative price of root beer is $5 a bottle divided by $10 a DVD, which
equals 1/2 DVD per bottle. The opportunity cost of a bottle of root beer is 1/2 DVD. The
opportunity cost of a bottle of root beer is the quantity of DVDs that must be forgone to obtain
a bottle of root beer. The price of root beer is $5 a bottle and the price of a DVD is $10, so to
buy one bottle of root beer Marc must forgo 1/2 DVD.
13. Calculate Marc’s real income in terms of root beer. Calculate his real income in
terms of DVDs.
Marc’s real income is 4 bottles of root beer. Marc’s real income in terms of bottles of root
beer is equal to his money income divided by the price of a bottle of root beer. Marc’s money
income is $20, and the price of root beer is $5 a bottle. Marc’s real income is $20 divided by
$5 a bottle of root beer, which is 4 bottles of root beer.
Marc’s real income is 2 DVDs. Marc’s real income in terms of DVDs is equal to his money
income divided by the price of a DVD, which is $20 divided by $10 a DVD or 2 DVDs.
14. Calculate the equation for Marc’s budget line (with the quantity of root beer on the
left side).
The equation that describes Marc’s budget line is QR = 4 – 2QDVD. Call the price of a bottle
of root beer PR and the quantity of root beer QR, the price of a DVD PDVD and the quantity of
DVDs QDVD, and income y. Marc’s budget equation is PRQR + PDVDQDVD = y. If we
substitute $5 for the price of a bottle of root beer, $10 for the price of a DVD, and $20 for
income, the budget equation becomes
$5QR + $10QDVD = $20. Next, divide both sides
by $5 to obtain QR + 2QDVD = 4. Finally subtract
2QDVD from both sides to give QR = 4 – 2QDVD.
15. Draw a graph of Marc’s budget line with the
quantity of DVDs on the x-axis. What is the
slope of Marc’s budget line? What
determines its value?
The budget line is in Figure 9.4. The slope of the
budget line, when DVDs are plotted on the x-
axis is 2. The magnitude of the slope is equal
to the relative price of a DVD. The slope of the
budget line is “rise over run.” If the quantity of
DVDs increases from 0 to 2, the quantity of root
beer decreases from 4 to 0 bottles. The rise is
4 and the run is 2. So the slope equals 4/2,
which is 2.

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 POSSIBILITIES, PREFERENCES, AND CHOICES 131

Use the following data to work Problems 16 to 19.

Amy has $20 a week to spend on coffee and cake. The price of coffee is $4 a cup, and
the price of cake is $2 a slice.
16. Calculate Amy’s real income in terms of cake. Calculate the relative price of cake
in terms of coffee.
Amy’s real income in terms of cake is $20/($2 per slice), which is 10 slices. The relative price
of cake in terms of coffee is ($2 per slice)/($4 per cup) = 0.5 cups of coffee per slice of cake.
17. Calculate the equation for Amy’s budget line (with cups of coffee on the left side).
The equation that describes Amy’s budget line is QCOFFEE = 5 – 0.5QCAKE. Call the price of a
cup of coffee PCOFFEE and the quantity of coffee QCOFFEE, the price of a slice of cake PCAKE
and the quantity of cake QCAKE, and income y. Amy’s budget equation is PCOFFEEQCOFFEE +
PCAKEQCAKE = y. If we substitute $4 for the price of a cup of coffee, $2 for the price of a slice
of cake and $20 for income, the budget equation becomes $4QCOFFEE + $2QCAKE = $20.
Next, divide both sides by $4 to obtain QCOFFEE + 0.5QCAKE = 5. Finally subtract 0.5QCAKE
from both sides to give QCOFFEE = 5 – 0.5QCAKE.
18. If Amy’s income increases to $24 a week and the prices of coffee and cake remain
unchanged, describe the change in her budget line.
Amy’s budget line shifts outward and its slope does not change.
19. If the price of cake doubles while the price of coffee remains at $4 a cup and
Amy’s income remains at $20, describe the change in her budget line.
Amy’s budget line rotates inward. If the quantity of cake is plotted on the horizontal axis, the
budget line rotates inward around the unchanged vertical intercept (which is the maximum
number of cups of coffee Amy can purchase) and becomes steeper.
Use the following news clip to work Problems 20 and 21.
Gas Prices Straining Budgets
With gas prices rising, many people say they
are staying in and scaling back spending to try
to keep within their budget. They are driving as
little as possible, cutting back on shopping
and eating out, and reducing other
discretionary spending.
Source: CNN, February 29, 2008
20. a. Sketch a budget line for a household
that spends its income on only two
goods: gasoline and restaurant meals.
Identify the combinations of gasoline
and restaurant meals that are affordable
and those that are unaffordable.
Figure 9.5 shows a budget line. The
combinations of gasoline and restaurant
meals that lie on and inside the budget line
are affordable. The combinations of gasoline
and restaurant meals that lie beyond the
budget line are unaffordable.

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132 CHAPTER 9

b. Sketch a second budget line to

show how a rise in the price of
gasoline changes the affordable
and unaffordable combinations
of gasoline and restaurant
meals. Describe how the
household’s consumption
possibilities change.
The rise in the price of gasoline
rotates the budget inward, as shown
in Figure 9.6. The combinations of
gasoline and restaurant meals that
were previously affordable that have
now become unaffordable are
shown by the grey triangle. The
household’s consumption
possibilities have been reduced.
21. How does a rise in the price of
gasoline change the relative price
of a restaurant meal? How does a
rise in the price of gasoline change real income in terms of restaurant meals?
The relative price of restaurant meals equals the price of restaurant meals divided by the
price of gasoline. The rise in the price of gasoline reduces the relative price of restaurant
meals. The rise in the price of gasoline does not change real income in terms of restaurant
meals.
Use the following information to work Problems 22 and 23.
Rashid buys only books and CDs and Figure 9.7 shows his preference map.
22. a. If Rashid chooses 3 books and 2 CDs,
what is his marginal rate of
substitution?
Rashid’s marginal rate of substitution is 1
book per CD. Rashid’s marginal rate of
substitution equals the magnitude of the
slope of his indifference curve at this point. If
Rashid buys 3 books and 2 CDs, the slope of
his indifference curve at this point is -1.
b. If Rashid chooses 2 books and 6 CDs,
what is his marginal rate of
substitution?
Rashid’s marginal rate of substitution is 1/2.
Rashid’s marginal rate of substitution equals
the magnitude of the slope of his indifference
curve at this point. If Rashid buys 2 books
and 6 CDs, the slope of his indifference
curve at this point is -1/2.

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 POSSIBILITIES, PREFERENCES, AND CHOICES 133

23. Do Rashid’s indifference curves display diminishing marginal rate of

substitution? Explain why or why not.
Rashid’s indifference curves display diminishing marginal rate of substitution. When moving
along either indifference curve the slope becomes smaller as the consumption of CDs
increases, which means that Rashid has diminishing marginal rate of substitution of books
for CDs.
24. You May Be Paid More (or Less) Than You Think
It’s so hard to put a price on happiness, isn’t it? But if you’ve ever had to choose
between a job you like and a better-paying one that you like less, you probably
wished some economist would tell you how much job satisfaction is worth. Trust
in management is by far the biggest component to consider. Say you get a new
boss and your trust in management goes up a bit (say, up 1 point on a 10-point
scale). That’s like getting a 36 percent pay raise. In other words, that increased
level of trust will boost your level of overall satisfaction in life by about the same
amount as a 36 percent raise would.
Source: CNN, March 29, 2006
a. Measure trust in management on a 10–
point scale, measure pay on the same
10–point scale, and think of them as two
goods. Sketch an indifference curve
(with trust on the x-axis) that is
consistent with the news clip.
The clip implies that a 1 point increase in trust
combined with a 3.6 point (which is 36
percent on a 10 point scale) decrease in
income leaves the person indifferent. So, as
shown in Figure 9.8, the indifference curve is
linear showing the tradeoff between trust and
income.
b. What is the marginal rate of substitution
between trust in management and pay
according to this news clip?
The news clip implies that the indifference
curves are linear, so that the marginal rate of
substitution is constant and equal to 3.6.
c. What does the news clip imply about the principle of diminishing marginal rate
of substitution? Is that implication likely to be correct?
The news clip implies that the indifference curves are linear. Linear indifference curves mean
that the marginal rate of substitution is constant, that is, the principle of diminishing marginal
rate of substitution does not hold. This assumption is likely to be incorrect. Increasing trust in
management from 0 to 1 is likely to be very worthwhile and the person will give up a large
amount of income to gain this unit increase. But increasing trust in management from, say, 8
to 9 is probably not nearly so worthwhile because at 8 management is already highly trusted.
So to gain this unit increase in trust, the person is likely willing to give up only a small amount
of income. So contrary to the article, increasing trust in management is subject to a
diminishing marginal rate of substitution.

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134 CHAPTER 9

Use the following information to work Problems 25 and 26.

Jim has made his best affordable choice of muffins and coffee. He spends all of his
income on 10 muffins at $1 each and 20 cups of coffee at $2 each. Now the price of a
muffin rises to $1.50 and the price of coffee falls to $1.75 a cup.
25. a. Will Jim now be able and want to buy 10 muffins and 20 coffees?
Jim is able to buy 10 muffins and 20 coffees because this combination remains affordable.
Jim will not want to buy this combination, however, because the relative price of muffins and
coffee has changed. At his best affordable choice, Jim’s MRS equals the relative price of
muffins and coffee and because the relative price has changed, Jim’s MRS has changed so
Jim will change his consumption point.
b. Which situation does Jim prefer: muffins at $1 and coffee at $2 a cup or muffins
at $1.50 and coffee at $1.75 a cup?
Jim prefers the $1.50 per muffin/$1.75 per coffee prices because he can attain a higher
indifference curve. The new budget line goes through the old budget line at the initial
consumption point. But, with coffee measured along the horizontal axis, the new budget line
is flatter than the old budget line and lies beyond the initial budget line at all points below the
initial consumption point.
26. a. If Jim changes the quantities that he buys, will he buy more or fewer muffins and
more or less coffee? Explain your answer.
Jim will buy more coffee and fewer muffins because the relative price of coffee has fallen and
the relative price of a muffin has risen.
b. When the prices change, will there be an income effect, a substitution effect, or
both at work? Explain your answer.
There will be a substitution effect and an income effect. A substitution effect arises when the
relative price changes and the consumer moves along the same indifference curve to a new
point where the marginal rate of substitution equals the new relative price. An income effect
arises when the consumer moves from one indifference curve to another, keeping the
relative price constant.
Use the following data to work Problems 27 to 29.
Sara’s income is $12 a week. The price of popcorn is
$3 a bag, and the price of cola is $1.50 a can. Figure
9.9 shows Sara’s preference map for popcorn and
cola.
27. What quantities of popcorn and cola does Sara
buy? What is Sara’s marginal rate of
substitution at the point at which she
consumes?
Sara buys 6 cans of cola and 1 bag of popcorn.
Sara’s budget line runs from 8 cans of cola on the
x-axis to 4 bags of popcorn on the y-axis and is
tangent to indifference curve I1 at 6 cans of cola and
1 bag of popcorn.
Sara’s marginal rate of substitution is ½. The
marginal rate of substitution is the magnitude of the
slope of the indifference curve at Sara’s
consumption point, which is the magnitude of the

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 POSSIBILITIES, PREFERENCES, AND CHOICES 135

slope of Sara’s budget line. The slope of Sara’s budget line is -½ bag of popcorn per can of
cola so the marginal rate of substitution is ½ bag of popcorn per can of cola.
28. Suppose that the price of cola rises from
$1.50 to $3.00 a can while the price of
popcorn and Sara’s income remain the
same. What quantities of cola and
popcorn does Sara now buy? What are
two points on Sara’s demand curve for
cola? Draw Sara’s demand curve.
Sara buys 2 cans of cola and 2 bags of
popcorn. Sara buys the quantities of cola and
popcorn that moves her onto the highest
indifference curve, given her income and the
(new) price of cola and price of popcorn. The
budget line is tangent to indifference curve I0
at 2 cans of cola and 2 bags of popcorn.
Two points on Sara’s demand for cola are the
following: At $3 a can of cola, Sara buys 2
cans of cola. At $1.50 a can of cola, Sara buys
6 cans. Her demand curve is downward
sloping and, as Figure 9.10 shows, goes
through these two points.
29. Suppose that the price of cola rises to $3.00 a can and the price of popcorn and
Sara’s income remain the same.
a. What is the substitution effect of this price change and what is the income effect
of the price change?
The substitution effect is 1 can of cola. To divide the price effect into a substitution effect and
an income effect, take enough income away from Sara and gradually move her new budget
line back toward the original indifference curve until it just touches Sara’s first indifference
curve I1. The point at which this budget line just touches indifference curve I1 is 5 cans of
cola. The substitution effect is the decrease in the quantity of cola from 6 cans to 5 cans
along the indifference curve I1. The substitution effect is 1 can of cola.
The income effect is 3 cans of cola. The income effect is the change in the quantity of cola
from the price effect minus the change from the substitution effect. The price effect is 4 cans
of cola (2 cans minus the initial 6 cans). The substitution effect is a decrease in the quantity
of cola from 6 cans to 5 cans. So the income effect is 3 cans of cola.
b. Is cola a normal good or an inferior good? Explain.
Cola is a normal good for Sara because the income effect is positive.

Economics in the News

30. After you have studied Economics in the News on pp. 214–215, answer the
following questions.
a. How do you buy books?
The answer will depend on how the student buys books.
b. Sketch your budget line for books and other goods.
Suppose the student has $800 to spend, the price of a paper book is $25, the price of an e-
book is $15, and the price of each “other good” is $1. The budget line between paper books

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136 CHAPTER 9

and other goods is a downward sloping budget line and is illustrated in Figure 9.11.
If the student buys e-books, the student needs to buy a $200 e-book reader. With other
goods on the vertical axis and e-books on the horizontal axis, the budget line shown in Figure
9.12 shows that if all income is spent on other goods, the student can purchase 600 other
goods. The budget line is flatter than the previous budget line to reflect the lower price of $15
per e-book compared to $25 for a print book.

c. Sketch your indifference curves for

books and other goods.
The indifference curves will be
conventional showing some substitutability
between books and other goods. This is
the situation illustrated in Figure 9.13.

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 POSSIBILITIES, PREFERENCES, AND CHOICES 137

d. Identify your best affordable point.

For the student who consumes paper books, the best affordable point is point A in Figure
9.14, with 20 books and 300 other goods. For the student who consumes e-books, the best
affordable point is point B in Figure 9.15 with 28 e-books and 200 other goods

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