Answers to Ch3 Practice Questions

1. Suppose Peggy consumes only two goods, gasoline and cigarettes. Her income is $120, the price of cigarettes per pack is $4 and the price of gasoline per gallon is $2. Currently, she consumes 40 gallons of gas. Sketch the following budget lines. (Put gas on the X axis.) Be sure to show how you calculated the slopes and end points. A. Graph this budget line first, before doing each of the following. Using an arbitrary convex indifference curve, indicate the current consumption combination is optimal. How many packs of cigarettes does she consume? 10 C
30

1 2

10

40

60

B. If the government imposes a sales tax of $1 per unit on gasoline, Peggy will consume 28 gallons of gas. C
30

3 4

28

40

C. What happens to the budget line if the $1 tax applies only to purchases of gasoline in excess of 20 gallons? (Do not put an indifference curve for this problem)

C
30

1 2 3 4
1

20

20

46.66666

D. In addition to the above prices (no tax) and income, Peggy is given 10 packs of cigarettes, which she cannot sell. (Do not put an indifference curve for this problem)

40

1 2

10

60

E. What happens if instead Peggy can sell the 10 packs at $4? (Do not put an indifference curve for this problem)
40

1 2

80

2. Given Marys current consumption of beer and French fries, her MRS of beer is 3 bags of French fries. The market price of French fries per bag is $1 and the market price of beer per bottle is $2. a. Graph the budget constraint below putting beer on the horizontal axis. What is the slope of the budget constraint? PB/PF=$2/$1=2 b. On the same graph, draw in the current indifference curve and indicate the current consumption bundle. MRS (or MB)=3> PB/PF=2. The current bundle is not her optimum. c. Can Mary be made better off by consuming a different quantity of beer and French fries than she is consuming now? Yes. Explain how if she can. MRS (or MB)> PB/PFMB>MCBuy more Beer and less French fries.

3. a. Assume Jessie consumes Lettuce (PL = 4) and Tomatoes (PT = 3) and has an income of $180.

Graph Jessies budget constraint below putting Tomatoes on the horizontal axis. What is the slope of the budget constraint and what economic relevance does it have for Jessie? Slope = Pt/Pl = .75. It tells us that Jessie must give up .75 lettuces to be able to afford one more tomato. b. On the same graph, draw in Jessies current indifference curve assuming for her current bundle, the MRS = 1.5. Using the MRS and the price ratio, explain whether Jessie is currently maximizing utility. If she is not, explain her decision rule for determining whether she should change her consumption of Tomatoes by 1. L Slope of I-curve = 1.5 Since MRS>Pt/Pl, utility cannot be maximized. She is willing to give up 1.5 lettuce for 1 tomato AT HER CURRENT BUNDLE while she only has to give up .75 lettuce for one more tomato. She should therefore consume more tomatoes.

LessL

Optimal

Slope = .75

MoreT

T
4. Suppose the marginal value of bread in terms of wine is 1/2 bottle of wine per loaf of bread, while the relative price of bread in terms of wine is 1/4 bottle of wine per loaf of bread. (a) Graph the budget constraint below putting bread on the horizontal axis. What is the slope of the budget constraint? PB/PW=1/4 (b) On the same graph, draw in the current indifference curve and indicate the current consumption bundle. MV=1/2 >PB/PW=1/4 Currently not at the optimal bundle. (c) Explain how the consumer can adjust his purchases to raise his level of satisfaction. The marginal value indicates that the consumer is willing to pay up to 1/2 bottle of wine in exchange for 1 loaf of bread. Under the given market prices, the consumer has to sacrifice only 1/4 bottle of wine to purchase 1 loaf of bread, so this opportunity is a good deal for the consumer. The consumer's satisfaction level will increase if he buys less wine and more bread, because the value he places on additional bread is greater than the price he must pay in the market.

5.

Suppose the price of cheese has recently risen from $4 to $6 per pound, while the price of fruit has fallen from $8 to $6 per pound. During this time, Miguel's income has stayed fixed at $48 per week. Before the price changes, Miguel had been buying 4 pounds of cheese and 4 pounds of fruit per week. Since the price changes, he has been buying 2 pounds of cheese and 6 pounds of fruit weekly. Consider an indifference curve-budget line diagram with cheese on the horizontal axis and fruit on the vertical axis. (i) Does the price change make Miguel's budget line flatter or steeper? Justify your choice. The Slope of Budget Line (PC/PF) was 4/8=0.5 but becomes 6/6=1. The budget line gets steeper. After the price change, will his new budget line lie above, lie below, or pass through her initial optimum? Justify your choice. After the price changes, Miguel could still purchase 4 pounds of cheese and 4 pounds of fruit, because this basket still costs $48 under the new prices. His new budget line pass through her initial optimum. Sketch an indifference curve-budget line diagram that illustrates this situation. Assuming Miguel's preferences have not changed, is it possible to say whether the price changes have made Miguel better off or worse off? Explain. Since Miguel chose not to continue purchasing this basket and instead chose to purchase a new basket, we can conclude that he must prefer having 2 pounds of cheese and 6 pounds of fruit to having 4 pounds of each good. Therefore, the price changes have made Miguel better off.

(ii)

(iii)

6. Perfect substitutes are more likely to result in an optimal bundle that is a Corner Solution.

7.Use the following figure to answer the questions below

One of these indifference (utility) curves belongs to Ellen; the other belongs to Cindy. All else equal, Ellen prefers Elvis over Cher and Cindy prefers Cher over Elvis. Which indifference curve, U1 or U2 belongs to Ellen and which belongs to Cindy. Verbally explain how you know (using some of the points on the graph to illustrate your example might be helpful). Starting at the bundle of 3 Cher CDs and 8 Elvis CDs, the person with U1 preferences is willing to give up .5 Elvis CDs for one more Cher CDs. The person with preferences 4

represented by curve U1 is willing to give up 3 Elvis CDs for one Cher CD. In fact, at EVERY number of Cher CDs, the person with U1 preferences is willing to give up more Elvis CDs. U1 must be Cindy and U2 is Ellen.

8.

Jeff likes going to the beach and only brings two things with her, beach towels and sunscreen. Right now, sunscreen costs $10 per bottle and beach towels cost $15 each. Jeff purchases six bottles of sunscreen and six beach towels. a. How much did Jeff have? (As usual, Jeff did not save.) We know his income is $150 as $15*6 + $10*6 = $150 b. Draw his budget constraint and note the optimal bundle (put beach towels on the horizontal axis). SS 15

BCb BCa

10

15

BT

c. Now assume the price of beach towels falls to $10. Draw his new budget constraint on the same graph above. d.Assume the government is going to charge a Beach Use Fee. With the new lower price of towels, how high a fee could be charged to Jeff so that he could still afford his original bundle of six bottles of sunscreen and six beach towels? To get 6 BT and 6S now only costs $120. A $30 Beach Use Fee would still exactly allow her the same bundle.

e. After the fee (equal to your finding in d above) is imposed, verbally explain how you know whether Jeff will be better off, worse off, or as well off as in part b above. Draw a new graph below to illustrate your answer. SS 15 He is better off b/c after the price change and fee, MRS > PBT/PSS and he can increase his utility by consuming more BT and less SS. BCd

12 BCa

6 U2 U1 6 10 12 BT

5. a. (7) Assume Jessie consumes Lettuce (PL = 4) and Tomatoes (PT = 3) and has an income of $180. Graph Jessies budget constraint below putting Tomatoes on the horizontal axis. What is the slope of the budget constraint and what economic relevance does it have for Jessie? Slope = Pt/Pl = .75. It tells us that Jessie must give up .75 lettuces to be able to afford one more tomato. c. (8) On the same graph, draw in Jessies current indifference curve assuming for her current bundle, the MRS = 1.5. Using the MRS and the price ratio, explain whether Jessie is currently maximizing utility. If she is not, explain her decision rule for determining whether she should change her consumption of Tomatoes by 1. L Slope of I-curve = 1.5 Since MRS>Pt/Pl, utility cannot be maximized. She is willing to give up 1.5 lettuce for 1 tomato AT HER CURRENT BUNDLE while she only has To give up .75 lettuce for one more tomato. She should therefore consume more tomatoes.

LessL

Optimal Slope = .75

MoreT

T
6