Z05 Perl2735 6e Im C05

2012 Pearson Education, Inc.
Publishing as Addison-Wesley
Chapter 5
Applying Consumer Theory
Solutions to Textbook Questions
1. Downward sloping and horizontal price-consumption curves are illustrated in Figure 5.1.

Figure 5.1
2. Yes. For this not to occur, it would imply that utility decreases with at least as much consumption of
one or both goods, which violates the more-is-better doctrine.
3. Lets say Olivia likes one scoop of ice cream with each piece of pie, each piece of pie costs $8, a
scoop of ice cream is $2, and Olivias pie and ice cream budget is $60. In the top panel of Figure 5.2
we can plot her indifference curve (a 90-degree angle) where it intersects the budget line to allow for
6 pieces of pie with ice cream. As the price of pie declines, the new budget curve will intersect new,
higher indifference curves. Panel (b) shows the resulting demand curve for pie.
Chapter 5 Applying Consumer Theory 237
2012 Pearson Education, Inc. Publishing as Addison-Wesley

Figure 5.2
4. Using the same values as in the solution to Problem 5.3, we can plot the effect an increase in income
to $120 or $180 has on demand for pie as shown in Figure 5.3, deriving the Engel curve.

Figure 5.3
238 Perloff Microeconomics, Sixth Edition
5. The figure will be similar to panel (a) and panel (c) of Figure 5.2 (in the chapter), but relabel the
vertical wine axis as other goods (or fun) in the panel (a) figure and the horizontal beer axis
as bequests in both panel (a) and (c) figures. The Engel curve will be steeper.
6. An opera performance must be a normal good for Don because he views the only other good he buys
as an inferior good. To show this result in a graph, draw a figure similar to Figure 5.3, but relabel the
vertical housing axis as opera performances. Dons equilibrium will be in the upper-left quadrant
at a point like a in Figure 5.3.
7. 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.
8. 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.
9. Let P
H
= price of high-quality oranges and P
L
= price of low-quality oranges in New York. We expect
P
H
> P
L
. 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:
(P
H
/P
L
) > [(P
H
+ c)/(P
L
+ 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.
10. In the graph, L
f
is the budget line at the factory store and L
0
is the constraint at the outlet store. At the
factory store, the consumer maximum occurs at e
f
on indifference curve I
f
. Suppose that we increase the
income of a consumer who shops at the outlet store to Y*, so that the resulting budget line L* is tangent
to the indifference curve I
.f
. The consumer would buy bundle e*. That is, the pure substitution effect
(the movement from e
f
to e*) causes the consumer to buy relatively more firsts. The total effect (the
movement from e
f
to e
0
) reflects both the substitution effect (firsts are now relatively less expensive)
and the income effect (the consumer is worse off after paying for shipping).

11. 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.
12. 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.
13. See Figure 5.4. Jean is equally well off at e
2
compared to e
1
. Even if coffee becomes relatively
cheaper, Jean will not raise her utility by consuming more coffee because cream and coffee are
prefect complements.

Figure 5.4
14. See Figure 5.5. 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.

Figure 5.5
15. The CPI accurately reflects the true cost of living because Alix does not substitute between the goods
as the relative prices change.
16. See Figure 5.6. The Paasche index effectively asks how much must my income decline in order for
me to be able to buy my current bundle of goods at the old prices? In the figure, the price of Y
increases in period 2. The new budget line is BC. As a result, the consumer moves from e
0
to e
1
.
However, for the consumer to achieve the same utility level at constant prices, as in the Paasche
index, the consumer would move instead to point e
2
, which represents a lower level of income than at
e
1
. Because the Paasche index is the ratio of the cost of the current bundle over the cost of the base
year, the Paasche index underestimates the true CPI.

Figure 5.6
17. 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.
18. See Figure 5.7. 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.

Figure 5.7
19. See Figure 5.8. 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.

Figure 5.8
20. Jeromes budget line is kinked at eight hours of work. At that point, the slope of the budget line
increases from w to w
*
. See Figure 5.9.

Figure 5.9
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.
21. 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.
22. Suppose we have leisure (L) on the horizontal axis and earned income (Y) on the vertical axis. Lets
denote H = 24 L, the hours of work. We know w = H = (24 L). The equation of the budget
constraint is thus Y = wH = (24 L)(24 L) Y = (576 + L
2
48L). Thus, the slope of the
budget constraint is dY/dL = (2L 48). It is obvious that for L < 24, the slope is negative and the
second derivative (2) is positive. Thus, 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 as you have more leisure. Lets denote the slope of the indifference curve by MRS. Thus, the
optimum choice is where |MRS| = |(2L 48)|. See Figure 5.10.

Figure 5.10
23. Audio-PowerPoint answer by James Dearden is also available (5C Labor Leisure and Lottery).
a. Budget before lottery win:
Y = w(24 N) + Y*,
where Y
*
is unearned income.
Budget after lottery win:
Y = w(24 N) + 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.
24. See Figure 5.11. 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 Figure 5.8a). If leisure is an inferior good, they worked less
hours with the poll tax than without the poll tax (Figure 5.8b). Whether a noble man or a peasant
worked more hours depends on the shape of the indifference curves. For example, in Figure 5.8a, the
noble man worked more hours than the peasant, while in Figure 5.8b, the peasant worked more hours
than the noble man.

Figure 5.11
25. Under progressive income taxes, the marginal tax is higher than the average tax.
26. a. A progressive tax is a tax structure in which the average tax is rising. Assume the marginal tax is
constant and equal to . Then the tax revenue is equal to:
T = 0, if Y < 10,000,
= (Y 10,000), if Y 10,000.
Then the average tax is T/Y = (Y 10,000)/Y = (10,000)/Y. As Y increases, (10,000)/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.
27. See Figure 5.12. Individuals with a high preference for leisure (with indifference curve I
B
) will accept
the welfare payment. Those with a greater preference for income than leisure (with indifference
curve I
A
) are likely to turn down the payment.

Figure 5.12
28. a. See Figure 5.13. 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.

Figure 5.13
b. The income tax is likely to reduce Georges 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.
29. 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, Prescotts (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.
30. See Figure 5.14. Doreens budget constraint with the education voucher is kinked, intercepting the
vertical axis at c, while $5000 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 $5000 value, say e
2
. With the voucher, Doreen would consume the $5000 worth of
education and less of other goods, at e
1
. 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
voucherb-c.

Figure 5.14
31. The government could give a smaller lump-sum subsidy that shifts the L
LS
curve down so that it is
parallel to the original curve but tangent to indifference curve I
2
. This tangency point is to the left of
e
2
, so the parents would consume fewer hours of child care than with the original lump-sum payment.
32. Parents who do not receive subsidies prefer that poor parents receive lump-sum payments rather than
a subsidized hourly rate for child care. 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.
Solutions to Textbook Problems
33. a. D is an economic bad. To show this, we take the partial derivative of U with respect to D. We
get:
U/D = 0.5D
1.5
A
0.5
< 0.
b. Lets have A (quantity of other goods on the vertical axis) and D on the horizontal axis. The budget
line is Y = 60 + A + (P
G
2.5) D, where Y is income. The slope of the budget line is P
G
2.5,
which is negative (because P
G
< 2.5), and the vertical intercept is Y 60.
c. To derive the demand functions, we have to solve the two equations MRS = the slope of the budget
constraint. For the above utility function we have MRS = A/D; therefore, the equations we have
to solve are:
A/D = 2.5 P
G

A = (P
G
2.5)D
and
Y = 60 + A + (P
G
2.5)D.
Substituting for A in the budget constraint, we get the demand functions
D* = (Y 60)/ [2(P
G
2.5)]
and
A* = (Y 60)/2.
d.
2
2(60 )
0
(2 5)
G G
D Y
P P

= <

for Y > 60.
e.
1
2( 2.5)
0.
G
D
Y P

= < Since this shows the distance travelled decreases with income, if Lans income
decreases, her distance travelled and her gas expenditures per day will increase.
34. a. MRS = (2N)/T
b. Absolute value of the slope of budget constraint = p
t
.
c. Solve the two equations (2N)/T = p
t
and N + p
t
T = 24. The demand functions are:
T* = 16/p
t
and N* = 8.
d. As p
t
decreases, the demand for T increases and therefore we can expect to witness a weight
increase.
35. Because the two commodities are perfect complements, the indifference curves have right angles.
Thus, the income consumption curve will be a straight line that passes through the point where the
indifference curves just touch the budget lines. See Figure 5.15a. In order for Hugo to buy one more
doughnut per week, his budget must rise enough to purchase both another doughnut and another cup
of coffee. The Engel curve is also linear; see Figure 5.15b.

Figure 5.15
36. The consumers budget constraint is
1 1 2 2
,
n n
p q p q p q Y + + + =
where Y is income and p
i
is the price and q
i
is the quantity of good i. Differentiating with respect to Y,
we find that
1 2
1 2
1.
n
n
dq dp dq dY
p p p
dY dY dY dY
+ + + = =
Multiplying and dividing each term by q
i
Y, we rewrite this last equation as
1 1 1 2 2 2
1 2
1,
n n n
n
p q dq p q dq p q dq Y Y Y
Y dY q Y dY q Y dY q
+ + + =
or
1 1 2 2
1,
n n
+ + + =
where
1
the income elasticity for each good i, equals ( / )( / ),
i i
dq dY Y q and the budget share of good
i is / .
i i i
p q Y = That is, the weighted sum of the income elasticities equals 1. For this equation to
hold, at least one of the goods must have a positive income elasticity; hence, not all the goods can be
inferior.
37. See Figure 5.16. The marginal rate of substitution is B/C.

Figure 5.16
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.
38. Eggs and toast are perfect complements. U = min(2Q
t
, 3Q
e
). 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 Figure 5.17. 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.

Figure 5.17
39. From Appendix 5B, we know that, when N is leisure and Y is income:
.
N
Y
MU
MRS w MRT
MU
= = =
We also know that if the utility function is U(Y, N) is Cobb-Douglas such that:
1 1
( ) (24 )
a a
U Y N wH H

= =
where H is the number of hours worked. Differentiating the utility function with respect to H and
setting it to zero, we find that 24 H = and 0.
dH
dw
= Therefore, a wage change will have no effect on
the number of hours worked with this utility function.

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