Economics 301 - Homework 3

Fall 2006
Stacy Dickert-Conlin

Answer Key

Equivalent loss in income

Football Cards

1. Andy collects baseball and football cards. The following graph shows a few of his indifference curves. The price
of a pack of baseball cards is $1, the price of a pack of football cards is $1. Andys allowance is $11 a day. The
price of baseball cards suddenly increases to $4. Assume that Andy can buy less than whole packs of cards.
a. On the graph below, draw Andys original budget line and label it BC0. Also put the label A on his chosen
consumption bundle. Label his initial indifference curve I0. Before the price change:
Andy consumes ___5_______ baseball cards and _____6___ football cards.
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21
20
19
18
17
16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0

BCH
BC2

I1
0

income effect
1

substitution effect
3
4

total effect

b.

I0

BC0

10

11

12

Base ball Cards

On the graph, draw Andys actual budget line after the price change and label it BC1. Label his actual
consumption bundle after the price change C and the new indifference curve I1. After the price change:
Andy consumes ____0.5____ baseball cards and _____9___ football cards.

c.

On the graph, draw (as carefully as possible) Andys budget line that reflects the substitution effect and label it
BCH. (Hint: Use the new price ratio to reach the initial indifference curve). Label this intermediate
consumption point B. With the substitution effect ONLY:
Andy consumes ___1.5____ baseball cards and_____14____ football cards.

d. Does the substitution effect of the increase in the price of baseball cards make him buy more or less baseball
cards? How many more or less?
He consumes 3.5 fewer baseball cards (from 5 to 1.5) as a result of the substitution effect.
Draw 3 dashed horizontal lines (- - -) on your graph, one from A to the horizontal axis, one from B to the
horizontal axis and one from C to the horizontal axis. Along the horizontal axis, label the income effect, the
substitution effect and the total effect on the demand for baseball cards.
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e. Fill in the blanks: The income effect of the increase in the price of baseball cards on Andys demand for
baseball cards is the same as the effect of a decrease in his income of $__8____ per day. How do you know?
The parallel shift that moves Andy from point B on IC0 to point C on IC1 is equivalent to taking $8 away from
him. Look at the y-axis. On BCH the y-intercept is 19 (which is equivalent to $19 of income because the price of
y is $1.) On BC1, the y-intercept is at 11 (which is equivalent to $11 of income because the price of y is $1).
f. Does the income effect make him consume more baseball cards or less? How many more or less?
He consumes 1 fewer (from 1.5 to 0.5) as a result of the income effect.

g. Can you tell whether football cards are a normal or inferior good? Can you tell whether baseball cards are a
normal or inferior good? Why or why not?
Both goods are normal goods because from B to C (the income effect) the consumption of both fell.
h. On the following graph, using the information given above, plot two points on Andys Marshallian demand curve
for baseball cards and connect them. Label this Dmarshallian:
When the price was $1/pack, Andy bought 5, when the price increased to $4/pack, he only bought 0.5 (see
points A and D above).
5
4.5

Price of Baseball Cards $

4
3.5
3
2.5
2
1.5

Dmarshallian

0.5

Dhicksian

0
0

0.5

1.5

2.5

3.5

4.5

5.5

6.5

7.5

Packs of Baseball Cards

i. On the above graph, using the information given above, plot two points and connect them on Andys Hicksian
demand curve for baseball cards. Label this DHicksian, Briefly explain the difference.
The Hicksian demand curve ignores the substitution effect. It only reflects the fact that baseball cards got relatively
more expensive. So, consumption would fall from 5 to 1.5.

2. Critically evaluate the following statements and explain in what way are they true, false, or uncertain.
a. Suppose Kelly consumes only two goods, books-ontape and coffee mugs and she has typical U-shaped,
convex indifference curves. If the price of books-ontape is $16 and the price of coffee mugs is $4 and
Kellys marginal rate of substitution for books-ontape in terms of coffee mugs is 5, she could increase
her satisfaction by consuming fewer books-on-tape
and more coffee mugs. (A graph is strongly
advised.)
In this case, Kellys MRS = 5 > the price ratio =
16/4=4. In other words, the benefit of an additional
book on tape is more than the cost of an additional book
on tape. The slope of the indifference curve is greater
than the slope of the budget constraint. This would
occur at a point like A. Kelly should consume more
books on tape in order to make herself better off.
b. If the price of a good decreases and the quantity
demanded increases, this implies that the good is normal.
False. This is just the law of demand. If the price
decreases, the quantity demand increases for all goods.
We can only tell if a good is inferior by knowing what
happens when income increases or decreases. Or, by
decomposing the total effect from a price change into the
income and substitution effect.

Coffee mugs

Books on tape
T

I1

A >> C Total effect, P decrease Q of S increases

A >> B Substitution effect
B >> C Income effect - S is inferior
I0
S

c. For a budget spent entirely on two goods, an increase in the price of one will necessarily decrease consumption of
both, unless at least one of the goods is inferior. Your answer is not complete without a diagram.
False. In the diagram below, an increase in the price of X leads to a reduction in the amount of X consumed,
but an increase in the quantity of Y. In addition, you can see from B to C, which shows the income effect,
that both goods are normal goods. That is, when the consumer feels the impact of the decline in income she
consumes fewer X and Y. See question 1 for another example.

C
A

Y1
Y0

I0
BC0
I1

BC1

X1

X0

3. Martha likes consume goods in an extremely well-balanced manner. In fact, for new home decor item she buys,
she insists on creating exactly 3 simple meals to go with it. Suppose she has an income of $240. The price of each
home decor item is $10 per unit and the price of each meal is $10 per unit.
a. On the graph, draw Marthas budget line,
labeling it BC0, and plot at least 3
indifference curves
Perfect Complements!

IC2

BC0

IC3

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Q of Home Decor Items (Y)

b. How many new home decor items will

Martha demand in this situation? How
many new meals? Show your answer
graphically AND algebraically (Hint: You
have two equations and two unknowns.
One equation tells the relationship between
her consumption of home decor items and
meals; the second equation is the budget
constraint.)

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20
18
16
14

BCH

12
10

BC1

A=B

8
6

IC1

(1) Preferences: 3Y = X
(2) BC: Y = 24-1X
Sub (1) into (2)
Y = 24-1(3Y) and solve:
4Y = 24
Y = 6, therefore X = 18.
Labeled Point A

IC0

0
0

10 12 14 16 18 20 22 24 26
Q of Meals (X)
Income effect= total effect

c. Suppose the price of home decor items increases to $30 per unit. Graphically illustrate Marthas new optimal
consumption point (including budget constraint and indifference curve).
(1) Preferences: 3Y = X
240 10
1
X = 8 X
(2) BC: Y =
30 30
3
Sub (1) into (2) and solve:
1
Y = 8 (3Y )
3
2Y = 8
Y = 4 X = 12
Labeled point C!
d. What is the substitution effect from this price change?
There is no substitution effect. Because these are perfect substitutes, the only point that touches the original
indifference curve (IC2 in my diagram), that reflects the new prices is the original point A!
e. Are meals and home decor items inferior or normal? Explain.
They are both normal. The total effect is the income effect because the substitution effect is 0. When she
moves from B to C, her purchasing power has fallen and you consume less of both.

f. Sketch Marthas Marshallian and Hicksian demand curves from the information above.

$30

Dhicksian

$10

Dmarshallian
0

Q of Home Dcor Items

4. Since losing his housekeeping job, Tony lives alone. He often has leftovers after cooking and he wraps them in
aluminum foil. As far as he is concerned, 2 square feet of generic aluminum foil is equivalent to 1 square foot of
Reynolds Wrap. That is, any job that can be done with 1 square foot of Reynolds Wrap requires 2 square feet of the
generic brand to be done as well. Tony has $24 to spend on aluminum foil. A roll of Reynolds Wrap costs $3 and a
roll of generic aluminum foil is $2.

d. Suppose the price of Reynolds Wrap

increases to $4/roll and the price of
generic aluminum foil remains at $2/roll.
Will he buy more generic aluminum?
Carefully explain. If not, at what point
will he buy more generic aluminum?
In this case, the MRS and the opportunity
cost of another roll of generic aluminum foil
are both . This means that Tony can afford
any point along BC1 and he is indifferent
between any point along BC1, because his
indifference curve(IC3) lies along the same
line. The price of Reynolds Wrap must be at
least 2 times the price of generic aluminum
foil before Tony buys any of it.

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11
10
9
8
7
6
5
4
3
2
1
0

BC0
IC0
IC1
IC2
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Q of Generic Aluminum Foil (X)

Q of Reynold Wrap Aluminum Foil (Y)

b. Show at least 3 of Tonys indifference

curves.
Perfect substitutes, therefore, straight
line indifference curves with a MRS of
(slope of 1/2)
c. How much of each kind of aluminum foil
will Tony use? Fully explain. Label this
point A on the graph.
Because the indifference curves are
linear with a slope different than the
slope of the budget constraint, Tony will
never reach a tangency. He will choose
a corner solution on the highest
indifference curve still touching the
budget constraint. In this case, he will
consume 8 rolls of Reynolds Wrap and
no generic Aluminum foil. This is at
Point A on the diagram. BC0 and IC0.

Q of Reynold Wrap Aluminum Foil (Y)

a. Graphically illustrate Tonys budget

constraint and label it BC0.

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11
10
9
8
7
6
5
4
3
2
1
0

IC3
BC1

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Q of Generic Aluminum Foil (X)

Q of Reynold Wrap Aluminum Foil (Y)

e. Return to the initial prices (Reynolds

Wrap is $3/roll and generic aluminum
foil is $2/roll). Suppose Tony receives a
coupon from his grocery store for $6 that
can be used only on rolls of generic
aluminum foil. Explain graphically AND
verbally how, if at all, this coupon will
alter Tonys decision, relative to part c.
The new budget constraint is kinked
(similar to the food stamp example)
because the coupon cant be used on
Reynolds Wrap but it is just like cash for
generic aluminum foil. In this case, the
best Tony can do is at point S where he
uses the entire $6 gift certificate for 3
rolls of generic aluminum foil and uses
his remaining $24 for 8 rolls of Reynolds
Wrap.

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11
10
9
8
7
6
5
4
3
2
1
0

ICcoupon

BC0

BCcoupon

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Q of Generic Aluminum Foil (X)

f. Describe Tonys demand function for generic aluminum foil as a function of general prices and income. Let the
prices of generic aluminum foil and Reynolds Wrap aluminum foil be pG and pRW, and let income be M. Using
this notation, fill in the blanks.
If pRW > 2pG, then the number of Reynolds Wrap foil he will demand is ____0_________.
If pRW < 2pG, then the number of Reynolds Wrap foil he will demand is _____ M

pRW

________. (Hint: this

answer should have letters in it).

If pRW = ___2___pG, he will be indifferent between any affordable combinations. (Hint: a number fills this
blank.)

5. Consider the following proposal to encourage energy conservation in East Lansing. Suppose that the
city authorities placed a tax on each unit of electricity used by city residents. However, in order not
to make people worse off the city gives each family a rebate check so that they can purchase the
same combination of electricity and all other goods as before the tax was imposed.
a) Using an indifference curve diagram illustrate the effect of the entire proposal on the consumption of electricity
(x) and all other goods (y).
Y

ICtax+rebate

BCtax

IC0
BCtax and rebate
BC0
Etax and rebate

E0

Electricity

b. Will electricity consumption necessarily go down? Why or why not.

The quantity of electricity demanded must decrease. At the original point A, the MRS on IC0 doesnt change after
the policy is implemented, but the opportunity cost of electricity (slope of the budget constraint) is higher after the
policy. This implies that the benefit of one more unit of electricity at Point A is the same, but the cost is higher after
the policy. Point A cant be a tangency any longer and the consumer should consume less electricity in order to
increase his/her satisfaction (move to point Z on ICtax+rebate).
c) Would the tax alone assure a reduction in electricity? Why or why not?
Yes. The amount of the decrease depends on whether electricity is a normal or inferior good. If it is a
normal good, the reduction in electricity consumption will be greater than if it is an inferior good because
the income and substitution effects will work together. Graphically this would be shown by drawing the
indifference curve tangent to BCtax.
d) Will consumers be better or worse off after the tax and rebate proposal? Explain.
Consumers are definitely better off because they are on a higher indifference curve. Their new budget
constraint, BCtax and rebate intersects their old consumption point AND their old indifference curve. The
consumers can definitely reach a higher indifference curve.
e) Is there a way the government can get people to consume less electricity, make them no worse off than they were
previously, and spend less money on rebates? Explain.
Yes, just give them enough of a rebate (income effect) to get back to IC0. This BC would be parallel to BCtax
and rebate, but at a slightly lower level. Can you imagine how difficult this would be to do in principle?
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6. Suppose that you were considering offering a transfer of $300 a month to low income individuals. However,
you are concerned about how they might use it in particular, you want to reduce the opportunity for them to
use the transfer for social bads - like alcohol, tobacco, and illicit drugs. To reduce the opportunity to use it on
these bads you can either give them the transfer as a Food Stamp (which must be used to purchase food) or
a Rent Stamp (which must be used to pay a rent or mortgage). Assume the average recipient spends a small
portion of their monthly budget on food ($100) and a large portion of their monthly budget on rent ($600) in the
absence of the transfer.
a. If you want to minimize how much they spend on social bads discuss whether it matters if the transfer is in the
form of a Food Stamp rather than a Rent Stamp. Explain and support your answer using the figures provided.

Y = Other Goods

Y = Other Goods

BCcash
BCvouchers

Ycash
Yvoucher

Icash
Ivoucher

Yno coucher
Yvoucher or cash

Ino voucher

Yno voucher

Ivoucher or cash
BC0
Hno voucher Hvoucher

BC0

BCvouchers
Ino voucher or cash
Housing

Fno voucher Fvoucher

Food

Fcash
Housing Voucher: For an individual who was already spending a large share of income on housing the
vouchers have the same effect as cash. Assuming they are both normal goods, the family will consume more of
both goods.
Food Voucher: Individuals who spends a small share of their income on food will also buy more food and Y
with the voucher. BUT, if they had cash, they would buy even more Y and less food than with the voucher. The
the budget constraint with cash gives the individual more satisfaction (higher indifference curve), than the BC
with a voucher.
Note that in both cases, the voucher does not prevent an increase in the consumption of "other goods". In
the food voucher case, vouchers do minimize the amount spent on other goods, relative to cash.

b. Is a black market in vouchers like to emerge in both markets? How would this affect your answer?
A black market is likely to arise in the food voucher market because consumers are happier with the cash
than with the voucher.

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