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PROBLEM SET 6

1. For this problem, assume that Joe has $80 to spend on books and movies
each month, and that both goods must be purchased whole (not fractional
units). Movies cost $8 each, while books cost $20 each. Joes preferences for
movies and books are summarized by the following information:

MOVIES BOOKS
No. TU MU MU/$ No. per TU MU MU/$
per month
month
1 50 ____ ____ 1 22 ____ ____
2 80 ____ ____ 2 42 ____ ____
3 100 ____ ____ 3 52 ____ ____
4 110 ____ ____ 4 57 ____ ____
5 116 ____ ____ 5 60 ____ ____
6 121 ____ ____ 6 62 ____ ____
7 123 ____ ____ 7 63 ____ ____

a. Fill in the figures for marginal utility and marginal utility per dollar for both
movies and books.
b. Are these preferences consistent with the law of diminising marginal utility?
Explain briefly.
c. Given the butget of $80, what quantity of books and what quantity of movies
maximize Joes level of satisfaction? Explain briefly.
d. Draw the budget constraint (with books on the horizontal axis) and identify the
optimal conditions of books and movies as point A.
e. Now suppose that price of books falls to 10$. Which of the colums in the table
must be recalculated? Do the required recalculations.
f. After the price change, how many movies and books will Joe purchase?
g. Draw in the new budget constraint and identify the new optimal combination of
books and movies as point B.
h. If you calculated correctly, you have found that a decrease in the price of
books has caused this person to buy more movies as well as more books.
How can this be?

2. Assume that Jim is a rational consumer who consumes only two goods,
apples (A) and nuts (N). Assume that his marginal rate of substitution of
apples for nuts is given by the following formula:

MRS = MUN / MUA = A / N

That is, Jims MRS is simply equal to the ratio of the number of apples consumed
to the number of nuts consumed.
a. Assume that Jims income is $100, the price of nuts is $5, and price of apples
is $10. What quantities of apples and nuts will be consumed?
b. Find two additional points on his demand curve for nuts (P N = $10 and PN =
$2).
c. Sketch one of the equilibrium points on an indifference curve graph.

3. Consider a person who spends a total of $200 on hats and violets. The price
of hats is $20, and the price of violets is $5. Draw a budget line with hats on
the horizontal axis and violets on the vertical axis.

a. What is the slope of the bugdet line?


b. Draw a convential indifference curve (negatively sloped and convex to the
origin) that intersects the budget line. Explain why the consumer can reach a
higher utility level than that shown by this indifference curve.
c. Draw a second indifference curve that shows a higher possible utility level.
d. Complete the statement: To maximize utility, the consumer finds the
combination of hats and violets such that ______________ equals 4.

4. Figure 1 Utility of Consuming Grapes and Bananas


5 26 34 38 40 41
4 25 33 37 39 40
Pounds of
3 23 31 35 37 38
Grapes 2 20 28 32 34 35
1 16 24 28 30 31
1 2 3 4 5

Pounds of Bananas

Using the Figure 1 above, find the quantity of each good the consumer will
purchase in the following cases

Case Budget Price of Grape Price of


Bananas
A $7 $1 $1
B $6 $2 $1
C $8 $1 $2

Multiple Choice Questions

1) Refer to the graph below. What is the marginal rate of substitution?


a) The indifference curve.
b) The slope of the budget line.
c) The budget line.
d) The ratio of the prices of goods X and Y.
e) The slope of the indifference curve.

2) Fill in the blanks.

Both the income and substitution effects imply a __________ relationship


between price and quantity demanded. The substitution effect is the change in
quantity demanded attributable to a change in __________ price, while the
income effect is the change attributable to a change in __________ price.

a) positive, relative, absolute.


b) negative, relative, absolute.
c) positive, absolute, relative.
d) negative, absolute, relative.

3) Suppose you have a fixed budget for two goods, X and Y. Px = $10 and Py = $5.
MUx= 60 utils and MUy = 15 utils. Should the consumption of X and/or Y be
higher, lower, or remain the same?

a) Consumption of good X should decrease, and consumption of good Y should


increase.
b) Both the consumption of goods X and Y should decrease.
c) Both the consumption of goods X and Y should increase.
d) Consumption of good X should increase, and consumption of good Y should
decrease.
e) The current combination of goods maximizes total utility. Consumption should
remain the same.

4) Refer to the graph below. What happens when the consumer buys 3 units of good
X and 4 units of good Y?
a) Utility could increase by buying more of good X and less of good Y.
b) Utility could increase by buying more of good Y and less of good X.
c) The utility maximizing-rule holds, and the combination of goods chosen is the
optimal combination.
d) Utility is maximized although the consumer may not have exhausted her entire
income.
e) The consumer's income has been exhausted, but the utility-maximizing rule
may or may not be satisfied.

5) In the formula below, the marginal utility per dollar spent on good X is less than
the marginal utility per dollar spent on good Y. To increase total utility, the
consumer should:

a) Decrease the consumption of both goods.


b) Increase the consumption of both goods.
c) Increase the consumption of good Y.
d) Increase the consumption of good X.
e) Maintain consumption constant.

6) To determine the utility-maximizing combination of goods X and Y the consumer


will purchase, the following assumption(s) are made:

a) The price of good X remains constant.


b) The price of good Y remains constant.
c) The consumer's income remains constant.
d) All of the above.

7) When diminishing returns are present in consumption, the relationship between


total utility and marginal utility is as follows:

a) Total utility increases at an increasing rate while marginal utility decreases.


b) Total utility and marginal utility decrease at an increasing rate.
c) Total utility increases at a decreasing rate while marginal utility decreases.
d) Total utility decreases at an increasing rate while marginal utility decreases.

8) Refer to the graphs below. What explains the moves in the budget lines, A and B,
respectively?

a) Both the rotation in A and the shift in B are caused by decreases in income.
b) Both the rotation in A and the shift in B are caused by increases in the prices of
goods X and Y.
c) Both the rotation in A and the shift in B are caused by increases in income.
d) Both the rotation in A and the shift in B are caused by decreases in the prices of
goods X and Y.
e) None of the above.