CHAPT 7 MICRO

The price of peaches goes up and I observe you buying fewer strawberries. Which of the following is consistent with this observation:

a. Strawberries are inferior and peaches are normal. b. Strawberries are normal and peaches are inferior. Since the substitution effect (from A to B) tells us to buy more strawberries, and since we end up buying fewer than at A, the final bundle lies below B and thus involves a decrease in strawberry consumption as income falls (from the dashed compensated to the final budget). Thus, strawberries must be normal and thus (a) can't be true. Peaches, on the other hand, could be normal (as when the final optimal bundle is C) or inferior (as when the final optimal bundle is D).

You and I both have homothetic tastes. When the price of peaches goes up, you buy more strawberries and I buy fewer. Which of the following must be true. a. Peaches are more substitutable with strawberries for me than they are for you. b. Peaches are more substitutable with strawberries for you than they are for me. c. Strawberries are normal goods for you and inferior goods for me. d. Strawberries are normal goods for me and inferior goods for you. e. Both (a) and (c). f. Both (b) and (c). g. Both (a) and (d) h. Both (b) and (d)

ANS: B When tastes are homothetic, all goods are normal. Thus, (c) and (d) must be false. The two graphs below then illustrate (b).

Wholesale clubs charge a fixed monthly fee but then offer goods at discount prices. For purposes of this question, suppose a wholesale club and a supermarket offer the same composite grocery item, with the supermarket charging no fixed fee but a higher price for the item. (Assume no corner solutions.) a. Anyone shopping at the wholesale club places less value on the marginal item bought than anyone shopping at the supermarket. b. Anyone indifferent between the two stores buys more (or at least no less) if she chooses the wholesale club. c. We cannot predict how much value different individuals place on the marginal item in each store because we cannot measure utility objectively. d. Both (a) and (b) are true. e. Both (b) and (c) are true.

ANS: D Since there are no corner solution, we know that those in the wholesale club as well as those in the supermarket will by the composite item until their MRS is equal to the negative price -- but the price is higher in the supermarket. Thus, those choosing to shop in the supermarket place a higher value on the marginal item bought. We can make these comparisons even though we cannot measure utility objectively -- because we know what the MRS is at the margin for those at interior solutions. Furthermore, anyone indifferent between the stores must shop less at the supermarket because of the substitution effect.

At most museums, you can either buy a year-long membership that gives you free access to the museum any time, or you can pay a daily fee every time you visit. (Assume for purposes of this exercise that everyone can in principle afford the year-long membership.) a. Those who choose to pay the daily fees all place the same value on their marginal museum visit. b. We cannot tell how much value anyone places on the marginal museum visit because we cannot compare utility across individuals. c. If someone is indifferent between the two options, she will go to the museum at least as much if she chooses the year-long membership than if she does not. d. Both (a) and (c) are true. e. Both (b) and (c) are true.

ANS: D The consumer chooses between two budgets --the solid budget (with daily fees) and the dashed budget (with one lump sum fee and then no fee per visit). Those who choose the solid budget (i.e. the daily fees) will all optimize at a point like A -- a point where their MRS is equal to the (negative) price of a daily entrance fee. Thus, they all place the same value on the marginal museum visit -- and (a) is true. Answer (b) is therefore false -- we can often tell what the marginal value is that someone places on a good, because the marginal value is equal to the price. Finally, if someone is indifferent between the two options, the graph below shows that she will visit less frequently under the daily fee.

Suppose the government spends the same for a particular consumer under two different policies: One subsidizes the price of good x while the other is a lump sum subsidy. Which of the following is true. a. Compared to the lump sum subsidy, the consumer will purchase more x under the price subsidy if and only if x is a normal good. b. Compared to the lump sum subsidy, the consumer will purchase less of x under the price subsidy if x is an inferior good. c. Compared to the lump sum subsidy, the consumer will purchase less of x under the price subsidy if x is a Giffen good. d. The consumer will spend the same on x under the two policy if and only if her indifference curves are kinked. e. Both (a) and (c). f. Both (b) and (c). g. All of the above. h. None of the above.

ANS: D The solid lines in the graphs below are the budget constraints under the two policies. If the government spends the same amount, it must be that A is optimal under the price subsidy -- which implies the indifference curve crosses the lump-sum subsidy budget in a way that implies the optimal bundle under the lump sum subsidy B lies to the left of A regardless of what kind of good x is (so long as there is some curvature at A). If there is a kink at A (as in the second graph), the two policies can result in the same choice.

Every Giffen good is a necessity but not every interior good is a necessity.

ANS: F All inferior goods --- including Giffen goods --- are goods whose consumption moves in the opposite direction from income. Necessities are goods whose consumption increases by less than the percentage increase in income, which is the case if consumption decreases with increases in income.

The price of peaches goes up and I observe you buying more strawberries. This implies that strawberries must be an inferior good.

ANS: F Below is a case where strawberries are a normal good.

Every necessity is a normal good, but not all normal goods are necessities

ANS: F Necessities can be normal or inferior.

Bottles of Coca-Cola and equally-sized bottles of Pepsi Cola are perfect substitutes for a consumer, but a bottle of Coke costs 10 cents less than bottles of Pepsi. The income effect of a 15 cent increase in the price of Pepsi will be for the consumer to drink less cola.

ANS: F The consumer is at a corners solution -- consuming only Coke -- before the price of Pepsi increases. The increase in the price of Pepsi therefore has not impact on the consumer.

Goods with small substitution effects tend to be normal goods.

ANS: F The definition of normal goods relates to income effects, not substitution effects. Normal goods can have large or small substitution effects.

Except for the case of Giffen goods, the substitution effect always tells us that a consumer will consume less (or at least no more) of a good whose price has increased.

ANS: F The statement is true --- except that it applies to Giffen goods as well.

A change in the price of one good cannot leave utility unchanged unless the price change is accompanies by a change in income.

ANS: F There are several types of counterexamples to this. For instance, it a consumer consumes at a corner solution and the price of the good that is not consumed increases, the consumer's utility is unchanged. Or, if a consumer consumes at an interior solution, an increase in the price of one good could be accompanied by a decrease in the price of the other good such that the consumer's utility remains unchanged.

The price of peaches goes up and I observe you buying more strawberries. This implies strawberries must be a normal good.

ANS: F When the price of peaches goes up, the substitution effect (from A to B) clearly suggests the purchase of more strawberries. But the optimal final bundle could be bundle C, which would make strawberries an inferior good.

Quasilinear goods are borderline goods between the set of normal and the set of inferior goods

ANS: T A quasilinear good is a good whose consumption remains unchanged with changes in income --- whereas an inferior good is a good whose consumption moves in the direction opposite to income and a normal good is a good whose consumption moves in the same direction as income.

All quasilinear goods are necessities

ANS: T Consumption of quasilinear goods does not depend on income --- which means that, as income increases, consumption does not change. Necessities are goods whose consumption increases by less than the percentage increase in income, which is true if consumption does not change at all with income.

All homothetic goods are normal goods

ANS: T Homothetic goods are goods whose consumption changes at the same rate (and in the same direction) as income --- which makes them normal goods.

The price of peaches goes up and I observe you buying fewer strawberries. This implies strawberries must be a normal good

ANS: T In the graph below, the substitution effect (from A to B) tells us that more strawberries should be consumed. If strawberry consumption decreases from the original A when we get to the final budget, the final bundle C lies below A --- implying it also lies below B. Thus, as income falls (from the dashed compensated to the final budget), strawberry consumption falls, making strawberries a normal good.

Every luxury good is a normal good but not every normal good is a luxury

ANS: T Luxuries are goods whose consumption increases with income by a bigger percentage than income --- so they are normal goods (whose consumption moves in the same direction as income). But a good whose consumption increases with income at a rate less than income is still a normal good without being a luxury good.

Bag of chips and bottles of salsa are perfect complements for consumer who eats only chips and salsa, but a bottle of salsa costs $1 more than a bag of chips. The income effect of a 50 cent increase in the price of a bag of chips will be fore the consumer to eat fewer chips and less salsa.

ANS: T When two goods are perfect complements (in a 2-good model), both are normal goods.