Chapter 25

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FT1. The table below shows the marginal utility a consumer receives from the weekly consumption of
On-Demand movie rentals and Thai takeout meals. One On-Demand movie rental costs $5, and Thai
takeout costs $10 per meal. Suppose this consumer is currently (for some reason) eating Thai takeout
10 times per week and is spending all of her $100 income, so that she has no money left over for movie
rentals. Is the consumer maximizing utility?
A.
The first movie would provide 50 utils of utility, and the
second movie provides 30 utils of utility. So, if the
consumer gave up one Thai meal, the consumer would
lose 5 utils of utility but gain 50 + 30 = 80 utils from the
two movies she could consume. So, it is clear that the
consumer is not maximizing utility.

Another way to see this is to note that the first movie has
MU/$ = 50/$5 = 10, and the tenth Thai meal has MU/$ =
5/$10 = 0.5. The “bang for the buck” is very far from being
equal—and that condition is necessary for utility
maximization.
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FT2. Imagine that for the past two years, you’ve consumed only two goods: lattes and scones. As
you’re probably aware, prices tend to go up over time. If the price of your lattes increased from $2
to $3 over the last two years, and the price of scones increased from $1.50 to $2.25, what impact
would this have on your budget constraint if your $240 weekly take-home pay didn’t change at all
over the same two-year period? Draw both budget constraints on the same set of axes. What if you
were able to negotiate a raise to $360 per week? Draw this final budget constraint on the same set
of axes as the first two. How does your final budget constraint compare to your original budget
constraint from two years ago?

A: When the two prices change, they both go up by 50%, so

the price ratio (the slope of the budget constraint) would not
change. Rather, the budget constraint would shift inward, as
shown in the diagram below. After the raise is negotiated,
income rises by 50% as well, so the budget constraint would
return to the original position.
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FT4. Fill in the blanks below with either “good X” or “good Y,” where good X is measured
on the x-axis and good Y is measured on the y-axis (vertical axis).

a. If the price of ____ is $8, and the price of ____ is $12, then the price ratio (also the slope of
the budget constraint) is 1.5.
[A. good Y / good X]

b. A price ratio of 1.5 means that the consumer is able to trade 1 unit of ____ for 1.5 units of
____.
[A. good X / good Y]

c. If another unit of ____ would give a consumer 20 extra units of utility, and another unit
of ____ would give a consumer 10 extra units of utility, then the marginal rate of
substitution for this consumer is equal to 2.
[A. good X / good Y]
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d. A marginal rate of substitution of 2 means that, from the consumer’s point of
view, 1 more unit of ____ is as good as 2 more units of ____.
[A. good X / good Y]

e. If the price ratio is 1.5, and the marginal rate of substitution is 2, then the
market values ____ more than the consumer does, and the consumer values ____
more than the market does. In this case, the consumer ought to buy less of ____
and more of ____.
[A. good Y / good X / good Y / good X]

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FT5. Suppose Haya has $120 of income left each week after she pays her bills and
puts some money away in a savings account, and she has two ways to spend this
extra money: go to the movies which costs $18 with popcorn and soda or go out to a
club which costs $33 including the cover charge and drinks. Assuming these are her
only two choices to spend the extra money, what can you say about the following
bundles of going to the movies and clubbing? Which of these could possibly be the
utility-maximizing bundle?

a. 3 movies and 2 nights out at the club

b. 2 movies and 3 nights out at the club

c. 2 movies and 2 nights out at the club

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A.
a. This bundle would cost $54 + $66 = $120. This bundle is on the budget
constraint. It is the only one that could possibly be the utility-maximizing bundle.

b. This bundle would cost $36 + $99 = $135. This bundle is beyond the budget
constraint and is too expensive for Haya. This cannot be her utility-maximizing
bundle because she cannot afford it.

c. This bundle would cost $36 + $66 = $102. This bundle is below the budget
constraint. If Haya purchased this bundle, she would have $18 left over that she
could use to see another movie. If she likes movies (which she does), then it would
be wasteful not to use that $18 to see another movie. This cannot be Haya’s utility-
maximizing bundle, because she forgoes the opportunity to consume more.

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FT6. The utility-maximizing bundle of goods is found at the point of tangency between the
budget constraint and an indifference curve. In the diagram below, the utility maximizing
bundle is the one labeled point K. There are two different, but equally important, ways to
interpret this point.
a. Of the three points on the consumer’s budget
constraint ( J, K and L ), what makes K special?

A. Point K is special because, of all of the points on the

budget constraint, it provides the most utility.

b. Of the three points on the consumer’s indifference

curve (M, K and N), what makes K special?

A. Point K is special because, of all of the points on that

indifference curve, K is the cheapest. (Or, stated
differently, it is the only one that is affordable.)
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PS1. Suppose we wanted to investigate the saving and borrowing behavior of
consumers. It’s not that hard to extend our basic model. We can use the same
framework as before but define our two goods as “consumption in period 1”
(horizontal axis) and “consumption in period 2” (vertical axis).

a. Construct a budget constraint for a consumer who earns $50 in income in period 1
and $150 of income in period 2. Label this point E for the “Endowment” point.
Assume that the individual can choose to save some income in period 1 to be used in
period 2, or to borrow some income from period 2 to use in period 1. (Let’s imagine
the consumer saves the money by putting it in a piggy bank and can borrow money
from parents, who don’t charge interest.)

b. For the consumer in the situation described above, do you think he would
consume at their endowment point or would he borrow or save?
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A.
a. The budget constraint would be drawn as a
straight line from $200 of consumption in period 1
to $200 of consumption in period 2, as seen below.
The endowment point E is at ($50, $150).

b. Since most consumers prefer to smooth out their

consumption as much as possible rather than
having wide swings in consumption from year to
year, this consumer would probably borrow in
period 1 so that consumption could be closer to
equal in both periods. If the consumer wanted to
make consumption exactly equal, he or she would
borrow $50 in period 1, and consumption in both
periods will be $100.
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PS3. Consider FT2. Explain the income and substitution effects of the price
changes on your optimal consumption bundle when the latte and scone prices
increased, but your income did not.

A. When the two prices changed, the price ratio did not change: the price of a
scone was still 25% less than the price of a latte. Since income did not also
increase, the budget constraint shifted inwards. Because the price ratio did not
change, there would be no substitution effect at all—only an income effect.
Though dollar income did not change, real income fell because the same dollar
income didn’t go as far. The income effect would cause a decrease in the
consumption of both scones and lattes, assuming they are both normal goods.

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PS4. With inferior goods (like ramen noodles), the income effect works in the opposite
direction from the income effect discussed in the text. If a consumer feels richer, she would
buy less of an inferior good. If she feels poorer, more.

a. Suppose that a consumer eats two different foods: potatoes and meat. Potatoes are
inferior and meat is a luxury. Describe both the income and substitution effects on the
consumer’s optimal choice of potatoes and meat if the price of potatoes were to rise. Put
the two effects together. What can you conclude?

A. If the price of potatoes were to rise, the substitution effect would cause the consumer to
purchase fewer potatoes and more meat. The price increase, however, makes the consumer
feel poorer, so the income effect would be to buy less meat (since it is a luxury) and more
potatoes (since it is inferior). When the two effects are combined, it is impossible to say
what will happen, without knowing which effect dominated.

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b. What if you knew for sure that the substitution effect dominated the income effect? What
would happen to the consumer’s optimal choices for potatoes and meat?

A. If the substitution effect dominated, then the consumer would purchase more meat and
fewer potatoes after the increase in the price of potatoes.

c. What if instead you knew that the income effect dominated the substitution effect? What
would happen in this case? Why is this result a bit unusual?

A. If the income effect dominated, then the consumer would purchase less meat and more
potatoes after the increase in the price of potatoes. This is unusual because the consumer is
responding to an increase in the price of potatoes by purchasing more potatoes, which
appears to violate the law of demand. Economists call a good that people consume more of
as the price rises a Giffen good. Giffen goods cannot be ruled out in theory but there are few
convincing examples in practice.
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PS6. In this chapter, we focused a lot on budget constraints, but time is an additional
constraint that consumers face. Jackson has $40 per week to spend on leisure activities.
He likes to bowl and to play racquetball. Bowling costs $4 per game, and a day pass to
the racquet club costs $8. Jackson only has 7 hours of leisure time per week, and both
bowling and racquetball each take 1 hour per game. Construct Jackson’s budget
constraint and his time constraint on the same diagram. Consider each of the
consumption bundles below that could possibly be Jackson’s utility-maximizing bundle.
How does each of these bundles relate to Jackson’s two constraints?

a. Bowling twice per week and playing racquetball four times per week
b. Bowling four times per week and playing racquetball three times per week
c. Bowling six times per week and playing racquetball once per week

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a. Bowling twice per week and playing racquetball four b. Bowling four times per week and
times per week playing racquetball three times per week

A. This bundle is on the budget constraint, but not the A. This bundle is on both of Jackson’s
time constraint. This means that Jackson would have constraints. (It is at the intersection of
leftover time, during which he would like to bowl or the two.) This means he would have
play racquetball, but no money left over to spend on neither left over time nor left over
either activity. money.

c. Bowling six times per week and

playing racquetball once per week

A. This bundle is on Jackson’s time

constraint but not his budget constraint.
This means that Jackson would have
money left over that he would like to
spend on bowling or racquetball, but no
time to engage in either activity.
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