Economic Principles 2020 - 2021

Week 4, Tutorial Sheet 3, ANSWERS

This tutorial sheet is based around chapter 5 of Mankiw and Taylor “Economics”.
Students are required to have read this chapter before the tutorial. Your tutor may not
have time to go over all questions in tutorial; however, students are responsible for revising
the answer sheets on their own time.

Chapter 5 of the textbook relates to the theory of consumer choice, the background
to demand.

1. Each of the following consumers exhibit behaviour that violates one of the
basic assumptions of consumer preferences. Identify the assumption that is
violated for each individual.

a. Arthur says that he can watch 2 movies a week but could not be paid
to watch another movie after that.

b. Alex says that he prefers going to a movie over hiking. He also

indicates that he prefers hiking to swimming. Alex then states that he
would rather go swimming than go to a movie.

c. Alicia says that she prefers hiking to watching a movie but can not
determine her preferences for swimming.

Answer: Arthur violates the assumption that consumers desire more of a good to
less. Alex’s preferences violate transitivity. Alicia violates the axiom of
comparison.

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2. Draw a set of indifference curves for the following pairs of goods:

a. Hamburgers and carrots for a vegetarian who neither likes nor dislikes
meat.

Answer:

b. Peanut butter and jelly for an individual that will not eat peanut butter
sandwiches or jelly sandwiches, but loves peanut butter and jelly
sandwiches made with two parts peanut butter and one part jelly.

Answer:

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 c. Tickets for Knottʹs Berry Farm (KBF) and Universal Studios (US) for a
tourist that believes that KBF and US are perfect substitutes.

Answer:

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 d. Ice cream and pie if these are goods that you like, but if you consume
enough of either, you get sick of them. If you are sick of a good,
consuming more of it lowers your utility.

Answer:

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 3. Angus has an income of £1000 per month. Living in Scotland, he only has
access to two goods, Haggis and Scotch (Whisky). Draw Angus’ budget line.
What is the slope of this budget line? Discuss and show in the graph the
implications of

a) a £100 increase in his income

b) an increase in the price of Scotch.

Answer:

The slope of the budget line is the ratio of prices PH / PS.

[See that the equation for the budget constraint is given by PH*H + PS*S = I or PH*H
+ PS*S = 1000.

If we rearrange,

(subtracting PH*H from both sides) PS*S = 1000 – PH*H

(dividing both sides by Ps ) S = 1000/ PS – (PH / PS ) * H

As expected the slope is negative.]

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a. a £100 increase in his income will make him ‘richer’ by making more
consumption bundles affordable for him. This is depicted as an
outward (to the right) parallel shift of the budget line.

b. an increase in the price of Scotch will imply that Angus can now
afford to buy less Scotch with his income. The budget line pivots
inwards.

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4. Assuming that both Haggis and Scotch are normal goods, draw Angus’
indifference curve map.

a) What does an indifference curve represent?

b) What is the slope of the indifference curve? Show how this would
differ in the case of perfect substitutes and perfect complements.

c) Given Angus’ budget line in question 3, show the point of optimal

choice.

Answer:

a. An indifference curve shows all the consumption bundles of Haggis

and Scotch that give Angus the same level of satisfaction.

b. The slope of the indifference curve is not constant along the curve and
is equal to the negative of the MRS. MRS = MUH / MUS, where MRS is
the rate at which Angus is willing to trade Scotch for Haggis (that is,
how much Scotch Angus requires to give up one unit of Haggis).

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Normal Good - Perfect Substitutes

Normal Good - Perfect Supplements

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 c. Angus will choose that point on his budget line that corresponds to the
highest indifference curve. At this point the slope of the indifference
curve equals the slope of the budget line, that is, MRS = PH / PS.

5. Imagine there is an outbreak of ‘mad sheep’ disease, which wipes out a

considerable portion of the sheep population in Scotland. This results in a
shortage of Haggis and an increase in its price.

a) Show the effect of this price increase on Angus’ budget line and
optimal choice, and explain the forces underpinning this outcome.
(Hint: Consider substitution and income effects).

b) Assuming that Haggis’ price continues to increase over the

subsequent months, derive the demand curve for Haggis.

c) Discuss the income and substitution effects within the context of

this price increase assuming that Haggis is an inferior good.

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Answer: (see also Giffen good)

a. When the price of Haggis increases, two things happen that will affect how
many (units of) Haggis Angus wishes to purchase given the new PH .

First, Haggis becomes relatively more expensive. The price ratio (the price of
Haggis divided by the price of Scotch) will change. Because Haggis is now
relatively more expensive and Scotch is relatively cheaper, consumers will
naturally substitute towards the cheaper good. This is called the substitution
effect. The optimal bundle will change because the price ratio has changed. The
substitution effect always works in this direction. Consumers always tend to
consume more of the cheaper good.

But this is not the only thing that happens when Haggis becomes more
expensive. When the price of Haggis increases, the consumer’s purchasing power
decreases. For buying the same quantity of Haggis as before more money are
needed now. It is as if income has decreased.

Because Angus’ purchasing power (effective income) has changed, the optimal
consumption bundle will also change. This is called the income effect.

The direction of the income effect will depend on whether the Haggis is a normal
or an inferior good.

If Haggis is a normal good, the increase in effective income will cause the
consumer to purchase more of it.

When combining the two effects after a price increase, Haggis consumption will
unambiguously decrease if Haggis is a normal good.

– The substitution effect decreases Haggis consumption.

– The income effect decreases Haggis consumption.

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b. We keep drawing the above graph for further increase in the price. And then
demand curve.

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c. If Haggis is an inferior good, the decrease in effective income will cause Angus to
purchase more Haggis. When combining the two effects after a price increase, it
is not clear what will happen to Haggis consumption if Haggis is an inferior
good.

- The substitution effect decreases Haggis consumption.

- The income effect increases Haggis consumption.
- The total effect depends on which effect is stronger.

6. Consider the change in income in question 3 and assume that Angus’ income
increases by £100 every month.

a) Draw the income expansion path and the corresponding Engel

curve for each good.

b) Now assume that Angus has to make a consumption choice

between Mash Potato and Scotch. (Treat the Mash Potato as an inferior
good!). Draw the new income expansion path and the new Engel
curves and discuss differences with those in part a).

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Answer:

a)

Engel curve will be similar for Scotch.

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b) For the inferior good Mash Potato, this will be the income expansion path

While the Engel curve will look like

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 7. Angus is looking to buy a new mobile phone. He really likes the iPhone 6s but
all the professional reviews he has read online indicate that the new Samsung
Galaxy S6 would be a better choice. At that moment his flatmate Fergus
returns home and tells him how cool the new iPhone 6s is. Which phone
would you expect Angus to buy according to the standard economic model?
Do you think he would actually behave in this manner?

Answer: Samsung Galaxy S6. No, he would probably go for the iPhone 6s. People
have a natural tendency to look for examples that confirm their existing views or
hypothesis (see ‘naïve empiricism,’ p. 105 of your textbook) or they are reluctant to
change their minds by interpreting evidence to confirm the beliefs they already hold
(see also p. 105).

8. Jane lives in a dormitory that offers soft drinks and chips for sale in vending
machines. Her utility function is U = 3SC (where S is the number of soft
drinks per week and C the number of bags of chips per week), so her
marginal utility of S is 3C and her marginal utility of C is 3S. Soft drinks are
priced at £0.50 each, chips £0.25 per bag.

a. Write an expression for Janeʹs marginal rate of substitution between

soft drinks and chips.

b. Use the expression generated in part (a) to determine Janeʹs optimal

mix of soft drinks and chips.

c. If Jane has £5.00 per week to spend on chips and soft drinks, how
many of each should she purchase per week?

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Answer:

a.
MU S
MRS =
MUC
3C C
MRS = =
3S S

b. The optimal market basket is where

PS
MRS =
PC
C 0.5
MRS = =
S 0.25
C
= 2, C = 2S
S

Jane should buy twice as many chips as soft drinks.

c. Jane must satisfy her budget constraint as well as optimal mix. Her
budget constraint is:

I = PS S + PC C

5 = 0.5S + 0.25C

But she must also satisfy C = 2S, the optimal mix. Substitute 2S for C into
budget constraint

5 = 0.5S + 0.25(2S)
5 = 0.5S + 0.5S
5=S

Buy 5 soft drinks.

Substitute into either expression to obtain C

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 C = 2S
C = 2(5)
C = 10

Jane should spend her £5.00 to buy 5 soft drinks and 10 bags of chips.

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