Solution Manual for Microeconomics for Today 8th

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Chapter 5
Applying Consumer Theory

◼ Chapter Outline
Challenge: Per-Hour Versus Lump-Sum Childcare Subsidies
5.1 Deriving Demand Curves
Indifference Curves and a Rotating Budget Line
Price-Consumption Curve
Application: Smoking Versus Eating and Phoning
The Demand Curve Corresponds to the Price-Consumption Curve
Solved Problem 5.1
5.2 How Changes in Income Shift Demand Curves
Effects of a Rise in Income
Solved Problem 5.2
Consumer Theory and Income Elasticities
Income Elasticities
Income-Consumption Curves and Income Elasticities
Some Goods Must Be Normal
Application: Fast-Food Engel Curve
5.3 Effects of a Price Change

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 Chapter 5 Applying Consumer Theory 67

Income and Substitution Effects with a Normal Good

Solved Problem 5.3
Solved Problem 5.4
Income and Substitution Effects with an Inferior Good
Solved Problem 5.5
*Compensating Variation and Equivalent Variation
Application: What’s Your Smart Phone Worth to You?
5.4 Cost-of-Living Adjustments
Inflation Indexes
Real Versus Nominal Prices
Calculating Inflation Indexes
Effects of Inflation Adjustments
CPI Adjustment
Application: Paying Employees to Relocate
*True Cost-of-Living Adjustment
Size of the CPI Substitution Bias
5.5 Deriving Labor Supply Curves
Labor-Leisure Choice
Income and Substitution Effects
Solved Problem 5.6
Shape of the Labor Supply Curve
Application: Working After Winning the Lottery
Income Tax Rates and Labor Supply

◼ Teaching Tips
This chapter contains a great deal of important material and requires several classes to cover effectively.
I find that covering the price consumption curve, Engel curve, and the derivation of demand curves usually
takes me about one 70-minute period. The material is not intuitively difficult, but students need to be clear
about these concepts in order to have the substitution and income effect material make sense. You may want
to spread the presentation of the substitution and income effects over more than one period because students
will benefit from having some time to process the first run-through, as well as refer back to the book.
The Challenge is a good way to introduce the topics covered. You might discuss why a family might make
different decisions when they are given a lump sum subsidy versus a per-hour subsidy. Then as you go
through the material in the chapter, you can refer back to the childcare Challenge. It is also a slightly
different approach to the income tax rates section, with the per-hour subsidy being a negative tax on
childcare.

When presenting the substitution and income effects, try to set up the presentation such that the class can
take good quality notes on the graphs. When students come in for help on this material, you might go through
their notes with them. What you are likely to discover is that hurriedly drawn indifference curves and freehand
wobbly budget constraints have led to a graph that looks almost nothing like the one you put on the board.
They may have the imaginary budget line drawn so that it intersects the original point of tangency, which
leaves them with no substitution effect. To minimize this problem, in addition to reminding them to bring in
a protractor and colored pencils with which to take notes, I do the following: The first time I demonstrate the
separation of the total effect into the two component effects, I replicate an example that is in the text (such as
the live music and music tracks example in Figure 5.4). I tell the class that I am doing this but ask them to

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68 Perloff • Microeconomics, Eighth Edition

take notes as they normally would rather than just watch me and look at the book. This way, if they make
errors in note taking, they can refer to the text to see the correct graph. The other thing that can be helpful
is to supply them with pre-drawn indifference curves because this is where most of the trouble occurs. For
example, if they draw their curves much differently than yours when you are demonstrating the separation of
income and substitution effects for an inferior good, theirs may not turn out to be inferior. Another
possibility is to give the class coordinates of points that make up the needed indifference curves. It may be
useful to assign a number of substitution and income effect questions as homework, some with supplied
graphs and some where students draw their own graphs. I find that the more practice that students get
drawing the graphs, the more comfortable they become.

The section on CPI and inflation indexes is an important tool for students to understand. News articles
often compare prices across years without accounting for inflation. Where the inflation figures come from,
the different indexes that can be used and the CPI substitution bias are important concepts that can easily
be applied outside of class.

The inclusion of the labor supply curve and the labor-leisure trade-off in this chapter is another good way
to make the point of the importance of the substitution and income effects. Solved Problem 5.6, about
Enrico’s scholarship, is a good place to start a class discussion. You might ask students to think about their
own work decisions and how they depend on the support they receive from their parents or from other
sources. The effect of income taxes on labor supply is also a good discussion topic. The text describes the
attempts by the Kennedy, Reagan, and George W. Bush administrations to increase both work effort and tax
receipts by decreasing marginal tax rates at the highest levels. If there is time, you might point out the
normative nature of “fair” marginal tax rates and that, while a primary issue for individuals is fairness,
another important aspect of the setting of tax rates is how they may affect work effort and thus revenues. It
may be the case that in order to construct tax proportions that the majority feels are fair, rates would have
to be higher than another scheme judged to be almost as fair but with lower rates and greater work effort.
The inverted-U curve in text Figure 5.10 is useful when discussing optimal tax rates. The fact that the
United States is far below the peak of the curve and the economic implications with respect to efficiency
and redistribution may be worth discussing. It would never be optimal to tax beyond the peak of the
curvebecause that would further distort the economy without increasing tax revenues. You might ask
students where on the curve would be optimal, and what other factors, such as economic growth and
redistribution, determine that choice.

As an extension of this section, you may want to discuss in class or assign as homework Question 7 in the
following Additional Problems section. This question requires the students to construct a piece-wise linear
budget line due to changes in the marginal tax rate as hours worked increases.

◼ Additional Applications
Rats Treat Quinine Solution as a Giffen Good1
Economists have long sought empirical confirmation of the Giffen good phenomenon—the occurrence of
a negative income effect so large that it overwhelms the substitution effect, creating a positively sloped
demand curve. Battalio, Kagel, and Kogut (1991) used a novel experimental procedure to demonstrate
that, within a certain income range, the Giffen phenomenon can occur at the individual level.

The authors began by providing six rats with the opportunity to consume liquid in the form of root beer,
a quinine solution (0.1 gram per liter), and water. The rats strongly preferred root beer to water and water
to quinine solution. Given these preferences, root beer was chosen as the normal good and quinine was
intended to serve as the Giffen good. In the experiment, the rats could “purchase” each liquid by pressing

1
Raymond Battalio, John H. Kagel, and Carl A. Kogut, “Experimental Confirmation of the Existence of a Giffen Good,”
American Economic Review, 81(4) September 1991:961–70.

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on a wall-mounted lever (one for root beer, one for quinine) in their cage. Income was controlled by fixing
the number of presses that would produce liquid. The rats could allocate their total presses across the two
levers in whatever proportion they chose.

The authors first searched for an income range in which quinine was strongly inferior (a necessary condition
for producing the Giffen phenomenon). They then imposed income-constant price changes at these income
levels to demonstrate the Giffen effect. The quinine price was changed by altering the amount received
per lever press. As the price went up, less quinine was received per press.

Of the six rats tested, three produced a Giffen response, and three did not. Not surprisingly, the Giffen-
response-producing rats were the same three that had treated quinine as a strongly inferior good in the
income range that was tested. The other three rats, for whom quinine was not strongly inferior, did not
exhibit the Giffen phenomenon.

The authors concluded that the Giffen good is observed rarely for two reasons. First, it is difficult empirically
to generate (or to observe in human experience) the “initial conditions of strong inferiority that the theory
calls for.” Further, when the responses were averaged across rats to produce a market effect, the effect was
not significantly different from zero. Thus, although some individuals did exhibit the Giffen phenomenon
in a specific income range, the heterogeneity of preferences and income levels across individuals makes
the observation of the Giffen phenomenon at the market level extremely unlikely.

1. The authors were able to demonstrate this result only at very low income levels. Why would this be
so?

2. Does this experiment reinforce or weaken the theory of choice?

Job Sharing May Help Workers to Maximize Utility

The model of labor supply presented in the chapter assumes that workers are free to choose the number of
hours that they work. However, in many occupations, employers typically do not offer part-time work, and
workers are constrained to full-time work. For workers who would choose to work any number of hours
per week other than 40, this alters their utility-maximizing hours choice and so reduces utility. For those
workers with a high preference for income who would like to work more than 40 hours per week, they
may be able to increase their income by working part-time at a second job. However, for those employees
who would like to work less than 40 hours per week, they could face the choice of working more than
they would like, or not at all. Job sharing is a relatively recent labor market innovation that can provide
a solution. In job sharing, two employees work as partners and share a single full-time position. The
employees receive the benefit of knowing that they have full-time coverage (and maybe even better than
full-time coverage if one partner can cover for the other during vacations and sick time), while the
employees receive the benefit of being able to choose fewer hours of labor market participation and can
devote more time to either leisure or work in the home. Partners may be spouses (as sometimes occurs in
academia when spouses with similar training share a single position) or completely unrelated individuals
who have significant at-home responsibilities that make full-time work undesirable. Employers have
responded to the increased demand for shared jobs. USA Today reports that as many as 28% of firms offer
job sharing. Those interested in sharing a job can even use Internet search services specifically designed to
match partners.2

1. Use a graph similar to Figure 5.8 in the text to show an individual who is constrained to working
40 hours per week but would prefer to work less (i.e., her utility would be higher if she could choose
another point on the budget line with about half as many hours of work).

2
Jerry Langdon, “Job Sharing Programs on the Upswing,” at http://www.usatoday.com/careers/news/2001-01-26-jobsharing.htm,
and “Job Share Partner Search,” at http://www.womans-work.com/job_share_search.htm. Accessed 1/1/03.

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2. Show how the individual in the graph would benefit from job sharing. It may help to assume that
there are two individuals with the same taste for market work.

◼ Discussion Questions
1. What kind of experiment could a firm conduct to determine the demand curve it faces?

2. Suppose the government wants to discourage consumption of some good (such as cigarettes or
liquor). How effective will specific taxes and lump sum taxes (a pure reduction in income) be in
reducing consumption? What type of information do you need to answer this question?

3. How can the firm use the information contained in an Engel Curve and government forecasts of
income to predict future demand?

4. Are you aware of any Giffen goods? What types of goods might these be?

5. Should the government try to pick the marginal tax rate to maximize government revenue?

6. Think of several goods that, at your current income level, you would consider normal, others that you
would consider inferior. Try to determine the defining characteristics of normal and inferior goods by
evaluating your list. What do the two groups have in common? How are they different from each other?

7. In the United States, Social Security is tied to the CPI-W, a consumer price index for urban and wage
earners. What are the advantages of this index over the more general CPI? How does the welfare of
Social Security recipients depend on the distribution of price changes across the goods in the basket?

◼ Additional Questions and Problems

1. Suppose the government wants to increase the ability of families to pay for college education. Would
a $500 income tax rebate differ from a $500 tax credit for tuition reimbursement? Explain.

2. True, False, or Uncertain; explain your answer. When income rises and the price of x falls, the
consumer will always buy more units of x.
3. Suppose that a consumer’s annual demand for office visits is described by the equation Q = 8 – 0.1p.
If office visits cost $30, and the consumer has no health insurance (i.e., the consumer pays full price),
how many office visits will she make? What is the elasticity of demand for office visits at this point?
Suppose a health insurance plan is instituted that pays for one-third of each office visit. How would
this affect the quantity and the demand elasticity at the new equilibrium?
4. A consumer faces prices for hot dogs and hamburgers of $1 each. Consumption of the two commodities
at various weekly income levels are shown below.

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 Chapter 5 Applying Consumer Theory 71

a. Use the information to sketch the income consumption curve on a graph.

b. Draw the Engel curves for hot dogs and hamburgers.

Income Hot Dogs Hamburgers

$10 3 7
15 6 9
20 10 10

c. What is the income elasticity of hot dogs for this consumer as income increases from $10 to $15?
5. Draw a graph with arcade games on the horizontal axis and newspapers on the vertical axis. Joe has
$10 per week to allocate between these commodities. The price of newspapers is $0.50. At the initial
price for arcade games of $0.25, Joe purchases 10 newspapers and plays 20 games. When the price of
games increases to $0.50, Joe purchases 8 newspapers and plays 12 games. When the price of games
increases again to $0.75, Joe buys 5 papers and plays 10 games.
a. Use this information to draw the utility maximizing points on a graph.
b. Draw the price-consumption curve.
c. Draw the individual demand curve for arcade games.
d. Use the information given to calculate Joe’s elasticity of demand for arcade games between
$0.25 and $0.50, and between $0.50 and $0.75.
6. Sarah allocates her income of $5.00 between the consumption of donuts and coffee. Her tastes and
preferences are indicated by the indifference curves shown in Figure 5.1. The price of donuts is
$0.50 each. Initially, the price of coffee is $1.00 per cup. Subsequently, the price of coffee falls to
$0.50 per cup. On the following graph, show the initial utility-maximizing position, the new utility-
maximizing position, and separate the income and substitution effects. For Sarah, is coffee a normal
or inferior good?

Figure 5.1

7. What would the value of the substitution effect be for two goods that are perfect complements? Use a
graph to demonstrate your answer.

8. What happens to the magnitude of the overcompensation due to the use of the CPI in Figure 5.5 of
the text if one views food and clothing as perfect complements?

9. Draw a graph showing the utility-maximizing labor and leisure choices for the typical lottery winner
described in the “Working After Winning the Lottery” application (the individual who wins $55,200
and decreases earnings by $1,877/yr). What does this change in work effort indicate about the

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standard assumption that working reduces an individual’s utility level? (Assume the individual’s
annual income was $16,100 prior to winning the lottery.)

10. The basic labor supply model presented in this chapter assumes that wage income is untaxed. Suppose
instead that a set of marginal tax rates was imposed such that at a wage of $10/hour, the first 5 hours
of labor were untaxed, the next 10 hours of labor were taxed at a 20% rate, and all labor thereafter
was taxed at a 50% rate. Show on a graph how this would affect the budget line. How might this alter
work effort?

11. The welfare program was designed to help low-income families. The benefit from this program is
calculated as the fixed percentage of the maximum benefit minus family income. Explain why this
design may cause an undesirable labor supply effect.

12. The conventional welfare program was replaced by the Earned Income Tax Credit program in 1997.
Under the new program, the benefit is calculated as a fixed percentage of earnings of low-income
families. Explain why this new design helps to encourage labor supply.

13. Suppose Nick’s salary is tied to an inflation index based on the average prices of food and clothing,
with equal weights on each. This year the index (and thus Nick’s salary) increased by 4%. Determine
the effect on Nick’s optimal consumption bundle and welfare if the following occur:

a. The prices of both food and clothing increased by 4%.

b. The price of food increased by more than the price of clothing, and Nick spent most of his salary
on food.

c. The price of food increased by more than the price of clothing, and Nick spent most of his salary
on clothing.

◼ Answers to Additional Questions and Problems

1. Yes. A $500 reduction in income taxes would represent a pure income effect, providing families with
additional disposable income that could be spent on anything (including, but not necessarily, college).
A $500 tax credit for tuition reimbursement would be a price change and so would involve both a
substitution and an income effect but would only be received if the family spent at least $500 on
tuition. All families will be as well or better off with the tax cut as they would with the tuition tax
credit (see Chapter 4). However, the demand for college education would be greater with the tax
credit than with the tax cut.

2. False. In order to make predictions using economic theory, it is best to change only one parameter at
a time. In this case, income rises, and price falls. If the good is inferior, the effects will be in opposite
directions.

3. If the consumer has no health insurance, she will make five office visits per year, and the elasticity
of demand is –0.6. If an insurance plan covers one-third of the cost of an office visit, the consumer’s
quantity will increase and price sensitivity will decrease. By substituting 0.667p into the demand
equation, we can see that the elasticity will fall, as the consumer now reduces visits by 0.0667
when price increases by $1, rather than 0.1. The result is the same as if the price were $20 per
visit instead of $30. The new equilibrium quantity is six visits per year, and the elasticity falls to
–0.33 [= –0.0667(20/6)].

4. a. See Figure 5.2.

b. See Figures 5.3 and 5.4.

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 Chapter 5 Applying Consumer Theory 73

c.  = (3/5)(10/3) = 2.

Figure 5.2

Figure 5.3

Figure 5.4

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74 Perloff • Microeconomics, Eighth Edition

5. a. See Figure 5.5.

b. See Figure 5.5.
c. See Figure 5.6.
d. 1 = (8/–0.25)(0.25/20) = –0.4.
2 = (2/–0.25)(0.50/12) = –0.3.

Figure 5.5

Figure 5.6

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 Chapter 5 Applying Consumer Theory 75

6. To separate the income and substitution effects, draw the imaginary budget line I*. In this case, because
the income effect partly offsets the substitution effect, coffee is an inferior good. See Figure 5.7.

Figure 5.7

7. Because the indifference curves are L-shaped, the substitution effect is zero. When the imaginary
budget line is drawn tangent to the original indifference curve, it passes through the same point as the
original tangency (e1). Thus, there is only an income effect. See Figure 5.8.

Figure 5.8

8. If the consumer views food and clothing as perfect complements, there is no bias. Indifference curves
will have the characteristic “L” shape. Restoring Klaas’s purchasing power to the original bundle
does not create an opportunity to increase his utility because he does not benefit by substituting away
from clothing toward food.

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76 Perloff • Microeconomics, Eighth Edition

9. See Figure 5.9. The individual’s budget constraint (wage line) shifts upward to reflect an increase in
nonlabor income. The slope of the constraint does not change because labor income is still earned
at the same wage rate. As described in the example, the individual works only fewer hours (hours
worked fall from H1 to H2) but does not retire completely. Earned income falls to $14,223.

Figure 5.9

This supports the assumption that working reduces an individual’s utility level because the individual
receives positive utility from leisure, and when total income increases they demand more leisure and
supply less labor. However, they do not stop working altogether even though their income level
without working is greater than their income was previously. This is because the marginal benefit
from their hourly wage is greater than the marginal utility from the 24th hour of leisure.
10. When the marginal taxes are imposed, the budget constraint becomes nonlinear. Beginning at zero
hours of labor (24 hours of leisure) until labor supply is equal to five hours, the slope of the budget
line is –w, the wage rate. Thereafter the after-tax rate drops to $8, reducing the slope of the budget
line, shown as line segment TR in Figure 5.10. This rate is in effect from the 6th through the 15th
hour worked. Thereafter the net wage falls to $5 per hour, again changing the slope (segment RP).
The dashed line shows the wage line without the tax. The effect of the tax is to reduce the price of
leisure but also to reduce the ability to buy leisure. Depending on whether the income effect or the
substitution effect is dominant, the individual may work more or less. In Figure 5.10, the indifference

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 Chapter 5 Applying Consumer Theory 77

curves shown result in the individual reducing work effort from H1 to H2 and increasing leisure
(substitution effect dominant).

Figure 5.10

11. Under the welfare program’s benefit calculation formula for low-income families, the more they
work, the less benefit they would receive from the government. Hence, this program generates
a negative substitution effect that discourages people’s labor supply. In fact, for people earning
minimum wage, the maximum benefit they could get from welfare is comparable to having a full-
time minimum-wage job. Hence, the income effect of working is close to zero for many people,
further reinforcing the substitution effect.

12. Under the Earned Income Tax Credit program, people get earning subsidies, which is a fixed
percentage of their earnings. This program essentially raises their after-tax wage rate. If, for low-
income families, the income effect dominates the substitution effect, this new program design might
help to encourage people’s labor supply.

13. a. If food and clothing increase by the same amount, Nick’s budget constraint does not change, and
his optimal bundle remains the same. Thus, there is no welfare effect.

b. If the price of food increases by more than the price of clothing, the slope of Nick’s budget
constraint will change. Nick will substitute from food to clothing, but because he was spending
most of his money on food, his welfare will likely decrease (left-hand graph).

c. If the price of food increases by more than the price of clothing, the slope of Nick’s budget
constraint will change (become steeper). Nick will substitute from food to clothing, but because
he was spending most of his money on clothing, his welfare will increase (right-hand graph).

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78 Perloff • Microeconomics, Eighth Edition

The red line is the new budget line with the change in prices, and the increase in income.
The blue line is Nick’s original budget line.

Clothing Clothing

Food Food

◼ Answers to Textbook Questions

1.1 Downward-sloping and horizontal price-consumption curves are illustrated in the figure
below.

1.2 As Mimi moves from E1 to E2 on her demand curve (in the bottom graph of Figure 5.1 in the
chapter), her utility increases. This is exemplified by e2 being on a higher indifference curve than
e1 in the top diagram of Figure 5.1. This illustrates that utility (or well-being) increases as we
move down along a demand curve because the good’s price decreases.

1.3. Let’s say Olivia likes one scoop of ice cream with each piece of pie, each piece of pie costs $8, a
scoop of ice cream is $2, and Olivia’s pie and ice cream budget is $60. In the top panel of the
following figure, we can plot her indifference curve (a 90-degree angle) where it intersects the
budget line to allow for 6 pieces of pie with ice cream. As the price of pie declines, the new budget

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 Chapter 5 Applying Consumer Theory 79

curve will intersect new, higher indifference curves. Panel (b) shows the resulting demand curve
for pie.

1.4 The demand curve for manufactured diamonds depends in part on whether the price of
manufactured diamonds is greater or less than the price of real diamonds. If the price of real
diamonds is less than the price of manufactured diamonds, the quantity demanded of
manufactured diamonds is zero. If the price of manufactured diamonds is less than the price of real
diamonds, then consumers purchased all manufactured diamonds, and thus q1 = Y/p1, where M and
N are the price and quantity demanded of manufactured diamonds, respectively.
1.5 In the previous problem, consumers would simply purchase all manufactured diamonds or all real
diamonds, depending on which had the lowest price. Because the marginal utility of both types of
diamonds is decreasing, but they still enter the utility function additively and symmetrically,
consumers will still purchase all of the cheapest diamond form but will simply receive less utility
than they would have in the previous problem.
1.6 In poorer countries, smokers are giving up cigarettes to buy cell phones. As cell phones have
recently become affordable in many poorer countries, the price ratio of cell phones to tobacco has
fallen substantially.
According to Labonne and Chase (2011), in 2003, before cell phones were common, 42% of
households in the Philippine villages they studied used tobacco, and 2% of total village income
was spent on tobacco. After the price of cell phones fell, from 2003 to 2006, ownership of the
phones quadrupled. As consumers spent more on mobile phones, tobacco use fell by one-third in
households in which at least one member had smoked (so that consumption fell by one-fifth for
the entire population).
Assume that the price of cell phones on budget line L1 is p1. Then the price of cell phones
decreases to p2, pivoting the budget line to L2.
The price-consumption curve is the line through the optimal bundles that an individual would
consume at different prices. Use the information in the price-consumption curve to draw the

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80 Perloff • Microeconomics, Eighth Edition

demand curve. Corresponding to each price on the vertical axis, record on the horizontal axis the
quantity demanded from the price-consumption curve, as illustrated.

1.7 Marginal rate of substitution (MRS) is the maximum amount of one good a consumer will
sacrifice to obtain one more unit of another good. The marginal rate of substitution of burritos for
pizza equals
0.25Z −0.75 B 0.75 B
MRS = − 0.75 −0.25
=− .
0.75Z B 3Z
Marginal rate of transformation (MRT) is the trade-off the market imposes on the consumer in
terms of the amount of one good the consumer must give up to obtain more of the other good.
Because the budget constraint is
pZZ + pBB = Y,
the slope of the budget line, which equals the marginal rate of transformation, MRT, is
pZ
MRT= − .
pB

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 Chapter 5 Applying Consumer Theory 81

Lisa optimizes utility such that

MRS = MRT
B p
= Z
3Z p B
3 pZ Z
B= .
pB
Substituting this into the budget constraint,
pZZ + pBB = Y,
pZZ + 3pzZ = Y
4pZZ = Y
0.25Y
Z= .
pZ
2.1 Using the same values as in the solution to Problem 1.3, we can plot the effect an increase in
income to $120 or $180 has on demand for pie, as shown in the following figure, deriving the
Engel curve.

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82 Perloff • Microeconomics, Eighth Edition

2.2 The figure will be similar to panel (a) and panel (c) of Figure 5.2 (in the chapter), but relabel the
vertical “wine” axis as “other goods” (or “fun”) in the panel (a) figure and the horizontal “beer”
axis as “bequests” in both panel (a) and (c) figures. The Engel curve will be steeper.
2.3 Because the two commodities are perfect complements, the indifference curves have right angles.
Thus, the income consumption curve will be a straight line that passes through the point where the
indifference curves just touch the budget lines. See panel (a) in the following figure. In order for
Hugo to buy one more doughnut per week, his budget must rise enough to purchase both another
doughnut and another cup of coffee. The Engel curve is also linear; see panel (b).

2.4 An opera performance must be a normal good for Don because he views the only other good he
buys as an inferior good. To show this result in a graph, draw a figure similar to Figure 5.3 (in the
chapter), but relabel the vertical “housing” axis as “opera performances.” Don’s equilibrium will
be in the upper-left quadrant at a point like a in Figure 5.3.
2.5 The consumer’s budget constraint is
p1q1 + p2 q2 + L + pn qn = Y ,

where Y is income and pi is the price and qi is the quantity of good i. Differentiating with respect to
Y, we find that
dp1 dq dq dY
p1 + p2 2 + L + pn n = = 1.
dY dY dY dY
Multiplying and dividing each term by qi Y, we rewrite this last equation as
p1q1 dq1 Y p2 q2 dq2 Y p q dq Y
+ +L + n n n = 1,
Y dY q1 Y dY q2 Y dY qn
or
11 + 22 + L + nn = 1,

where 1 the income elasticity for each good i, equals (dqi / dY )(Y /qi ), and the budget share of
good i is i = pi qi /Y . That is, the weighted sum of the income elasticities equals 1. For this
equation to hold, at least one of the goods must have a positive income elasticity; hence, not all the
goods can be inferior.

2.6 An Engel curve shows the relationship between the quantity demanded of a single good and
income, holding prices constant. It this example, it shows consumption of good X when income is
Y1, Y2, and Y3.

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A good is called a normal good if as much or more of it is demanded as income rises. A good is
called an inferior good if less of it is demanded as income rises. If less of a good is consumed with
income initially but then more of a good is consumed with income at higher income levels, then
the good is an inferior good for low-income levels but a normal good for higher income levels.

3.1 a. The substitution effect causes her to buy more clothing. The convexity of indifference curves
assures that the substitution effect will always be positive for a price decrease.
b. The income effect could be either positive or negative depending on whether clothing is a normal
or inferior good for Cora. If clothing is a normal good, the income effect would be positive; if
clothing is an inferior good, the income effect would be negative.

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3.2 See the following figure. The marginal rate of substitution is B/C.

The marginal condition is B/C = 1/2.

B = C/2.
Substituting into the budget constraint yields:
2B + C = 120
2C = 120
C* = 60,
B* = 30.
When the price changes due to the tax, the new marginal condition is
B = C/3.
Substituting into the new budget constraint yields:
3B + C = 120
2C = 120
C* = 60,
B* = 20.
3.3 Eggs and toast are perfect complements. U = min(2Qt, 3Qe). If the price of eggs increases but we
compensate Cori to make her just as “happy” as she was before (which means her utility is the
same as before), her consumption of eggs will still be the same as shown in the following figure.
There is only an income effect but no substitution effect because eggs and toast are perfect
complements; Cori will not substitute toast with eggs even though the price of eggs increases.

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3.4 The income effect reinforces the substitution effect for normal goods. It partially offsets the
substitution effect for inferior goods. When the income effect more than offsets the substitution
effect, it is known as a Giffen good.
3.5 Assume for simplicity that the price of a can of Coke increases such that it becomes twice the
price of a can of Pepsi.
The substitution effect is the change in the quantity of a good that a consumer demands when a
good’s price changes, holding other prices and the consumer’s utility constant. Because Coke and
Pepsi are perfect substitutes for Mahdu (and the price of Coke increases from being less than the
price of Pepsi to being greater than the price of Pepsi), Mahdu substitutes from consuming only
Coke to consuming only Pepsi, so the substitution effect is C1 fewer cans of Coke (from e1 to e2,
which contains no Coke and only cans of Pepsi). The income effect is the change in the quantity of
a good a consumer demands because of a change in income, holding prices constant. The income
effect is zero cans of Coke. The total effect is the substitution effect plus the income effect. Thus,
the total effect is equal to the size of the substitution effect.

3.6 Let PH = price of high-quality oranges and PL = price of low-quality oranges in New York. We
expect PH > PL. We have to add the transportation costs, c, (which are the same for high- and low-
quality oranges) to get the prices in California. Now it is easy to check that: (PH /PL) < [(PH +
c)/(PL + c)].
Therefore, considering the transportation costs, the high-quality oranges are relatively cheaper in
California than in New York. Therefore, the demand for high-quality oranges should be higher in
California compared to in New York.
3.7 In the graph, Lf is the budget line at the factory store, and L0 is the constraint at the outlet store. At
the factory store, the consumer maximum occurs at ef on indifference curve I f. Suppose that we
increase the income of a consumer who shops at the outlet store to Y*, so that the resulting budget
line L* is tangent to the indifference curve I.f. The consumer would buy bundle e*. That is, the pure
substitution effect (the movement from ef to e*) causes the consumer to buy relatively more firsts.
The total effect (the movement from ef to e0) reflects both the substitution effect (firsts are now
relatively less expensive) and the income effect (the consumer is worse off after paying for

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shipping).

3.8 It is impossible for either ice cream or fudge sauce to be a Giffen good. dq/dp is negative for both
members of a perfectly complementary pairing.
3.9 Equivalent variation is the amount of income that, if taken from a consumer, would lower utility
by the same amount as a price increase. This measure is the same or equivalent harm as that of the
price increase.
In the figure, the individual is initially maximizing utility at bundle e1 on budget line L1. Then the
price of good X increases, pivoting the budget line to L2. The consumer maximizes utility at the
new prices at bundle e2.
Line L3 is parallel to L1 and just tangent to I2. Equivalent variation is equal to the vertical distance
between budget lines L1 and L3.
The total effect is from X1 to X2. The substitution effect is from X3 to X2. The income effect is from
X1 to X3.

4.1 The attractive feature of the Big Mac Index as an indicator of price indexes is its uniform
composition. The component ingredients of the Big Mac are the same across a long period of time
and among most countries, allowing an “apple-to-apple” comparison. For cross-country
comparisons, we should assume that other factors such as taxes, tariffs, and service costs are the
same for all countries. We also should assume that consumers in each country consume the same

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proportion of Big Macs (or their ingredients) as other goods.

4.2 He is better off. If he were to buy all new books, the increase in income would just cover the price
increase. However, if he buys all used books, he will spend only $24 more than if he bought all
used books at the old prices. Thus, any combination of books that includes one or more used
books leaves him with leftover or extra income.
4.3 See the following figure. Ann will buy more books and less ice cream this year, and her utility will
be better off this year on I 2 than on I 1. This is because the price of books rose by less than the
price of ice cream. So, Ann can gain higher utility by consuming more books and less ice cream.

4.4 See the following figure. Alix is equally well off at e2 compared to e1. Even if coffee becomes
relatively cheaper, Alix will not raise her utility by consuming more coffee because cream and
coffee are prefect complements.

The CPI accurately reflects the true cost of living because Alix does not substitute between the
goods as the relative prices change.
4.5 The figure shows Klaas maximizing utility along budget line L1 at bundle e1 in year 1. Then, in
year 2, the price of food increases by more than the price of clothing, but Klaas is given a cost-of-
living adjustment such that he is able to attain his original consumption bundle (bundle e1) in
year 2.

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A budget line (or budget constraint) shows the bundles of goods that can be bought if the entire
budget is spent on those goods at given prices. The new budget line (L2) will pass through Bundle
e1, where Klaas maximizes utility in year 2. However, it will be steeper than the original budget
line to illustrate the price of food is relatively more expensive and the price of clothing is
relatively less expensive in year 2. An indifference curve shows the set of all bundles of goods that
a consumer views as being equally desirable. Bundle e2 will be on an indifference curve that is just
tangent to the new budget line.
Klaas is given enough additional income such that he has the option of continuing to consume
Bundle e1. Therefore, Klaas should be no worse off in year 2. However, because relative prices are
different in year 2, Klaas can substitute toward the cheaper good, increasing his utility.
4.6 Answers will vary depending on the date at which the price of French fries is checked.
5.1 From Appendix 5B, we know that, when N is leisure and Y is income:
MU N
MRS = − = −w = MRT .
MUY
We also know that if the utility function is U(Y, N) is Cobb-Douglas such that:
U = Y  N 1− a = (wH ) (24 − H )1− a
where H is the number of hours worked. Differentiating the utility function with respect to H and
setting it to zero, we find that H = 24 and dH
dw
= 0. Therefore, a wage change will have no effect
on the number of hours worked with this utility function.
5.2 Leisure is not a Giffen good. When the wage increases, it increases the opportunity cost of the
individual. If leisure is a normal good, the individual will purchase more of it as wages rise, just as
he or she may purchase more of other commodities. When the income effect dominates, it
generates a backward-bending labor supply curve at high wages. If leisure is inferior, the income
and substitution effects reinforce one another, and leisure falls as the wage increases.
5.3 See the following figure. Bessie is unambiguously worse off. Because her original optimal bundle
lies in the dashed section in the figure, now she has to choose the corner solution as her optimal
bundle.

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5.4 See the following figure. Whether he decides to work additional hours, given the overtime
premium, depends on his taste for income versus leisure. Roy may or may not choose to work
more hours.

5.5 Jerome’s budget line is kinked at eight hours of work. At that point, the slope of the budget line
increases from –w to –w*. See the figure below.

Jerome will obviously pick the higher paying job for his first eight hours. How many total hours
he works will depend on the shape of his indifference curve.
5.6 If the higher paying job had no restriction on hours, as long as the lower paying job provided no
utility other than income he would not work there, and his budget line would be linear, with slope
–w.
5.7 Suppose we have leisure (L) on the horizontal axis and earned income (Y) on the vertical axis. The
budget constraint is curved and the absolute value of its slope becomes smaller as L increases.
Therefore, the opportunity cost of leisure becomes smaller and smaller because you have more
leisure. Let’s denote the slope of the indifference curve by MRS. Thus, the optimum choice is

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where |MRS| = aH, the wage rate. Bill’s tastes determine the MRS, and thus determine the point
on the budget constraint at which his indifference curve will be tangent.

5.8 a. Budget before lottery win:

Y = w(24 - L) + Y*,
where Y * is unearned income.
Budget after lottery win:
Y = w(24 - L) + Y* + 1000.
Thus, the budget shifts up parallel to itself.
b. The income effect is zero.
c. After the wage increase, the budget constraint becomes steeper and rotates up clockwise. As
the wage increases, leisure becomes relatively more expensive. The income effect of the price
increase is zero; however, the substitution effect will still exist and makes the person want to
work more and have less leisure.
5.9 See the following figure. The effect of the poll tax is dependent on whether leisure is normal or
inferior. If leisure is a normal good, both the noble man and the peasant had to work more hours
with the poll tax than when there was no poll tax (see panel (a)). If leisure is an inferior good, they
worked less hours with the poll tax than without the poll tax (see panel (b)). Whether a noble man
or a peasant worked more hours depends on the shape of the indifference curves. For example, in
panel (a), the noble man worked more hours than the peasant, while in panel (b), the peasant
worked more hours than the noble man.

5.10 Under progressive income taxes, the marginal tax is higher than the average tax.
5.11 a. A progressive tax is a tax structure in which the average tax is rising. Assume the marginal tax
rate is constant and equal to a. Then the tax revenue is equal to

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T = 0, if Y < 10,000,
T = a (Y – 10,000), if Y  10,000.
Then the average tax is T/Y = a(Y – 10,000)/Y = a + (10,000a)/Y. As Y increases, (10,000a)/Y
decreases and as a result the average tax will increase. Thus, even though the marginal tax rate
is constant, the average tax is still increasing.
b. Whether the labor supply curve slopes upward or bends backward depends on the income
elasticity of leisure. If a worker always views leisure as an inferior good, then he will work
more hours as his income increases. Therefore, production is stimulated by the flat tax where
the marginal tax rate does not increase with income. If a worker views leisure as inferior at low
wages but a normal good at higher wage rates, then his labor supply curve might bend
backward.
5.12 See the following figure. Individuals with a high preference for leisure (with indifference curve IB)
will accept the welfare payment. Those with a greater preference for income than leisure (with
indifference curve IA) are likely to turn down the payment.

5.13 a. See the following figure. Assume all goods have a unit price. George will work more hours
under a lump-sum tax than under a per-hour tax. A per-hour tax reduces the effective wage,
but a lump-sum tax does not; therefore, when a lump-sum tax is used, the price for leisure is
higher. Hence, George will consume less leisure but work more hours under a lump-sum tax.

b. The income tax is likely to reduce George’s hours of work more. An income tax reduces the
effective wage. However, an inheritance tax is similar to a lump-sum tax, which does not
reduce the effective wage. Therefore, the price of leisure is lower when an income tax is used
and George will consume more leisure but work less.
5.14 As the marginal tax rate on income increases, people substitute away from work due to the pure
substitution effect. However, the income effect can be either positive or negative, so the net effect

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of a tax increase is ambiguous. Also, because wage rates differ across countries, the initial level of
income differs, again adding to the theoretical ambiguity. If we know that people work less as the
marginal tax rate increases, we can infer that the substitution effect and the income effect go in the
same direction or the substitution effect is larger. However, Prescott’s (2004) evidence alone about
hours worked and marginal tax rates does not allow us to draw such an inference because U.S. and
European workers may have different tastes and face different wages.
5.15 Kiki will change her consumption bundle once she moves, substituting toward goods that are
cheaper in the new country. Thus, as in Figure 5.5, Kiki will be better off.
6.1 See the following figure. Doreen’s budget constraint with the education voucher is kinked,
intercepting the vertical axis at c, while $5,000 cash would cause the constraint to intercept at a.
Given that Doreen would prefer cash to a voucher, with cash she would choose to consume
education at some point under the $5,000 value, say e2. With the voucher, Doreen would consume
the $5,000 worth of education and less of other goods, at e1. We can measure the cash value of the
education voucher to Doreen as the difference in the amount of other goods she would purchase
with cash versus with the voucher—b-c.

6.2 The government could give a smaller lump-sum subsidy that shifts the LLS curve down so that it is
parallel to the original curve but tangent to indifference curve I2. This tangency point is to the left
of e2, so the parents would consume fewer hours of childcare than with the original lump-sum
payment.
6.3 Parents who do not receive subsidies prefer that poor parents receive lump-sum payments rather
than a subsidized hourly rate for childcare. If the supply curve for day-care services is upward
sloping, by shifting the demand curve farther to the right, the price subsidy raises the price of day
care for these other parents.

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