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PM Page S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 S-141 chapter: 10 The Rational Consumer 1. For each of the following situations, decide whether Al has increasing, constant, or diminishing marginal utility. a. The more economics classes Al takes, the more he enjoys the subject. And the more classes he takes, the easier each one gets, making him enjoy each additional class even more than the one before. b. Al likes loud music. In fact, according to him, "the louder, the better." Each time he turns the volume up a notch, he adds 5 utils to his total utility. c. Al enjoys watching reruns of the old sitcom Friends. He claims that these episodes are always funny, but he does admit that the more he sees an episode, the less funny it gets. d. Al loves toasted marshmallows. The more he eats, however, the fuller he gets and the less he enjoys each additional marshmallow. And there is a point at which he becomes satiated: beyond that point, more marshmallows actually make him feel worse rather than better. 1. Solution a. Al has increasing marginal utility of economics classes. Each additional class adds more to his total utility than the previous class. b. Al has constant marginal utility of volume of music. His total utility increases by 5 utils for each additional notch of volume, so his marginal utility is constant at 5 utils. c. Al has diminishing marginal utility of Friends episodes. Although additional episodes increase his total utility, they do so less and less. That is, his marginal utility declines. d. Al has diminishing marginal utility of marshmallows. For a certain range, additional marshmallows add to his total utility, so total utility increases. But total utility increases by less and less. In fact, total utility eventually begins to decline. In other words, his marginal utility becomes smaller and smaller and eventually becomes negative. 2. Use the concept of marginal utility to explain the following: Newspaper vending machines are designed so that once you have paid for one paper, you could take more than one paper at a time. But soda vending machines, once you have paid for one soda, dispense only one soda at a time. 2. Solution After you have taken the first newspaper, the marginal utility of the second newspaper is zero: you don't learn any more news by having two copies of the same paper instead of just one. So once you have paid for the vending machine to open, you will take only one paper. For soda, on the other hand, marginal utility is positive: after you have drunk the first soda, the second will still give you more utility. It will give you less utility than the first soda--that is, there is diminishing marginal utility--but the marginal utility of the second soda is still positive. If the vending machine allowed you to take more than one soda at a time after paying for only one, you would. So the soda vending machine has to be designed to prevent you from taking more than one soda, and it does so by dispensing only one soda at a time. S-141 S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 PM Page S-142 S-142 CHAPTER 10 T H E R AT I O N A L C O N S U M E R 3. Brenda likes to have bagels and coffee for breakfast. The accompanying table shows Brenda's total utility from various consumption bundles of bagels and coffee. Consumption bundle Quantity of bagels Quantity of coffee (cups) Total utility (utils) 0 0 0 1 1 2 2 3 3 4 4 0 2 4 2 3 0 2 1 2 0 2 0 28 40 48 54 28 56 54 62 40 66 Suppose Brenda knows she will consume 2 cups of coffee for sure. However, she can choose to consume different quantities of bagels: she can choose either 0, 1, 2, 3, or 4 bagels. a. Calculate Brenda's marginal utility from bagels as she goes from consuming 0 bagel to 1 bagel, from 1 bagel to 2 bagels, from 2 bagels to 3 bagels, and from 3 bagels to 4 bagels. b. Draw Brenda's marginal utility curve of bagels. Does Brenda have increasing, diminishing, or constant marginal utility of bagels? Solution 3. a. If Brenda consumes 2 cups of coffee, the consumption bundles that are relevant are those in the accompanying table. The first two columns are the bundles, and the third column shows the total utility of each bundle. The fourth column calculates her marginal utility of bagels. Consumption bundle Quantity of bagels Quantity of coffee (cups) Total utility (utils) Marginal utility per bagel (utils) 0 1 2 3 4 2 2 2 2 2 28 20 48 8 56 6 62 4 66 S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 PM Page S-143 CHAPTER 10 T H E R AT I O N A L C O N S U M E R S-143 b. The accompanying diagram shows Brenda's marginal utility of bagels. Since Brenda's marginal utility curve of bagels slopes downward, she has diminishing marginal utility of bagels. Marginal utility per bagel (utils) 20 18 16 14 12 10 8 6 4 2 0 1 2 Marginal utility curve 3 4 Quantity of bagels 4. Brenda, the consumer in Problem 3, now has to make a decision about how many bagels and how much coffee to have for breakfast. She has $8 of income to spend on bagels and coffee. Use the information given in the table in Problem 3 to answer the following questions. a. Bagels cost $2 each, and coffee costs $2 per cup. Which bundles are on Brenda's budget line? For each of these bundles, calculate the level of utility (in utils) that Brenda enjoys. Which bundle is her optimal bundle? b. The price of bagels increases to $4, but the price of coffee remains at $2 per cup. Which bundles are now on Brenda's budget line? For each bundle, calculate Brenda's level of utility (in utils). Which bundle is her optimal bundle? c. What do your answers to parts a and b imply about the slope of Brenda's demand curve for bagels? Describe the substitution effect and the income effect of this increase in the price of bagels, assuming that bagels are a normal good. 4. Solution a. The first two columns in the accompanying table list the bundles that lie on Brenda's budget line, and the third column shows her total utility from these bundles. Consumption bundle Quantity of bagels Quantity of coffee (cups) Total utility (utils) 0 1 2 3 4 4 3 2 1 0 40 54 56 54 40 Of all the bundles on her budget line, the bundle that contains 2 bagels and 2 cups of coffee gives Brenda the highest total utility. So this is her optimal bundle. S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 PM Page S-144 S-144 CHAPTER 10 T H E R AT I O N A L C O N S U M E R b. The first two columns in the accompanying table list the bundles that lie on Brenda's budget line, and the third column shows her total utility from these bundles. Consumption bundle Quantity of bagels Quantity of coffee (cups) Total utility (utils) 0 1 2 4 2 0 40 48 28 Of all the bundles on her budget line, the bundle that contains 1 bagel and 2 cups of coffee gives Brenda the highest utility. So this is her optimal bundle. c. As the price of bagels increased, Brenda's consumption fell from 2 bagels to 1 bagel, implying that her demand curve for bagels slopes downward. This happens for two reasons. First, the substitution effect: as the price of bagels increases, bagels become relatively less attractive, so Brenda is likely to substitute coffee in place of bagels. Second, the income effect: as the price of bagels increases, it is as if Brenda had become poorer--her money now buys fewer goods than before. Since bagels are a normal good, a reduction in a consumer's real income results in a lower quantity of bagels demanded. The two effects move in the same direction. 5. Bruno can spend his income on two different goods: Beyonc CDs and notebooks for his class notes. For each of the following three situations, decide if the given consumption bundle is within Bruno's consumption possibilities. Then decide if it lies on the budget line or not. a. CDs cost $10 each, and notebooks cost $2 each. Bruno has income of $60. He is considering a consumption bundle containing 3 CDs and 15 notebooks. b. CDs cost $10 each, and notebooks cost $5 each. Bruno has income of $110. He is considering a consumption bundle containing 3 CDs and 10 notebooks. c. CDs cost $20 each, and notebooks cost $10 each. Bruno has income of $50. He is considering a consumption bundle containing 2 CDs and 2 notebooks. 5. Solution a. This consumption bundle costs $10 3 + $2 15 = $60, which is exactly equal to Bruno's income of $60. So the bundle is within Bruno's consumption possibilities. And, since he spends all his money, it lies on his budget line. b. This consumption bundle costs $10 3 + $5 10 = $80, which is less than Bruno's income of $110. So the bundle is within Bruno's consumption possibilities. However, since he does not spend all his money, it does not lie on his budget line; it lies below his budget line. c. This consumption bundle costs $20 2 + $10 2 = $60, which is more than Bruno's income of $50. So the bundle is not within Bruno's consumption possibilities; it lies above his budget line. S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 PM Page S-145 CHAPTER 10 T H E R AT I O N A L C O N S U M E R S-145 6. Bruno, the consumer in Problem 5, is best friends with Bernie, who shares his love for notebooks and Beyonc CDs. The accompanying table shows Bernie's utilities from notebooks and Beyonc CDs. Quantity of notebooks Utility from notebooks (utils) Quantity of CDs Utility from CDs (utils) 0 2 4 6 8 10 0 70 130 180 220 250 0 1 2 3 4 5 0 80 150 210 260 300 The price of a notebook is $5, the price of a CD is $10, and Bernie has $50 of income to spend. a. Which consumption bundles of notebooks and CDs can Bernie consume if he spends all his income? Illustrate Bernie's budget line with a diagram, putting notebooks on the horizontal axis and CDs on the vertical axis. b. Calculate the marginal utility of each notebook and the marginal utility of each CD. Then calculate the marginal utility per dollar spent on notebooks and the marginal utility per dollar spent on CDs. c. Draw a diagram like Figure 10-4 in which both the marginal utility per dollar spent on notebooks and the marginal utility per dollar spent on CDs are illustrated. Using this diagram and the optimal consumption rule, predict which bundle-- from all the bundles on his budget line--Bernie will choose. Solution 6. a. Bernie can consume the following bundles if he spends all his income: 0 notebooks, 5 CDs 2 notebooks, 4 CDs 4 notebooks, 3 CDs 6 notebooks, 2 CDs 8 notebooks, 1 CD 10 notebooks, 0 CDs The accompanying diagram shows Bernie's budget line. Quantity of CDs 10 9 8 7 6 5 4 3 2 1 BL 0 1 2 3 4 5 6 7 8 9 10 Quantity of notebooks S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 PM Page S-146 S-146 CHAPTER 10 T H E R AT I O N A L C O N S U M E R b. The accompanying table shows the marginal utility for each notebook and for each CD, the marginal utility per dollar spent on notebooks, and the marginal utility per dollar spent on CDs. Note that the utility numbers for notebooks are given in increments of 2: for instance, going from 4 notebooks to 6, utility increases by 50 utils (from 130 utils to 180 utils). Per notebook, this is a marginal utility of 25 utils. Utility Marginal Marginal Quantity from utility per utility of notebooks notebook per dollar (utils) (utils) notebooks (utils) Marginal utility per CD (utils) Quantity of CDs Utility from CDs (utils) Marginal utility per dollar (utils) 0 2 4 6 8 10 0 35 70 30 130 25 180 20 220 15 250 3 4 5 6 7 0 1 2 3 4 5 0 80 80 70 150 60 210 50 260 40 300 4 5 6 7 8 c. The optimal consumption rule states that the optimal bundle, from all those on a consumer's budget line, is the one at which the marginal utility per dollar spent on each good is equal. The accompanying diagram shows the marginal utility per dollar spent on notebooks and the marginal utility per dollar spent on CDs. When Bernie consumes 4 notebooks and 3 CDs, the marginal utility per dollar spent on notebooks is the same as the marginal utility per dollar spent on CDs, so this is the optimal consumption bundle. It is also the only bundle--from all the bundles he can consume (that is, from all the bundles on his budget line)--for which the marginal utility per dollar is equal for the two goods. Marginal utility per dollar (utils) 8 7 6 5 4 3 2 1 0 5 2 4 4 6 8 Quantity of notebooks 3 2 Quantity of CDs 1 10 0 Optimal choice MU CD /PCD MUN /PN 7. For each of the following situations, decide whether the bundle Lakshani is considering optimal or not. If it is not optimal, how could Lakshani improve her overall level of utility? That is, determine which good she should spend more on and which good should she spend less on. S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 PM Page S-147 CHAPTER 10 T H E R AT I O N A L C O N S U M E R S-147 a. Lakshani has $200 to spend on sneakers and sweaters. Sneakers cost $50 per pair, and sweaters cost $20 each. She is thinking about buying 2 pairs of sneakers and 5 sweaters. She tells her friend that the additional utility she would get from the second pair of sneakers is the same as the additional utility she would get from the fifth sweater. b. Lakshani has $5 to spend on pens and pencils. Each pen costs $0.50 and each pencil costs $0.10. She is thinking about buying 6 pens and 20 pencils. The last pen would add five times as much to her total utility as the last pencil. c. Lakshani has $50 per season to spend on tickets to football games and tickets to soccer games. Each football ticket costs $10 and each soccer ticket costs $5. She is thinking about buying 3 football tickets and 2 soccer tickets. Her marginal utility from the third football ticket is twice as much as her marginal utility from the second soccer ticket. Solution 7. a. This bundle lies on Lakshani's budget line, but the marginal utility per dollar for sneakers and for sweaters is not equal. The marginal utility per pair of sneakers is equal to her marginal utility per sweater. However, since sneakers cost $50 and sweaters cost only $20 (that is, sneakers are 2.5 times as expensive as sweaters), Lakshani's marginal utility per dollar spent on sweaters is 2.5 times greater than her marginal utility per dollar spent on sneakers. That is, she would improve her level of utility if she spent more money on sweaters and less on sneakers. b. This bundle lies on Lakshani's budget line. The marginal utility per pen is five times as great as the marginal utility per pencil. However, pens are also five times as expensive as pencils, so her marginal utility per dollar spent on pens is just equal to her marginal utility per dollar spent on pencils. So this is her optimal bundle. c. Although Lakshani's marginal utility per dollar spent on soccer tickets is equal to her marginal utility per dollar spent on football tickets, this bundle is not optimal: it does not lie on her budget line. She could buy more of both goods and probably will. But for a precise answer about how many football tickets and how many soccer tickets she will actually buy, we would need more information about her utility at other consumption bundles. 8. Cal "Cool" Cooper has $200 to spend on cell phones and sunglasses. a. Each cell phone costs $100 and each pair of sunglasses costs $50. Which bundles lie on Cal's budget line? Draw a diagram like Figure 10-4 in which both the marginal utility per dollar spent on cell phones and the marginal utility per dollar spent on sunglasses are illustrated. Use this diagram and the optimal consumption rule to decide how Cal should allocate his money. That is, from all the bundles on his budget line, which bundle will Cal choose? The accompanying table gives his utility of cell phones and sunglasses. Utility from cell phones (utils) Quantity of cell phones Quantity of sunglasses (pairs) Utility from sunglasses (utils) 0 1 2 0 400 700 0 2 4 0 600 700 S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 PM Page S-148 S-148 CHAPTER 10 T H E R AT I O N A L C O N S U M E R b. The price of cell phones falls to $50 each, but the price of sunglasses remains at $50 per pair. Which bundles lie on Cal's budget line? Draw a diagram like Figure 10-4 in which both the marginal utility per dollar spent on cell phones and the marginal utility per dollar spent on sunglasses are illustrated. Use this diagram and the optimal consumption rule to decide how Cal should allocate his money. That is, from all the bundles on his budget line, which bundle will Cal choose? The accompanying table gives his utility of cell phones and sunglasses. Utility from cell phones (utils) Quantity of cell phones Quantity of sunglasses (pairs) Utility from sunglasses (utils) 0 1 2 3 4 0 400 700 900 1,000 0 1 2 3 4 0 325 600 825 700 c. How does Cal's consumption of cell phones change as the price of cell phones falls? In words, describe the income effect and the substitution effect of this fall in the price of cell phones, assuming that cell phones are a normal good. Solution 8. a. The following bundles lie on Cal's budget line: 0 cell phones, 4 pairs of sunglasses 1 cell phone, 2 pairs of sunglasses 2 cell phones, 0 pairs of sunglasses Going from 0 cell phones to 1 cell phone, the marginal utility per cell phone is 400 utils; that is, the marginal utility per dollar spent on cell phones is 4 utils. Going from 1 cell phone to 2 cell phones, the marginal utility per cell phone is 300 utils; that is, the marginal utility per dollar spent on cell phones is 3 utils. Going from 0 pairs of sunglasses to 2 pairs of sunglasses, the marginal utility per pair is 600/2 = 300 utils; that is, the marginal utility per dollar spent on sunglasses is 6 utils. Going from 2 pairs of sunglasses to 4 pairs, the marginal utility per pair is 100/2 = 50 utils; that is, the marginal utility per dollar spent on sunglasses is 1 util. The marginal utility per dollar spent on cell phones and the marginal utility per dollar spent on sunglasses are plotted in the accompanying diagram. Marginal utility per dollar (utils) 6 5 4 3 2 1 0 4 1 Quantity of cell phones 2 Quantity of sunglasses (pairs) 2 0 Optimal choice MUS /PS MUC /PC S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 PM Page S-149 CHAPTER 10 T H E R AT I O N A L C O N S U M E R S-149 Of all the possible bundles Cal could consume (that is, from all the bundles on his budget line), the bundle that contains 1 cell phone and 2 pairs of sunglasses is optimal. At that bundle, the marginal utility dollar per spent on cell phones and the marginal utility per dollar spent on sunglasses are equal. By the optimal consumption rule, this is Cal's optimal consumption bundle. b. The bundles that lie on Cal's budget line are: 0 1 2 3 4 cell cell cell cell cell phones, 4 pairs of sunglasses phone, 3 pairs of sunglasses phones, 2 pairs of sunglasses phones, 1 pair of sunglasses phones, 0 pairs of sunglasses The accompanying table calculates marginal utility per cell phone, marginal utility per pair of sunglasses, marginal utility per dollar spent on cell phones, and marginal utility per dollar spent on sunglasses. Marginal utility per cell phone (utils) Marginal utility per dollar (utils) Marginal utility per dollar (utils) Quantity of cell phones Utility from cell phones (utils) Quantity Utility Marginal of from utility sunglasses sunglasses per pair (pairs) (utils) (utils) 0 1 2 3 4 0 400 400 300 700 200 900 100 1,000 2 4 6 8 0 1 2 3 4 0 325 325 275 600 225 825 700 -125 4.5 -2.5 5.5 6.5 The accompanying diagram plots the marginal utility per dollar spent on cell phones and the marginal utility per dollar spent on sunglasses. Marginal utility per dollar (utils) 8 7 6 5 4 3 2 1 0 1 2 3 0 4 1 2 3 4 Quantity of cell phones 3 2 1 0 Quantity of sunglasses (pairs) Optimal choice MUS /PS MUC /PC S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 PM Page S-150 S-150 CHAPTER 10 T H E R AT I O N A L C O N S U M E R From all the bundles on Cal's budget line, the marginal utility per dollar spent on cell phones is the same as the marginal utility per dollar spent on sunglasses at 2 cell phones and 2 pairs of sunglasses. By the optimal consumption rule, this is Cal's optimal consumption bundle. c. Cal's consumption of cell phones increases from 1 to 2 as the price of cell phones falls. This is due to two effects. The substitution effect says that as the price of cell phones falls, their opportunity cost falls: Cal now has to give up fewer pairs of sunglasses for 1 cell phone. This makes cell phones more attractive, and Cal substitutes cell phones in place of sunglasses. The income effect says that as cell phones become cheaper, Cal gets richer in a real sense: his income now buys more goods. Since cell phones are a normal good, when the purchasing power of Cal's income rises, he consumes more cell phones. Both effects contribute to the fact that as the price of cell phones falls, Cal's consumption of cell phones increases. 9. Damien Matthews is a busy actor. He allocates his free time to watching movies and working out at the gym. The accompanying table shows his utility from the number of times per week he watches a movie or goes to the gym. Quantity of gym visits per week Utility from gym visits (utils) Quantity of movies per week Utility from movies (utils) 1 2 3 4 5 6 7 100 180 240 280 310 330 340 1 2 3 4 5 6 7 60 110 150 180 190 195 197 Damien has 14 hours per week to spend on watching movies and going to the gym. Each movie takes 2 hours and each gym visit takes 2 hours. (Hint: Damien's free time is analogous to income he can spend. The hours needed for each activity are analogous to the price of that activity.) a. Which bundles of gym visits and movies can Damien consume per week if he spends all his time either going to the gym or watching movies? Draw Damien's budget line in a diagram with gym visits on the horizontal axis and movies on the vertical axis. b. Calculate the marginal utility of each gym visit and the marginal utility of each movie. Then calculate the marginal utility per hour spent at the gym and the marginal utility per hour spent watching movies. c. Draw a diagram like Figure 10-4 in which both the marginal utility per hour spent at the gym and the marginal utility per hour spent watching movies are illustrated. Use this diagram and the optimal consumption rule to decide how Damien should allocate his time. S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 PM Page S-151 CHAPTER 10 T H E R AT I O N A L C O N S U M E R S-151 Solution 9. 0 1 2 3 4 5 6 7 gym gym gym gym gym gym gym gym a. Damien can consume the following bundles if he spends all his time going to the gym and watching movies: visits, 7 movies visit, 6 movies visits, 5 movies visits, 4 movies visits, 3 movies visits, 2 movies visits, 1 movie visits, 0 movies The accompanying diagram illustrates Damien's budget line. Quantity of movies 7 6 5 4 3 2 1 BL 0 1 2 3 4 5 6 7 Quantity of gym visits b. The accompanying table shows Damien's marginal utility per gym visit, marginal utility per movie, marginal utility per hour spent on gym visits, and marginal utility per hour spent on movies. Quantity Utility Marginal Marginal of gym from gym utility per utility visits per visits gym visit per hour week (utils) (utils) (utils) Utility from movies (utils) Marginal utility per movie (utils) Marginal utility per hour (utils) Quantity of movies per week 1 2 3 4 5 6 7 100 80 180 60 240 40 280 30 310 20 330 10 340 5 10 15 20 30 40 1 2 3 4 5 6 7 60 50 110 40 150 30 180 10 190 5 195 2 197 1 2.5 5 15 20 25 S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 PM Page S-152 S-152 CHAPTER 10 T H E R AT I O N A L C O N S U M E R c. The accompanying diagram shows Damien's marginal utility per hour spent on gym visits and his marginal utility per hour spent watching movies. Of all the bundles on his budget line, the bundle containing 4 gym visits and 3 movies is optimal: this is the bundle at which the marginal utility per hour spent in the gym is equal to the marginal utility per hour spent watching movies. Marginal utility per dollar (utils) 40 35 30 25 20 15 10 5 0 7 1 6 2 3 4 5 Quantity of gym visits 5 4 3 2 Quantity of movies 6 1 7 0 Optimal choice Marginal utility per hour spent on movies Marginal utility per hour spent in the gym 10. Anna Jenniferson is an actress, who currently spends several hours each week watching movies and going to the gym. On the set of a new movie she meets Damien, the consumer in Problem 9. She tells him that she likes watching movies much more than going to the gym. In fact, she says that if she had to give up seeing 1 movie, she would need to go to the gym twice to make up for the loss in utility from not seeing the movie. A movie takes 2 hours, and a gym visit also lasts 2 hours. Damien tells Anna that she is not watching enough movies. Is he right? 10. Solution Damien is right. Since Anna's marginal utility for the last movie is twice as large as the marginal utility for a gym visit, but gym visits and movies "cost" the same in terms of hours spent, Anna's marginal utility per hour spent on movies is twice as large as her marginal utility per hour spent on gym visits. So she should spend more of her time going to movies and less going to the gym. Sven is a poor student who covers most of his dietary needs by eating cheap breakfast cereal, since it contains most of the important vitamins. As the price of cereal increases, he decides to buy even less of other foods and even more breakfast cereal to maintain his intake of important nutrients. This makes breakfast cereal a Giffen good for Sven. Describe in words the substitution effect and the income effect from this increase in the price of cereal. In which direction does each effect move, and why? What does this imply for the slope of Sven's demand curve for cereal? 11. 11. Solution As its price increases, cereal becomes relatively less attractive compared to other goods: its opportunity cost is now higher. As a result, Sven will tend to substitute away from cereal. This is the substitution effect. But as the price of cereal increases, the purchasing power of Sven's income falls: in a real sense, Sven is now poorer. Since he spends a large fraction of his income on cereal, this effect is large. So Sven buys less of other foods, since they are normal goods. However, he buys more cereal, so cereal must be an inferior good for him. This is the income effect. In fact, this S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 PM Page S-153 CHAPTER 10 T H E R AT I O N A L C O N S U M E R S-153 effect is so strong that it outweighs the substitution effect: with both effects taken together, Sven consumes more cereal. For a Giffen good, the income effect works opposite to and is stronger than the substitution effect. Since Sven's consumption of cereal rises as the price of cereal rises, his demand curve slopes upward. 12. In each of the following situations, describe the substitution effect and, if it is significant, the income effect. In which direction does each of these effects move? Why? a. Ed spends a large portion of his income on his children's education. Because tuition fees rise, one of his children has to withdraw from college. b. Homer spends much of his monthly income on home mortgage payments. The interest on his adjustable-rate mortgage falls, lowering his mortgage payments, and Homer decides to move to a larger house. c. Pam thinks that Spam is an inferior good. Yet as the price of Spam rises, she decides to buy less of it. Solution 12. a. As tuition fees rise, college education becomes relatively more expensive compared to other goods. So Ed decides to substitute away from college education and toward other goods. This is the substitution effect. Since tuition takes up a large portion of his income, the income effect will also be significant. As tuition rises, Ed, in a real sense, becomes poorer: the purchasing power of his income falls. As a result, he will buy less of all normal goods. College education is a normal good, so the income effect also moves in the direction of less college education. The effects reinforce each other. b. As mortgage payments decrease, large homes become cheaper compared to other goods. So Homer will substitute toward buying a larger home. This is the substitution effect. Since he spends much of his income on mortgage payments, the fall in mortgage rates also increases his income in a real sense: the purchasing power of his income is now higher. This implies that Homer will now buy more of all normal goods. Housing is a normal good, so the income effect will also move in the direction of more housing. The effects reinforce each other. c. As its price rises, Spam becomes relatively more expensive compared to other goods. So Pam will substitute away from Spam and toward other goods. This is the substitution effect. Spam probably does not account for a large portion of Pam's income, so the income effect is likely to be negligible. However, we do know that since Spam is an inferior good, the income effect would make Pam want to consume more of it. As the price of Spam rises, Pam is now, in a real sense, poorer: her income buys fewer goods. Since she is now poorer, she will buy more inferior goods--that is, the income effect will lead her to buy more Spam. However, we know that overall she buys less Spam as its price rises, so the substitution effect outweighs the income effect. 13. Restaurant meals and housing (measured in the number of rooms) are the only two goods that Neha buys. She has income of $1,000. Initially, she buys a consumption bundle such that she spends exactly half her income on restaurant meals and the other half of her income on housing. Then her income increases by 50%, but the price of restaurant meals increases by 100% (it doubles). The price of housing remains the same. After these changes, if she wanted to, could Neha still buy the same consumption bundle as before? Solution 13. Yes, she could. If she spends equally as much money on housing as before, she gets the same number of rooms as before (the price of housing has not changed). However, she now has twice as much money left over as before to spend on restaurant meals (her income increased by 50%). But the price of restaurant meals has doubled also, so she could still buy the same quantity of restaurant meals as before. S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 PM Page S-154 S-154 CHAPTER 10 T H E R AT I O N A L C O N S U M E R 14. Scott finds that the higher the price of orange juice, the more money he spends on orange juice. Does that mean that Scott has discovered a Giffen good? Solution 14. Scott has not necessarily discovered a Giffen good. For a good to be a Giffen good, the quantity demanded of the good has to increase as its price rises. However, Scott has only found that the amount of money he spends on purchases of orange juice has increased as its price rises. For instance, suppose the price of orange juice were to rise from $5 per half-gallon to $10 per half-gallon, and as a result Scott reduces the quantity of orange juice demanded from 3 half-gallons to 2 half-gallons. This means that orange juice is not a Giffen good, since the quantity demanded decreases as the price rises. However, Scott's spending on orange juice would have increased from $5 3 = $15 to $10 2 = $20. So an increase in spending on a good as its price rises need not necessarily imply that the good is a Giffen good. Margo's marginal utility of one dance lesson is 100 utils per lesson. Her marginal utility of a new pair of dance shoes is 300 utils per pair. The price of a dance lesson is $50 per lesson. She currently spends all her income, and she buys her optimal consumption bundle. What is the price of a pair of dance shoes? 15. Solution 15. Since Margo buys her optimal consumption bundle, the marginal utility per dollar spent on dance lessons must be equal to the marginal utility per dollar spent on dance shoes. Here, the marginal utility per dollar spent on dance lessons is 100 utils per lesson/$50 per lesson = 2 utils per dollar. The marginal utility per dollar spent on dance shoes therefore has to equal 2 utils per dollar. Since the marginal utility of a pair of dance shoes is 300 utils per pair, the price of a pair of shoes has to be $150 per pair, so that 300 utils per pair/$150 per pair = 2 utils per dollar. According to data from the U.S. Department of Energy, the average retail price of regular gasoline rose from $0.93 in 1985 to $1.81 in 2005, a 95% increase. a. Other things equal, describe the effect of this price increase on the quantity of gasoline demanded. In your explanation, make use of the optimal consumption rule and describe income and substitution effects. In fact, however, other things were not equal. Over the same time period, the prices of other goods and services rose as well. According to data from the Bureau of Labor Statistics, the overall price of a bundle of goods and services consumed by an average consumer rose by 82%. b. Taking into account the rise in the price of gasoline and in overall prices, other things equal, describe the effect on the quantity of gasoline demanded. However, this is not the end of the story. Between 1985 and 2005, the typical consumer's nominal income increased, too: the U.S. Census Bureau reports that U.S. median household nominal income rose from $23,618 in 1985 to $46,326 in 2005, an increase of 96%. c. Taking into account the rise in the price of gasoline, in overall prices, and in consumers' incomes, describe the effect on the quantity of gasoline demanded. 16. Solution 16. a. The optimal consumption rule states that, at the optimal consumption bundle, the marginal utility per dollar spent on gasoline is equal to the marginal utility per dollar spent on other goods and services. As the price of gasoline rises, other things equal, the marginal utility per dollar spent on gasoline falls. Now the marginal utility per dollar spent on gasoline is less than the marginal utility per dollar spent on other goods and services. But there is a simple way for the consumer to S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 PM Page S-155 CHAPTER 10 T H E R AT I O N A L C O N S U M E R S-155 make him- or herself better off: spend less on gasoline and more on other goods and services. This raises the marginal utility of gasoline, which raises the marginal utility per dollar spent on gasoline; and it lowers the marginal utility of other goods and services, which lowers the marginal utility per dollar spent on other goods and services. This continues until the marginal utility per dollar spent on gasoline is again equal to the marginal utility per dollar spent on other goods and services. That is, the quantity of gasoline demanded falls. Almost certainly, the whole story is captured by the substitution effect: as the price of gasoline rises, most consumers substitute other goods and services in place of gasoline. Only for consumers for whom spending on gasoline makes up a major portion of their total spending will there be a noticeable income effect: as the price of gasoline rises, they will be made poorer. Since gasoline is a normal good, they will consume less gasoline, further reducing the quantity of gasoline demanded. b. First, if all prices had increased by the same percentage, the effect would be the same as if all prices had remained unchanged but the consumer's income had fallen. In other words, the quantity demanded of all normal goods, such as gasoline, would fall. However, the price of gasoline rose slightly more than the prices of other goods and services. So it is likely that there would still be a substitution effect at work, leading consumers to consume less gasoline. c. First, consider the following: If income had increased by the same percentage as the prices of all goods and services, then consumers' optimal consumption bundle would remain unchanged. In fact, however, income increased by more (96%) than did overall prices (only 82%). As a result, consumers would be likely to consume more of all normal goods, including gasoline. Finally, adding in the fact that the price of gasoline increased by more (95%) than did the prices of other goods and services (82%), there would still be some substitution effect at work, leading consumers to substitute other goods and services in place of gasoline. So the overall effect on the quantity of gasoline demanded would, theoretically at least, be inconclusive. (If you would like to know, the quantity of regular gasoline bought and sold in the United States has, in fact, increased from 149 million gallons per day in 1985 to 316 million gallons per day in 2005, according to data from the U.S. Department of Energy.) S141-S156_Krugman2e_PS_Ch10.qxp 9/16/08 9:21 PM Page S-156 ... View Full Document