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Unformatted text preview: Chapter 4: Practice Problems Econ 80a Instructor: Jura Liaukonyte 41 Chapter 4 Questions: 2, 3, 9, 13 Exercises: 4, 7, 13 ANSWERS 2. Suppose that an individual allocates his or her entire budget between two goods, food and clothing. Can both goods be inferior? Explain. If an individual consumes only food and clothing, then any increase in income must be spent on either food or clothing (recall, we assume there are no savings). If food is an inferior good, then, as income increases, consumption falls. With constant prices, the extra income not spent on food must be spent on clothing. Therefore, as income increases, more is spent on clothing, i.e. clothing is a normal good. For both types of goods, normal and inferior, we still assume that more is preferred to less. 3. Explain whether the following statements are true or false. a. The marginal rate of substitution diminishes as an individual moves downward along the demand curve. This is true. The consumer will maximize his utility by choosing the bundle on his budget line where the price ratio is equal to the MRS. Suppose the consumer chooses the quantity of goods 1 and 2 such that P 1 P 2 = MRS . As the price of good 1 falls, the price ratio becomes a smaller number and hence the MRS becomes a smaller number. This means that as the price of good 1 falls, the consumer is willing to give up fewer units of good 2 in exchange for another unit of good 1. b. The level of utility increases as an individual moves downward along the demand curve. This is true. As the price of a good falls, the budget line pivots outwards and the consumer is able to move to a higher indifference curve. c. Engel curves always slope upwards. This is false. The Engel curve identifies the relationship between the quantity demanded of a good and income, all else the same. If the good is inferior, then as income increases, quantity demanded will decrease, and the Engel curve will slope downwards. 9. Suppose that the average household in a state consumes 800 gallons of gasoline per year. A 20- cent gasoline tax is introduced, coupled with a $160 annual tax rebate per household. Will the household be better or worse off under the new program? If the household does not change its consumption of gasoline, it will be unaffected by the tax-rebate program, because in this case the household pays 0.20*800=$160 in taxes and receives $160 as an annual tax rebate. The two effects would cancel each other out. To the extent that the household reduces its gas consumption through...
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- Spring '08