Problems And Applicatio

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1. lennifer divides her income between coffee and croissants (both of which are normal goods). An early frost in Bra/il causes a large increase in the price of coffee in the United States.

a. Show the effect of the frost on Jennifer's budget constraint.

b. Show the effect of the frost on Jennifer's optimal consumption bundle assuming that the substitution effect outweighs the income effect for croissants.

c. Show the effect of the frost on Jennifer's optimal consumption bundle assuming that the income effect outweighs the substitution effect for croissants.

2. Compare the following two pairs of goods:

• Skis and ski bindings a. In which case are the two goods complements? In which case are they substitutes?

b. In which case do you expect the indifference curves to be fairly straight? In which case do you expect the indifference curves to be very bowed?

c. In which case will the consumer respond more to a changc in the relative price of the two goods?

3. Marks consumes only cheese and crackers.

a. Could cheese and crackers both be inferk>r gixxJs for Mario? Explain.

b. Suppose that cheese is a normal good for Mario while crackers ate an inferior good. If the price of cheese falls, what happens to Mario's consumption of crackers? What happens to his consumption of cheese? Explain.

4. Jim buys only milk and cookies.

a. In year 1, Jim earns$lf»0. milk costs$2 per quart, and cookies cost 54 per dozen. Draw lim's budget constraint.

b. Now suppose that all prices increase by 10 percent in year 2 and that Jim's salary increases by 10 percent as well. Draw Jim's new budget constraint. How would Jim's optimal combination of milk and cookies in year 2 compare to his optimal combinatum in year 1?

5. A college student has two options for meals: eating at the dining hall for $6 per meal, or eating a Cup O' Soup for $1.150 per meal. His weekly food budget is $60.

a. Draw the budget constraint showing the trade-off between dining hall meals and Cups O' Soup. Assuming that he spends equal amounts on both goods, draw an indifference curve showing the optimum choice. Lalvl the optimum as point A.

b. Suppose the prke of a Cup O' Soup now rises to 52. Using your diagram from part (a), show the consequences of this change in price. Assume that our student now spends only 30 percent of his income on dining hall meals, Label the new optimum as point B

c. What happened lo the quantity of Cups O" Soup consumed as a result of this price change? What does this result say about the income and substitution effects? Explain.

d. Use points A and B to draw a demand curve for Cup O' Soup. What is this type of g<x>d called?

6. Consider your decision about how many hours to work.

a. Draw your budget constraint assuming that you pay no taxes on your income. On the same diagram, draw another budget constraint assuming that you pay 15 percent tax.

b. Show how the tax might lead to more hours of work, fewer hours, or the same number of hours. Explain.

7. Sarah is awake for 100 hours per week. Using one diagram, show Sarah's budget constraints if she earns per hour, $8 per hour, and $10 per hour. Now draw indifference curves such that Sarah's labor-supply curve is upward sloping when the wage is between S6 and 58 per hour, and backward »loping when the wage is between S8 and $10 per hour.

8. Draw the indifference curve for someone deciding how to allocate time between work and leisure. Suppose the wage increases. Is it possible that the person's consumption would fall? Is this plausible? Discuss. (Hint: Think about income and substitution effects.)

9. Suppose you take a job that pays $30J)00 and set some of this income aside in a savings account that pays an annual interest rate of 5 percent. Use a diagram with a budget constraint and indifference curves to show how your consumption changes in each of the following situations. To keep things simple, assume that you pay no taxis on your income.

a. Your salary increases to $40XXX).

b. The interest rate on your bank account rises to 8 percent.

10- As discussed in the text, we can divide an individual's life into two hypothetical periods: "young" and "old." Suppose the individual earns income only when young and saves some of that income to consume when old. If the interest rate on savings falls, can you tell what happens to consumption when young? Can you tell what happens to consumption when old? Explain.

11. Consider a couple's decision about how many children to have. Assume that over a lifetime a couple has SOO.fKX) hours of time to either work or raise children. The wage is $10 per hour. Raising a child takes 204300 hours of time.

a. Draw the budget constraint showing the trade-off between lifetime consumption and number of children. (Ignore the fact that children come only in whole numbers!) Show indifference curves and an optimum choice.

b. Suppose the wage increases to $12 per hour. Show how the budget constraint shifts. Using income and substitution effects, discuss the impact of the change on number of children and lifetime consumption.

c. We observe that, as societies get richer and wages rise, people typically have fewer children. Is this fac t consistent with this model? Explain.

12. Economist George Stigler once wrote that, according to consumer theory, "if consumers do not buy less of a commodity when their incomes rise, they will surely buy less when the price of the commodity rises." Explain this statement using the concepts of income and substitution effects.

13. The welfare system provides income to some needy families. Typically, the maximum payment goes to families that earn no income; then, as families begin to earn income, the welfare payment declines gradually and eventually disappears. Let's consider the possible effects of this program on a family's labor supply.

a. Draw a budget constraint for a family assuming that the welfare system did not exist On the same diagram, draw a budget constraint that reflects the existence of the welfare system.

b. Adding indifference curves to your diagram, show how the welfare system could reduce the number of hours worked by the family. Explain, with reference to both the income and substitution effects.

c. Using your diagram from part (b). show the effect of the welfare system on the well-being of the family.

14. Five consumers have the following marginal utility of apples and pears:

Marginal Utility Marginal Utfey of Applet of Pea's

Elalna 6 3

Ncwmyi 12 3

The price of an apple is 32, and the price of a pear is $1. Whkh, if any, of these consumers are optimizing over their choice of fruit? For those who are not. how should they change their spending?

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