METU, Department of Economics Fall 2020

Instructor: Esma Gaygısız

T.A.: Ayşenur Ahsen

ECON 211 – Problem Set

Chapter 4
Solutions
1. An individual consumes two goods, clothing and food. Given the information below, illustrate
both the income-consumption curve and the Engel curve for clothing and food.

Solution:

The income-consumption curve connects each of the four optimal bundles given in the table
above. As the individual’s income increases, the budget line shifts out and the optimal bundles
changes. The Engel curve for each good illustrates, the budget shifts out and the optimal bundles
change. The engel curve for each good illustrates the relationship between the quantity consumed
and income (on the vertical axis). Both Engel curves are upward sloping, so both goods are normal.
2- A consumer has a utility function: 𝑢𝑢(𝑥𝑥1 , 𝑥𝑥2 ) = 𝑥𝑥1𝑎𝑎 𝑥𝑥21−𝑎𝑎
a. Derive the demand functions of both goods for prices p1, p2 and income M.
b. Derive the income expansion path (income consumption curve) and show it on a graph.
c. Derive the Engel curve for both goods and show it on a graph.
Solution:
3- a. Orange juice and apple juice are known to be perfect substitutes. Draw the appropriate
price-consumption curve (for a variable price of orange juice) and income-consumption curve.
b. Left shoes and right shoes are perfect complements. Draw the appropriate price-
consumption and income-consumption curves.

Solution:
a. Orange juice and apple juice are known to be perfect substitutes. Draw the appropriate
price-consumption curve (for a variable price of orange juice) and income-consumption curve.

We know that indifference curves for perfect substitutes are straight lines like the line EF in the
price-consumption curve diagram below. In this case, the consumer always purchases the
cheaper of the two goods (assuming a one-for-one tradeoff). If the price of orange juice is less
than the price of apple juice, the consumer will purchase only orange juice and the price-
consumption curve will lie along the orange juice axis of the graph (from point F to the right).

If apple juice is cheaper, the consumer will purchase only apple juice and the price-consumption
curve will be on the apple juice axis (above point E). If the two goods have the same price, the
consumer will be indifferent between the two; the price-consumption curve will coincide with
the indifference curve (between E and F).

Assuming that the price of orange juice is less than the price of apple juice, the consumer will
maximize her utility by consuming only orange juice. As income varies, only the amount of
orange juice varies. Thus, the income-consumption curve will be along the orange juice axis
as in the figure below. If apple juice were cheaper, the income-consumption curve would lie on
the apple juice axis.
 b. Left shoes and right shoes are perfect complements. Draw the appropriate price-
consumption and income-consumption curves.

For perfect complements, such as right shoes and left shoes, the indifference curves are L-
shaped. The point of utility maximization occurs when the budget constraints, L1 and L2 touch
the kink of U1 and U2. See the following figure.

In the case of perfect complements, the income consumption curve is also a line through the
corners of the L-shaped indifference curves. See the figure below.

4- For which of the following goods is a price increase likely to lead to a substantial
income (as well as substitution) effect? Why?
a. Salt
b. Housing
c. Theater tickets
d. Food

Solution:
a. salt
Small income effect, small substitution effect: The amount of income that is spent on salt is very
small, so the income effect is small. Because there are few substitutes for salt, consumers will
not readily substitute away from it, and the substitution effect is therefore small.
 b. housing
Large income effect, small substitution effect: The amount of income spent on housing is
relatively large for most consumers. If the price of housing rises, real income is reduced
substantially, leading to a large income effect. However, there are no really close substitutes for
housing, so the substitution effect is small.
c. theater tickets
Small income effect, large substitution effect: The amount of income spent on theater tickets is
usually relatively small, so the income effect is small. The substitution effect is large because
there are many good substitutes such as movies, TV shows, bowling, dancing and other forms of
entertainment.
d. food
Large income effect, virtually no substitution effect: As with housing, the amount of income
spent on food is relatively large for most consumers, so the income effect is large. Although
consumers can substitute out of particular foods, they cannot substitute out of food in general,
so the substitution effect is essentially zero.

5- Explain which of the following items in each pair is more price elastic.
a. The demand for a specific brand of toothpaste and the demand for toothpaste in general
b. The demand for gasoline in the short run and the demand for gasoline in the long run
Solution:
a. The demand for a specific brand of toothpaste and the demand for toothpaste in general
The demand for a specific brand is more elastic because the consumer can easily switch to
another brand if the price goes up. It is not so easy to switch to a different tooth brushing
agent (baking soda?).
b. The demand for gasoline in the short run and the demand for gasoline in the long run
Demand in the long run is more elastic since consumers have more time to adjust to a
change in price. For example, consumers can buy more fuel efficient vehicles, move closer to
work or school, organize car pools, etc.

6- Illustrate the substitution and income effect in the following situations using necessary graphs:
a. Price of good x which is inferior but not a Giffen good decreases
b. Price of good x which is Giffen good increases.
Solution:
 7- There are four individuals, Alice, Bob, Chris and Dale who buy widgets. Their individual demands
are given by the following inverse demand functions:
𝑃𝑃(𝑥𝑥𝐴𝐴 ) = 5 − 𝑥𝑥𝐴𝐴
𝑃𝑃(𝑥𝑥𝐵𝐵 ) = 10 − 5𝑥𝑥𝐵𝐵
𝑃𝑃(𝑥𝑥𝐶𝐶 ) = 20 − 𝑥𝑥𝐶𝐶
𝑃𝑃(𝑥𝑥𝐷𝐷 ) = 10 − 2𝑥𝑥𝐷𝐷
a. Derive an expression for the market demand for widgets (you can assume that above people are
the only people buying widgets). Graph this market demand with price on the vertical axis and
widgets on the horizontal axis.
b. Along which segment of the market demand curve is demand most elastic? Along which segment
is demand most inelastic?
c. Suppose that the market supply of widgets at a given price is 𝑆𝑆(𝑃𝑃) = −6 + (3/2)𝑃𝑃. What is the
equilibrium price and quantity? Which consumers are buying positive amounts of the good?

Solution:
Multiple Choice
1. If an Engel curve has a positive slope
A) both goods are normal.
B) the good on the horizontal axis is normal
C) as the price of the good on the horizontal axis increases, more of both goods in consumed.
 D) as the price of the good on the vertical axis increases, more of the good on the horizontal axis is
consumed.

2. Which of the following claims is true at each point along a price-consumption curve?
A) Utility is maximized but income is not all spent.
B) All income is spent, but utility is not maximized.
C) Utility is maximized, and all income is spent.
D) The level of utility is constant.

3. When a good has a unitary price elasticity, consumer expenditures for the good
A) change in the same direction as a price change.
B) change in the opposite direction to a price change, but not necessarily by the same
percentage as the price change.
C) do not change when the price of the good decreases.
D) change in the opposite direction and by the same percentage as any price change.

4. The demand for sirloin steak (bonfile) is probably more elastic than the demand for all meat
because
A) steak is very expensive.
B) people are worried about cholesterol.
C) cattle raising is not very profitable.
D) there are more substitutes for sirloin steak than for all meats.

5. The point price elasticity of demand is -1/2. The price of the product increases from $1.00 to
$1.10. Given the information in Scenario 4.3, the quantity demanded will decrease by
approximately:
A) 5 units.
B) 5 percent.
C) 10 units.
D) 10 percent.
E) none of the above

6. Economists Robert Jensen and Nolan Miller reasoned that to be a Giffen good, with an income
effect larger than its substitution effect, a good must be ________ and make up a ________
portion of a consumer's budget.
A) a normal good; very small
B) an inferior good; very small
C) a normal good; very large
D) an inferior good; very large

7. The difference between what a consumer is willing to pay for a unit of a good and what must be
paid when actually buying it is called
A) producer surplus.
B) consumer surplus.
C) cost benefit analysis.
D) net utility.
8. The demand curve for tickets to the George Winston concert (with special guest star, Kenny G) is
given as follows:
Q = 200 - 0.1P
At a price of $30, what is the consumer surplus from concert tickets?
A) $0
B) $20
C) $2,000
D) $1,970
E) $194,045

9. When the price of audio books, a normal good, falls, causing your purchasing power to rise, you
buy more of them due to
A) the substitution effect.
B) the income effect.
C) the deadweight loss effect.
D) the elasticity effect.

10. When the price of summer tank tops falls and you buy more of them because they are relatively
less expensive, this is called
A) the substitution effect.
B) the income effect.
C) the deadweight loss effect.
D) the elasticity effect.

11. If the price of lattes, a normal good you enjoy, falls

A) the income and substitution effects offset each other but the price effect leads you to buy more
lattes.
B) both the income and substitution effects lead you to buy more lattes.
C) the income effect which causes you to increase your latte consumption outweighs the
substitution effect which causes you to reduce your latte consumption, resulting in more latte
purchased.
D) the substitution effect which causes you to increase your latte consumption outweighs the
income effect which causes you to reduce your latte consumption, resulting in more latte
purchased.

12. The demand curve for corn is downward sloping. If the price of corn, an inferior good, falls
A) the income effect which causes you to reduce your corn purchases is smaller than the
substitution effect which causes you to increase your corn purchases, resulting in a net increase
in quantity demanded.
B) the income effect which causes you to increase your corn purchases is larger than the
substitution effect which causes you to reduce your corn purchases, resulting in a net increase in
quantity demanded.
C) both the income and substitution effects reinforce each other to increase the quantity
demanded.
D) the income and substitution effects offset each other but the price effect of an inferior good
leads you to buy less corn.
13. Based on the diagram below it can be inferred that:

A) hot dogs are a normal good for all levels of income.

B) hot dogs are an inferior good, but not a Giffen good, for all levels of income.
C) hot dogs are a Giffen good for all levels of income.
D) hot dogs are an inferior good for low levels of income, but at higher levels of income become
a normal good.
E) none of the above