Block 4: Consumer choice

MCQs

1. Judith spends all her money buying turmeric juice and cheese and wants to maximise her
utility from consuming these two goods. The marginal utility of the last bottle of turmeric
juice is 60, and the marginal utility of the last block of cheese is 30. The price of turmeric
juice is £3, and the price of cheese is £2. Judith:

a) is buying turmeric juice and cheese in the utility-maximising amounts.

b) should buy more turmeric juice and less cheese.
c) should buy more cheese and less turmeric juice.
d) is spending too much money on turmeric juice and cheese.

(b) is the correct answer.

2. Harry considers coffee and tea to be perfect substitutes, but he requires two cups of tea to
give up one cup of coffee. His budget constraint can be written as 3𝐶 + 𝑇 = 10. How
should Harry pick his optimal consumption bundle?

a) Harry should only consume tea and demand 𝑇 = 10.

"!
b) Harry should only consume coffee and demand 𝐶 = '
c) Harry should pick a bundle at the tangency between his indifference curve and his
budget constraint, where his MRS equals the price ratio.
d) Harry can consume any affordable bundle containing both tea and coffee.

(a) Is the correct answer

3. The price of an inferior good goes down. As a result:

a) Consumption increases as income and substitution effects enhance each other.

b) Consumption decreases as income and substitution effects enhance each other.
c) Consumption increases if the good is not Giffen.
d) Consumption is unchanged as income and substitution effects offset each other.

(c) is the correct answer.

True/False/Uncertain

1. If Daniel’s rent went up by 10% this year, but his income increased by 15% he cannot be
worse off than last year.

Uncertain. We do not know whether the increase in Daniel’s income is enough for him to

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 be able to afford his previous bundle. If that is the case, he cannot be worse off, but if all
other prices have increased by a lot Daniel might end up worse off.

2. Carla’s income increased by 20% last year and she bought 10% more audiobooks. This
means that audiobooks are inferior goods for Carla.

False. Carla’s income increased and she consumed more audiobooks. This is the definition
of normal goods.

3. Mark likes jeans and cowboy boots. He experiences diminishing marginal utility over these
two goods. He is indifferent between a bundle with 3 pairs of jeans and 2 pairs of cowboy
boots (bundle A) and a bundle with 2 pairs of jeans and 4 pairs of cowboy boots (bundle B).
Given this information we infer that he would prefer a bundle with 3 pairs of jeans and 3
pairs of cowboy boots.

True. Mark experiences diminishing marginal utility and considers jeans and cowboy boots
as substitutes, so he will be better off at a bundle with 3 pairs of both goods.

Long questions

1. Ivan earns £80 per week and needs to decide how many cans of Coke and sandwiches to buy.
Each sandwich costs £4 and every can of Coke costs £2. His utility function is 𝑈(𝑠, 𝑐) = 𝑠𝑐,
where 𝑠 stands for sandwich and 𝑐 for can of Coke.

a) Find an equation for Ivan’s budget constraint and show the budget constraint in a diagram.
b) Calculate the optimal weekly amounts of sandwiches and cans of Coke for Ivan and show
the optimal bundle on a graph.
c) Ivan has worked hard this year and his boss decides to give him a raise. He now earns £100
per week. Show the increase in income on a graph and discuss how it affects his demand
for sandwiches and Coke.
d) Explain what would happen if the price of sandwiches went up by £5 and income remained
at £100 per week. Show Ivan’s new budget line on a graph. Would Ivan still demand the
same amounts of sandwiches and cans of Coke?
e) Explain the difference between normal, inferior, and Giffen goods and what sign the
income and substitution effects are in each of these cases. Are sandwiches a normal good
in this case?

Guideline

a) See BVFD Section 5.1 for the derivation of the budget line and budget constraint. If the
price of a can of coke is £2, the price of a sandwich is £4 and with income £80 the equation
of the budget line is 2𝑐 + 4𝑠 = 80. This is the equation of a straight line. With cans of
coke on the horizontal axis and sandwiches on the vertical axis the budget line meets the
horizontal axis at 80/2 = 40 and the vertical axis at 80/4 = 20. The line has slope
−2/4 = −1/2. See the figure below.

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 !"
!#
* " +
b) The tangency condition requires that: 𝑀𝑅𝑆 = () = + = # so 𝑠 = #. The consumer’s
$%

chosen bundle must also lie on the budget line so 2𝑐 + 4𝑠 = 80. Solving simultaneously
gives 𝑐 = 20 and 𝑠 = 10. The indifference curve is tangent to the budget line at the
point (20, 10).
c) The increase in income results in a parallel shift up in Ivan’s budget constraint. As prices
and preferences have not changed, but income has, demand will be at the point where:
+
𝑐 = 2𝑠 → 2𝑐 + 4𝑠 = 100 so 𝑐 = 25 and 𝑠 = 12.5. Note that in both cases 𝑠 = # so
+
the points the consumer chooses both lie on the straight line through the origin 𝑠 = #.
d) The price of sandwiches goes up by £5, so the final price is £9, but the price of cans of Coke
stays at £2. This changes the slope of the budget line from −2/4 = −1/2 to −2/9. This
#
implies that 𝑠/𝑐 = 2/9 = 0.22, so 𝑠 = 0.22𝑐 or equivalently 𝑠 = N,O 𝑐.The new budget
line, with 𝑐 on the horizontal axis, is flatter. The budget constraint is now 2𝑐 + 9𝑠 = 100.
Solving gives 𝑠 = 50/9 = 5.56 and 𝑐 = 25. See the figure below.

e) Diagrams illustrating the ideas in an indifference curve diagram are helpful here.
A normal good is a good for which demand increases when income increases. Sandwiches
are a normal good. Income and substitution effects both decrease demand when price
increases. An inferior good is a good for which demand decreases when income increases.
The income effect increases demand, the substitution effect decreases demand. A Giffen

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 good is a good for which demand increases when its price increases. The substitution effect
of a price increase always decreases demand for that good. If the good is inferior the
income effect increases demand for the good so the income and substitution effects work
in opposite directions. It is theoretically possible that the income effect is larger than the
substitution effect, so the effect of the price increase is an increase in the demand for the
good. In this case the good is a Giffen good. As BVFD says, Giffen goods are very rare, if
they exist at all.

2. Susan buys bagels and falafels. The price of a falafels is £1 and the price of a bagels is £3. Susan
has £12 to spend on bagels and falafels.

a) Draw Susan’s budget constraint and a possible indifference curve. Explain the assumptions
behind the shape of the indifference curve you have drawn.
b) If the price of falafels falls to £0.80 each, how will this affect her purchases? Answer in
words and graphically, clearly indicating income and substitution effects of the price
change.
c) If Susan only enjoys bagels and falafels when she has 2 falafels for every bagel that she
eats, draw her indifference curves. How many bagels and falafels should she buy to
maximise her utility? Assume Susan has £12, one falafel costs £0.80 and bagels costs £3
each.
d) Susan’s friend Declan grows 100 potatoes each year and all of his income comes from
selling them. He spends all of his income each year consuming potatoes and other goods.
For Declan, potatoes are a Giffen good, in that for a given income his consumption of
potatoes will rise when their price rises. The price of potatoes falls and he consumes more
potatoes. Taking into account the fact that his income actually comes from selling
potatoes, explain how the last statement can be consistent with those that precede it.

Guideline

a) The indifference curve is downward sloping because we assume both falafels and bagels
are ‘goods’ not ‘bads’, such that Susan prefers more of these to less (this is called non-
satiation). The curve is concave to the origin because we assume that Susan experiences a
diminishing marginal rate of substitution between the two goods, such that when she has a
small amount of bagels she requires more falafels to give up some of this, but when she
has more falafels, she requires a smaller amount of bagels to give up some of this, and vice
versa.

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 bagels

0 12 falafels

b) When the price of falafels falls, Susan’s budget line rotates outward. She can now buy a
maximum of 15 falafels rather than 12. Her consumption of falafels will increase due to the
substitution effect (falafels are now cheaper relative to bagels compared to what it was
before) and the income effect (the lower price means she can buy more of everything).
These effects are marked on the diagram. In terms of her consumption of bagels, the
overall effect is ambiguous – she may buy more or less. The income effect will lead to an
increased demand for bagels, but the substitution effect will lead to a decrease, because
bagels are now more expensive relative to falafels.

bagels

C
A
B

0 12 15 falafels

"
c) The goods are now perfect complements. Her preferences are min S𝑥" , # 𝑥# T where 𝑥" are
"
bagels and 𝑥# falafels. Susan should optimally set 𝑥" = # 𝑥# . Substituting this into her
' - #' "!
budget line 3𝑥" + 0.8𝑥# = 12 gives # 𝑥# + "! 𝑥# = 12 so "! 𝑥# = 12 and 𝑥# = 12 ∗ #' =
"#! " &!
#'
and 𝑥" = # 𝑥# = #'.

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 bagels

4
1
!! = !
2 "

60
23

0 120 15 falafels
23

d) Giffen goods are always inferior goods because they have a negative income effect.
Because potatoes are a Giffen good for Declan, we would expect the quantity demanded to
fall when the price falls. However, the question states that the quantity demanded rises.
The reason for this is because Declan’s income derives from selling the potatoes. Since the
quantity he sells is fixed at 100, a fall in the price of potatoes signifies a fall in Declan’s
income. For inferior goods, the quantity demanded rises when income falls (negative
income effect). In this case, the rise in quantity Declan demands due to the fall in his
income more than offsets the decrease due to the fall in price.

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