Solutions for Topic 6: Possibilities, Preference and Choice

Question 6.1

Anna earns $150 a week and she consumes fish and shrimp. The price of fish is $3 a pound and the price of shrimp is $5 a pound. Anna can therefore buy a maximum of _____ pounds of fish or a maximum of _____ pounds of shrimp.

(A) 30, 50 

(B)  50, 30

(C)  15, 30

(D)  30,15

(E)  50,15

Solution 6.1

The correct answer is (B).

Out of $150, he can buy a maximum of $150/$3 = 50 pounds of fish, or a maximum of $150/$5 = 30 pounds of shrimps.

Question 6.2

The quantity of Revlon nail polish demanded by Jen decreased after the price of Revlon nail polish increased. Jen decides to find a cheaper brand of nail polish. This is called

      A)        substitution effect of a price change

      B)        increase in buyer's reservation price

      C)        income effect of a price change

      D)        shift in the supply curve

      E)        decrease in buyer's reservation price

Solution 6.2

The correct answer is (A)

When a consumer switch to a cheaper substitute due to a higher price of the original product, this reflects the substitution effect of a price change

Question 6.3

Units               Total Utility of Food             Total utility of rooms

1                      75                                            480

2                      135                                          720

3                      180                                          960

4                      210                                          1120

Refer to the table above.  If the price of Food is $5 and the price of Rooms is $80, then the best spending consumption implies _____ units of Food and ______ Rooms will be purchased.

(A)  4;3

(B)  3;4

(C)  4;4

(D)  3;3

(E)  4;1

Solution 6.3

The correct answer is (E).

We need to calculate the MU/P for both products.

The optimal consumption combination occurs when (MU/P)_Food = (MU/P)_Room.

From the table, the best combination is 4 units of food and 1 unit of room

Note that if information on income is available, then this combination should also exhaust the income.

Units                     MU/P food                  MU/P rooms

1                            15                                            6

2                            12                                            3

3                            9                                              3

4                            6                                              2

Question 6.4

(a) Explain why the best affordable point is the point at which the budget line touches the highest attainable indifference curve.

(b) What happen when the consumer has a higher income and one of the product is an inferior good?

Solution 6.4

(a)  At the tangency point of an indifference curve with the budget line, the consumer gets the highest total utility given his budget constraint, and hence the point is the optimal consumption point. Draw a diagram like slide 22

(b)  With a higher income, the budget line shifts outwards in a parallel manner.

Assume that X is inferior and Y is normal.  The final equilibrium must indicate a smaller quantity of Y demanded and a larger X demanded. Draw a diagram like slide 27 showing the shift out of the curve.

Question 6.5

Consider two products, A and B.  Represent A on the Y axis and B on the X axis and establish the best affordable point.  What happen to the best affordable point when the price of B increases and B is a normal good?

Solution 6.5

With a higher price of B, the budget line becomes steeper. Consumption of B decreases. Draw a diagram like slide 25, but with prices rising (not falling like in the slide!)