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62. Suppose Reta is planning for retirement in a two-period world. In the first period Reta is young and
earns $1 million, and in the second period Reta is old and retired and earns nothing. The interest
rate is initially 10 percent, but then it falls to 7 percent. After the interest rate falls, the
a. substitution effect will induce Reta to consume more when she is young.
b. substitution effect will induce Reta to consume less when she is young.
c. income effect will induce Reta to consume more when she is young.
d. change in interest rates affects the substitution effect but not the income effect.
63. The opportunity cost of current household consumption is the
a. wage rate.
b. market interest rate.
c. price of the goods consumed.
d. explicit cost of consumption.
5324 The Theory of Consumer Choice
64. Suppose that you have $100 today and expect to receive $100 one year from today. Your money
market account pays an annual interest rate of 25%, and you may borrow money at that interest
rate. If you save all your money, how much money will you have one year from today?
a. $100
b. $125
c. $200
d. $225
65. Suppose that you have $100 today and expect to receive $100 one year from today. Your money
market account pays an annual interest rate of 25%, and you may borrow money at that interest
rate. Suppose that you borrow $60 and spend $160 today. After you repay your loan one year
from today, how much money will you have available for consumption one year from today?
a. $0
b. $25
c. $50
d. $75
The Theory of Consumer Choice 5325
66. Suppose that you have $100 today and expect to receive $100 one year from today. Your money
market account pays an annual interest rate of 25%, and you may borrow money at that interest
rate. Consider the budget constraint between “spending today” on the horizontal axis and
“spending a year from today” on the vertical axis. What is the slope of this budget constraint?
a. –0.75
b. –1.00
c. –1.25
d. –2.25
67. Consider the budget constraint between “spending today” on the horizontal axis and “spending a
year from today” on the vertical axis. Suppose that you have $100 today and expect to receive
$100 one year from today. Your money market account pays an annual interest rate of 25%, and
you may borrow money at that interest rate. Suppose now that the interest rate increases to 40%.
What happens to the slope of your budget constraint relative to when the interest rate was 25%?
The slope
a. becomes steeper.
b. becomes flatter.
c. doesn‘t change because the budget constraint shifts in parallel to the original budget constraint.
d. doesn’t change because the budget constraint shifts out parallel to the original budget constraint.
5326 The Theory of Consumer Choice
68. Consider the budget constraint between “spending today” on the horizontal axis and “spending a
year from today” on the vertical axis. Suppose that you have $100 today and expect to receive
$100 one year from today. Your money market account pays an annual interest rate of 25%, and
you may borrow money at that interest rate. Suppose now that the interest rate decreases to 10%.
What happens to the slope of your budget constraint relative to when the interest rate was 25%?
The slope
a. becomes steeper.
b. becomes flatter.
c. doesn‘t change because the budget constraint shifts in parallel to the original budget constraint.
d. doesn’t change because the budget constraint shifts out parallel to the original budget constraint.
69. If an increase in the interest rate raises savings, then
a. the substitution effect is greater than the income effect.
b. the income effect is greater than the substitution effect.
c. the income effect and the substitution effect move in the same direction.
d. we are unable to determine the sizes of the income and substitution effects without more
information.
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70. If an increase in the interest rate lowers savings, then
a. the substitution effect is greater than the income effect.
b. the income effect is greater than the substitution effect.
c. the income effect and the substitution effect move in the same direction.
d. we are unable to determine the sizes of the income and substitution effects without more
information.
71. Giffen goods are
a. normal goods for which the income effect dominates the substitution effect.
b. normal goods for which the substitution effect dominates the income effect.
c. inferior goods for which the income effect dominates the substitution effect.
d. inferior goods for which the substitution effect dominates the income effect.
5328 The Theory of Consumer Choice
72. If Chad’s labor-supply curve is upward–sloping, then, for Chad,
a. an increase in the wage creates an income effect that is greater than the substitution effect.
b. an increase in the wage creates a substitution effect that is greater than the income effect.
c. leisure and consumption are perfect substitutes.
d. leisure and consumption are perfect complements.
73. If Suzette responds to an increase in the interest rate by decreasing her saving, then, for Suzette,
a. the increase in the interest rate creates an income effect that is greater than the substitution
effect.
b. the increase in the interest rate creates a substitution effect that is greater than the income
effect.
c. consumption when young and consumption when old are perfect substitutes.
d. consumption when young and consumption when old are perfect complements.
The Theory of Consumer Choice 5329
True/False and Short Answer
1. The theory of consumer choice illustrates that people face tradeoffs, which is one of the Ten
Principles of Economics.
a. True
b. False
2. A consumer’s budget constraint for goods X and Y is determined by how much the consumer likes
good X relative to good Y.
a. True
b. False
3. The slope of the budget constraint reveals the relative price of good X compared to good Y.
a. True
b. False
5330 The Theory of Consumer Choice
4. The slope of a consumer’s budget constraint is unaffected by a change in income.
a. True
b. False
5. If a consumer experiences a decrease in income, the new budget constraint will have the same
slope as the old budget constraint.
a. True
b. False
6. A budget constraint illustrates bundles that a consumer prefers equally, while an indifference curve
illustrates bundles that are equally affordable to a consumer.
a. True
b. False
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7. For a typical consumer, most indifference curves are bowed inward.
a. True
b. False
8. For a typical consumer, most indifference curves are downward sloping.
a. True
b. False
9. For a typical consumer, indifference curves can intersect if they satisfy the property of transitivity.
a. True
b. False
5332 The Theory of Consumer Choice
10. A typical indifference curve is upward sloping.
a. True
b. False
11. When two goods are perfect complements, the indifference curves are right angles.
a. True
b. False
12. The indifference curves for left shoes and right shoes are right angles.
a. True
b. False
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13. The indifference curves for left gloves and right gloves are straight lines.
a. True
b. False
14. The indifference curves for perfect substitutes are right angles.
a. True
b. False
15. The indifference curves for perfect substitutes are straight lines.
a. True
b. False
5334 The Theory of Consumer Choice
16. The indifference curves for nickels and dimes are straight lines.
a. True
b. False
17. If goods A and B are perfect substitutes, then the marginal rate of substitution of good A for
good B is constant.
a. True
b. False
18. The slope at any point on an indifference curve equals the absolute price at which a consumer is
willing to substitute one good for the other.
a. True
b. False
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19. The marginal rate of substitution between goods A and B measures the price of A relative to the
price of B.
a. True
b. False
20. The marginal rate of substitution is the slope of the budget constraint.
a. True
b. False
21. The marginal rate of substitution is the slope of the indifference curve.
a. True
b. False
5336 The Theory of Consumer Choice
22. When indifference curves are downward sloping, the marginal rate of substitution is usually
constant.
a. True
b. False
23. When indifference curves are bowed inward, the marginal rate of substitution varies at each point
on the indifference curve.
a. True
b. False
24. A consumer’s optimal choice is affected by income, prices of goods, and preferences.
a. True
b. False
The Theory of Consumer Choice 5337
25. At a consumer’s optimal choice, the consumer chooses the combination of goods that equates the
marginal rate of substitution and the price ratio.
a. True
b. False
26. At a consumer’s optimal choice, the consumer chooses the combination of goods such that the
ratio of the marginal utilities equals the ratio of the prices.
a. True
b. False
27. If consumers purchase more of a good when their income rises, the good is a normal good.
a. True
b. False
5338 The Theory of Consumer Choice
28. If a consumer purchases more of good B when his income rises, good B is an inferior good.
a. True
b. False
29. A typical consumer consumes both coffee and donuts. After the consumer’s income decreases,
the consumer consumes more coffee but fewer donuts than before. For this consumer, coffee is a
normal good, but donuts are an inferior good.
a. True
b. False
30. A typical consumer consumes both coffee and donuts. After the consumer’s income decreases,
the consumer consumes more coffee but fewer donuts than before. For this consumer, donuts are
a normal good, but coffee is an inferior good.
a. True
b. False
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31. If a consumer purchases more of good X and good Y after her income increases, then neither
good X nor good Y is an inferior good for her.
a. True
b. False
32. If a consumer purchases more of good A when her income falls, good A is an inferior good.
a. True
b. False
33. The income effect of a price change is unaffected by whether the good is a normal or inferior
good.
a. True
b. False
5340 The Theory of Consumer Choice
34. The income effect of a price change is the change in consumption that results from the movement
to a new indifference curve.
a. True
b. False
35. The direction of the substitution effect is not influenced by whether the good is normal or inferior.
a. True
b. False
36. The substitution effect of a price change is the change in consumption that results from the
movement to a new indifference curve.
a. True
b. False
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37. All points on a demand curve are optimal consumption points.
a. True
b. False
38. Giffen goods violate the law of demand.
a. True
b. False
39. Giffen goods are inferior goods for which the income effect dominates the substitution effect.
a. True
b. False
5342 The Theory of Consumer Choice
40. Economists have found evidence of a Giffen good when studying the consumption of rice in the
Chinese province of Hunan.
a. True
b. False
41. Katie wins $3 million in her state’s lottery. If Katie drastically reduces the number of hours she
works after she wins the money, we can infer that the income effect is larger than the substitution
effect for her.
a. True
b. False
42. Susie wins $2 million in her state’s lottery. If Susie keeps working after she wins the money, we
can infer that the income effect is larger than the substitution effect for her.
a. True
b. False