98 ❖ Chapter 21/The Theory of Consumer Choice
49. Assume that consumption when young and consumption when old are both normal goods. The in-
come effect of an increase in the interest rate will result in
a.
an increase in saving when young.
b.
an increase in saving when old.
c.
a decrease in saving when young.
d.
a decrease in saving when old.
50. Jordan is planning ahead for retirement and must decide how much to spend and how much to save
while he’s working in order to have money to spend when he retires. When the income effect domi-
nates the substitution effect, an increase in the interest rate on savings will cause him to
a.
decrease his savings rate.
b.
increase his savings rate.
c.
continue saving at the current rate.
d.
Any of the above could be correct.
51. Calvin is planning ahead for retirement and must decide how much to spend and how much to save
while he’s working in order to have money to spend when he retires. When the substitution effect
dominates the income effect, an increase in the interest rate on savings will cause him to
a.
increase his savings rate.
b.
decrease his savings rate.
c.
continue saving at the same rate.
d.
Any of the above are possible.
52. John is planning ahead for retirement in a two-period world. When John is young he will earn $1
million, and when John is old and retired he will be given $50,000 from Social Security. If the inter-
est rate between the two time periods is 7 percent, what is the slope of John’s budget constraint when
considering the consumption possibilities between the two periods if consumption when young is
graphed on the horizontal axis and consumption when old is graphed on the vertical axis?
a.
-0.89
b.
-1.05
c.
-1.07
d.
-1.12
Chapter 21/The Theory of Consumer Choice ❖ 99
53. 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.
54. 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.
55. 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
56. 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
57. 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.
100 ❖ Chapter 21/The Theory of Consumer Choice
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
58. 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 hap-
pens 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.
59. 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 hap-
pens 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.
60. 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.
Chapter 21/The Theory of Consumer Choice ❖ 101
61. 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.
CONCLUSION
1. The theory of consumer choice explains how people choose between
a.
textbooks and energy drinks.
b.
labor and leisure.
c.
spending now and spending in the future.
d.
All of the above are correct.
2. The theory of consumer choice provides a(n)
a.
literal account of how people make decisions.
b.
unrealistic picture of how people make decisions.
c.
model that is consistent with how people make decisions.
d.
in-depth model that is based more in psychology than in economics.
3. The theory of consumer choice describes the
a.
literal process by which people make decisions.
b.
irrational decisions made by consumers on a daily basis.
c.
implicit, psychological process by which people make explicit, economic decisions.
d.
Both a) and b) are correct.
TRUE/FALSE
1. The theory of consumer choice illustrates that people face tradeoffs, which is one of the Ten Princi-
ples of Economics.
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.
102 ❖ Chapter 21/The Theory of Consumer Choice
3. The slope of the budget constraint reveals the relative price of good X compared to good Y.
4. The slope of a consumer’s budget constraint is unaffected by a change in income.
5. If a consumer experiences a decrease in income, the new budget constraint will have the same slope
as the old budget constraint.
6. A budget constraint illustrates bundles that a consumer prefers equally, while an indifference curve
illustrates bundles that are equally affordable to a consumer.
7. For a typical consumer, most indifference curves are bowed inward.
8. For a typical consumer, most indifference curves are downward sloping.
9. For a typical consumer, indifference curves can intersect if they satisfy the property of transitivity.
10. A typical indifference curve is upward sloping.
11. When two goods are perfect complements, the indifference curves are right angles.
12. The indifference curves for left shoes and right shoes are right angles.
Chapter 21/The Theory of Consumer Choice ❖ 103
13. The indifference curves for left gloves and right gloves are straight lines.
14. The indifference curves for perfect substitutes are right angles.
15. The indifference curves for perfect substitutes are straight lines.
16. The indifference curves for nickels and dimes are straight lines.
17. If goods A and B are perfect substitutes, then the marginal rate of substitution of good A for good B
is constant.
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.
19. The marginal rate of substitution between goods A and B measures the price of A relative to the
price of B.
20. The marginal rate of substitution is the slope of the budget constraint.
21. The marginal rate of substitution is the slope of the indifference curve.
22. When indifference curves are downward sloping, the marginal rate of substitution is usually con-
stant.
104 ❖ Chapter 21/The Theory of Consumer Choice
23. When indifference curves are bowed inward, the marginal rate of substitution varies at each point on
the indifference curve.
24. A consumer’s optimal choice is affected by income, prices of goods, and preferences.
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.
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.
27. If consumers purchase more of a good when their income rises, the good is a normal good.
28. If a consumer purchases more of good B when his income rises, good B is an inferior good.
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 nor-
mal good, but donuts are an inferior good.
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 nor-
mal good, but coffee is an inferior good.
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.
Chapter 21/The Theory of Consumer Choice ❖ 105
32. If a consumer purchases more of good A when her income falls, good A is an inferior good.
33. The income effect of a price change is unaffected by whether the good is a normal or inferior good.
34. The income effect of a price change is the change in consumption that results from the movement to
a new indifference curve.
35. The direction of the substitution effect is not influenced by whether the good is normal or inferior.
36. The substitution effect of a price change is the change in consumption that results from the move-
ment to a new indifference curve.
37. All points on a demand curve are optimal consumption points.
38. Giffen goods violate the law of demand.
39. Giffen goods are inferior goods for which the income effect dominates the substitution effect.
40. Economists have found evidence of a Giffen good when studying the consumption of rice in the
Chinese province of Hunan.
106 ❖ Chapter 21/The Theory of Consumer Choice
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.
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.
43. Shelley wins $1 million in her state’s lottery. If Shelley keeps working after she wins the money,
we can infer that the substitution effect must exactly offset the income effect for her.
44. A rational person can have a negatively-sloped labor supply curve.
45. The substitution effect in the work-leisure model induces a person to work less in response to higher
wages, which tends to make the labor-supply curve slope upward.
46. The income effect in the work-leisure model induces a person to work less in response to higher
wages, which tends to make the labor-supply curve slope backward.
47. A worker with a backward-bending labor supply curve responds to an increase in wages by working
more hours.
48. A rise in the interest rate will generally result in people consuming more when they are old if the
substitution effect outweighs the income effect.
Chapter 21/The Theory of Consumer Choice ❖ 107
49. A rise in the interest rate will generally result in people consuming less when they are old if the sub-
stitution effect outweighs the income effect.
50. The theory of consumer choice is representative of how consumers make decisions but is not in-
tended to be a literal account of the process.
SHORT ANSWER
1. Answer the following questions based on the table. A consumer is able to consume the following
bundles of rice and beans when the price of rice is $2 and the price of beans is $3.
RICE
BEANS
12
0
6
4
0
8
a.
How much is this consumer’s income?
b.
Draw a budget constraint given this information. Label it B.
c.
Construct a new budget constraint showing the change if the price of rice falls $1. Label this C.
d.
Given the original prices for rice ($2) and beans ($3), construct a new budget constraint if this
consumer’s income increased to $48. Label this D.
$24
108 ❖ Chapter 21/The Theory of Consumer Choice
2. Draw a budget constraint that is consistent with the following prices and income.
Income = 200
PY = 50
PX = 25
a.
Demonstrate how your original budget constraint would change if income increases to
500.
b.
Demonstrate how your original budget constraint would change if PY decreases to 20.
c.
Demonstrate how your original budget constraint would change if PX increases to 40.
3. Assume that a consumer faces the following budget constraints.
Chapter 21/The Theory of Consumer Choice ❖ 109
a.
Assuming that income is the same on both occasions, describe the difference in relative
prices between Panel A and Panel B.
b.
If income in Panel B is $126, what is the price of good X?
c.
If income in Panel A is $84, what is the price of good Y?
d.
Assuming that the price of good X is the same on both occasions, describe the
difference in income and price of good Y between Panel A and Panel B.
4. Evaluate the following statement, “Warren Buffet is the second richest person in the world. He
doesn’t face any constraint on his ability to purchase commodities he wants.”
5. List and briefly explain each of the four properties of indifference curves.
110 ❖ Chapter 21/The Theory of Consumer Choice
6. Draw indifference curves that reflect the following preferences.
a.
b.
c.
d.
7. Graphically demonstrate the conditions associated with a consumer optimum. Carefully label all
curves and axes.
Chapter 21/The Theory of Consumer Choice ❖ 111
8. Explain the relationship between the budget constraint and indifference curve at a consumer’s opti-
mum.
9. Assume that a person consumes two goods, Coke and Snickers. Use a graph to demonstrate how the
consumer adjusts his/her optimal consumption bundle when the price of Coke decreases. Carefully
label all curves and axes. What will happen to consumption if Coke is a normal good? What will
happen to consumption if Coke is an inferior good? (Remember to explain the possible change when
the income effect dominates and when the substitution effect dominates.)
112 ❖ Chapter 21/The Theory of Consumer Choice
10. Using the graph shown, construct a demand curve for M&M’s given an income of $10.
Chapter 21/The Theory of Consumer Choice ❖ 113
11. Using indifference curves and budget constraints, graphically illustrate the substitution and income
effect that would result from a change in the price of a normal good.
12. Explain the difference between inferior and normal goods. As a developing economy experiences
increases in income (measured by GDP), what would you predict to happen to demand for inferior
goods?
13. Janet knows that she will ultimately face retirement. Assume that Janet will experience two periods
in her life, one in which she works and earns income, and one in which she is retired and earns no
114 ❖ Chapter 21/The Theory of Consumer Choice
income. Janet can earn $250,000 during her working period and nothing in her retirement period.
She must both save and consume in her work period and can earn 10 percent interest on her savings.
a.
Use a graph to demonstrate Janet’s budget constraint.
b.
On your graph, show Janet at an optimal level of consumption in the work period equal
to $150,000. What is the implied optimal level of consumption in her retirement period?
c.
Now, using your graph from part b above, demonstrate how Janet will be affected by an
increase in the interest rate on savings to 14 percent. Discuss the role of income and
substitution effects in determining whether Janet will increase, or decrease her savings in
the work period.
a.
see graph below
c.
see graph below