Economics 101 L - Solutions

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Economics 101 L - Solutions

Homework No. 4

(due in lab on Sept. 29, 2008)

WORTH 100 POINTS TOTAL

1. WORTH 12 POINTS – 2 POINTS EACH

i. Pesticide residues on oranges are found to be too high for safe orange consumption by children.

ii.  A new orange variety with higher yields is released.

iii.  An increase in the price of apples.

iv.  A reduction in the price of insecticides for oranges.

v.  It is discovered that apples increase the risk of heart disease.

vi.  There is a very damaging freeze in the regions producing oranges.

2. Referring to the following figure depicting the budget line and indifference curves: WORTH 12 POINTS -

3 POINTS EACH

Beef

150

A x

x

B

0 600 Chicken

a.   Consider the budget line. If the price of chicken is $2.00, what is the price of beef?

Available budget = 600*2.00=1200

Price of Beef = 1200/150 = $8.00

b.   What is the relative price of beef? What is the relative price of chicken?

Relative Price of Chicken = 150/600 = 0.25 units of Beef

Relative Price of Beef = 600/150 = 4 units of Chicken

c.   Is point B superior or inferior to A? Inferior

d.   In the figure, show the best affordable point. What is the marginal rate of substitution at that point?

Tangency point on 3rd indifference curve from origin. MRS of indifference curve = slope of budget line = -p1/p2 = -1/4

3. Up to this month, Sofia has spent all of her monthly allowance buying 34 candies and 12 beanie babies, at a cost of $1 per candy and $3 per beanie baby. Next month, the price of candies will decrease to $0.50 per candy, and the price of each beanie baby will increase to $5. WORTH 40 POINTS

a.   What is Sofia's monthly allowance? Allowance (w) = p1x1 + p2x2 = 34*1 + 12*3 = 70 (3 POINTS)

b.   Using Excel, depict graphically Sofia's budget constraint for the current month and for next month assuming that Sofia's monthly allowance does not change. Put beanie babies in the horizontal axis and candies in the vertical axis. Answer questions (c), (d), and (e) below with reference to this graph. (5 POINTS)

c.   Will Sofia be able to buy 34 candies and 12 beanie babies next month? p1X1 * p2X2 = 77>70 No.

(3 POINTS)

d.   Based on your answer to part (c), will Sofia change her consumption next month relative to the current month? Why? Yes, 34 candies and 12 beanie babies are no longer attainable with the price changes and budget allowance.

(3 POINTS)

e.   Can you tell which situation Sofia prefers: Candies at $1 and beanie babies at $3, or candies at $0.50 and beanie babies at $5? Why? No, cannot tell. Don’t know the location of the indifference curves. If Sofia wishes to buy a lot of candy relative to beanie babies, she would prefer a lower relative price of candy. If she wishes to buy a lot of beanie babies relative to candy, she would prefer a lower relative price of beanie babies. (5 POINTS)

f.   Assume now that, because of the changes in the prices of candies and beanie babies, Sofia's parents decided to increase her monthly allowance to $77 starting next month. Using Excel, construct a graphic analogous to the one in part (b), but employing the new monthly allowance of $77, to construct next month's budget constraint. Answer questions (g), (h), and (i) below with reference to this graph. (5 POINTS)

g.   With the increased allowance, will Sofia be able to buy 34 candies and 12 beanie babies next month? Yes. p1X1 * p2X2 = 77

(3 POINTS)

h.   If next month Sofia changes her consumption relative to what she has been consuming in the past, which good will she buy more of and which will she buy less of? Assume that candies and beanie babies are not perfect complements for Sofia.

She will buy more candies and fewer beanie babies. If she buys more beanie babies, she will be on a lower indifference curve relative to past months since the point lies under the original budget line.

(5 POINTS)

i.   Assume that candies and beanie babies are not perfect complements for Sofia. Which situation does Sofia prefer: (I) Candies at $1, beanie babies at $3, and a monthly allowance of $70; or (II) candies at $0.50, beanie babies at $5, and a monthly allowance of $77? Why?

If Sofia wishes to purchase more than 12 beanie babies, she would prefer scenario 1. If she wishes to purchase more than 34 candies, she would prefer scenario 2. If she keeps her consumption at 34 candies and 12 beanie babies, she would be indifferent between the two. When purchasing more than 12 beanie babies the first budget line (allowance=$70) gives rise to a higher indifference curve. When purchasing more than 34 candies, the second budget line (allowance=$77) gives rise to a higher indifference curve.

(8 POINTS)

4. Referring to the following diagrams depicting indifference curves: WORTH 12 POINTS – 2 EACH

A B

Good y Good y

Good x Good x

C D

Good y Good y

Good x Good x

E F

Good y Good y

Good x Good x

a.   Which diagram(s) depict(s) perfect complements for all indifference curves? E

b.   Which diagram(s) display(s) a constant marginal rate of substitution for all indifference curves? D

c.   Which diagram(s) depict(s) perfect substitutes for all indifference curves? D

d.   In which diagram(s) do(es) the indifference curve(s) violate the assumptions about preferences? A,C

e.   Which diagram(s) display(s) an always diminishing marginal rate of substitution for all indifference curves? B

f.   Which diagram(s) best reflect(s) a person's preferences between (i) two different brands of mineral water, (ii) a right-foot shoe and the corresponding left-foot shoe, and (iii) coffee and tea?

i) D

ii) E

iii) B

5. Referring to the following figure, which depicts indifference curves and budget lines:

S

Quantity

of Milk

b

a

d

c

T R

Quantity of Eggs

a.   If the budget line shifts from SR to ST, then the price of milk must have risen, fallen, or stayed unchanged?

Unchanged

b.   If the budget line shifts from SR to ST, then the price of eggs must have risen, fallen, or stayed unchanged?

Risen

c.   If the budget line shifts from SR to ST, the substitution effect is illustrated by the move from a to b, a to c, a to d, b to c, b to d, or c to d? a to b

d.   If the budget line shifts from SR to ST, the income effect is illustrated by the move from a to b, a to c, a to d, b to c, b to d, or c to d? b to d

6. Referring to the following table: (WORTH 24 POINTS)

a.   Using Excel, depict the budget constraints for the three countries on a single graph. Put milk in the horizontal axis and pork in the vertical axis. (10 POINTS)

b.   In terms of units of pork, what is the real income in each country? In terms of units of pork, which country has the lowest real income? (4 POINTS)

Country A – 4,000 units of pork

Country B – 2,000 units of pork

Country C – 3,000 units of pork

Country B has the lowest real income in terms of units of pork.

c.   In terms of units of milk, what is the real income in each country? In terms of units of milk, which country has the highest real income? (4 POINTS)

Country A – 8,000 units of milk

Country B – 20,000 units of milk

Country C – 12,000 units of milk

Country A has the lowest real income in terms of units of milk.

d.   Which country has the lowest relative price of milk? (6 POINTS)

Country A relative price = (4,000/8,000) = 0.5

Country B relative price = (2,000/20,000) = 0.1

Country C relative price = (3,000/12,000) = 0.25

Country B has the lowest relative price of milk at 0.1 units of pork per unit of milk.