Solution Manual for Microeconomics Principles

and Applications 6th Edition Hall Lieberman

1111822565 9781285119434
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CHAPTER 6
CONSUMER CHOICE

SPECIAL NOTE:

The authors give instructors a choice of teaching with (1) marginal utility, (2) indifference
curves, or (3) both. The body of the chapter uses marginal utility alone, while the optional
appendix presents a full, elementary introduction to indifference curves. Those instructors who
wish to use marginal utility alone should simply skip the appendix; those who wish to use
indifference curves only should tell students to read about the budget constraint in the body of
the chapter, but substitute the appendix in place of the sections on marginal utility.

MASTERY GOALS

The objectives of this chapter are to:

1. Define the budget constraint and explain how to interpret its slope.
2. Describe how a budget constraint changes in response to a change in income or prices.
3. Explain and justify the assumptions economists make about preferences in order to
develop the theory of consumer choice.
4. Define utility and marginal utility and state the law of diminishing marginal utility.
5. Explain how a budget constraint helps us analyze utility maximization.

57
58 Instructor’s Manual for Economics: Principles and Applications, 6e

6. Explain how changes in income affect consumer choices in the case of normal goods
and inferior goods.
7. Explain how price changes affect consumer behavior and use this information to
construct an individual demand curve.
8. Describe the substitution and income effects of a price change.
9. Explain why we expect the law of demand to hold, even in the case of inferior goods.
10. Discuss how budget constraints can be used to show the usefulness of consumer theory
whenever two alternatives are considered.
11. Discuss some problems that complicate the basic model of consumer behavior presented
in the chapter.
12. Describe the subfield of economics known as behavioral economics, and discuss the
challenge it presents to the basic model of consumer behavior.
13. (Optional Appendix) Identify the major difference between the marginal utility
approach and the indifference curve approach to utility maximization.
14. (Optional Appendix) Describe indifference curve analysis, and derive the condition for
the consumer’s optimal choice (the marginal rate of substitution must equal the slope of
the budget constraint).
15. (Optional Appendix) Use indifference curve analysis to derive the individual's demand
curve.

THE CHAPTER IN A NUTSHELL

Chapter 6 analyzes choices faced by consumers and takes two approaches to analyzing the
decisions of individual households.
In one approach, the concept of marginal utility together with the budget constraint explains
how an individual chooses the best combination of different goods or services. Generally, this
theory of consumer behavior explains how an individual chooses between any two alternatives.
A budget constraint identifies which combinations of goods and services a consumer can afford
with a limited budget, at given prices. Changes in income will cause the budget constraint to
shift, while a change in a price will cause the budget constraint to rotate.
Utility is the satisfaction that a consumer gets from consuming goods or services. Marginal
utility is the increment in utility an individual gets from an additional unit of a good. The law
of diminishing marginal utility states that the marginal utility of a thing to anyone diminishes
with every increase in the amount one already has.
The concept of utility helps us to characterize peoples’ preferences. Our theory of consumer
choice focuses on the assumptions that people have preferences, that preferences are transitive,
 Chapter 6 Consumer Choice 59

and that marginal utility is positive. A consumer will maximize utility by choosing the point on
the budget line where marginal utility per dollar is the same for both goods.
Goods can be classified as normal or inferior depending on how the consumer responds to
changes in income. When price changes, and the budget line rotates, we can distinguish two
separate effects on the consumer: the substitution effect and the income effect. In the case of a
normal good, these two effects work together to support the law of demand; in the case of an
inferior good, the two effects oppose each other. Still, even when goods are inferior, we expect
the law of demand to hold: price increases virtually always cause consumers to decrease the
quantity demanded.
The market demand curve is the horizontal summation of the individual demand curves of every
consumer in the market.
In some circumstances, our model of consumer choice will not work well, at least not without
some modification. Problems that complicate these basic models of consumer behavior are
uncertainty, imperfect information, borrowing or saving, unselfish behavior, and judging
quality by price.
A broader challenge to our model of consumer choice has emerged from a new subfield of
economics known as behavioral economics. Behavioral economics tries to incorporate the
approaches of psychology and sociology to answer economic questions. It incorporates notions
about people’s actual thinking process in making decisions, and points out that such behavior
by large groups of people can alter a market’s equilibrium.
In the section “Using the Theory: Improving Education,” consumer theory is extended to show
how an individual chooses the best use for his or her time. The section explains why
experiments in the field of education may give erroneous results because the experimenters
ignore the insights of the theory of consumer choice.
The appendix to this chapter presents indifference curve analysis as a second approach to
consumer theory, and can be read in place of the approach in the body of the chapter. The main
difference between this approach and the one developed in the body of the chapter is that
indifference curve analysis does not use the concept of marginal utility. It is able to come to the
same conclusions as the marginal utility approach, but with fewer and less restrictive
assumptions.
An indifference curve represents all combinations of two categories of goods that make the
consumer equally well off. Consumers are assumed to prefer “more” to “less” of every good,
so that any point on a higher indifference curve is preferred to any point on a lower one. The
marginal rate of substitution between two goods along any segment of an indifference curve is
the absolute value of the indifference curve’s slope along that segment. It tells how much of
one good must be traded for the other good in order to keep the consumer indifferent to the
change. A consumer’s indifference map is the complete set of her indifference curves.
The optimal combination of goods for a consumer is that combination on the budget line at
which the indifference curve has the same slope as the budget line. We can also use indifference
curve analysis to derive the individual’s demand curve.
60 Instructor’s Manual for Economics: Principles and Applications, 6e

DEFINITIONS

In order presented in chapter.

Budget constraint: The different combinations of goods a consumer can afford with a limited
budget, at given prices.

Budget line: The graphical representation of a budget constraint, showing the maximum
affordable quantity of one good for given amounts of another good.

Relative price: The price of one good relative to the price of another.

Rational preferences: Preferences that satisfy two contions: (1) Any two alternatives can be
compared, and one is preferred or else the two are valued equally, and (2) the comparisons are
logically consistent or transitive.

Utility: A quantitative measure of pleasure or satisfaction obtained from consuming goods and
services.

Marginal utility: The change in total utility an individual obtains from consuming an additional
unit of a good or service.

Law of diminishing marginal utility: As consumption of a good or service increases, marginal

utility decreases.

Substitution effect: As the price of a good falls, the consumer substitute that good in place of
other goods whose prices have not changed.

Income effect: As the price of a good decreases, the consumer’s purchasing power increases,
causing a change in quantity demanded for the good.

Behavioral economics: A sub-field of economics focusing on decision-making patterns that

deviate from those predicted by traditional consumer theory.

TEACHING TIPS

1. Ask students if they have ever found the optimal combination of two goods, x and y, by
drawing their budget line and indifference curve set to determine where MRSx,y =
Px/Py. They will find this question ludicrous. Remind them that this is an “as if” model
used by economists to explain human behavior. Since this model has good predictive
power, it is a valuable tool that economists will continue to use, even if does not
represent consumers’ actual mental processes.
2. Emphasize that the income effect is something of a misnomer, since it isn’t income that
changes, but rather the purchasing power of a given amount of income, in response to a
change in a good’s price. It is helpful for beginning students to refer to this as “the-
purchasing-power-of-a-given-amount-of-income effect” until they grasp the fact that
income does not change. You can even have them practice saying this phrase as a group.
 Chapter 6 Consumer Choice 61

DISCUSSION STARTERS

1. Relate the law of diminishing marginal utility to eating at an all-you-can-eat restaurant,

such as CiCi’s Pizza. At CiCi’s you get all the pizza you want for $5.99. Ask students
how many pieces of pizza they would eat for lunch at CiCi’s. While they will have
different answers, 10 or 12 slices will not be uncommon. Ask them if they get as much
utility from their last piece as they do from the first piece. (Some might say they do.
This would imply a flat marginal utility curve, at least over a certain range. This is okay.)
Ask them why they stop at whatever number they chose, instead of eating 40 or 50
slices. This will help them see that marginal utility does eventually fall, so that the law
of diminishing marginal utility is a useful principle.
2. Think about imperfect information and the cost of making a mistake.
a. Should you choose a name brand, a store brand, or a generic product? What are the
costs and benefits of each choice?
b. Studies have found that people with higher incomes are more likely to buy store
(generic) brands. Why do you think this is? Is this because they are less susceptible
to advertising (these people tend to have higher education levels) or could it be that
they are more able to afford a mistake?
c. Would the same result apply to generic cars, if they were available? That is, do you
think richer people would be more likely than poorer people to buy generic cars?
Discuss.

ANSWERS, SOLUTIONS, AND EXERCISES

PROBLEM SET
Novels
1. a.

Original budget line

15

Budget line after

PCD  to $10
s

12 20 Hamburgers
62 Instructor’s Manual for Economics: Principles and Applications, 6e

b.

2. [Marginal Utility Approach] No, he is not maximizing utility. The marginal utility
Parvez gets per dollar spent on his last novel is 5, whereas the marginal utility Parvez
gets per dollar spent on his last CD is 4. He should spend less of his budget on CDs and
more on novels. As he does so, the marginal utility of CDs will rise and the marginal
utility of novels will fall, until the ratio of marginal utility to price is the same for both
goods.
3. [Marginal Utility Approach] Anita’s utility is maximized where
MU pizza MU Pepsi
=
Ppizza PPepsi

20 10
This condition will be satisfied at 8 cans of Pepsi and 5 slices of pizza since =
$2 $1
Pizza Pepsi
Quantity Utility Marginal Quantity Utility Marginal
Utility Utility
4 slices 115 -- 5 cans 63 --
5 slices 135 20 6 cans 75 12
6 slices 154 19 7 cans 86 11
7 slices 171 17 8 cans 96 10

4. a. Recall that the market demand curve is simply the horizontal sum (summed over
quantities at each price) of the individual demand curves. In this case, then, the
market demand schedule is:
 Chapter 6 Consumer Choice 63
Price

$5.00

$4.00

$3.00 D

$2.00

$1.00

3 5 7 9 Quantity

Price Quantity Demanded

$5.00 3
$4.50 5
$4.00 7
$3.50 9

b. The three consumers have different demand schedules because they have different
preferences for the cereal.

5. a. 75,000 bottles. This is 1000  (100 – 25($1)) = 1000  75.

b. 50,000 bottles. This is 1000  (100 – 25($2)) = 1000  50.

c. QD = 100,000 – 25,000P
6. An increase in income always decreases demand for an inferior good. Hence, the
demand curve would behave as below, with new (post-income increase) demand shown
by D2.
Price

S1

P1

P2

D1

D2

Q2 Q1 Quantity

7. a. Since the price of inputs is a determinant of the supply curve, an increase in paper
prices will shift the firm’s supply curve to the left, increasing the equilibrium price
for its books to P2 as shown below:
64 Instructor’s Manual for Economics: Principles and Applications, 6e
Price
S2
S1
P2

P1

D1

Q2 Q1 Quantity

b. By the substitution effect, the increased price for Pulp Fiction’s books will cause
consumers to substitute other goods (perhaps the publications of other publishers)
for Pulp’s books, decreasing quantity demanded. Assuming Pulp’s novels are
normal goods for most consumers, the income effect acts to reinforce the substitution
effect, decreasing quantity demanded. (If Pulp’s novels are inferior goods, then the
income effect will work against the substitution effect—tending to increase quantity
demanded while the substitution effect decreases quantity demanded.)
8. False. The price increase generates both income and substitution effects. With an
inferior good, the effects work against each other. While it is possible for the income
effect to dominate (a case that would, indeed, violate the law of demand), this would be
extremely rare. More commonly, the substitution effect dominates, so the good would
obey the law of demand. If the good is inferior and the income effect dominates the
substitution effect, we call the good a “Giffen good”.
9. a. Violates the assumption of rational preferences, since the condition that Joseph will
be able to state that he prefers one choice over the other, or that he is indifferent
between the two, is not fulfilled.
b. Does not violate the assumption of rational preferences. Brenda can state her
preference for mustard.
c. Violates the assumption of rational preferences, since the condition that Brewster’s
preferences are transitive, i.e. logically consistent, is not fulfilled.
 Chapter 6 Consumer Choice 65

3. [Indifference Curve Approach]

a.

b.

c.
66 Instructor’s Manual for Economics: Principles and Applications, 6e

4. [Marginal Utility Approach]

Budget = $200
Concerts at $20 each Movies at $10 each
Marginal Marginal
Marginal Utility per Marginal Utility per
Utility Dollar Spent Utility Dollar
Number of from Last on Last Number of from Last Spent on
Concerts per Concert Concert Movies Movie Last Movie
Month (MUC) (MUC/PC) per Month (MUM) (MUM/PM)
5 250 12.5 10 11 1.1
9 12 1.2
6 180 9 8 12.5 1.25
7 13 1.3
7 100 5 6 14 1.4
5 15 1.5
8 50 2.5 4 16 1.6
3 18 1.8
9 40 2 2 20 2
1 25 2.5
10 30 1.5 0 -- --

Max’s utility maximizing combination is at the point where MUC/PC = MUM/PM. This
is achieved at 9 concerts and 2 movies. With these new marginal values, movies are an
inferior good.
12. [Marginal Utility Approach]
Concerts at $20 each Movies at $10 each
Marginal Marginal Utility Number Marginal Marginal Utility
Number of Utility from per Dollar Spent of Movies Utility from per Dollar Spent
Concerts Last Concert on Last Concert per Last Movie on Last Movie
per Month (MUC) (MUC/PC) Month (MUM) (MUM/PM)
0 -- 20 10 1
19 15 1.5
1 36 1.8 18 18 1.8
17 20 2
2 32 1.6 16 22 2.2
15 25 2.5
3 28 1.4 14 30 3
13 35 3.5
4 20 1 12 38 3.8
11 45 4.5
5 15 7.5 0 --
 Chapter 6 Consumer Choice 67

Max’s utility maximizing combination is at the point where MUC/PC = MUM/PM. This
is achieved with 1 concert and 18 movies per month. With these new marginal values,
concerts are an inferior good.
13. [Indifference Curve Approach]
a.

The original equilibrium is at point A.

b. The new budget line is BL2. The new tangency must occur at a point with MORE
THAN 25 pounds of potatoes, for instance, at point B. If potatoes are inferior, then
Cameron will consume more potatoes and fewer steaks than at his original position.
14. [Indifference Curve Approach]
a.
68 Instructor’s Manual for Economics: Principles and Applications, 6e

The original equilibrium is at point A.

b. The new budget line is BL2. The new tangency must occur at a point where
Rafaella is consuming MORE THAN 4 pounds of chicken, and LESS than 10
eggs, for instance, at point B.
15. [Indifference Curve Approach]
a.

The original equilibrium is at point A.

b. A new tangency will occur at a point where she consumes more clothes and less
food, such as point B.
c. A new tangency will occur at a point where she consumes fewer clothes and more
food, such as point C.
 Chapter 6 Consumer Choice 69

MORE CHALLENGING
16. a. Current consumption is at A, where 2,500 units of food and 5,000 units of shelter
are consumed. The Smiths spend $5000 = $2 x 2500 on food and $5000 = $1 x 5000
on shelter.

Food (in units)

7,500

B''
5,000

A
2,500

B'

Shelter
5,000 10,000 (in sq ft/ year)
7,500

b. When the price of housing rises to $2 per square foot, the new budget line is given
by the line marked B in the figure above. The Smiths cannot continue to consume
at point A.
c. The income supplement shifts the budget constraint rightward to the line marked
B. The original consumption level, represented by point A, is again affordable.
d. No, the family will not necessarily return to point A. The utility-maximizing
consumption choice will be somewhere on the new budget line, B. But all the
points on this budget line below A could have been reached with the original prices
and income, and were not chosen before, so they must be less preferred than point
A. They will not be chosen now. All the points above point A are newly available.
Any of these points might be preferred to point A, and could be chosen. (If you use
the indifference curve approach, you can actually show that point A will never be
chosen after the cash grant. To do so, draw an indifference curve tangent to point
A, reflecting the best initial choice before the price change and the cash grant. Then,
after the price change and the cash grant, the best choice is the point of tangency
between some new indifference curve and budget line B”. This new tangency
cannot occur at point A, as you can see by trying to draw it.)
70 Instructor’s Manual for Economics: Principles and Applications, 6e

17. Nothing would happen to consumer choices in this situation. If prices alone were
increasing, then the budget line would shift towards the origin. However, in this
example, wages are increasing by enough to keep the combination of goods and services
the consumer can afford unchanged.
18. [Indifference Curve Approach]
a.

Popcorn

Ice Cream

b. Indifference curves must be upward sloping and utility increases as we move rightward.
Note that that the picture below gives one possible solution in which the indifference
curves are curved (they could also be straight lines, for example).

Popcorn

Ice Cream
 Chapter 6 Consumer Choice 71

19. [Indifference Curve Approach]

EXPERIENTIAL EXERCISES
1. Access a copy of “Creating Value and Destroying Profit? Three Measures of
Information Technology’s Contributions,” by Loren Hitt and Erik Brynjolfsson at
http://ccs.mit.edu/papers/CCSWP183.html . Use your browser’s Edit/Find function to
search for the words consumer surplus in this paper. How do Hitt and Brynjolfsson use
the concept of consumer surplus to measure the value of information technology?
2. When you consume something, you pay a money price, but there is also a time price
involved. It takes valuable time to decide what you wish to buy, to compare items and
prices, and to actually use or consume the good. Use the Work and Family column in
the Wednesday Wall Street Journal to find an example of a new good, service, or
government policy that you think will reduce the time price of some product. How do
you think it will affect the demand for the product? Will any related products be
affected?