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PS 12 - Consumption

The document outlines a problem set for an economics course focused on consumption decisions, budget constraints, and the effects of price changes on consumption. It includes various scenarios involving Gertrude's consumption choices, budget lines, and the impact of price and income changes on her decisions. Additionally, it discusses the effects of price changes on the consumption of food and entertainment, as well as the implications of substitution and income effects.

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5 views

PS 12 - Consumption

The document outlines a problem set for an economics course focused on consumption decisions, budget constraints, and the effects of price changes on consumption. It includes various scenarios involving Gertrude's consumption choices, budget lines, and the impact of price and income changes on her decisions. Additionally, it discusses the effects of price changes on the consumption of food and entertainment, as well as the implications of substitution and income effects.

Uploaded by

orinswaby4
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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DEPARTMENT OF ECONOMICS

ECON1012: Principles of Economics II


Problem Set 2: The Consumption Decision

1. Gertrude had a weekly income of $9. At that time, a bulla sold for $1 and a
drink for
$1.50.
a) What is Gertrude’s real income in terms of bullas?
9 bullas
b) What is her real income in terms of drinks?
6 drinks
c) What is the relative price of a drink (in terms of bullas)?
$1.50
d) Sketch Gertrude’s budget constraint (placing drinks on the vertical axis).
e) Suppose she chooses to consume 3 bullas and 4 drinks per week. Is she
satisfying her budget constraint?
Yes as the 3 bullas for $3 and the 4 drinks for $6 would equate to $9
which is her budget constraint.
f) Sketch the budget line if the price of bullas rises to $2 and all other
values remain unchanged.
g) Sketch the budget line if the price of drinks rises to $3 and all other
values remain at their original levels.
h) Sketch the budget line if Gertrude gets a raise to earn $18 a
week and prices remain at their original levels.
i) Supposes all changes take place together: the price of bullas rises to $2,
the price of drinks rises to $3, and Gertrude gets a raise to earn $18 a
week. How does the new budget line compare to the original one?

2. Sketch the budget constraint for a prisoner at the general penitentiary


who has been smuggled a pack of cigarettes (with 20 cigarettes) if one
cigarette can be traded for two cell-phone calls.

3. Consider the consumption bundles indicated C to B


on the diagram. For each of the following e) C and E.
pairs, determine if one is preferred to the other C to E
(i) with certainty, (ii) likely but not with
certainty, or (iii) can’t say at all. Explain your
reasoning. [Hint: sketch some possible
indifference curves]
a) D and E.
D to E
b) C and D.
D to C
c) A and C.
C to A
d) B and C.
9

Shoes
8 A
7
6
5 B
4 C D
3
2
1 E
Pants
1 23 4 5 6 7 8 9
4. Suppose your preferences are reflected in the
18
indifference map shown. A burger costs $100 and a
slice
of pizza sells for $50. You have a food budget of 16
$500 per week. 14
How 12
a) many burgers and slices of pizza will you
consume in a typical week? Explain your choice.
Two burgers and six pizzas as its in the budget constraint
I would prefer more pizzas as they are cheaper. 10
Demonstrate 8
b) the effect on your consumption
choice if pizza falls in price. Burgers

Pizza
I would consume more pizzas and less burgers
as pizza would be cheaper and burgers would be
more expensive. It will pivot outwards and to
6
a higher indifference curve.
4
2

1 2 3 4 5 6

5. Your budget is spent on either food or entertainment, both being


normal goods. Suppose there is a rise in the price of food.
a) In what direction would the substitution effect push the consumption of
food? [Hint: The substitution effect measures the effect of what on
what? What is the sign of the effect? In which direction has the relative
price of food changed? So in what direction will the consumption of
food change?] *The sign of the substitution effect is always negative.
As the substitution effect measures the effect of a change in the
relative price on the quantities of commodities consumed, if the price
of food increases then the consumption of food would decrease.
b) In what direction would the income effect push the consumption of food?
Consumption would decrease.
c) In what direction would the substitution effect push the
consumption of entertainment?
It would increase
d) In what direction would the income effect push the
consumption of entertainment.
It would decrease
e) If you know that consumption of entertainment falls, what would
you conclude about the relative magnitudes of the income and
substitution effects?
The substitution effect is greater than the income effect.

6. Assume both goods are normal goods. On a diagram similar to Y


the one at right, show the location of the new
consumption choice when there is a fall in the price
of…
a) good X, if the substitution effect dominates.
Down on same budget line
b) good X, if the income effect dominates.
Down on different budget line
c) good Y, if the substitution effect dominates.
Up on same budget line
d) good Y, if the income effect dominates.
Up on different budget line

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