Chapter 21. The Theory of Consumer Choice.

1. The slope of the budget constraint shows

a. the rate at which a consumer can trade one good for another.Correct. The slope of the budget constraint is determined by the relative prices of the two goods.

b. the rate at which a consumer is willing to trade one good for another.Incorrect. The slope of the budget constraint is determined by the relative prices of the two goods.

c. the rate at which a firm can substitute one input for another.Incorrect. The slope of the budget constraint is determined by the relative prices of the two goods.

d. the rate at which a firm is willing to substitute one input for another.

Incorrect. . The slope of the budget constraint is determined by the relative prices of the two goods.

2. An indifference curve

a. measures the total amount of two goods an individual could possibly consume.Incorrect. This would be a definition of the budget constraint.

b. shows all combinations of two goods that give an individual the same level of satisfaction.Correct. The indifference curve is set at a constant level of satisfaction for all designated combinations of goods.

c.

shows all combinations of two goods that an individual can purchase with a given amount of income.Incorrect. This would be a definition of the budget constraint.

d. illustrates the negative relationship between price and quantity consumed.

Incorrect. This is the description of the demand curve.

3. Which of the following statements is correct?

a. Indifference curves are positively sloped.Incorrect. Indifference curves have a negative slope.

b. Indifference curves can intersect.Incorrect. Indifference curves do not intersect.

c. Indifference curves are bowed outward.Incorrect. Indifference curves are bowed inward.

d. Higher indifference curves are preferred to lower ones.Correct. The farther an indifference curve is from the origin the higher level of utility.

4. The consumer's optimum shown in the figure is located at point

a. A. Incorrect. Point C is on the highest indifference curve possible given the budget constraint.

b. B. Incorrect. Point C is on the highest indifference curve possible given the budget constraint.

c. C. Correct. Point C is on the highest indifference curve possible given the budget constraint.

d. D. Incorrect. Point C is on the highest indifference curve possible given the budget constraint.

5. The marginal rate of substitution measures

a. the slope of the indifference curve.

Correct. The MRS measures the tradeoff in utility when one unit of a good is given up and one unit is added to the consumption amount. b. the slope of the budget constraint.Incorrect. The MRS measures the tradeoff in utility when one unit of a good is given up and one unit is added to the consumption amount.

c. the slope of the demand curve.Incorrect. The MRS measures the tradeoff in utility when one unit of a good is given up and one unit is added to the consumption amount.

d. the relative price of two goods.

Incorrect. The MRS measures the tradeoff in utility when one unit of a good is given up and one unit is added to the consumption amount.

6. The consumer optimum occurs where

a. the budget constraint and an indifference curve intersect.Incorrect. An intersection would not get to the highest indifference curve.

b. the budget constraint and an indifference curve are tangent.Correct. The tangency point of the indifference curve and the budget constraint gives the highest indifference curve possible given a specific budget constraint.

c. the slope of the indifference curve equals the ratio of the quantities of the goods consumed.Incorrect. The slope of the indifference curve is always the ratio of quantities.

d. the budget constraint cuts the indifference curve from below.Incorrect. If the budget constraint cuts an indifference curve, this is not the highest possible indifference curve attainable.

7. At point B in the figure, consumers would be

a. spending all of their income but not maximizing utility.Correct. With the budget constraint, the consumer can reach indifference curve II.

b. spending all of their income and maximizing utility.Incorrect. Maximum utility would be reached on indifference curve II.

c. maximizing utility without spending all of their income.Incorrect. They are on the budget constraint and, therefore, spending all their income.

d. maximizing income and utility.Incorrect. Utility would be maximized on indifference curve II given the budget constraint.

8. Indifference curves are downward sloping because

a.

the more an individual has of a particular good, the less an additional unit of the good is valued.Incorrect. This is the reason for the curvature of the indifference curve.

b. bigger bundles mean more utility.Incorrect. This is the reason that utility increases as you move away from the origin.

c. marginal utility of additional goods is negative beyond a particular level of consumption.Incorrect. Marginal utility decreases but does not go to zero or negative.

d. consumers typically like both goods.Correct. If consumers lose one good, they must be compensated with more of the other good to maintain constant total utility.

9. From the diagram, we know that goods X and Y are

a. perfect substitutes.Incorrect. Perfect substitutes would have a downward, straight slope.

b. perfect complements.Correct. With a certain amount of one good, a fixed amount of the other good is necessary for certain level of utility.

c. Giffen goods.

Incorrect. Giffen goods depend on price effects which are not illustrated here.

d. inferior goods.Incorrect. We would need two budget constraints to determine if there were inferior goods.

10. The budget constraint is

a. upward sloping.Incorrect. A fixed budget line has to be downward sloping because more of one good must reduce the quantity of the other consumed.

b. downward sloping and nonlinear.Incorrect. The price ratio is constant and, therefore, the line must be linear.

c. downward sloping and linear.Correct. With a fixed income, more of one good requires purchasing less of the other good at the price ratio.

d. horizontal. Incorrect. The constraint must slope downward because the more of one good purchased must reduce the quantity of the other consumed.

11. The change in consumption that occurs when a price change makes a consumer move to a different indifference curve is

a. the price change effect.

Incorrect. The income effect lifts the consumer to a higher indifference curve, the price effect moves the consumer along the new indifference curve to a different point represented the new price ratio.

b. the utility effect.Incorrect. The utility effect would explain the change in utility represented by moving to a different indifference curve.

c. the income effect.Correct. The income effect lifts the consumer to a higher indifference curve, the price effect moves the consumer along the new indifference curve to a different point represented the new price ratio.

d. the substitution effect.Incorrect. The substitution effect is obtained by using the new price ratio on the original indifference curve.

12. In the figure, assume the consumer is initially in an optimum position at point A. The price of good X falls. The substitution effect of the price change is represented by a movement from

a. point A to point B.Incorrect. The new price ratio on the old indifference curve shows the substitution effect caused by the price change. This is shown by moving from the original point A to the point that would obtain if only the price ratio had changed, point C.

b. point B to point A.Incorrect. The new price ratio on the old indifference curve shows the substitution effect caused by the price change. This is shown by moving from the original point A to the point that would obtain if only the price ratio had changed, point C.

c. point A to point C.Correct. The new price ratio on the old indifference curve shows the substitution effect caused by the price change. This is shown by moving from the original point A to the point that would obtain if only the price ratio had changed, point C.

d. point B to point C.

Incorrect. The new price ratio on the old indifference curve shows the substitution effect caused by the price change. This is shown by moving from the original point A to the point that would obtain if only the price ratio had changed, point C.

13. According to indifference curve analysis, an increase in the wage will increase the quantity of labor supplied if

a. the substitution effect and the income effect are equal.Incorrect. These cancel each other out and the effect will be no increase in quantity supplied.

b. the substitution effect is less than the income effect.Incorrect. If the income effect is larger, leisure will increase and labor quantity supplied will decrease.

c. the substitution effect is greater than the income effect.Correct. Increased consumption outweighs the extra leisure possible at the same consumption level with higher wages.

d.

there is no substitution effect associated with the wage change.Incorrect. If there is no substitution effect, there is no increase in the quantity of labor supplied.

14. An increase in income will cause the budget constraint to

a. make a parallel shift towards the origin.Incorrect. This would represent a decrease in income.

b. make a parallel shift away from the origin.Correct. An increase in income means more consumption of both goods is possible in the same ratio.

c. rotate towards the origin on the horizontal axis.Incorrect. If there is no change in relative prices, the slope of the budget constraint will not change.

d. rotate towards the origin on the vertical axis.Incorrect. If there is no change in relative prices, the slope of the budget constraint will not change.

15. A Giffen good

a. has an upward-sloping demand curve.Correct. A Giffen good is a strongly inferior good where the income effect is so strong that it reduces the consumption of the other good.

b. has a downward-sloping demand curve.Incorrect. A Giffen good has an upward sloping demand curve.

c. has a horizontal demand curve.Incorrect. A Giffen good has an upward sloping demand curve.

d.

has a vertical demand curve.Incorrect. A Giffen good has an upward sloping demand curve.

16. A normal good

a. must have an upward-sloping demand curve.Incorrect. Normal goods always have a downward sloping demand curve.

b. must have a downward-sloping demand curve.Correct. A normal good has a negative substitution effect that also has a positive income effect.

c. could possibly have an upward-sloping demand curve.Incorrect. Normal goods always have a downward sloping demand curve.

d. will have a horizontal demand curve.Incorrect. Normal goods always have a downward sloping demand curve.

17. Every point that lies to the right of the consumer's budget constraint is

a. undesirable.Incorrect. They represent higher utility but not attainable at current income.

b. inefficient, given current income.Incorrect. Inefficiency refers to production, not consumption.

c. unattainable, given the current income.Correct. The budget constraint represents the maximum combinations possible and larger combinations, to the right are not possible to be purchased.

d. inferior in terms of utility to points within the constraint.Incorrect. Higher budget constraints would reach higher levels of utility.

18. The budget constraint

a. shows how much money a consumer will spend on each good.Incorrect. The budget constraint contains many combinations of spending on the two goods.

b. shows all combinations of two goods that can be purchased with different money incomes, given a fixed price of each good.Incorrect. Each budget constraint represents a fixed level of income.

c. shows all combinations of two goods that can be purchased with fixed money incomes, given variable prices.Incorrect. Along a given budget constraint the price ratio is fixed.

d. shows all combinations of two goods that can be purchased with fixed money incomes, given a fixed price of each good.Correct. The two variables that are fixed along a single budget constraint are the level of income and the price ratio.

19. The consumer's demand curve for a specific product slopes downward because

a. as the price of the product rises, it will be substituted for other products whose prices are unchanged.Incorrect. The consumption of the good whose price rose will decrease.

b. as the price of the product rises, the consumer's real income rises, enabling the consumer to buy more of all normal commodities, including the cheaper commodity.

Incorrect. Price increases cause real incomes to decrease.

c. as the price of the product rises, the opportunity cost of consuming that product declines.Incorrect. More of the other good is sacrificed to pay the higher price.

d. as the price of the product rises, the opportunity cost of consuming that product rises.Correct. More of the other good is sacrificed to pay the higher price.

20. In order to have a Giffen good, which of the following situations must be true?

a. The good is a normal good.Incorrect. A Giffen good must be an inferior good.

b. The good is inferior and the substitution effect outweighs the income effect.Incorrect. The income effect must be greater than the substitution effect.

c. The good is inferior and the income effect outweighs the substitution effect.Correct. The income effect must be strong enough to outweigh the substitution effect caused by the higher price.

d. The good is normal and the income effect outweighs the substitution effect.

Incorrect. A Giffen good must be an inferior good.

21. Suppose pizza is a normal good. The price of pizza increases. The income and substitution effects associated with the price increase

a.

are always of equal size.Incorrect. There is no necessary relationship between the relative sizes.

b. always push in the same direction.Correct. Normal goods have positive income effects and negative substitution effect.

c. always push in the opposite direction.Incorrect. The income and price effects will both work to reduce quantity demanded.

d. are not accurately described by any of the above statements.Incorrect. The income and price effects will both work to reduce quantity demanded.

22. According to indifference curve theory,

a. indifference curves are bowed in towards the origin.Correct. This reflects the diminishing marginal utility of each good.

b. indifference curves further from the origin indicate less satisfaction.Incorrect. Further from the origin indicated higher levels of satisfaction.

c. indifference curves can intersect, but only for inferior goods.Incorrect. Indifferences curves do not intersect.

d. all curves in an indifference map yield an equal level of satisfaction.Incorrect. The further an indifference curve is from the origin, the higher the level of satisfaction.

23. Indifference curves further from the origin are preferred to indifference curves closer to the origin because

a.

more goods are preferable to fewer goods.Correct. Higher quantities of goods represent higher levels of utility.

b. indifference curves are bowed in towards the origin.Incorrect. The bowed shaped represents diminishing levels of marginal utility.

c. a consumer must substitute one good for another in order to hold utility constant.Incorrect. This explains the downward slope of the indifference curve.

d. any two bundles of goods can be compared.Incorrect. Higher quantities of goods represent higher levels of utility.

24. The rate at which a consumer is willing to trade one good for another is referred to as

a. the principle of diminishing marginal returns.Incorrect. The describes the effect of consuming one more unit of a good.

b. consumer surplus.Incorrect. This is relevant for a demand curve.

c. marginal rate of technical substitution.Incorrect. This is a production side variable.

d. the marginal rate of substitution.Correct. This determines the slope of the indifference curve.

25. In the diagram, the consumer's optimum is given by point:

a. A. Incorrect. Point D on indifference curve 2 is the highest curve possible give the budget constraint.

b. C. Incorrect. Point D on indifference curve 2 is the highest curve possible give the budget constraint.

c. D. Correct. Point D on indifference curve 2 is the highest curve possible give the budget constraint.

d. E. Incorrect. Point D on indifference curve 2 is the highest curve possible give the budget constraint.

26. In the diagram, an unattainable point would be represented by point

a. A. Incorrect. Point E is the only point that lies outside the current budget constraint

b. C. Incorrect. Point E is the only point that lies outside the current budget constraint

c. D. Incorrect. Point E is the only point that lies outside the current budget constraint.

d. E. Correct. Point E is the only point that lies outside the current budget constraint.

27. Indifference curves normally have negative slopes because

a. as consumers get more of one good, they must give up some of another good in order to hold utility constant.Correct. The reduction in utility caused by reduced consumption of one good must be counteracted by an increase in consumption of the other good.

b. as consumers get more of one good, they must have more of another good in order to hold utility constant.Incorrect. If more of both goods were consumed, utility would increase and you would not remain on the same indifference curve.

c. the marginal rate of substitution is not constant.Incorrect. This is the reason the indifference curve is bowed.

d. the marginal rate of substitution is positive.Incorrect. The marginal rate of substitution is negative.

28. Which of the following leads to a parallel shift of the budget line?

a. a 10 percent increase in the price of both goods.Correct. Only if the price changes are equal would there be no change in relative prices and no change in slope.

b. a 20 percent reduction in the price of one good.Incorrect. If the price of one good changes, there will be a change in the slope.

c. a 30 percent increase in the price of one good.Incorrect. If the price of one good changes, there will be a change in the slope.

d. a 10 percent increase in the price of one good and a 20 percent decrease in the price of the other good.Incorrect. This would cause a change in relative prices and a change in the slope.

29. To derive a demand curve using indifference curves, one finds a consumer's optimum and then

a. lets income increase to find a new optimum.Incorrect. The price change is the independent variable on the demand curve.

b. lets income decrease to find a new optimum.Incorrect. The price change is the independent variable on the demand curve.

c. lets price change to find a new optimum.Correct. The price change is the independent variable on the demand curve.

d. finds all other combinations of the two goods that have the same total cost.Incorrect. The price change is the variable that generates the demand curve.

30. In indifference curve analysis, when the price of one of the goods under consideration decreases

a. the slope of the budget constraint will change.Correct. A change in the price of one good alters relative prices and the slope of the budget constraint.

b. the indifference curves will shift.Incorrect. This would be caused by a change in utility.

c. the individual's nominal income will be reduced.Incorrect. There will be an increase in real income.

d. the individual's real income will decrease.

Incorrect. There will be an increase in real income.

31. All bundles of goods on a budget constraint

a. cost the same amount of money.Correct. All points on a budget constraint represent all possible combinations of two goods that can be purchased with a fixed amount of income.

b. provide the same level of utility.Incorrect. The budget constraint represents the same level of income.

c. contain equal amounts of the two goods.Incorrect. The budget constraint represents different amounts of goods purchased with the same income.

d. contain goods that have the same price.Incorrect. It contains different amounts of goods at some fixed relative price.

32. A decrease in the price of good Y is represented by figure

a. a. Incorrect. Figure b represents more of Y that can be purchased with the same income amount.

b. b. Correct. Figure b represents more of Y that can be purchased with the same income amount.

c. c.Incorrect. Figure b represents more of Y that can be purchased with the same income amount.

d. d. Incorrect. Figure b represents more of Y that can be purchased with the same income amount.

33. The budget constraint is

a. curved. Incorrect. The budget line is a straight line because of fixed relative prices.

b. a straight line.Correct. The budget line is a straight line because of fixed relative prices.

c. vertical.Incorrect. The budget line slopes downward.

d. horizontal.Incorrect. The budget line slopes downward.

34. The change in consumption that occurs when a price change moves a consumer along a given indifference curve to a point with a new marginal rate of substitution is called the

a. income effect.Incorrect. The substitution effect is the change in consumption caused only by the change in relative prices not income.

b.

substitution effect.Correct. The substitution effect is the change in consumption caused only by the change in relative prices not income.

c. utility effect.Incorrect. The substitution effect is the change in consumption caused only by the change in relative prices not income.

d. marginal consumption effect.

Incorrect. The substitution effect is the change in consumption caused only by the change in relative prices not income.

35. In the diagram, assume the consumer is initially in an optimum position at point A. The price of good Y changes. The income effect of the price change is illustrated by a movement from

a. point A to point B. Incorrect. The income effect from B to C is shown on the higher indifference curve with the original relative prices.

b. point B to point A. Incorrect. The income effect from B to C is shown on the higher indifference curve with the original relative prices.

c. point A to point C. Incorrect. The income effect from B to C is shown on the higher indifference curve with the original relative prices.

d. point B to point C. Correct. The income effect from B to C is shown on the higher indifference curve with the original relative prices.

36. For Giffen goods

a. the substitution effect is larger than the income effect.Incorrect. For a Giffen good the income effect is much stronger than the substitution effect.

b. the income effect is larger than the substitution effect.Correct. For a Giffen good the income effect is much stronger than the substitution effect.

c. the income effect and the substitution effect are the same size.Incorrect. For a Giffen good the income effect is much stronger than the substitution effect.

d. there is no income effect.Incorrect. For a Giffen good the income effect is much stronger than the substitution effect.

37. If the income effect and the substitution effect work in the same direction, we know that:

a. the good has a positively sloped demand curve.

Incorrect. Normal goods have a negatively sloped demand curve.

b. the good is an inferior good.Incorrect. The income effect of an inferior good is negative.

c. the good might be an inferior good or a normal good.Incorrect. The good must be a normal good if the income and substitution effect both work in the same direction for a given price change.

d. the good is a normal good.Correct. In a normal good, the income effect is positive and the substitution effect is negative. Therefore, with a price increase, the positive income effect would reduce quantity demanded and the negative substitution effect would also reduce quantity demanded.

38. Which of the following permits a consumer to reach a higher indifference curve?

a. a higher price for good 1.Incorrect. Higher prices cause the budget line to rotate inward.

b. a higher price for good 2.Incorrect. Higher prices cause the budget line to rotate inward.

c. a higher income.Correct. A higher income enables a consumer to reach indifference curves further from the origin.

d. a lower income.Incorrect. Lower incomes would move the consumer closer to the origin.

39. An indifference curve shows combinations of two goods that yield

a. negative or zero utility to the consumer.Incorrect. An indifference curve show a constant level of utility.

b. the same level of satisfaction.Correct. More of one good is substituted for less of the other good such that total utility is held constant.

c. the same marginal utility.Incorrect. Marginal utilities change as more of one good is consumed.

d. various levels of satisfaction.Incorrect. More of one good is substituted for less of the other good such that total utility or total satisfaction is held constant.

40. Indifference curves cross when

a. the total satisfaction of two bundles is equal.Incorrect. One of the key properties of indifference curves is that they never cross.

b. the marginal rates of substitution for two indifference curves are equal.Incorrect. One of the key properties of indifference curves is that they never cross.

c. consumers are satiated by a particular good.Incorrect. One of the key properties of indifference curves is that they never cross.

d. Indifference curves for an individual consumer never cross.Correct. One of the key properties of indifference curves is that they never cross.