ECON130 Tutorial Exercise 03: Consumer 2

Part 1: Multiple Choice:

MC1. Consider an individual whose income is spent on two products, A and B. The price of A
increases (income is fixed). The quantity demanded of A decreases and demand for B decreases. If B
is a normal good, in absolute terms,

(a) the substitution effect is greater than the income effect for good B.

(b) the substitution effect is equal to the income effect for good B.

(c) the substitution effect is less than the income effect for good B.

(d) (a) or (b) or (c).

MC2. The figure below shows an individual’s two-period budget constraint before and after a change
in the interest rate. If the individual chose E on the original budget constraint and E0 on the new
budget constraint, this indicates that the

(a) income effect is non-existent.

(b) change in the interest rate decreased savings.

(c) substitution effect dominates the income effect.

(d) substitution effect exactly offsets the income effect.

MC3. A downward-sloping demand curve for a particular commodity indicates that the price of the
commodity

(a) is the only determinant of the demand for it.

(b) is the principal determinant of the demand for it.

(c) is one of the determinants of the demand for it.

(d) and the consumer’s income are the two principal determinants of the demand for it.

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Part 2: Structured Questions:

Q1: Utility

Hint: refer to Excel tool #3f on Blackboard to assist with this question. For guidance on how to
conceptualise a budget constraint and the relationship to a budget line, see Renshaw and Norman
(2021) Maths for economics - section 5.12 Applications of inequalities in economics- sub-section
5.12 Applications of inequalities in economics

Suppose c1 and c2 represent the quantities of two goods that an individual consumes. The consumer
has preferences that can be represented by the following utility function, U = 2(√ c1 + √ c2).

1. Complete the following tables, calculating the utility level for each bundle.

IC1 IC2
c1 c2 Utility c1 c2 Utility
1 13.50 9.35 1 16.00 10.00
2 10.63 9.35 2 12.86 10.00
3 8.66 9.35 3 10.68 10.00
4 7.15 9.35 4 9.00 10.00
5 5.94 9.35 5 7.64 10.00
6 4.95 9.35 6 6.51 10.00
7 4.11 9.35 7 5.54 10.00
8 3.41 9.35 8 4.72 10.00

2. Plot the bundles, with c1 on the horizontal axis.

18.00
16.00
14.00
12.00
10.00
IC2

8.00 IC1
6.00 IC2
4.00
2.00
0.00
0 1 2 3 4 5 6 7
IC1

3. Based on your calculations, draw appropriate indifference curves through the points you
have plotted.
- Refer to the above graph.
4. What type of marginal utility do these preferences exhibit?

- Diminishing Marginal Utility

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5. Suppose the consumer’s budget is M=30, and the prices of the two goods are P1=3.00 and
P2=2.00. On your previous diagram, plot the consumer’s budget constraint (BC). Identify their
optimal choice and comment on this choice.
Budget
Constraint
m(income
c1 c2 )
0 15 30
1 13.5 30
2 12 30
3 10.5 30
4 9 30
5 7.5 30
6 6 30
7 4.5 30
8 3 30
9 1.5 30
10 0 30

18.00
16.00
14.00
12.00
10.00
IC2

8.00 IC1
IC2
6.00
Budget Constraint
4.00
2.00
0.00
0 1 2 3 4 5 6 7
- The best
IC1
option for
consumption is revealed at C1 = 4 and C2 = 9, when the indifference curve is tangent to the
budget constraint.

Q2: Subsidies and Benefits

You have a new job in the office of the Minister for Housing. Suppose that housing for low income
families is at present subsidised by the government. A briefing paper from the Department of Social
Welfare suggests that the housing subsidy could be abolished and replaced by a general increase in
the benefit level for these low-income families, leaving them no worse or better off (i.e. no change
to their level of utility). The Minister asks you to analyse the implications of the proposed policy
change. Using an indifference curve framework, with housing measured in square metres on the
horizontal axis and “all other goods” on the vertical axis:

(a) show the effect of the removal of the current housing subsidy and the effect of introducing
in its place a general low-income benefit supplement for these families.

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 -

(b) discuss the effect of the policy change on the quantity of housing demanded.

- We were able to consume at point A since the housing subsidy made housing more affordable in
contrast to other items (q1). When the subsidy was eliminated, there was less money available to
pay for housing, but we were still able to consume at point B (q2). Given that we spent more money
on housing and other items, we were able to consume at point C (q3) with an improved benefit. The
demand for other goods increase.

Q3: Borrowing

Sophie consumes today and tomorrow and earns $100 today and $100 tomorrow. The money prices
of goods – both today and tomorrow – are fixed. Consumption today and consumption tomorrow
are both normal goods.

a) If Sophie is currently a borrower, what does an increase in the interest rate do to her
consumption (at today and at tomorrow)?
- She would be negatively impacted since she would have less disposable income due to
having to start paying back the bank more money than she had planned to, which would
lead to a decrease in her consumption. The substitution effect results in a fall in
consumption today and an increase tomorrow when Sophie is a borrower. In both states,
the income effect results in lower consumption.

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 b) If Sophie is currently a lender (i.e., saver), what does an increase in the interest rate do to
her consumption (at today and at tomorrow)?

- She will benefit from this since her income will increase and her consumption will rise as a
result of receiving more money back from the bank than she originally did when she stored
it. The substitution effect results in a fall in consumption today and an increase tomorrow
when Sophie is a lender. In both states, the income effect raises consumption (lending is
more profitable with higher interest rates).

c) If Sophie currently chooses to spend $100 today, what does an increase in her income
tomorrow (to $120) do to her saving behaviour (with the interest rate unchanged)?

- Since she has already spent all of her income, she continues to spend more today and
tomorrow because the interest rate has not changed to encourage her to save with the
bank. As well, since there is no substitution impact, the price of consumption today has not
risen, but Sophie's income has increased, therefore consumption has increased both today
and tomorrow (income effect).

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