Chapter 5

Applying Consumer Theory

 Answers to Textbook Questions

1.1 Downward-sloping and horizontal price-consumption curves are illustrated in the figure below.

1.3. Let’s say Olivia likes one scoop of ice cream with each piece of pie, each piece of pie costs $8, a
scoop of ice cream is $2, and Olivia’s pie and ice cream budget is $60. In the top panel of the
following figure, we can plot her indifference curve (a 90-degree angle) where it intersects the
budget line to allow for 6 pieces of pie with ice cream. As the price of pie declines, the new
budget curve will intersect new, higher indifference curves. Panel (b) shows the resulting demand
curve for pie.

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67 Perloff • Microeconomics, Eighth Edition, Global Edition

1.5 In both this and the previous question, GM foods and non-GM foods are perfect substitutes, so the
indifference curves are straight lines with slopes equal to –1.

In the previous question, consumers purchase all GM foods or all non-GM foods depending on
which has the lowest price. The same result holds in this question as well, because both goods still
enter the utility function additively and symmetrically. Thus, if pG < pN, the demand curve for GM
foods remains

The difference between the two questions is that consumers receive less utility for the same
quantity of GM foods in this question because the additional benefit falls as more of the good is
purchased:

In the previous question, the marginal utility was constant and equal to one,

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 Chapter 5 Applying Consumer Theory 68

1.7 Marginal rate of substitution (MRS) is the maximum amount of one good a consumer will
sacrifice to obtain one more unit of another good. The marginal rate of substitution of burritos for
pizza equals
−0 . 75 0 .75
0. 25 Z B B
− 0 . 75 −0 .25
=−
0. 75 Z B 3Z
MRS = .
Marginal rate of transformation (MRT) is the trade-off the market imposes on the consumer in
terms of the amount of one good the consumer must give up to obtain more of the other good.
Because the budget constraint is
pZZ + pBB = Y,
the slope of the budget line, which equals the marginal rate of transformation, MRT, is
pZ
−
pB
MRT= .
Lisa optimizes utility such that
MRS = MRT

B pZ
=
3 Z pB

3 pZ Z
pB
B= .
Substituting this into the budget constraint,
pZZ + pBB = Y,
pZZ + 3pzZ = Y
4pZZ = Y
0.25Y
pZ
Z= .
2.1 Using the same values as in the solution to Problem 1.3, we can plot the effect an increase in
income to $120 or $180 has on demand for pie, as shown in the following figure, deriving the
Engel curve.

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2.3 Because the two commodities are perfect complements, the indifference curves have right angles.
Thus, the income consumption curve will be a straight line that passes through the point where the
indifference curves just touch the budget lines. See panel (a) in the following figure. In order for
Hugo to buy one more doughnut per week, his budget must rise enough to purchase both another
doughnut and another cup of coffee. The Engel curve is also linear; see panel (b).

2.5 The consumer’s budget constraint is

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where Y is income and pi is the price and qi is the quantity of good i. Differentiating with respect to
Y, we find that

Multiplying and dividing each term by qi Y, we rewrite this last equation as

or

where the income elasticity for each good i, equals and the budget share of

good i is That is, the weighted sum of the income elasticities equals 1. For this
equation to hold, at least one of the goods must have a positive income elasticity; hence, not all the
goods can be inferior.

3.1 a. The substitution effect causes her to buy more clothing. The convexity of indifference curves
assures that the substitution effect will always be positive for a price decrease.
b. The income effect could be either positive or negative depending on whether clothing is a normal
or inferior good for Cora. If clothing is a normal good, the income effect would be positive; if
3.3 Eggs and toast are perfect complements. U = min(2Qt, 3Qe). If the price of eggs increases but we
compensate Cori to make her just as “happy” as she was before (which means her utility is the
same as before), her consumption of eggs will still be the same as shown in the following figure.
There is only an income effect but no substitution effect because eggs and toast are perfect
complements; Cori will not substitute toast with eggs even though the price of eggs increases.

3.5 Assume for simplicity that the price of a can of Coke increases such that it becomes twice the
price of a can of Pepsi.
The substitution effect is the change in the quantity of a good that a consumer demands when a

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71 Perloff • Microeconomics, Eighth Edition, Global Edition

good’s price changes, holding other prices and the consumer’s utility constant. Because Coke and
Pepsi are perfect substitutes for Mahdu (and the price of Coke increases from being less than the
price of Pepsi to being greater than the price of Pepsi), Mahdu substitutes from consuming only
Coke to consuming only Pepsi, so the substitution effect is C1 fewer cans of Coke (from e1 to e2,
which contains no Coke and only cans of Pepsi). The income effect is the change in the quantity of
a good a consumer demands because of a change in income, holding prices constant. The income
effect is zero cans of Coke. The total effect is the substitution effect plus the income effect. Thus,
the total effect is equal to the size of the substitution effect.

3.7 In the graph, Lf is the budget line at the factory store, and L0 is the constraint at the outlet store. At
the factory store, the consumer maximum occurs at ef on indifference curve I f. Suppose that we
increase the income of a consumer who shops at the outlet store to Y*, so that the resulting budget
line L* is tangent to the indifference curve I.f. The consumer would buy bundle e*. That is, the pure
substitution effect (the movement from ef to e*) causes the consumer to buy relatively more firsts.
The total effect (the movement from ef to e0) reflects both the substitution effect (firsts are now
relatively less expensive) and the income effect (the consumer is worse off after paying for
shipping).

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3.9 Equivalent variation is the amount of income that, if taken from a consumer, would lower utility
by the same amount as a price increase. This measure is the same or equivalent harm as that of the
price increase.
In the figure, the individual is initially maximizing utility at bundle e1 on budget line L1. Then the
price of good X increases, pivoting the budget line to L2. The consumer maximizes utility at the
new prices at bundle e2.
Line L3 is parallel to L1 and just tangent to I2. Equivalent variation is equal to the vertical distance
between budget lines L1 and L3.
The total effect is from X1 to X2. The substitution effect is from X3 to X2. The income effect is from
X1 to X3.

4.1 The CPI measures the cost of a basket (bundle) of goods and services that a typical consumer buys.
The composition of this representative bundle changes every few years to reflect changes in what the
average consumer buys. The CPI also differs somewhat from country to country in terms of what is
included in the representative bundle and how the cost of the bundle is measured, which reduces the
accuracy of cross-country comparisons. An attractive feature of the Starbucks index is that it
compares the price of an identical product—a 473 milliliter Starbucks grande latte—over time and
across countries. However, neither index takes into account differences in, for example, taxes and
tariffs across countries. The Starbucks index also implicitly assumes that the demand for lattes is the
same in each country. By including many goods and services, the CPI provides a much more
comprehensive indication of changes in the cost of goods for a typical consumer, despite its
shortcomings.
4.3 See the following figure. Ann will buy more books and less ice cream this year, and her utility will
be better off this year on I 2 than on I 1. This is because the price of books rose by less than the
price of ice cream. So, Ann can gain higher utility by consuming more books and less ice cream.

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4.5 The figure shows Klaas maximizing utility along budget line L1 at bundle e1 in year 1. Then, in
year 2, the price of food increases by more than the price of clothing, but Klaas is given a cost-of-
living adjustment such that he is able to attain his original consumption bundle (bundle e1) in
year 2.

A budget line (or budget constraint) shows the bundles of goods that can be bought if the entire
budget is spent on those goods at given prices. The new budget line (L2) will pass through Bundle
e1, where Klaas maximizes utility in year 2. However, it will be steeper than the original budget
line to illustrate the price of food is relatively more expensive and the price of clothing is
relatively less expensive in year 2. An indifference curve shows the set of all bundles of goods that
a consumer views as being equally desirable. Bundle e2 will be on an indifference curve that is just
tangent to the new budget line.
Klaas is given enough additional income such that he has the option of continuing to consume
Bundle e1. Therefore, Klaas should be no worse off in year 2. However, because relative prices are
different in year 2, Klaas can substitute toward the cheaper good, increasing his utility.

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5.1 As there are 24 hours in a day, N = 24 – H, where H is the number of hours per day Frieda works.
Her wage income is Y = wH, where w is the minimum wage rate. Substituting these relationships
into her utility function,

Differentiating this utility function with respect to H, setting the result equal to zero to find its
maximum, and rearranging terms,

As H is independent of w, the minimum wage increase will not affect the number of hours Frieda
works each day. She will continue to spend one-third of her day working, that is,  = 8/24 = 1/3.
5.3 See the following figure. Bessie is unambiguously worse off. Because her original optimal bundle
lies in the dashed section in the figure, now she has to choose the corner solution as her optimal
bundle.

5.5 Jerome’s budget line is kinked at eight hours of work. At that point, the slope of the budget line
increases from –w to –w*. See the figure below.

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75 Perloff • Microeconomics, Eighth Edition, Global Edition

Jerome will obviously pick the higher paying job for his first eight hours. How many total hours
he works will depend on the shape of his indifference curve.
5.7 Suppose we have leisure (L) on the horizontal axis and earned income (Y) on the vertical axis. The
budget constraint is curved and the absolute value of its slope becomes smaller as L increases.
Therefore, the opportunity cost of leisure becomes smaller and smaller because you have more
leisure. Let’s denote the slope of the indifference curve by MRS. Thus, the optimum choice is
where |MRS| = aH, the wage rate. Bill’s tastes determine the MRS, and thus determine the point
on the budget constraint at which his indifference curve will be tangent.

5.9 A reduction in the rate of flat tax from tH to tL will change earned income, Y, from Y1 = (1 – tH)wH1
to Y2 = (1 – tL)wH2, where w is the before-tax wage rate and H1, H2 are the hours worked before
and after the tax is imposed. The tax will rotate the budget line upward, similar to the shift in panel
(a) of Figure 5.9 from L2 to L3. The negative substitution effect will cause leisure to decrease (or
hours worked to increase).
If leisure is an inferior good, then the negative income effect will also cause leisure to decrease (or
hours worked to increase) and reinforce the substitution effect so that the total effect will be an
increase in hours worked. Depending on how much hours worked increases, a rise in tax revenue
could result from the tax rate reduction.
If leisure is a normal good, then the positive income effect will cause leisure to increase (or hours
worked to decrease) and offset the substitution effect. If the income effect is smaller than the
substitution effect, the total effect will be an increase in hours worked, but it is more likely that the
tax rate reduction will reduce tax revenues. If the income effect exceeds the substitution effect, the
total effect will be a fall in hours worked, so the tax rate reduction will reduce tax revenues.
5.11 Under a progressive income tax system, the marginal tax rate increases with income, and the
marginal tax rate is greater than the average tax rate. Given her income, Grete’s income tax
payable for 2017 would be 0.2 × (14,000 – 2,160) = €2,368. Her average tax rate would therefore
be 2,368/14,000 = 17%, which is less than the marginal tax rate of 20% on income over the
amount of the basic exemption. Furthermore, the marginal tax rate increases, with income tax
being 0% on income up to the basic exemption and 20% on income in excess of that amount.
Thus, the Estonian “flat tax” is actually a progressive tax.
5.13 As shown in the figure below, Mika initially works 10 hours per day and earns income equal to
10w. A tax on earnings rotates Mika’s budget line from the dotted line to Lt. As the income effect
equals the substitution effect, the tax will not affect the number of hours she works (H remains at
10 hours per day), but her income will fall from 10w to 10w(1 – t) as indicated at the point of

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 Chapter 5 Applying Consumer Theory 76

tangency with her after-tax indifference curve, It. Tax revenue at this point equals the difference
between what Mika earned before and after the tax:
10w – 10w(1 – t) = 10wt.
A lump-sum tax that raises the same amount of tax revenue, T = 10wt, would shift Mika’s budget
line closer to the origin but parallel to her original budget line (the dotted line) such that it
intersects Lt at the point represented by 10 hours of work and the after-tax wage of 10w(1 – t). As
this is not a point of tangency, Mika could obtain a higher level of utility by moving to the higher
indifference curve, It. Doing so would increase the number of hours she works.
Thus, a lump-sum tax that raises the same amount of revenue as a tax on earnings increases the
number of hours worked. This is because the tax on earnings reduces the effective wage, but the
lump-sum tax does not. As the opportunity cost of leisure is higher when a lump-sum tax is used,
Mika will consume less leisure and work more.

5.15 Kiki will change her consumption bundle once she moves, substituting toward goods that are
cheaper in the new country. Thus, as in Figure 5.5, Kiki will be better off.

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77 Perloff • Microeconomics, Eighth Edition, Global Edition

6.1 As shown in the figure below, with a cash subsidy of 625 kr, Berit would consume a combination
of childcare and other goods at point eC on the linear budget constraint. If she were instead to
receive a voucher of equal value, her budget constraint would be kinked and intercept the vertical
axis at c instead of at a. She would choose the consumption bundle, eV, which is situated on a
lower indifference curve and at which she would consume more childcare than she desires and less
of other goods. The benefit to Berit of having the subsidy provided in the form of cash instead of a
voucher is b – c, which represents the value of other goods she foregoes with the voucher. Berit
would definitely prefer the subsidy in the form of cash rather than a voucher.

6.3 Parents who do not receive subsidies prefer that poor parents receive lump-sum payments rather
than a subsidized hourly rate for childcare. If the supply curve for day-care services is upward
sloping, by shifting the demand curve farther to the right, the price subsidy raises the price of day
care for these other parents.

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