CHAPTER 3 QUESTIONS FOR REVIEW
11. Based on his preferences, Bill is willing to trade 4 movie tickets for 1 ticket to a
basketball game. If movie tickets cost $8 each and a ticket to the basketball game costs
$40, should Bill make the trade? Why or why not?
No Bill should not make the trade. If he gives up the 4 movie tickets then he will
save $8 per ticket for a total of $32. However, this is not enough for a basketball
ticket. He would in fact have to give up 5 movie tickets if he wanted to buy another
basketball ticket. Notice also, that the marginal utility per dollar is higher for movie
tickets so Bill will be better off if he consumes more movie tickets and fewer
basketball tickets. To figure this out recall that what Bill is willing to do defines his
MRS. His MRS is 4 so this means that the marginal utility of a basketball game is 4
and the marginal utility of a movie is 1:
MRS  4  
MUball
4
 .
MUmovie
1
Now the marginal utility per dollar can be computed:
MU bal l
4
1


Pbal l
40 10
MU movie 1
 .
Pmovie
8
13. The price of computers has fallen substantially over the past two decades. Use this
drop in price to explain why the Consumer Price Index is likely to overstate substantially
the cost-of-living index for individuals who use computers intensively.
The consumer price index measures the cost of a typical basket of goods purchased by
the consumer in the current year relative to the cost of the basket in the base year.
Each good in the basket is assigned a weight, which reflects the importance of the good
to the consumer, and the weights are kept fixed from year to year. The problem with
fixing the weights is that consumers will shift their purchases from year to year to give
more weight to goods whose prices have fallen, and less weight to goods whose prices
have risen. The CPI will therefore give too much weight to goods whose prices have
risen, and too little weight to goods whose prices have fallen. For the individual who
uses computers intensively, the fixed weight for computers in the basket will
understate the importance of this good, and will hence understate the effect of the fall
in the price of computers. The CPI will overstate the rise in the cost of living for this
type of individual.
14. Explain why the Paasche index will generally understate the ideal cost-of-living
index.
The Paasche index measures the current cost of the current bundle of goods relative
to the base year cost of the current bundle of goods. The Paasche index will
understate the ideal cost of living because it assumes the individual will buy the
current year bundle in the base period. In reality, at base year prices the consumer
would have been able to attain the same level of utility at a lower cost by altering
their consumption bundle. Since the base year cost is overstated, the denominator
will be larger and the index will be lower, or understated.
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CHAPTER 3 EXERCISES
12. Ben allocates his lunch budget between two goods, pizza and burritos.
a.
Illustrate Ben’s optimal bundle on a graph with pizza on the horizontal axis.
This is the standard graph, where Ben’s budget line is linear and he consumes at the
point where his indifference curve is tangent to his budget line. This places him on
the highest possible indifference curve.
b.
Suppose now that pizza is taxed, causing the price to increase by 20%. Illustrate
Ben’s new optimal bundle.
When the price of pizza increases, the budget line will pivot inwards. This will
shrink the size of Ben’s budget set and he will no longer be able to afford his old
bundle. His new optimal bundle is where the indifference curve is tangent to his new
budget line and this indifference curve is below his original indifference curve.
c.
Suppose instead that pizza is rationed at a quantity less than Ben’s desired
quantity. Illustrate Ben’s new optimal bundle.
Rationing the quantity of pizza that can be purchased will result in Ben not being
able to choose his optimal bundle. He will have to choose a bundle on the budget line
that is above his original bundle. This new bundle will have a lower level of utility.
burrito
rationed bundle
original bundle
pizza
CHAPTER 4 EXERCISES
7. The director of a theatre company in a small college town is considering changing the
way he prices tickets. He has hired an economic consulting firm to estimate the demand
for tickets. The firm has classified people who go the theatre into two groups, and has
come up with two demand functions. The demand curves for the general public ( Qgp ) and
students ( Qs ) are given below.
Qgp  500  5P
Qs  200  4P
a.
(THIS PART NOT ASSIGNED)
b.
Find the price elasticity of demand for each group at the current price and
quantity.
The elasticity for the general public is
the students is
gp 
gp 
5(35)
 0.54 and the elasticity for
325
4(35)
 2.33 . If the price of tickets increases by one percent
60
then the general public will demand .54% fewer tickets and the students will demand
2.33% fewer tickets.
c.
Is the director maximizing the revenue he collects from ticket sales by charging
$35 for each ticket? Explain.
2
No he is not maximizing revenue since neither one of the calculated elasticities is
equal to –1. Since demand by the general public is inelastic at the current price, the
director could increase the price and quantity demanded would fall by a smaller
amount in percentage terms, causing revenue to increase. Since demand by the
students is elastic at the current price, the director could decrease the price and
quantity demanded would increase by a larger amount in percentage terms, causing
revenue to increase.
d.
What price should he charge each group if he wants to maximize revenue collected
from ticket sales?
To figure this out, find the formula for elasticity, set it equal to –1, and solve for price
and quantity. For the general public:
5P
 1
Q
5P  Q  500  5P
gp 
P  50
Q  250.
For the students:
4P
 1
Q
4P  Q  200  4P
s 
P  25
Q  100.
3