Download Answers to Questions in Chapter 4

Chapter 4
Answers to Questions in Chapter 4
Note: No. before  indicates a page number
Page
90 
1. Do you ever purchase things irrationally? If so, what are they and why is your
behaviour irrational?
A good example is things you purchase impulsively, when in fact you do have time to
reflect on whether you really want them. It is not a question of ignorance but a lack of
care. Your behaviour is irrational because the marginal benefit of a bit of extra care
would exceed the marginal effort involved.
90 
2. If you buy something in the shop on the corner when you know that the same item
could have been bought more cheaply two kilometres up the road in the supermarket, is
your behaviour irrational? Explain.
Not necessarily. If you could not have anticipated wanting the item and if it would cost
you time and effort and maybe money (e.g. petrol) to go to the supermarket, then your
behaviour is rational. Your behaviour a few days previously would have be irrational,
however, if, when making out your weekly shopping list for the supermarket, a
moment's thought could have saved you having to make the subsequent trip to the shop
on the corner.
91 
(Box 4.2) The diagram illustrates
a person's MU curves of water
and diamonds. Assume that
diamonds are more expensive
than water. Show how the MU of
diamonds will be greater than
the MU of water. Show also how
the TU of diamonds will be less
than the TU of water.
(Remember: TU is the area
under the MU curve.)
See diagram 4.1 opposite.
92 
Are there any goods or services
where consumers do not
experience diminishing marginal
utility?
Virtually none, if the time period
is short enough. If, however, we
Diagram 4.1. MU of water and diamonds
are referring to a long time
period, such as a year, then initially as more of an item is consumed people may start
‘getting more of a taste for it’ and thus experience increasing marginal utility. But even
with such items, eventually, as consumption increases, diminishing marginal utility will
be experienced.
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Answers to questions in Economics by Sloman and Norris
93 
If David were to consume more and more chips would his total utility ever (a) fall to
zero; (b) become negative? Explain.
Yes, both. If he went on eating more and more, eventually he would feel more
dissatisfied than if he had never eaten any in the first place. He might actually be
physically sick!
95 
If a good were free, why would total consumer surplus equal total utility? What would
be the level of marginal utility?
Because there would be no expenditure.
At the point of maximum consumer surplus, marginal utility would be equal to zero,
since if P = 0, and MU = P, then MU = 0.
96 
Why do we get less consumer surplus from goods where our demand is relatively
elastic?
Because we would not be prepared to pay such a high price for them. If price went up,
we would more readily switch to alternative products.
96 
How would marginal utility and market demand be affected by a rise in the price of a
complementary good?
Marginal utility and market demand would fall (shift to the left). The rise in the price of
the complement would cause less of it to be consumed. This would therefore reduce the
marginal utility of the other good. For example, if the price of lettuce goes up and as a
result we consume less lettuce, the marginal utility of mayonnaise will fall.
98 
Give some examples of gambling (or risk taking in general) where the odds are (a)
unfavourable; (b) fair; (c) favourable.
(a) Betting on the horses; firms launching a new product in a market that is already
virtually saturated and where the firm does not bother to advertise.
(b) Gambling on a private game of cards which is a game of pure chance; deciding
which of two alternative brands to buy when they both cost the same and you have
no idea which you will like the best.
(c) Not taking an umbrella when the forecast is that it will not rain (weather forecasts
are right more often than they are wrong!); an employer taking on a new manager
who has excellent references.
(Note that in the cases of (a) and (c) the actual odds may not be known, only that they
are unfavourable or favourable.)
99 
Which gamble would you be more likely to accept, a 60:40 chance of gaining or losing
$10 000, or a 40:60 chance of gaining or losing $1? Explain why.
Most people would probably prefer the 40:60 chance of gaining or losing $1. The
reason is that, given the diminishing marginal utility of income, the benefit of gaining
$10 000 may be considerably less than the costs of losing $10 000, and this may be
more than enough to deter people, despite the fact that the chances of winning are
60:40.
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Chapter 4
99 
Do you think that this provides a moral argument for redistributing income from the
rich to the poor? Does it prove that income should be so redistributed?
Arguments like this are frequently used to justify redistributing income and form part
of people's moral code. Most people would argue that the rich ought to pay more in
taxes than the poor and that the poor ought to receive more state benefits than the rich.
The argument is frequently expressed in terms of a pound being worth more to a poor
person than a rich person. It does not prove that income should be so redistributed,
however, unless you argue (a) that the government ought to increase total utility in
society and (b) that it is possible to compare the utility gained by poor people with that
lost by rich people - something that is virtually impossible to do.
100 
If people are risk averse why do so many around the world take part in national
lotteries?
Because the amount they stand to win is very large compared to the very small amount
most people stake.
101 
1. Why are insurance companies unwilling to provide insurance against losses arising
from war or `civil insurrection'?
Because the risks are not independent. If family A has its house bombed, it is more
likely that family B will too.
101 
2. Name some other events where it would be impossible to obtain insurance.
Against losses on the stock market; against crop losses resulting from drought.
101 
When you take out private health insurance there is a waiting period before you can
claim certain expenses such as dental charges. Why is this?
Otherwise some people would wait until they knew they needed dental treatment before
paying for insurance. A waiting period makes it unlikely that many people would act in
this way.
102  (Appendix) How will the following reduce moral hazard?
(a) A no-claims bonus.
(b) The company only being prepared to insure an item for part of its value.
(c) You having to pay the first $X of any claim.
(d) Offering lower premiums to those less likely to claim (e.g. lower house contents
premiums for those with burglar alarms).
In the case of (a), (b) and (c) people will be more careful as they would incur a financial
loss if the event they were insured against occurred (loss of no-claims bonus; paying
part of the value; paying the first so much of the claim). In the case of (d) it
distinguishes people more accurately according to risk. It encourages people to move
into the category of those less likely to claim (but it does not make people more careful
within a category: e.g. those with burglar alarms may be less inclined to turn them on if
they are well insured!).
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Answers to questions in Economics by Sloman and Norris
103 
Although indifference curves will normally be bowed in toward the origin, on odd
occasions they might not be. Which of the diagrams below correspond to which of the
following?
(a) X and Y are left shoes and right shoes.
(b) X and Y are two brands of the same product, and the consumer cannot tell them
apart.
(c) X is a good but Y is a `bad' - like household refuse.
(a) Diagram (ii). An additional left shoe will give no extra utility without an additional
right shoe to go with it!
(b) Diagram (i). The consumer is prepared to go on giving up one unit of one brand
provided that it is replaced by one unit of the other brand.
(c) Diagram (iii). If consumers are to be persuaded to put up with more of the `bad',
they must have more of the good to compensate.
104 
1. Draw another two indifference curves on Figure A4.1, one outward from and one
inward from the original curve. Read off various combinations of pears and oranges
along these two new curves and enter them on a table like Table A4.1.
The curves would look like those in Figure 4.8 (on page 105). The curve further
outward would represent a higher level of utility. This would be obtained by consuming
a larger quantity of pears for each quantity of oranges consumed and a larger quantity
of oranges for each quantity of pears (i.e. an increase in each of the figures in Table
4.3). The curve further inward would represent a lower level of utility. This would be
experienced with a smaller quantity of pears for each quantity of oranges and vice
versa.
106 
1. Assume that the budget remains at $30 and the price of X stays at $2, but that Y rises
in price to $3. Draw the new budget line.
The budget line will pivot inwards on point d (i.e. where it crosses the horizontal axis).
It will now connect 10Y on the vertical axis with 15X on the horizontal.
106 
2. What will happen to the budget line if the consumer's income doubles and the price
of both X and Y double?
It will not move. Exactly the same quantities can be purchased as before. Money
income has risen, but real income has remained the same.
107 
Refer back to Table A4.1 and plot the indifference curve like that shown in Figure
A4.1. Assume that pears cost 10c each and that oranges cost 15c. Draw a series of
budget lines for different levels of expenditure, making one of them tangential to the
indifference curve that you have drawn. Assuming that Grant wants to gain the
particular level of satisfaction from eating fruit that is shown by the indifference curve
you have drawn, what is the least amount of money he must spend to achieve this? How
many pears and how many oranges will he buy?
The lowest possible budget line is $2.85, with 12 pears (= $1.20) and 11 oranges
(= $1.65). Thus $2.85 is the least amount of money that Grant must spend to gain the
level of satisfaction shown by the indifference curve.
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Chapter 4
108 
Illustrate on an indifference diagram the effects of the following:
(a) A rise in the price of good X (assuming no change in the price of Y).
(b) A fall in the price of good Y (assuming no change in the price of X).
(a) The budget line will pivot inwards (e.g. from B2 to B1 in Figure 4.18, causing a fall
in consumption from point k to point j).
(b) The budget line would pivot outward on the point where the budget line crosses the
horizontal axis. It is likely that the new tangency point with an indifference curve
will represent an increase in the consumption of both goods. Diagram 4.3 below
can be used to illustrate this. Assume the budget line pivots outwards from B2 to
B1. The optimum consumption point will move from point c to point a.
109 
As quantity demanded increases from Q1 to Q2 in Figure A4.9 the expenditure on all
other goods decreases. (Point b is lower than point a.) This means, therefore, that the
person's total expenditure on X has correspondingly increased. What, then, can we say
about the person's price elasticity of demand for X between points a and b? What can
we say about the price elasticity of demand between points b and c and points c and d?
Between a and b the demand for X is price elastic: a fall in the price of X leads to an
increase in expenditure on it. Between b and c price elasticity is equal to (minus) one: a
fall in the price of X leads to no change in expenditure. Between c and d demand for X
is price inelastic: a fall in price leads to a reduction in expenditure on X (and hence an
increase in expenditure on the total of all other goods).
110 
Illustrate on two separate indifference diagrams the income and substitution effects of
the following
(a) A decrease in the price of good X (and no change in the price of good Y).
(b) An increase in the price of good Y (and no change in the price of good X)
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Answers to questions in Economics by Sloman and Norris
See Diagram 4.2 above. In each case the substitution effect is shown by a movement
from point a to point b and the substitution effect is shown by a movement from point b
to point c.
110 
Do you consume any Giffen goods? If not, could you conceive of any circumstances in
which one or more items of your expenditure would become Giffen goods?
It is unlikely that any of the goods you consume are Giffen goods. One possible
exception may be goods where you have a specific budget for two or more items, where
one item is much cheaper: e.g. fruit bought from a greengrocer. If, say, apples are
initially much cheaper than bananas, you may be able to afford some of each. Then you
find that apples have gone up in price, but are still cheaper than bananas. What do you
do? By continuing to buy some of each fruit you may feel that you are not eating
enough pieces of fruit to keep you healthy and so you substitute apples for bananas,
thereby purchasing more apples than before (but probably less pieces of fruit than
originally).
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