Download Indifference curve analysis

Queen’s College
AL Economics
Test 4
Test 4
Chapter 3: Consumer Behaviour I – Indifference curve approach
Date: 17th November, 2003
Time allowed: 30 minutes
1. This paper consists of two sections, Section A and B.
2. Section A contains 7 MC questions, each carries one mark, Section B contains 2 essay type
questions. Attempt ALL questions.
3. The total score of this test is 20.
Section A: Multiple choice questions (1 mark@)
1. Which of the following properties CANNOT be applied to the indifference curves of two
bads?
A.
B.
C.
D.
Indifference curves are negatively sloped.
Indifference curves cannot intersect.
The x-y plane is fully covered by indifference curves.
None of the above.
2. Study the diagram. Suppose the budget line shifts from AB to CD. The possible causes are
A. increase in income and rise in the price of X.
Y
B. rise in the price of X and fall in the price of Y
C. decrease in income and fall in the price of Y. D
D. all of the above.
A
0
X
C
B
3. The equilibrium conditions of indifference curve analysis include
A.
B.
C.
D.
Tangency between the budget line and the highest indifference curve attainable.
reaching the highest indifference curve attainable.
equality between relative price and MRS.
all of the above
4. If the law of diminishing marginal rate of substitution is violated,
A. indifference curves are positively sloped
B. the problem of scarcity no longer exists
C. specialization in consumption appears
D. none of the above
Queen’s College
AL Economics
Test 4
5. Which of the following statements is INCORRECT?
A. Income consumption curves is a curve joining all consumer’s equilibriums in response to
a change in income, holding Px and Py constant.
B. Engel curve is a curve showing the relationship between income and consumption
C. Price consumption curve is a curve joining all consumer’s equilibriums in response to a
change in Px, holding income and Py constant.
D. None of the above.
6. Which of the following statements is correct?
A. If good X is an inferior good, both the income consumption curve and its Engel curve are
negatively sloped.
B. If good X is a Giffen good, both the price consumption curve and its demand curve are
negatively sloped.
C. If good X is a superior good, the price consumption curve is vertical while its demand
curve is negatively sloped.
D. All of the above.
7. Which of the following statements about total price effect is INCORRECT?
A. substitution effect of a Giffen good is positive
B. substitution effect does not affect the real income level
C. total price effect of a normal good is negative
D. none of the above
Section B: Essay type questions
8. If there is a divergence between MRS and price ratio, explain why the consumer will
adjust his consumption choice. (5 marks)
9. The government offers two schemes to subsidize people in buying houses:
(1) The government subsidizes the price of the housing
(2) The government subsidizes people in ‘cash’ of which the amount is just enough for
them to buy the same amount of housing as they would buy under the price subsidy.
Which scheme will people prefer? Why?
Illustrate your answer with the aid of an indifference curve diagram. (8 marks)
Bonus question: Explain the substitution effect for perfect complements. (5 marks)
Queen’s College
AL Economics
Test 4
Answer key to test 4
Section A: Multiple Choice
1. D
2. D
3. B
4. C
5. D
6. A
7. A
Section B: Essay type questions
8. If MRS > relative price, i.e. the maximum amount one is willing to pay for an additional
unit of X is larger than the amount required to pay in the market, (2)
one will gain the difference between MRS and relative price in purchasing this marginal unit
of X. (1)
On the other hand, if MRS < relative price, one will gain the difference between MRS and
relative price in selling this marginal unit of X. (2)
So whenever there is a divergence between MRS and price ratio, the consumer will adjust his
consumption choice.
9. If an individual is subsidized by price, according to the maximization axiom, he will
increase his consumption of housing from point A to point B as illustrated in the above
diagram. (1+1)
However, if he is given a cash subsidy that is just enough for him to buy the same amount of
housing as he would under the price subsidy, then the new budget line will pass through point
B (i.e., the consumer equilibrium for the price subsidy). (1+1)
At point B the relative price of housing of the new budget line is higher than its MRS. (1+1)
As a result, he can attain a higher utility level as and the consumption of housing will change
from point B to point C. (1+1)
Therefore, people will prefer taking a cash subsidy because it enables them to acquire a more
preferable option of goods than the price subsidy.
$
Good Y
C
A
0
B
U
Housing
0
Good X
BL1 BL2
10. If two goods, X and Y are perfect complements, the indifference curves of the two goods
are right angled lines as shown in the diagram. (1)
Therefore, if we hold real income constant, then a decrease in price of good X will rotate the
budget line from BL1 to BL2. (1+2)
As a result, we can see that the consumption of both goods will remain unchanged. Hence,
the substitution effect for perfect complements is equal to zero. (1)