Chapter 02
Economist's View of Behavior
Essay Questions
1. It is commonly believed that the best ways to motivate an employee are (1) to improve the quality of the workplace and (2) to make the employee feel like he/she is part of the company. How would an economist analyze these statements?
Answer: An economist would be skeptical about these claims. The economic model shows that people respond to incentives. The economic model implies that desired changes in employee behavior can be achieved by changing the relevant costs and benefits of actions by employees.
Difficulty: 03 Hard
Blooms: Analyze
AACSB: Analytic
Topic: Economic Behavior: An Overview
2. Stella Ann Freeman is having a difficult time deciding whether or not to purchase a new car. How would understanding the concept of opportunity cost help her make a decision?
Answer: Opportunity cost is the value of the best forgone alternative. The opportunity cost of purchasing a new car is the value of what is given up to purchase the car.
Difficulty: 02 Medium
Blooms: Understand
AACSB: Reflective Thinking
Topic: Economic Behavior: An Overview
3. Jim Range has to choose between buying more soda or more pasta for the week. He has a fixed income and he knows the prices of both products. Using indifference curves and budget constraints, illustrate the amount of soda and pasta that Jim will purchase. When he gets to the store, he finds that the price of soda has fallen dramatically. How does this change his optimal purchase? Can a general rule of human behavior be developed from this graphical example?
Answer: If quantity of soda is measured along the horizontal axis and that of pasta is measured along the vertical axis, a reduction in the price of soda pivots out Jim’s budget constraint along the horizontal axis. His new consumption bundle, containing a lot more soda, is located on the higher indifference curve that lies to the right of his initial highest attainable indifference curve. In response to a lower price, he changes his behavior to buy more of the good with the lower relative price. Consumers generally respond to the incentives given by prices. At lower prices, consumers demand greater amounts. Depending on the location of the indifference curve, he may choose to consume more of both pasta and soda.
Difficulty: 03 Hard
Blooms: Apply
AACSB: Analytic
Topic: Graphical Tools
4. Patrick consumes only two goods: Celtic Music concerts and Celtic Springs Water. Patrick earns $100 per month at his parttime job in the library. The price of Celtic concerts is $10. The price of Celtic Springs Water is $2. Patrick currently goes to 5 Celtic concerts and consumes 25 bottles of Celtic Spring Water in a month.
(a) Draw Patrick's budget constraint and optimal consumption bundle such that Celtic concerts are measured on the horizontal axis.
(b) In April, Patrick receives a 5 percent pay increase. Inflation raises the price of concerts to $10.50 and the price of Celtic Springs Water to $2.10. Draw Patrick's new budget constraint and optimal consumption bundle, considering that the number of Celtic concerts is measured along the horizontal axis. How many Celtic concerts does he attend in April? How many bottles of water does he drink in April?
Answer:
(a)
(b) His budget constraint does not change. The new vertical intercept of 50 bottles of water is the same as the old vertical intercept of 50 bottles of water. The new horizontal intercept of 10 concerts is the same as the old horizontal intercept of 10 concerts. The relative price of Celtic concerts is always 5 bottles of Celtic Springs Water. He consumes 5 Celtic concerts and 25 bottles of Celtic Spring Water in April.
Difficulty: 03 Hard
Blooms: Apply
AACSB: Analytic
Topic: Graphical Tools
5. Ali inherits $10,000 from his greatgreat aunt in 2008. His greatgreat aunt's will requires that Ali spend the money before December 31, 2009. He has two spending options: He can either spend the amount in 2008 or in 2009. Suppose this is Ali's only source of income and the interest rate on loans or savings is 10 percent.
(a) How much could Ali spend in 2008 if he only consumes in 2008? How much could Ali spend in 2009 if he only consumes in 2009?
(b) What is the opportunity cost of consuming $1.00 in 2008 in terms of forgone consumption in 2009? Draw Ali's budget constraint and optimal consumption bundle, considering that the spending in 2008 is measured along the horizontal axis.
(c) Ali decides to spend $6,000 in 2008 and $4,400 in 2009. Show this optimal consumption bundle using a budget constraint and indifference curve diagram.
Answer:
(a) If Ali only consumes in 2008, he can spend $10,000 in 2008, whereas if he consumes only in 2009, he can spend (1 + 0.10) × 10,000 = (1.10) × 10,000 or $11,000 in 2009.
(b) You give up $1.10 in 2009 consumption for every dollar you spend in 2008.
(c)
Difficulty: 03 Hard
Blooms: Apply
AACSB: Analytic
Topic: Graphical Tools
6. What is the relationship between the slope of the budget line and the notion of opportunity cost?
Answer: The slope of the budget line represents the opportunity cost of one good in terms of the other. Suppose we have two goods: fish and chips. If the price of fish (P_{f}) is $2 and the price of chips (P_{c}) is $8, then the price ratio −P_{c}/P_{f} = − 8/2 = − 4. This means that if I want 1 more unit of chips, I have to give up 4 more units of fish. Therefore, the opportunity cost of 1 unit of chips is given by the slope, − 4, in terms of the number of fish that has to be given up.
Difficulty: 02 Medium
Blooms: Understand
AACSB: Reflective Thinking
Topic: Graphical Tools
7. What does the tangency between an indifference curve and the budget line determine?
Answer: The point of tangency between the budget line and an indifference curve tells us that for a given income level, that point is the best combination for the consumer. That combination of goods is the one that will maximize utility, given the consumer’s income. Since the budget line is straight, linear, and downward sloping, its slope is the priceratio, and this represents the opportunity cost of one good in terms of the other. Indifference curves are convex to the origin, and the slope of an indifference curve is different at each point. Further, the slope of an indifference curve at any point can be found by drawing a tangent at that point. This slope tells us the subjective opportunity cost for the consumer, of one good in terms of the other. The point of tangency between the budget line and an indifference curve brings the two opportunity costs together and sets them equal to each other. Any other combination is hence inefficient from the consumer's point of view.
Difficulty: 02 Medium
Blooms: Understand
AACSB: Reflective Thinking
Topic: Graphical Tools
8. Contrast the goodcitizen model with the economic model to explain the reason why people engage in charitable behavior.
Answer: The goodcitizen model views charitable behavior as the result of individuals placing the good of society ahead of their own wellbeing. The model assumes that if individuals knew how best to improve society they would choose to help others. The economic model holds that people engage in charitable behavior as part of their utility maximization, given constraints. In contrast to the goodcitizen model, the economic model successfully predicts that charitable donations respond to changes in the cost of charitable donations created by changes in the tax code.
Difficulty: 02 Medium
Blooms: Understand
AACSB: Reflective Thinking
Topic: Alternative Models of Behavior
9. Wanda Weeks has decided to stay in a lowerpaying position with a local electric company rather than accept a much higherpaying job with a new information technology company. Use a risk model to explain her decision.
Answer: Wanda is exhibiting riskaversion. The risk model shows the tradeoffs riskaverse individuals are willing to make between higher average salaries and greater variance in compensation. The more preferred job for a riskaverse individual is the job that offers the best package of both expected compensation and variance of compensation, not the position with the highest expected compensation.
Difficulty: 02 Medium
Blooms: Understand
AACSB: Reflective Thinking
Topic: Decision Making under Uncertainty
10. You have $64 to spend on fish (F) and chips (C). Suppose the price per unit of fish (P_{f}) is $8 and the price of chips (P_{c}) is $2. Your utility function for fish and chips is given as
such that
and
are the marginal utilities of F and C. How many units of C and F should you buy to exhaust all income and to maximize utility?
Answer: First, in order to maximize utility, you have to be at equilibrium. This means that the following condition has to be satisfied:.
It is better to write this as
.
Now substitute the corresponding values in the above expression:
.
Canceling the 2s in the denominator and crossmultiplying, we get
C = 4 F.
Now, the second aspect of this is your income of $64 that has to be spent on F and C. Therefore, the budget constraint should satisfy this condition:
64 = C P_{c} + F P_{f} or
64 = 2C + 8F, and now from the previous condition, we have
64 = (4F) 2 + 8F or
F = 4 units.
C = 16 units and total utility is
utils.
Difficulty: 03 Hard
Blooms: Apply
AACSB: Analytic
Topic: Appendix A: Consumer Choice
