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Indifference Curves

Prof. Carlos Jos Blanco Huitrn

1. Carmen consumes nothing but cafeteria meals and CDs. Cafeteria meals have a price of $5 each, and CDs a price of $10.

Carmen has $50 to spend.

a) Draw Carmen's budget line and an indifference curve that illustrates her best affordable consumption point. Place cafeteria

meals on the horizontal axis and CDs on the vertical axis. Show the two real incomes, in terms of CDs and meals. You do not

have enough information to know the specific tangency point, so choose one arbitrarily.

b) Now Carmen's income rises to $70.

b.1) Build a matrix that shows the more/less consumption of CDs/meals as a consequence of the substitution and income

effects (use + / - symbols to reflect your answer).

b.2) On the same diagram, draw the new budget line reflecting the rise in income. Also, draw an indifference curve that

illustrates her best affordable consumption point. Assume that cafeteria meals are inferior goods.

b.3) What happened to the real income in terms of CDs? (Did it change or did not?)

b.4) What happened to the real income in terms of meals? (Did it change or did not?)

b.5) What is the original numerical value of the slope of the budget line?

b.6) What is the numerical value of the slope of the budget line after the income changed?

b.7) Indicate clearly the substitution effect and the income effect, both on the indifference curves and on the axes, to show

the more/less consumption of the two goods (use arrows for this purpose).

b.8) Show the final best affordable consumption point (draw the necessary indifference curve to illustrate this point).

2. Bill has $16, which he can spend on either magazines or baseball games. Below is a graph that shows Bills budget lines and

Bills consumer maximization points for each of the three budget lines. Using this information, derive Bills demand curve for

magazines showing the corresponding schedule. Plot the demand curve and write the three budget equations using the explicit

form.

4.5

4

3.5

3

2.5

2

1.5

1

0.5

0

0

Quantity of Magazines

10

3.

a) Could cheese and crackers both be inferior goods for Mario? Explain.

b) Suppose that cheese is a normal good for Mario while crackers are an inferior good. If the price of cheese falls,

what happens to Marios consumption of crackers? Explain your answer stating whether more or less crackers are

consumed by substitution effect, and more or less crackers by income effect.

c) What happens to the consumption of cheese? Explain your answer in a similar way than in the previous letter

(what happens to the consumption of cheese by substitution and income effect).

4. For Crandall, cheese cubes and crackers are perfect complements: he wants to consume exactly 1 cheese cube with each

cracker. He has $2.40 to spend on cheese and crackers. One cheese cube is sold for 20 cents, and 1 cracker is sold for 10 cents.

a) Draw a diagram, with crackers on the horizontal axis and cheese cubes on the vertical axis.

b) What is Crandalls optimal consumption bundle?

c) The price of crackers increases to 20 cents. How many portions of cheese and crackers will Crandall consume now?

c.1) Build a matrix showing the more/less consumption of cheese/crackers as a consequence of the substitution and

income effects (use + / - symbols to reflect your answer).

c.2) On the same original diagram, illustrate the new budget line and the final optimal consumption bundle. Also draw

the indifference curve on which this bundle lies.

c.3) In your diagram, show the substitution and income effects, both on the indifference curves and on the axes, to show

the more/less consumption of the two goods (use arrows for this purpose).

5. Consider your decision about how many hours to work. Suppose that your budget line shows two alternatives (showed on the

axes): consumption or leisure time.

a) Draw your budget line. Place leisure time on the X axis, and consumption on the Y axis.

b) On the same diagram, draw another budget line, assuming that you pay a percentage of your income in taxes.

c) Show, on three different graphs, the following situations:

c.1) The tax leads to more hours of work. El impuesto conduce a un mayor nmero de horas de trabajo

c.2) The tax leads to fewer hours of work.

c.3) The tax leads to the same hours of work.

Note: For each letter, you should graph the budget line and the indifference curve, as well as the best point.

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