Question

1. For each of the following statements, define all of the underlined terms. Then, explain why the statement is true, false or uncertain. (a) If a consumer views two goods as perfect substitutes then their optimal choice will be a corner solution. (b) The substitution effect from a price increase states that the consumer will always choose a smaller amount of that good to consume. However, the income effect states that consumption can move in either direction. (c) Suppose Alf and Bo have convex indifference curves. Alf likes units of ”X” more than units of ”Y” but Bo likes units of ”Y” much more than units of ”X.” Then, in the optimum, Alf’s marginal rate of substitution will be different from Bo’s even if they face the same prices. (d) All Giffen goods are normal goods, but not all normal goods are Giffen goods. (e) Economists assume that preferences are ordinal. This implies that given two utility functions and one is a monotonic transformation of the other, then they represent the same preferences over bundles of goods.

Answer 1

a. True.

If the two goods are perfect substitutes then the consumer may want to substitute one good for the other at a constant rate. For doing so, the consumer would end up consuming either of the two goods and thus corner solution would be the optimal solution where the relative price ratio is not equal to the slope of the indifference curve.

b. True.

The substitution effect shows that with an increase in the price of a good, the consumer substitutes that good for another and thus consumption of the former good will reduce. However income effect tells that with an increase in income, the consumer tend to increase or decrease consumption depending on the type of the good. For example, if the good is an inferior good then with the rise in income, consumer will tend to reduce his/her consumption of that good whereas the effect will be opposite for luxury goods.

c. False.

When both Alf and Bo face the similar prices of both the goods X and Y then in the equilibrium state both will be having the same marginal rate of substitution. Thus both of them will trade the goods in a similar way.

d. False.

All giffen goods are inferior goods but not normal goods. Normal goods are those which have both positive substitution effect and positive income effect whereas giffen goods are those which has a negative income effect and a positive substitution effect. Additionally this negative income effect outweighs the positive substitution effect.

e. Uncertain.

It is true that when one utility function is a monotonic transformation of the other then it implies the same preferences of the bundles of good but all economist do not consider utility to be ordinal. Some economists also measure utility cardinally and the theory of cardinal utlity exists where utility is measured in utils. Thus there are two theories of measuring/finding utility.