Economics Homework 4 - Model
1. A consumer's overall satisfaction is expressed in economics as his _________________.
- total utility
2. Suppose you see a sleek-looking used sports car and you immediately want to buy it. You think to yourself, "I can paint that car and fix it up so it looks brand new!" You like it so much that you would very work hard for a year and save up $10,000 to buy it. You ask the owner how much he'd sell the car for, and he says $9,000. If you buy it for $9,000, then what is your "consumer surplus"? What does that concept mean?
- Your consumer surplus would be the value to you ($10,000) minus what you paid ($9,000), for a total of $1,000.
- The consumer surplus is the total net benefit which a buyer obtains when purchasing a good or service. The consumer surplus is the money the buyer was willing to pay but did not have to.
3. Suppose your favorite hobbies are reading books and hiking, and imagine that they have the following values for marginal utility. The first hour that you hike gives you lots of utility: 10 units. But as you start to tire, you enjoy and benefit from it less. The next hour of hiking is worth only 8 units of utility (in other words, it has a marginal utility of 8 units rather than 10), and the next hour of hiking is worth only 5 units, and then 3, then 1, and then zero for the next hours, in that order. Your marginal utility for reading books does not decline so quickly. In the first hour, reading a book gives you utility of 6 units; the next hour is worth 5 units; the next hour is worth 4 units; and then 3, 2, 1 and 0. Suppose that you have 5 extra hours today. How should you spend those hours on hiking and reading in order to maximize your utility, and what will be your total utility for those 5 hours? Explain your answer.
- You would attain the maximum utility as follows: 10 (hiking) + 8 (hiking) + 6 (reading) + 5 (hiking) + 5 (reading), which equals 34 units of utility.
- If you had spent your entire 5 hours hiking, then your total utility would be only 27 units. If you had spent your entire time reading, then your total utility would be only 21 units. Neither of these options attains maximum utility.
4. Suppose you plan to buy a brand new car for $25,000. When you do to the car dealership to make your purchase, you notice that there is a car on the lot that looks brand new but not longer has the sticker price on it. The dealer says it was returned by someone after driving it only 100 miles. You like the color and ask if you can buy it. The dealer, seeing that you’re so interested, says he’ll sell it to you for the same price as a brand new car that has never been sold. You’re willing to buy it at full price, and do not mind one bit that someone else used it briefly and returned it. But you notice that other people (the “market”) would not pay full price for a returned car. Relying on the “market” rather than your personal preferences, what should you tell the dealer in order to maximize your benefits from your purchase?
- In order to maximize your consumer surplus, you should not pay any higher than the free market price, which is less than the full price of a new car.
5. Explain why the shape of an indifference curve for two goods that are perfect substitutes is a straight line going from the upper left down to the lower right. Extra credit: why must its slope be negative 1?
- The line's slope must be negative one because you must give up the exact same quantity of one good and receive the exact same quantity of the other good in order to maintain the same level of happiness.
- If the line's slope were not negative one, then one of the goods would be preferred to the other rather than the goods' being perfect substitutes.
6. Describe either the "income effect" or the "substitution effect." Take your pick.
- The income effect is the wealth that is gained or lost when the price of an item changes. For example, if hamburger is on sale for $.99 per pound vs $1.99 a pound, the effect is a gain of $1 and the consumer will purchase more hamburger as a result.
- The substitution effect begins when the price a good increases. Since people do not want to pay the higher price, they buy a substitute. As a result the demand for the good with the higher price decreases as the demand for the lower priced substitute increases.
- Each of the above effects contributes to the Law of Demand.
7. Charity is based on the foundation of a successful free market. Or is a successful free market based on a foundation of charity? Describe and explain which is the cart, and which is the horse (in other words, which comes first or is most important, charity or the free market).
- Two possibilities:
- Charity comes first because free enterprise cannot get started without a foundation of charity.
- Free enterprise comes first because it is needed to generate wealth, from which extra wealth can flow to charity.
Write in about 300 of your own words on one or more of the following topics:
8. "A penny saved is a penny earned!" In fact, once taxation is taken into account, "a penny saved is almost two pennies earned!" Discuss one or both of these quotations.
- "A penny saved is a penny earned!" describes how being frugal is the same as making more money.
9. Do you think a Giffen good really exists? Can you see any possible political bias in the claim that Giffen goods exist? Your views, please.
- A Giffen good is a good whose demand actually increases as its price increases. It's doubtful that Giffen good really exists because it is contrary to the Law of Demand.
10. Prove the Law of Demand as simply as you can, perhaps using the assumption that the consumer always tries to maximize marginal utility.
- The Law of Demand is a combination of the income effect and the substitution effect, such that demand for a good always decreases when its price increases.
11. Discuss the Irish Potato Famine between 1846 and 1849, and whether you think potatoes were an "inferior good" then.
- Potatoes in Ireland were inferior goods because they were the cheapest possible food available in the country. As people's income increased, they bought more expensive foods and the demand for potatoes decreased.
Extra Credit for Anyone
- They are perfect complements. The curves show that "extra" of one good is useless (adds no utility) without "extra" of the other good to go along with it. Extra ketchup provides no added utility without an extra hamburger to go along with it, for example. But if the quantity of both goods increase along the dotted line, then utility does increase.