ECON 100 Tutorial: Week 4

www.lancaster.ac.uk/postgrad/alia10/a.ali11@lancaster.ac.uk

office hours: 3:45PM to 4:45PM tuesday LUMS C85

Outline for this week’s tutorial

Past exam question ( from last week) – 5 min.Question 1 – 2 min.Question 2 – 3 min. Question 4 – 5 min. Question 5 – 10 min.Question 7 – 20 min.

Solutions for Q6 and Q8 are in the slides (and on Moodle) – please review them and email me or come to office hours if you have questions, but we will not be going over them in tutorial.

Past exam question from last week

From Week 3 tutorial (Question 6), we learned the following equations: The Incidence of a tax (or change in price with respect to a change in tax):

Price Elasticity of Supply and Price Elasticity of Demand (this is the point elasticity method, which involves taking the derivative of the demand or supply curve):

= =

Suppose D=120-4P. Find the price elasticity at a price of 10 and at a price of 20. Use the standard mathematical method, not the midpoint method.

a) -0.2, -2, respectivelyb) -0.5, -2, respectivelyc) -0.5, -4, respectivelyd) Not possible to say without knowing what

the corresponding level of demand is.

An Inferior Good:a) Is a Giffen goodb) Has a positive income elasticity of demandc) Has a negative income elasticity of demandd) Has an upward sloping demand function

Suppose a demand curve is written D=60-3P. Find the intercept and slope of the corresponding inverse demand curve.

a) Slope of -20, intercept of 3b) Slope of -1/3, intercept of 20c) Slope of -3, intercept of 20d) Slope of 1/3, intercept of 60

Suppose D=200-2P and S=20+4P. What is the equilibrium price and quantity?

a) P*=20, Q*=100b) P*=30, Q*=140c) P*=50, Q*=220d) P*=40, Q*=180

Question 1Assuming an indifference curve which is convex to the origin, what can this tell us about a consumer’s marginal rate of substitution between coffee and muffins?

Question 2Explain why the consumer’s optimal choice occurs where the marginal rate of substitution (MRS) is equal to the relative price of the two goods.

The optimal choice is where one indifference curve is touching the budget constraint at exactly one point (where the indifference curve is tangent to the budget constraint).

The MRS is the same thing as the slope of the budget constraint.

If a line is tangent to another line, their slopes are equal at the point of tangency.

Question 4

Would the assumption that goods are perfect substitutes be valid in a study of intertemporal food purchases?

Food today

Food tomorrow

Perishable foods in one time period are not a perfect substitute for food in another time period.

Question 5(a)Use a diagram to distinguish between the income and substitution effects of a change in the price of muffins when the price of coffee stays constant. Assume both goods are normal goods.

So, what are a substitution effect and an income effect?

First, we draw our original budget constraint, original indifference curve, and the new budget constraint. Next, we can find the substitution effect, the movement along the indifference curve, to a point whose MRS is equal to the slope of the new budget constraint.Finally, we can find the income effect – which will move us to a new indifference curve on the new budget constraint – this depends on whether our good whose price changed is a normal, inferior or giffen good.

Question 5(b)Suggest an example of an inferior good. Use a diagram to distinguish between the income and substitution effects of a change in the price of the inferior good.

Question (c)

Suggest an example of a Giffen good. Use a diagram to distinguish between the income and substitution effects if a change in the price of the Giffen good.

Question 7(a)Suppose the price of a magazine is £2, the price of a book is £10, and the consumer's income is £100. Which point on the graph represents the consumer's optimum: X, Y, or Z? What are the optimal quantities of books and magazines this individual chooses to consume?

Answer: Point Z. 25 magazines and 5 books.

Question 7(b)Suppose the price of books falls to £5. What are the two optimum points on the graph that represent the substitution effect (in sequence)?

Answer: From point Z to point X.

What is the change in the consumption of books due to the substitution effect?

Answer: From 5 to 8 books.

Question 7(c)

Again, suppose the price of books falls to £5. What are the two optimum points on the graph that represent the income effect (in sequence)?

Answer: From point X to point Y.What is the change in the consumption of books due to the income effect?

From 8 to 6 books.

Question 7(c) ctd.

Is a book a normal good or an inferior good for this consumer? Explain.

Books are inferior because an increase in income decreases the quantity demanded of books.

Question 7(d)

For this consumer, what is the total change in the quantity of books purchased when the price of books fell from £10 to £5? Answer: The quantity demanded increased from five books to six books.

Question 7(e)

Use the information in this problem to plot the consumer's demand curve for books on a diagram.

Next Week

• Tutorial 5 Worksheet• Practice exam questions in tutorial.• Access past exams here: http://

www.lancaster.ac.uk/sbs/registry/Exams/PastPapers/PastPapers.htm– You will need to select a year, then select ECON

100 or ECON 101. You will be looking at approximately the first 10 questions from each year’s exam.