Economics 172 Name: ___________________

Spring 2006 Quiz 4

1. If a good is an inferior good, then its

a. demand curve will be upward sloping.

b. income effect reinforces the substitution effect. The income effect reinforces the substitution effect for a normal good.

c. income elasticity is negative. This is correct. Income elasticity is the percent change in quantity divided by the percent change in the income. An inferior good has a negative income elasticity.

d. Engel curve cannot be drawn. You can always draw an Engel Curve. They relate the quantity consumed to the income level.

e. All of the above.

2. Suppose Lisa spends all of her money on books and coffee. When the price of coffee decreases, the

a. substitution effect on coffee is positive, and the income effect on coffee is positive.

b. substitution effect on coffee is ambiguous, and the income effect on coffee is ambiguous.

c. substitution effect on coffee is positive, and the income effect on coffee is ambiguous.

d. substitution effect on coffee is ambiguous, and the income effect on coffee is positive.

The substitution effect is ALWAYS negative, so that means a or c are possible answers. We don’t know whether coffee is a normal or inferior good, so we can’t tell the direction of the income effect. Therefore (c).

3. The adjoining figure shows Bobby’s indifference map for soda and juice. B1 indicates his original budget line. B2 indicates his budget line resulting from a decrease in the price of soda. What change in quantity represents his income effect?

The substitution effect is along the original indifference curve so it is the movement from 15 to 18. The income effect is from 18 to 25, so 7.

4. A firm makes health insurance available to its employees. The employee has to pay $1,000 a year for the policy, but if the employee pays, the family gets unlimited health care coverage at no charge. On the graph below, draw two budget lines. Label Budget Line 1 (BL1) for an employee who participates in the health plan. Label Budget Line 2 (BL2) for an employee who elects not to participate.

Comp

Good

BL1

BL2

Health Care

BL2 is the line with the negative slope. That employee can consume either good based on the normal budget line. Employee 1 gives up $1000 worth of the compositive good to buy health insurance, so her budget line starts on the Y axis $1,000 below the other employee. But her budget line is now a horizontal line. She can consume that amount of the composite good and unlimited health care.