Test Questions with Answers
Chapter 9. Demand Theory II.
Elasticity. Indifference Analysis
Chapter 9 ― Question 1
If an increase in the price of good X leads to a decline in demand for good Y
- X and Y are substitutes
- X and Y are complements
- X and Y are inferior goods
- X and Y are luxuries
*B. If the price of hardware increases, demand for software declines.
Chapter 9 ― Question 2
Price elasticity of demand stands for the percentage change in the price of a product in response to a percentage change in demand for the product. True or false?
*False. There are two mistakes in the sentence.Elasticity measures the response of quantity demanded (not demand) to price changes. It does not measure the response of price to quantity demanded.
Chapter 9 ― Question 3
On a linear demand curve, elasticity of demand is unit elastic
- where the demand curve intersects the supply curve
- at its midpoint
- where the demand curve intersects the x-axis
- where the demand curve intersect the y-axis
*B. Answer A is nonsense. Answers C and D are traps. Supply is elastic if you can extend the supply curve to the y-axis and inelastic if you can extend it to the x-axis.
Chapter 9 ― Question 4
The quantity demanded of laptops has increased by 30 per cent. If the price elasticity for laptops is 3.0, the price for laptops must have fallen by
- 6 percent
- 3 percent
- 30 percent
- 10 percent
*D. 30 percent = 3.0
? percent
Chapter 9 ― Question 5
If a normal good has many close substitutes, demand for it is price elastic. True or false?
* True. Consumers respond to price changes by substituting goods for each other.
Chapter 9 ― Question 6
The price of a commodity falls from $10 to $8. Quantity demanded rises from 100 to 200 units.
What is the price elasticity of demand between the two prices? Use the midpoint formula.
- 5.0
- 3.05
- 2
- 2.5
| *B. | Change in quantity : | Change in price | 100 : | 2 = 3.05 | ||
| Average quantity | Average price | 150 | 9 |
Chapter 9 ― Question 7
If the cross elasticity for two goods is + 1.5, they are complements. True or false?
* False. The goods are substitutes. For complements, quantity demanded of good A and price of B move in opposite directions. When the price of cars rises, the quantity demanded of petrol falls.
Chapter 9 ― Question 8
If marginal utility falls slowly, the demand curve is price inelastic. True or false?
* True. Slowly falling marginal utility is illustrated by a steep demand curve as is price inelasticity. Remember that complete inelasticity is reflected by a vertical demand curve. At any price consumers buy the same quantity.
Chapter 9 ― Question 9
In order to increase its revenues, a firm decides to raise the price of its product. The firm obviously assumes that the price elasticity of demand for its product is
- above one
- one
- below one
- none of the above
*C. The firm hopes that demand for its product is inelastic. Consumers will not lower purchases significantly as price rises.
Chapter 9 ― Question 10
Using our wine-water example, write down the equations which a consumer uses to make an optimal choice between water and wine
1) when he applies the equimarginal principle for bundles
2) when he applies indifference analysis
| *1) | Marginal utility of water | = | Marginal utility of wine |
| Price of water | Price of wine | ||
| *2) | Amount of water sacrificed | = | Price of wine gained |
| Amount of wine gained | Price of water sacrificed |
Chapter 9 ― Question 11
A consumer's budget for commodity X and commodity Y is $100. X costs $10 per unit, Y $5 per unit.
1) Draw the budget line on a diagram.
2) The consumer wants to spend half of his budget on each commodity. Label this point on the budget line.
3) What is the marginal rate of substitution between X and Y at this point?
*1) Here is the schedule for the budget line:
| x | y |
| 0 | 20 |
| 1 | 18 |
| 2 | 16 |
| 3 | 14 |
| 4 | 12 |
| 5 | 10 |
| 6 | 8 |
| 7 | 6 |
| 8 | 4 |
| 9 | 2 |
| 10 | 0 |
| *3) | Change in Y = | 2 = 2. |
| Change in X | 1 |
Chapter 9 ― Question 12
Explain how a demand curve can be derived from indifference analysis.
* The answer consists of several steps:
1) You need a budget constraint and a budget line. You can take the one in Question 11. Choose one commodity, say X.
2) Sketch a couple of indifference curves. The budget line must be tangent to one of them. If it is tangent to several of them, choose the highest attainable indifference curve.
3) The point of tangency indicates how much of X the consumer gets at which price. This gives you one point for the demand curve.
4) Now lower the price of the commodity you have chosen. This gives you a second budget line.
5) The point of tangency with the highest attainable indifference curve gives you a second point indicating quantity and price.
6) Connect the two points to get a demand curve.
Chapter 9 ― Question 13
Income elasticity for luxuries is
- above zero but below 1
- below zero
- equal to 1
- above 1
*D. Luxuries have by definition a very high income elasticity.
Chapter 9 ― Question 14
Look at the table below.
| Price | Quantity | |
| $40 | 2 | |
| $30 | 4 | |
| $20 | 6 | |
| $10 | 8 |
Demand is most price elastic between
- $30 and $40
- $20 and $30
- $10 and $20
*A. The schedule shows that the demand curve is a linear line. Elasticity rises as price rises along a linear demand curve. So the highest price range is the right answer.
There is, of course, a second possibility of finding the correct answer. You can calculate elasticity with the formula you have learnt: percentage change in quantity/percentage change in price.
For A: 50%/33%. For B: 33%/50%. For C: 25%/100%.
Chapter 9 ― Question 15
Your utility function for commodities x and y is u(x,y) = 8x + 4y. You buy 10 units of x and 4 units of y. You now lower your purchases of x to 8. How many units of y must you buy to get the same utility?
- 8 units of y
- 4 units of y
- 12 units of y
- None of the above.
*A. You used to have 96 utils. You then changed your mind and had 64x only. To receive the initial 96 utils, you must buy 8 units of y, which yield 32 utils. (I am sorry for the utils. I have written often enough in the book that they do not exist. But you are asked such questions in exams.)
Chapter 9 ― Question 16
If a firm plans to raise its product's price, the firm believes that
- the price of complements will also increase
- the prices of substitutes will fall
- demand for the product is price inelastic
- its product is an inferior good
*C. Consumers are expected to buy unchanged quantities when price is raised.
Chapter 9 ― Question 17
You are offered a job. The pay is $10 per hour. You can choose the number of hours. The maximum you are able to work is 50 hours. Your utility function for leisure and money to spend on consumption is U(C,L) = CL.
1) Write down your budget constraint for leisure and consumption. This gives you your options in terms of the allocation of time. (Consider only options with a difference of 5 hours, otherwise the list becomes too long.)
2) Calculate the utility each bundle yields. This gives you your options in terms of utility.
3) Find the optimal bundle of leisure and consumption.
*1) Here is your budget constraint:
| Option | Leisure | Work |
| A | 0 | 50 |
| B | 5 | 45 |
| C | 10 | 40 |
| D | 15 | 35 |
| E | 20 | 30 |
| F | 25 | 25 |
| G | 30 | 20 |
| H | 35 | 15 |
| I | 40 | 10 |
| J | 45 | 5 |
| K | 50 | 0 |
*2) The calculation of utility with the help of your utility function shows you your options in terms of utility.
| Option | Leisure | Consumption | Utility | |
| A | 0 | 500 | 0 | |
| B | 5 | 450 | 2250 | |
| C | 10 | 400 | 4000 | |
| D | 15 | 350 | 5250 | |
| E | 20 | 300 | 6000 | |
| F | 25 | 250 | 6250 | |
| G | 30 | 200 | 6000 | |
| H | 35 | 150 | 5250 | |
| I | 40 | 100 | 4000 | |
| J | 45 | 50 | 2250 | |
| K | 50 | 0 | 0 |
*3). Optimal bundle: F
Please note that such questions are very, very frequent. The utility function for leisure and money is an instrument to prove that unemployment is voluntary.
Chapter 9 ― Question 18
Explain why two indifference curves cannot intersect.
* An intersection would violate the more-is-better rule. An intersection would imply that you switch from a higher indifference curve to a lower one or vice versa. The lower one has fewer units of both goods everywhere.
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