More Demand Theory

True/ False

1.     An exact measure of the individual's willingness to pay for the opportunity to purchase an automobile at some price is the consumer surplus.

2.     If the substitution effect is zero, then an individual will be indifferent between a subsidy on each unit consumed of some good and a lump-sum cash subsidy that costs the government an equal amount of money.

3.     A two-part tariff on some good that laves a consumer at the same level of utility as received under a simple per-unit price is always more profitable for the firm selling the product.

4.     If the government can subsidize a low-income family with a subsidy on clothing or with a lump-sum cash transfer, and both programs are equally costly to the government, then the family will be better off with the subsidy on clothing.

5.     If the government wants to increase its revenue through a tax on some good, then it can collect more revenue through a lump sum tax than through a per-unit tax that would leave the individual at the same utility level.

6.     The higher the price of a good, the larger the Consumer Surplus associated with that good will be.

Answers:  1.F     2.T    3.T    4.F    5.T    6.F

3. Short Questions

1.     Explain using a diagram how to calculate the equivalent variation associated with introducing a new good.

4. Long Questions

1.     Mohammed spends all of his income on two goods, left shoes and right shoes.
His utility function is given by:
U(x₁,x₂)=min(x₁,x₂).
The price of right shoes is $10 and the price of left shoes is $20. His income is $60.
Suppose the price of left shoes falls to $10. Measure the change in Mohammed's well-being

(i) Using compensating variation
(ii) Using equivalent variation

Answers: 1. Show it in the diagram. In this case there is no substitution effect. CV=20, EV=30. Be careful when you calculate CV and EV. It is not the vertical distance between two budget lines because the price of right shoes is not 1 but 10.