Review of Chapter 2

Topics: Indifference curve, Consumer theory, Utility Pages: 6 (1408 words) Published: February 18, 2014
Chapter 02 - Economists’ View Of Behavior

CHAPTER 2
REVIEW QUESTIONS
2–1. Which costs are pertinent to economic decision making? Which costs are not relevant?
The marginal (incremental) costs and benefits are pertinent to economic decision making. Sunk costs and benefits are not relevant. In economics, “bygones are forever bygones.”

2-3. The Solace Company has an inventory of steel that it originally purchased for $20,000. It currently has an offer to sell the steel for $30,000. Should Solace’s management agree to sell? Explain.

You cannot answer this question without additional information. The historic cost of the steel is irrelevant. What is important is the current opportunity cost of the steel. For example, if the current market price of steel is $40,000 you should not sell the steel for $30,000.

2-4. Suppose that you have $900 and what to invest the money for one year. There are three existing options.
(a) The city of Rochester is selling bonds at $90 per unit. The bonds pay $100 at the end of one year when they mature (no other cash flows).
(b) Put the money under your mattress.

(c) The one-year interest rate of saving in the Chase Bank is 7 percent. Which one will you choose? What is the opportunity cost of your choice? Explain. Choose option (a). By definition, opportunity cost is the value of the bestforegone option. So the opportunity cost of (a) is the value of (c) in this case, $63 = $900 ×7%.

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Chapter 02 - Economists’ View Of Behavior

2-5. Suppose Juan’s utility function is given by U = FC, where F and C are the two goods available for purchase: food and clothing.
a. Graph Juan’s indifference curves for the following levels of utility: 100, 200, and 300. Juan’s indifference curves for U = 100, 200 and 300 are pictured as follows. The general formula for the graph of an indifference curve for a given level of utility, U*, is F=U*/C (since U* = F x C). For example, the indifference curve for U* = 100 is given by the formula: F = 100/C.

b. Are these curves convex or concave to the origin? What does this shape imply about Juan’s willingness to trade food for clothing?
The curves are convex to the origin. This implies that Juan’s willingness to trade food for clothing falls when the amount of food that he has declines relative to the amount of clothing. He is willing to give up a relatively large amount of food for a unit of clothing when he has lots of food and little clothing. This is not true when he has little food and numerous clothing. c. Suppose Juan’s budget is $100 and the prices of F and C are both $5. budget constraint.

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Graph the

Chapter 02 - Economists’ View Of Behavior

Juan’s budget constraint (I = $100 and PC = PF = $5) is pictured as follows:

d. How many units of food and clothing will Juan purchase at these prices and income? Show graphically. What is his corresponding level of utility? Juan will purchase 10 units of food and 10 units of clothing. This provides Juan with 100 units of utility. Note that at current prices he can buy a total of 20 units of the two goods (in any combination). Any other combination produces lower utility. For example, 9 units of one good and 11 units of the other produces 99 units of utility. Graphically:

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Chapter 02 - Economists’ View Of Behavior

e. The Johnson Company is the sole producer of clothing. What can the company do to induce Juan to purchase more clothing? Show graphically. (The graph does not have to be exact.)
It can lower the price of clothing. Graphically (does not have to be exact)

2-7. Suppose that Bob’s indifference curves are perfectly L-shaped with the right angle occurring when Bob has equal amounts of both goods. What does this imply about Bob’s willingness to trade one good for the other? Give examples of goods where this type of behavior might be expected?

Perfectly L-shaped indifference curves imply that the Bob considers the two goods to be perfect complements. His...
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