Inventory

Economics 101

Fall 2003

Answers to Practice Questions 6

1. Winners of lotteries are a good example to study

a. the substitution effect.

b. the income effect.

c. how the income effect dominates the substitution effect.

d. how the substitution effect dominates the income effect.

Answer: b.

2. Dick owns a dog whose barking annoys Dick’s neighbor Jane. Suppose that the benefit of owning the dog is worth $700 to Dick and that Jane bears a cost of $500 from barking. Assuming Dick has the legal right to keep the dog, a possible private solution to this problem is that

a. there is no private solution that would improve this situation.

b. Jane pays Dick $650 to get rid of the dog.

c. Jane pays Dick $800 to get rid of the dog.

d. Dick pays Jane $600 for her inconvenience.

Answer: a.

3. Diane knows that she will ultimately face retirement. Assume that Diane will experience two periods in her life, one in which she works and earns income, and one in which she is retired and earns no income. Diane can earn $250,000 during her working period and nothing in her retirement period. She must both save and consume in her work period with an interest rate of 10 percent on savings.

a. Assume that Diane decides to consume $150,000 in the work period. How much will she consume in her retirement period?

Answer:(250000-150000)*1.1=$110000.

b. If the interest rate on savings increases, will Diane increase or decrease her consumption in the work period? why? If possible, give a graph to demonstrate your conclusion.

Answer: Diane will increase, decrease or not change his consumption in the work period, depending on the relative importance of income effect and substitution effect for him. If income effect is dominant, then he will consume more in his work period; If substitution effect is dominant, then he will consume less in his work period: If these two effects are the same for him, then he won’t change. The key point here is that rise of interest rate is equivalent to...