Economics 308

1. Economics 308 Managerial Economics Indifference and Budget Line Quiz #1 Fall 2009

2. Rules of Engagement • The quiz is worth 10 points to be added onto the next exam after the curve is computed. • The quiz will done in 2 parts. You will have 30 minutes to do the first part. We will go over the answer and you will have the remaining time to do the second part. • The quiz is open book, open note, and students may freely collaborate among themselves.

3. Question • Question 1 (25 points).Consider an individual with $10,000 of annual income who sometimes eats at home and sometimes eats out at restaurants. Suppose cooking a meal at home costs $5 and eating out costs $20 per meal. • Draw the individual's budget line and indifference curves, if he eats half his meals at home and half of his meals in restaurants (hint: this is different from spending half his income on eating out and half his income on eating and home). Label this point on your budget line and put the relevant values on the vertical and horizontal axes. • Suppose there was a change in the world and the individual ate only 200 meals at home and the rest of his meals he ate out. Show the IC's and budget lines representing this change in consumption if it is caused by a change in income. • Suppose instead that the change to eating only 200 meals at home was caused by a change in preferences. What change in the world could cause such a change in the person’s indifference curves? Show IC’s and budget lines representing this change if it is caused by a change in preferences. • What could cause such a change in preferences? • Suppose the person received an offer in the mail from a credit card company. For $1000 a year the person can get a credit card and each time he eats in a restaurant and charges the meal on his credit card, the credit card company will rebate 25% of his restaurant bill. Show how the credit card offer will affect his budget line (hint: don’t forget to take into account the $1000 fee). • Draw BL's and indifference curves showing an individual who would accept the offer and one who would reject the offer.

4. Question 1 (25 points).Consider an individual with $10,000 of annual income who sometimes eats at home and sometimes eats out at restaurants. Suppose cooking a meal at home costs $5 and eating out costs $20 per meal. • Draw the individual's budget line and indifference curves, if he eats half his meals at home and half of his meals in restaurants (hint: this is different from spending half his income on eating out and half his income on eating and home). Label this point on your budget line and put the relevant values on the vertical and horizontal axes. • Suppose there was a change in the world and the individual ate only 200 meals at home and the rest of his meals he ate out. Show the IC's and budget lines representing this change in consumption if it is caused by a change in income. • Suppose instead that the change to eating only 200 meals at home was caused by a change in preferences. What change in the world could cause such a change in the person’s indifference curves? Show IC’s and budget lines representing this change if it is caused by a change in preferences. • What could cause such a change in preferences? Meals Eaten Out Normal or Inferior? Change in preference makes the IC shallower. 500 Start 400 200 Normal or Inferior? 400 180 2,000 200 Meals Eaten at Home

5. Suppose the person received an offer in the mail from a credit card company. For $1000 a year the person can get a credit card and each time he eats in a restaurant and charges the meal on his credit card, the credit card company will rebate 25% of his restaurant bill. • Show how the credit card offer will affect his budget line (hint: don’t forget to take into account the $1000 fee). • Draw BL's and indifference curves showing an individual who would accept the offer and one who would reject the offer. Meals Eaten Out With a 25% discount, meals cost $15 each. With 9000 to spend, he will be able to buy a maximum of 600 meals eaten out. With the solid blued IC’s, the person would be better off with the credit card. 600 500 400 Because the green budget line has points outside the budget Iine where the person could have more of both goods by accepting the offer, it is impossible to draw IC of a person who would reject the offer. If he pays $1000 for the credit card, that will leave $9000 of income. If he spends the $9000 on meals at home he can buy 1800 meals. 400 1800 2,000 Meals Eaten at Home