Questions
1. The use of utility functions in consumer decision making means the idea of agents making the preferred choices from among available alternatives is translated into a mathematical exercise in constrained optimization. That is, an agent is assumed to make the feasible choice (feasible in a sense that it is not prohibited by constraints) that results in the highest possible value of his or her utility function. Do people typically engage in optimizing behavior? Is the application of rational choice methods in consumer decision making troubling to you? If so, discuss? If not, discuss why not?

2. This course focuses on microeconomic theories and models of consumer and household decision making. Talk about several ways we have been using microeconomic theory to explain our choices.

3. George has been working as an architect’s assistant. When his wage was $8.00 an hour, he earned a weekly paycheck of $360. However, his wage was recently lowered to $6 an hour. As a result, he currently works 48 hours. (i) Draw a leisure-consumption indifference map that describes George’s weekly labor supply decision before and after his wage cut. Measure the quantity of leisure in hours and assume the price of a unit of consumption is $1.00. There are 168 hours in a week. Include the original budget constraint (BC1), the original indifference curve (U1), the new budget constraint (BC2), and the new indifference curve (U2). Label the original utility maximizing consumption bundle “a” and the new utility maximizing consumption bundle “b”. (ii) Isolate the substitution effect. Label point C that makes the substitution effect A to C and the income effect C to B. (iii) Fill out a substitution/income/total effect table for work and consumption when a person’s wage rate is lowered.
Response to a wage decrease:
Substitution
Effect Income Effect
Total Effect
Leisure
Hours of Work

4. Ronald Reagan used supply-side economic policies to generate economic growth in an effort to get us out of the 1981-1982 recession. One part of “Reaganomics” was to try to get people to work more. Reagan sought to do this by raising the after-tax wage rate. Because the government affects the wage rate through taxation, Reagan's policies sought to reduce income taxes to achieve the goals of supply-side economics. In this example, suppose initially the after-tax wage rate is w(1-t1) where t1 is the initial income tax rate. Suppose the Reagan administration lowered the tax rate to t2 where t1 > t2. The effect of this will be to increase the after-tax wage rate that workers get to take home to their families -- a real wage increase.
a) Graph the effect of Reagan’s tax cut using a carefully labeled diagram. Show the original budget constraint and the new budget constraint consistent with a higher real wage. What is the slope of this new budget constraint?
b) Explain the substitution and income effects that result from the wage increase. Are they positive or negative in terms of hours worked?
c) What is the sign of the total effect? According to the theory, did Reagan's economic policy get people to work more?

5. Jules owns a Van Gogh masterpiece worth $5 million. There is a 1% chance the painting will get stolen, leaving Jules with nothing.
(a) What is the expected value of this gamble?
(b) What is the minimum insurance premium an insurance company would charge to fully insure the
painting against theft? (Note: minimum insurance premium = fair insurance premium = Expected loss) (c) Jules's certainty equivalent for this risky situation is $4,900,000. What is the maximum insurance premium he'd be willing to pay for full insurance?

6. Suppose that an individual owed no taxes on the first $10,000 she earned and 15 percent of any income she earned over $10,000. Now suppose that Congress is considering two ways to reduce the tax burden: a reduction in the tax rate and an increase in the amount on which no tax is owed.
a. What effect would a reduction in the tax rate have on the individual’s labor supply if she earned $30,000 to start? Explain in words/graphs using the income and substitution effects.
b. What effect would an increase in the amount on which no tax is owed have on the individual’s labor supply? Explain in words/graphs using the income and substitution effects.

Questions 1. The use of utility functions in consumer decision mak...