1. D. Numerical Example Suppose Jean purchases 2 goods: Toilet Paper and conditioner. Let X = rolls of toilet paper purchased Let Y = bottles of conditioner purchased Marginal utility for toilet paper can be found using the equation MU X = 1/X, while the marginal utility for conditioner can be found using the equation MU Y = 1/Y. You know that the price of a roll of toilet paper is 50cents, and that the price of a bottle of conditioner is $4. Suppose that Jean has $120 a month budgeted for her bathroom supplies. Given the above information determine Jean’s optimal bundle of toilet paper and conditioner.

2. A. The Income Effect Suppose the price of Good X increases while your budget is unchanged. You are going to have to either consume less of Good X or less of other products. In short, you will feel “poorer” due to the increase in the price of Good X.

3. B. The Substitution Effect Suppose that the price of Good X rises while the prices of other goods you purchased remain unchanged. As a result, Good X becomes relatively more expensive than other goods. The opportunity cost of Good X increases. Households will quickly substitute away from the good that has increased in price.

4. C. Summary When the price of a good increases two things will happen: (1)Households feel poorer and would likely purchase less of the good, because they feel as if their income has fallen (income effect) (2)The good becomes expensive relative to other goods making it likely that the household will buy more of the other goods and less of the now expensive good (substitution effect) The end result is that as the price of a good increases, both the substitution and income effect will result in a decrease in the quantity of the good purchased.

5. Labor Supply Decisions Main Questions that households have to answer are: (1)Whether or not to work (2)If they do work how many hours will they work (3)What kind of job that they will work in. The tradeoff is between working and not working Choice: WorkCost: Leisure Time or Doing Housework

6. Labor Supply Decision The tradeoff is between working and not working Choice: WorkCost: Leisure Time or Doing Housework Households must decide how many hours do they wish to work vs. how many hours they want to spend enjoying leisure. The “price” of leisure = hourly wage rate

7. Deriving the Labor Supply Curve Key relationship: Quantity of labor supplied and the wage rate The labor supply curve shows the quantity of labor supplied at different wage rates. The shape of the labor supply curve depends on the assumptions made about how households respond to wage changes.

8. Labor Supply Decisions Assumption #1 (Substitution Effect): If there is an increase in wages, holding all else constant, the opportunity cost of leisure will increase. Households will substitute away from the expensive good. In other words households will consume less leisure and will thus work more. The substitution effect argues that as wages increase households will supply more labor.

9. Labor Supply Decisions Assumption #2 (Income Effect): If there is an increase in wages, all else constant, then households are made better off. An increase in wages will make a household feel richer. Households with more income will consume more of every good (including leisure). Households will enjoy more leisure and will work less.

10. Capital Supply Decisions At any given point in time, households must decide whether they should: (1)Use current (today’s) income to finance current consumption (2)Use current income to partially finance future consumption (save) (3)Use future income to partially finance current consumption (borrow) Households engage in both borrowing and savings. However we will focus on the saving side of the equation.

11. Capital Supply Decision Interest rate is the cost of borrowing. It is what borrowers must pay to borrow funds. Conversely, it is what savers receive for lending funds. The key relationship we are interested in is the relationship between capital supply (savings) and interest rate.

12. Capital Supply Decision Assumption #1 (substitution effect): If you spend $1, you are sacrificing the interest you could have earned. Thus the opportunity cost of spending the $1 is the foregone interest. What if interest rates fell? If they fell, then the opportunity cost of spending today decreases. Spending today is “cheaper” since the price of spending (the lost interest) has fallen.

13. Capital Supply Decision Assumption #2 (Income Effect): Consider you are saving for retirement. Your goal is to have $1 million at the end of 40 years. Every month you contribute some of your income toward your retirement account. What if the average interest rate of your retirement fund fell from 10% to 5%? You will get less interest than you were expecting. To reach your goal, you’ll have to invest more of your income to compensate for the lower interest.