Class Test- Principles of Microeconomics (12 marks)
Q.1 Explain the effect of an imposition of tax on manufactures of drugs using demand-
supply diagram on the price and quantity traded of the illegal drugs market. (3 marks)
Ans.1) The market demand curve D1 slopes downward: at higher prices, users in the aggregate
purchase a lower quantity of the drug in question. The market demand curve reflects two types of
responses to higher prices: some drug users cut back on their consumption, while others may
drop out of the market and become. Addiction raises the possibility of asymmetry in that lower
prices may increase participation; higher prices may not reduce participation in the short run.
FIGURE 2-1 Impact of a supply-side enforcement
The market supply curve S1 slopes upward: at higher prices, the supply network is willing to
provide more drugs to the market. The market supply curve again reflects two types of responses
to higher prices: some current suppliers expand the size of their drug-dealing business, and there
may also be new entrants who provide new sources of supply.
A supply-side intervention—such as tax imposition on manufacturers of drugs—causes the
market supply curve to shift up, or alternatively to the left, to curve S2. The vertical distance
between S1 and S2 may be interpreted as the increase in unit production and distribution costs
induced by supply-side interventions (tax imposition).
This shift captures the idea that to compensate for the extra risks and costs created by the policy
intervention, suppliers require a higher price to bring any given quantity of drugs to the market.
How much the supply curve shifts depend on the effectiveness of the enforcement efforts and
suppliers’ ability to respond to those efforts. Suppose, for example, that police increase arrests of
street-level dealers. How much this raises unit production costs reflects how much drug-selling
organizations have to raise wages to compensate dealers for the additional risk, on the
assumption that the dealers can estimate that rise. It also reflects how effectively these
organizations can shift their production and distribution systems in response to these
enforcement shifts. If sellers can shift sales activities indoors or otherwise avoid the increased
enforcement, the shift from S1 to S2 will be small.
The standard model assumes that the market price adjusts until an equilibrium is reached at
which the quantity demanded equals the quantity supplied. The original equilibrium in Figure 2-
1 is E1: Q1, P1. After the supply-side intervention, a new equilibrium is reached, E2: Q2, P2.
This new equilibrium reflects an interaction of both supply and demand factors. The relative
slopes of these curves determine the extent that increased production costs are borne by
consumers in the form of higher prices. The supply-and-demand model yields the fundamental
insight that a supply-side intervention. At the new drug market equilibrium E2, the market price
of the drug is higher (P2 > P1), and the quantity of drugs purchased and consumed is lower (Q2
< Q1).
Q.2 Consider a consumer consuming two goods X and Y, where X is an inferior good for
him. Suppose the price of the good X rises. What would be the effect of this change on
consumption of good Y. Illustrate with the help of diagrams. (2.5 marks)
Ans.2) Inferior Good: A good for which demand decreases as consumer income increases.
Giffen Good: A subset of inferior goods where demand increases with an increase in price. This
occurs only if the income effect of a price change is stronger than the substitution effect,
leading to an upward-sloping demand curve.
The substitution effect: it means the change in the quantity purchased of a good as a
consequence of a change in relative prices of the two goods alone keeping real income or level of
satisfaction constant.
The income effect: results from an increase or decrease in the consumer’s real income or
purchasing power as a result of the as a result of the price change. Income effect of a good can be
both positive or negative. Positive in case of normal goods, where increase in income of the
consumer leads to greater consumption of that good. It is negative when with the increase in
income of the consumer reduces his consumption of the good.
The sum of these two effects is called the price effect. It is net result of the two distinct forces
namely, substitution effect and income effect. The approach used to decompose the price effect
into 2 parts is Hicksian Approach- Compensating Variation in Income.
Effects of a Price Change
Let’s consider the price of Good X (Inferior) rising. The consumer experiences two effects:
1. Substitution Effect (SE): As Good X becomes relatively expensive compared to Good Y, the
consumer substitutes Good X with more of Good Y. On the diagram, this is represented by the
movement from e to e'. This effect is reflected using the compensated budget line drawn tangent
to the Indifference curve. This shows new relative prices keeping the gains from real income
constant.
2. Income Effect (IE): A higher price of Good X effectively reduces the consumer’s purchasing
power, making them feel poorer. Since Good X is an inferior good, the consumer now demands
more of Good X and less of Good Y. On the diagram, this is shown by the movement from e′ to e
′′.
Price Effect: The total effect of the price increase is given by e→ e′′ which combines both SE
and IE:
SE: Reduces consumption of Good X and increases consumption of Good Y (e→ e′)
IE: Increases consumption of Good X and reduces consumption of Good Y (e′→ e′′)
Conclusion
Since SE>IE, the total effect is that the quantity of Good X consumed decreases when its price
rises. Good X is therefore not a Giffen good. Not all inferior goods are Giffen goods. For Good
X to be a Giffen good, IE>SE, which is not the case here.
Q.3 Explain what would be the shape of indifference curves when marginal rate of
substitution between two goods is zero. (2.5 marks)
Ans.3 Two products are perfect complements when you always want to consume X and Y
together in the same proportion (ratio). The MRS is 0.
Example: Right shoe and left shoe. You need exactly one right shoe with every left shoe. The
indifference curves for perfect complements will always be right angles. In the diagram, if you
have one right shoe, you only need one left shoe. So if you have one right shoe and 5 left shoes
you are still on the same indifference curve because those extra left shoes will just go to waste.
The best point to be at is on the corner of each indifference curve (least amount of waste). The
ratio for perfect complements does not always have to be 1 to 1.
Example: You could have 2 ice cubes in every glass of orange juice. There is no substitution
effect in the case of perfect complements because the consumer’s preference dictates that the two
goods be used together in a fixed proportion without the possibility of substituting one for the
other even if the relative price of the two goods has changed.
Q.4 Using indifference curve analysis, explain the labor- leisure choice of an individual
when the wages change, and the resulting shape of the labor supply curve. (4 marks)
Ans.4 The time-allocation problem for individuals, such as Person A, involves balancing the
trade-off between leisure and consumption. Person A's decision-making process and labor supply
curve can be analyzed using the concepts of income and substitution effects, as well as
indifference curve analysis.
Person A’s Budget Constraint and Indifference Curves
Budget Constraint: Person A has 100 hours per week to allocate between leisure and work. If
they work all 100 hours, they earn $5,000 weekly (at $50/hour). If they take all 100 hours as
leisure, they earn no income for consumption. Any combination of work and leisure lies on the
budget line, with its slope representing the wage rate.
Indifference Curves: These curves depict Person A's preferences between leisure and
consumption. Higher curves represent higher utility levels, as Person A prefers more of both
leisure and consumption.
The Effect of a Wage Increase
When Person A's wage rises from $50 to $60/hour, their budget constraint shifts outward and
becomes steeper, as they earn more for each hour worked. The resulting change in their labor-
leisure choice depends on their preferences, represented by indifference curves.
Substitution Effect: Leisure becomes relatively more expensive in terms of forgone earnings.
This encourages Person A to substitute leisure with work, leading them to work more hours. The
substitution effect pushes the labor-supply curve to slope upward.
Income Effect: The higher wage increases Person A’s income, allowing them to move to a
higher indifference curve. If leisure is a normal good, they may choose to enjoy more leisure
while working fewer hours. The income effect can lead to a backward-sloping labor-supply
curve.
Two Possible Outcomes
1. Panel (a): Upward-Sloping Labor Supply Curve If the substitution effect outweighs
the income effect, Person A reduces leisure and works more as wages increase. The labor
supply curve slopes upward.
2. Panel (b): Backward-Sloping Labor Supply Curve If the income effect outweighs the
substitution effect, Person A chooses to work fewer hours while enjoying more leisure as
wages increase. The labor supply curve bends backward.
Economic theory does not predict definitively whether Person A will work more or less as their
wage increases. The outcome depends on:
The relative strength of the income and substitution effects.
Person A’s preferences for leisure and consumption.
Therefore, Person A's response to a wage increase, and the shape of their labor-supply curve,
depends on whether the substitution effect (leading them to work more) or the income effect
(leading them to work less) dominates.