CFA Level 1 - Economics Session 4 - Reading 14 (Notes, Practice Questions, Sample Questions) 1. Earl Hakkim is indifferent between consuming 10 DVDs and 5 books or consuming 8 DVDs and 6 books. The condition of non-satiation in utility theorypredicts that: A)Hakkim would also be indifferent to consuming 6 DVDs and 7 books. B)Hakkim would prefer to consume 11 DVDs and 5 books. [Explanation: Thecondition of non-satiation refers to the assumption that consuming more ispreferable to consuming less. This means Hakkim would prefer 11 DVDs and 5books to 10 DVDs and 5 books. Because Hakkim is indifferent between 10DVDs and 5 books or 8 DVDs and 6 books, and prefers 11 DVDs and 5 books to10 DVDs and 5 books, we can assume he also prefers (gets more utility from)11 DVDs and 5 books versus 8 DVDs and 6 books. Although the otherstatements may or may not be true, they do not reﬂect the condition ofnon-satiation] C)books have twice as much utility for Hakkim as DVDs. 2. When modeling consumer decision making, indifference curves: A)represent the set of affordable consumption bundles.B)reﬂect an increasing marginal rate of substitution. C)represent consumption bundles that have equal total utility to theconsumer. [Explanation: Indifference curves reﬂect consumption bundles thathave the same total utility to the consumer, whether or not they areaffordable. Indifference curves reﬂect a diminishing marginal rate ofsubstitution]
3. If a consumer’s budget for pens and pencils remains stable, but the price of both pens and pencils doubles, the slope of the budget line is most likely to: A)double. B)remain unchanged. [Explanation: The slope of the budget line reﬂects therelative price of two goods. If the price of both pens and pencils doubles, therelative price is unchanged and thus the slope of the budget line will also beunchanged] C)decrease by half. 4. Given a choice between consuming oranges and beans, a consumer’s equilibrium bundle of goods is most likely to: A)lie on the consumer’s highest indifference curve.B)have equal quantities of oranges and beans to maintain equilibrium. C)represent the most preferred affordable combination of oranges and beans.[Explanation: A consumer’s equilibrium bundle of goods represents thehighest indifference curve that is tangent to her budget line of affordablebundles. The consumer has higher indifference curves than this, but theyconsist of unaffordable bundles. The equilibrium bundle does not necessarilyreﬂect equal quantities of the two goods] 5. Which of the following is most likely to cause a decrease in the consumption of a good in response to a decline in the price of the good? A)Income effect. [Explanation: The income effect can be negative if the goodis an inferior good. The substitution effect is always positive and will causeconsumption of a good to increase if the price declines. The law of demandassumes that a decrease in the price of a good will cause an increase in thequantity demanded] B)Law of demand.C)Substitution effect.
6. A distinction between Giffen goods and Veblen goods is that: A)Giffen goods are inferior goods, while Veblen goods are not inferior goods.[Explanation: Giffen goods are inferior goods for which the quantitydemanded decreases when the price decreases, because the negative incomeeffect is larger than the positive substitution effect. Veblen goods are goodsfor which the quantity demand increases when the price increases, such as ahigh-status good for which the consumer gains utility from being seen toconsume the good. Giffen goods and Veblen goods, if they exist, have demandcurves that slope upward over at least some range of prices. The substitutioneffect is positive for all goods] B)demand curves for Giffen goods slope upward, while demand curves forVeblen goods slope downward.C)the substitution effect is positive for a Veblen good but negative for a Giffengood.