CFA Level 1 - Economics Session 6 - Reading 21

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 theory predicts 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: The condition of non-satiation refers to the assumption that consuming more is preferable to consuming less. This means Hakkim would prefer 11 DVDs and 5 books to 10 DVDs and 5 books. Because Hakkim is indifferent between 10 DVDs and 5 books or 8 DVDs and 6 books, and prefers 11 DVDs and 5 books to 10 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 other statements may or may not be true, they do not reflect the condition of non-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 the consumer. [Explanation: Indifference curves reflect consumption bundles that have the same total utility to the consumer, whether or not they are affordable. Indifference curves reflect a diminishing marginal rate of substitution] 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 the relative price of two goods. If the price of both pens and pencils doubles, the relative price is unchanged and thus the slope of the budget line will also be unchanged] 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 the highest indifference curve that is tangent to her budget line of affordable bundles. The consumer has higher indifference curves than this, but they consist of unaffordable bundles. The equilibrium bundle does not necessarily reflect 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 good is an inferior good. The substitution effect is always positive and will cause consumption of a good to increase if the price declines. The law of demand assumes that a decrease in the price of a good will cause an increase in the quantity 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 quantity demanded decreases when the price decreases, because the negative income effect is larger than the positive substitution effect. Veblen goods are goods for which the quantity demand increases when the price increases, such as a high-status good for which the consumer gains utility from being seen to consume the good. Giffen goods and Veblen goods, if they exist, have demand curves that slope upward over at least some range of prices. The substitution effect is positive for all goods] B)demand curves for Giffen goods slope upward, while demand curves for Veblen goods slope downward. C)the substitution effect is positive for a Veblen good but negative for a Giffen good.