36 Pindyck/Rubinfeld, Microeconomics, Eighth Edition
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.
consumer should spend all her income on this good, resulting in a corner solution. With a corner
solution, the equal marginal principle does not hold.
12. The price of computers has fallen substantially over the past two decades. Use this drop in price
to explain why the Consumer Price Index is likely to overstate substantially the cost-of-living
index for individuals who use computers intensively.
The Consumer Price Index measures the cost of a basket of goods purchased by a typical consumer in
the current year relative to the cost of the basket in the base year. Each good in the basket is assigned
a weight, which reflects the importance of the good to the typical consumer, and the weights are
kept fixed from year to year. One problem with fixing the weights is that consumers will shift their
purchases from year to year to give more weight to goods whose prices have fallen, and less weight
to goods whose prices have risen. The CPI will therefore give too much weight to goods whose
prices have risen, and too little weight to goods whose prices have fallen. In addition, for non-
typical individuals who use computers intensively, the fixed weight for computers in the basket will
understate the importance of this good, and will hence understate the effect of the fall in the price of
computers for these individuals. The CPI will overstate the rise in the cost of living for this type of
individual.
13. Explain why the Paasche index will generally understate the ideal cost-of-living index.
The Paasche index measures the current cost of the current bundle of goods relative to the base year
cost of the current bundle of goods. The Paasche index will understate the ideal cost-of-living index
because it assumes the individual buys the current year bundle in the base period. In reality, at base
year prices the consumer would have been able to attain the same level of utility at a lower cost by
altering his or her consumption bundle in light of the base year prices. Since the base year cost is
overstated, the denominator of the Paasche index will be too large and the index will be too low, or
understated.
Exercises
1. In this chapter, consumer preferences for various commodities did not change during the
analysis. In some situations, however, preferences do change as consumption occurs.
Discuss why and how preferences might change over time with consumption of these two
commodities:
a. Cigarettes
The assumption that preferences do not change is a reasonable one if choices are independent
across time. It does not hold, however, when “habit-forming” or addictive behavior is involved,
as in the case of cigarettes. The consumption of cigarettes in one period influences the consumer’s
preference for cigarettes in the next period: the consumer desires cigarettes more because he has
become more addicted to them.
b. Dinner for the first time at a restaurant with a special cuisine
The first time you eat at a restaurant with a special cuisine can be an exciting new dining
experience. This may make eating at the restaurant more desirable. But once you’ve eaten there,
it isn’t so exciting to do it again (“been there, done that”), and preference changes. On the other
hand, some people prefer to eat at familiar places where they don’t have to worry about new and
unknown cuisine. For them, the first time at the restaurant would be less pleasant, but once they’ve
eaten there and discovered they like the food, they would find further visits to the restaurant more
desirable. In both cases, preferences change as consumption occurs.