Economic Principles

Question 1

i.
The marginal utility of a good provides the rate of increase or decrease in the utility
from that good as the total consumption of it rises. It is not a measure of the total utility of a
good; the marginal utility is based in the idea that, for goods that can be consumed
repeatedly (like a bottle of water, whose content is drinkable in a series of gulps), the utility
derived from the nth gulp in inferior to the utility derived from the very first gulp. The
marginal utility provides a rate of this decrease in utility as the consumption increases.

ii.
Whenever consumers are faced with the task of choosing among different baskets
(which are essentially a collection of goods and services), their choices are dictated by
rational criteria. Let's assume that all such rational behaviour conforms to three
assumptions:
1. preferences are complete, which means the consumer is able of ranking the
baskets;
2. preferences are transitive, which means they are internally consistent with each
other;
3. more is always preferred to less.
In order to decide which basket to choose, consumer must rank the baskets. The
ranking criteria is the utility derived from each basket; The consumer will rationally choose
the basket from which he or she gets the most utility.
Consumers can usually rank the utility of the basket in a qualitative way – saying
they prefer one basket to the other, but not by how much. This measure is the qualitative
utility derived from that basket – consumers can say which brings them the most utility, but
not by how much. This means there is no information about the strength of the preference.
When consumers can actually rank the intensity of the utility, we get information
about the rate of preferences. This means that we are is a position to say that one basket
is preferred to another by, for instance, ten percent more.

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iii.

Perfect Substitutes
U=x+6y
1,8
1,6
1,4
1,2
U=6
1
Pencil, y

U=8
0,8 U=10
0,6
0,4
0,2
0
0 2 4 6 8 10 12
Pen, x

Perfect Complements
U=3min(x,y)
4,5
4
3,5
3
Coca-Colas , y

U=3
2,5 U=6
2 U=9
1,5
1
0,5
0
0,5 1 1,5 2 2,5 3 3,5 4 4,5
BigMacs , x

This example considers that the economic agent wants to have a Coca-Cola for every
BigMac he consumes.

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Satiated Preferences
X2

X1

iv.
Consider that a consumer obtains a fixed amount of utility from a basket composed
of two goods, x and y, and he or she is presented with the opportunity of substituting a
certain amount of one good for a certain amount the other. The rate at which the consumer
is willing to substitute one product for the other, while maintaining the utility constant, is the
Marginal Rate of Substitution.

v.
The following chart depicts a generic utility function for two goods, x and y, such that
Uxy = xy:

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18

A
16

14

12

10

Y B
8 U=4

C
4

D
2 E

0
0 2 4 6 8 10 12 14 16 18

The Marginal Rate of Substitution of x for y on any specific point on the indifference
curve is given by the slope of a line tangent to that point. Consider the lines tangent to
points A to E in the example above: their slopes equal the absolute value of the MRS xy at
each point:

Point Good X Good Y Slope/MRSxy

A 1 16 16
B 2 8 4
C 4 4 1
D 8 2 0,25
E 16 1 0,06

This shows that along the same utility curve (along which the consumer always gets

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 Economic Principles

the same utility), when a consumer has a lot of good x and little of good y, he is prepared
of giving up lots of x for a little more y; but as he gets more y he is less willing to give up
any of x for a greater amount of y – hence the diminishing slope of the utility curve and the
diminishing Marginal Rate of Substitution of x for y. mar. This circumstance only holds for
utility functions that, like the one depicted here, are bowed towards the origin.

Question 2

i. a = 0.5, b = 0.5 and u = 1,2,3,4,5.

Indifference Curves
U(x1,x2)=x1^a*x2^a; a=b=0,5
30

25

20

U=1
U=2
15 U=3
x2

U=4
U=5

10

0
0 1 2 3 4 5 6

x1

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ii. a = 0.2, b = 0.8 and u = 1,2,3,4,5.

Indifference Curves
U(x1,x2)=x1^0,2*x2^0,8
25

20

15 U=1
U=2
U=3
x2

U=4
U=5
10

0
0 1 2 3 4 5 6

x1

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Question 3

This is a Cobb-Douglas function, so it has 2 useful properties:

1. MRSx1,x2 and MRSx2,x1 are both positive
2. Diminishing rate of substitution with the utility functions bowing towards the origin.

The optimal basket will be on the budget line; so:

Px1x1+Px2x2=I

Since u(x1,x2)=x1a+x2b, we get

lnu(x1,x2)=alnx1+blnx2

MRSx1,x2=u(x1,x2)=x1a+x2b, dx1 = a/x1

and
MRSx2,x1=u(x1,x2)=x1a+x2b dx2 = b/x2

Since, at the maximum point in the logarithmic function

MRSx1,x2=MRSx2,x1
a/x1=b/x2
x2=(bx1)/a and x1=(ax2)/b

And we can substitute it in the first equation:

Px1x1+Px2x2=I
Px1x1+(Px2bx1)/a=I
x1=(aI)/(aPx1+bPx2) – Demand Curve for x1, depending on price

Px1x1+Px2x2=I
(Px1ax2)/b+Px2x2=I
x2=(bI)/(aPx1+bPx2) – Demand Curve for x2, depending on price

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Question 4

Suppose two goods, x and y, with x being the good whose demand curve we are
trying to determin, and y being a composite good, with a price of 1. These two goods
account for all the goods the individual buys, and the individual will maximize his utility,
spending all of his income in buying those goods. The resulting bundle of goods bought
will therefore depend on the income of the individual and on the relative prices of the
goods – and, since y is a composite with a price of 1, it will depend on the price of x and
on the individual's income.
We will assume the individual's income is 20.
Our objective is to derive the individual's budget curve for various prices of x.
Imagining the price of y and the individual's income both remain constant, chart 1 shows
three budget curves for three different possible prices of x: Px=10, Px=5 and Px=2.
The chart displays the budget lines at each of these prices of x, and it also displays
the individual's indifference curves for each of the budget lines – U1, U2 and U3.

Budget Lines
25

20

15
Units of y

BL1
BL2
U3
BL3
10

U1 U2
5

0
0 2 4 6 8 10 12

Units of x

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The point at which each of the indifference curves touches (is tangent) to the
respective budget line gives us the number of units of x and y that the subject will acquire
for that price, maximizing his utility in the process. These numbers of units of x and their
respective prices may than be plotted into a demand curve for that individual:

Demand Curve for Good x

12

10

6
Price

0
0,5 1 1,5 2 2,5 3 3,5 4 4,5 5 5,5

Quantity

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Question 5

The uncompensated (Marshallian) demand curve gives us information about the

amount of a good demanded for a certain level of price, keeping the subject's income
constant. This way, it's the utility of the subject that may vary along the line. Thanks to the
uncompensated demand curve, it is possible to observe the income effect and the
substitution effect.
On the other hand, the compensated (Hicksian) demand curve gives us information
about the amount of good demanded for a level of price, keeping the subject's utility
constant. This means that, to keep the subject in the same utility curve as the price of the
good changes, it's the income that must change, meaning the consumer is “compensated”.
The compensated demand curve cannot depict the income effect, but it gives information
about the substitution effects, should it occur.

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