Answer Keys (ME-2018 Problem Set-II)

1.

Without the gift certificate, Bobby's budget constraint is indicated by the line segment from
10 books and 0 pizza to 0 books and 50 pizzas (labelled BC1). With the gift certificate that
can only be used for book purchases, Bobby still cannot afford anymore than 50 pizzas.
However, she is guaranteed 6 books even if she spends all her money on pizza. Since the
price of books and pizza hasn't changed, the slope of her new budget constraint is the same as
the slope of the old budget constraint. The new budget constraint is drawn above as BC2.
Note that with the gift certificate, Bobby has an expanded opportunity set and is guaranteed
more of both goods no matter what her original consumption choice on BC1 was. This
implies that Bobby is strictly better-off with the gift certificate.

2. (a)
F
Preference
Directions

A
B
C
H
(b) At point A, Dr. Strangetaste’s indifference curve, which is bowed out from the origin,
is tangent to his budget line. This point is not an optimum because, for example, Dr.
Strangetaste could move to point B on his budget line and achieve a higher level of total utility.
Point B, though, is not an optimum either because Dr. Strangetaste could move to point C, a

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corner point, to achieve an even higher level of total utility. When the MRS is increasing, a
corner point optimum will occur (with F = 0 in this picture, though it could equivalently be
with H = 0 for another set of indifference curves).

When the consumer maximizes utility, his optimal consumption basket will be on the budget
constraint and satisfy the tangency condition.
Any basket on the budget line will satisfy pxx + pyy = I, or 2x + 5py = 40.
The tangency condition requires that MUx / px = MUy / py, or that 5 / 2 = x / py. This implies
that 5py = 2x.
Putting these two equations together reveals that 5py + 5py = 40; thus py = 4.

3.
y
(a) Using the tangency condition,  4 , and the budget constraint, 4 x  y  120 , your
x
initial optimum is the basket (x, y) = (15, 60) with an utility of 900.

(b) First we need the decomposition basket. This would satisfy the new tangency
y
condition,  3 and would give you as much utility as before, i.e. xy  900 . This gives
x
( x, y )  (10 3 ,30 3 ) or approximately (17.3,51.9). Now we need the final basket, which
satisfies the same tangency condition as the decomposition basket and also the new budget
constraint: 3x  y  120. Together, these conditions imply that (x, y) = (20, 60). The
substitution effect is therefore 17.3 – 15 = 2.3, and the income effect is 20 – 17.3 = 2.7.

4. Self-expnanatory !!! It is a normal good !

5.

(a)
QUd  10000  100(300)  99(300)
QUd  9700
Using PU  300 and QUd  9700 gives
 300 
 Q , P  100    3.09
 9700 
Market demand is given by Q d  QUd  QAd . Assuming the airlines charge the same
price we have

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 Q d  10000  100 PU  99 PA  10000  100 PA  99 PU
Q d  20000  100 P  99 P  100 P  99 P
Q d  20000  2 P
When P  300 , Q d  19400 . This implies an elasticity equal to
 300 
 Q , P  2    .0309
 19400 

6.
(a) Both demand curves are downward sloping and linear. For the general
public, Dgp, the vertical intercept is 100 and the horizontal intercept is 500.
For the students, Ds, the vertical intercept is 50 and the horizontal intercept is
200. When the price is $35, the general public demands
Qgp  500  5(35)  325 tickets and students demand Qs  200  4(35)  60
Price Demand Curves for Tickets

100

75

50
$35
25
Ds Dgp
100 200 300 400 500 Tickets
tickets.

5(35)
(b) The elasticity for the general public is gp   0.54 and the
325
4(35)
elasticity for students is gp   2.33 . If the price of tickets increases
60
by ten percent then the general public will demand 5.4% fewer tickets and
students will demand 23.3% fewer tickets.

(c) No he is not maximizing revenue because neither of the calculated elasticities is equal
to –1. The general public’s demand is inelastic at the current price. Thus the director
could increase the price for the general public, and the quantity demanded would fall
by a smaller percentage, causing revenue to increase. Since the students’ demand is
elastic at the current price, the director could decrease the price students pay, and their
quantity demanded would increase by a larger amount in percentage terms, causing
revenue to increase.


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 (d) To figure this out, use the formula for elasticity, set it equal to –1, and solve for price
and quantity. For the general public:
5P
gp   1
Q
5P  Q  500  5P
P  50
Q  250.
For the students:
4P
s   1
Q
4P  Q  200  4P
P  25
Q  100.
These prices generate a larger total revenue than the $35 price. When price is
$35, revenue is (35)(Qgp + Qs) = (35)(325 + 60) = $13,475. With the separate
prices, revenue is PgpQgp + PsQs = (50)(250) + (25)(100) = $15,000, which is an
increase of $1525, or 11.3%.

7.
Ms. Pampered’s initial budget constraint is the line AC, allowing her to purchase at most 50
burgers or at most 100 pizzas. The $60 cash certificate shifts out her budget constraint
without changing the maximum number of burgers that she can buy. The new budget
constraint is ABD and she can now buy a maximum of 120 pizzas.
Hamburgers

60
55
B
50
A

C D
20 100 120 Pizza

Initially, Ms. Pampered’s optimal basket contains all burgers and no pizza, at point A where
(P, H) = (0, 50), because MUH /PH = 4/6 > MUP / PP = 1/3. Her utility level at point A is U(0,
50) = 200. When she gets the gift certificate, her optimal basket is at point B, spending all of
her regular income on burgers and the $60 gift certificate on pizza. So point B is where (P,
H) = (20, 50) with a utility of U (20, 50) = 220.

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However, she could also achieve a utility of 220 by consuming 220/4 = 55 burgers. To buy
the extra 5 burgers she would require 5*6 = $30. So, if she had received a cash gift of $30 it
would have made her exactly as well off as the $60 gift certificate for pizzas.

8. (a)
Before the drop in export demand, the market equilibrium price is found by
setting total demand equal to domestic supply:
3244  283P = 1944 + 207P, or
P = $2.65.
Export demand is the difference between total demand and domestic demand: Q
= 3244  283P minus QD = 1700  107P. So export demand is originally Qe =
1544  176P. After the 40 percent drop, export demand is only 60 percent of the
original export demand. The new export demand is therefore, Qe = 0.6Qe =
0.6(1544  176P) = 926.4  105.6P. Graphically, export demand has pivoted
inward as illustrated in the figure below.
The new total demand becomes
Q = QD + Qe = (1700  107P) + (926.4  105.6P) = 2626.4  212.6P.
Equating total supply and the new total demand,
1944 + 207P = 2626.4  212.6P, or
P = $1.63,
which is a significant drop from the original market-clearing price of $2.65 per
bushel. At this price, the market-clearing quantity is about Q = 2281 million
bushels. Total revenue has decreased from about $6609 million to $3718 million,
so farmers have a lot to worry about.

8.77

Qe
926.4 1544

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(b) With a price of $3.50, the market is not in equilibrium. Quantity demanded and
supplied are
Q = 2626.4  212.6(3.50) = 1882.3, and
QS = 1944 + 207(3.50) = 2668.5.
Excess supply is therefore 2668.5  1882.3 = 786.2 million bushels. The government must
purchase this amount to support a price of $3.50, and will have to spend $3.50(786.2 million) =
$2751.7 million.

9. A half-price sale cuts the price of each and every unit in half. In contrast, a buy-one, get-
one-free deal does not change the relative price of any units between 0 and 1 unit. Furthermore,
it makes the price of units purchased between 1 and 2 units purchased zero.

10.

a) MUF = C + 1 MUC = F
Tangency: MUF/MUC = PF / PC. (C + 1)/ F = PF/4 => 4C + 4 = PFF. (Eq 1)
Budget Line: PFF + PCC = I . PFF + 4C = 20. (Eq 2)
Substituting (Eq 1) into (Eq 2): 4C + 4 + 4C = 20. Thus C = 2, independent of PF.

From the budget line, we see that PFF + 4(2) = 20, so the demand for F is F = 12/PF .

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PF5 Demand for food

4
3
2
1

2 3 4 6 F 12

b) Initial Basket: From the demand for food in (a), F = 12/1 = 12, and C = 2.
Also, the initial level of utility is U = FC + F = 12(2) + 12 = 36.
Final Basket: From the demand for food in (a), we know that F = 12/4 = 3, and C = 2. (Also,
U = 3(2) + 3 = 9.)
Decomposition Basket: Must be on initial indifference curve, with U = FC + F = 36 (Eq 5)
Tangency condition satisfied with final price: MUF/MUC = PF / PC. (C + 1)/ F = 4/4 =>
C + 1 = F. (Eq 3)
Eq 5 can be written as F(C + 1) = 36. Using Eq 3, (C + 1)2 = 36, and thus, C = 5. Also, by
Eq 3, F = 6.
So the decomposition basket is F = 6, C = 5.

Income effect on F: Ffinal basket – Fdecomposition basket = 3 – 6 = -3.

Substitution effect on F: F decomposition basket – Finitial basket = 6 – 12 = -6.