XLRI - Xavier School of Management

Midterm Exam (Solution)

Managerial Economics (MGEBJ21-1)

1. Each week, Hari, Mary, and Lalit select the quantity of two goods, x1 and x2 , that
they will consume in order to maximize their respective utilities. They each spend
their entire weekly income on these two goods.

(a) Suppose you are given the following information about the choices that Hari makes
over a three-week period:

x1 x2 p1 p2 m
Week 1 10 20 2 1 40
Week 2 7 19 3 1 40
Week 3 8 31 3 1 55

Did Hari’s utility increase or decrease between week 1 and week 2? Between week
1 and week 3? Explain using a graph to support your answer.
Solution: Budget line for week 1 and we1k 2 is given below:

week 1 : 2x1 + x2 = 40
week 2 : 3x1 + x2 = 40

Plotting them we get

x2

40

20
19
U (week 1)
U (week 2)

x1
710 40 20
3

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 Hari’s utility decreases from week 1 to week 2.
Between week 1 and week 2 his utility rose. You can see the argument in the
following graph:
Budget line for week 1 and we1k 2 is given below:

week 1 : 2x1 + x2 = 40
week 3 : 3x1 + x2 = 55

Plotting them we get

x2

40

U (week 3)
U (week 1)

x1
55 20
3

(b) Now consider the following information about the choices that Mary makes:

x1 x2 p1 p2 m
Week 1 10 20 2 1 40
Week 2 6 14 2 2 40
Week 3 20 10 2 2 60
Did Mary’s utility increase or decrease between week 1 and week 3? Does Mary
consider both goods to be normal goods? Explain breifly.
Solution: Solution: Budget line for week 1 and we1k 2 is given below:

week 1 : 2x1 + x2 = 40
week 3 : 2x1 + 2x2 = 60

Plotting them we get

2
 x2

40

week 1
35

week 3

U (week 3)
U (week 1)
x1
20 35

Mary’s utility increases from week 1 to week 3.

Mary does not consider both the goods normal. In fact, good 1 x1 is normal and
good 2 s2 is inferior. x2 is inferior because when her income went up from week
2 to week 3, she consumed less of the good (holding prices the same).
(c) Finally, examine the following information about Lalit’s choices:

x1 x2 p1 p2 m
Week 1 12 24 2 1 48
Week 2 16 32 1 1 48
Week 3 12 24 1 1 36

Draw a budget line, indifference curve graph that illustrates Lalit’s three chosen
bundles. What can you say about Lalit’s preferences in this case? Identify the
income and substitution effects that result from a change in the price of good 1.
Solution: Budget line for week 1 and we1k 2 is given below:

week 1 : 2x1 + x2 = 48
week 2 : x1 + x2 = 48
week 3 : x1 + x2 = 36

Plotting them we get

3
 x2

48 week 2

36
U (week 2)
week 1 and week 3
U (week 1)

x1
24 36 48

Notice that Lalit always consumes the two goods in a fixed 1:2 ratio. This means
that Lalit views the two goods as perfect complements, and his indifference curves
are L-shaped.
Intuitively if the two goods are complements, there is no reason to substitute one
for the other during a price change because they have to be consumed in a set
ratio. Thus the substitution effect will be zero. When the price ratio changes and
utility is kept at the same level, Lalit will choose the same point (12,24). The
income effect causes him to buy 4 more units of good 1 and 8 more units of good
2.

2. Hari and Mary have fallen on hard times, but remain rational consumers. They are
making do on $80 a week, spending $40 on food and $40 on all other goods. Food costs
$1 per unit.

(a) Draw a budget line. Label their consumption bundle with the letter A.
Solution:

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 Clothes

80

Food
80

(b) They suddenly become eligible for food stamps. This means that they can go to
the agency and buy coupons that can be exchanged for $2 worth of food. Each
coupon costs them $1. However, the maximum number of coupons they can buy
per week is 10. On the graph, draw their new budget line.
Solution:
Clothes

80

Food
20 80

3. Suppose that a consumer’s utility function is U (x, y) = xy + 10y. The price of x is Px

and the price of y is Py , with both prices positive. The consumer has income m.
Derive the demand function of x and y and write it carefully. What is the demand of
x when px = 4?
Solution:Tangency condition implies that
M Ux px y px
= =⇒ = =⇒ py y = px (x + 10)
M Uy py x + 10 py

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 Putting the vlaue py y into the budget line

px x + py y = m
px x + px (x + 10) = m
m − 10px m
x∗ = = −5
2px 2px
m + 10px
y∗ =
2py

The deman dunction for x is written as

(
m m
2px
−5 if px < 10
x= m
0 if px ≥ 10

m−40 m
x= 8
if px = 4 and px < 10
.

4. A firm’s production function is Q = 5L2/3 K 1/3 .

(a) Does this production function exhibit constant, increasing, or decreasing returns
to scale?
Solution: constant returns to scale (CRS)
(b) What is the marginal rate of technical substitution of L for K for this production
function?
Solution:
M PL K
M RT SL,k = =2
M PK L
(c) What is the elasticity of substitution for this production function? Show it.
Solution: From above we know that M RT S = 2 K
L
. Thus, K
L
= M RT S
2
.

%∆(K/L)
σ=
%∆M RT S
∆(K/L) M RT S
= ·
∆M RT S (K/L)
∆(K/L) 2(K/L)
= ·
2∆(K/L) (K/L)
=1

5. The director of a theatre company in a small college town is considering changing the
way he prices tickets. He has hired an economic consulting firm to estimate the demand

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for tickets. The firm has classified people who go the theatre into two groups, and has
come up with two demand functions. The demand curves for the general public (Qgp )
and students (Qs ) are given below.
Qgp = 500 − 5P
Qs = 200 − 4P
(a) Graph the two demand curves on one graph, with P on the vertical axis and Q on
the horizontal axis. If the current price of tickets is Rs. 35, identify the quantity
demanded by each group.
Solution: We plot the inverse demand curves which are given below:
P = 100 − 0.2Qgp
P = 50 − 0.25Qs

100

50

Ds Dgp
Q
200 500

Qgp = 500 − 5 × 35 = 325

Qs = 200 − 4 × 35 = 60

(b) Find the price elasticity of demand for each group at the current price and quan-
tity.
Solution:

dQgp (P = 35) 35
EP,Qgp = · = −5 · = −0.54
dP (Qgp = 325) 325
dQs (P = 35) 35
EP,Qs = · = −4 · = −2.33
dP (Qs = 60) 60

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(c) Is the director maximizing the revenue he collects from ticket sales by charging
Rs. 35 for each ticket? Explain briefly.
Solution:
No he is not maximizing revenue since neither one of the calculated elasticities
is equal to −1. Since demand by the general public is inelastic at the current
price, the director could increase the price and quantity demanded would fall by
a smaller amount in percentage terms, causing revenue to increase. Since demand
by the students is elastic at the current price, the director could decrease the price
and quantity demanded would increase by a larger amount in percentage terms,
causing revenue to increase.
(d) What price should he charge each group if he wants to maximize revenue collected
from ticket sales?
Solution: To solve this, find the formula for elasticity, set it equal to −1, and
solve for price and quantity.
For the general public:

P
−5 · = −1
Qgp
5P = Qgp = 500 − 5P
P = 50
Qgp = 250

For the students:

P
−4 · = −1
Qs
4P = Qs = 200 − 4P
P = 25
Qs = 100