NAME:

NO:
SECTION:

Boğaziçi University
Department of Economics
Fall 2019
EC 203 MICROECONOMICS I
MIDTERM - Solutions
07.11.2019, Thursday, 17:30

• Do not forget to write your full name, student number and registered section on the top of this page.

• Turn off your cell phone and put it away. During the exam if you are seen with a cell phone, or any
other electronic device (including calculators), on or off, 50 points will be taken off from your exam
immediately.

• Put away all your lecture notes, books, etc.

• There are 3 questions and 7 pages in the exam. Make sure you have them all.

• The last page is blank and you can use it as a scrap paper.

• Please answer all of the questions in the space provided for each question.

• Show all your work. Credit will not be given for any answers for which work has not been explicitly
presented. Furthermore, you may receive partial credit even if your final answer is incorrect.

• Please put a circle or box around your final answer to each question.

• You have 120 minutes.

GOOD LUCK!!

1
1. (30 pts) Suppose Marta consumes two goods, x and y, which have the prices px = py = 4, and she has an income
m = 240, all in euros, to spend on these two goods only. Suppose that the utility she gets from a bundle b = (x, y) is
given by u(x, y) = 120 ln(x) + ay, where a > 0.

(a) (16 pts) Suppose Marta picks a corner bundle with only x in it at these prices and income. Now, suppose that
there is a per unit tax imposed on good x: Marta pays 1 euro tax for each unit of x she buys more than 30 units.
When this tax is imposed, she consumes a positive amount of y and pays a positive amount of tax. Find a range
for a values that is consistent with the given information.
M Ux 120/x
Solution: The absolute value of the marginal rate of substitution is given by M Uy = a = 120
ax , and the price
120
ratio without the tax is just 1. Thus, for a corner solution with only x in it we must have ax ≥ 1. The intercept
at the x−axis is 240/4 = 60, thus, a must satisfy 120/a60 ≥ 1, that is, a ≤ 2.
Now when there is tax imposed, the maximum x amount Marta can but is 30 + [240 − (30 × 4)]/5 = 30 + 24 = 54.
If she is paying some positive tax it means that x > 30 and since she is consuming some positive y it means that
120
x < 54. The price ratio on the steeper portion of the budget line is 5/4. Thus, |M RS| = 5/4 gives ax = 5/4,
which is ax = 96, or x = 96/a. Now, since x < 54, it must be that 96/a < 54, that is, a > 96/54 = 16/9. Also
note that x > 30 implies 96/a > 30, that is, a < 96/30 = 16/5, which is larger than 2: a ≤ 2 implies a < 16/5.
Thus, the range for a is ( 16
9 , 2].

(b) (14 pts) Suppose a = 3. Find the Engel curve for y, when prices are as given above and the tax described in part
(a) is imposed.
Solution: |M RS| is 120/3x = 40/x. If the price ratio is 1, we get x = 40, but this is more than 30 in which case
she has to pay tax, thus the price ratio cannot be 1 here.
If the price ratio is 5/4, then 40/x = 5/4 implies x = 32 > 30, which costs 30 × 4 + 2 × 5 = 130. If m > 130, then
m−130
y= 4 , and if m ≤ 130, then y = 0.
m−130
Note that Marta wants to have more than 30 units. When m > 130, the demand for y is y = 4 and when
m ≤ 130, then y = 0. Thus the Engel curve for y can be written as
(
m−130
4 if m > 130
y(m) =
0 if m ≤ 130

2
2. (60 pts) Jonas consumes only three goods, xtal (x), yoghurt (y) and zeracks (z). He needs xtal, a special kind of crystal
that provides light in dark environments; yoghurt for nutrition; and zeracks, a special edible substance which is a source
of energy, providing both nutrition and light. His utility function from a bundle of these three goods, b = (x, y, z) is
given by
u(x, y, z) = 3x1/3 y 1/3 + z

Prices are given by p = (px , py , pz ) and Jonas’ income is given by m, all in euros. To simplify notation, assume that
pz = 1. Throughout this entire question, assume that none of the solutions are corner solutions.

(a) (12 pts) Find Jonas’ demand functions (x∗ (px , py , m) , y ∗ (px , py , m) , z ∗ (px , py , m)) .
Solution: Jonas’ consumer problem is given by

1/3 1/3
max 3 (x) (y) +z
x,y,z≥0
subj. to px x + py y + z ≤ m.

The Lagrangian is

1/3 1/3
L (x, y, z, px , py , m, λ) = 3 (x) (y) + z + λ (m − px x − py y − z) .

The FOCs are

∂L −2/3 1/3
= (x) (y) − λpx = 0, (1)
∂x
∂L −2/3 1/3
= (y) (x) − λpy = 0, (2)
∂y
∂L
= 1 − λ = 0, (3)
∂z
∂L
= m − px x − py y − z = 0. (4)
∂λ

Equation (3) yields λ = 1, which plugged into (1) yields

−2/3 1/3
(x) (y) = px
 y 1/3
= px
x2
y = p3x x2 , (5)

2
which then plugged into a similarly rearranged version of (2) yields x = p3y y 2 = p3y p3x x2 , that is,

1
x=
py p2x

which plugged back into (5) yields

2
p3x

1 1
y = p3x x2 = p3x = = ,
py p2x p2y p4x px p2y

which finally all plugged into (4) yields

   
1 1 2
z = m − px x − py y = m − px − py =m− .
py p2x px p2y py px

And so  
∗ ∗ ∗ 1 1 2
(x (px , py , m) , y (px , py , m) , z (px , py , m)) = , , m−
py p2x px p2y py px

3
(b) (12 pts) Find Jonas’ Hicksian (compensated) demand functions (hx (px , py , u) , hy (px , py , u) , hz (px , py , u)) .
Solution: Jonas’ expenditure minimization problem is given by

min px x + py y + z
x,y,z≥0
1/3 1/3
subj. to 3 (x) (y) + z ≥ u.

The Lagrangian is
 
1/3 1/3
L (x, y, z, px , py , u, λ) = px x + py y + z + λ u − 3 (x) (y) − z .

The FOCs are

∂L −2/3 1/3
= px − λ (x) (y) = 0, (6)
∂x
∂L −2/3 1/3
= py − λ (y) (x) = 0, (7)
∂y
∂L
= 1 − λ = 0, (8)
∂z
∂L 1/3 1/3
= u − 3 (x) (y) − z = 0. (9)
∂λ

From (8) we get λ = 1 and so (6) and (7) become identical to (1) and (2) from part (a), and so we again get
1 1
x= py p2x and y = px p2y , which plugged into (9) yields

1/3 1/3
z = u − 3 (x) (y)
 1/3  1/3
1 1
= u−3
py p2x px p2y
 1/3
1
= u−3
p3y p3x
3
= u− .
py px

And so  
1 1 3
(hx (px , py , u) , hy (px , py , u) , hz (px , py , u)) = , , u−
py p2x px p2y py px

4
(c) (6 pts) Suppose the initial prices are given as px = 1/4, py = 1/4 and Jonas’ income is m = 100. Find the total
effect on the zeracks consumption of Jonas, if prices change to p0x = 1, p0y = 1/8.
2 2
Solution: The optimal zeracks at the initial prices is z1 = m − px py = 100 − (1/4)(1/4) = 100 − 32 = 68. At the
2 2
new prices, z2 = m − p0x p0y = 100 − (1/8)(1) = 100 − 16 = 84. Thus, the total effect is z2 − z1 = 84 − 68 = +16.

(d) (12 pts) Find the Hicksian compensation amount in euros, and then decompose the total effect on z you found in
part (c) into substitution and income effects.
Solution: The original utility level is

1 1 2
u = 3x1/3 y 1/3 + z = 3[ ]1/3 [ ]1/3 + 100 − = 3(4)(4) + 100 − 32 = 116
(1/4)(1/4)2 (1/4)(1/4)2 (1/4)(1/4)

To achieve this utility level at the new prices we need

1 1 2
116 = 3[ 2
]1/3 [ 2
]1/3 + m0 − = 3(2)(4) + m0 − 16 = m0 + 8
(1/8)(1) (1)(1/8) (1)(1/8)

Thus, the compensated income should be m0 = 116 − 8 = 108, and the Hicksian compensation must be giving to
Jonas 8 euros.
Now the demand for zeracks with this compensation at the new prices will be

2 2
z = m0 − = 108 − = 92
p0x p0y 1/8

The substitution effect is the change from the initial z1 to this z: SE= z − z1 = 92 − 68 = +24
The income effect is the change from this z to the final amount z2 : IE= z2 − z = 84 − 92 = −8
Thus, TE=SE+IE= 24 − 8 = 16.
Alternatively you could have found the decomposition by looking at the Hicksian demand with u = 116 at the
3 3
new prices: z = u − p0x p0y = 116 − (1)(1/8) = 116 − 24 = 92. Rest would be the same.

5
(e) (8 pts) Find the Slutsky compensation amount in euros.
Solution: To find the Slutsky compensation, at the compensated income m0 the original bundle must be just
affordable at the new prices p0x and p0y . The expenditure is given by

1 1 2 1 1 1 2
m0 = p0x 2
+ p0y 2
+m− =1 2
+ 2
+ 100 − = 64 + 8 + 100 − 32 = 140
py px px py px py (1/4)(1/4) 8 (1/4)(1/4) (1/4)(1/4)

That is, the Slutsky compensation is +40.

(f) (6 pts) Which compensation does Jonas prefer, if the compensation was actually made? Show your answer by
comparing the utility levels under the two compensation levels.
Solution: The Slutsky compensation, +40, is larger than the Hicksian compensation, and Jonas would prefer
Slutsky compensation as more income means more utility, since utility is increasing in each good. To see this
through the utility levels first note that under Hicksian compensation, the original utility level,

uhi = 116

is achieved with the Hicksian compensation at the new prices.

With the Slutsky compensation, the new income is m0 = 140 and at the new prices the demand for zeracks is
z = m0 − p02p0 = 140 − (1)(1/8)
2
= 140 − 16 = 124. Then the utility level is
x y

1 1 2
usl = 3[ 2
]1/3 [ 2
]1/3 + 140 − = 3(2)(4) + 140 − 16 = 148
(1/8)(1) (1)(1/8) (1)(1/8)

which is larger than uhi = 116.

6
 (g) (4 pts) Is zeracks a normal good or an inferior good for Jonas?
Solution: When prices changed as above Jonas feels poorer, since the compensation (either Hicksian or Slutsky)
is positive. The income effect is negative as well. Thus, as Jonas gets poorer, he demands less zeracks due to IE.
Thus, zeracks is normal good for Jonas.

3. (10 pts) Recall the labor supply model we discussed in class: Consumer receives utility from daily leisure hours (n)
and daily consumption (c); she can work for a wage rate of wTL per hour and labor is her only source of income. The
price of the consumption per unit is p = 1TL. Suppose that when there is a wage rate increase, say from w1 to w2
(w2 > w1 ), her daily labor supply decreases from h1 to h2 (h2 < h1 ).

(a) (5 pts) Focusing on this change, is leisure a normal good or an inferior good? Explain.
(b) (5 pts) Determine the sign of the substitution effect and the income effect for leisure. Explain.

Solution:
(a) If labor supply decreases, it means that leisure demand increases with this increase in wage rate from w1 to w2 .
Since wage rate increases, the consumer has a higher purchasing power. If in turn she increases her leisure demand,
then we can say that leisure must be a normal good.
(b) Substitution effect always works in the opposite direction of the price change: As price of leisure (wage rate)
increases, leisure should be decreased: SE < 0.
For the income effect, we know that total effect of wage increase is positive on leisure demand. Since SE < 0, it must
be that IE > 0 (and dominating SE). This is consistent with the answer in part (a): wage increases, thus purchasing
power increases, and IE > 0 implies that leisure demand increases due to IE, thus leisure is normal good.