Problem Set 4: Solutions

ECON 301: Intermediate Microeconomics

Prof. Marek Weretka

Problem 1

Note that for this problem, we can just use the formulas for demand with Cobb-Douglas
utility:
a m 4m b m m
x1 = · = and x2 = · =
a + b p1 5p1 a + b p2 5p2
While the utility function we’re given, U (x1 , x2 ) = 4 ln x1 + ln x2 , is not Cobb-Douglas, we
can always take a monotonic transformation of it and obtain the same answers. Here, let
f (u) = eu be the transformation so we’re working instead with U (x1 , x2 ) = x41 x2 .

(a) With initial prices p1 = 10, p2 = 1, and income m = 100, we get demand
4m m
x1 (p1 , p2 , m) = = 8 and x2 (p1 , p2 , m) = = 20 .
5p1 5p2

With new price p01 = 5 we have that

4m m
x1 (p01 , p2 , m) = 0
= 16 and x2 (p01 , p2 , m) = = 20 .
5p1 5p2

So the change in the number of movies (x1 ) watched is

∆x1 = x1 (p01 , p2 , m) − x1 (p1 , p2 , m) = 16 − 8 = 8 .

(b) Movies are ordinary goods since the number demanded increases when its price decreased
(demand is downward sloping).

(c) To find the substitution effect, we first need to find m0 , which is the amount of income
that would be required to purchase the (x1 , x2 ) = (8, 20) bundle (which was optimal at the
original prices) at the new price p01 :

m0 = p01 x1 + p2 x2 = 5 · 8 + 1 · 20 = 60 .

So to purchase the original bundle at the new prices would require an income of m0 = $60
(rather than $100). To find what amount of the total change in demand can be attributed
to the substitution effect, we need to find the quantity demanded with income m0 = 60 and
price p1 = 5:
0 0 4m0 3
x1 (p1 , p2 , m ) = 0 = 9 .
5p1 5

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So we have that the substitution effect is
3 3
∆xs1 = x1 (p01 , p2 , m0 ) − x1 (p1 , p2 , m) = 9 − 8 = 1 .
5 5
(d) The income effect is
3 2
∆xn1 = x1 (p01 , p2 , m) − x1 (p01 , p2 , m0 ) = 16 − 9 = 6 .
5 5
(Of course, since ∆x1 = ∆xs1 + ∆xn1 we can get this from 8 = 1 35 + ∆xn1 =⇒ ∆xn1 = 6 25 as
well.)

(e) The income effect is positive (with prices p01 and p2 , less of x1 was demanded with the
lower hypothetical m0 than was demanded at income m). This means preferences over these
goods are normal, which is true with Cobb-Douglas preferences.

(f ) These effects are shown graphically below. Point a represents the initial bundle, where
demand for x1 is x1 (p1 , p2 , m) = 8. Point c represents demand after the price change where
we had x1 (p01 , p2 , m) = 16. Point b represents the optimal (and hypothetical) value with p01
and m0 , with x1 demand x1 (p01 , p2 , m0 ) = 9 53 . The difference between a and c is the total
effect; between a and b is the substitution effect; between b and c is the income effect.

x2

a c
b

xa1 xb1 xc1 x1

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Problem 2

Recall that Trevor’s preferences are represented by the utility function U (x1 , x2 ) = min{5x1 , x2 }.
(He consumes five times as many strawberries (x2 ) as he does milk (x1 ) in making the perfect
strawberry milkshake.) We found that his demand functions are given by:
m 5m
x1 = and x2 = .
p1 + 5p2 p1 + 5p2

(a) With m = 200, p1 = 15, and p2 = 1, his demands for milk (x1 ) and strawberries (x2 )
are:
m 200 5m 5 · 200
x1 (p1 , p2 , m) = = = 10 and x2 (p1 , p2 , m) = = = 50 .
p1 + 5p2 15 + 5 · 1 p1 + 5p2 15 + 5 · 1

With the price of milk decreasing to p01 = 5, his new quantities demanded become:
m 200 5m 5 · 200
x1 (p01 , p2 , m) = = = 20 and x2 (p01 , p2 , m) = 0 = = 100 .
p01 + 5p2 5+5·1 p1 + 5p2 5+5·1

The total change in the demand for milk is

∆x1 = x1 (p01 , p2 , m) − x1 (p1 , p2 , m) = 20 − 10 = 10.

(b) The substitution effect, ∆xs1 , for complementary goods is always zero. Let’s verify this.

First, we need to find the m0 income that would make the original bundle just affordable
with the price change:

m0 = p01 x1 + p2 x2 = 5 · 10 + 1 · 50 = 100 .

Next we find the quantity of x1 demanded with m0 = 100, p01 = 5 and p2 = 1:

m0 100
x1 (p01 , p2 , m0 ) = 0
= = 10 .
p1 + 5p2 5+5·1

So we have that the substitution effect is

∆xs1 = x1 (p01 , p2 , m0 ) − x1 (p1 , p2 , m) = 10 − 10 = 0 .

(c) The income effect is

∆xn1 = x1 (p01 , p2 , m) − x1 (p01 , p2 , m0 ) = 20 − 10 = 10 .

(Again, since ∆x1 = ∆xs1 + ∆xn1 we can get this from 10 = 0 + ∆xn1 =⇒ ∆xn1 = 10 as well.)

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Problem 3

(a) The MRS for these preferences is MRS(x1 , x2 ) = − x51 . (Notice that this does not depend
on x2 , over which utility is linear.) The two secrets of happiness for an interior solution
(with x1 > 0 and x2 > 0) are:

• (1) p1 x1 + p2 x2 = m

• (2) MRS(x1 , x2 ) = − pp12 =⇒ − x51 = − pp21

(b) Solving for the two above equations for x1 and x2 we get demand functions
5p2 m − 5p2
x1 = and x2 =
p1 p2
m
as long as m ≥ 5p2 . (If m < 5p2 we have a corner solution with x1 = p1
and x2 = 0.)

(c) Given that m = 10 and p2 = 1, at price p1 = 5, our Miriam’s demand for coffee x1 is
x1 (p1 , p2 , m) = 5·1
5
= 1. (Also, x2 (p1 , p2 , m) = 10−5·1
1
= 5.)

With a price of p01 = 1, her demand is x1 (p01 , p2 , m) = 5·1

1
= 5.

The total effect on demand for x1 resulting from the price change is ∆x1 = x1 (p01 , p2 , m) −
x1 (p1 , p2 , m) = 5 − 1 = 4.

To find the substitution effect, we first find m0 = p01 x1 + p2 x2 , the hypothetical income
that would be necessary for her to buy her initial bundle with the price change, which is
m0 = 1 · 1 + 1 · 5 = 6.

Next we need to find the bundle Miriam would actually choose if her income were m0 = 6.
(We know she can afford the initial bundle, but that’s not necessarily what she buys given
the new relative prices.) At p01 = 1, p2 = 1 and m0 = 6, we have that x1 (p01 , p2 , m0 ) = 5·1
1
= 5.

The substitution effect is then

∆xs1 = x1 (p01 , p2 , m0 ) − x1 (p1 , p2 , m) = 5 − 1 = 4 .

(d) The income effect on the demand for x1 is

∆xn1 = x1 (p01 , p2 , m) − x1 (p01 , p2 , m0 ) = 5 − 5 = 0 .

(Again, since ∆x1 = ∆xs1 + ∆xn1 we can get this from 4 = 4 + ∆xn1 =⇒ ∆xn1 = 0 as
well.) With quasilinear preferences, the good in which utility is linear (here, x2 ) “absorbs
all income effects.”

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Problem 4

(a) Let x1 be the consumption of apples and x2 be the consumption of oranges. Dave’s
budget constraint is given by

p1 x1 + p2 x2 ≤ p1 ω1 + p2 ω2 =⇒ 2x1 + 2x2 ≤ 80 .

The bundles for which Dave would be selling apples and buying oranges is shown below:

x2 , oranges

bu
y
x2
,
se
ll
x1 (!1 , !2 )

20
bu
y
x1
,
se
ll
x2

20 x1 , apples

(b) First, the MRS of U (x1 , x2 ) = x1 x2 is MRS(x1 , x2 ) = − xx12 . At his endowment point
x1 = ω1 = 20 and x2 = ω2 = 20, we have MRS(20, 20) = − 20 20
= −1.

The utility associated with this bundle is U (20, 20) = 20 · 20 = 400. Dave is indifferent then
among his endowment and all the other bundles for which x1 x2 = 400 so the indifference
curve passing through his endowment is, analytically, x2 = 400/x1 . This is shown graphically
below:

x2 , oranges

(!1 , !2 )
20
slope = 1
u = 400

20 x1 , apples

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(c) Demand with these preferences is
m m
x1 (p1 , p2 , m) = and x2 (p1 , p2 , m) = .
2p1 2p2

Holding p2 = 2 fixed, for the three different p1 prices (and resulting m changes), we have the
following demand:
60 60
• (1) p1 = 1, m = 1 · 20 + 2 · 20 = 60: x1 (1, 2, 60) = 2·1
= 30 and x2 (1, 2, 60) = 2·2
= 15

– Net demand for x1 is given by x1 (1, 2, 60) − ω1 = 30 − 20 = 10

– Net demand for x2 is zero since x2 (1, 2, 60) = 15 < 20 = ω2 . (He will be a net
supplier of x2 .)
80 80
• (2) p1 = 2, m = 2 · 20 + 2 · 20 = 80: x1 (2, 2, 80) = 2·2
= 20 and x2 (2, 2, 80) = 2·2
= 20

– Net demand for x1 is given by x1 (2, 2, 80) − ω1 = 20 − 20 = 0. (He is neither a

net supplier for nor a net demander of x1 .)
– Net demand for x2 is given by x2 (2, 2, 80) − ω2 = 20 − 20 = 0. (He is neither a
net supplier for nor a net demander of x2 .)
100 50 100
• (3) p1 = 3, m = 3·20+2·20 = 100: x1 (3, 2, 100) = 2·3
= 3
and x2 (3, 2, 100) = 2·2
= 25
50
– Net demand for x1 is zero since x1 (3, 2, 100) = 3
> 20 = ω1 . (He will be a net
supplier of x1 .)
– Net demand for x2 is given by x2 (3, 2, 100) − ω1 = 25 − 20 = 5

(d) The magnitude of the slope of the indifference curve at the endowment point is
|MRS(20, 20)| = | − 20
20
| = 1.
p1
• (1) For p1 = 1, |MRS(20, 20)| = 1 > 21 = | − p2
|. He is better off buying more apples
(x1 ) and selling some of his oranges (x2 ).

• (2) At p1 = 2, |MRS(20, 20)| = 1 = 1 = | − pp12 |. He can not get any greater utility
from buying or selling apples and oranges; he is best off with his endowment.
p1
• (3) At p1 = 3, |MRS(20, 20)| = 1 < 32 = | − p2
|. He is better of buying more oranges
(x2 ) and selling some of his apples (x1 ).

(e) Dave’s optimal bundles for the three price combinations found above analytically are
shown graphically below with bundles (1), (2), and (3) labeled. The price-offer curve
must pass through these points, and is shown in the second graph. You will see that at all
but one point (the endowment, point (2)=(ω1 , ω2 )), the price offer curve lies strictly above
the indifference curve passing through the endowment (where u = 400). This is significant:
It means that one is always at least as well off trading as he is just consuming his endowment!

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x2 , oranges

(3)

p1 = 1
(2)
(1)
u = 450 2
(!1 , !2 ) u = 416
u = 400 3
p1 = 3 p1 = 2

x1 , apples

price-o↵er curve
x2 , oranges

(3)

p1 = 1
(2)
(1)
u = 450 2
(!1 , !2 ) u = 416
u = 400 3
p1 = 3 p1 = 2

x1 , apples

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Problem 5

(a) Kate’s real wage in terms of bananas is 20 pounds of bananas per hour. (She can pur-
chase pwc = 100
5
= 20 pounds per hour of work.)

(b) Her budget set is shown in the consumption-leisure space below:

480

w
slope = = 20
pc

24 R

(c) To find her optimal time spent at work and consumption of bananas, notice that she has
Cobb-Douglas utility with a = 1 and b = 1 (just replace x1 with R and x2 with C). Then
her demand for hours of relaxation is:
1 m 1 24w
R= = = 12 (She is endowed with 24 hours which is worth 24w on the market.)
1+1w 2 w
Her demand for the consumption good bananas is:
1 24w 12w
C= = = 240
1 + 1 pc pc
Hours of labor supplied is LS = 24 − R = 24 − 12 = 12. (So she consumes 12 hours of
relaxation and supplies 12 hours of work with her endowment of 24 hours.)

(d) With w = 200, we have

R = 12 and C = 480 .
Her labor supply is unchanged because, in this case, the substitution effect (where a higher
wage encourages a higher number of hours of labor supplied) is exactly offset by the income
effect.