Massachusetts Institute of Technology Department of Economics

14.01 Principles of Microeconomics Midterm Exam #1 SOLUTIONS March 5, 2013

1
1.

True/False Questions

Please write whether the answer is true or false in the box, and on the line below explain in one sentence.

(4 points) Explain:

Rover the dog only consumes two goods: dog food and bacon. If dog food is an inferior good for Rover, then bacon must be a normal good. True or False? True
Rational consumers must consume at least one normal good. If dog food is inferior, bacon must be normal.

2.

(4 points) At a rational consumer's optimal consumption bundle, the MRS always equals the price
ratio. True or False? False
This is only true for an interior solution, at a corner this may not hold.

Explain: 3. (4 points) Julie consumes long dresses (L) and short dresses (S ). Her utility function is U (L, S ) =
2L + S . Fractional dress consumption is allowed. If the price of long dresses is $30 and the price of

short dresses is $20, Julie will consume zero long dresses. True or False? False (True/Uncertain if explained correctly)

Explain: Julie will consume only long dresses, since long and short dresses are perfect substitutes,
and the price divided by the marginal utility for long dresses is higher than the price divided by marginal utility for short dresses. True/Uncertain accepted if the explanation states that Julie will consume zero long dresses when her income is zero. 4.

(4 points) Explain:
premium.

No rational consumer will ever buy an actuarially unfair insurance policy (that is, a policy where the premium exceeds the expected loss). True or False? False
Risk averse consumers are willing to pay to reduce risk. This is the idea of a risk

5.

(4 points) Explain:
quantity.

The demand for soda is downward sloping and the supply is upward sloping. A tax on soda consumption will increase the pre-tax price of soda. True or False? False
A consumption tax shifts the demand line inward, which decreases equilibrium price and

6.

(4 points)

The utility function U (x) = (x 3)2 + 9 satises the completeness, transitivity, and non-satiation ("more is better") axioms. True or False? False
dU dx

Explain: For x > 3, is downward sloping. The non-satiation axiom is not satised. 7. (4 points) Milton consumes potatoes and carrots. Last year, Milton consumed 300 potatoes and

200 carrots. This year, Milton's income is $1,000, potatoes cost $2 each, carrots cost $1 each, and Milton's preferences haven't changed. Milton will have lower utility this year than last year. True or False? False

Explain:
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1.

Milton's bundle last year cost $900. He can aord it again this year, so he will be at least as well o.

Longer Questions

(8 points) Suppose the supply of wheat is given by Q

s = 2p 2 and the demand for wheat is given by Qd = 7 p, where quantity is in pounds and price is in dollars.

(a) Calculate the market equilibrium price and quantity, as well as consumer surplus. Market price Market quantity Consumer Surplus $3 4 8 We set supply equal to demand equilibrium price and quantity. Consumer surplus is the area between the demand curve and the market price line. This is a triangle with a base of 4 and height of 4, thus the consumer surplus is 8. (b) Suppose the government imposes a price ceiling of $2 per pound. What is the new market price and quantity? What is the change in consumer surplus? Draw a clearly labeled graph in the price-quantity plane, showing the area that corresponds to the change in consumer surplus. Market Price Market Quantity Change in Consumer Surplus $2 2 0 Since the market price exceeds the price ceiling, we know that it binds. Thus the market price is $2, as mandated by the government. At this price, producers are only willing to supply 2 pounds of wheat. This yields a new consumer surplus of 8: we add the rectangle between $3 and $2 and 0 and 2 (so area of 2) but we subtract the triangle to the right of 2 pounds of wheat (base=2, height =2, so area is 2). Thus consumer surplus is unchanged, however the distribution is quite dierent: the people that get to consume have extra surplus (since the price is lower) but fewer people get to consume. 2

Initial CS (whole triangle) Lost CS QS

$3 $2 Gained CS QD 2 4 Q

2.

(x points)

Manuel consumes chicken C and beef B . His preferences are described by the utility function U (C, B ) = max{C, B }. The price of chicken is $3 per pound and the price of beef is $4 per pound. Manuel's income is equal to M .
How many pounds of beef will Manuel consume? How many pounds of chicken will Manuel consume?

Pounds of beef 0

Pounds of Chicken
M/3

Manuel wants the highest value available to him of C or B , since only the maximum value matters. He can get the highest value by spending all his money on chicken, since it is cheaper. 3. the T.

(10 points) In this question, we will explore the price elasticity of demand for Boston's subway,
(a) Is demand for the T more elastic in the short run or the long run? Briey explain your answer. More elastic in the long run. In the short run people without other means of transportation are locked into using the T, and people who don't live near the T or have already purchased cars and parking are locked into not using the T. In the long run, both users and non-users can make changes. If the price of the T rises, some people may choose to purchase cars or bicycles, and if the price drops, others may choose to sell their cars or move closer to a station. (b) Suppose demand for the T is given by the following function: Qd = 100 P 2 if P < 10 and Qd = 0 if P >= 10. P d i. (optional ) Write the formula for price elasticity of demand: Q P Q ii. Find the price elasticity when the price is $5. Price elasticity

Explain:

2 3

4.

Tom consumes bananas ( B ) and apples (A). Bananas and apples each cost 1 marble. Tom's utility function is U (B, A) = 12 B + 2A. (a) (Optional ) Write down Tom's MRS 3 (or inverse) B dU 6 , dU = 2, divide to get the MRS. dB = B dA (b) If Tom has 5 marbles, how many bananas does he consume? # of Bananas: 5 Setting MRS equal to the price ratio gives 3B = 1, which suggests that B should be 9. Tom will spend all his marbles on bananas until B = 9 because the marginal utility/price ratio is favorable for bananas until that point. After that point, the constant marginal utility from apples is preferred. So, in this case, he will spend all 5 marbles on bananas. (c) If Tom has 12 marbles, how many bananas does he consume? # of Bananas: 9 As discussed above, Tom will spend all his marbles on bananas until his income hits 9, then he will switch to apples. dA (d) Now let M denote Tom's income in marbles. For what range of M is dM = 1? # of Marbles:
M >9

(10 points)

Applying the formula we get

(2p)p 100p2

, which yields 2/3 when p = 5

5.

(10 points)

(Explained above.)

Huck consumes sh (F ) and cigarettes (C ). The price for one sh is P dollars, and cigarettes cost $2 each. His utility function is U (F, C ) = F (C ). Huck has $48 in income. (a) (optional ) Write down Huck's budget constraint PF + 2C = 48 (b) If P = $8, how many cigarettes will Huck smoke? # of Cigarettes: 8
1 MRS is 2F C . The price ratio is 4 , so setting them equal gives C = 2F . Plugging into the BC gives 8F + 4F = 48, so F = 4 and C = 8. (c) If the price of sh P decreases to $2, what is Huck's new consumption of cigarettes? # of Cigarettes: 8

The price ratio is now one, so F = 2C . Plugging into the budget constraint gives 4C +2C = 48, so C = 8 and F = 16. 4

(d) What is the substitution eect of this price change on Huck's consumption of cigarettes? Substitution Eect: 321/3 8 or 4 Note that there are two ways to calculate substitution eects which give slightly dierent answers. The rst solution is based on the method taught in class, and you should focus on this solution for the purposes of this course. The second solution is an alternative method, and we gave full credit for either answer. First approach: The slope of Huck's indierence curves is given by the marginal rate of substitution, which is 2F C . We want to shift the new budget line to its point of tangency with the old indierence curve. The new budget line has slope 1 , so we want to nd a point where MRS = 1 and tells us that 2F utility equals the old level of U (4, 8) = 4 8. The rst condition C = 1, F= 2C . Plugging into the second condition, we see that 4 8 = 2C C , which means that 2 8 = C 3/2 , C = 321/3 . The substitution eect is the dierence between this and the original level of C : 321/3 8. Second approach: Alternatively, we can think about giving Huck just enough money to consume his old bundle and then allowing him to reoptimize. At P = 2, Huck would need (2)(4) + (2)(8) = $24 to consume his original bundle at new prices. If he had $24 at P = 2, his consumption would be given by plugging into the new BC: 4C + 2C = 24, so C = 4 and F = 8. This substitution eect is again the dierence between this and the original bundle, so it is 4 8 = 4 in this case.

6.

Agnes has income M and consumes iPhone apps (A) and Groupons (G). Her utility function is U (A, G) = ln(A) + 2ln(G), where ln is the natural log. The price of iPhone apps is PA and the price of Groupons is PG . (a) (optional ) Write down Agnes's budget constraint
P A A + PG G = M

(12 points)

(b) (optional ) Write down Agnes's MRS G 2A (or inverse) dU 1 dU 2 dA = A and dG = G . Dividing gives the MRS. (c) Calculate Agnes's demand for iPhone apps in terms of income and prices. Demand for apps:
M 3PA PA PA Equating price ratio and MRS gives 2G A = PG , so G = 2A PG . Plugging into the BC gives M 2PA A + PA A = M , so A = 3PA . (d) Does Agnes consider Groupons to be a normal or inferior good? Normal or Inferior? Normal

Given the demand for apps, we can plug back in to determine G = increasing in income, so it is a normal good.

2M 3PG

. Demand for G is

(e) So long as M > 0, is there any range of prices PA and PG where Agnes consumes no Groupons? Explain briey. Any range of prices where Agnes consumes no Groupons? (Yes/No/Uncertain): No is innite when G = 0, since utility is when either G or A = 0. Any other utility value is preferred to , so Agnes will always spend at least a little bit of money on groupons (and on iPhone apps). (f) Does Agnes consider Groupons and iPhone apps to be gross substitutes, gross complements, or neither? Gross Subs/Comps/Neither? Neither The demands for A and G do not depend on the price of the other good (see above) - they only depend on income. Therefore, the cross-price derivatives of demand are zero.

Explain: No matter how expensive Groupons become, Agnes's marginal utility from Groupons

7.

Julio and Max are roommates. Each can spend his daily beverage allowance of $10 on coee (C ) or tea (T ). Julio's utility function is Uj (Cj , Tj ) = Cj + Tj . Max's utility function is Um (Cm , Tm ) = 2Cm + Tm . The price of coee, pC , is variable, while the price of tea is xed at pT = 1. (a) In a clearly labeled diagram in the price-quantity plane, graph the household's combined demand for coee as a function of the price pC .

(10 points)

P $2

$1

10

20

40 Q

(b) Suppose that pC = $1.50. What is household's combined demand for coee? Combined demand for coee
20 3

Both consumers consider tea and coee to be perfect substitutes. Julio will choose to consume only tea, since he values tea and coee equally in his utility function, and tea is cheaper. Max, however, gains double marginal utility from coee compared to tea, and since the price 20 dierence is less than double, he is best o spending all his money on coee ( 110 .50 = 3 ). (c) Suppose that the price of coee decreases from pC = $1.50 to pC = $0.50. What is the household's gain in consumer surplus from coee and tea consumption? Gain in consumer surplus
110 3

8.

(10 points)

In the rst part, consumer surplus is Julio's utility minus his cost (10 10 = 0) plus Max's 20 10 utility minus his cost ((2)( 20 3 ) (1.50)( 3 ) = 3 ). Now, both guys will choose coee and consume 20 cups each. So the new consumer surplus is 20 (0.50)(20) + (2)(20) (0.50)(20) = 110 40. So the change is 40 10 3 = 3 .

Melissa is trying to decide whether to buy insurance coverage for her high-end laptop. There is a 40% chance that her laptop will be stolen, in which case she will lose $3,600. Her current wealth is $10,000. Her utility function is U (W ) = W . (a) Is Melissa risk averse, risk neutral, or risk loving? Risk Preference Risk averse
d2 U dW 2

< 0 for all positive W .

(b) An insurance policy that fully covers Melissa's loss has a premium of $1,900. Will Melissa purchase the policy? Yes or No No If Melissa purchases the policy, she must pay $1,900 whether she loses her laptop or not, but at least she gets repaid the $3,600 if she loses her laptop. So, buying the policy gives her a constant utility of 10, 000 1, 900 = 90. If Melissa doesn't purchase, then she gets $10,000 and $6,400 with 40% probability, so her expected utility is with 60% probability (0.6) 10, 000 + (0.4) 6, 400 = 60 + 32 = 92, which is higher than 90, so she prefers to take the risk and not buy the policy. (c) What is the maximum insurance premium that Melissa will pay for full coverage? Maximum insurance premium that Melissa will pay $1,536 or $1,535 or $1,535.99 Melissa is willing to pay for insurance if it gives her utility higher than 92. A utility of 92 corresponds to a dollar value of 922 = 8464, which implies an insurance cost of $10, 000 $8, 464 = $1, 536. We can knock $1 (or one cent) o to ensure that Melissa will strictly prefer buying insurance to not buying insurance.