Economics 207

Intermediate Microeconomics
Spring 2007
Dr. Léonie L. Stone
Homework 2

1. Paul says, I always buy $100 worth of books whether the price rises or falls. Jonathan
says, I always buy 100 books. What is the price elasticity of demand for each consumer,
and how do you know?

Paul’s elasticity is 1 (or -1) because his spending doesn’t change no matter what the price is; in
other words, a 1% change in price leads to a 1% change in quantity. Jonathan’s elasticity is 0,
because his quantity does not change, no matter what the price is. A 1% change in price leads to
a 0% change in quantity demanded.

2.  Larry and Teri allocate their consumption between two goods: hats and bats. The price of hats is

$4 each and the price of bats is $8 each. For Larry, the marginal utility of the last hat consumed 
was 8 and the marginal utility of the last bat was 24. For Teri the marginal utility of the last hat was
6 and the marginal utility of the last bat was 12. Which consumer is not maximizing his/her utility? 
How can you tell? How should he/she change their allocation?

Set up the marginal condition.

For Larry, 8/4 (=2) is not equal to 24/8 (=3).  Larry is not maximizing his utility and should consume 
more bats AND FEWER HATS.  Teri is maximizing her utility; 6/4 = 12/8.
3. Suppose that you consume only two goods, socks and a composite commodity that
represents everything else. Your income is $100, the price of socks is $5, and the price of
everything else is $1. You have ordinary, convex preferences (so you can assume that your
indifference curves lie wherever you like, as long as they have the usual shape).
a. Carefully draw a graph representing your current utility-maximizing point.
b. Now assume that your mother gives you 5 pairs of socks. Draw your new budget
constraint, and use it to prove that you can’t be better off with the sock than with an
equivalent gift of money, even if you really like socks.
Graph should show nonlinear budget constraint with all appropriate points labeled.
Ideally, there should be two graphs OR there should be a graph showing tangency in the
lower part of the budget constraint (a person who would be indifferent between the socks
and the money), and another graph showing a consumer who would be forced to the 5-
sock spike in the budget constraint and would thus be worse off with the socks than the
cash. It should be made clear that while some people are better off with the cash than the
socks, you can’t be better off with the socks than the cash (because every point that is
attainable with the socks is attainable with the cash).