University of the Philippines SCHOOL OF ECONOMICS Economics 102 Exercise Set 2 2nd Semester, 2011-2012 Date Due: January

13, 2012 Please show your solutions. 1. We begin again with Charlie of the apples and bananas. Recall that Charlies utility function is U ( x A , x B ) ! x A x B . Suppose that the price of apples is 1, the price of bananas is 2, and Charlies income is 40. (a) On a graph below, use blue ink to draw Charlies budget line. (Use a ruler and try to make this line accurate.) Plot a few points on the indifference curve that gives Charlie a utility of 150 and sketch this curve with red ink. Now plot a few points on the indifference curve that gives Charlie a utility of 300 and sketch this curve with black ink or pencil. Can Charlie afford any bundles that give him a utility of 150? Can Charlie afford any bundles that give him a utility of 300? On your graph, mark a point that Charlie can afford and that gives him a higher utility than 150. Label that point A. Neither of the indifference curves that you drew is tangent to Charlies budget line. Lets try to find one that is. At any point, (xA, xB), Charlies marginal rate of substitution is a function of xA and xB. In fact, if you calculate the ratio of marginal utilities for Charlies utility function, you will find that Charlies marginal rate of substitution is MRS(xA , xB) = xB/xA. This is the slope of his indifference curve at (xA, xB). The slope of Charlies budget line is ____. Write an equation that implies that the budget line is tangent to an indifference curve at (xA, xB) . ______________ The best affordable bundle happens where xA = ____and xB = ____. Verify your answer by solving the two simultaneous equations given by his budget equations and the tangency condition. What is Charlies utility if he consumes the bundle (20, 10)? A.D.Kraft

(b) (c) (d) (e)

(f) (g)

(h) 2.

Claras utility function is U(X, Y) = (X + 2)(Y + 1), where X is her consumption of good X and Y is her consumption of good Y. (a) (b) (c) Write an equation for Claras indifference curve that goes through the Point (X, Y) = (2, 8). Suppose that the price of each good is 1 and that Clara has an income of 11. Can Clara achieve a utility of 36 with this budget? At the commodity bundle (X, Y), what is Claras MRS?

(d) (e) (f)

If we set the absolute value of the MRS equal to the price ratio, we have the equation: _________________ The budget equation is: ____________ Solving these two equations for the two unknowns, X and Y, we find X = ____ and Y= _____.

3.

Ambrose, the nut and berry consumer, has a utility function U ( x1 , x2 ) ! 4 x1  x2 , where x1 is his consumption of nuts and x2 is his consumption of berries. (a) The commodity bundle (25, 0) gives Ambrose a utility of 20. Other points that give him the same utility are (16, 4) (9, ____), (4, ____) , (1, ____ ), and (0, ____). Suppose that the price of a nuts is 1, the price of a unit of berries is 2, and Ambroses income is 24. How many units of nuts does he choose to buy? How many units of berries? Now suppose that the prices are as before, but Ambroses income is 34. How many units of nuts will he choose? How many units of berries?

(b) (c) (d)

4.

A consumer has the utility function U ( x1 , x 2 ) ! x12 x 2 . The price of good 1 is p1 = 1, the price of good 2 is p2 = 3, and his income is 180. a) b) c) d) Then, MU1(x1, x2) = _______ and MU2(x1, x2) = ______ . Therefore his marginal rate of substitution is: ___________ This implies that his indifference curve will be tangent to his budget line when: What are the optimal values for x1 and x2?

5.

A consumer has the utility function U(x1, x2) = min{x1, 3x2}. The price of x1 is 2, the price of x2 is 1, and her income is 140. a) b) x1 and x2 are _____ and for every x1, the consumer consumes ____ x2 Since this consumer will choose a combination at the corners of the indifference curve, one of the equations that she will need to find the unknowns is: ______. The second equation is: __________ . Solving these two equations, the optimal choice bundle for this consumer is (x1, x2) =__________.

c)

6.

Nancy Lerner is trying to decide how to allocate her time in studying for her economics course. There are two examinations in this course. Her overall score for the course will be the minimum of her scores on the two examinations. She has decided to devote a total of 1,200 minutes to studying for these two exams, and she wants to get as high an overall score as possible. She knows that on the first examination if she doesnt study at all, she will get a score of zero on it. For every 10 minutes that she spends studying for the first examination, she will increase her score by one point. If she doesnt study at all for the second examination she 2

will get a zero on it. For every 20 minutes she spends studying for the second examination, she will increase her score by one point. (a) (b) (c) (d) Write an equation for the line passing through the kinks of Nancys indifference curves.________. Write an equation for Nancys budget line.. Solve these two equations in two unknowns to determine the intersection of these lines. This happens at the point (x1, x2) = __________. Given that she spends a total of 1,200 minutes studying, Nancy will maximize her overall score by spending ______ minutes studying for the first examination and _______ minutes studying for the second examination.

7.

Charlie is backstill consuming apples and bananas. His utility function is U ( x A , xB ) ! x A xB . We want to find his demand function for apples, x A ( p A , pB , m) and his demand function for bananas, xB ( pa , pB , m). a) When the prices are pA and pB and Charlies income is m, the equation for Charlies budget line is p A x A  pB xB ! m . The slope of Charlies indifference curve at the bundle ( x A , x B ) is:  MU 1 ( x A , x B ) / MU 2 ( x A , x B ) ! _____ . The slope of Charlies budget line is _____. Charlies indifference curve will be tangent to his budget line at the point (xA, xB) if the following equation is satisfied: _________. You now have two equations, the budget equation and the tangency equation, that must be satisfied by the bundle demanded. Solve these two equations for xA and xB. Charlies demand function for apples is_______ and his demand function for bananas is ______. In general, the demand for both commodities will depend on the price of both commodities and on income. But for Charlies utility function, the demand function for apples depends only on income and the price of apples. Similarly, the demand for bananas depends only on income and the price of bananas. Charlie always spends the same function of his income on bananas. What fraction is this?

(b)

(c)

(d )

8.

Our thoughts return to Ambrose and his nuts and berries. Ambroses utility function is U ( x1, x2 ) ! 4 x1  x2 , where x1 is his consumption of nuts and x2 is his consumption of berries. (a) Let us fund his demand function for nuts. The slope of Ambroses indifference curve at ( x1 , x 2 ) is______. Setting this slope equal to the slope of the budget line, you can solve for x1 without even using the budget equation. The solution is _____. Let us find his demand for berries. Now we need the budget equation.

(b)

In part (a), you solved for the amount of x1 that he will demand. The budget equation tells us that p1x1  p2 x2 ! M . Plug the solution that you found for x1 into the budget equation and solve for x2 as a function of income and prices. The answer is ______. 9. Shirley Sixpack thinks that two 8-ounce cans of beer are as good as one 16-ounce can of beer. Suppose that these are the only sizes of beer available to her and that she has $30 to spend on beer. Suppose that an 8-ounce beer costs $.75 and a 16ounce beer costs $1. On the graph below, draw Shirleys budget line in blue ink, and draw some of her indifference curves in red. (a) (b) (c) (d) At these prices, which size can will she buy, or will she buy some of each? Suppose that the price of 16-ounce beers remains $1 and the price of 8ounce beers falls to $.55. Will she buy more 8-ounce beers? What if the price of 8-ounce beers falls to $.40? How many 8-ounce beers will she buy then? If the price of 16-ounce beers is $1 each and if Shirley chooses some 8ounce beers and some 16-ounce beers, what must be the price 8-ounce beers? Now let us try to describe Shirleys demand function for 16-ounce beers as a function of general prices and income. Let the prices of 8-ounce and 16-ounce beers be p8 and p16, and let her income be m. If p16 < 2p8, then the number of 16-ounce beers she will demand is _____. If p16 > 2p8, then the number of 16-ounce beers she will demand is ____ If p16 = she will be indifferent between any affordable combinations.

(e)

10.

Miss Muffet always likes to have things just so. In fact the only way she will consume her curds and whey is in the ratio of 2 units of whey per unit of curds. She has an income of $20. Whey costs $.75 per unit. Curds cost $1 per unit. a) b) How many units of curds will Miss Muffet demand in this situation? How many units of whey? Write down the demand function for whey as a function of the prices of curds and whey and of her income, where pc is the price of curds, pw is the price of whey, and m is her income.

11.

Percy consumes cakes and ale. His demand function for cakes is qc = m 30pc + 20pa, where m is his income, pa is the price of ale, pc is the price of cakes, and qc is his consumption of cakes. Percys income is $100, and the price of ale is $1 per unit. (a) (b) Is ale a substitute for cakes or a complement? Explain Write an equation for Percys demand function for cakes where income and the price of ale are held fixed at $100 and $1.

(c)

(d)

Write an equation for Percys inverse demand function for cakes where income is $100 and the price of ale remains at $1. At what price would Percy buy 30 cakes? Suppose that the price of ale rises to $2.50 per unit and remains there. Write an equation for Percys inverse demand for cakes.