Professional Documents
Culture Documents
Prof. Barham
Problem Set 3 Solutions
1. Aunt Joyce purchases two goods, perfume and lipstick. Her preferences are
represented by the utility function
U (P , L ) = PL ,
where P denotes the ounces of perfume used and L denotes the quantity of
lipsticks used. Let PP denote the price of perfume, PL denote the price of lipstick,
and I denote Aunt Joyces income.
a. What is Aunt Joyces maximization problem?
Max U (P, L) = P.L
L,P
s.t. PL L + Pp P = I
b. What are the endogenous and exogenous variables?
The endogenous variables are: P and L
The exogenous variables are: PL, Pp, I
c. Derive her demand for perfume. Your answer should be an equation that
gives P as a function of PP , PL , and I. Determine this by using calculus and
maximizing the objective function, do not use the tangency condition.
To find the demand for perfume we need to find the optimal amount of perfume, it will
be a function of income and prices.
Step 1: Utility is a function of two variables. Since we dont know how to maximize
when utility is a function of two variables we need to substitute for one of them.
Since we are trying to find the demand for perfume, we will substitute for lipstick, so
we are utility will be just a function of perfume.
Rewriting the budget constraint:
L=
I ! PP P
PL
"I !P P%
" I % "P
%
P
Max U(P)=P*$$
'' = P $$ '' ! $$ P * P 2 ''
P
# PL &
# PL & # PL
&
Econ 3070
Prof. Barham
Step 2: Now we need to find the value of P that maximizes utility. We know that we
need the value of P where the slope of the utility curve is zero.
!U
= gives us the slope of the utility function with respect to P
!P
!U
I P
= " P 2P = 0
!P PL PL
2
PP
I
P=
PL
PL
P=
I PL
PL 2PP
P=
I
2PP
d. Derive her demand for lipstick. Your answer should be an equation that gives
L as a function of PP , PL , and I.
To find the demand function for lipstick, we can repeat a similar exercise that we did in
part A. Or we can substitute our value of P back into the budget constraint. (Or
recognize that the answer has to be symmetric).
! I $
PL L + PP ##
&& = I
" 2PP %
I
PL L = I '
2
I
PL L =
2
I
L=
demand function for lipstick
2PL
Econ 3070
Prof. Barham
d. Is lipstick a normal good? Draw her demand curve for lipstick when I = 200.
Label the demand curve D1. Draw her demand curve for lipstick when I = 300
and label this demand curve D2.
A normal good is a good that a consumer purchases more of as income rises. Since
Aunt Joyces demand for lipstick increases as I increases, lipstick is a normal good.
The two demand curves are depicted in the figure below:
PL
12.25
10
D2
D1
10 12.25
e. What can be said about her cross-price elasticity of demand of perfume with
respect to the price of lipstick?
In part a, we found that Aunt Joyces demand for perfume is given by
P=
I
.
2PP
Since her demand for perfume does not depend on PL, Aunt Joyces cross-price
elasticity of demand of perfume with respect to the price of lipstick is zero. That is,
a 1% change in the price of lipstick generates a 0% change in the demand for
perfume.
2. Ch 5, Problem 5.7
Karls preferences over hamburgers (H) and beer (B) are described by the utility
function U(H,B)=min(2H,3B). His monthly income is I dollars, and he only buys
these two goods out of his income. Denote the price of hamburgers by PH and of
beer by PB.
a. Write out the consumers maximization problem. Remember this is a case of
perfect complements so the indifference curves would be L shaped.
Econ 3070
Prof. Barham
s.t. PH H + PB B = I
b. Derive Karls demand curve for beer as a function of the exogenous variables
(hint, you cant maximize this function normally but you know that to be at
an optimum 2H=3B).
We are maximizing utility at the corner point of the L shaped indifference curve, so at
that point
Equation 1 from Utility function: 2H=3B of H=3/2B (I rewrote it this way as we are trying
to find the demand curve for B.
Equation 2: The budget constraint also has to hold PHH + PBB=I
We have 2 equations and 2 unknowns. We can substitute equation 1 into equation 2.
PH(3/2B) + PBB=I
Now I can try to solve for B as a function of price and income which give us our demand
curve.
3
B( PH + PB ) = I
2
3
B( PH + PB ) = I
2
I
B=
3
PH + PB
2
4
Econ 3070
Prof. Barham
b. You can answer this just by looking at the demand curve. Because it has a larger
coefficient, the price of hamburgers affects the demand for beer more than the price
of beer. A one dollar increase in PH decreases demand for beer more than a one
dollar increase in PB .
3. Uncle Bob purchases two goods, tweed sport coats and bow ties. His preferences
are represented by the utility function
s.t. PB B + PC C = I
I PB B
Step 1: Rewrite budget constraint. C =
sub into utility function
Pc
Econ 3070
Prof. Barham
3
1
4
I PB B 4
Max U ( B) = B *
B
Pc
3
U 1 34 I PB B 4 3 14 I PB B
= B
+ B
B 4
Pc 4 Pc
1 I PB B
4 Pc
B
3
4
1
4
PB
=0
PC
3 PB 14
B
4 PC
3
4
I PB B 4
Pc
3
1 I PB B 4 I PB B 4 3 PB 14 43
B B
=
4 Pc Pc
4 PC
1 I PB B 3 PB
B
=
4 Pc 4 PC
P
I PB B
=3 B B
Pc
Pc
PC
3
PB
I
B=
Pc
Pc
B=
I Pc
Pc 2PB
B=
I
I
=
4*25 100
Econ 3070
Prof. Barham
I
Engel Curve
100
c. Are bow ties a normal good? What can be said about Uncle Bobs income
elasticity of demand for bow ties?
Bow ties are a normal good because the demand for bow ties increases as income
increases. Since bow ties are a normal good, Uncle Bobs income elasticity of
demand for bow ties is positive.
We can calculate the income elasticity of demand as follows:
B , I =
dB I
1 I
=
= 1.
dI B
100 I 100
So, Uncle Bobs income elasticity of demand for bow ties is 1 a 1% increase in his
income leads to a 1% increase in his demand for bow ties.
Econ 3070
Prof. Barham
4. Ch 5, Problem 5.9
Rick purchases two goods: food and clothing. He has a diminishing marginal
rate of substitution of food for clothing. Let x denote the amount of food
consumed and y the amount of clothing. Suppose the price of food increases from
Px1 to Px 2 . On a clearly labeled graph, illustrate the income and substitution
effects of the price change on the consumption of food. Do so for each of the
following cases:
a. Case 1: Food is a normal good.
Given the increase in the price of x, we expect to see the following effects:
Substitution Effect
Income Effect
Because the price of x increased, x became relatively more expensive, and y became
relatively less expensive. As a result, Rick substitutes away from x in favor of y. This
is represented in the table by a down arrow for x and an up arrow for y in the
substitution effect column.
Moreover, the increase in the price of x reduced Ricks purchasing power. Since x
and y are both normal goods (x being a normal good is given by the problem, y being
a normal good is assumed), the reduction in purchasing power causes Rick to
purchase less of both x and y. This is represented in the table by the down arrows in
the income effect column.
The following diagram gives us a graphical representation of the information
presented in the table:
y
BL2
BL1
x
The initial consumption bundle is represented by point A, which lies on the initial
budget line BL1. The increase in the price of x causes the budget line to shift
Econ 3070
Prof. Barham
inwards to BL2. The new consumption bundle is represented by point C. We then
construct point B in order to separate the substitution effect from the income effect.
The movement from A to B represents the substitution effect. Note that as
suggested by the table, the movement from A to B shows x going down and y going
up. The movement from B to C represents the income effect. Once again, note that
as suggested by the table, the movement from B to C shows both x and y going
down.
b. Case 2: The income elasticity of demand for food is zero.
In this case, we expect to see the following effects:
Substitution Effect
Income Effect
Once again, because the price of x increased, Rick substitutes away from x in favor
of y. This is represented in the table by a down arrow for x and an up arrow for y in
the substitution effect column.
However, the information in the income effect column has changed. Since the
income elasticity of demand for x is zero, the reduction in Ricks purchasing power
has no effect on x. This is represented by the horizontal line for x in the income
effect column. (The down arrow for y reflects the fact that we are continuing to
assume that y is a normal good.)
The following diagram gives us a graphical representation of the information
presented in the table:
y
BL2
BL1
x
As before, the initial consumption bundle is represented by point A, and the new
consumption bundle is represented by point C. Point B is constructed in order to
separate the substitution effect from the income effect.
Econ 3070
Prof. Barham
The movement from A to B represents the substitution effect, and as suggested by
the table, we observe x going down and y going up. The movement from B to C
represents the income effect. As suggested by the table, we observe no change in x
since the income elasticity of demand for x is zero. On the other hand, we do
observe y going down since y is assumed to be a normal good.
c. Case 3: Food is an inferior good, but not a Giffen good.
In this case, we expect to see the following effects:
Substitution Effect
Income Effect
Once again, because the price of x increased, Rick substitutes away from x in favor
of y. Moreover, the reduction in Ricks purchasing power reduces his demand for y
(a normal good).
What is new is that x is an inferior good; that is, the reduction in Ricks purchasing
power causes Rick to purchase more x. This is represented by the up arrow for x in
the income effect column.
The following diagram gives us a graphical representation of the information
presented in the table:
y
B
BL2
BL1
x
As before, the initial consumption bundle is represented by point A, and the new
consumption bundle is represented by point C. Point B is constructed in order to
separate the substitution effect from the income effect.
The movement from A to B represents the substitution effect, and as suggested by
the table, we observe x going down and y going up. The movement from B to C
represents the income effect. As suggested by the table, we observe y going up (since
y is assumed to be a normal good) and x going down (since x is assumed to be an
inferior good).
10
Econ 3070
Prof. Barham
The last thing to take note of is that the diagram indicates that x is not a Giffen good.
The diagram indicates that the income effect is not strong enough to dominate the
substitution effect; that is, the increase in x going from B to C is smaller than the
decrease in x going from A to B.
The last thing to take note of is that the diagram indicates that x is a Giffen good.
The diagram indicates that the income effect dominates the substitution effect; that
is, the increase in x going from B to C is larger than the decrease in x going from A to
B.
5. Ch 5, Problem 5.11 ed. 5.
Gingers Utility function is U(x,y)=x2y. She has income I=240 and faces prices Px=$8
and Py=$2.
Part A.
The maximization problem is:
Max U ( x, y ) = x 2 y
x, y
s.t. 8X + 2Y = 240
Part B.
Using the budget constraint we rewrite the maximization problem in terms of one variable.
MaxU ( x) = x 2 (120 4 x)
X
U
= 240 x 12 x 2 = 0
x
x* = 20
y* = 120 4(20) = 40
Her optimal bundle is (x,y)=(20,40) and utility is 16,000
Part C.
To be just as well off as before, her utility must be 16,000. We will use this fact later to help
us. But first we can just set this up as a usual maximization problem like in part A. Ill start
after I sub in the budget constraint since the steps are just the same as in part A. I will
change the price of y to be $8, and will use Px in the place of the price of X
11
Econ 3070
Prof. Barham
MaxU ( x) = x 2 (30
x
Px x
)
8
3P x 2
U
= 60 x x = 0
x
8
8
Px x = 60 = 160
3
Now we can sub PxX into the budget constraint to find Y. 160+8Y=240. So Y* =10.
To find out what X is we can use the fact that utility must equal 16,000
U(x,y)=16,000=x210
X*=40.
We know PxX=160 and X* is 40, so Px=4 if Ginger is just as well off as before the price
change.
6. Ch 5, Problem 5.18 ed 5.
The demand function for Kendamas is given by D(P)=16-2P (note that D(P) is just a
way of saying writing the demand function where the quantity demanded is a
function of P which you are used to seeing as QD. Compute the change in consumer
surplus when the price of a widget increases from $1 to $3. First show your results
graphically.
First lets graph this demand curve it is linear, so the slope is -2
If P=0, Q=16
If Q=0 then P= ? just write the inverse demand curve P=(16-QD)/2 so P=8
If P=1 then QD or D(1) =14
If P=3 then QD or D(1) =10
For price of a widget equal to $1 consumer surplus is
CS$1 = (8 1) D(1) = 7 14 = 49.
When price is equal to $3 consumer surplus is
CS$3 = (8 3) D(3) = 5 10 = 25.
So the change in consumer surplus is 49-25=24 or Area EBDC
12
Econ 3070
Prof. Barham
P
$8
D(P) = 16 2P
$3
$1
D(P)
7.
Bart will only consume when the price is less than 10. To see this, see what the price has
10 P
to be if QB is zero. Therefore his demand curve for 7-UP is QB =
, when P<10
4
and zero otherwise.
Homer will only consume if the price is less than 25 so his demand curve is
25 P
QH =
, when P < 25 and zero otherwise.
2
Therefore the market demand curve for 7-UP as a function of all possible values of price
is:
13
Econ 3070
Prof. Barham
Q M = 0, if P > 25
25 P
, if 10 < P < 25
2
60 3P
QM =
, if P < 10
4
QM =
14