Chapter 3

A Consumers Constrained Choice

Chapter Outline

3.1

Preferences
Properties of Consumer Preferences
Completeness
Transitivity
More is Better
Application: You Cant Have Too Much Money
Preference Maps
Indifference Curves
Solved Problem 3.1

3.2

Utility
Utility Function
Ordinal Preferences
Utility and Indifference Curves
Willingness to Substitute Between Goods
The Relationship Between the Marginal Rate of Substitution and Marginal Utility
Solved Problem 3.2
Application: MRS Between Recorded Tracks and Live Music
Diminishing Marginal Rate of Substitution
Curvature of Indifference Curves
Straight Line Indifference Curve
Right Angle Indifference Curve
Convex Indifference Curve
Solved Problem 3.3
Application: Indifference Curves Between Food and Clothing

3.3

Budget Constraint

3.4

Constrained Consumer Choice

Finding an Interior Solution Using Graphs
Solved Problem 3.4
Finding an Interior Solution Using Calculus
Substitution Method

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Solved Problem 3.5

Lagrangian Method
Solved Problem 3.6
Solved Problem 3.7
Application: Utility Maximization for Recorded Tracks and Live Music
Finding Corner Solutions
Perfect Substitutes Utility Function
Quasilinear Utility Function
Optimal Bundles on Convex Sections of Indifference Curves
Minimizing Expenditure
Solved Problem 3.8
3.5

Behavioral Economics
Tests of Transitivity
Endowment Effect
Application: How You Ask the Question Matters
Salience

Teaching Tips

The material in this chapter represents a challenge to students for a number of reasons. Most will not have
learned constrained optimization before. Also, utility analysis may seem quite abstract to them. Some take
issue with the assumption of rational behavior on the part of individuals and it needs to be stressed that the
models require only rational behavior on average. Finally, this is the point where the calculus techniques
go beyond the methods they are likely to have learned in their calculus prerequisite.
To overcome these stumbling blocks, you may want to devote one class to presenting and discussing the
technical points of utility theory and budget lines using one or two running examples, and another class to
applications. Whether you decide to present applications as you go, or after presenting the technical material,
this is one area where the students have to see the theory applied in order for it to make sense. You might
also consider breaking the class into small groups to work on problems that test their understanding (additional
problems are provided below). This way, you can migrate among the groups to get a better idea of how
many are struggling and who needs help. The methods presented in this chapter will be needed in Chapter 4
for the derivation of demand curves. If they are not confident with the material in this chapter, they are
almost certain to struggle not only in Chapter 4, but also when it comes to production and cost, since the
methodology there is similar.
The class should see that the notion of a measurable util is nonsense and will find the model more believable
given that only ordinal measurability is needed. In Section 3.3 on budget lines, more difficult
manipulations of the budget constraint can be introduced using taxes, subsidies, and binding quotas with or
without transferability, and this is good background for the problems that follow.
For Section 3.4, Constrained Choice, the technical portion of the material should come fairly easily if the
class has a solid grasp of indifference curves. Using plenty of examples and applications will make the
process of utility maximization seem less abstract. There are several in the text as well as in the additional
applications below. You may want to spend some time contrasting interior solutions and corner solutions.
Corner solutions are an effective way to show that the model makes predictions that are intuitively accurate.
For example, you can choose combinations of goods such that they are perfect substitutes to demonstrate
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that the model predicts that the consumer will always buy the one that is cheaper. You can also choose two
goods such that one is a good and the other is neutral to show that the consumer will only purchase the good
that provides utility. Also spend some time on the notion of bads (see discussion question 2 below).
Try to get the class to realize that if the bad is turned on its head, it becomes a good (e.g., less air pollution
is more clean air) and that clean air has a positive price that can be measured as the price of abatement.
Once transformed, standard maximization methods apply. Finally, show, using graphs, simple examples of
cases where the standard maximization solution does not exist, such as nonlinear budget lines. For example,
a consumer may be shown to be indifferent between fewer goods at a higher price, and a larger quantity at
a lower price in the case of declining marginal prices.
When discussing the marginal rate of substitution, note that in this text, MRS is left as a negative number
(MRS = X/ Y, which, of course, is negative, rather than MRS = X/ Y as in some texts). When presenting
the MRS, it is worth the time spent to try to get the class to think hard about the special cases of perfect
complements and substitutes. This is especially true when using the Lagrangian technique where the method
fails to find an optimal bundle. Not only does it help them with commodities that fall into this category,
but it also helps them to better understand the more typical case of convexity. Several examples are normally
required before students become comfortable with solving these types of problems.
Introduction of the duality at this time makes it easier when discussing profit maximization and cost
minimization later on.
Section 3.5, Behavioral Economics, is largely conceptual, but very interesting. It is harder to do explicit
problems with this material, but it is wonderful fodder for class discussions, especially after the
mathematical rigor of the previous section. The increasing literature on this subject gives room for a
variety of applications.

Additional Applications

Transitivity of Preferences
How realistic is the assumption of transitive preferences? A number of studies of both humans and animals
show that preferences usually are transitive. For example, Wienstein (1968) uses an experiment to determine
how frequently people give intransitive responses. 1 None of the subjects knew the purpose of the experiment.
They were given choices between ten goods, offered in pairs, in every possible combination. The goods
included $3 in cash, an 8-cup Wearever aluminum coffee percolator, and a free pass to the next four
Saturday matinees at the subjects favorite movie theatre. They were told that all of the goods had a value
of $3, to ensure that monetary value would not affect their calculations. Weinstein found that 93.5% of the
responses of adults (at least 18 years old) were transitive. Of children aged 912, however, only 79.2%
of the responses were transitive. He reasoned that this difference may be a justification for political and
economic restrictions and protections placed on youths.
Psychologists have also tested for transitivity using preferences for colors, photos of faces, and so forth.
For example, Bradbury and Ross (1990) found that, given a choice of three colors, nearly half of 45 year
olds are intransitive, compared to 15% for 1113 year olds, and 5% for adults. 2 Bradbury and Ross show
that a novelty (preference for a new color) is responsible for most intransitive responses, and that this effect
is especially strong in children.

Arnold A. Weinstein, Transitivity of Preferences: A Comparison Among Age Groups, Journal of Political Economy, 76(2),
March/April 1968:30711.
2
Hinton Bradbury and Ross Karen, The Effects of Novelty and Choice Materials on the Intransitivity of Preferences of Children
and Adults, Annals of Operations Research, 23(14) June 1990:14159.
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1.

Show using indifference curves and a budget line that if preferences are intransitive, standard utility
maximization solutions may not result.

2.

Suppose three of the subjects meet on the street after the above experiment. Each is carrying one item
(the money, the tickets, or the coffee percolator). Two of these individuals have intransitive preferences;
the other does not. How many exchanges could take place involving all three people before one would
be unwilling to trade? What would your answer be if only one had intransitive preferences?

Additional Questions and Problems

1. Maximizing behavior in the context of school performance (not utility maximization) would imply
trying to get straight As. Is maximizing behavior a good assumption in this case? Can you think of
another assumption that may be more appropriate for some individuals when attempting to model
school performance behavior?
2. Consider two goods that are perfect substitutes. What is likely to be true about their relative prices?
Can you confirm your hypothesis with examples?
3. From the total utility schedule shown below, calculate the marginal utility of each additional unit of
X consumed.
Units of X

Utility

15

35

50

62

70

74

76

77

77

4. Suppose a consumers utility derived from consuming bananas is described by the function
U = 10X + 3X 2 (1/3)X 3. Compute marginal utility.
a. Make a table showing total and marginal utility for X from 0 to 7 units.
b. Would this individual ever choose to consume more than 7 units? Explain.
5. What information is contained in the slope of an indifference curve? Why are these curves typically
convex to the origin?
6. For each of the utility functions below, draw a set of indifference curves showing utility levels
U = 12, U = 16, and U = 24.
a. U = XY
b. U = X + Y
c. U = X Y
d. What is true about the commodities in (b)?
e. What about the commodities in (c)?
7. Suppose a consumer has an income of $500 and faces prices pX = 5 and pZ = 10.
a. Write the equation for the budget constraint.
b. Draw the budget constraint, placing good X on the horizontal axis. Label it BC.
c. What is the slope of BC?
d. Suppose income decreases to $300. Draw the new budget constraint and label it RS.
8. Larry and Teri allocate their consumption between two goods: hats and bats. The price of hats is $4

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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?
9. Suppose a consumer has income of $120 per period, and faces prices pX = 2 and pZ = 3. Her goal is to
maximize her utility, described by the function U = 10X 0.5Z 0.5. Calculate the utility maximizing
bundle (X *, Z *) using the Lagrangian method.
10. Confirm that if a consumers utility function is described by U = 2X + Z, and prices are pX = 2 and
pZ = 1, there is no unique utility maximizing solution regardless of income level. What does this tell
you about X and Z as commodities? (Hint: draw a graph showing a budget constraint and indifference
curve using the information provided.)
11. Suppose Carmelas income is $100 per week, which she allocates between sandwiches and books.
Sandwiches cost $2 each. Books cost $10 each if she purchases between 1 and 5 books. If she
purchases more than 5 books in a week, the price falls to $5 for the 6th book and all subsequent
books. Draw the budget constraint. Is it possible that Carmela might have more than one utilitymaximizing solution?
12. Show in graph a persons utility function such that he will be indifferent between an education
voucher and cash.
13. What happens to the budget line if the government increases tax on cigarettes but nothing else?

Answers to Additional Questions and Problems

1. Some individuals may practice what is known as satisficing behavior. In the context of school
performance, this would mean performing to some minimum acceptable standard, such as C quality
work. In the work environment, it implies working just hard enough to not get fired. However, in
cases where the individual does not have good information about what minimal performance standards
are, or the standards cannot be achieved with certainty, it becomes a very risky strategy.
2. Goods that are perfect substitutes are generally priced equally, or nearly so. For example, stores often
price different brands of golf or tennis balls all at one level, or at very similar prices because they must
be produced to professional association standards, and so are by definition good substitutes. Different
brands of basic food commodities such as bread and milk are also usually priced in a very narrow
range at a given store.
3.
1

15

20

15

12

Units of X
MU

4. MU = 10 + 6X X 2
a.
Units of X
MU

0
(10)

1
15

2
18

3
19

4
18

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15

6
10

7
3

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b. No. Marginal utility of the 8th unit would be negative.

5. The slope of an indifference curve indicates the rate at which the consumer is willing to exchange
one commodity for the other. This is the Marginal Rate of Substitution (MRS). Indifference curves
are typically convex because the consumer places greater value on the last unit of the commodity that
is more scarce.
6. a.

b.

c.

d. They are perfect substitutes.

e. X is a good, and Y is a bad, providing exactly the opposite of X in utility per unit.
7. a. 5X + 10Z = 500
b. See figure below.
c. Slope = 1/2

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d. See figure below.

8. The ratio of marginal utility per dollar should be equal for the last unit of all commodities. For Teri,
the marginal utilities per dollar are equal, for Larry they are not. Larry needs to increase his expenditures
on bats, and decrease expenditures on hats, which will cause the marginal utility of hats to rise, and
marginal utility of bats to fall.
9. Setting up the Lagrangian results in
L = 10X 0.5Z 0.5 l(2X + 3Z 120)
Taking the partial derivative of this function with respect to X, Z, and , and setting equal to zero,
results in three equations and three unknowns:

L/ X = 5X0.5Z0.5 2 = 0
L/ Z = 5X0.5Z5 3 = 0
L/ = 120 2X 3Z = 0
The easiest way to solve is to take the ratio of the first two equations, and plug the resulting X/Z ratio
into the third. In this case, X* = 30, Z* = 20.
10. Because the commodities are perfect substitutes, and the price ratio is equal to the MRS, any budget
line drawn would be coincident with some indifference curve, resulting in no unique solution. The
consumer is equally happy choosing any point on the budget line.

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11. Because the price of books falls when Carmela purchases more than 5 books in one week, the budget
constraint is nonlinear. As Figure 3.5 shows, the budget line is kinked at a. This nonlinearity makes it
possible that a single indifference curve could be tangent to the constraint in two places. In this case,
the consumer is indifferent between purchasing 3 books per week at full price and purchasing 10 books
per week with the discount.

12. See figure below. If ones indifference curve touches the budget line under the voucher at the kink
point e, then he is indifferent between the voucher and cash of the same value.

13. See figure below. With the higher cigarette tax, the budget line AB will rotate to AC such that the
maximum bundle for all other goods remains the same but becomes smaller for cigarette.

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Answers to Exercises in the Text

1.1 If consumers receive more of any product, even if they have as much of that product as they need for
now, they can save the product for future use, sell the product for money, or exchange it for other
goods. Under the free disposal assumption, economists assume that there is no cost to getting rid of
unwanted goodshence, people are no worse off (weakly better off) with more goods.
1.2 At the lower-right (or upper-left) portion, the indifference curve could switch from convex to
concave, forming a hook. An example of when this may occur might be with Apple products versus
Microsoft productsthere comes a point where even though you have a lot of Apple products, you
would still trade away more Microsoft products for fewer Apple products. However, from the
principle of nonsatiation (more is better), the curve would never fully bend back under or over itself,
as that would imply the same utility with less, or more, of both products.
1.3 Indifference curves are convex because the rate at which consumers are willing to trade one good for
another varies with their endowments of the goods. Along a single indifference curve, utility is constant.
In order to keep the consumers utility at the same level, some of one good must be forgone in order
to consume more of the other without altering total utility. This trade-off creates the negative slope.
The convexity comes from the changes in relative endowments as one moves along the curve. As one
moves down an indifference curve, the marginal utility of the good on the X-axis falls while the
marginal utility of the good on the Y-axis rises. Thus, as the endowment of Y falls, the consumer is
willing to trade less and less of Y to get an additional unit of X, creating the nonlinear relationship.
The slope of the indifference curve, the marginal rate of substitution, is the negative ratio of the
marginal utilities. Diminishing marginal utilities makes the second derivative of the indifference
curve positive.
1.4 In this case, charity is considered a good. Increases in charity increase his utility but with diminishing
returns, similar to most goods. Thus, indifference curves would have the typical convex shape, with
quantity of charity giving on one axis and all other goods on the other.
1.5 If the neutral product is on the vertical axis, the indifference curves are parallel vertical lines.

2.1 U = a(A + B); where a is a

positive constant, A denotes
number of tickets to the opera,
and B denotes number of tickets
to the baseball games.

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2.2 Sofias indifference curves are right angles. Her utility function is U = min(H, W), where min means
the minimum of the two arguments, H is the number of units of hot dogs, and W is the number of
units of whipped cream.
2.3 In this case, the commodities are perfect substitutes above the threshold level, resulting in linear rather
than convex indifference curves. The more is better assumption is violated below the threshold
level. For example, an increase in X from 1 to 2 provides no additional utility unless Y is greater
than 3.

2.4 In this example, there is a positive monotonic transformation for U = (q1 + q2 ) such that there is an
equivalent utility function U = q1 + q2 because
1

q1 + q2 > q *1 + q *2 only if (q1 + q2 ) > (q *1 + q *2 ) .

2.5 The marginal rate of substitution (MRS) is the slope at a point on an indifference curve. It is the
maximum amount of one good that a consumer will sacrifice (trade) to obtain one more unit of
another good.
If V (q1 , q2 ) = F (U (q1 , q2 ) , then the marginal rate of substitution for the transformed utility function,
U
V
1 , is the same as the marginal rate of substitution for the original utility function, 1 , because
V2
U2
F
U1
V1
U

= 1 .
= U
F

V2
U2
U2
U

2.6 The marginal rate of substitution is

1
2

= (1) 1
2

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2.7
1 = 1 + 11 2

2 = 1 + 1 21
=

1
1 + 11 2
=
2
1 + 1 21

2.8 The marginal rate of substitution (MRS) is the slope at a point on an indifference curve. Phil's MRS is
the same for a given q1 because
1
U
q
1
MRS= 1 =
1 =
,
1
U2
q1
which does not depend on q2.
3.1 Suppose that Dale purchases two goods at prices p1 and p2. If her original income is Y, the intercept of
the budget line on the Good 1 axis (where the consumer buys only Good 1) is Y/p1. Similarly, the
intercept is Y/p2 on the Good 2 axis. A 50 percent income tax lowers income to half its original level,
Y/2. As a result, the budget line shifts inward toward the origin. The intercepts on the Good 1 and
Good 2 axes are Y/(2p1) and Y/(2p2), respectively. The opportunity set shrinks by the area between the
original budget line and the new line.
3.2 When all prices and income double, the budget constraint remains unchanged. The consumer is
indifferent between income of $100 and prices of $10 and $20 for X and Z, respectively, and income
of $50 and prices of $5 and $10 for X and Z.
3.3 The consumer can afford to buy up to 12,000 gallons of water a week if not constrained. The
opportunity set, area A and B, is bounded by the axes and the budget line. A vertical line at 10,000 on
the water axis indicates the quota. The new opportunity set, area A, is bounded by the axes, the
budget line, and the quota line. Because of the rationing, the consumer loses part of the original
opportunity set: the triangle B to the right of the 10,000--gallons quota line. The consumer has fewer
opportunities because of rationing.

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3.4 Assume other goods (Y) are on the vertical axis and gasoline (G) is on the horizontal axis. If the slope
of the budget constraint before the tax is PG /PY, after the tax it will become (PG + 1)/PY. Thus, a tax
increases the price of gasoline and makes the budget constraint become steeper and rotate inward.

In the case where tax is applied to consumption of more than 10 gallons per week, the slope of the
budget constraint is (PG /PY) up to 10 gallons and (PG + 1)/PY beyond that. This creates a kink in
the budget constraint.
4.1 Consumers in both cities will equate their respective marginal rates of substitution with the relative
price in their local market. In Boston, MU A /MU T = 2/1 , and in San Diego, MU A /MU T = 1/2 . Note
that this does not require that consumers in Boston have the same tastes as the consumers in San
Diego, only that both have well-behaved preferences.
4.2 She will prefer the bundle with two anchovies and two boxes of biscuits because if MRS = 1 at this
point and the indifference curve is convex, she will be unwilling to trade down to any lower quantity
of biscuits at a one-for-one ratio. At the point where she has three anchovies and one box of biscuits,
her indifference curve will have a slope of less than 1. Thus, if forced to trade one for one, her utility
level would fall.
4.3 Andys marginal utility of apples divided by the price of apples is 3/2 = 1.5. The marginal utility for
kumquats is 5/4 = 1.2. That is, a dollar spent on apples gives him more extra utils than a dollar spent
on kumquats. Thus he maximizes his utility by spending all his money on apples and buying 40/2 =
20 pounds of apples.

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4.4 In order for him to be maximizing his utility, he must set his consumption such that the marginal
utility per dollar (MU/p) of the last unit consumed is equal across commodities. In this case:
10 / 10 5/2.

Specifically, the marginal utility per dollar is greater for cookies. Therefore, he should decrease his
consumption of books and increase his consumption of cookies.
4.5 In what follows it is assumed we have the number of $12 shoes on the vertical axis and the number of
$3 shoes on the horizontal axis. After the tariff, the $3 shoes cost 3 1.67 = 5.01, and the $12 shoes
cost 12 1.37 = 16.44. The slope of the budget constraint before the tariff is 3/12 = 0.25, and after
tariff it becomes = 5.01/16.44 = 0.305. Note that before tariff, Laura had to give up 0.25 units of
expensive shoes to get a cheap shoe, but after the tariff, this rate increases to 0.3. This means that
after the tariff cheap shoes have become relatively more expensive. Assuming Lauras nominal
income is fixed, the budget constraint shifts inward as a result of the tariff and becomes steeper.
Since, as a result of tariffs, real income (the purchasing power) has decreased, Laura will buy less of
both types of shoes, but because $3 shoes are now relatively more expensive, there will be some
substitution away from $3 shoes to $12 shoes, so Laura will end up buying relatively more expensive
shoes.
4.6 Helens indifference curves are right-angles. If her new budget line passes through her original
consumption bundle, then points on higher indifference curves are unattainable. Furthermore, at the
corner of a right-angle, no substitution is possible, so Helen will not substitute raspberries for
blackberries. Therefore, after the price changes, Helens optimal bundle will remain unchanged
because shell continue to consume raspberries and blackberries in equal proportions.

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4.7 Perfect complements result in indifference curves shaped like I4 (L-shaped), perfect substitutes in
curves shaped like I3 (straight lines), Cobb-Douglas and Constant-Elasticity-of-Substitution
preferences result in indifference curves shaped like indifference curve I2 (convex), and Quasilinear
preferences like I1 (convex and intersecting the axes).

4.8 =
MRS

U /q1 q1 1 q12
= =
. (Technically, marginal rates of substitution are negative.)
U /q2 q2 1 q11

Equating with relative price and solving for q2:

q1 P11/1
q2 = 1/1 .
P2
Substituting into the budget constraint:

Y Pq
=
1 1 + P2

q1 P11/1
P21/1

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and solving for q1:

q1 =

Y
1/1

1/1

P
P1 + P2 1
P2

By symmetry:
q2 =

Y
P
P2 + P1 2
P1

(C C ) ( F F )
U /C
(F F )
MRS =
=
. (Technically, marginal rates of
4.9 =

U /F (1 ) ( C C ) ( F F )
1 (C C )
substitution are negative).
1

Equating MRS with relative price:

PF ( F F )= PC ( C C ) .
1
The budget constraint can be written as:

Y CPC FPF= PC (C C ) + PF ( F F ).
Substituting:
Y CPC =
FPF

PF ( F F ) + PF ( F F )
1

and solving for F:

F = F + (1 )
where

Y*
PF

Y * =
Y CPC FPF .

Therefore,
C= C +

Y *
pC

The text uses I* for income instead of Y*. Use Y* for consistency.
4.10 From equation 3.29 and 3.30 in the text:
q1 ( P1 , P2 , Y ) =

Y
Y
and q2 ( P1 , P2 , Y )= (1 ) .
P1
P2

If we multiply all arguments by some positive value , then:

Y
Y
Y
Y
q1 ( P1 , P2 ,=
Y ) = and q2 ( P1 , P2 , Y ) =
(1 )
=
(1 ) .
P1
P1
P2
P2

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This is the same result that would occur if all prices and income in the budget constraint were
multiplied by .
3q2
. Equating this with the relative price (1/2) and substituting into the budget
q1
constraint, we get

4.11 Diogos MRS =

80 = 62 + 22

His optimal bundle is such that q1= 60 and q2=10.

4.12 Consumers spent $932 million in total; $202 million (22 percent) on radios and $730 million (78
percent) on home theatres. The exponents of a Cobb-Douglas utility function determine the portion of
income spent on each of the goods. Therefore, we can estimate the utility function as:
U (q1 , q2 ) = Aq1.22 q2.78 .
4.13 In general, with a Cobb-Douglas utility function of the form
U = (q1 ) (q2 )1

when behaving optimally, is the share of income spent on q1 and (1 ) is the share of income
spent on q2. Given that the student spent about 45 percent on phones and 28 percent on Internet
access and 27 percent on music, her Cobb-Douglas utility function would be
U(P, I, M)= P 0.45 I 0.28 M 0.27 .

4.14 If we plot Good 2on the vertical axis and Good 1 on the horizontal axis, the slope of the indifference
curve is MU1/MU2 = 2. The marginal utility from one extra unit of 1 is twice that from one extra
unit of 2. Thus, if the price of 1 is less than twice as much as that of 2, the consumer will buy only
Good 1 (the optimal bundle is on the Good 1 axis at Y/p1, where Y is his income and p1 is the price of
Good 1). If the price of 1 is more than twice that of 2, David buys only Good 2. If the price of Good 1
is exactly twice as much as that of Good 2, he is indifferent between buying any bundle along his
budget line.
4.15 We can solve this problem by noting that Vasco determines his optimal bundle by equating the ratios
of prices and marginal utilities, such that

a.

At the original prices, yields

1
2

1
.
2

201 2 10
=
5
1012
Or

q1 = q2.
Substituting in to the budget constraint yields q1 = q2 = 6.

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b. At the new price, the optimum condition requires that UR/10 = 2RC = R2 = UC/10, or 2C = R. By
substituting this condition into her budget constraint, 90 = 10R + 10C, and solving, we learn that
C = 3 and R = 6. Thus as the price of chickens doubles, she cuts her consumption of chicken in
half but does not change how many slabs of ribs she eats.
U q2 ( q1 + q2 ) q1q2
4.16
=
=
2
q1
( q1 + q2 )

q22
U q1 ( q1 + q2 ) q1q2
=
=
2
2
q2
( q1 + q2 )
( q1 + q2 )

q12

( q1 + q2 )

Equating MRS with relative price:

q22 P1
=
q12 P2

and substituting into the budget constraint:

1

P 2
=
Y P1q1 + P2 q1 1 .
P2

Solving for q1:

q1 =

and by symmetry:

q2 =

Y
1

P1 + ( P1 P2 ) 2

Y
P2 + ( P1 P2 )

1
2

4.17 The optional value of q1 as a function of a is

1 =

and the optimal value of q2 as a function of a is

q2 =

0.52 2

p1Y (0.5ap2 ) 2
.
p1 p2

Given these optimal values, Wolf will be at a corner solution, where q1 = 0, if a = 0. Perhaps this is
not a surprise because Wolf receives no utility (in the utility function U = a (q1 )0.5 + q2 from good q1
if a = 0.
4.18 The expenditure function is the relationship showing the minimal expenditures necessary to achieve a
specific utility level for a given set of prices.
Kips Lagrangian, L, for expenditure minimization is

L= pC C + pM M + U C 0.5 + M 0.5 ,

where pC is the price of good C (rewritten as C for qc) and pM is the price of good M (rewritten as M
for qm). After solving the first order conditions, the optimal value for good C is

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Perloff Microeconomics: Theory and Applications with Calculus, Third Edition

UpM
C =

pM + pC

and the optimal value for good M is

2

UpC
M =
.
pM + pC
Substituting these values for C and M into expenditure function E,

=
E pC C + pM M .
The expenditure function is
2

UpM
UpC
=
E pC
+ pM
.
( pC + pM
( pC + pM
5.1 a.

See the figure below. Suppose you are at point O. Assume you are willing to accept AD units of Y
in order to give up OA units of X. On other hand, to buy OB units of X(OA = OB) you are willing
to pay BC units of Y. Therefore you value the same unit of X differently, depending on whether
you want to give it up or you want to buy it. The indifference curve would be DOC and has a
kink at the endowment point. The graph shows different budget constraints at three different
relative prices for X. As you can see, the optimum does not change for small changes of relative
price. Therefore for a range of prices the demand curve for X will be vertical.

b. A consumers optimum bundle must lie on the budget line and be on an indifference curve that
does not cross it, even when the consumers indifference curves have kinks (for example, when
endowment effects are present). However, with kinked indifference curves, the slope of the
budget constraint does not necessarily equal the consumers marginal rate of substitution at the
optimum bundle, as is true for interior solutions. Since the indifference curve is not continuously
differentiable, we cannot use calculus to identify the consumers optimal bundle. Instead, the
optimum must be identified as with corner solutions, by separately examining utility at each kink.
6.1 If Bob and Max viewed the two types of books as imperfect substitutes and had the usual convex
indifference curves, they would each buy a mix of e-books and printed books. However, because of
the relatively lower price of e-books in the United States, Bob would buy relatively more e-books.
6.2 Describe the indifference curves of the consumer for Canadian and American gasoline: Presumably
the consumer views American gasoline and Canadian gasoline as perfect substitutes, so the
indifference curves are straight lines with a slope of 1.

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Chapter 3

A Consumers Constrained Choice

57

Draw the initial budget line where prices are relatively low in the United States, and show the
optimum: For specificity, we assume that, initially, a gasoline budget of Y bought 15 gallons of
gasoline in the United States but only 10 gallons in Canada: budget line L1. The consumer picks the
highest indifference curve, I2, that touches this budget constraint. The optimum, e1, is a corner
solution: The consumer buys gasoline only in the United States. More generally, as long as the budget
line is flatter than the indifference curve, the consumer buys only American gasoline. Letting pa be
the American price and pc be the Canadian price, the slope of the budget line, pa/pc, is greater
(closer to zero) than the slope of the indifference curves, 1, because pa < pc.
Draw the new budget line where prices are relatively low in Canada and show the new optimum:
After the price change, pa/pc < 1, so the consumer buys only Canadian gasoline. In the figure, after
the price change, Y buys 15 gallons in Canada and only 10 gallons in the United States: budget line
L1. As a result, the consumer only buys in Canada at e2, where I2 hits L2. Thus, the consumer buys in
whichever country the gasoline is cheapest: a corner solution.
6.3 This explanation is not exactly the same as that in the Challenge Solution because, with the state sales
tax increase, there appears to be some substitution between online purchases and in-store purchases
(e.g., if sales taxes increase by 1 percent, online sales increase by 2 percent). If so, then the
corresponding indifference curves are convex, not straight lines, as would be the case for perfect
substitutes. If online purchases and in-store purchases were perfect substitutes (with straight-line
indifference curves), then the state sales tax increase would either have no effect on sales or would
reduce in-store sales to zero, with all sales occurring online.
6.4 If gasoline and ethanol were perfect substitutes, such that 1 gallon of gas equals 1 gallon of ethanol,
then consumers would only purchase the fuel whose price is cheaper. That consumers do not (or that
at least 40 percent of consumers do not behave this way) indicates gas and ethanol are not perfect
substitutes. That is, some consumers have indifference curves (for gas and ethanol) that are not
straight lines but are instead the typical convex curved indifference curves. Perhaps utility from
fuel is a result of more than just energy. This would be true, for example, if it is difficult to find
stations that sell ethanol or if some believe there is a benefit to the environment from using ethanol
instead of gasoline.

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