INTERMEDIATE MICROECEONOMICS BA (HONOURS) ECONOMICS, MIRANDA HOUSE SEMESTER 3, 2013-14 PRACTICE QUESTIONS True/False/Uncertain 1.

If you know the slope of the budget constraint for two goods, X and Y, then you know the prices of the two goods, X and Y. Explain. 2. A person who gives money away to people on the street does not have preferences that can be represented by a utility function. 3. If Patrick's utility function is U ( x , y ) = x y and Julie's utility function is U(x,y) = x1/2 y1/2, then Patrick will always derive more happiness than Julie does from any combination of x and y . 4. A monotonic transformation of a utility function does not change the marginal rate of substitution at any point. 5. If Lori has downward-sloping indifference curves, then this is the same thing as saying that she prefers averages to extremes. 6. If Steve is maximizing U(x,y) subject to a budget constraint, then at the maximal point, the marginal utilities of x and y will be equal.

Short Answer 1. Keith's preferences over cars are described as follows: One car is preferred to another if its fuel efficiency is lower by 2 km/lt. Otherwise Keith is indifferent between the two. Are Keith's preferences complete? Are they transitive? Can they be represented by a utility function. 2. Mr. Smith likes cashews better than almonds and likes almonds better than walnuts. He likes pecans equally well as macadamia nuts and prefers macadamia nuts to almonds. Assuming his preferences are transitive, which does he prefer i. pecans or walnuts? ii. cashew or macadamia? Picabo, an aggressive skier, spends her entire income on skis and bindings. (Binding are the mechanism by which skiers attach their boots to the skis.) a. If Picabo wears out one pair of bindings for every one pair of skis, graph her indifference curves for skis and bindings, illustrating bindings on the horizontal axis and skis on the vertical axis. b. If Picabo wears out two pairs of bindings for every one pair of skis, graph her indifference curves for skis and bindings, illustrating bindings on the horizontal axis and skis on the vertical axis. c. Now assume that Picabo has $5,760 in income to spend on binding and skis each year. Skis cost $480 per pair, and bindings cost $240 per pair. i. Graph Picabo's optimal consumption bundle for skis and bindings under the assumptions in part a). ii. Graph Picabo's optimal consumption bundle for skis and bindings under the assumptions in part b).

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Paula, a former actress, spends all her income attending plays and movies. She likes plays exactly three times as much as she likes movies. a. b. Graph Paula's indifference curves, illustrating plays on the horizontal axis and movies on the vertical axis. Paula earns $120 per week. If tickets to plays cost $12 each and tickets to movies cost $5 each, graph her optimal consumption bundle, illustrating plays on the horizontal axis and movies on the vertical axis.

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Sally likes peppermint candy canes in her hot chocolate. Specifically, she will only drink hot chocolate with 2 candy canes in each cup. Sally has a weekly income of $15 to spend on hot chocolate and candy canes. Hot chocolate costs $1.50 per cup. For the purposes of deriving Sally's demand curve for candy canes, use the following three prices for candy canes: P1=$0.25, P2=$0.50, and P3=$0.75. Draw two separate graphs. On the top graph, illustrate the three optimal consumption points. On the bottom graph, illustrate Sally's demand curve.

6. Consumer A has utility function u(x,y)=x1/3y2/3. Provide an expression that describes the consumer maximization problem. Derive the optimal bundle when px=10, py=5 and I=60. How does the bundle change if py=10? 7. Consumer B's utility for goods x1 and x2 is described by u(x1,x2)=x1ax2b. Prices and income are given by p1; p2 and I. Derive consumer A's demand for goods x1 and x2. What are the shares of income spent on goods x1 and x2, respectively? How do the shares change if the price of good x1 doubles?

8. Consumer C's preferences are described by the utility function u(x,y)=sqrt(xy). Her desired utility level is given by the parameter u*. Given prices px and py, derive the expenditure-minimizing bundle of goods that provides this level of utility u*. Describe how the consumption of goods x and y changes in response to changes in u*, px and py. 9. Maximize u(x,y)=x1/2+y subject to pxx+pyy=I. You may need to consider different solutions for different values of the parameters. Briefly explain your solution.

10. Suppose there are three commodities, all of which can be consumed in any non-negative amount, and a consumer has a utility function u ( x 1 , x 2 , x 3 ). The consumer's choice of a commodity bundle must satisfy the budget inequality: P1 + P2 + P3 < m, where P1 , P2 , P3 and m denote the market prices and income, respectively (all assumed to be strictly positive). If the marginal utility for each commodity is positive (all commodities are goods), is it possible that a utility maximizing consumer will choose a commodity bundle which costs less than m? Explain your answer. Prove that if m were to increase, while prices remain unchanged, the demand for at least one commodity will increase, i.e., at least one commodity is a normal good.

11. Suppose a consumer has an income of $25 and buys 10 apples and 5 oranges when the price of apples is $2 and that of oranges is $1. At another time, the same consumer is observed consuming 5 apples and 10 oranges when the price of apples is $1 and that of oranges is $2. Is this behavior consistent with utility maximization? Explain. (A diagram will help). You may assume that the consumer's income and tastes remain unchanged during the period these observations were made. Also assume that both commodities are goods. 12. Consumer 1 has a utility function u(x1, x2) = x1 x2 and consumer 2 has a utility function u(x1, x2) = min(x1, x2). Derive the demand functions for each consumer. a. Suppose each consumer has income of $90 and the market prices are p1 = 1, p2 =1. How much does each consumer demand of each commodity? b. Suppose the government needs to raise revenues through taxation the two proposals being considered are the following: i. a specific tax of $ 1 per unit will be imposed on commodity 2. This means that the consumers will face a new price of $2 for commodity 2. For every unit of commodity 2 that a consumer buys the government collects $1. ii. a lump-sum tax of $30 on each consumer. This means that the prices remain (1,1) but each consumers disposable incomes goes down from $90 to $60. How much total revenue does the government collect from policy (A)? How much does it collect from policy (B)? Does consumer 1 prefer one tax policy to the other? If so, which one and why? Make the same comparison for consumer 2. Based on your answers can you conclude that one kind of tax policy is better than the other? Explain.

13. Derive the demand functions for the utility function U(x1 , x2) = x11/2 + x21/2 a. Assume that the consumption of both commodities in non-negative and that prices and income are strictly positive. You do not need to explicitly use the Lagrangian for the derivation but state clearly why the solution to the consumer's problem is unique. For example, if you get a tangency solution state clearly why there is no corner solution. b. What are the demands when p1 = p2 = 1 and m = 4? Suppose the price of commodity 1 goes up to 2 (but p2 remains unchanged). Of course, if income remains unchanged, the consumer is made worse-off. Suppose the consumer succeeds in convincing her employer that her income should be raised to m' so that even after p1 goes up from 1 to 2, she can still just afford to buy her original demand bundle. What is the value of m'? c. Sketch the original budget line, the original demand, and the new budget line. Although the consumer can now continue to consume the original commodity bundle (before the change in p1 and m), is it rational to do so? From your figure can you argue that the consumer is actually better-off with this new budget line? d. Use your derivation of the demand functions to compute the demands on the new budget line, and use these to prove that the consumer is better-off on the new line. (Use the utility function to check whether or not one bundle is better than another). e. Calculate the value of income, m*, which would leave the utility of the consumer unchanged, after p1 goes up to 2 but p2 remains unchanged. In other words, find the value of m* such that when the budget line is 2x1 + x2 = m*, the consumer's utility remains the same as it was with the original demand bundle.

14. (Special credit) Consider the consumption maximization problem of young John D. Rockefeller in 1855. He chooses to work hours L for wage w, since he is only a clerk in the merchant house of Hewitt & Tuttle. He must choose how to spend his income on two goods: clothing C and housing H, from which he derives utility via utility function U = Ca + Ha L where a (0,1). Suppose that prices of one year of rent for housing and on year's worth of clothing are r and p, respectively. 1. Solve for Rockefeller's optimal choice of L1 , C1, H1. 2. It is now 1872, and John D. Rockefeller has just finished consolidating his competitors in oil refining to form Standard Oil. His hourly wage has now jumped to W> w . He still lives in the same small house in Cleveland as he did in 1855, though, since he still has time left on his lease. Solve for his optimal choice of C2 and L2. 3. At the end of the year, Rockefeller's lease is finally up, so he can choose housing freely. Solve for his new choices of L3,C3, and H3. 4. In which period did Rockefeller work the most?