Q. A vegetable fiber is traded in a competitive world market, and the world price is $9 per pound.

Unlimited
quantities are available for import into the United States at this price. The U.S. domestic supply and demand
for various price levels are shown below.
Price U.S. Supply U.S. Demand
(million lbs.) (million lbs.)
3 2 34
6 4 28
9 6 22
12 8 16
15 10 10
18 12 4

a. What is the equation for demand? What is the equation for supply?
The equation for demand is of the form Q=a-bP. First find the slope which is
Q 6
  2  b.
P 3 You can figure this out by noticing that every time price increases by 3
quantity demanded falls by 6 million pounds. Demand is now Q=a-2P. To find a, plug in any of the
price quantity demanded points from the table: Q=34=a-2*3 so that a=40 and demand is Q=40-2P.
The equation for supply is of the form Q=c+dP. First find the slope which is
Q 2
 .
P 3 You can figure this out by noticing that every time price increases by 3 quantity
2
Q c P.
supplied increases by 2 million pounds. Supply is now 3 To find c plug in any of
2
Q  2  c  (3)
the price quantity supplied points from the table: 3 so that c=0 and supply is
2
Q  P.
3
b. At a price of $9, what is the price elasticity of demand? At a price of $12?
P Q 9 18
 (2)   0.82.
Elasticity of demand at P=9 is Q P 22 22
P Q 12 24
 (2)   1.5.
Elasticity of demand at P=12 is Q P 16 16
c. What is the price elasticity of supply at $9? At $12?
P Q 9 2  18
     1.0.
Elasticity of supply at P=9 is Q P 6 3 18
P Q 12 2  24
    1.0.
Elasticity of supply at P=12 is Q P 8 3 24
d. In a free market, what will be the U.S. price and level of fiber imports?
With no restrictions on trade, world price will be the price in the United States, so that P=$9. At this
price, the domestic supply is 6 million lbs, while the domestic demand is 22 million lbs. Imports
make up the difference and are 16 million lbs.

4. The rent control agency of New York City has found that aggregate demand is
QD = 100 - 5P. Quantity is measured in tens of thousands of apartments. Price, the average monthly rental
rate, is measured in hundreds of dollars. The agency also noted that the increase in Q at lower P results from
more three-person families coming into the city from Long Island and demanding apartments. The city’s board
of realtors acknowledges that this is a good demand estimate and has shown that supply is QS = 50 + 5P.
a. If both the agency and the board are right about demand and supply, what is the free market price?
What is the change in city population if the agency sets a maximum average monthly rental of $100,
and all those who cannot find an apartment leave the city?
To find the free market price for apartments, set supply equal to demand:
100 - 5P = 50 + 5P, or P = $500,
since price is measured in hundreds of dollars. Substituting the equilibrium price into either the
demand or supply equation to determine the equilibrium quantity:
QD = 100 - (5)(5) = 75
and
QS = 50 + (5)(5) = 75.
We find that at the rental rate of $500, 750,000 apartments are rented.
If the rent control agency sets the rental rate at $100, the quantity supplied would then be 550,000
(QS = 50 + (5)(1) = 55), a decrease of 200,000 apartments from the free market equilibrium.
(Assuming three people per family per apartment, this would imply a loss of 600,000 people.) At the
$100 rental rate, the demand for apartments is 950,000 units, and the resulting shortage is 400,000
units (950,000-550,000). The city population will only fall by 600,000 which is represented by the
drop in the number of apartments from 750.000 to 550,000, or 200,000 apartments with 3 people
each. These are the only people that were originally in the City to begin with.
 Ren t

$1,000
900 Dem a n d Su pply
800
700
600
500
400
300
E xcess
200
Dem a n d
100

Appa r t m en t s
20 40 60 80 100
(10,000’s)

Figure 2.4

Chap 3

Q. Betty is indifferent between bundles of either three beers or two hamburgers. Her preferences do not
change as she consumes any more of either food.
Since Betty is indifferent between three beers and two burgers, an indifference curve connects these
2
two points. Betty’s indifference curves are a series of parallel lines with slope of 3 . See
figure 3.2b.
H a m bu r ger s

9
8
7
6
5
4
3
2
1
U1 U2 U3

Beer
3 6 9

Figure 3.2.b
c. Chris eats one hamburger and washes it down with one beer. He will not consume an additional unit of
one item without an additional unit of the other.
 For Chris, hamburgers and beer are perfect complements, i.e., he always wants to consume the goods
in fixed proportions to each other. The indifference curves are L-shaped, with corners on a 45-
degree line out of the origin. See figure 3.2c.

d. Doreen loves beer but is allergic to beef. Every time she eats a hamburger she breaks out in hives.
For Doreen, hamburgers are not considered a “good” but rather a “bad,” and thus her preferred
position is not upwards and to the right, but rather downward and to the right. For Doreen, U1 is
preferred to U2 and U2 is preferred to U3. See figure 3.2d.

Ha m bu r gers

3 U3

2 U2

1 U1

Beer
1 2 3

Figure 3.2.c

H a m bur ger s

U3

U2

U1

Beer

Figure 3.2.d

3. The price of tapes is $10 and the price of CD’s is $15. Philip has a budget of $100 and has already purchased
3 tapes. He thus has $70 more to spend on additional tapes and CD’s. Draw his budget line. If his remaining
expenditure is made on 1 tape and 4 CD’s, show Philip’s consumption choice on the budget line.
Given Philip’s remaining income of $70, he can afford 7 tapes if he spends the entire amount on
tapes, and he can afford 4.7 CD’s if he spends the entire amount on CD’s. According to figure 3.3,
his budget line therefore intersects the vertical axis at a quantity of 7 tapes and the horizontal axis at
 a quantity of 4.7 CD’s. Since he faces constant prices, the budget line has a constant slope and is a
straight line.

Tapes

4 4.7 CD’s
Figure 3.3

Q. Anne is a frequent flyer whose fares are reduced (through coupon giveaways) by 25 percent after she flies
25,000 miles a year, and then by 50 percent after she flies 50,000 miles. Can you graph the budget line that Anne
faces in making her flight plans for the year?
In Figure 3.8, we plot miles flown, M, against all other goods, G, in dollars. The budget constraint
is:
Y = PM M + PG G, or

Y  P 
G  M M .
PG  PG 
PM

PG
The slope of the budget line is . In this case, the price of miles flown changes as the
number of miles flown changes, so the budget curve is kinked at 25,000 and at 50,000 miles. If we
assume PM is $1 per mile for less than or equal to 25,000 miles, then PM = $0.75 for 25,000 < M 
50,000, and PM = $0.50 for M > 50,000. Also, assume that PG = $1.00. The slope of the budget
line from A to B is -1, the slope of the budget line from B to C is -0.75, and the slope of the budget
line from C to D is -0.5.
 All Other
Goods

55
50 A

45
40 Slope = -1

35
30
25 B

20 Slope = -0.75
15
10 C
Slope = -0.50
5

Miles
25 50

Figure 3.8

9. Antonio buys 8 new college textbooks during his first year at school at a cost of $50 each. Used books cost
only $30 each. When the bookstore announces that there will be a 20 percent price increase in new texts and a
10 percent increase in used texts for the next year, Antonio’s father offers him $80 extra. Is Antonio better off
or worse off after the price change?
It follows from the axiom of revealed preferences that, since Antonio chose to purchase only new
textbooks when both new and used textbooks were available, it must be the case that Antonio does
not consider used textbooks substitutes for new textbooks at the old prices. With the increase in
price, however, to $60 for new textbooks and $33 for used texts, the relative price of new texts to
50 60
 1.67  1.82
used texts increases from 30 to 33 . Antonio may react to the relative price
increase in one of two ways:
(1) If new and used texts are not substitutes for Antonio (L-shaped indifference curves), then
Antonio will be just as well off when the price of new texts rises and his father gives him $80 (= (60
- 50)8).
(2) If he chooses to buy a few used texts in response to the relative price increase (given the extra
$80), he will move to a higher indifference curve and will therefore be better off. See Figures 3.9.a
and 3.9.b.
 All Ot h er Goods
(In clu din g Used Text s)

L2 L 1 r eflect s t h e pr ice
in crea se for t exts a n d
t h e ext r a $80.00
L1

U1

New Text s

Figure 3.9.a
All Ot h er Goods
(In clu din g Used Text s)

A
U2
U1
L2 L1
New Text s

Figure 3.9.b
10. Suppose that Samantha and Jason both spend $24 per week on video and movie entertainment. When the
prices of videos and movies are both $4, they both rent 3 videos and buy 3 movie tickets. Following a video price
war and an increased cost of movie tickets, the video price falls to $2 and the movie ticket increases to $6.
Samantha now rents 6 videos and buys 2 movie tickets; Jason, however, buys 1 movie ticket and rents 9 videos.
a. Is Samantha better off or worse off after the price change?
Samantha’s original point of utility maximization may be represented by point A on U1 in Figure
3.10.a. With the new prices, Samantha could still afford to choose bundle A: $24 = $2(3 videos) +
$6 (3 movies). The fact that she chose bundle B reveals she has obtained a higher level of utility,
U2. See Figure 3.10.a.
 Videos

12

L2
9

6 B

3 A
U2
L1 U1

12 Movies
3 6 9

Figure 3.10.a

b. Is Jason better off or worse off?

Similarly, Jason must also be better off.

12. The utility that Jane receives by consuming food F and clothing C is given by:
u(F,C) = FC.
a. Draw the indifference curve associated with a utility level of 12 and the indifference curve associated
with a utility level of 24. Are the indifference curves convex?
To find the baskets of food, F, and clothing, C, which yield satisfactions of 12 and 24 solve the
12 24
C C
equations F and F .

U = 12 U = 24

Food Clothing Food Clothing

1.0 12.0 1.0 24.0
1.5 8.0 2.0 12.0
2.0 6.0 3.0 8.0
3.0 4.0 4.0 6.0
4.0 3.0 6.0 4.0
6.0 2.0 8.0 3.0
8.0 1.5 12.0 2.0
12.0 1.0 24.0 1.0

The indifference curves are convex.

b. Suppose that food costs $1 a unit, clothing costs $3 a unit, and Jane has $12 to spend on food and
clothing. Graph the budget line that she faces.
The budget constraint is:
 1 
C 4 F
Y = PF F + PC C, or 12 = 1F + 3C, or 3  .

See Figure 3.12.a.

Clot h in g

4
U = 24
2
U = 12

F ood
2 4 6 8 10 12

Figure 3.12.a

c. What is the utility-maximizing choice of food and clothing? (Hint: Solve the problem graphically.)
The highest level of satisfaction occurs where the budget line is tangent to the highest indifference
curve. In Figure 3.12.a this is at the point F = 6 and C = 2. To check this answer, note that it
exhausts Jane’s income, 12 = 6PF + 2PC. Also, this bundle yields a satisfaction of 12, as (6)(2) =
12. See Figure 3.12.a.
d. What is the marginal rate of substitution of food for clothing when utility is maximized?
At the utility-maximizing level of consumption, the slope of the indifference curve is equal to the
slope of the budget constraint. Since the MRS is equal to the negative slope of the indifference
curve, the MRS in this problem is equal to one-third. Thus, Jane would be willing to give up one-
third of a unit of clothing for one unit of food.
e. Suppose that Jane buys 3 units of food and 3 units of clothing with her $12 budget. Would her
marginal rate of substitution of food for clothing be greater or less than 1/3? Explain.
If Jane buys 3 units of food for $1.00 per unit and 3 units of clothing for $3.00 per unit, she would
spend all her income. However, she would obtain a level of satisfaction of only 9, which represents
a sub-optimal choice. At this point, the MRS is greater than one-third, and thus, at the prices she
faces, she would welcome the opportunity to give up clothing to get more food. She is willing to
trade clothing for food until her MRS is equal to the ratio of prices. See Figure 3.12.e.
Clot h in g

4
3
2
U = 12
U=9
F ood
2 3 4 6 8 10 12

Figure 3.12.e