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Problem Set 1

The document provides answers to 12 problems related to economics and consumer choice. It includes sketches of budget constraints and indifference curves, calculations of opportunity costs, determinations of utility-maximizing bundles, and analyses of whether consumers are maximizing utility given their preferences and budgets. The problems cover topics such as how changes in prices affect consumption, the relationship between marginal rates of substitution and price ratios, and the implications of different functional forms for utility.

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Sankar Adhikari
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2K views

Problem Set 1

The document provides answers to 12 problems related to economics and consumer choice. It includes sketches of budget constraints and indifference curves, calculations of opportunity costs, determinations of utility-maximizing bundles, and analyses of whether consumers are maximizing utility given their preferences and budgets. The problems cover topics such as how changes in prices affect consumption, the relationship between marginal rates of substitution and price ratios, and the implications of different functional forms for utility.

Uploaded by

Sankar Adhikari
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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UGBA101A: Economics for Business

Decisions
Answers to Problem Set # 1

1. Martha has $150 of disposable income to spend each week and cannot
borrow money. She buys Malted Milk Balls and the composite good. Suppose
that Malted Milk Balls cost $2.50 per bag and the composite good costs $1
per unit.

a. Sketch Martha’s budget constraint.

ANSWER

b. What is the opportunity cost, in terms of bags of Malted Milk Balls, of


an additional unit of the composite good?

ANSWER:

The opportunity cost of an additional unit of the composite good is


1/2.5 = 0.4 bags of milk balls.
2. In problem 1, suppose that in an inflationary period the cost of the composite
good increases to $1.50 per unit, but the cost of the Malted Milk Balls remains
the same.

a. Sketch the new budget constraint.

ANSWER

b. What is the opportunity cost of an additional unit of the composite


good?

ANSWER

The opportunity cost of a unit of the composite good is now 0.6 bags of
milk balls.
3. In problem 2, suppose that Martha demands a pay raise to fight the inflation.
Her boss submits and raises her salary so that her disposable income is now
$225/wk.

a. Sketch the new budget constraint.

ANSWER

b. What is the new opportunity cost of an additional unit of the composite


good?

The opportunity cost of a unit of the composite good is again 0.6 bags
of milk balls

4. Picabo, an aggressive skier, spends her entire income on skis and bindings.
She wears out one pair of skis for every pair of bindings that she wears out.

a. Graph Picabo’s indifference curves for skis and bindings.

ANSWER

To get any enjoyment from them, Picabo must consume skis and
bindings in exactly the right proportion. This means that the
satisfaction Picabo gets from the bundle consisting of 4 pairs of skis
per year and 5 pairs of bindings will be no greater than the satisfaction
provided by the bundle (4, 4). Thus the bundle consisting of 4 pairs of
skis per year and 5 pairs of bindings lies on exactly the same
indifference curve as the original bundle. By similar reasoning, the
bundle consisting of 5 pairs of skis per year and 4 pairs of bindings lies
on this indifference curve as well. Proceeding in like fashion, we can
trace out the entire indifference curve passing through the bundle (4,
4), which is denoted as I1 in the diagram.

b. Now draw her indifference curves on the assumption that she is such
an aggressive skier that she wears out two pairs of skis for every pair
of bindings that she wears out.

ANSWER

5. Suppose that Picabo from question 4 has $3600 in income to spend on skis
and bindings each year. Find Picabo’s best affordable bundle of skis and
bindings under both of the preferences described in the previous problem.
Skis are $480/pair and bindings are $240/pair.

ANSWER

Picabo's budget constraint is B = 15 - 2S. Initially, she needs the same


number of pairs of skis and bindings S = B. Inserting this consumption
equation into her budget constraint yields B = 15 - 2B, or 3B = 15, which
solves for B = 5 pairs of bindings (and thus S = 5 pairs of skis). As an
aggressive skier, she needs twice as many skis as bindings S = 2B. Inserting
this consumption equation into her budget constraint yields B = 15 - 4B, or
5B = 15, which solves for B = 3 pairs of bidings (and thus S = 6 pairs of skis).
She consumes more skis and fewer bindings as an aggressive skier than as a
recreational skier. See graph below

6. For Alexi, coffee and tea are perfect subsitutes: One cup of coffee is
equivalent to one cup of tea. Suppose Alexi has $90/month to spend on these
beverages, and coffee costs $0.90/cup and tea costs $1.20/cup. Find Alexi’s
best affordable bundle of tea and coffee. How much could the price of a cup
of coffee rise without harming her standard of living?

ANSWER

Alexi's budget constraint is T = 75 - (3/4)C. Her perfect substitute preferences


yield linear indifference curves with slope equal to negative one, such as T =
75 - C and T = 100 - C. By consuming 90/0.90 = 100 cups of coffee each
month, she reaches a higher indifference curve than consuming 90/1.20 = 75
cups of tea (or any affordable mixture of coffee and tea). Thus Alexi buys 100
cups of coffee and no tea. Any increase in the price of coffee would force
Alexi to a lower indifference curve, and thus lower her standard of living.
7. Continental long distance Telephone Service offers an optional package for in-
state calling whereby each month the subscriber gets the first 50 minutes of
instate calling free, the next 100 minutes at $0.25/minute and any additional
time at the normal rate of $0.50/minute. Draw the budget constraint for in-
state phone calls and the composite good for a subscriber with an income of
$400/month.

ANSWER

8. For the Continental long distance problem above, what is the opportunity cost
of making an additional 20 minutes of calls if he currently makes:

a. 40 minutes of calls each month?

ANSWER
10(0) + 10(0.25) = 2.50

b. 140 minutes of calls each month?

ANSWER

10(0.25) + 10(0.50) = 2.50 + 5.00 = 7.50

9. Tom spends all of his $100 weekly budget on two goods, X and Y. His utility
function is given by U(X,Y) = XY. If PX = 4 and PY= 10, how much of each good
should he buy?

ANSWER:

Solve the budget constraint, 100 = 4X + l0Y, to get Y = 10  0.4X, then


substitute into the utility function to get U = X(10  0.4X ) = 10X  0.4X2.
Equating aU/aX to zero we have 10  0.8X = 0, which solves for X = 12.5.
Substituting back into the budget constraint and solving for Y, we get Y = 5

10.Same as problem 9, except now Tom’s utility function is given by U(X,Y) = X


1/2
Y 1/2.

ANSWER:
The result of solving the budget constraint for Y and substituting back into the utility function is
now U=X1/2(10  0.4X)1/2.

U / X = (1/2)X-1/2(10  0.4X)1/2 + X1/2(1/2)(10  0.4X)-1/2( 0.4) = 0


Rearranging terms, we get (10  0.4X)/X = 0.4, which solves for X = 12.5. Plugging back into the
budget constraint, we get Y = 5. Thus the optimal bundle is (12.5, 5), the same as in problem 9.

11.Note the relationship between your answers in Problems 1 and 2. What


accounts for this relationship?

ANSWER:

Note that the utility function in Problem 9 is simply the square root of the
utility function in Problem 10. Since the square root function is an increasing
function, it follows that the values of X and Y that maximize utility in Problem
9 will also maximize utility in Problem 10.

12.Sue consumes only two goods, food and clothing. The marginal utility of the
last dollar she spends on food is 12 and the marginal utility of the last dollar
she spends on clothing is 9. The price of food is $1.20 per unit and the price
of clothing is $0.90/unit. Is Sue maximizing her utility?
ANSWER:

Since we are given the marginal utility per last dollar spent on each good, the
prices, per se, do not matter. If Sue spent $1 less on clothing and $1 more on
food, her total utility would change by 9 +12=3. So, no, she cannot be
maximizing utility.

13.Albert has a weekly allowance of $17 all of which he spends on music


downloads (M) and film downloads (F), whose respective prices are $4 and
$3. His utility from these purchases is given by U(M)+V(F). If the values of
U(M) and V(F) are shown in the table, is Albert a utility maximizer if he buys 2
music albums and 3 films? If not how should he reallocate his allowance?

M U(M) F V(F)

0 0 0 0

1 12 1 21

2 20 2 33

3 24 3 39

4 28 4 42

ANSWER:

For Albert to be a utility maximizer, he must allocate his allowance so that


the extra utility per dollar is the same for both the last CD he purchased and
the last movie he rented. As shown in the table, this condition is satisfied
when he purchases 2 CDs and rents 3 movies. And since this bundle costs
exactly his weekly allowance (2x4 + 3x3 = 17), he is maximizing his utility.

N U(N) MU(N) MU(N)/PN M U(M) MU(M) MU(M)/PM


__________________________________________________________________

0 0 0 0

12 3 21 7

1 12 1 21

8 2 12 4

2 20 2 33
4 1 6 2

3 24 3 39

4 1 3 1

4 28 4 42

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