BC3035: Microeconomic Theory

Problem Set #4: solutions

1) David N. gets $3 per week as an allowance to spend any way he pleases. Because he
likes only peanut butter and jelly sandwiches, he spends the entire amount on peanut
butter (at $0.05 per ounce) and jelly ($0.10 per ounce). Bread is provided free of charge
by a concerned neighbor. David is a particular eater and makes his sandwiches with
exactly 1 ounce of jelly and 2 ounces of peanut butter. He is set in his ways and will
never change these proportions.

a) How much peanut butter and jelly will David buy with his $3 allowance in a week?

Utility maximization requires pb = 2j and the budget constraint is .05pb+.1j = 3.

substitution gives pb = 30, j = 15.

b) Suppose the price of jelly were to rise to $0.15 an ounce. How much of each

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commodity would be bought?

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If pj = $0.15, substitution now yields j = 12, pb = 24.

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c) By how much should David’s allowance be increased to compensate for the rise in
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the price of jelly in part (b)?
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To continue buying j = 15, pb = 30, David would need to buy 3 more ounces of jelly
and 6 more ounces of peanut butter. This would require an increase in income of:
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3(0.15) +6(.05) = 0.75

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d) Graph your results in part (a) to (c).

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 PB
PB = 2J

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e) Discuss the results of this problem in terms of income and substitution effects

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involved in the demand for jelly.

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There is no substitution effect due to the fixed proportion. A change in price results
in only an income effect.
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2) Assume that utility is given by

U(x,y) = x0.3y0.7
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Find the uncompensated demand functions. Compute the indirect utility function and
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expenditure function for this case.

From FOC we have:

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(0.3y)/(0.7x) = Px/Py

Hence, Pyy = 0.7/0.3) Pxx

Substitution into the budget constraint and solving for x gives us
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X* = 0.3I/ Px
Y* = 0.7I/Py
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The indirect utility function is:

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V(Px, Py, I) = U(x*, y*) = (0.56I)/(Px0.3Py0.7)

Expenditure function:

E(px,py,U) = 1.8 UPx0.3Py0.7

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 3) Suppose the utility functions for goods x and y is given by:

U(x,y) = xy + y.

a) Calculate the uncompensated demand functions for x and y and describe how the
demand curves for x and y are shifted by changes in I or in the price of the other
good.
From FOC:

y/(x+1) = px/py
so, y = (x+1)(px/py)
from budget constraint:

I = pxx+(x+1)px So,
x* = (I-px)/2px So,
Y* =( I+px)/2py

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b) Calculate the expenditure function for x and y.

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First get the indirect utility function as follows:

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V = ((I-px)/2px)) * (( I+px)/2py)) + (( I+px)/2py)
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=( I2+px2+2Ipx)/4pxpy
V = ((I+px)2)/ 4pxpy
And so E = (4pxpyU)0.5 - px
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c) Use the above expenditure function to compute the compensated demand functions
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for x and y. describe how the compensated demand curves for x and y are shifted by
changes in income or by changes in the price of the other good.

To get compensated demand functions, simply substitute E = (4pxpyU)0.5 - px into the

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uncompensated demand functions (and remember that E = I).

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So, X = ((4pxpyU)0.5 - px – px )/2px

= ((4pxpyU)0.5 - 2px )/2px
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Or X = (Upy/px)0.5 – 1
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Y = (4pxpyU)0.5)/2py
Or Y = (Upx/py)0.5
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4) Suppose that a person regards ham and cheese as pure complements – he or she will
always use one slice of ham in combination with one slice of cheese to make a ham and
cheese sandwich. Suppose also that ham and cheese are the only goods that this person
buys and that bread is free. Show:

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 a) That if the price of ham is equal to the price of cheese, the own price elasticity of
demand for ham is -0.5 and that the cross price elasticity of demand for ham with
respect to cheese is also -0.5.

Because of the fixed proportions between h and c, know that the demand for ham is

H = I/(ph+pc). Hence,

eh, ph = (δh/ δph).(ph/h) = (-I/((ph+pc)2)).(ph(ph+pc))/I = -ph/(ph+pc)

Similar algebra shows that eh, pc = -pc/(ph+pc). so, if ph = pc, eh, ph = eh, pc = -0.5.

b) What are the compensated price elasticities in this problem?

With fixed proportions there are no substitution effects, here the compensated price
elasticities are zero, so the Slutsky equation shows that ex, px = 0-sx = -0.5.

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5) Over a three year period, a person exhibits the following consumption behavior:

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Px py x y

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Year 1
Year 2
3
4 rs e 3
2
7
6
4
6
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Year 3 5 1 7 3

Is this behavior consistent with the strong axiom of revealed preference?

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Year 2’s bundle is revealed preferred to Year 1’s bundle since both cost the same in
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Year 2’s prices. Year 2’s bundle is also revealed preferred to Year 3’s for the same
reason. But in year 3, Year 2’s bundle costs less than year 3’s but is not chosen.
Hence, these violate the axiom.
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6)
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a) Suppose consumers buy only two goods, food and shelter, and that they buy these in
fixed proportions – one unit of food for each unit of shelter. In this case, what does
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the compensated demand curve for food look like? What is the price elasticity of
demand along this curve. (es). Are there any substitution effects in this demand?
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Compensated demand is totally inelastic; es = 0.

b) Under the above conditions, what is the income elasticity of demand for food (eF,I)?
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Since there are only two goods to buy, eF,I = 1.

c) Continuing as in part (a), suppose one unit of food costs half what one unit of housing
costs. What fraction of income will be spent on food? (call this sF).

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 sF = 1/3
d) Using the information in part (c), what is the overall price elasticity of demand
(including both substation and income effects) for food (eF,P)?

eF,P = 1/3. if Pf rises by say 3%, will have to reduce spending on both food and
shelter by 1% to compensate for the price rise. Hence, eF,P = -1%/-3% = -1/3.

7) Suppose that the market demand curve for pasta is a straight line of the form Q = 300-
50P where Q is the quantity of pasta bought in thousands of boxes per week and P is the
price per box.

a) At what price does the demand for pasta go to zero? Develop a numerical
example to show that the demand for pasta is elastic at this point.

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At P = $6.
Since elasticity = (δQ/δP)*(P/Q), so we can show that for any small price decline,

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P/Q = P/0 = infinity. So elasticity is infinity.

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b) How much pasta is demanded at a price of zero? Develop a numerical example to
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show that demand is inelastic at this point.
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Q = 300.
Again, from the formula for price elasticity, we can show that for a small price
increase, P/Q = 0/Q =0, which makes elasticity = 0.
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8) Consider the three demand curves

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Q = 100/P

Q = 100/√P
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Q = 100/P3/2

a) Compute the value of Q for each demand curve for P = 1 and P = 1.1.
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(i) (ii) (iii)

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P=1 100 100 100

P= 1.1 90.9 95.3 86.7
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b) What do your calculations show about the price elasticity of demand at P=1 for each of
the three demand curves?

Demand function (i) has e = -1

Demand function (ii) has e = -0.5
Demand function (iii) has e = -1.5.

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 c) Now do the similar set of calculations for the three demand curves at P=4 and
P=4.4. How do the elasticities computed here compare to those from part b?

(i) (ii) (iii)

P=4 25 50 12.5
P=4.4 22.7 47.7 10.8

9) Consider the linear demand curve Q = a-bP

a) Using the above demand curve, find an expression for total revenue?

Q = a-bP
P = (a – Q)/b
TR = (aQ – Q2)/b

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b) Find the quantity that maximizes total revenue (Hint: your first order condition

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should be to find marginal revenue and set it equal to 0).

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FOC:

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δTR/δQ = MR = (a – 2Q)/b = 0
so, Q* = a/2 rs e
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c) Find an expression for the price elasticity of demand of the demand curve.
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e = (δQ/δP)*(P/Q)
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from demand curve,

δQ/δP = -b
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so, in general, the expression for price elasticity is e = (δQ/δP)*(P/Q) = -b*(P/Q)

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d) Show that at the point where revenue is maximized, the price elasticity of demand
= -1. (Hint: from FOC, find optimal Q and P and substitute these into the
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elasticity you found in c)).

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At Q* = a/2, P* = a/2b
So, e = -b*(P/Q) = -b*(a/2b)/( a/2) = -1
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