XLRI - Xavier School of Management

Midterm Exam (Solution)

Managerial Economics (MGE(BJ23-1))

1. Suppose Rohit wants to consume two goods cold drinks (x) and fruit salad (y). The
price of cold drinks is px = 20 rupees per 200 ml bottle, and the price of fruit salad is
py = 10 rupees per plate, and he has a total income of m = 1000 rupees to spend on
these two goods.

(a) Suppose the price of x decreased to p′x = 10 and price of y increased to p′y = 20.
Draw both the budget lines before and after price changes on the same graph and
label their slope clearly.
Solution:
y

100

slipe = −2

slipe = − 21
50

x
50 100

(b) Suppose that the government imposes taxes of 5 rupees for each unit of x beyond
70 units at the new set of prices p′x = 10 and p′y = 20. That is, no tax is collected
for units x < 70, and 5 rupees tax for each x ≥ 70. Draw the new budget line.
Indicate the slopes of the budget line pretax and post-tax.
Solution:

1
 y

50
slipe = − 12

slipe = − 43

x
70 100

(c) Suppose that on top of the part (b) government subsidizes the consumer with 4
rupees for each unit of y he buys beyond 40 units. That is, there is no subsidy
for y < 40, and the consumer pays 4 rupees less for each y ≥ 40. Show the new
budget set indicating slopes for every case. (Consider tax and subsidy together.)
Solution:
y

52.5
slipe = − 58

40
slipe = − 12

slipe = − 34

x
20 70 100

2. Sanjeeda would like to consume two goods during exam times at school to relax, choco-
late (c) and music (m). Her utility from consuming these two goods is represented by
the following utility function, u(c, m) = c2 m. She had set aside 1200 rupees to spend
on these two goods during exam time when the price of a bar of chocolate was pc = 40
rupees, and the price of downloading a piece of music was pm = 20 rupees. When the
exam was about to start, she saw a spike in the price of downloading music, which

2
rose to p′y = 30 rupees per download. She approached her father and argued that her
initial utility was adversely affected because of the price rise, so her exam may go bad.
Her father approached an economic consultant for advice. What could be the consul-
tant’s advice to him so that his daughter’s exam could not go bad? (Hint: justify the
consultant’s answer using the concept of compensating variation (CV) and equivalent
variation (EV)). (6)
Solution: Let us find out the general demand function for this problem. Let y be
income, then the budget line is pc c + pm m = y. From the tangency condition, we
obtain MM Uc
Um
= 2cm
c2
= ppmc , which simplifies to pc c = 2pm m. Substitute this into the
budget line,

pc c + pm m = y
2pm m + pm m = y
y 2pm 2y
y∗ = , and c∗ = · m∗ = .
3pm pc 3pc
2y y
Initial consumption (before price rise): c0 = 3pc
= 20, m0 = 3p′m
= 20, and u0 =
202 × 20 = 8000.
2y y 40
Final consumption (after price rise): c1 = 3pc
= 20, m1 = 3pm
= 3
, and u1 =
202 × 40
3
= 16000
3
≈ 5333.3.

CV: To calculate CV, we want to know how much money is required to sustain u0
M Uc
at new prices. Thus, we have c2 m = 8000 and M Um
= 2cm
c2
= 40
30
, which simplifies to
2
m = 3 c. Thus, we have

c2 m = 800
3
c3 = · 8000 = 12000
2
2
cd ≈ 22.9, and md = · 22.9 = 15.3.
3
Therefore, yd = 40×22.9+30×15.3 = 1375. Thus, CV = y−yd = 1200−1375 = −175.
Sanjeeda requires Rs. 175 more to sustain her initial utility.

EV: To calculate EV, we want to know how much she can get to sustain u1 at initial
prices so that she can be as happy as u0 with having some money. Thus, we have
M Uc
c2 m = 5333.3 and M Um
= 2cm
c2
40
= 20 , which simplifies to m = c. Thus, we have

3
 c2 m = 5333.3
c3 = 5333.3
cd ≈ 17.5, and md = 17.5.
Therefore, yd = 40×17.5+20×17.5 = 1050. Thus, EV = yd −y = 1050−1200 = −150.
Sanjeeda requires Rs. 150 to be as happy as the initial case.

3. XLRI Fruit Shop sells cookies (good x) and bananas (good y). The shop owner observes
that the banana sale is good, but the cookies sale is not encouraging. He offered the
following deal to his customers. The price of bananas is fixed at 1 rupee each. The
first three cookies that a consumer buys are free; after the third cookie, the price of
the cookie is also 1 rupee each. Ramesh’s utility function is u(x, y) = x(y + 3), and his
income is 5 rupees. (Assume bananas and cookies are divisible.)

(a) Draw Ramesh’s budget line.

Solution:
y

x
3 8

(b) Find his optimal consumption bundle.

Solution:
The budget constraint is given by px (x − 3) + py y = 5, that is, (x − 3) + y = 5
because px = py = 1. From the tangency point, we get
y+3 1
= , =⇒ x = 3 + y.
x 1
Substituting for x in the budget line, we obtain 2y = 5, which implies y ∗ = 2.5
and x∗ = 5.5.

4
4. Suppose that potato chop and cheese are pure complements - they will always be used in
the ratio of one piece of potato chop to one slice of cheese to make a sandwich. Suppose
also that potato chop and cheese sandwiches are the only goods that a consumer can
buy and that bread is free. Show that if the price of a piece of potato chop equals the
price of a slice of cheese,

(a) The own-price elasticity of demand for potato chop is − 12 ; and

Solution: Let x = potato chop and y = slice of cheese. Since the preference here
is fixed proportion preferences, therefore the demand function for x and y is
m
x=y= .
px + p y
∂x px
The own-price elasticity of demand for potato chop = ∂p x
· x . The partial deriva-
∂x −m
tive of x with respect to px is ∂px = (px +py )2 . Thus, we have

∂x px
Ex,px = ·
∂px x
−m px
= · sabstitute the value of x
(px + py )2 x
−m px (px + py ) px
= · = −
(px + py )2 m p x + py
1
=− ∵ px = py .
2
(b) The cross-price elasticity of a change in the price of cheese on potato chop con-
sumption is also − 12 .
Solution: The cross-price elasticity of a change in the price of cheese on potato
chop consumption is = ∂p ∂x
y
· pxy . The partial derivative of x with respect to py is
∂x
∂py
= (px−m
+py )2
. Thus, we have

∂x py
Ex,py = ·
∂py x
−m py
= 2
· sabstitute the value of x
(px + py ) x
−m py (px + py ) py
= · = −
(px + py )2 m px + p y
1
=− ∵ px = py .
2
(c) How would your answers to (a) and (b) change if a potato chop costs twice as
much as a slice of cheese?

5
 ∂x px
The own-price elasticity of demand for potato chop = ∂p x
· x . The partial deriva-
∂x
tive of x with respect to px is ∂p x
= (px−m
+py )2
. Thus, we have

∂x px
Ex,px = ·
∂px x
−m px
= 2
· sabstitute the value of x
(px + py ) x
−m px (px + py ) px
= 2
· =−
(px + py ) m p x + py
2
=− ∵ px = 2py .
3
The cross-price elasticity of a change in the price of cheese on potato chop con-
sumption is = ∂p ∂x
y
· pxy . The partial derivative of x with respect to py is ∂p
∂x
y
=
−m
(px +py )2
. Thus, we have

∂x py
Ex,py = ·
∂py x
−m py
= · sabstitute the value of x
(px + py )2 x
−m py (px + py ) py
= 2
· =−
(px + py ) m px + p y
1
=− ∵ px = 2py .
3
5. Suppose the production function is given as
 α
Q= min{2K, 3L}

where α > 0. Does this production function exhibit increasing, decreasing, or constant
returns to scale?
Solution:
 α
Suppose 2K < 3L, then we know Q = = (3K)α and multiplying
min{2K, 3L}
 α
by λ we get λα (2K)α . Similarly, if 2K ≥ 3L, then Q = min{2K, 3L} = (3L)α .
Again, multiply by λ, we obtan λα (3L)α . Therefore, if α > 1, then IRS, if α < 1, then
DRS, and if α = 1, then it is CRS.