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Problem Set 2 (Solution)

The document contains 4 problem sets regarding economics concepts: 1) It examines the equilibrium price and quantity for a good under different demand and supply curves, and how a tax impacts these. 2) It analyzes the expected value and variance of outcomes for a 3-option lottery. 3) It determines if an individual with a utility function for income is risk-averse and whether they should take a new higher-risk job. 4) Given utility functions for consuming goods x, y, z, it calculates the utility-maximizing bundle and the compensating variation when the price of x increases.

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Akshit Gaur
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15 views

Problem Set 2 (Solution)

The document contains 4 problem sets regarding economics concepts: 1) It examines the equilibrium price and quantity for a good under different demand and supply curves, and how a tax impacts these. 2) It analyzes the expected value and variance of outcomes for a 3-option lottery. 3) It determines if an individual with a utility function for income is risk-averse and whether they should take a new higher-risk job. 4) Given utility functions for consuming goods x, y, z, it calculates the utility-maximizing bundle and the compensating variation when the price of x increases.

Uploaded by

Akshit Gaur
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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P ROBLEM SET 2

1. Suppose the demand curve of a good is given by P = 1200 − 3QD and the supply curve is
given by P = 7QS .

(a) What is the equilibrium quantity and the equilibrium price?


Equilibrium price is P ∗ = 840 and equilibrium quantity is Q∗ = 120.

(b) What is the consumers’ surplus at the equilibrium?


The consumers’ surplus at the equibrium = 0.5 × Q∗ × (1200 − P ∗ ) = 0.5 × 120 × (1200 −
840) = 21600.

(c) Suppose the government introduces a per unit tax of $2 on the sellers. Find the
equilibrium price and quantity after the tax is introduced.
The new equilibrium price is P ∗∗ = 840.6 and equilibrium quantity is Q∗∗ = 119.8.

(d) What is the tax revenue of the government?


The tax revenue of the government=2 × Q∗∗ = 2 × 119.8 = 239.6.

(e) Will your answer to (d) change if instead the tax is levied on the buyers instead of the
sellers?
No as even then the equilibrium quantity will be Q∗∗ = 119.8.

(f) Suppose that the government introduces a value added tax of 5%on the buyers. This
means if the price is P then a tax of 0.05P must be paid by the buyers as tax. How will
the demand and supply curves change?
8000 20
The new demand curve will be P = − QD . Since the tax is on buyers, there
7 7
will be no change in the supply curve.

2. Consider a lottery with three possible outcomes:

• $125 will be received with probability 0.2

• $100 will be received with probability 0.3

• $50 will be received with probability 0.5

(a) What is the expected value of the lottery?


The expected value of the lottery=0.2 × $125 + 0.3 × $100 + 0.5 × $50 = $80.

1
(b) What is the variance of the outcomes?
Variance=975

(c) What is the maximum amount that a risk-neutral person will be willing to pay to play
the lottery?
Let X be the maximum amount that a risk-neutral person is willing to pay to play the
lottery and let W be her wealth. So, if she does not play the lottery, she has a total
wealth of W with certainty. If she plays the lotter, then her wealth will be (W+125-X)
with probability .2, (W+100-X) with probability .3 and (W+50-X) with probability .5.
So, her expected wealth will be W-X+80. The maximum she is willing to pay should
make her indifferent between participating in the lottery and not participating in the
lottery. Since she is risk neutral, it means that X is such that W+80-X=W. Hence, X=$80.

√
3. Suppose that Natasha’s utility function is given by u(I) = 10I, where I represents annual
income in thousands of dollars.

(a) Is Natasha risk loving, risk neutral, or risk averse? Explain.


u′′ (I)
Natasha is risk-averse. Since r(I) = − ′ > 0, Natasha is risk-averse.
u (I)
(b) Suppose that Natasha is currently earning an income of $40000(I = 40) and can earn
that income next year with certainty. She is offered a chance to take a new job that offers
a 0.6 probability of earning $62500 and a 0.4 probability of earning $36100. Should she
take the new job?
Natasha’s expected utility if she takes the job is 0.6 × u(62.5) + 0.4 × u(36.1) = 22.6.
Her expected utility if she continues her current job is u(40) = 20. Since her expected
utility is higher if she takes the new job, Natasha should take the new job.

(c) What is her expected income if she takes the job?


Natasha’s expected income if she takes the job is 0.6 × $62500 + 0.4 × $36100 = $51940.

(d) Suppose she is offered an insurance that gives her the expected income with certainty.
How much will she be willing to pay for such an insurance?
Let X be the amount that she is willing to pay for the insurance. If she buys the
insurance then her income will be $51940 − X with certainty. So, her utility if she buys
  s  
X X
the insurance is u 51.940 − = 10 51.940 − . If she does not buy the
1000 1000

2
insurance her expected utility is 22.6. Hence, X should be such that
s  
X X
u(51.940 − )= 10 51.940 − = 22.6
1000 1000

⇐⇒ X = 864.

4. Find the utility-maximizing bundle when the utility function is given by U (x, y, z) = x2 y 2 z 2
and Px = 20, Py = 30, Pz = 50 and M = 450. Find the compensating variation when the
price of x rises to Px′ = 50.
When Px = 20, Py = 30, Pz = 50 and M = 450, the optimal bundle is (x = 7.5, y = 5, z = 3).
Let X be the compensating variation. Hence, at the prices Px′ = 50, Py = 30, Pz = 50 and
income 450 + X, the optimal consumption bundle is
 
450 + X 450 + X 450 + X
x= ,y = ,z = .
150 90 150

By the definition of compensating variation,


 
450 + X 450 + X 450 + X
u(x = 7.5, y = 5, z = 3) = u x = ,y = ,z =
150 90 150

X = 160.74.

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