INTERMEDIATE MICROECONOMICS (EC 221)

Instructor: Subrato Banerjee Total Points: 60 Deadline: --

Problem set 2: Consumer theory

Q1: A consumer spends all his income (M) on two commodities X and Y that are perfect
compliments. Can X be an inferior good?

[5 points]
NO
Answer: Try yourself.

Q2: Suppose your housemaid works for an hour every day. You want her to work for an
additional hour, so you offer her a certain multiple of the existing hourly wage rate so that she
agrees. Call this amount X. You then, suddenly remember that you need to hire her for at least
three hours. Now you offer a yet higher multiple amounting to Y. Explain if offering X or Y
(whatever you chose them to be) could force Bill Gates to put in those additional hours of
work-effort. Why in general, you would expect your housemaid to work for more hours in a
day compared to Bill Gates. Use your understanding of income and substitution effects to
frame your answer.

[5 points]

Answer: Use the logic of the backward-bending labour supply curve. It is clear that if you
multiply her wage rate, it becomes costlier for her to stay home and not work for you. This
substitution effect will force her to work more. Since leisure is a good, more of it is
consumed at higher incomes – so the income effect dominates the substitution effect, thereby
explaining why your housemaid works more hours in a day in comparison to Bill Gates.

Q3: A consumer with the utility specification U(x, y) = xαy1 – α (with α ϵ (0, 1)), faces prices
PX and PY, and has income M. For what range of values of α, will X be a Giffen good?

[5 points]

Answer: Under Cobb-Douglas specification, it is impossible for x to be a Giffen good. The

Q4: Suppose you can work anywhere between 0 to 24 hours per day at a wage of $1 per hour.
You are subject to a tax of 50% on all wages over $5 per day (the first $5 per day is untaxed).
You elect to work 10 hours per day.

(a) Show you budget constraint and the equilibrium point

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 (b) Suppose that the tax law is changed so that all wages are subject to a 25% tax. Do you
now work for more or less than 10 hours? Does the government collect more or less tax
revenue than before?

What do you prefer: the old tax law of the new one?

[10 points]

Answer:

(a) Do this yourself.

(b) You work more hours now, so that the tax revenue increases.

(c) The new tax scheme is better as you could now attain a higher indifference curve.

Q5: For a normal good, is the compensated demand curve steeper than the uncompensated
demand curve? Is the reverse true for an inferior good? Is it true that your compensated and
uncompensated demand curves for bubble gum are likely to be very similar to each other, but
for your college tuition they are likely to be very different?
Yes, for a normal good, the compensated demand curve is steeper than the uncompensated demand curve.
This is because the compensated demand curve only takes into account the substitution effect of a price [5 points]
change, while the uncompensated demand curve also takes into account the income effect.

Answer: The income effect is likely to be smaller for bubble gum. So the uncompensated and
the compensated demand curves are similar. The income effect for college tuition is likely to
be high. Thus, the compensated and the uncompensated demand curves are likely to be
significantly different.

Q6: Currently bread costs $2 per loaf. When the price of bread increases by $0.50, the price
of sandwich spread decreases by $1 and the demand for sandwich spread falls by 10%. Also,
you find that wraps now cost 20% more.

(a) What can you infer about how the three goods above are related (given all the
information)?

(b) Calculate the cross price elasticity of demand between bread and sandwich spread.

(c) What happens to the demand for wraps? If the cross-price elasticity of demand between
bread and wraps is 1.2, find the percentage change in the demand for wraps.

[10 points]

Answer:

(a) Bread and sandwich spread are compliments. Bread and wraps are substitutes.

(b) Cross price elasticity between bread and sandwich spread is –0.4.

(c) Demand for wraps increases by 30%.

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Q7: Suppose you are on a three-day trip to Rome (from Monday to Wednesday) and during
your stay you decide to consume only Waffle and Ravioli (measured on the horizontal and
vertical axes respectively). You have a given amount of money (I) to spend individually on
each of the three days.

(a) Suppose that the price of Waffle rises between Monday and Tuesday. If your optimum
points of consumption on Monday and Tuesday are respectively called M and T, such that M
is to the left of T, what does it say about both the commodities? Illustrate your answer using
an appropriate diagram.

(b) Suppose now, that on Wednesday the price of Waffle returns to its Monday level, but at
the same moment, one of your money bags gets stolen (i.e. you have lower money than I to
spend on Wednesday). You realise that you are just as well off as you were on Tuesday. If W
is the optimum point of consumption on Wednesday, is it to the left or to the right of T?
Validate your argument using an appropriate diagram.

(c) Use your answers to the previous two parts to compare the positions of M and W. What
does it say about Waffles? Does your answer necessarily follow from the previous two parts?

[4 + 4 + 2 points]

Answer: The conclusion is that all Giffen goods are inferior goods.

Q8: Uncle Scrooge felt charitable for a change. He figured that his nephew Louie doesn't believe in
utility maximization. So he gave each of his other two (utility-maximizing) nephews Huey and Dewey
a debit card that allows them to spend Rs. 50 each week (as their pocket money) on two commodities
X and Y. In the first week, the price of X was 1 per unit, and the price of Y was 2 per unit. At these
prices Huey bought 10 units of X and 20 units of Y, and Dewey bought 30 units of X and 10 units of
Y. In the third week, however, uncle Scrooge lost records indicating who had which debit card. From
the bank statement, for the third week, he learned that the price of X was 0.50 and the price of Y was
2.50 per unit. At these prices, one debit card (call it A) was used to purchase 25 units of X and 15
units of Y. The other debit card (call it B) was used to purchase 10 units of X and 18 units of Y. Uncle
Scrooge (being himself), has an urge to know who has which debit card. How will you help him
figure this out (show your arguments carefully)?

[10 points]

Hint: Use the weak axiom of revealed preference as discussed in class.

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