EconS 301 – Intermediate Microeconomics

Review Session #4

1. Suppose a person's utility for leisure (L) and consumption (Y) can be expressed as U = YL and
this person has no non-labor income.

a) Assuming a wage rate of $10 per hour, show what happens to the person's labor supply when the
person wins a lottery prize of $100 per day.

Answer
Plug in what we know to the utility function above, U = YL. Y should express total income
earned and L should express all non-work time per day.
Rearranging yields U = (Y* + 10H) (24 - H) = 24Y* + 240H - Y*H – 10H2.
Maximizing utility with respect to H yields dU/dH = 240 - Y* - 20H = 0. (Remember that where
U=0 it is at its maximum.)
Before winning the lottery, Y* = 0, so H = 12.
After winning the $100 per day lottery, Y* = 100, so H = 7.
Winning the lottery reduces this person's quantity of labor supplied by 5 hours when w = $10.
Intuitively this makes sense because the more wealth they have the less desirable work becomes.
L becomes more attractive with greater wealth.

b) Suppose a person's utility for leisure (L) and consumption (Y) can be expressed as U = Y + L0.5.
Show what happens to the person's labor supply curve when the income tax is cut from 70 % to
30 %. Denote hours worked as H and wage per hour as w.

Answer
Since Y = net income, U = w(1 - t)H + (24-H)0.5. Note that w(1-t) represents real wage.

Maximizing utility with respect to hours worked, H, yields H = 24 - (2(1 - t)w)-2. Any decrease
in t would increase the number of hours worked. Note: This person is a workaholic. Even at a net
wage of $1, this person only relaxes for 3/4 of an hour!

2. Suppose you work for a government agency that is considering removing certain agricultural
subsidies. The removal of these subsidies will increase the price, thus lowering consumers'
welfare. Because only aggregate market data is available, you are unable to measure the exact
values for the compensated and equivalent variation by consumer. However, you are able to
estimate the change in market consumer surplus. Assuming agricultural products are normal
goods, how does your estimate of consumer surplus compare to the unknown EV and CV?
Explain. Under what conditions will the three measures of welfare be close to one another?

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 Answer
For normal goods, the CS will be less than the CV and greater than the EV (in absolute value).
Typically, these measures will be close for (1) small price changes, (2) small income
effects/elasticity, and (3) small budget share. Remember that the CV and EV are used to measure
the change of welfare (income) of the consumer after a price change and that typically the EV and
the CV will not be close in magnitude. This is because most price changes have a nonzero income
effect. Similarly, in the case of a quasi-linear utility function, the CV and EV will be the same
because the income effect is zero.

3. Ed's utility from vacations (V) and meals (M) is given by the function U(V,M) = V2M. Last year,
the price of vacations was $200 and the price of meals was $50. This year, the price of meals
rose to $75, the price of vacations remained the same. Both years, Ed had an income of $1500.

a) Calculate the change in consumer surplus from meals resulting from the change in meal
prices. (Note: we need to compare his optimal consumption baskets before and after the price
change to be able to see the change in CS)

Answer
Ed’s optimization problem is
Max V2M
subject to pMM + 200V = 1500
where pM is the price of meals and the price of vacations is represented by the constant 200.
Using the Lagrangian (solve utility function for V and then plug V into the budget constraint and
solve for M), we derive the demand for meals:
M* = 500/pM
The change in consumer surplus is found from the integral (space under curve):
75
500
∫ dpM = −500 ln( pM ) 50 = −500 ( ln 75 − ln 50 ) = −202.7
75
∆CS =
50
pM
So the change in consumer surplus is –$202.7.

b) What is the compensating variation for the price change in meals?

Answer
Recall the CV is simply the difference in the consumer’s income and the income necessary to
purchase the decomposition basket at the new prices. In this case, the CV is the amount of money
needed to offset a consumer’s harm from a price increase (that is, CV will be additive here
because the consumer will need more money to be equally happy after the price increase as she
was before). So we first need to find his initial optimum basket.

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 max L = V 2 M + λ ( y − pM M − pV V )
δL ⎫
= V 2 − λ pM = 0 ⎪ 2
δM ⎪ V V p
⎬ = = M
δL 2VM 2 M pV
= 2VM − λ pV = 0 ⎪
δV ⎪⎭
2 pM M
V= into the budget constraint
pV
⎛ 2p M ⎞
1500 = pM M − pV ⎜ M ⎟ solving for M,
⎝ pV ⎠
1500 500
= = M plug back into V and solve,
3 pM pM
⎛ 500 ⎞
2 pM ⎜ ⎟
⎝ pM ⎠ 1000
V= =
pV pV

Ed’s utility before the price change is based on his optimal consumption bundle where M1 =
500/50 = 10 and V1 = 1000/200 = 5. Thus, his initial utility is U(5,10)=(5)2(10) = 250. In order
to find the decomposition basket, we need to use the MRS and the initial level of utility. From
V p
above, we know the MRS is = M .
2M pV
Using this and plugging in the new prices we can solve for V in terms of M,
2(75) M 150 M 3M
V= = = .
200 200 4

Plug this result into the utility function when initial utility is 250 and solving for M, 250 =
(3M/4)2M => M= 7.63. Solve for V = 5.72. This is our decomposition basket. The expenditure
required to purchase this bundle is:
75M + 200V = 75(7.63) + 200 (5.72) = 1717.25
(we need total expenditure because CV and EV are measures of income before and after price
change)
Thus the CV is $1,500 - $1,717.25 = $217.25.

c) Calculate the equivalent variation for the price change in meals.

Answer
The EV is similar to the CV, except that we need to find the consumption basket that would put
him on his new utility level holding prices constant (sort of the opposite of the decomposition
basket where the new prices are used holding the initial utility constant). The EV is the amount
of money Ed will pay to prevent the price increase. First we need to find his optimal
consumption basket at new prices so we can find the new level of utility. To do this, simply use
the demand equations we derived in part (b) and plug in the new prices. From above, V = 5 and
M = 500/75 = 6.67. His utility from this bundle is U = (5)2(6.67)=166.75. Now use the MRS and

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 2(50) M 100 M M
new prices to solve for V in terms of M, V = = = . Plug this result into the
200 200 2
utility function with U=166.75 and we can solve for M,
2
⎛M ⎞ M3
166.75 = ⎜ ⎟ M =
⎝ 2 ⎠ 4
667 = M 3
8.74 = M
8.74
V= = 4.37
2

The expenditure of this bundle is:

4. Linda consumes two goods, X and Y . Her utility function is U = XY , with MU X = Y and
MU Y = X . Initially, PX = $18 and PY = $2 . Linda’s income is $288. Then the price of X
falls to $8. [The following questions ask you to calculate a mathematical example of the income
and substitution effects of a price decrease for good X .]
a) Complete the following table.

Basket X Y U = XY MU X PX Expenditure
= PX X + PY Y
MU Y PY
A
B 12 48
C

Answer
For bundle A, For bundle C,
MU X PX MU X PX
= =
MU Y PY MU Y PY
Y 18 9 Y 8 4
= = = =
X 2 1 X 2 1
9X = Y 4X = Y
Px X + PY Y = I Px X + PY Y = I
18 X + 2Y = 288 8 X + 2Y = 288
18 X + 18 X = 288 8 X + 8 X = 288
36 X = 288 16 X = 288
X =8 X = 18
Y = 72 Y = 72

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 Basket X Y U = XY MU X PX Expenditure
= PX X + PY Y
MU Y PY
A 8 72 8 * 72 = 576 Y 72 9 18 18 * 8 + 2 * 72 = 288
= = =
X 8 1 2
B 12 48 12 * 48 = 576 Y 48 4 8 8 *12 + 2 * 48 = 192
= = =
X 12 1 2
C 18 72 18 * 72 = 1296 Y 72 4 8 8 *18 + 2 * 72 = 288
= = =
X 18 1 2

b) The movement from point A to point B illustrates which effect, the income effect or the
substitution effect? Explain.

Answer
The movement from point A to point B illustrates the substitution effect because the consumer
moves along the same indifference curve (notice that total utility remains constant) to the new
tangency point between the original indifference curve and the new budget constraint (where
PX = $8 ). That is, we are looking at the change in optimal choice induced solely by the change
in the price relationship between x and y and not any change due to a change in income.

c) The movement from point B to point C illustrates which effect, the income effect or the
substitution effect? Explain.

Answer
The movement from point B to point C illustrates the income effect because the consumer moves
to a higher indifference curve. Point C represents the new tangency point between the new
budget constraint and the new indifference curve. Here, we look solely at how the income change
affects the optimal choice for this consumer. (Notice that the slope of the budget constraint does
not change between points B and C but that the utility does.)

d) Is good X a normal, inferior, or Giffen good? Explain.

Answer
Good X is a normal good because as “income” increases from point B to point C, Linda
consumes more X . Remember that the gap between B and C is solely measuring the effect of
increased income (income effect) so we can use it to make conclusions on whether a good is
giffen or normal. Note that the change between bundle A and bundle B could not be used to
check this.

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5. If x is an inferior good and the price of x rises
a. The substitution effect will induce the consumer to purchase more x and the income
effect will induce the consumer to purchase more x .
b. The substitution effect will induce the consumer to purchase more x and the income
effect will induce the consumer to purchase less x .
c. The substitution effect will induce the consumer to purchase less x and the income effect
will induce the consumer to purchase more x .
d. The substitution effect will induce the consumer to purchase less x and the income effect
will induce the consumer to purchase less x .

Answer
Recall that with inferior goods, the income and substitution effects move in opposite directions.
So immediately you can eliminate choices A and D. Now consider the example given in figure
5.8.

In this figure, we have a price decrease and we can see that the substitution effect (bundle A to B)
causes the consumer to purchase more. Similarly, we can see the income effect (bundle B to C)
causes the consumer to purchase less. Again this is for a price decrease. So for a price increase,
you simply change the direction of the effects. So in our case, the SE results in less x and the IE
results in more x, thus the answer is choice C.

6. Rich purchases two goods, food and clothing. He has a diminishing marginal rate of substitution
of food for clothing. Let x denote the amount of food consumed and y the amount of clothing.
Suppose the price of food increase from Px1 to Px2. On a clearly labeled graph, illustrate the
income and substitution effects of the price change on the consumption of food. Do so for each
of the following cases:
a. Food is a normal good.
b. The income elasticity of demand for food is zero.

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 c. Food is an inferior good, but not a Giffen good.
d. Food is a Giffen good.

Answer

7. Suppose that Bart and Homer are the only people in Springfield who drink 7-UP. Moreover, their
inverse demand curves for 7-UP are, respectively, P=10-4QB and P=25-2QH, and, of course,
neither one can consume negative amounts. Write down the market demand curve for 7-UP in
Springfield, as a function of all possible prices.

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 Answer
Recall that the market demand is simply the horizontal summation (adding in x and not in y) of
all the individual demand curves. That is, you sum the quantities demanded. We have the
inverse demand equations, so we need to solve each for their respective quantities,

P = 10 − 4QB
4QB = 10 − P
⎧ 2.5 − .25P when P < 10
QB = ⎨
⎩0 when P ≥ 10
and
P = 25 − 2QH
2QH = 25 − P
⎧12.5 − .5 P when P < 25
QH = ⎨
⎩0 when P ≥ 25
now sum QH and QB ,
Qmarket = QB + QH = 2.5 − .25P + 12.5 − .5P = 15 − .75P
⎧15 − .75 P when P < 10
⎪
Qmarket = ⎨12.5 − .5 P when 10 ≤ P < 25
⎪0 when P ≥ 10
⎩
For a graphical representation refer to Figure 5.21. Notice the “kink” once one consumer’s maximum
price is reached.