MICROECONOMICS I (TSUNG-SHENG TSAI) FALL 2021

Midterm Exam
2021.11.22
1. [20%] In each of the following questions, consider a consumer (he) who consumes only two goods,
good 1 (𝑥1 ) and good 2 (𝑥2 ), whose prices are 𝑝1 and 𝑝2 , respectively. He has a positive income 𝐼.
Determine whether each of the following statements is TRUE or FALSE.
a. [5%] When 𝑝1 = 2, 𝑝2 = 3, 𝐼 = 30, he chooses (𝑥1 , 𝑥2 ) = (6, 5). Then his preference must
violate monotonicity.
b. [5%] Suppose that his preference satisfies strict monotonicity but violates convexity. Then in the
optimum, the marginal rate of substitution (𝑀𝑅𝑆12 ) is not equal to the price ratio 𝑝1 /𝑝2.
c. [5%] Suppose that 𝑥1 and 𝑥2 are perfect complements. Then the price-consumption curve and
the income-consumption curve are indeed the same.
d. [5%] Suppose that the demand function for good 1 is 𝑥1 (𝑝1 , 𝑝2 , 𝐼) = 𝑎𝐼/𝑝1 for any 𝑝1, where 𝑎
is some positive number. Then good 2 must be a normal good.

2. [25%] There are two kinds of cigarettes in the market, electronic cigarettes (𝑥1 ) and regular cigarettes
(𝑥2 ). There are two consumers, Amy and Billy, who have the following utility functions:
Amy: 𝑢𝐴 (𝑥1 , 𝑥2 ) = √𝑥1 ⋅ 𝑥2 , Billy: 𝑢𝐵 (𝑥1 , 𝑥2 ) = 𝑥1 + 𝑥2 .
Amy considers e-cigarettes and regular cigarettes to be “imperfect” substitutes, while Billy thinks that
they are perfect substitutes. The prices of e-cigarettes and regular cigarettes are 𝑝1 and 𝑝2 ,
respectively. They each have the same income 𝐼.
a. [8%] For each consumer, set up the maximization problem. Find Amy’s demand functions,
𝑥1𝐴 (𝑝1 , 𝑝2 , 𝐼) and 𝑥2𝐴 (𝑝1 , 𝑝2 , 𝐼), and Billy’s demand functions 𝑥1𝐵 (𝑝1 , 𝑝2 , 𝐼) and 𝑥2𝐵 (𝑝1 , 𝑝2 , 𝐼).
b. [4%] Draw the demand curve for e-cigarettes for each consumer. Does it always satisfy the “law of
demand”? Explain why or why not.
c. [8%] Recently, there are many cases of lung injuries and deaths associated with e-cigarettes.
Therefore, the Center for Disease Control (CDC) considers regulating the consumption of e-
cigarettes. Suppose that currently, 𝑝1 = 1, 𝑝2 = 4 and 𝐼 = $30. The CDC considers adopting
one of the following two policies:
Policy 1: A limit of consumption. Keeping the prices unchanged, every consumer is prohibited
from buying more than 5 units of e-cigarettes, i.e., 𝑥1 ≤ 5. A violator needs to pay a fine of $30.
Policy 2: A “sin tax” on e-cigarettes. The CDC imposes a tax rate of $1 for each unit of e-cigarettes
so that their price becomes 𝑝1′ = 2.
Does Amy prefer Policy 1 or Policy 2? How about Billy?
d. [5%] Suppose that the CDC maximizes the total utility of the two consumers, 𝑢𝐴 + 𝑢𝐵 , in
determining which policy to be adopted. Then which policy is preferable to the CDC? Does this
policy also make the total consumption of e-cigarettes lower than the other policy? Explain your
finding. (Note: you do not have to consider the tax revenue incurred in Policy 2.)

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MICROECONOMICS I (TSUNG-SHENG TSAI) FALL 2021

3. [30%] Fiona has a budget 𝐼 to be spent at a beauty parlor. She is buying two products: skin care
products (𝑥1 ) and hair products (𝑥2 ). She has the following utility function:
𝑢(𝑥1 , 𝑥2 ) = 𝑥1 + 𝑥2 + 𝑥1 𝑥2 .
Suppose that the prices of 𝑥1 and 𝑥2 are 𝑝1 and 𝑝2 , respectively.
a. [4%] Find the 𝑀𝑅𝑆12 of this utility function. Draw some of the indifference curves.
b. [4%] Determine whether or not the preference represented by this utility function satisfies strict
monotonicity and strict convexity.
c. [7%] Set up her maximization problem. Find the demand functions for 𝑥1 and 𝑥2 .
d. [4%] Draw the demand curve for 𝑥1 . Does it always satisfy the “law of demand”? Explain your
finding.
e. [4%] Let 𝑝1 𝑥1 and 𝑝2 𝑥2 be her “expenditures” on skin care products and hair products. Compare
𝑝1 𝑥1 and 𝑝2 𝑥2 . Explain your finding.
f. [7%] Suppose that currently, 𝑝1 = 1, 𝑝2 = 2 and 𝐼 = 13 . However, the price of skin care
products is about to increase to 𝑝1′ = 2. Other things remain unchanged. Identify the total effect,
substitution effect and income effect in terms of 𝑥1 due to the price change. Draw a figure to show
them. (Note: you need to precisely compute the value of each effect.)

4. [25%] David lives for two periods, period 1 and period 2. In the beginning of period 1, he needs to
decide the consumption in each period, 𝑐1 and 𝑐2 . His preference can be represented by the following
utility function:
𝑢(𝑐1 , 𝑐2 ) = 23.1(ln 𝑐1 ) + 𝑐2 .
His incomes in period 1 and period 2 are 𝐼1 = $20 and 𝐼2 = $22, respectively. He can save and
borrow money from the bank at the same interest rate 𝑟 = 10%.
a. [7%] Set up his maximization problem. Find the optimum (𝑐1∗ , 𝑐2∗ ). Is he a saver or a borrower?

For the following questions b.-d., consider the situation where the interest rate is expected to reduce to
𝑟 ′ = 5%. Other things remain unchanged.
b. [3%] Find the new optimum (𝑐1′ , 𝑐2′ ) after the change. By comparing with a., discuss how this
change will affect his consumption in each period and the role of being a saver or a borrower.
c. [7%] Precisely compute the total effect, income effect, and substitution effect caused by the change
in terms of 𝑐1. Draw a figure to show these effects. Provide an economic explanation for each effect.
d. [3%] Will he be better off or worse off due to this change? Explain your answer.
e. [5%] Suppose that the interest rate remains 𝑟 = 10%, but his income in the first period will
increase to 𝐼1′ = 25. By comparing with (𝑐1∗ , 𝑐2∗ ) that you found in a., discuss how this change will
affect his consumption in each period and the role of being a saver or a borrower. Draw a figure to
show the change. Explain your finding.

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MICROECONOMICS I (TSUNG-SHENG TSAI) FALL 2021

Answer Key to Midterm Exam

1. a. 𝑥2 True. The chosen bundle (𝑥1 , 𝑥2 ) = (6, 5) is affordable because 2 ⋅ 6 +
10 3 ⋅ 5 = 27 < 30. There are some other bundles that are also affordable but
not chosen, such as (6.5, 5.5), which is on the budget line. This means that
(6, 5) (6.5, 5.5) (6, 5) ≻ (6.5, 5.5) . However, this implies that his preference does not
satisfy “the more, the better,” i.e., monotonicity, because (6.5, 5.5) has a
15 𝑥1 strictly larger amount of each good than (6, 5).
b. 𝑥2 𝑥2 False. The preferences in both figures satisfy [SM]
𝑒 Case A Case B but violate convexity [C]. The difference between
𝑒 these two cases is that in Case A, [C] is violated
𝑒′
everywhere, while in Case B, [C] is violated only
𝑥1 𝑥1 in some part of the indifference curve.
As we can see in the figures, in Case A, the optimal choice is at the corner 𝑒; however, 𝑀𝑅𝑆12 ≠
𝑝1 /𝑝2 at this point. Another interior point like 𝑒′ satisfies 𝑀𝑅𝑆12 = 𝑝1 /𝑝2 but it is not optimal.
By contrast, in Case B, the optimal choice 𝑒 is interior, at which 𝑀𝑅𝑆12 = 𝑝1 /𝑝2 is also satisfied.
That is, a preference that violates [C] does not necessarily mean that 𝑀𝑅𝑆12 ≠ 𝑝1 /𝑝2.
c. 𝑥2 𝑥2
True. The price-consumption curve (PCC) is the path
𝐼𝐶𝐶 𝑃𝐶𝐶
that depicts the optimal choices under different prices.
The income-consumption curve (ICC) is the path that
𝑒 𝑒
depicts the optimal choices under different incomes.
𝑥1 𝑥1
When 𝑥1 and 𝑥2 are perfect complements, the optimal choices always have 𝑥1 and 𝑥2
consumed in a fixed ratio. As we can see from the figures, the optimal choice 𝑒 does not change
under different prices, which means that there is no substitution effect. Therefore, PCC and ICC are
indeed the same curve, both of which reflect only the income effect.
d. False. If a preference satisfies [SM], then the optimal choice must satisfy the budget constraint
𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝐼. Then for 𝑥1 (𝑝1 , 𝑝2 , 𝐼) = 𝑎𝐼/𝑝1 to be a legitimate demand function, it must be
𝑎 ≤ 1, because if 𝑎 > 1 otherwise, he overspends and the budget constraint is violated. Then
𝜕𝑥2
𝑥2 (𝑝1 , 𝑝2 , 𝐼) = (1 − 𝑎)𝐼/𝑝2 . If 0 < 𝑎 < 1, then 𝑥2 is a normal good because > 0. However,
𝜕𝐼

if 𝑎 = 1, he will not buy any 𝑥2 , which means that 𝑥2 is either a neutral good or a bad. In this case,
𝑥2 is not a normal good.
If the preference does not satisfy [SM], then he may not use up all his money, and so the optimal
choice may not satisfy the budget constraint. In such a case, we have no enough information to tell
whether or not 𝑥2 is a normal good.

2. a. Amy’s maximization problem is: max 𝑢(𝑥1 , 𝑥2 ) = √𝑥1 ⋅ 𝑥2 , 𝑠. 𝑡. 𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝐼. Since her

𝑥1 , 𝑥2

preference satisfies [SM] and [SC], we can apply the Lagrange method.

The Lagrange is max ℒ = √𝑥1 ⋅ 𝑥2 + 𝜆(𝐼 − 𝑝1 𝑥1 − 𝑝2 𝑥2 ).

𝑥1 , 𝑥2

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MICROECONOMICS I (TSUNG-SHENG TSAI) FALL 2021

𝑥2 𝑥2 𝑝
FOCs: = 𝜆𝑝1 … ①, √𝑥1 = 𝜆𝑝2 … ②. ① and ② imply = 𝑝1 . By substituting this into
2√𝑥1 2𝑥1 2

𝐼 2𝐼
the budget constraint, we obtain 𝑥1𝐴 (𝑝1 , 𝑝2 , 𝐼) = 3𝑝 and 𝑥2𝐴 (𝑝1 , 𝑝2 , 𝐼) = 3𝑝 .
1 2

Billy’s maximization problem is: max 𝑥1 + 𝑥2 , 𝑠. 𝑡. 𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝐼.

𝑥1 , 𝑥2

Since both the indifference curve and the budget constraint are linear, the solution is such that he
uses all his income to buy the good whose price is lower, namely:
0 if 𝑝1 > 𝑝2 ; 𝐼
if 𝑝1 > 𝑝2 ;
𝐼 𝑝2
𝑥1𝐵 (𝑝1 , 𝑝2 , 𝐼) = [0, 𝑝1 ] if 𝑝1 = 𝑝2 ; and 𝑥2𝐵 (𝑝1 , 𝑝2 , 𝐼) = [0, ] if 𝑝 = 𝑝 ;
𝐼
𝑝2 1 2
𝐼
{ 𝑝 if 𝑝1 < 𝑝2 . { 0 if 𝑝 < 𝑝 .
1 1 2

b. Amy’s and Billy’s demand curves for 𝑥1 are shown in the following figures:
𝑝1 𝑝1 For Amy, the “law of demand” is always satisfied, in that
the quantity demand increases when the price is lower.
𝑝2 However, the law of demand is not always satisfied for
𝐷𝐴𝑚𝑦 𝐷𝐵𝑖𝑙𝑙𝑦 Billy, particularly when 𝑝1 > 𝑝2 . In such a case, 𝑝1 is
𝑥1 𝑥1 so high that he will not consume any 𝑥1 . Therefore, even
when it is cheaper, he does not increase his purchase.
∗ ∗ )
c. When 𝑝1 = 1, 𝑝2 = 4 and 𝐼 = 30, Amy’s optimal choice is (𝑥1𝐴 , 𝑥2𝐴 = (10, 5), and Billy’s
∗ ∗
optimal choice is (𝑥1𝐵 , 𝑥2𝐵 ) = (30, 0) since 𝑝1 < 𝑝2 .
For Amy: under Policy 1 (which requires 𝑥1 ≤ 5), she will choose (𝑥1𝐴 , 𝑥2𝐴 ) = (5, 6.25), from
𝑝𝑜𝑙𝑖𝑐𝑦 1
which she will obtain a utility of 𝑢𝐴 = 6.25√5. Under Policy 2 (in which 𝑝1′ = 2), she will
𝑝𝑜𝑙𝑖𝑐𝑦 2
choose (𝑥1𝐴 , 𝑥2𝐴 ) = (5, 5), from which she will obtain a utility of 𝑢𝐴 = 5√5. Thus, Amy
prefers Policy 1 since 6.25√5 > 5√5.
For Billy: under Policy 1, he will choose (𝑥1𝐵 , 𝑥2𝐵 ) = (5, 6.25), from which she will obtain a utility
𝑝𝑜𝑙𝑖𝑐𝑦 1
of 𝑢𝐵 = 11.25. Under Policy 2, she will choose (𝑥1𝐵 , 𝑥2𝐵 ) = (15, 0), from which she will
𝑝𝑜𝑙𝑖𝑐𝑦 2
obtain a utility of 𝑢𝐵 = 15. Thus, Billy prefers Policy 2 since 11.25 < 15.
d. For CDC: the total utilities under different policies are:
𝑝𝑜𝑙𝑖𝑐𝑦 1 𝑝𝑜𝑙𝑖𝑐𝑦 1
Under Policy 1, 𝑢𝐴 + 𝑢𝐵 = 6.25√5 + 11.25 ≈ 25.23.
𝑝𝑜𝑙𝑖𝑐𝑦 2 𝑝𝑜𝑙𝑖𝑐𝑦 2
Under Policy 2, 𝑢𝐴 + 𝑢𝐵 = 5√5 + 15 ≈ 26.18. Thus, Policy 2 is better for CDC.
The total consumptions of e-cigarettes under different policies are::
Under Policy 1, 𝑥1𝐴 + 𝑥1𝐵 = 5 + 5 = 10; under Policy 2, 𝑥1𝐴 + 𝑥1𝐵 = 5 + 15 = 20.
Policy 2 is less effective in reducing the consumption of e-cigarettes than Policy 1.
The intuition for this result is the following. Although Policy 2 increases the price of e-cigarettes, it
is still relatively cheaper than regular cigarettes, and so Billy still consumes a large amount of e-
cigarettes, which gives him a higher utility and can compensate the disliking of Amy compared to
Policy 1. On the other hand, Policy 1 gives a much tighter restriction on Billy’s consumption of e-
cigarettes so that it reduces his utility more substantially.

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 MICROECONOMICS I (TSUNG-SHENG TSAI) FALL 2021

3. a. 𝑥2 𝑀𝑈1 1+𝑥2
For 𝑢(𝑥1 , 𝑥2 ) = 𝑥1 + 𝑥2 + 𝑥1 𝑥2 , 𝑀𝑅𝑆12 = − =− . Since
𝑥 𝑀𝑈2 1+𝑥1

|𝑀𝑅𝑆12 | is decreasing in 𝑥1 and increasing in 𝑥2 , the indifference

𝑧 curves are convex to the origin, as shown in the figure.
𝑦
𝑥1
b. Since 𝑀𝑈1 = 1 + 𝑥2 > 0 and 𝑀𝑈2 = 1 + 𝑥1 > 0 for any 𝑥1 , 𝑥2 > 0, the more 𝑥1 and/or 𝑥2
that she consumes, the higher the utility is. Thus, the preference satisfies [SM].
Moreover, since the indifference curves are convex to the origin, for any three consumption bundles
𝑥, 𝑦, 𝑧 on the same indifference curve, we have 𝑥 ≽ 𝑧 and 𝑦 ≽ 𝑧 ⟹ 𝑡𝑥 + (1 − 𝑡)𝑦 ≻ 𝑧 for 𝑡 ∈
(0,1) due to [SM]. Thus, [SC] also holds.
c. Her maximization problem is: max 𝑥1 + 𝑥2 + 𝑥1 𝑥2 , 𝑠. 𝑡. 𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝐼.
𝑥1 , 𝑥2

The Lagrange is max ℒ = 𝑥1 + 𝑥2 + 𝑥1 𝑥2 + 𝜆(𝐼 − 𝑝1 𝑥1 − 𝑝2 𝑥2 ).

𝑥1 , 𝑥2

1+𝑥2 𝑝
The FOCs imply = 𝑝1. By substituting this into the budget constraint, the “interior” solution is
1+𝑥1 2

𝐼+𝑝2 −𝑝1 𝐼+𝑝1 −𝑝2

𝑥1∗ = and 𝑥2∗ = . However, the solution may be at the corner since it is required that
2𝑝1 2𝑝2

𝑥1∗ , 𝑥2∗ ≥ 0. Therefore, the demand functions are:

𝐼+𝑝2 −𝑝1
if 𝐼 + 𝑝2 − 𝑝1 > 0 and 𝐼 + 𝑝1 − 𝑝2 > 0,
2𝑝1
𝑥1 (𝑝1 , 𝑝2 , 𝐼) = 𝐼
if 𝐼 + 𝑝2 − 𝑝1 > 0 and 𝐼 + 𝑝1 − 𝑝2 ≤ 0,
𝑝1
{ 0 if 𝐼 + 𝑝2 − 𝑝1 ≤ 0.
𝐼+𝑝1 −𝑝2
if 𝐼 + 𝑝1 − 𝑝2 > 0 and 𝐼 + 𝑝2 − 𝑝1 > 0,
2𝑝2
𝑥2 (𝑝1 , 𝑝2 , 𝐼) = 𝐼
if 𝐼 + 𝑝1 − 𝑝2 > 0 and 𝐼 + 𝑝2 − 𝑝1 ≤ 0,
𝑝2
{ 0 if 𝐼 + 𝑝1 − 𝑝2 ≤ 0.
d. The demand curve for 𝑥1 is shown in the figure. When 𝑝1 is very small, i.e., 𝑝1 < −𝐼 + 𝑝2 ,
𝑝1 she only consumes 𝑥1 (but this part disappears if 𝐼 > 𝑝2 ). When 𝑝1 is
intermediate, i.e., −𝐼 + 𝑝2 < 𝑝1 < 𝐼 + 𝑝2 , she consumes both goods. The law
𝐼 + 𝑝2 of demand holds for these two cases. However, when 𝑝1 is sufficiently large,
i,e, 𝑝1 ≥ 𝐼 + 𝑝2 , the price is so high that he won’t consume any 𝑥1 . Therefore,
−𝐼 + 𝑝2 𝐷1 even when 𝑥1 becomes cheaper, the quantity demanded does not increase.
𝑥1 The law of demand does not hold for this part.
e. When 𝐼 + 𝑝2 − 𝑝1 > 0 and 𝐼 + 𝑝1 − 𝑝2 > 0, she consumes both goods. Then the expenditures on
each good are 𝑝1 𝑥1∗ = (𝐼 + 𝑝2 − 𝑝1 )/2 and 𝑝2 𝑥2∗ = (𝐼 + 𝑝1 − 𝑝2 )/2 . It is easy to show that
𝑝1 𝑥1∗ ⋛ 𝑝2 𝑥2∗ if 𝑝1 ⋚ 𝑝2 . That is, she spends more on skin care products (𝑥1 ) if it is cheaper than
hair products (𝑥2 ), and vice versa.
There are two opposite effects when 𝑝1 < 𝑝2 : on the one hand, the expenditure on skin care products

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MICROECONOMICS I (TSUNG-SHENG TSAI) FALL 2021

can be lower apparently because skin care products are cheaper. On the other hand, she also buys
more skin care products because of the lower price. It turns out that the second effect dominates the
first one so that the expenditure on skin care products is higher. The cases for 𝑝1 > 𝑝2 and 𝑝1 =
𝑝2 are analogous.
In the case when 𝑥1 is much cheaper, i.e., 𝑝1 < −𝐼 + 𝑝2 , she buys only skin care products, and it
is trivial that 𝑝1 𝑥1∗ > 𝑝2 𝑥2∗ .
f. The current status, 𝑝1 = 1, 𝑝2 = 2 and 𝐼 = 13, belongs to the case 𝐼 + 𝑝2 − 𝑝1 > 0 and 𝐼 +
𝑝1 − 𝑝2 > 0. Then the optimal choice is (𝑥1∗ , 𝑥2∗ ) = (7, 3), where she obtains utility of 𝑢 = 31.
When the price of 𝑥1 increases to 𝑝1′ = 2, the new optimal choice is (𝑥1′ , 𝑥2′ ) = (3.25, 3.25).
To identify the substitution effect and income effect, we solve the following minimization problem:

min 2𝑥1 + 2𝑥2 , 𝑠. 𝑡. 𝑥1 + 𝑥2 + 𝑥1 𝑥2 = 31.

𝑥2 auxiliary line 𝑥1 , 𝑥2
6.5
1+𝑥2
𝒆′′ The FOCs imply = 1 ⟹ 𝑥1 = 𝑥2 . Then the solution is
1+𝑥1

3.25 𝒆′ 𝑥1′′ = 𝑥2′′ = 4√2 − 1. Thus, in terms of 𝑥1 :

3 𝒆
Total effect (TE): 𝑥1′ − 𝑥1∗ = 3.25 − 7 = −3.75.
3.25 4√2 − 1 7 𝑥1 Substitution effect (SE): 𝑥1′′ − 𝑥1∗ = 4√2 − 1 − 7 = 4√2 − 8 ≈ −2.34.
𝑥1′ 𝑥1′′ 𝑥1∗
Income effect (IE): 𝑥1′ − 𝑥1′′ = 3.25 − (4√2 − 1) = 4.25 − 4√2 ≈ −1.41.

2 2 𝑐 𝐼
4. a. His maximization problem is: max 23.1(ln 𝑐1 ) + 𝑐2 , 𝑠. 𝑡. 𝑐1 + 1+𝑟 = 𝐼1 + 1+𝑟 .
𝑐1 , 𝑐2

2 2 𝐼 𝑐
The Lagrange: max ℒ = 23.1(ln 𝑐1 ) + 𝑐2 + 𝜆 [𝐼1 + 1+𝑟 − 𝑐1 − 1+𝑟 ].
𝑐1 , 𝑐2

23.1
The FOCs yield 𝑐1∗ = 1+𝑟 and 𝑐2∗ = (1 + 𝑟)𝐼1 + 𝐼2 − 23.1.

Thus, when 𝐼1 = 20, 𝐼2 = 22, and 𝑟 = 10%, (𝑐1∗ , 𝑐2∗ ) = (21, 20.9).
Since 𝑐1∗ > 𝐼1 , he is a borrower.
23.1
b. When 𝑟′ = 5%, the optimal solution is 𝑐1′ = 1.05 = 22, 𝑐2′ = 20(1.05) + 22 − 23.1 = 19.9. Since

𝑐1′ > 𝐼1 , he is still a borrower.

c. When 𝑟 decreases to 𝑟′, the budget line becomes flatter.
𝑐2 Note that the optimal choice of 𝑐1 only depends on the interest
𝐵𝐿𝑟=10% rate 𝑟 . That is, the choice 𝑐1′′ at point 𝑒′′ under the new
𝐵𝐿𝑟′=5% interest rate 𝑟′ = 5% when maintaining the original utility
23.1
𝐼2 level is the same as 𝑐1′: 𝑐1′′ = 1.05 = 22.
𝑐2∗ 𝒆′ TE = 𝑐1′ − 𝑐1∗ = 22 − 21 = 1.
𝑒 𝒆′′ 𝑢′ SE = 𝑐 ′′ −𝑐 ∗ = 22 − 21 = 1.
1 1
𝑢 IE = 𝑐1′ −𝑐1′′ = 22 − 22 = 0.
𝐼1 𝑐1∗ 𝑐1′′ = 𝑐1′ 𝑐1

4
MICROECONOMICS I (TSUNG-SHENG TSAI) FALL 2021

Substitution effect: when 𝑟 decreases, the opportunity cost of 𝑐1 decreases, and so he will consume
more 𝑐1 and fewer 𝑐2 .
Income effect: due to the property of the quasi-linear preference, his first-period consumption only
depends on 𝑟, and so there is no income effect because the choices are under the same price.
Thus, the total effect is completely due to the substitution effect.
d. Since 𝑒 and 𝑒 ′′ are on the same indifference curve, we know 𝑒 ∼ 𝑒′′. We also know that 𝑒′ ≻ 𝑒′′
because while 𝑐1 remains the same, 𝑐2 increases. Thus, his utility increases after the reduction of
𝑟. Intuitively, since he is a borrower, a reduction in the interest rate means that his the “real” income
is higher than before, so he feels better off.
e. 𝑐2 The new optimum (𝑐1∗∗ , 𝑐2∗∗ ) after income increases is 𝑐1∗∗ = 𝑐1∗ =
23.1
= 21 < 𝐼1′ = 25, and 𝑐2∗∗ = 26.4, which means that he is a saver.
1.1
𝒆′ Again, since his first-period consumption only depends on 𝑟, when
𝐼2 𝒆 the first-period income increases to a great extent, he becomes a saver
and spends all the extra money in the second period. This comes from
𝐼1 𝑐1∗ 𝐼1′ 𝑐1 an income effect.
𝑐∗∗
1