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Problem Set For TA Session 4 (041124) Solutions

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23 views4 pages

Problem Set For TA Session 4 (041124) Solutions

Uploaded by

Veronika Zera
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Problem set for TA session 4 (041124)

Solutions

Question 1:

Consider an individual who can choose consumption of two goods X 1 and X 2 .

a) What is the individual’s indifference curve. Explain. Illustrate graphically.

Solution: An individual’s indifference curve are combinations of the two goods X 1 and X 2
that corresponds to a given utility level. The further to the right the indifference curve is in
the graph below, the higher is the individual’s utility level.

b) What is the marginal rate of substitution (MRS)?


Solution: MRS is how many units of one good the individual is willing to sacrifice in order to
obtain one more unit of the other good. MRS is the slope of the individual’s indifference
curve.
Assume that the individual’s preferences for the two goods can be described by the
following utility function:
'
0, 5 0 ,5
UX ' '
U ( X 1 , X 2)=2 X 1 X . MRS=
2 '
1
. U X is the marginal utility of X 1 , while U X is the marginal
U X2
1 2

utility of X 2 .

c) Derive the marginal rate of substitution.

Question 2:

a) Illustrate graphically how an individual’s preferences for consumption today(C 1) versus


consumption in the future(C ¿¿ 2)¿. can be presented.
Solution: The indifference curve I 0shows combinations of consumption today (C 1 ¿ and
consumption in the future (C 2 ¿ that gives the same utility level for the individual.

b) Explain how the indifference curve changes if the individual’s preferences changes in the
direction of the future and at the cost of consumption today. That is, if the individual tends
to prefer to postpone consumption more than before.
Solution: The change in preferences menas that consumption today becomes less important
relative to consumption in the future. This gives a flatter indifference curve (I 1) . The slope (in
absolute terms) decreases. The interpretation is the that the individual is willing to sacrifice
more consumption today for an increase in future consumption.

Question 3:
Consider an individual who finances consumption in period 1 with borrowing. The loan must
be repaid in period 2.
a) Illustrate the individual’s budget constraint (feasible frontier) and the consumption
possibility set (feasible set) in a graph.
Solution:
b) Use the graph in the figure you constructed in a) to discuss the effects on the feasibility
frontier and the feasibility set of increased interest rates.
Solution. The slope of the feasibility fronter is –(1+r). When the interest rate increases the
feasibility frontier becomes steeper and it shifts to the left. The increase in the interest rates
reduces the individual’s consumption possibility/feasible set. Consumption in the first period
must fall.

Question 4:
a) Explain why individuals tend to smooth their consumption over time.
Solution: This follows since the marginal utility of consumption is decreasing. The effect on
utility from one extra unit of consumption is positive but decreasing. Therefore consumers
want to avoid high consumption in one period and low consumption in another period.
Consider the below graph.
b) Why do the indifference curves (I0 og I1) bend towards origo?
Solution: This is because of decreasing marginal utility of consumption in each period. The
more is consumed in period 1, the less extra utility the consumer gains from consumption of
one extra unit. Therefore the relative increase in utility from extra consumption in the next
period increases. MRS (the marginal rate of substitution), which is the ratio of the marginal
utility of consumption in period 1 to period 2, falls. The MRS is the slope of the indifference
curves.
c) Explain why point A represents the optimal choice for the consumer. Also explain why
point B cannot be an optimal choice.
Solution: A is the optimal choice. In A the indifference curve is tangent to the budget curve
(the feasibility frontier). The individual cannot obtain a higher utility since higher indifference
curves are outside the feasibility set. B cannot be an optimal choice. The individual can
obtain a higher utility on a higher indifference curve by choosing a different allocation of
consumption in the two periods. Note that in in B, the indifference curve is flatter than the
budget line. The consumer can therefore reduce consumption in period 1 and obtain a larger
increase in consumption in period 2 than what is necessary to compensate for the loss in
utility in period 1.

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