Intermediate Microeconomics Assignment 2

ECON2210 Fall 2023

Suggested answers

1. For pedagogical purpose, we first approach this problem mathematically. Let (x̂1 , x̂2 )
be the marked bundle on the budget line. x̂2 = 12 because it is at the same vertical
level as the bundle D. (x̂1 , 12) is on the budget line, thus

p1 x̂1 + p2 · 12 = 80

We then calculate the cost of bundle D

p1 · 10 + p2 · 12 = 74

Taking the difference between the two equations

p1 (x̂ − 10) = 80 − 74 = 6
6
⇒ ∆x1 = x̂ − 10 = = 1.2
p1

In words, bundle D costs only $74 and $6 is left unspent. If the household spends
the remaining $6 on good 1, she can buy 6
p1 = 1.2 more units. This is precisely the
economics meaning of ∆x1 .

2. (a) First, notice that the bundle (64, 3, 0) is on the budget line. We can attain a
higher utility level only by reallocating the expenditure between goods. The
marginal utilities for all goods are given by
√
M U1 = 12 √xx21 ; M U2 = x1 + x3 ; M U3 = x2

At the given bundle, the marginal utilities per dollar spent are given by
M U1 (64, 3, 0) 13 3 M U2 (64, 3, 0) 8 2 M U3 (64, 3, 0) 3
= = ; = = ; =
p1 28 16 p2 12 3 p3 4

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 Hence,
M U1 (64, 3, 0) M U2 (64, 3, 0) M U3 (64, 3, 0)
< <
p1 p2 p3
The household can increase her utility by reallocating an incremental amount
of expenditure from good 1 to good 3. That is, increasing x3 and decreasing x1
simultaneously.

She can also increase her utility by reallocating an incremental amount of

expenditure from good 1 to good 2, or from good 2 to good 3.
(b) First, notice that the bundle (16, 4, 9) is on the budget line. We now look at how
to reallocate the expenditure between goods. Using the expressions of marginal
utilities in the previous part, we obtain the marginal utilities per dollar spent
at the given bundle
M U1 (16, 4, 9) M U2 (16, 4, 9) M U3 (16, 4, 9)
= 21 ; = 13
12 ; =1
p1 p2 p3
Hence,
M U1 (16, 4, 9) M U3 (16, 4, 9) M U2 (16, 4, 9)
< <
p1 p3 p2
The household can increase her utility by reallocating an incremental amount
of expenditure from good 1 to good 2. That is, increasing x2 and decreasing x1
simultaneously.

She can also increase her utility by reallocating an incremental amount of

expenditure from good 1 to good 3, or from good 3 to good 2.
(c) The bundle (4, 4, 10) is not on the budget line. 4 + 12 × 4 + 4 × 10 = 92 < 100.
The household can increase her utility by spending the remaining 8 dollars on
any of the goods, say increase x1 , x2 and x3 at the same time.

3. (a) U (x1 , x2 ) = x1 + x2 − exp(−2x1 ) represents a quasilinear preference

M U1 (x1 , x2 ) = 1 + 2 exp(−2x1 ); M U2 (x1 , x2 ) = 1

Since exp(−2x1 ) > 0, we conclude that for every point on the budget line,
2
M RS12 (x1 , x2 ) = 1 + 2 exp(−2x1 ) > 1 > 5

We have the corner solution x

e1 = 50 and x
e2 = 0.

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 40 1
(b) U (x1 , x2 ) = 1 − x1 − x2
 x 2
40 1 2
M U1 = (x1 )2
; M U2 = (x2 )2
;
M RS12 (x1 , x2 ) = 40
x1
Inspecting the expression of MRS, we learn that the indifference curves never
touch the two axes. The optimal bundle must be an interior solution. The
tangency condition is given by
 x 2
2
40 = 25 ⇔ x1 = 10x2
x1
Substitute it into the budget line, we solve out x
e1 = 40 and x
e2 = 4. It is indeed
an interior solution.
x1 x2 1 1
(c) U (x1 , x2 ) = = . h(u) = 1−u is a strictly increasing
40x2 + x1 1 − [1 − x401 − x12 ]
function. The utility function is a monotonic transformation of that in (b). As
the utility functions in (b) and (c) represent the same preference, the optimal
bundles are the same.
Alternatively, if you find out the expression of MRS, it will be same as part (b).
 x 2
2
M RS12 (x1 , x2 ) = 40
x1
Thus the remaining steps are the same.

4. (a) At p1 = 4, Sally can redeem her food stamp for 300 ÷ 4 = 75 units of good. She
buys the rest of the food from the market, which costs 4 × (300 − 75) = 900.
The remaining budget is $2100, which may purchase 2100 ÷ 6 = 350 units of
shelter. Hence, Sally initial consumes x̂2 = 350.
(b) First, we write out Sally’ budget line without the food stamp. Before the price
increase,
4x1 + 6x2 = 3000
After the price increase,
5x1 + 6x2 = 3000
When Sally redeems all her food stamp, the quantity of food she received
decreases from 75 to 60 after the price increase. The food redeemed from the
food stamp is an in-kind transfer. We then add the quantities of food from food
stamp to the previous budget lines. shifting the budget lines to the right by 60
and 75 respectively. The colored graph below depicts the situation.

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 Mathematically, the budget line before the price increase is given by

4 max(x1 − 75, 0) + 6x2 = 3000

and the budget line after the price increase is given by

5 max(x1 − 60, 0) + 6x2 = 3000

The intercepts can be calculated in the following manner: Sally can afford at
most 3000 ÷ 6 = 500 unit of good 2 if she spends all her income on shelter. She
can afford at most 3000 ÷ 4 + 75 = 825 unit and 3000 ÷ 5 + 60 = 660 unit of
good 1 before and after the increase in food price.
(c) The cost of the bundle (300, 350) is 5 × 300 + 6 × 350 = 3600. Sally will receive
subsidy 5 × 300 × q on top of her income 3000. The initial bundle (300, 350) is
affordable if
3000 + 1500q ≥ 3600 ⇒ q ≥ 40%
The minimum subsidy rate q is 40%.

5. (a) With a 40% off on good 2, Betty’s budget line is given by

240 = 4x1 + 0.6 × (5x2 ) = 4x1 + 3x2
We first draw the dotted budget lines 4x1 + 5x2 = 240 and 4x1 + 3x2 = 240 in
one graph. Notice that they have the same horizontal intercepts.

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(b) To enjoy the discount, Betty has to buy at least 20 units of good 2, so that the
spending on good 2 is 5x2 ≥ 100.

When Betty purchases fewer than 20 units of good 2, the discount does not
apply and her budget line is the same as 4x1 + 5x2 = 240. Once she starts
buying more than 20 units of good 2, the discount kicks in and her budget line
switches to 4x1 + 3x2 = 240.

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 We can also represent Betty’s budget constraint as follows

4x1 + 5x2 = 240 if x2 < 20

4x1 + 3x2 = 240 if x2 ≥ 20

Let us interpret the qualitative features of the budget set. When Betty increases
x2 from slightly below 20 to 20 units, the discount provides an instant saving of
$40. The amount $40 can be used to buy 10 units of good 1. In the graph, this
is represented by the discrete jump of 10 units of good 1 at x2 = 20. The slope
also changes at x2 = 20, representing the change in the cost of an additional
unit of good 2.
(c) The bundle X̂ = (40, 16) is affordable. When Betty buys 16 units of good
2, the spending on good 2 is $80 and below the discount threshold. She can
afford 40 units of good 1 with the rest of her budget 240 − 80 = 160 dollars.
Mathematically, the bundle (40, 16) satisfies the following part of budget constraint

4x1 + 5x2 = 240 if x2 < 20

(d) The budget set shows us what bundles Betty can choose. Let us compare the
bundle (40, 16) with other feasible bundles. In particular, the bundle (45, 20) is
also affordable. Betty’s preference is monotonic. She strictly prefers the bundle
(45, 20) to the given bundle (40, 16). She will never choose the latter.

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 Depending on Betty’s preference, her optimal bundle needs not be (45, 20).
However, (40, 16) is never optimal.

6. (a) The tangency condition is given by

x2 + 1 3
M RS12 (x1 , x2 ) = =
x1 + 1 4

Together with the budget line 3x1 + 4x2 = 17, we solve out X
e = (3, 2). Alice is
consuming 3 cigarettes.
(b) i. As Alice quits smoking, her new consumption bundle is a corner solution
on the vertical axis.

ii. As Alice quits smoking, she would spend her income entirely on good 2, so
the consumption bundle will be (0, 17
4 ). As shown in the above graph, this
bundle will be optimal for her if and only if

21 17 3+t
= M RS12 (0, ) ≤
4 4 4

Hence, we solve out t ≥ 18.

iii. Cigarettes is perfectly divisible. Even if p1 + t > 17 and she cannot afford
one unit of cigarettes, Alice may consume a fraction of cigarettes and needs
not quit smoking. Bobby’s comment overlooks such a possibility.
e = ( 1 , 31 ). We
For example, if t = 15, Alice’s optimal bundle will be X 12 8
1
may interpret x
e1 = 12 as Alice will smoke one unit of cigarettes every 12
periods.

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 As goods are perfectly divisible, a household can always afford some positive
quantity at any tax rate. Whether the optimal optimal is a corner solution
depends on the household’s preference. However, Bobby considers only the
budget line in the utility maximization problem.

7. (a) For simplicity, let’s assume the current bundle is an interior solution. We depict
the situation in the colored graph below. The current optimal bundle X e is the
tangency point between the indifference curve and Ramesh’ current budget line
in Singapore. If Ramesh relocates to Hong Kong, his new budget line will be
flatter as the relative price of good 2 is higher. Moreover, the new budget line
must pass through the bundle X e because Xe is just affordable at the new income
level.

(b) To anaylze Ramesh’s relocation decision, we have to compare his maximal utility
levels in Singapore and in Hong Kong.
He will still afford the current bundle X.
e Indeed, there are strictly better bundles
on the new budget line. As depicted in the colored graph, these bundles are
those lie above the current indifference curve. Therefore, Ramesh’s new optimal
bundle in Hong Kong will be on a higher indifference curve. He is better off
with the relocation and should agree to it.

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Why there are strictly better bundles? Let pSG HK denote the prices of
n and pn
good n in Singapore and in Hong Kong respectively. X
e satisfies the tangency
condition for the budget line in Singapore. Hence
pSG
1 pHK
1
M RS12 (X)
e = >
pSG
2 pHK
2

The above inequality informs us X

e is no longer optimal in Hong Kong as well
as the incremental adjustment which leads to a higher utility level. We can
increase the utility level by moving the bundle slightly towards the right along
the Hong Kong budget line. This is exactly illustrated in the colored graph.
In general, as long as the current optimal bundle X e remains feasible on the
Hong Kong budget line, Ramesh cannot be worse off. He can always choose X e
or switch to another bundle to attain a higher utility level.