Price Theory Study questions-Set #2 Consumer Choice Model 1.

Elizabeth has the following utility function for goods X and Y: U =X Y. !er income is "#$$ %er unit of time& the %rice of X e'uals "1$ %er unit& and the %rice of good Y e'uals " %er unit. a. (ind the M)*. b. Calculate and s+etch the budget constraint. c. ,hat is the utility-ma.imizing consum%tion bundle for Elizabeth/ d. !ow would your answer to %art 0c1 change if the %rice of X increased to " $ %er unit/ e. 2eri3e Elizabeth4s demand cur3e for good X. f. *u%%ose Elizabeth5s utility function too+ the general form : U =Xa Yb . 2eri3e the demand cur3e for goods X and Y. g. Using your answer from %art 0f1 and assuming a=b=1& find the indirect utility function. . 6om li+es Xs& hates Ys& and is com%letely indifferent to 7s. 2raw his indifference cur3es between 0a1 Xs and Ys& 0b1 Xs and 7s& and 0c1 Ys and 7s. #. (ind the MU. & MUy & and M)* e'uations for each of the following utility functions. a. U = .$.8y$.9. b. U = . : y .&y;$. c. U = . : 9y. d. U = . y . e. U = .ayb. 9.(or 0a1-0d1& which of the utility functions e.hibit diminishing marginal utility for good X/ !int: Using your e'uation for MU.& determine if MU. falls as X rises. <. ,hich of the abo3e utility functions e.hibit diminishing M)*/ 06hat is& which of the abo3e yield con3e. indifference cur3es/1. 8. 2o you thin+ diminishing marginal utility is a necessary condition to get diminishing M)*/ Use your answers for 0a1& 0d1& and 0e1 to =ustify your answer. >. Consider the CE* utility function: U = a0X ?1 : b0Y ?1 if $ and U= a lnX : b lnY if =$. a. @ssuming $& deri3e the e'uation for MU. and MUy. (ind M)*. b. ,hat sort of %references are e.hibited when = 1/ Awhen = $/ Awhen $B B 1/ Awhen $;/ C. @ssume that U =.y and that D. ="1$& Dy="<& and E="1$$. Use the Fagrange method to find the firstorder conditions and the o%timal 3alues 0i.e.& utility ma.imizing 3alues1 of . and y. G. (or each case below& draw a gra%h of the budget line. Endicate the 3alues of X and M at the +in+s and interce%ts. @ssume E = "1$$ and D. = "1. a. 6he go3ernment %ro3ides a %er-unit subsidy of "$.<$?X 0so the consumer faces a %rice of "$.<?unit1 but only beyond the first 1$ units of X. b. 6he go3ernment %ro3ides a %er-unit subsidy of "$.<$?X 0so the consumer faces a %rice of "$.<?unit1 but only up to the first 1$ units of X. c. 6he go3ernment introduces a %rogram in which the first < units of X are free . @fter that& the go3ernment %ro3ides a %er-unit subsidy of "$.<$?X 0so the %rice of X to consumers is "$.<$ %er unit1 but only u% to 1$th unit of X. 6he go3ernment does not %ro3ide any subsidy for units %urchased beyond the 1$th unit. 06he consumer still retains the HgiftI for the earlier units.1 d. *ame as in %art 0c 1& e.ce%t that in this case if the consumer consumes more than 1$ units of X& the go3ernment ta+es away @FF subsidiesJi.e.& the consumer no longer gets the first < units for free&etc.

e. 6he go3ernment im%oses a %rice ceiling on good X at "$.<?unit. 6he consumer is only allowed to %urchase a ma.imum amount of <$ units at this %rice. 1$. @ consumer faces the following utility function: U=.M& with M re%resenting dollars s%ent on all goods other than good . 0therefore DM 11. @ssume that D. ="1 and E = "1$$. a. (ind the o%timal consum%tion bundle and the le3el of utility at that bundle. *how the result from this %art on a gra%h. Dlace . on the horizontal a.is and M on the 3ertical a.is. b. *u%%ose the go3ernment %ro3ides the consumer with " $ worth of X-stam%s. (ind the new o%timal consum%tion bundle. !EK6: 6o find the solution you should assume that the consumer recei3ed a gift of " $ cash. 0LUE*6EMK* 6M DMK2E): ,hy can ma+e we ma+e this assum%tionJafter all& the consumer recei3ed food stam%s not cash/ Can we always ma+e this assum%tion/1. *how this result on the same gra%h as used in %art 0a1. c. *u%%ose the go3ernment re%laces its food stam% %rogram with a %er-unit subsidy %rogram. 6he %er-unit subsidy is selected so as to allow the consumer to achie3e the same le3el of utility as under the food stam% %rogram. Using the indirect utility function& find the %er-unit subsidy that would be re'uired to achie3e this result. 0KM6E: 6he %er-unit subsidy e'uals "1 minus %rice of X under the %er-unit subsidy. Kotice that we are im%licitly assuming that the su%%ly of X is %erfectly elastic and therefore the entire subsidy is %assed on to consumers1. (ind .& M& and the cost to the go3ernment of %ro3iding this subsidy. *how this outcome on the same gra%h as used in %arts 0a1 and 0b1. Mn your gra%h& indicate the cost to the go3ernment of each %rogram. 11. @ssume the following: U=($.1M$.G & D.="1 and E = "1$$. a. (ind the o%timal consum%tion bundle and the le3el of utility at that bundle. *how the result from this %art on a gra%h. b. *u%%ose the go3ernment now grants the consumer " $ worth of food stam%s. (ind the new o%timal consum%tion bundle. !EK6: 6o find the solution %roceed as follows: i. @ssume that the consumer had instead been granted " $ cash and find the o%timal bundle under this assum%tion. ii. Kow see if that bundle is actually obtainable under the food stam% %rogram 0does it lie on the food stam% budget line or abo3e it/1. Ef it is KM6 obtainable then that cannot be our solution. )ather the solution would be the bundle that is nearest to this bundle. !a3ing now found the new o%timal bundle& find the le3el of utility at this bundle. *how the food stam% budget line on the same gra%h as used in %art 0a1. 2o KM6 yet draw in the corres%onding EC. c. ,hat is the M)* at the bundle selected in %art 0b1/ d. *u%%ose the consumer can sell his food stam%s for >$N of face 3alue 0hence the effecti3e %rice of food for ( B $ is "$.>$1. 2raw in the budget line corres%onding to this new situation. Use the same gra%h as used abo3e. Kow draw in the EC the consumer was on in part (b1. OE C@)E(UF how you draw itJyou will find the information about the M)* from %art 0c1 and the slo%e of the budget line under this new situation useful in drawing in this EC. e. Oased on your gra%h& will this consumer end u% selling some of his food stam%s/ E.%lain. f. (ind the o%timal consum%tion bundle when the consumer can sell his food stam%s for >$N of face 3alue. !EK6: 6o find the solution& assume that the consumer has additional income of "19 0the dollar 3alue recei3ed if the consumer sold off all of his food stam%sJ$.>P" $="191. !ow many food stam%s are sold/ 2raw the EC corres%onding to this outcome on your abo3e gra%h. 1 . @ firm desires to lower absenteeism by rewarding attendance. 6he firm currently %ays its wor+ers a wage of 7 dollars %er day. @ only two goods in a wor+er4s utility function are money income and days of leisure and both are assumed to be normal goods. 6he number of days of leisure e'uals F = #8< - 2& where F is number of days of leisure and 2 is number of days of wor+. 6he firm has information which indicates the a3erage number of days wor+ed %er year was 1$. *ome wor+ers wor+ed as many as <$ days %er year& whereas others showed u% for wor+ as few as 1C$ days. 6he firm desires to increase the a3erage to $ days %er year. Et attem%ts to do this by offering the following deal: Mffer a lum%-sum annual bonus of O dollars to each wor+er who wor+s at least $ days a year. a. 2raw the budget line for the ty%ical wor+er before the bonus %rogram is im%lemented. b. 2raw the budget line for the ty%ical wor+er after the bonus %rogram is im%lemented.

c. *how the effect of this %rogram on the total days wor+ed by em%loyees who were initially 0i1 wor+ing less than $ days %er yearQ 0ii1 wor+ing $ days or more %er year. d. ,ill this %rogram necessarily raise the a3erage days wor+ed to $/ E.%lain. 1#. 6o encourage additional s%ending on education by local school districts& the state go3ernment %lans to offer aid. @ll families are ali+e in district X and these families determine the amount of money s%ent on education and on all other %rograms. Ooth education and all other %rograms are normal goods. 2istrict X is currently s%ending "<$$ %er student& and the state would li+e to increase this amount to "<<$ %er student. 6he state is considering two %ro%osals: E. Fum% sum grant 1. 6he state will %ay "<$ %er child toward educational e.%enditures if the district s%ends at least "1$$ %er child 0which it does1. EE. Fum% sum grant . 6he state will %ay "<$ %er child toward educational e.%enditures if the district s%ends at least "<$$ %er child. a. Drior to the im%lementation of any state %ro%osal& show the o%timum %oint for a re%resentati3e family. b. !ow does each %ro%osal alter the budget line/ c. Using gra%hs& indicate whether the families in district X are more li+ely to increase %er %u%il e.%enditure 0i.e.& total %er %u%il e.%enditure minus %er %u%il state aid1 under %ro%osal 1 or under %ro%osal . d. Es it %ossible to determine if total s%ending on education %er %u%il 0local: state s%ending1 will be higher under %ro%osal 1 or under %ro%osal / E.%lain. 19. *u%%ose that you ha3e 18 wa+ing hours %er day& which you can allocate between wor+ing for a wage of "1 %er hour and rela.ing 0hours of leisure1. a. 2raw your budget constraint between money income and hours of leisure. b. Kow su%%ose that you ha3e the ability to get by on 9 hours of slee% %er night& and therefore ha3e $ wa+ing hours %er day. 2raw your new budget line. Es it %ossible you choose to wor+ fewer hours than you did before/ E.%lain. c. *u%%ose we go bac+ to the initial situation--18 wa+ing hours %er day. !owe3er& you now recei3e a wage of "1.<$ %er hour. 2raw your new budget constraint. En drawing in this new cur3e& assume that the wage increase ma+es it %ossible for you to attain the same combination of money income and leisure that you would choose if you had $ wa+ing hours %er day. !ow much will you wor+ after the wage increase& com%ared to how much you wor+ed when you had $ wa+ing hours %er day/ E.%lain. 1<. *u%%ose that the only two goods consumed are food and housing. @ssume that housing is an inferior good. Kow the %rice of food rises. a. Ellustrate the substitution and income effects. !ow does your gra%h reflect the fact that housing is an inferior good. b. 6rue or false: ,hen the %rice of food increases& you certainly consume more housing than before. E.%lain. c. 6rue or false: (ood could not %ossibly be a Riffen good. E.%lain. 18. @ wor+er has 9 hours %er day to allocate between leisure and wor+. Use gra%hs to answer the following 'uestions. a. Ef leisure is a normal good& show how it is %ossible to deri3e a negati3ely-slo%ed labor su%%ly cur3e. E.%lain how this is %ossible. b. ,hat ha%%ens to hours wor+ed if a wor+er has an increase in non-wage income 0that is& income that is recei3ed e3en when hours wor+ed e'uals zero1/ @ssume that leisure is a normal good. c. Ef leisure is an inferior good& then an increase in wage rate must increase hours wor+ed %er day. 2o you agree/ E.%lain. d. @ssume that an indi3idual %ays ta.es but recei3es no benefit from them. !ow will an increase in the income ta. rate affect this indi3idual4s su%%ly of labor/ Feisure is a normal good. ,hat if this same %erson recei3es enough non-wage income which lea3es him =ust as well off as if he had %aid no ta.es. ,hat will be the effect on his labor su%%ly relati3e to the case

where he %ays no ta. with no benefit/ 1>. @ssume the following utility function: U=.$.<y$.<. Encome = "1$$ and the initial %rices for good X is "1 and the initial %rice for good Y is "1. a. Using the uncom%ensated demand cur3e& find the 'uantity consumed for each good. ,hat is utility at this bundle/ b. *u%%ose the %rice of . falls to "$. <. !olding )E@F EKCMME constant& what ha%%ens to the 'uantity of . consumed/ 6a+ing into account both the substitution and income effects& what ha%%ens to the 'uantity of . consumed/ c. *how the substitution and income effects on a gra%h. Use the numbers you calculated in the abo3e sections. 1C. @ssume the following utility function: U=FPE where F = leisure hours 0hrs?day1 and E = money income. 6he wage rate is "1$?hour. a. (ind the utility-ma.imizing bundle. b. *u%%ose this wor+er had KMK-,@RE income of " $. (ind the new o%timal bundle. 1G. @ssume the following: U =.$.<y$.<& E = "18& D. = "1 and Dy = "1. a. (ind the utility-ma.imizing bundle. ,hat is utility/ b. *u%%ose the go3ernment im%oses a ta. of "1?unit on good X such that the new %rice of X is " . ,hat is the new o%timal bundle/ ,hat is utility/ ,hat is ta. re3enue/ c. *u%%ose the go3ernment remo3es the %er-unit ta. on good X 0so the %rice of X again e'uals "11. Et re%laces this ta. with a lum%-sum ta.. 6he lum%-sum ta. is selected so as to allow the consumer to achie3e the same le3el of utility as under the %er-unit ta.. Using the indirect utility function& determine the size of the lum%-sum ta.. Com%are this ta. re3enue with the ta. re3enue collected under the %er-unit ta.. @lso& find the o%timal bundle under this ta.. d. 2raw a gra%h showing all rele3ant budget lines& ECs& and ta. re3enue amounts from %arts 0a1& 0b1& and 0c1.

Answers
1. a. M)*.y = MU.?MUy where MU. = U?. = .y and MUy = U? y = . . 6herefore& M)* = .y?. = y?.. 1.b. Oudget Fine: "#$$ = "1$. : " y. 1.c. 6wo conditions must be satisfied: 0E1 M)* = D.? Dy and 0ii1 E = D. : Dy with both %rices and income ta+en as gi3ens. *o our two e'uations are: 0i1 y?. = "1$?" = < which can be rearranged as y = .<.& and 0ii1 "#$$ = "1$. : " y. Ke.t& substitute 0i1 into 0ii1 and sol3e for . as follows-- "#$$ = "1$. : " 0 .<.1 = "1<. and so x = 20. ,e can now find y by %lugging .= $ into 0E1 : y = 2.5(20) = 50. 1. d. 0E1 y?. = " $?" = 1$ which can rearranged as y= <.. *ubstitute this e'uation into 0ii1: "#$$ = " $. : " 0<.1 = "#$. x = 0 and y = 5( 0) = 50. e. 6he demand cur3e is an e'uation which shows 'uantity demanded as a function of %rice. Using abo3e two e'uations again & we can find the demand cur3e as follows: y?. = D.?" which sol3ing for y gi3es us y = 0D..1?9. Ef we substitute this e'uation into the budget constraint and sol3e for . we get the demand cur3e-"#$$ = D.. : 0D..?91 = D.. : D..? = 1.<0D..1 " $$ = 0D..1 which gi3es us 200!Px = x. This is the "e#and $ur%e. 1.f. (irst& find the e'uation for the M)*. ,e +now M)*.y = MU.?MUy where MU. = U?. = a.a-1yb and MUy = U? y = b.a yb-1 . 6herefore& M)* =0a.a-1yb1?0b.a yb-11 = 0a?b10y?.1. *econd& set M)* e'ual to D.?Dy and sol3e for y: 0a?b10y?.1= D.?Dy or& y = 0b?a10D..?Dy1. 6hird& %lug the abo3e result into budget line and sol3e for .: E = D.. : Dy S0b?a10D..?Dy1T = S0a:b1?aTS D..T. *ol3ing for . we get: x = &a!(a'())(*!Px ). 6his is the demand cur3e for Cobb-2ouglas utility functions. (or y& following the same ste%s& you would get y = &(!(a'())(*!Py). g. *ince it is assumed that a=b=1& the direct utility function is U = .y and the demand functions for . and y are& res%ecti3ely& . = E?0 D.1 and y = E?0 Dy1. Oy substituting these last two e'uations into the direct utility function we get the indirect utility function: + = *2!(,Px Py).

. *ee gra%hs on last %age. #a. MU. = U?. = $.8.-$.9y$.9=$.80y?.1$.9. MUy = U?y =$.9.$.8y-$.8=$.90.?y1$.8 M)* = MU.?MUy = 1.<0y?.1. #b. MU. = U?. = .. MUy = U?y = y. M)* = MU.?MUy = 0.?y1. #c. MU. = U?. = . MUy = U?y = 9. M)* = MU.?MUy = $.<. #d. MU. = U?. = .y . MUy = U?y = . y. M)* = MU.?MUy = 0y?.1. #e. MU. = U?. = a.a-1 yb= a 0yb?.1-a1. MUy = U?y =b.ayb-1= b0.a ?y1-b1. M)* = MU.?MUy = 0a?b10y?.1. 9a. the MU. e'uation shows that as . increases MU decreases& so this e.hibits diminishing marginal utility for good X. 0Kote: you can more formally %ro3e this by ta+ing the deri3ati3e of MU function with res%ect to X. Ef this deri3ati3e is negati3e& then this indicates that MU of . falls as . rises. (or e.am%le&

MU.?. =- $. 9.-1.9y$.9 which is negati3e for .&y ;$.1 9b. 6his utility function e.hibits increasing marginal utility since MU rises as . increases. 9c. 6his utility function e.hibits constant marginal utility since MU. e'uals a constant. 9d. 6his utility function e.hibits increasing marginal utility since MU rises as . increases. <a. *ince M)* = 1.<0y?.1& then for a gi3en le3el of utility& as . rises M)* falls. 6herefore& this utility function yields con3e. indifference cur3es. <b. *ince M)* = 0.?y1& then for a gi3en le3el of utility& as . rises M)* rises. 6his im%lies conca3e indifference cur3es. <c. *ince M)* = constant = $.<& the M)* remains constant as . rises& for a gi3en le3el of utility. 6his utility function yields linear indifference cur3es 0U%erfect substitutes in consum%tionU1. <d. *ince M)* = 0y?.1& then for a gi3en le3el of utility& as . rises M)* falls. Con3e. indifference cur3es. <e. *ince M)* = 0a?b1 0y?.1& then for a gi3en le3el of utility and for a&b;$& as . rises M)* falls. Con3e. indifference cur3es. 0Math note: More formally& if the deri3ati3e of the M)* function with res%ect to X is negati3e& then this indicates con3e. indifference cur3es1. 8. Ko& it is not. Ooth 0a1 and 0d1 e.hibit diminishing M)* 0con3e. indifference cur3es1& yet 0a1 e.hibits diminishing MU of X and Y and whereas 0d1 shows increasing MU for X and Y. Kotice that 0e1 shows that we get con3e. indifference cur3es for any utility function of the general form U=. ayb with a&b ;$. >a. MU. = U?. = aX-1 and MUy = U?y = bY-1 . M)* = 0MU.? MUy1 = 0a?b1SX-1?Y-1T. 6his can be rewritten as M)* =0a?b1SY1-?X1-T = 0a?b1SY?XT1- . >b. Ef = 1& then M)* = 0a?b1 =constant. 6his would gi3e us the %erfect substitute case 0linear indifference cur3es1. Ef = $& then M)* = 0a?b1SY?XT which is the Cobb-2ouglas case 0notice that you get this same e'uation for the M)* if you use the function U = lnX : b lnY1. Ef $B B 1& then we get the case of %references between the Cobb-2ouglas case the and %erfect substitute caseJthat is& the indifference cur3es will ha3e cur3atures between Cobb-2ouglas ECs and %refect-substitute ECs. (or e.am%le& if =$.GG then ECs will almost be linear. Ef $;& then %references will lie between the Cobb-2ouglas case and %erfect com%lement case 0right-angled ECs1. (or e.am%le& if = -1$$& then ECs will still ha3e some cur3ature but will be 3ery close to loo+ing li+e right-angles. 0Ef = -& we ha3e the case of %erfect com%lements1.

C. (irst& we set u% the following Fagrangian ob=ecti3e function: F = .y : S"1$$ - 0"1$. : "<y1T. 6he first-order conditions are: 0a1 F?. = y -1$ = $. 0b1 F?y = . -< = $. (c1 F? = 1$$ - 01$. : <y1 = $. ,e can rearrange 0a1 and 0b1 as: 0a51 y = 1$ and 0b51 . = < 2i3iding 0a51 by 0b51 gi3es us: 0y?.1 = 1$?<. Kotice that this is sim%ly the familiar M)* = 0D.?Dy1 condition. E'uation 0c 1 can be rearranged to gi3e us the familiar budget constraint 1$. : <y = 1$$. *ince 0y?.1 = & it follows that y = .. Dlugging this into the budget constraint gi3es us 1$. : <0 .1 = 1$$& or $. = 1$$. *ol3ing for . yields x=5. 6herefore& y= 0. G. *ee gra%hs below. 1$. a. i. M)* = M?. ii. *et M)* = D.?DM and sol3e for M. M?. = D.?DM = 1& or M=.. iii. Dlug the result for ste% 0ii1 into the constraint and sol3e for .. 1$$ = . : M = . and so . =<$ i3. (ind M. M = . = <$. 3. (ind Utility: U=<$P<$ = <$$ b. (ood stam%s of " $ that we treat as if the consumer has income of "1 $. i. M)* = M?. ii. M?. = D.?DM = 1& or M=.. iii. Dlug into constraint and sol3e for .. 1 $ = . : M = . and so . =8$ i3. (ind M. M = . = 8$. 6he bundle .=8$ and M="8$ is obtainable under the food stam% %rogram 0i.e. & is on the food stam% budget line1 and therefore re%resents the o%timal bundle. 3. (ind Utility: U=8$P8$ = #8$$ c. Oac+ to the original situation& but %er-unit subsidy is selected so as to achie3e same le3el of utility. Use indirect utility function to new D.. 6he indirect utility function is V = E ?9D.DM = E ?9D.. #8$$ = E ?9D. = 01$$ 1?9D. 199$$= 1$$$$?D. D. = 1$&$$$?19&9$$ = "$.8G %er .. En other words& with income of "1$$& the %rice of . would ha3e to be "$.8G?unit for this consumer to achie3e the utility le3el of #8$$. 6herefore& the subsidy would be "1-"$.8G="$.#1?unit. M)* = M?. = D.?DM = $.8G& or M = $.8G. Dlugging into the constraint: 1$$=$.8G. : M = 1.#C. 1$$ = 1.#CX & or . = 1$$?1.#C = > .< M = $.8G. =0$.8G10> .<1= <$ *ubsidy = "$.#1?unit and Cost to the go3ernment = 0"$.#110> .<1 =" .< 11. a. (irst we find M)*& M)* = M?G( *econd& set M)* = D(?DM and sol3e for M M?G( = 1& or M = G(. 6hird& %lug the abo3e result into the constraint and sol3e for ( 1$$= (:M = (:G(=1$( or ( = 1$. Ke.t& find M. M = G(= 0G101$1= "G$. (inally& find utility. U=1$$.1G$$.G > . . b. (ood stam%s of " $& but act as if E="1 $. i. M)* = M?G(& ii. M?G( = 1& or M = G( iii. 1 $ = 1$( or ( = 1 and M=1 $-1 ="1$C. KM6ECE 6!@6 6!E* OUK2FE E* NOT MO6@EK@OFE UK2E) 6!E (MM2 *6@MD D)MR)@M. 6herefore& the consumer will choose the bundle that is nearest to this bundleJnamely& (= $ and M="1$$. 0*ee gra%h below.1 Utility le3el is U= $$.11$$$.G C<.1. 0notice that the bundle (=1 and 1$C would yield a higher le3el of utility -- U=1 $.11$C$.G C8.>Jbut this bundle is not obtainable under the food stam% %rogram1. c. M)* = M?G( = 1$$?G0 $1=1$$?1C$= "$.<8. e. Consumer can sell food stam%s for >$N of face 3alue and therefore D( = "$.>$ for (B $. 6hat is& if the consumer uses a "1 worth of food stam%s to ac'uire a 1 unit of food then he will be forgoing >$ cents.

*ince M)* =$.<8 B $.>$ = slo%e of budget line for (B $ 0see gra%h below1& the consumer will sell off some of his food stam%s. f. @ct as if consumer had income of "119 0if the consumer sold off all of his food stam%s& he could get 0"$.>$10 $1 = "19 cash. M?G( = D(?DM = $.>& or M = 8.#( 119 = $.>( : M = $.>( :8.#(= >( or ( = 119?> 18.#. M=119-0$.>P18.#1 "1$ .8 $-18.# = #.> gi3es us the number of food stam%s sold off. Cash recei3ed = "$.>P#.>=" .8$. U=18.#$.11$ .8$.G C<.9. 1 . a. *ee gra%h. 1 . b. *ee gra%h. @t 19< days of leisure 0 $ days of wor+1 your income would =um% u% by the amount of the bonus. 1 . c. *ee gra%h. (or those wor+ing less it can either ha3e no effect on number of wor+ days or it will increase wor+ days to $. (or indi3iduals wor+ing more than $ days& it will cause number of wor+ing days to fall. 6his is because the %arallel shift of the rele3ant segment of the budget line creates an income effect. *ince leisure is a normal good& the increase in income for these wor+ers will cause leisure to increase. 1 .d. Et is %ossible that these %rograms will not increase the a3erage number of wor+ing days to $. 6hose who wor+ less than $ hours will either not change hours wor+ed or will wor+ $ hours& whereas those wor+ing more than $ hours will decrease hours wor+ed. @s a result the a3erage may still be below $. (or e.am%le& su%%ose there are < wor+ers--two wor+ 99 hrs %er yr. and the other three wor+ 1C> hours %er yr. 6his yields an a3erage %er wor+er of a%%ro.imately 1$ hrs. %er year. Kow su%%ose that due to this com%any %rogram the first two wor+ers decrease hours wor+ed?yr. to $ hours &and the ne.t three now wor+ $& 1C>& 1C>& res%ecti3ely. 6he a3erage has actually fallen to a%%ro.imately $> hrs. 1#.a. W b. *ee gra%hs. 1#. c. Under %ro%osal 1& district s%ending on education actually falls 0although total educ. s%ending increases1. *ince both goods are normal goods& the local district will increase its consum%tion of both goods 0i.e& mo3e to the northeast of the original tangency1. Out this means an increase in total s%ending of less than "<$. 0*ince total s%ending = local s%ending : state s%ending& it follows that the change in total s%ending = change in local s%ending : change in state s%ending. $B....B:"<$ = / : "<$ 6hus& local s%ending falls under %ro%osal 1.1. Under %ro%osal & total s%ending increases by "<$ 0i.e.& to at least "<<$1. 6hus& local s%ending on education remains unchanged. 0Kote: total s%ending will not increase by more than "<$ if s%ending on other %rograms is a normal good1. 1#.d. !igher under %ro%osal 0"<<$1 than under %ro%osal 1 0some amount less than "<<$1. 19. a. *ee gra%h on last %age. 19. b. *ee gra%h on last %age. Kotice that the shift in the budget line re%resents a %ure income effect 0 the budget lines are %arallel1. Ef both leisure and M 0money income1 are normal goods then the tangency of the indifference cur3e on the new budget line must lie somewhere between %oints b and c 0i.e.& this consumer must end u% consuming more of both goods1. Out this im%lies that the increase in leisure hours must be some amount less than 9 hours. 6herefore hours wor+ed must increase. 6his can be shown as follows. ,e +now that 6otal hours = leisure hours : hours wor+ed and therefore we can say that the change in total hours = change in leisure hrs. : change in hours wor+ed :9 = $B ... B :9 : / Et follows that the change in hours wor+ed must be %ositi3e. 0note: if M is an inferior good& then hours wor+ed would fall. En this case the tangency of the indifference cur3e on the new budget line would ha3e to lie between %oints b and d. 6hus leisure hours increase by more than 9 hours.1 19.c. *ee gra%h. 6he budget line corres%onding to a wage of "1.< would cross %oint z and is therefore not the o%timum since there is no tangency at this %oint. 6he consumer can mo3e to a higher indifference cur3e 0%t. w1. @t this %oint& the wor+er is wor+ing more hours.

1<.a. *ee gra%h. Et is reflected by the fact that !# e.ceeds ! . @ %rice increase tends to ma+e a consumer %oorer 0less income1. @s income effecti3ely falls& consumers desire to consume more of an inferior good. 6he mo3ement from %t. b to %t. c reflects the income effect for an inferior good. 1<. b. 6he income and substitution effects for housing reinforce each other when housing is considered an inferior good. 1<. c. Riffen good is one in which the good is inferior and the income effect is stronger than the substitution effect. Ef housing is inferior good& then food cannot %ossibly be inferior--it is not %ossible for all goods to be inferior. 18. a. *ee gra%h. Ef leisure is a normal good and if the income effect is stronger than the substitution effect& then an increase in the wage rate will decrease the 'uantity of labor su%%lied. 18. b. *ee gra%h. *ince this is %ure income effect& leisure increases and thus labor su%%lied falls. 18. c. *ee gra%h. Yes. @n increase in the wage rate creates a substitution effect which decreases leisure 0the %rice of leisure is higher1 and an income effect which also decreases leisure if leisure is an inferior good. 18. d. *ee gra%h. Et will decrease labor su%%ly if the substitution effect is greater than the income effect. 6he new budget line would also be tangent to EC1 &but is further to the right--more leisure than in the case of no income ta.. 1>. a. Uncom%ensated demand cur3es: X = Sa?0a:b1T SE?%. T and Y= Sb?0a:b1T SE?%y T *o X = <$?1= <$ and Y = <$?1= <$. U=<$$.<<$$.< = <$. b. !olding real income constant means holding the le3el of utility constantJand so we must use the com%ensated demand cur3e to find . . X = U1?0a:b1 S0a?b10Dy?D.1Tb?0a:b1 . X = S<$TS1?$. <T$.< = 1$$. Kotice that this shows the substitution effect. 6o ta+e into account both the substitution effect and the income effect& we need to use the uncom%ensated demand cur3e again. X = <$?$. < = $$. c. Rra%h is on last %age. 1C. a& (irst& we need to find the M)*. M)* = MUF? MUE = 0XU?XF1?0XU?XE1 = E?F. *econd& set M)* e'ual to the wage rate 0the wage rate is the relati3e %rice of leisure1& and sol3e for E. E?F = , = 1$& or E = 1$F. 6hird& %lug the result from ste% 0 1 into the constraint. 6he constraint must be e.%ressed so as to show each choice 3ariableJF and E. 6he constraint is 9 = F : ! where is ! is hours wor+ed %er day. Out since E = ,P!& we can write ! = E?, and so write the constraint as 9 = F : E?, = F : E?1$. Kow we can ma+e the substitution for E and sol3e for F. 9 = F : 1$F?1$ = F or - = 2 hours. 6herefore& != 1 hours and * = ( 0)( 2)= . 20. b. (irst& we need to ma+e a few %reliminary changes: E = ,P! : Kon-,age Encome. *ol3ing for ! gi3es us ! = 0E-nonwage income1? , = E?1$ Y . *o the constraint is written 9 = F : ! = F : E?1$- . Kow when we can ma+e the substitution of E = 1$F into the constraint. ,e get: 9 = F : 01$F1?1$ Y & or 8 = F & - = / hours. Feisure increases. * = ( 0)( ) ' 20 = . /0. 1G. a. (irst& M)* = y?.. *econd& y?. = D.?Dy = 1 or y = .. 6hird& %lug into constraint and sol3e for X. 18 = 1PX : 1PY = X. X = C. Y also e'uals C. U =C$.<C$.< = C. b. M)* = y?.& y?. = & or y = .. 18 = . : y = 9.& or X = 9 . Y = C. U = 9$.<C$.< = P .C# = <.88. 6a. re3enue = "1P9 = "9. c. (irst& we need to find the indirect utility function. V = Sa?0a:b1Ta Sb?0a:b1Tb SEa:b?0D.a P Dyb1T = E?0 D.$.< P Dy$.<1 !olding utility constant at <.88 and %lugging in for each %rice we get <.88 = E? & or E = "11.# . *ince the consumer initially has income of "18& this new income would im%ly a lum%-sum ta. of "18-"11.# = "9.8C. Kotice that this ta. re3enue is greater than the ta. re3enue collected under the %er-unit ta.. Using the demand functions for X and Y 0as a short cut1 we can find the new o%timal bundleJX = 11.# ? = <.88 and Y = 11.# ? = <.88.

y0bad1

012ST*34 2. z 0neutral1 EC$ EC1

z0neutral1 EC1 EC$

EC$

EC1 .0good1 . 0good1 y 0bad1

012ST*34 ,a A4" ,(. Money Encome

" $

original budget line

"18

c b a EC

!1 .

18hrs.

$hrs.

9hrs.

Feisure 0!ours?2ay1

9 hrs.

012ST*34 ,c.

budget line when wage="1.<$?hour " $

w

EC1
z

EC$
! 18hrs. $hrs. Feisure !ours

!#

!ousing

012ST*34 5.

!# ! !1

c b EC$ a EC1

(#

(1

(ood

Money %rice of ( increases&holding E and %rice of ! constant. Consumer mo3es to lower indifference cur3e. (or food& (1 to ( re%resents the substitution effect 0%t. a to %t. b1 and ( to (# re%resents the income effect 0%t. b to %t. c1. (or housing& !1 to ! re%resents the substitution effect 0%t. a to %t. b1 and ! to !# re%resents the income effect 0%t. b to %t. c1.

012ST*34S 2a A4" 2(. Money Encome 0E1 0#8<10z1:Oonus e 0#8<10z1 c d Oonus b budget line before: abc budget line after: abde

a 19< $ days of wor+ Money Encome 0E1 0#8<10z1:Oonus e 0#8<10z1 c d b 012ST*34 2c. Case 1: Ko effect on this wor+er 0all %oints on new budget line lie below original EC1. #8< Feisure 02ays1

EC a 19< $ days of wor+ #8< Feisure 02ays1

Money Encome 0E1 0#8<10z1:Oonus e 0#8<10z1 c d b

012ST*34 2c. Case : wor+er increases wor+ hours to $ days?yr. *ome %oints on the new budget line lie abo3e EC1& so they must be %referred to the original consum%tion bundle.

EC EC1 EC a

19< F1 $ days of wor+ Money Encome 0E1 0#8<10z1:Oonus e 0#8<10z1 c d b EC EC1

#8<

Feisure 02ays1

LUE*6EMK 1 c. Case #: ,or+er reduces wor+ hours 0%erha%s to $ days1. Feisure is a normal good& and since the bonus %rogram creates an income effect in the rele3ant range& leisure increases.

a F1 F 19< $ days of wor+ #8< Feisure 02ays1

012ST*34 / Rrant 1

EC1

M EC M1

E
"1$$ "1<$ E1 E "<<$

"<$ horizontal ga% E = dollars s%ent on education M= dollars s%ent on other %rograms E1= "<$$ and "<$$BE B"<<$. 6hat is& E increases& but by less than "<$. 012ST*34 /. M Rrant

M1

EC EC1 E
"<$$ "<<$

E = dollars s%ent on education

M= dollars s%ent on other %rograms

Money Encome 012ST*34 5a.

Money Encome 18b.

EC EC1 non-wage income

F1 F 9hrs. Feisure F1 F 9hrs. Feisure

18c Money Encome c Money Encome

18d. no ta. budget line 0original1

a b
b a budget line with income ta.

F#

F1

9hrs.

Feisure

F1

9hrs. Feisure

F1 to F : substitution effect F to F#: income effect

Dt. b re%resents the tangency between EC 1 and the budget line that e.ists with ta. %lus non-wage income. Dt. a re%resents the tangency between EC1 W the original budget line 0no ta.1.

012ST*34 6.

1$$

<$ ECU=<$ <$ 1$$ $$

EC

9$$

*ub. effect

Encome effect

Encome 0E1

012ST*34 7. ,ith non-wage income of " $& F = 1# hours and so !=11 hours. ,or+ing 11 hours means wage income of "11$. 6otal income 0E1 is "11$ : " $ = "1#$.

"1#$ "1 $ "11$ EC1 EC

" $ non-wage income

e'uals this 3ertical distance. 1 1# 9 Feisure 0F1

M "1$$

012ST*34 8a.

"G$

1$

1$$

1G$

M "1$$ "G<

Gb

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<

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!ea3y shaded budget line is the budget line under the %rice ceiling

<$

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M 0uestion 0.

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(ood stam% budget line Under the food stam% %rogram& the tangency occurs at the bundle .=8$ and M="8$.

"8$ "<$ "9>.<

b a

Under the %er-unit subsidy %rogram& the tangency occurs at %oint a. ECU=#8$$ %er-unit subsidy budget line

EC1 " >.<

c

<$ 8$

> .<

1$$

1 $

19<

6he cost to the go3ernment of the food stam% %rogram = bc = " $. 6he cost to the go3ernment of the %er-unit subsidy = ac = " .<.

012ST*34 M "1 $ "119

b EC9 a

Mriginal budget line: segment ce (ood stam% budget line: cdf Oudget line if had " $ cash gift: adf Oudget line if can sell food stam%s for >$N of face 3alue: bdf 0IF had " $ cash gift1 EC# 0under food stam% %rogram& can sell food stam%s for >$N of face 3alue1 e EC 0under food stam% %rogram& cannot sell food stam%s1
EC1

"1$ .8 "1$$
c d

"G$

If had " $ additional cash& would choose bundle (=1 and M="1$C. Out as can be seen from this gra%h& that bundle is not obtainable under the food stam% %rogram . 6herefore& the consumer will choose the bundle nearest to this bundleJ namely& (= $ W M=1$$ 0the bundle at the +in+1.

1$ 1

$ 18.#

1$$

1 $

(ood

Kotice at the corner %oint of (= $ and M=1$$& the slo%e of the indifference cur3e 0EC 1 is flatter than the slo%e of the budget line formed when the consume can sell the food stam%s for >$N of face 3alue 0the rele3ant segment of this budget line is be1. 6his tells us the consumer will be better off by selling some of his food stam%s. 6he new o%timal bundle is at (=18.# and M= "1$ .8.

Y 012ST*34 8 18 6a. re3enue collected under the %er-unit ta.= segment ab="9 6a. re3enue collected under lum%-sum ta.=segment ac="9.8C a 11.#

C c <.88

b EC1 ECU=<.88

<.88

11.#

18

Kew Oudget Fine good g# EC EE g *E g1 Mriginal Oudget Fine

EC1

b1 b# b bad *E EE