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University of Toronto | Department of Economics | ECO 204 | Summer 2013 | Ajaz Hussain
TEST 1 SOLUTIONS

TIME: 1 HOUR AND 50 MINUTES
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Question Maximum Possible Points Score
1 20
2 10
3 15
4 20
5 15
6 20
Total Points = 100

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Question 1 [20 POINTS]
[ALL PARTS ARE INDEPENDENT OF EACH OTHER]

(a) [5 POINTS] Consider the following problem:

()
Under what conditions is a stationary point

(i.e. where

) ) a (or the) solution to this problem?

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(b) [5 POINTS] Consider the following problem:

()
At the optimal solution to this problem, why will the optimal value of the Lagrange equation equal

? Show all
calculations and state all assumptions.

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(c) [5 POINTS] Consider the following problem:

()

At the optimal solution to this problem, why will the optimal value of the Lagrange equation equal

? Show all
calculations and state all assumptions.

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(d) [5 POINTS] Give an example of a single-variable function that is both concave and convex but not strictly concave nor
strictly convex.

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Question 2 [10 POINTS]
[ALL PARTS ARE INDEPENDENT OF EACH OTHER]

(a) [5 POINTS] A business analyst has solved the following problem:

Here
After solving the problem, the analyst finds that the value of the Lagrange multiplier is . Interpret this result
and, if appropriate, make a recommendation to the analyst. Explain your answer.

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(b) [5 POINTS] A business analyst has solved the following problem:

The analyst tells you that the value of the Lagrange multiplier is . What do you recommend the analyst do?
Explain your answer.




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Question 3 [15 POINTS]
[ALL PARTS ARE INDEPENDENT OF EACH OTHER]

(a) [5 POINTS] Graph and express mathematically the consumption set of a consumer for whom:

Assume neither good can be consumed in negative amounts.


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(b) [5 POINTS] Graph and express mathematically the consumption set of a consumer for whom:

Assume neither good can be consumed in negative amounts.

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(c) [5 POINTS] Graph and express mathematically the consumption set of a consumer for whom:

Assume neither good can be consumed in negative amounts.

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Question 4 [20 POINTS]
[ALL PARTS ARE INDEPENDENT OF EACH OTHER]
(a) [4 POINTS] A consumer perceives goods 1 and 2 to be good goods as well as perfect substitutes with a marginal
rate of substitution

. Write down two utility functions representing this consumers preferences and use one of
these utility functions to state the simplest possible UMP. Do not solve the UMP but do explain how you simplified the
UMP.







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(b) [4 POINTS] A consumer perceives goods 1 and 2 to be good goods as well as imperfect substitutes. She tells you
that she must consume both goods and that shell always spend 43% of her income on good 2. Write down two utility
functions representing this consumers preferences and use one of these utility functions to state the simplest possible
UMP. Do not solve the UMP but do explain how you simplified the UMP.

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(c) [4 POINTS] A consumer perceives

and

to be good goods as well as complements. A unit of

consists of a
combination of

and

: the consumer perceives 2 units of

to be a perfect substitute for 5 units of

, and 2
units of

to be a perfect substitute for a unit of

. Write down a utility function representing this consumers

preferences. What is the between

and

? Show all calculations.

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(d) [4 POINTS] A consumer perceives

as a bad good and

as a neutral good. Write down a utility function

representing this consumers preferences and graph the indifference curve for an arbitrary level of utility . Show
all calculations.



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(e) [4 POINTS] For the consumer in part (d), could the optimal choice be the bundle (

) ()? What about

(

) ()? Explain briefly. Hint: Feel free to use a graphical argument.

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Question 5 [15 POINTS]

(a) [5 POINTS] Consider a UMP where the utility function is defined on the consumption set {(

) }.
Prove that if the consumer has monotone preferences then her marginal utility of income must be strictly positive.



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(b) [10 POINTS] Consider a general UMP where the utility function is defined on the consumption set
{(

) }. Prove that if the optimal choice is in the interior of the consumption set then at the optimal bundle the
indifference curve must be tangent to the budget line. Show all calculations.


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Question 6 [20 POINTS]
(a) [5 POINTS] Solve the following problem in two separate ways:

You are expected to use the appropriate constrained optimization methods. Show key calculations and state
assumptions.

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(b) [5 POINTS] Suppose

Without re-solving the problem, calculate the

impact on optimal demands due to a 1% income tax. Show key calculations and state assumptions.


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(c) [5 POINTS] Suppose

Without re-solving the problem, calculate the impact

on optimal utility due to an 1% income tax in two separate ways. Show key calculations and state assumptions.
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(d) [5 POINTS] Suppose

Suppose the government imposes an excise tax on

good 2 (in dollars per unit) that is designed to raise the same amount of tax revenue as a 1% income tax. Calculate this
excise tax rate on good 2 (dollars per unit). Which tax scheme hurts consumers the least? Show key calculations and
state assumptions.