UNIVERSITY OF TORONTO AT SCARBOROUGH

DEPARTMENT OF MANAGEMENT
ECMB02: Price Theory: A Mathematical Approach
Spring 2011

Instructor: A. Mazaheri
Test-1 (Solutions)
Instructions: This is a closed book test.

You have 2 Hours.

Good Luck!
Last
Name:
First
Name:

ID

FOR MARKERS ONLY:

Q1

Q2

Q3

Q4

Q5

Total

35

17

15

24

100

Marks
Earned
Maximum
Marks
Possible

Page 1 of 1

Answer all following 5 questions:

Question-1 [35 Points] Answer the following Short Questions:
a) [4 points] During the last two decades or so the cost of health care has risen dramatically. For
the same time period the quantity of health care provided has risen as well but not as dramatically
as the cost. Use a demand and supply framework to show why. Comment on your answer

The demand has shifted out but the supply has shifted in due to the dramatic rise in the cost
of equipment and labor employed in the health care. The result is quantity has increased
but not as much as the cost.
b) [4 points] Using the following graph, what can you conclude about the relation between X and
Y?
X and Y are complement since a decline in the change in the price of X leads to an increase
in the demand for Y.
Y

Price-consumption Path

X
Page 2 of 2

c) [7 Points] Graph the indifference curves for the following two cases:
i) (3 Points) Ahmed does not care whether he has Coke or Pepsi, as long as it is cola. Graph his
representative indifference curves.
Perfect Substitute:
Pepsi

Coke
1

ii) (4 Points) Ali likes coffee but does not want more than two cups of coffee a day. If he is given
more than two cups of coffee a day he will leave it untouched. Graph his indifference curves.

Everything else

Coffee
2

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d) [8 Points] Suppose skis and binding are perfect, two-for-one complements and Jack spends all
of his equipment budget of $1,200 per year on these two goods. That is, assume that Jack wears
out two pairs of skis for every pair of bindings he wears out. Skis and bindings each cost $200 per
pair. On the graph below, draw Jacks budget line and at least two of his indifference curves.
Label the lines appropriately and identify the values of the intercepts.
Skis (pairs per year)

(2,4)

Bindings (pairs per year)

Find Jacks optimal consumption choice? That is, how many pair of skis and how many pairs of
bindings would maximize his utility? Identify his optimal consumption on the graph above.
If price of bindings increases to 400, what would be the income effect?

Solution:

U = min{Y, 2X}
Y = 2X
1200 = 200X + 200Y
=> 1200 = 200X + 200( 2X)
=> X = 2, Y = 4
If the price X rises to 400 the demand of the X declines to:

1200 = 400X + 200( 2X)

=> X = 1.5
There will be no SE, the TE = 2-1.5=.5 is equal to IE as well.

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e) [5 Points] L-Mart is having a special. The price of X is Px = 2 and the price of Y is Py = 1. But
for a limited time, for the 1st unit of X that you buy they will give you one unit of Y for free. This
deal is only good for the first unit - after that you must pay for both X and Y. if Jane has $10 to
spend, draw her budget line. Make sure you label all the points.

Solution:
X
0
1
2
3
4
5

Y
10
1+8=9
1+6=7
1+4=5
1+2=3
1+0=1

10
9

X
1

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f) [7 Points] Assume a utility function that is given by U(x,y) = xy. Further assume a budget of
$80. When the prices where Px=1 and Py=1, you consumed x= 40 and y = 40, while when the
prices changed to Px=2 and Py=1, you consumed x = 20 and y = 40.
Numerically find and then use the following diagram to graph the substitution effect and the
income effect of this price change on the purchase of x.

1 : U = 40 40 = 1600 = xy
y 2
= => y = 2 x
x 1
(1), (2) => 1600 = x 2 x => x = 28.28
2 : MRS =

SE = 40 28.28 = 11.72
IE = 28.28 20 = 8.28
Graphically:
y
80

40

SE
IE

x
20

28.28

40

80

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Question-2 [17 Points] In a city with a medium sized population, the equilibrium price for a city
bus ticket is $1.00, and the number of riders each day is 10,800. The short-run price elasticity of
demand is -0.60, and the short-run elasticity of supply is 1.0.
a) (8 Points) Estimate the short run linear supply and demand curves for bus tickets.
b) (5 Points) If the demand for bus tickets increased by 10% because of a rise in the world price
of oil, what would be the new equilibrium price of bus tickets?
c) (4 Points) If the city council refused to let the bus company raise the price of bus tickets after
the demand for tickets increases (see (b) above), what daily shortage of tickets would be created?
Solution:
Given: P* = $1.00 per ticket Q* = 10,800
Ed = -0.60 Es = 1.0
a) Demand: Qd = a0 + a1P

Supply: Qs = b0 + b1P

Use: E = (P/Q) (Q/P) to compute a1 and b1.

-0.6 = (1/10800)a1
a1 = -6,480

1.0 = (1/10800) b1
b1 = 10,800

Solve for a0 and b0

Qd = a0 + a1P
10800 = a0 + -6,480(1)

Qs = b0 + b1P
10800 = b0 + 10,800(1)

a0 = 17,280
Qd = 17,280 6,480P

b0 = 0
Qs = 10,800P

b)
New demand = (1.10)Qd = (17,280 - 6,480P)(1.10)
Qd = 19,008.00 - 7,128P
Equate Qd to Qs to get new equilibrium price.
19,008 - 7,128P = 0.0 + 10,800 P
P* = $1.06 per ticket
c)
The shortage would be the quantity demanded at P = $1.00
minus the quantity supplied at P=$1.00
Qd = 19,008 - 7,128($1.00) = 11,880
Qs = 0.0 + 10,800($1.00) = 10,800
Shortage = 11,800 - 10,800 = 1,080 rides per day

d) No. The bus company has no incentive to supply more than 10,800 rides
per day, as long as the price is restricted at $1.00.

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Question-3 [15 Points] Janice Doe consumes two goods, X and Y. Janice has a utility function
given by the expression:
U = 4X0.5 Y0.5
The current prices of X and Y are 25 and 50, respectively.
Janice currently has an income of 750 per time period.
a) (4 Points) Calculate the optimal quantities of X and Y that Janice should choose, given her
budget constraint.
b) (6 Points) Suppose that the government rations purchases of good X such that Janice is limited
to 10 units of X per time period at a price of 20. Assuming that Janice chooses to spend her entire
income, how much Y will Janice consume? Is she better off with or without rationing?
c) (5 Points) Illustrate your solution on a clearly labeled graph.
Solution:
a)

MRS =

P
2 X 0.5Y 0.5 Y
25
=
= X =
0.5 0.5
2X Y
X
PY 50

1)Y = 0.5 X
2)750 = 25 X + 50Y = 25 X + 50(0.5 X ) = 50 X
=> X = 15, Y = 7.5
b)

MRS =

Y
P
20
= X =
X PY 50

1)Y = 0.4 X
2)750 = 25 X + 50Y = 20 X + 50(0.4 X ) = 40 X
=> X = 18.75, Y = 7.5
But the constraint is binding therefore she will consume 15 units of X:
750 = 20*10+50Y=> Y = 11
Her initial utility is:

U initial = 4 150.57.50.5 = 42.43

Her utility with rationing is:

U ration = 4 10 0.5110.5 = 41.95

better off without rationing.

Page 8 of 8

c) Graph

Initial
U=42.43
>
Post ration
U=41.95

15

10

15

30

37.5

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Question-4 [24 Points] Kumar has the following utility function: U ( x , y ) = 6 x 1 / 2 + y . Let px
and py be the corresponding prices and I his income.
a) [6 Points] Setup the Lagrangian function and find the first order conditions (FOCs). Use these
FOCs to find the expression for the marginal rate of substitution (MRS). Do you see anything
specific about this MRS?
Solution:

L = 6 x 1 / 2 + y ( p x X + p yY I )
L
= 3x 1 / 2 p x = 0
x
L
= 1 p y = 0
x
L
= ( p x X + p yY I ) = 0
x
3 x 1 / 2 p x
=
= MRS
1
py
MRS does not depend on y.

Page 10 of 10

b) [8 Points] Find the demand functions for x and y. Find the optimal bundle if px=1and py=1and
I =2. Graph your solution.
Solution:

3py
3 x 1 / 2 p x
=
=> x =
1
py
px

Demand for x = 9
3py
I p x
I px x
px
Demand for y =
=
py
py

= I 9 py 0
py
px

y=0
This is a corner solution as if x = 9, y = -7 which is not possible
Therefore, y=0, x = 2. (3 Points for the graph)
2

Page 11 of 11

c) [5 Points] Graph the Income-consumption and the Engle curve for x. Briefly explain your
findings.
y

I-C Curve

x
9

Engle Curve
I

x
9

He consumes all his money if he own less than $9 (corner solution). Thereafter he only
consumes 9 units.

Page 12 of 12

d) [5 Points] If Kumars income is $20 and the price of x rises from $1 to $2, what would be the
substitution and the income effects on x.
Solution:

3py
x =
px

9
3
=> x = =
4
2

His consumption of x drops from 9 to 9/4. There is no income effect therefore all the change
would be due to the substitution effect.

Page 13 of 13

Question-5 [9 Points] There are 1000 consumers in the economy. Half of them live in city A and
demand coffee according to the individual inverse demand curve P = 5 Q. The other half live in
city B and demand coffee according to the individual inverse demand curve P = 42Q. Derive
the total market demand curve for coffee and illustrate the market demand on the following
graph. Make sure to clearly label your graph.
Solution:

500q A = 500[5 P ] = 2,500 500 P

500q B = 500[2 0.5P ] = 1,000 250 P
Q M = 3,500 750 P
But demand seize to exist in B when the P >= 4 while in (A) the demand is zero when P>=5
therefore the demand will be kinked at P=12.5 or:

Q M = 2,500 500 P ( P > 4)

Q M = 3,500 750 P ( P 4)

500

3500

Page 14 of 14