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UNIVERSITY OF TORONTO AT SCARBOROUGH

DEPARTMENT OF MANAGEMENT


ECMB02: Price Theory: A Mathematical Approach

Fall 2009

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
Marks
Earned



Maximum
Marks
Possible
30 20 15 20

15 100
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Answer all following 5 questions:

Question-1 [30 Points] Answer the following Short Questions:

a) [6 points] You are analyzing the market for hot chocolate. Sketch a basic supply and demand
diagram, and state the impact on the equilibrium price and quantity of each of the following
events affecting the market:

i) An abnormally cold winter:


Demand shifts right, P & Q increase











ii) A reduction in the price of coffee beans:

D shifts left, P and Q decreases










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b) [6 Points] Jack loves CranCream drink, which he makes by combining one glass of cranberry
juice and two scoops of ice cream. Julie is on a special diet that assigns points to food and drinks.
One glass of cranberry is one point and one scoop of ice cream is one point. She can consume any
combination of cranberry and ice cream as long as the total number of points is two.

i) What kind of goods are cranberry and ice cream for Jack? Show his indifference curves on the
following graph.

Perfect complement:















ii) What kind of goods are cranberry and ice cream for Julie? Show her indifference curve on the
following graph.


Perfect Substitute:


Cranberry Juice
Ice Cream
Ice Cream
Cranberry Juice
2
2
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c) [6 Points] Assume you have a fixed budget of $100. Further assume that you spend your entire
budget. Both good x and good y cost $10 each. You are spending all your money on y. At this
bundle, your marginal utility of x is 8 while your marginal utility of y is 10.

Are you optimizing your utility? Why or why not? Using a graph explain your answer.


Then you are at point A. You:

(1) spend your entire income because you are on the budget line
(2) The MRS<Px/Py, or (MU
x
/ Px)<(MU
y
/ Py).

That is, the marginal utility of x per dollar spent is lower than that of y. However, you
already gave away all x and cannot get more y. Therefore a corner solution (Point A) where
you consume no x is your optimal bundle.



U1
U2

y
x
A
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d) [7 Points] Assume a utility function that is given by U(x,y) = 2xy. Further assume a budget of
$100. When the prices where Px=1 and Py=1, you consumed x= 50 and y = 50, while when the
prices changed to Px=2 and Py=1, you consumed x= 25 and y = 50. With the help of the
following graph decompose the total effect of the price change into the substitution and income
effects.


We know TE = 50-25. We need to find the SE. Having SE we can solve for IE as TE=SE+IE.
SE is the change in the quantity of x demanded, if (1) the individual remains at the same
indifference curve and (2) if MRS is equal to the new price ration.
6 . 10 25 6 . 35
4 . 14 6 . 35 50
6 . 35 ) 2 ( 2 5000 ) 2 ( ), 1 (
2
1
2
: 2
2 5000 50 50 2 : 1
= =
= =
= => = =>
= => = =
= = =
IE
SE
x x x
x y
x
y
MRS
XY U


Graphically:














25
100
50
50
100
35.6
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e) [5 Points] You have $10. You spend it on two products. A composite product (y) with a price
of p
y
= 1 and coffee (x) with a price of p
x
= 1. If you purchase six coffees, you will be offered one
coffee for free. Show graphically how this affects your budget line. Could this induce you to
drink more coffee, yes or no, show it on the graph?











11
10
6
y
x
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Question-2 [20 Points] Canadian Mining Company (CMC) is interested in obtaining quick
estimates of the supply and demand curves for coal. The firms research department informs you
that the elasticity of supply is approximately 1.7, the elasticity of demand is approximately -0.85,
and the current price and quantity are $41 and 1,206, respectively. Price is measured in dollars
per ton, quantity the number of tons per week. Assume that both demand and supply are linear.

a) [6 Points] Estimate supply and demand curves at the current price and quantity.
b) [5 Points] What impact would a 10% increase in demand have on the equilibrium price and
quantity?
c) [3 Points] If the government refused to let CMC raise the price when demand increased in (b)
above, what shortage is created?
d) [6 Points] Ignore part (c). Suppose the government subsidizes coal producers by 5 dollars per
ton. What would be the new equilibrium price? Use a graph to show your answer.

Solution:
a)

Demand curve

Q =a0 - b0P
E
d
=b0 P/Q = .85 =b0 41/1206

b0 =25 => 1206 =a0 - 25(41) => 1206 =a0 1025 => a0 =2231

Q
d
=2231 - 25P

Next, we estimate the supply curve
Q =a1 +b1P

E
1
=b1 P/Q = 1.7 =b1 41/1206

b1 =50 => 1206 =a1 +50(41) => a1 =-844

Qs =-844 +50P

b)

Multiply demand equation by 1.10
Qd = 1.10 (2231 - 25P)
Qd =Qs and solve

2454.1 - 27.5P =-844 +50P

P =42.56 => Qd =2454.1 - 27.5(42.56) Qd =1283.7 or 1284

c) Since price cannot rise, the shortage will be the quantity demanded with the new demand
minus the quantity supplied with the unchanged supply

Quantity demanded: Q =2454.1 - 27.5(41) =1326.6
Quantity supplied: Q =-844 +50(41) =1206.0
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Shortage =1326.6 - 1206.0 =120.6 tons per week.

d)
Q
d
=2231 - 25P
Qs =-844 +50P => Qs
/
=-844 +50(P+5)
Q
d
= Qs
/
=>2231 - 25P =-844 +50(P+5) => P = 37.67 => Q = 1289.33
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Question-3 [15 Points] Consider your preferences for Gasoline (X) and a composite good
(Y). Your utility function is U(X,Y) = X
0.5
+ 2Y
0.5
. You have an annual income of
$45,000. Suppose the price of the composite good is $1.
a) [5 Points] Due to shortages, the government has introduced a rationing system such
that you can only consume 12500 liters a year at $.75 a liter. What would be your optimal
consumption bundle.
b) [6 Points] The government removes the rationing system and the free market price of
gasoline jumps to $1. What would be your new optimal consumption bundle. Are you
better off with or without the rationing?
c) [4 Points] Illustrate your solution in a clearly labeled graph.

a)
33750
000 , 15
000 , 45 25 . 2 75 . 0
25 . 2 5 . 1
5 . 0
1
75 . 0 5 . 0
2
5 . 0
5 . 0
5 . 0
5 . 0
= =>
= =>
= + =>
= = =>
= = =

Y
X
X X
X X Y
X
Y
Y
X
MRS

But cannot consume more than 12,500 L, therefore corner solution:
625 , 35
500 , 12
000 , 45 75 .
= =>
=
= +
Y
X
Y X


b)
Without the rationing and with the new price:
000 , 36
000 , 9
000 , 45 4
4
5 . 0
1
1 5 . 0
5 . 0
5 . 0
5 . 0
5 . 0
= =>
= =>
= + =>
= =>
= = =

Y
X
X X
X Y
X
Y
Y
X
MRS


You are better off with the rationing because:

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without Ration
without
Ration
U U
U
U
>
= + =
= + =
34 . 474 000 , 36 2 000 , 9
30 . 489 625 , 35 2 500 , 12
5 . 0 5 . 0
5 . 0 5 . 0


c)


45
60
12.5 15
45
9
15
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Question-4 [20 Points] Lynda has the following utility function: U(x, y) = y + 2x
1/2
. Let p
x
and
p
y
be the corresponding prices and I her 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) and graph it.

2
2 / 1
2 / 1
2 / 1
1
0 ) (
0 1
0
) ( 2
|
|
.
|

\
|
= => =
= + =
c
c
= =
c
c
= =
c
c
+ + =

x
y
y
x
y x
y
x
y x
p
p
x
p
p x
I Y p X p
x
L
p
x
L
p x
x
L
I Y p X p x y L

b) [6 Points] Find the demand functions for x and y. Graph the Engle curve for x. What is
special about these indifference curves? What does this imply about the income and
substitution effects resulting from an increase in the price of x? Explain.

x
y
y y
x
y
x
y
x
x
y
y
x
p
p
p
I
p
p
p
p I
p
x p I
y
p
p
x
p
p x
=
|
|
.
|

\
|

=
|
|
.
|

\
|
= => =

2
2
2 / 1
1


c) [3 Points] Suppose Lynda lives in a city where p
x
= 1, p
y
= 2 and her job offers her I = 44.
Find the optimal consumption levels for x and y?


20
2
4 44
4
1
2
2
2
=

=
=
|
.
|

\
|
= =>
|
|
.
|

\
|
=
y
x
x
y
p
p I
y
x
p
p
x


d) [5 Points] Now suppose she is offered a new that offers her an income of 60 (I = 60) but the
job is in another city with p
x
= 1, p
y
= 4. Should she take the job?
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11
4
16 60
16
1
4
2
2
=

=
=
|
.
|

\
|
= =>
|
|
.
|

\
|
=
y
x
x
y
p
p I
y
x
p
p
x

Her utility in the old job is:

24 4 2 20 ) 20 , 4 (
2 / 1
= + = U

Her utility in the new job is:

19 16 2 11 ) 11 , 16 (
2 / 1
= + = U

Better off with the old job.
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Question-5 [15 Points] There are 100 consumers in the economy. Half of them live in city A and
demand Apple Juice according to the individual inverse demand curve P = 6 3Q. The other half
live in city B and demand Apple Juice according to the individual inverse demand curve P =
96Q. Suppose that the market-clearing price for Apple Juice is $3.

a) [6 Points] Write down the market demand for Apple Juice in this economy and then graph it?
Is the market demand function linear? If not, where is the kink?

b) [4 Points] At the market-clearing price, what is the total demand? What is the price elasticity
of demand for the market at this price?

c) [5 Points] If the price increases from $3 to $10, how does the consumer surplus change? Graph
the demand curve with quantity on the horizontal axis and price on the vertical axis, and show the
change in consumer surplus.

Solution:

P Q
P P
Q
P P
Q
M
B
A
25 175
3
25
75
6 2
3
50 50
3
50
100
3
2 50 50
=
=
(

=
=
(

=


But demand seize to exist in city A when the P >= 6 while in city B the demand is zero when
P>=9 therefore the demand will be kinked at P=6 or:

) 6 ( 25 175
) 6 (
3
25
75
s =
> =
P P Q
P
P
Q
M
M


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b)

75 . 0
100
3
25
100 3 25 175
= =
= =
d
M
E
Q


c) - 225

150 75
150 50 6 5 . 0
50
6 2
3
50 50 : 3
75 50 3 5 . 0
50
3
2 50 50 : 3
+ =
= =
=
(

= =
= =
=
(

= =
TS
CS
P
Q P
CS
P
Q P
B
B
A
A


When the price increases to 9 all surplus will be lost
the total surplus change = -225
can show in the graph as well