Elements of Economic Analysis I: Problem Set 1

Santiago Caicedo
Pablo Robles
Quiz on Monday October 5th

We encourage you to work in groups to solve all the problem set. First try them on your own, then discuss
your answers with others. The quiz will be a subset of these questions (randomly chosen at the beginning
of every TA session).

True or False

An answer without a justification will get no points.

1. The infinite divisibility of goods assumption, makes the applications of economics limited since we
never consume 0.2 of a car.
2. A good is defined by the state and date it is consumed.
3. A road is a private good, since it is rival and excludable.
4. Economic models cant describe the behavior of people who dont know how to solve constrained
optimization problems.
5. If the government levies a tax on gasoline, the consumers are going to pay most of the tax.
6. Assume there are lots of substitutes for apples. If the government increases the sales tax on apples,
most of the tax burden would go to the consumer in the short term, but to the producer in the long
term (when supply can adjust).

Demand and Supply analysis

Suppose both demand and supply of apples is linear,

q d = a bp

(1)

q s = c + dp,

(2)

with a > c > 0 and b, d > 0.

1. Use the demand q d (p) and supply q s (p) functions to solve for the equilibrium price p and quantity
q .
2. Calculate the inverse demand pd (q) and inverse supply function ps (q).
3. Calculate the equilibrium price p and the equilibrium quantity q . Show that they are the same as
the ones you calculated before.
4. Plot the inverse demand function and the inverse supply function in a graph with p on the y-axis and
q on the x-axis.
I. Elasticity and comparative statics
d

p
and the elasticity of supply s =
1. Calculate the elasticity of demand d = dq
dp q
for different values of p and q? What happens to d when q 0?

dq s p
.
dp q

Are they constant

2. Suppose that scientists discover that apples are good for your health and the demand for apples doubles
(for a given price there is twice more demand). Which is the new demand function q d (p)? What is the
new equilibrium? Plot the new and the old inverse demand and supply functions showing the change
in equilibrium.
II. Taxes
1. Suppose a quantity tax (a tax levied per unit of quantity bought or sold) of t > 0 dollars per apple.
Suppose that the tax is imposed to the suppliers such that pd = ps + t. Show that the equilibrium
demand price is pd = ac+dt
and supply price ps = acbt
using the market equilibrium equation
d+b
d+b
d d
s s
q (p ) = q (p ).
2. Show that the equilibrium quantity with tax is qt = c + d acbt
.
d+b
3. Would it make any difference if the tax is charged to consumers instead of suppliers?
4. Sketch the demand and supply functions with the tax for the two cases on separate figures.
5. How does the pd and ps depend on b and d? Give some intuition in terms of the elasticity of demand
and supply.
III. Welfare
1. Calculate the consumer surplus and producer surplus in equilibrium without tax p , q .
2. Calculate the consumer surplus and producer surplus in equilibrium without tax pd , ps , qt .
3. What would be the deadweight loss DW L ?
4. Illustrate your results graphically.

Short answer questions

1. Suppose that the university is giving free t-shirts to the incoming students, but there is a line to get
them.
2

a. Are the t-shirts really free?

b. Who are the ones that are most likely to get the t-shirts?
c. Is this allocation system Pareto efficient? (Hint: Can there be any gains from trade?)

2. In class we showed f (x) = log(x), f (x) = x and f (x1 , x2 ) = x

1 x2 with , > 0 and + < 1, are
concave functions. Show if the following functions are concave of convex, or none.

a. g(x) = 3 log(x)
b. g(x1 , x2 ) = x
1 log(x2 )

c. g(x1 , x2 ) = log(x
1 x2 )

Constrained optimization

Consider the following optimization problem,

max x12 x22

x1 ,x2

s.t

p1 x1 + p2 x2 = m.

1. Write the lagrangian L(x1 , x2 , ), using as the lagrange multiplier.

2. Write down the FOC.
3. Solve the FOC, for x1 , x2 and .
4. Are these FOC also sufficient conditions for a maximum? (Hint: Is L(x1 , x2 , ) concave?) Fully
justify your answer.