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Problem Set-II

1. Bobby is a college student who has $500 of income to spend each semester on books

and pizzas. The price of a pizza is $10 and the price of a book is $50. Draw Bobby's

budget constraint.

Now, suppose Bobby's parents buy her a $300 gift certificate each semester that can

only be used to buy books. (Bobby doesn’t like the idea though!! She thinks her parents

always make sure that Bobby lives a miserable life with books only!!) But eventually

Bobby could find herself better-off with those gift certificates. Why?

2. Dr. Strangetaste buys only french fries (F) and hot dogs (H) out of his income. He has

positive marginal utilities for both goods, but his MRSH,F is increasing. The price of

hot dogs is PH, and the price of french fries is PF.

a) Draw several of Dr. Strangetaste’s indifference curves, including one that is tangent

to his budget line.

b) Show that the point of tangency does not represent a basket at which utility is

maximized, given the budget constraint. Using the indifference curves you have drawn,

indicate on your graph where the optimal basket is located.

3. Your preferences over pizza (x) and other goods (y) are given by U(x, y) = xy, with

associated marginal utilities MUx = y and MUy = x. Your income is $120.

a) Calculate your optimal basket when Px = 4 and Py = 1.

b) Calculate h income and substitution effects of a decrease in the price of food to $3.

4. “If consumers do not buy less of a commodity when their incomes rise, they will

surely buy less when the price of the commodity rises.” Why?

5. Suppose that the market for air travel between Chicago and Dallas is served by just

two airlines, United and American. An economist has studied this market and has

estimated that the demand curves for round-trip tickets for each airline are as follows:

QdU = 10,000 − 100PU + 99PA (United’s demand) QdA = 10,000 − 100PA + 99PU

(American’s demand) where PU is the price charged by United, and PA is the price

charged by American.

(a) Suppose that both American and United charge a price of $300 each for a round-

trip ticket between Chicago and Dallas. What is the price elasticity of demand for

United flights between Chicago and Dallas?

(b) What is the market-level price elasticity of demand for air travel between Chicago

and Dallas when both airlines charge a price of $300?

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6. The director of a theater company in a small college town is considering changing the

way he prices tickets. He has hired an economic consulting firm to estimate the

demand for tickets. The firm has classified people who go the theater into two groups,

and has come up with two demand functions.The demand curves for the general

public ( Qgp ) and students ( Qs ) are given below:

Qgp 500 5P

7. Qs 200 4P

(a) Graph the two demand curves on one graph, with P on the vertical axis and Q on

the horizontal axis. If the current price of tickets is $35, identify the quantity

demanded by each group.

(b) Find the price elasticity of demand for each group at the current price and

quantity.

(c) Is the director maximizing the revenue he collects from ticket sales by charging

$35 for each ticket? Explain.

(d) What price should he charge each group if he wants to maximize revenue

collected from ticket sales?

7. Ms.Pampered consumes only two goods, pizza (P) and burgers (H) and considers them to

be perfect substitutes, as shown by her utility function: U(P, H) = P + 4H. The price of pizza

is $3 and the price of burgers is $6, and Ms.Pampered’s monthly income is $300. Knowing

that she likes pizza, her grandmother gives her a birthday gift certificate of $60 redeemable

only at Pizza Hut. Though Ms. Pampered is happy to get this gift, her grandmother did not

realize that she could have made her exactly as happy by spending far less than she did. How

much would she have needed to give her in cash to make her just as well off as with the gift

certificate?

8. Much of the demand for U.S. agricultural output has come from other countries. In 2014, the

total demand for wheat was Q = 3244 – 283P. Of this, total domestic demand was QD = 1700 –

107P, and domestic supply was QS = 1944 + 207P. Suppose the export demand for wheat falls

by 40 percent.

(a) U.S. farmers are concerned about this drop in export demand. What happens to the free-

market price of wheat in the United States? Do the farmers have much reason to worry?

(b) Now suppose the U.S. government wants to buy enough wheat to raise the price to $3.50

per bushel. With the drop in export demand, how much wheat would the government have to

buy? How much would this cost the government?

9. Provide an intuitive explanation for why a “buy one, get one free” deal is not the same as a

“half-price” sale.

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10. Karina buys two goods, food F and clothing C, with the utility function U = FC + F.. She

has an income of 20. The price of clothing is 4.

a) Derive the equation representing Karina’s demand for food, and draw this demand curve

for prices of food ranging between 1 and 6.

b) Calculate the income and substitution effects on Karina’s consumption of food when the

price of food rises from 1 to 4.

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