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Chapter 3

3.1

Preferences

1)

A)

B)

C)

D)

Answer:

A

Topic:

Preferences

2)

A)

1

B)

C)

D)

Answer:

A

Topic:

Preferences

3)

If a consumer prefers Apples to Bananas and prefers Bananas to Citrus Fruit, in order to satisfy

assumptions about preferences she has to prefer

A)

Bananas to Apples.

B)

C)

D)

Answer:

C

Topic:

Preferences

4)

2

The principle that "More is better" results in indifference curves

A)

sloping down.

B)

not intersecting.

C)

reflecting greater preferences the further they are from the origin.

D)

Answer:

D

Topic:

Preferences

5)

A)

transitivity.

B)

completeness.

C)

rationality.

D)

nonsatiation.

Answer:

B

Topic:

3

Preferences

4

6)

A)

completeness.

B)

transitivity.

C)

more is better.

D)

Answer:

C

Topic:

Preferences

7)

If two indifference curves were to intersect at a point, this would violate the assumption of

A)

transitivity.

B)

completeness.

C)

D)

Answer:

5

A

Topic:

Preferences

8)

A)

B)

C)

D)

Answer:

B

Topic:

Preferences

9)

A consumer's willingness to trade one good for another can be expressed by the consumer's

A)

indifference curve.

B)

C)

D)

6

None of the above.

Answer:

C

Topic:

Preferences

10)

A)

give up more "y" to get an extra "x" the more "x" they have.

B)

give up more "y" to get an extra "x" the less "x" they have.

C)

D)

acquire more "x" only if they do not have to give up any "y".

Answer:

B

Topic:

Preferences

11)

Measuring "y" on the vertical axis and "x" on the horizontal axis, convexity of indifference curves implies

that the MRS of "y" for "x"

A)

B)

C)

7

is constant as "x" increases.

D)

Answer:

A

Topic:

Preferences

12)

A)

cross.

B)

are convex.

C)

D)

Answer:

D

Topic:

Preferences

13)

For which of the following pairs of goods would most people likely have convex indifference curves?

A)

8

B)

C)

D)

Answer:

C

Topic:

Preferences

14)

If two goods are perfect substitutes, then the indifference curves for those two goods would be

A)

B)

C)

D)

L-shaped.

Answer:

C

Topic:

Preferences

15)

The indifference curves for left shoes and right shoes would most likely be

9

A)

B)

C)

D)

L-shaped.

Answer:

D

Topic:

Preferences

10

For the following, please answer "True" or "False" and explain why.

16)

Answer:

True. As seen in the above figure, points a and c are on the same indifference curve and are therefore

equally preferred. Points b and c are also on the same indifference curve and are therefore equally

preferred. Transitivity implies that the consumer would be indifferent between a and b; however, since

more is preferred to less, a is preferred to b. Thus as a result of the assumption of transitivity and the

assumption that more is preferred to less, indifference curves cannot intersect.

Topic:

Preferences

17)

Answer:

False. While indifference curves are typically convex, they can be concave. This means, however, that the

MRS of y for x increases as x increases. That is, the consumer places greater value on the next x the more x

she has. The interpretation is that a consumer with concave indifference curves prefers to specialize in

either x or y but not have a mix of both.

Topic:

11

Preferences

18)

Indifference curves for perfect substitutes must be parallel lines with a slope of negative one.

Answer:

False. Indifference curves for perfect substitutes are parallel lines, but the slope is not necessarily negative

one.

Topic:

Preferences

19)

Indifference curves on the same indifference map can have different shapes.

Answer:

True. Indifference curves can meet all the necessary requirements and still have different shapes.

Topic:

Preferences

20)

Lisa views pizzas and burritos as goods. If she prefers a bundle of four burritos and four pizzas to a

bundle of four burritos and five pizzas, which property of consumer preference is violated? What change

in the assumptions could lead a rational consumer to prefer the first bundle?

Answer:

The property of more-is-better is violated. However, if pizza is a bad, then a rational consumer would

prefer the first bundle.

Topic:

Preferences

21)

Answer:

12

Diminishing marginal rates of substitution make most indifference curves convex. When people have a

lot of one good, they are willing to give up a relatively larger amount of it to get a good of which they

have relatively little.

Topic:

Preferences

13

22)

Draw the indifference curves for rock concerts and food for each of the following:

(b) a typical 75-year-old

Answer:

See the above figure. These graphs assume that a typical 17-year-old would enjoy both food and rock

concerts. The 75-year-old might find the rock concerts neutral or even bad.

Topic:

Preferences

14

23)

Draw the indifference curves for nickels and dimes. Would they ever have a non-constant slope? Explain.

Answer:

See the above figure. Two nickels are worth 1 dime. Yet for extremely large amounts of money, people

might prefer dimes to nickels for carrying purposes. That is why people often pay with exact change or

don't like to break a twenty.

Topic:

Preferences

3.2

Utility

1)

A)

15

B)

C)

D)

Answer:

B

Topic:

Utility

2)

A)

B)

the consumer derives the same level of ordinal utility from each but not the same level of cardinal utility.

C)

no comparison can be made between the two bundles since utility cannot really be measured.

D)

Answer:

A

Topic:

Utility

3)

16

If the utility function (U) between food (F) and clothing (C) can be represented as U = FxC , the

marginal utility of food equals

A)

F/C .

B)

C/F .

C)

1/2 C/F .

D)

1/2 F/C .

Answer:

C

Topic:

Utility

4)

If the utility function (U) between food (F) and clothing (C) can be represented as U = FxC , the

marginal utility of food

A)

is not positive.

B)

C)

D)

Answer:

17

D

Topic:

Utility

5)

If the utility function (U) between food (F) and clothing (C) can be represented as U = FxC , the

marginal rate of substitution of clothing for food equals

A)

-C/F.

B)

-F/C.

C)

- C/F .

D)

- F/C .

Answer:

A

Topic:

Utility

6)

If Fred's marginal utility of pizza equals 10 and his marginal utility of salad equals 2, then

A)

B)

C)

18

D)

Answer:

B

Topic:

Utility

7)

If Fred's marginal rate of substitution of salad for pizza equals five, then

A)

B)

C)

D)

Answer:

B

Topic:

Utility

19

8)

Adrian's total utilities of two consumption bundles are 50 and 100. This implies that

A)

B)

C)

D)

Answer:

B

Topic:

Utility

9)

If Fred's marginal utility of pizza equals 10 and his marginal utility of salad equals 2, then we know that

A)

B)

C)

D)

Answer:

20

D

Topic:

Utility

10)

If the utility for two goods "x" and "y" is measured as U = x + y, then it can be concluded that

A)

B)

C)

D)

Answer:

A

Topic:

Utility

11)

If the utility for two goods "x" and "y" can be measured as U = x, then it can be concluded that

A)

B)

"y" is a "bad".

C)

the indifference curves on the x,y graph are upward sloping where "x" is measured on the horizontal axis.

D)

21

the indifference curves on the x,y graph are vertical where "x" is measured on the horizontal axis.

Answer:

D

Topic:

Utility

12)

If the utility for two goods "x" and "y" can be measured as U = y, then it can be concluded that

A)

B)

"x" is a "bad".

C)

the indifference curves on the x,y graph are upward sloping where "x" is measured on the horizontal axis.

D)

the indifference curves on the x,y graph are horizontal where "x" is measured on the horizontal axis.

Answer:

D

Topic:

Utility

22

13)

If two goods, "x" and "y", are perfect substitutes, then which of the following best represents the utility

function for the two goods?

A)

U=x+y

B)

U=x∗y

C)

2 2

U=x +y

D)

Answer:

A

Topic:

Utility

14)

If Johnny likes homework (H) but hates exercise (E), which of the following might best represent his

utility function for homework and exercise?

A)

U=H+E

B)

U = H/E

C)

2

U=H + E

D)

2

U=H × E

23

B

Topic:

Utility

15)

Clifford lives by the motto "Eat, drink and be merry today, for tomorrow doesn't matter." If today's

consumption is measured on the horizontal axis and tomorrow's consumption is measured on the vertical

axis, Clifford's indifference curves

A)

B)

C)

D)

Answer:

B

Topic:

Utility

16)

Clifford lives by the motto "Eat drink and be merry today, for tomorrow doesn't matter." If today's

consumption is represented by "x" and tomorrow's consumption is represented by "y", then which of the

following best represents Clifford's utility function?

A)

U=x-y

B)

U = x/y

C)

24

U=x

D)

U=y

Answer:

C

Topic:

Utility

For the following, please answer "True" or "False" and explain why.

17)

The absolute value of the slope of an indifference curve equals the ratio of the marginal utilities of the two

goods involved.

Answer:

True. The MRS can be represented as the ratio of both those quantities.

Topic:

Utility

25

18)

Answer:

Prices are measured in money, which is a cardinal measure. When you have $100 you are twice as well

off compared to having $50. With an ordinal measure like an exam grade you can say that an A is better

than a B but not how much better it is.

Topic:

Utility

19)

Suppose Joe's utility for lobster (L) and soda (S) can be represented as U = L0.5 S0.5. Draw the

indifference curve that yields a utility level of 9. Calculate the MUL, MUS, and MRS of L for S on that

indifference curve when S = 3.

Answer:

0.5

S = 3, L = 27. MUL = 0.5 ∗ (S/L) = 1/6.

0.5

MUS = 0.5 ∗ (L/S) = 1.5.

26

MRS = - MUS / MUL = -9.

Joe is willing to give up nine lobsters to get another soda.

Topic:

Utility

20)

Paul has the utility function U(q1,q2)=q1q2. If Paul consumes q1=4 and q2=2 his Marginal Rate of

Substitution is

A)

-2

B)

1

C)

-1

D)

-1/2

Answer:

A

Topic:

Utility

21)

Sarah has the utility function U(X,Y)=X.5Y.25. When Sarah consumes X=2 and Y=6 she has a marginal

rate of substitution of

A)

-12

B)

-1/6

C)

27

-6

D)

-1/12

Answer:

A

Topic:

Utility

22)

Teddy has preferences given by the utility function U(K,L)=2L+K where K=pounds of Kale per month

and L=pounds of lettuce per month. What is Teddy's Marginal Utility of Kale? What is Teddy's

Marginal Utility from Lettuce? If Kale is on the horizontal axis, what is Teddy's marginal Rate of

Substitution?

Answer:

The marginal utility of Kale is the partial derivative of the utility function with respect to K: MU K=1. For

lettuce, the marginal utility is MUL=2. The marginal rate of substitution is the ratio of marginal utilities:

MRS= -MUK/MUL= -1/2.

Topic:

Utility

23)

Amanda consumes only two goods, X and Y. Her indifference curves satisfy the four standard

assumptions. True or False: If she is indifferent between bundles (1,3) and (3,1), then bundle (2,2) must be

strictly preferred.

Answer:

True. Convexity implies that for any two bundles a consumer is indifferent to, any bundle that is a convex

combination of the two is strictly preferred. (2,2) = 1/2 (3,1) + 1.2 (1,3)

28

Topic:

Utility

29

24)

A friend whom you are studying with for this class has drawn three sets of indifference curves. Explain

what he has done wrong on each graph and what assumption of preferences is violated by each

particular graph.

Answer:

The first has portions that are upward instead of downward sloping, which implies a consumer can

consume so much of Y that they are actually made worse off from more units (satiation). Thus this

violates the assumption that more is better.The second graph violates convexity since the curves are

bowed outward instead of inward towards the origin. The last graph violates transitivity since the

indifference curves are intersecting one another. If they cross, then all points on both indifference curves

are equally preferred. But then points exist which are on the same indifference curve but contain less of

each good.

Topic:

Utility

25)

Ed has the utility function U(F,M)= CM , where C = number of comic books per month and

M=number of movies per month. Gloria has the utility function V(F,M)=15+ CM . Do Ed and Gloria

have the same preference ordering of comics and movies? How can you tell?

Answer:

Yes, they do. Gloria's utility function is an increasing monotonic transformation of Ed's preferences.

Therefore, if U(X1,Y1)>U(X2,Y2), then it must be that V(X1,Y1)>V(X2,Y2).

Topic:

Utility

26)

30

Compute the MRS for the following Utility functions:

(a) U(X,Y) = aln(X)+bln(Y), (b) U(X,Y)=XaYb, and (c) U(X,Y)=aX+bY, where a and b are strictly

positive constants.

Answer:

(b) MUX= aYbXa-1, MUY=bXaYb-1, thus MRS=MUX/MUY=aY/bX.

(c) MUX= a, MUY=b, thus MRS=MUX/MUY=a/b.

Topic:

Utility

31

3.3

Budget Constraint

1)

Joe's income is $500, the price of food (F) is $2 per unit, and the price of shelter (S) is $100. Which of the

following represents his budget constraint?

A)

500 = 2F + 100S

B)

F = 250 - 50S

C)

S = 5 - .02F

D)

Answer:

D

Topic:

Budget Constraint

2)

Joe's income is $500, the price of food (F) is $2 per unit, and the price of shelter (S) is $100. Which of the

following represents his marginal rate of transformation of food for shelter?

A)

-5

B)

-50

C)

-.02

32

D)

Answer:

B

Topic:

Budget Constraint

3)

Joe's income is $500, the price of food (F) is $2 per unit, and the price of shelter (S) is $100. Which of the

following represents his budget constraint?

A)

500 = 100F + 2S

B)

500 = 2F + 100S

C)

S = 500 - 2F

D)

Answer:

B

Topic:

Budget Constraint

4)

Joe's budget constraint equals 500 = 2F + 100S, where $500 is Joe's income, $2 is the price of food (F) and

$100 is the price of shelter (S). How much food can Joe buy if he buys one unit of shelter?

A)

two units

33

B)

200 units

C)

250 units

D)

400 units

Answer:

B

Topic:

Budget Constraint

5)

Joe's income is $500, the price of food (F) is $2, and the price of shelter (S) is $100. Which of the following

bundles is in Joe's opportunity set?

A)

B)

C)

D)

Answer:

C

Topic:

Budget Constraint

6)

34

The marginal rate of transformation of y for x represents

A)

B)

the rate at which the consumer must give up y to get one more x.

C)

- Px/ Py.

D)

Answer:

D

Topic:

Budget Constraint

7)

A)

B)

the rate at which the consumer must give up x to get one more y.

C)

- Px/ Py.

D)

Answer:

35

Topic:

Budget Constraint

8)

The rate at which a consumer must give up y to get one more x is equal to

A)

- Px/ Py.

B)

- Px/ Py

C)

- MUx/MUy.

D)

- MUx/MUy.

Answer:

A

Topic:

Budget Constraint

9)

Betty consumes good x and good y. If the price of x = $3 and the price of y = $4, then

A)

B)

C)

D)

36

Both B and C.

Answer:

D

Topic:

Budget Constraint

10)

If the price of one good increases while the price of the other good and the consumer's income remain

unchanged, what will happen to the budget line?

A)

The budget line rotates inward from the intercept on the axis of the good that did not change in price.

B)

The budget line rotates outward from the intercept on the axis of the good that did not change in price.

C)

D)

Answer:

A

Topic:

Budget Constraint

37

11)

Lisa eats both pizzas and burritos. If the price of a pizza increases, Lisa's opportunity set

A)

becomes larger.

B)

becomes smaller.

C)

is unchanged.

D)

Answer:

B

Topic:

Budget Constraint

12)

If the consumer's income increases while the prices of both goods remain unchanged, what will happen

to the budget line?

A)

The budget line rotates inward from the intercept on the horizontal axis.

B)

The budget line rotates outward from the intercept on the vertical axis.

C)

D)

Answer:

38

D

Topic:

Budget Constraint

13)

If the prices of both goods and income increase by the same percentage, what will happen to the budget

line?

A)

The budget line rotates inward from the intercept on the axis of the good that did not change in price.

B)

The budget line rotates outward from the intercept on the axis of the good that did not change in price.

C)

D)

Nothing.

Answer:

D

Topic:

Budget Constraint

14)

A consumer buys food (F) and shelter (S). If the consumer's income rises and there is no change in the

prices of F or S, the marginal rate of transformation of F for S will

A)

increase.

B)

decrease.

C)

39

D)

Answer:

C

Topic:

Budget Constraint

15)

A)

B)

C)

D)

Answer:

B

Topic:

Budget Constraint

40

16)

A)

B)

C)

D)

Answer:

D

Topic:

Budget Constraint

17)

If a consumer's budget line for food (F) and shelter (S) is represented as F = 250 - 5S, we know that

A)

B)

C)

D)

Answer:

41

C

Topic:

Budget Constraint

For the following, please answer "True" or "False" and explain why.

18)

The slope of the budget line represents the rate at which the consumer is willing to trade one good for

another at any given bundle.

Answer:

False. This describes the slope of the indifference curve. The slope of the budget line represents the rate at

which the consumer must trade one good for another at any given bundle.

Topic:

Budget Constraint

42

19)

Joe subscribes to an Internet provider that charges $2 per hour. Draw his budget line for Internet access

on the horizontal axis and money spent on all other goods on the vertical axis assuming he has $100 per

month to spend. Another company offers unlimited Internet access for a flat monthly fee of $20. Draw

this budget line.

Answer:

Topic:

Budget Constraint

43

20)

Lisa has an income of $100. She spends all of her income on pizza and burritos. A pizza costs $10 and a

burrito costs $5. However, the store where Lisa buys her burritos has a special deal. After you've bought

six burritos, then you can buy each burrito for $2.50. Draw Lisa's opportunity set.

Answer:

Topic:

Budget Constraint

21)

Explain the difference between the marginal rate of substitution and the marginal rate of transformation.

Answer:

The marginal rate of substitution is a consumer's willingness to trade one good for another based on

utility. The marginal rate of transformation is the consumer's ability to trade one good for another based

on prices.

Topic:

Budget Constraint

For the following, please answer "True" or "False" and explain why.

22)

44

An increase in a consumer's income will increase the Marginal Rate of Transformation.

Answer:

False. In increase in income will result in a paralell shift of the budget constraint, leaving the slope (MRT)

unchanged.

Topic:

Budget Constraint

45

23)

Suppose Charley only purchases boardgames (B) and haircuts (H) with his income. If the price of

boardgames increases by 100% while the price of haircuts increases by 300%, how will the MRT change

(consider the budget constraint drawn on a graph with boardgames on the horizontal axis)?

Answer:

Before the price change, the MRT=-pB/pH. After the price change, the MRT'= -(2)pB/(4)pH=MRT/2.

The MRT is half.

Topic:

Budget Constraint

3.4

1)

Economists assume consumers select a bundle of goods that maximizes their well-being subject to

A)

B)

their income.

C)

relative prices.

D)

Answer:

A

Topic:

2)

46

An optimum that occurs as a corner solution

A)

B)

cannot be an equilibrium.

C)

D)

Answer:

A

Topic:

3)

A)

MRT = MRS.

B)

Px/ Py = MUx/MUy

C)

the budget line is tangent to the indifference curve at the bundle chosen.

D)

Answer:

D

Topic:

47

Constrained Consumer Choice

4)

A)

B)

C)

D)

Answer:

B

Topic:

48

5)

A)

B)

"I am willing to trade one good for the other at the same rate that I am required to do so."

C)

D)

Answer:

B

Topic:

6)

Assume the price of beer is $4, the price of pizza is $10 and the consumer's income is $250. Which

consumption bundle will NOT be the consumers choice?

A)

A (5 Beers, 5 Pizzas)

B)

B (0 Beers, 25 Pizzas)

C)

D)

Answer:

49

A

Topic:

7)

With respect to consuming food and shelter, two consumers face the same prices and both claim to be in

equilibrium. We therefore know that

A)

B)

C)

D)

Answer:

C

Topic:

50

8)

Johnny has allocated $30 toward coffee and tea and feels that coffee and tea are perfect substitutes. Due to

differences in caffeine levels, his MRS of tea for coffee equals two. If coffee and tea sell for the same price,

Johnny will

A)

B)

C)

D)

Answer:

B

Topic:

51

9)

Max has allocated $100 toward meats for his barbecue. His budget line and an indifference map are

shown in the above figure. Which bundle will Max choose?

A)

a

B)

b

C)

c

D)

d

Answer:

B

Topic:

52

10)

Max has allocated $100 toward meats for his barbecue. His budget line and an indifference map are

shown in the above figure. What is the price of chicken?

A)

$0.80/lb

B)

$1.25/lb

C)

$4/lb

D)

$5/lb

Answer:

D

Topic:

11)

Max has allocated $100 toward meats for his barbecue. His budget line and an indifference map are

shown in the above figure. If the price of burger increases,

A)

B)

Max will buy less burger and the same quantity of chicken.

C)

D)

Answer:

53

D

Topic:

12)

Max has allocated $100 toward meats for his barbecue. His budget line and an indifference map are

shown in the above figure. What happens if Max's mother gives him 10 pounds of burger?

A)

B)

Max is indifferent between this gift and the dollar-value of the burger.

C)

D)

Answer:

B

Topic:

13)

Max has allocated $100 toward meats for his barbecue. His budget line and an indifference map are

shown in the above figure. What happens if Max's mother gives him 30 pounds of burger?

A)

B)

Max is indifferent between this gift and the dollar-value of the burger.

C)

54

D)

Answer:

A

Topic:

14)

Max has allocated $100 toward meats for his barbecue. His budget line and an indifference map are

shown in the above figure. What happens if Max receives a $100 cash grant to buy either meat or chicken?

A)

B)

Max will spend it all on burger. Because of its lower price, he can buy more of it.

C)

Max will take advantage of the gift by buying all chicken because it is the more expensive meat.

D)

Answer:

A

Topic:

15)

Max has allocated $100 toward meats for his barbecue. His budget line and an indifference map are

shown in the above figure. Which of the following best describes Max's preferences?

A)

d>b>e

55

B)

d=b=e

C)

a=b>c

D)

a=b>e

Answer:

D

Topic:

16)

Max has allocated $100 toward meats for his barbecue. His budget line and an indifference map are

shown in the above figure. Which of the following bundles are in Max's opportunity set?

A)

a, b, c

B)

b, d, e

C)

a, b, d

D)

Answer:

B

Topic:

17)

56

Max has allocated $100 toward meats for his barbecue. His budget line and indifference map are shown

in the above figure. If the price of burger increases, which of the following bundles are in Max's

opportunity set?

A)

b, d, e

B)

d, e

C)

a, b, c, d, e

D)

Answer:

D

Topic:

18)

Max has allocated $100 toward meats for his barbecue. His budget line and indifference map are shown

in the above figure. If Max is currently at point e

A)

B)

C)

D)

Answer:

57

D

Topic:

19)

Max has allocated $100 toward meats for his barbecue. His budget line and indifference map are shown

in the above figure. If Max is currently at point d

A)

B)

C)

D)

Answer:

D

Topic:

For the following, please answer "True" or "False" and explain why.

20)

If MRS > MRT, then the consumer is better off than at equilibrium.

Answer:

False. MRS > MRT implies that the consumer values the next unit of "x" more than it costs to obtain it.

That is, there is a gain from trade to be made. As more "x" is purchased, MRS falls and eventually MRS =

MRT. At this point, all gains from trade have been made.

Topic:

58

59

21)

Joe subscribes to an Internet provider that charges $2 per hour. He has $100 per month to spend and is at

equilibrium by buying 10 hours of Internet access and $80 worth of other goods. Draw the indifference

curve and budget line. If the company switches to a $20 monthly fee for unlimited Internet access, is Joe

better off?

Answer:

See the above figure. Under the new plan Joe can still purchase his original bundle and get additional

time on the Internet for free. Note that had Joe been consuming less than 10 hours at $2 per hour, the new

pricing policy would leave him worse off.

Topic:

22)

0.5 0.5

Suppose Joe's utility for lobster (L) and soda (S) can be represented as U = L S . Joe walks into a

restaurant with $72. Lobsters cost $18 each and sodas cost $2 each. How much lobster and soda will Joe

consume if he intends to spend all his money? (There are no tax and no tips.)

Answer:

60

Maximizing Joe's utility subject to his budget constraint yields:

0.5 0.5

U=L S + l(72 - 18L - 2S)

-0.5 0.5

1. dU/dL = 0.5 L S - l18 = 0

0.5 -0.5

2. dU/dL = 0.5 L S - l2 = 0

3. dU/dL = 72 - 18L - 2S = 0

From 1) and 2), S/L = 9 or S = 9L. Substituting into 3) yields 72 - 36L = 0 or L = 2. Since S = 9L, S = 18.

Thus Joe will buy two lobsters and wash it all down with 18 sodas.

Topic:

23)

Joe's indifference map for lobster and soda is shown in the above figure along with his budget line. Will

Joe choose point a? Explain your answer in terms both of MRS and the level of utility.

Answer:

Joe will not choose point a. Since the slope of his budget line tells us that he must give up only nine sodas

to get a lobster, Joe will wish to buy more lobsters and less soda than bundle a provides. From a utility

standpoint, Joe will not choose point a because another bundle that lies on a higher indifference curve is

obtainable.

61

Topic:

62

24)

John is indifferent between canned soup and fresh soup. Canned soup sells for $1 per serving and fresh

soup sells for $2 per serving. Assuming that John has allocated $4 toward soup, how will he spend it?

Explain your answer by drawing John's budget line and indifference curves.

Answer:

See the above figure. Canned and fresh soups are perfect substitutes. A corner solution exists where John

spends all $4 on canned soup.

Topic:

63

25)

Suppose that left shoes and right shoes must be purchased separately. Ingrid needs an equal number of

each type of shoe and has a budget of $100 for shoes. Left shoes always cost $1. If right shoes cost $19

each, how many of each will Ingrid buy? If the price of right shoes increases to $49 each, how will Ingrid

react? Explain your answer by drawing the indifference curves and budget lines.

Answer:

See the above figure. Since Ingrid needs an equal number of each type of shoe, left shoes and right shoes

are perfect complements. If right shoes are $19 each, Ingrid purchases 5 pairs of shoes. If right shoes are

$49 each, Ingrid purchases two pairs.

Topic:

64

26)

Johnny has $100 to spend on books and all other goods. Books cost $20 each and Johnny is at equilibrium

consuming 3 books and $40 worth of other goods. Johnny's grandmom wants to give Johnny either a

book or $20 for his birthday. Which gift does Johnny prefer? Explain using an indifference map and

budget lines.

Answer:

See the above figure. Since Johnny's equilibrium book consumption exceeds the quantity of books in the

gift-in-kind, Johnny is indifferent between receiving the book or the cash. Had Johnny been consuming

less than one book, he would have preferred the cash.

Topic:

27)

0.5 0.5

Lisa consumes only pizzas (P) and burritos (B). Her utility function is U = P B . The price of per

pizza is $10 and the price per burrito is $5. In equilibrium, Lisa consumes four pizzas. Using Lisa's utility

function, calculate how many burritos she consumes.

Answer:

65

0.5/ 0.5 0.5 0.5

The marginal utility of pizza equals B 2P . The marginal utility of a burrito equals P /2B . In

equilibrium, the ratio of the marginal utilities will equal the ratio of prices. The ratio of marginal utilities

simplifies to B/P. The ratio of prices is 10/5. Since we know that Lisa consumes 4 pizzas, she must

consume 8 burritos.

Topic:

66

28)

Lisa consumes only pizzas and burritos. In equilibrium, her marginal utility of pizza is 20 and her

marginal utility of a burrito is 10. The price of a pizza is $4. What is the price of a burrito?

Answer:

In equilibrium, the ratio of the marginal utility of a pizza divided by the price of a pizza must equal the

marginal utility of a burrito divided by the price of a burrito. Thus the price of a burrito must be $2.

Topic:

29)

Joseph has the utility function U(F,H)=10F2H, where F is the quantity of food he consumes per year and

H is the quantity of housing per week. Suppose the price of food is $10 and the price of housing is $5,

while Joseph has an income of $150/week.

(a) Calculate Joseph's MRS as a function of the quantities F and H.

(b) Write out Joseph's constrained optimization problem with the information provided.

(c) Using the substitution method, solve for Joseph's optimal consumption bundle of food and housing.

(d) Show that at the optimum, Joseph consumes the bundle along the budget constraint where

MRS=MRT.

Answer:

(b) max 10F2H subject to 10F+5H=150

(c) Solve the BC for F=15-.5H. Substitute this function of F into the utility function to get the

unconstrained maximization problem:

max 10(15-.5H)2H

The derivative is

10(15-.5H)2+10*2(15-.5H)(-.5)H=0

Solving for H=10. Plug H=10 into the BC to get F=10.

(d) The MRS = -2H/F. At the optimal bundle from (c), MRS = -2. The MRT = -10/5 = -2. Hence the

slope of the BC equals the slope of the IC at the optimal bundle.

Topic:

For the following, please answer "True" or "False" and explain why.

30)

If a consumer views the two goods they consume as perfect substitutes, the optimal bundle will be a

corner solution. Explain.

Answer:

67

Perfect substitutes are goods for which at any point you will trade one good in the same proportion for

the other. The specific utility function is U(x,y)=ax+by, and the ICs are linear throughout.

A corner solution is when the optimal bundle is all of one good and none of the other (i.e. the solution is

at the intercept of the BC and one of the axis)

True, since the MRS is constant for p.s.’s, the optimal bundle will occur at a corner

Topic:

68

31)

Consider Jen, a consumer with preferences U(H,F)=F1/3H2/3, where H is the quantity of housing and F is

the quantity of food (per month). Suppose Jen has a stipend of $600/month which she uses to purchase

food at a price of $1/unit and housing at a price of $10/unit.

a. Compute Jen's utility-maximizing bundle of goods.

b. Suppose that Jen's employer subsidizes housing by paying 50% of her total housing costs, thereby

effectively lowering the price Jen pays for housing to $5/unit. Compute Jen's new optimal consumption

bundle.

c. How much does Jen's employer pay in total for this subsidy? How much utility does Jen enjoy with

this subsidy (compute her utility at the optimal bundle).

d. Suppose that her employer simply gave Jen the dollar cost you found in (c) as a lump sum (instead of

subsidizing housing). Will Jen gain a higher utility from the housing subsidy or the lump-sum equivalent

transfer?

Answer:

b. At a price of $5/unit, Jen will increase housing consumption to 80 and consume 200 units of food as

before.

c. The cost to her employer is $5 times 80 = $400. Jen's utility is approximately 109 (utils/month).

d. Jen's optimal bundle when I=1000 is 333 units of food and 67 units of housing (approximate) and a

utility of 114 (approximately). Jen is better off from getting the lump-sum transfer.

Topic:

32)

Suppose that the preferences a typical American has for quantities of electricity (E) and gasoline (G) is

given by

U(E,G) = a ln(E) + (1-a) ln(G)

where 0<a<1. Suppose the prices of gasoline and electricity in the units provided are both $1/unit and

the consumer has an income of $100. Suppose in addition, the government has chosen to ration

electricity by allowing a maximum consumption of 50 units of electricity (E≤50).

a. If a=.25, find the optimal consumption bundle of gasoline and electricity. Does the electricity

rationing constraint have an influence on consumer's choice?

b. If a=.75, find the optimal consumption bundle of gasoline and electricity. Does the electricity

rationing constraint of the government have an influence on the consumer?

Answer:

For each case, the best approach is to solve while ignoring the rationing constraint. If the solution you

find violates the constraint, you know then that the optimal bundle will be where E=50.

a. The MRS = .25G/.75E = 1 = MRT or simply G=3E. Using the budget constraint:

E + 3E = 100

Solving gives E=25 and G=75. The electricity rationing does not have an effect.

69

b. The MRS=.75G/.25E = 1 = MRT or simply G=E/3. The solution from the budget constraint is E=75.

However, this violates the rationing constraint and so E=50, G=50.

Topic:

70

33)

Howie consumes only beer (B) and donuts (D) each week with his $100 income. Beer costs $1, while

donuts cost only 50¢. Howie has Cobb-Douglas preferences given by:

U(B,D) = B(D-d)

where d is the quantity of donuts that his neighbor Nord consumes. Assume throughout this question

that Howie always consumes more donuts than Nord.

a. How does Nord's beer consumption influence Howie's utility function? Specifically, compute and

determine the sign of ∂U/∂d. Intuitively, what does this tell you about Howie's happiness and Nord's

consumption of donuts?

b. Holding d fixed, compute Howies's optimal consumption bundle of Beer and Donuts as functions of

Nord's consumption of donuts, d.

c. How does Nord's consumption of donuts affect Howie's optimal bundle? Specifically calculate and

determine the sign of ∂B*/∂d and ∂D*/∂d where (B*,D*) is Howie's optimal consumption bundle.

Answer:

a. The derivative is -B, meaning Howie's utility decreases as Nord consumes more donuts (holding all

else fixed). Howie apparently does not like to see Nord consume donuts.

b. D*=100+.5d, B*=50-.25d.

c. ∂B*/∂d=-.25<0 and ∂D*/∂d=.5>0. As Nord consumes more donuts, Howie will consume more

donuts and less beer.

Topic:

71

34)

Consider a consumer with the Cobb-Douglas utility function U(q1,q2) = q1 q 2 , where q1 and q2 are

the quantities of goods 1 and 2 consumed, respectively. This consumer derives a level of utility denoted

by U0. The prices of goods 1 and 2 are denoted p1 and p2.

a. Write out the Lagrangian for the consumer's expenditure minimization problem.

b. Using the Lagrangian method, derive the consumer's (expenditure-minimizing) quantity of good 1 as

functions of the variables p1, p2, and U0.

c. Derive the consumer's expenditure function, E(p1, p2, U0).

Answer:

L = p1q1 + p2q2 + λ[U0 - q1q 2 ]

where λ denotees the Lagrange multiplier.

b. The first-order conditions are:

1 q2

∂L/∂q1 = p1 – λ =0

2 q1

1 q1

∂L/∂q2 = p2 – λ =0

2 q2

∂L/∂λ = U0 - q1 q 2 = 0

Combining the first two conditions yields the familiar MRS=MRT condition:

q2 p1

=

q1 p 2

p1

or q2 = q . Substituting this into the third condition (the utility -constant constraint)

p2 1

p2

q1 = U 0 <--- expenditure-minimizing demand for good 1

p1

c. From the MRS=MRT condition, we get p1q1 = p2q2. The expenditure function is:

p2

E = p1q1 + p2q2 = 2p1q1 = 2p1U0 = 2U0 p1 p 2

p1

Topic:

72

35)

The preferences for Californians can be represented by the following utility function:U(X,Y) = XaY1-a.

The consumer faces the budget constraint I = p.X + q.Y, where I is the agent's income, and p and q are

the prices. Suppose the government imposes a consumption restriction so that any person in the state is

allowed to consume 50 units of electricity at most.

a. If a=0.25, I=100, and both prices are equal to one, find the optimal consumption of gasoline and

electricity by the agent. Is the electricity constraint binding? (Hint: solve the problem without the 50≥X

constraint and see if the solution satisfies the constraint. If your answer then does not satisfy 50≥X, the

solution must be 50=X)

b. How does your answer in part a. change if a=0.75? Explain.

c. On a graph, illustrate the answers to parts a. and b.

Answer:

max U(X,Y) subject to 100=X+Y and X≤50

First, ignore the quantity restriction on X and solve using the lagrangian method:

L = X.25Y.75 + λ[100 - X - Y]

The derivatives are:

LX = .25X-.75Y.75 - λ

LY = .75X.25Y-.25 - λ

Lλ = 100 - X - Y

Solving the system of equations yields X = 25, Y = 75. Because X<50, the rationing constraint is satisfied.

b. Repeating the steps in a. with a=.75, the optimal bundle ignoring the constraint is X=75, Y=25. As a

result, the rationing constraint must bind, so X=Y=50.

c.

Topic:

73

36)

Suppose Paul's utility depends on the amount of time spent playing on the Internet (x) and the amount of

time playing video games (y), and his utility function is

U(x,y) = 3x0.2 y0.8

He has 15 hours of free time to spend on these two activities each week, and his goal is to maximize his

utility.

a. Set up the Lagrangian for this constrained maximization problem.

b. What are the necessary conditions for the optimum from the Lagrangian?

c. What is the optimal amount of time spent surfing the Internet and playing video games each

week?

Answer:

b. The optimality conditions are

Lx = .6x-0.8y0.8 - = 0

Ly = 2.4x0.2y-0.2 - = 0

L = 15 – x – y = 0

c. First solve for the MRS = MRT condition using the first two conditions above:

.6x-0.8y0.8 /2.4x0.2y-0.2 = y/4x = 1

or simply y = 4x. Substitute this into the budget constraint

5x = 15

So x = 3 and y = 12. Paul will spend 3 hours on the Internet and 12 hours playing video games. What a

day!

Topic:

74

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