NAME:

Problem Set #3
Micro I – Spring Term 2020
Instructor:Nida Jamil
Due Date 29-April 2020, 9:30 AM

Instructions: Students may work in groups on the problem set. Each student must turn in his/her OWN
response to the problem set (i.e. one assignment with multiple names on it will not be accepted). The group’s
assignments should be turned in stapled together.

NO LATE PROBLEM SETS WILL BE ACCEPTED!!

1.Use a red pen for the initial budget constraint (before the price change), use a blue pen for the intermediate
budget constraint (for determining the substitution effect), and use a black pen for the final budget constraint.

Label the initial optimal bundle “A”, the demand due to the substitution effect “B” and the final optimal bundle
“C”.

Let good 2 be an inferior good. Graph the substitution and income effects of a rise in the price of good 2.

a. Since the price is rising, what is the sign (positive or negative) of the change in demand due to the
substitution effect? Indicate >0 or <0 below:

b. Since the price of a good has risen, the level of income for the blue intermediate budget line is temporarily
higher than the actual income. Therefore, when we move from the intermediate to the final budget line, income
falls. What is the sign (positive or negative) of the change in demand due to the income effect? Indicate >0 or

<0 below:

c. How would your answer in part (a) and (b) change if this had been a (i) Normal good (ii) Giffen good?
2. Ross derives utility from only two goods chocolates (x) and donuts (y). His utility function is as follows:
U(xy) = 2xy.
Ross has an income of $100 and the price of chocolates (Px) and donuts (Py) are both $0.50. Suppose price of
donuts (Py) increase to $1.00 price of chocolates and income remain unchanged. How much is the total effect of
this price change on Ross consumption of donuts? How much of this total effect is due to income effect and
how much is due to substitution effect? Represent this graphically.
3. (Income and Substitution effect: the case of perfect substitutes) Lisa loves drinking coffee and tea. Drinking
one cup of tea gives Lisa 10 utils, and drinking one cups of coffee gives her the same utility. Suppose Lisa has
an income of $12 to buy coffee and tea. The price of a cup of tea is $1, and the price of a cup of coffee is $2.
Draw Lisa’s budget line (BL1) given her income is $12. (Measure tea on the X-axis and coffee on the Y-axis.)

a) Find the utility maximization point and draw an indifference curve (IC1) through the utility
maximization point. (Hint: in this example, coffee and tea are perfect substitutes.)

b) Suppose the price of a cup of tea increases from $1 to $4, draw Lisa’s new budget lines (BL2) and find
her new utility maximization consumption bundles.
 c) Draw an imaginary budget line (BL3) parallel to the new budget line (BL2) and make it cross the initial
indifference curve (IC1) at the lowest income level. Show the income and substitution effect of the
decrease in the consumption of tea as the price of tea increases

4. (Income and Substitution effect: the case of perfect compliments) Mary is a student in the Math department
who has a lot of math homework. In doing the math homework she will use pencils (assume these pencils have
no erasers on their ends) to make all her calculations and an eraser to correct her answers. Mary knows that for
every 2 pencils, 1 eraser will be needed. Any more pencils will serve no purpose, because she will not be able to
erase the calculations. The price of an eraser is $2, and the price of a pencil is $1. Draw Mary’s budget line
(BL1) given her income is $12. (Measure pencils on the X-axis and erasers on the Y-axis.)

a) Find the utility maximization point and draw an indifference curve (IC1) through the utility
maximization point. (Hint: in this example, pencils and erasers are perfectly complements).
b) Suppose the price of a pencil increases from $1 to $4, draw Mary’s new budget lines (BL2) and find her
new utility maximization consumption bundles.

c) Draw an imaginary budget line (BL3) parallel to the new budget line (BL2) and make it cross to the
initial indifference curve (IC1) at the lowest income level. Show the income and substitution effect of
the decrease in the consumption of pencils as the price of pencils increase.
5. Let Jackie’s utility for CDs (good 1) and DVDs (good 2) be represented as:
U = q10.6q20.4.
a. For changes in the price of CDs, draw her price-consumption curve. Explain its shape. How does
demand for DVDs depend on the price of CDs?

b. Graph Jackie’s income consumption curve.

c. Derive an expression (equation) for and graph Jackie’s Engel curve for CDs.
6. Madeline views Coke and Pepsi as one-for-one perfect substitutes. Derive her demand curve for Coke
graphically and mathematically.
7. Derive and plot Olivia’s demand curve for pie if she eats pie only with a scoop of ice cream (i.e. they are one-
for-one perfect complements).

b. How much does her weekly budget have to rise for her to buy one more piece of pie per week?
8. (Labor Supply – Utility Max with Leisure/Consumption) Mr. Smith works in a factory. He can work as
many hours per day a he wishes at a wage rate of w. Let C be the number of dollars he has to spend on
consumer goods and let R be the number of hours of leisure that he chooses.

a. Suppose Mr. Smith earns $8/hour and has 18 hours per day to devote to labor or leisure, and suppose that he
has $16 of non-labor income per day. Write his budget constraint for consumption and leisure.

b. Draw his budget constraint IN RED INK for consumption and leisure on the graph below, and mark his
endowment point “A”. Let leisure be on the horizontal axis.

c. If Mr. Smith’s utility function is U(R,C) = RC, how many hours each day will he choose for leisure, and how
many hours will he work?

d. Suppose Mr. Smiths wage rate rose to $12 an hour. Use BLACK INK to draw his new budget line on the
graph in part b. (He still has $16/day of non-labor income.)

 
e. If Mr. Smith continued to work as many hours as he did before (as calculated in part c) but earns $12/hour,
how much more money would he have to spend on consumption than in part b?

f. However, at a wage of $12/hour, Mr. Smith will choose to work how many hours? At the new optimal
combination of consumption and leisure, his consumption will increase by how much (compared to part c)?

g. Suppose Mr. Smith’s wage is $8/hour but that his non-labor income rises to $48/day. Use BLUE INK to
draw his budget line. How many hours does he choose to work?
9. The "Greasy Wrench" shop specializing in auto repairs rents a building at the corner of 77th and
Moonawalker. In the short run, it can vary its output (the number of cars fixed) only by varying the number of
mechanics it employs. Each Greasy Wrench employee is paid a fixed wage.
Over the years, Wu Wei, the owner of "Greasy Wrench", has tried hiring different numbers of workers. The
data about the average productivity of each worker (also known as the Average Product of Labor) for each
number of workers are given in the table below.

a) Complete the table by calculating the Total Product of Labor (total output of the firm) and Marginal
Product of Labor corresponding to each number of workers.

b) At which worker does the Law of Diminishing Marginal Returns start working? How do you know?

c) Using the Greasy Wrench example, explain why every firm, as it hires more people in an attempt to
increase its output, will sooner or later hit the range of diminishing marginal returns.
d) When Mr. Wei’s son looked at the table, he said to his dad: “Hiring 5th and 6th person makes no sense!”
Do you agree? Explain.
10. For each production function, put an I, C, or D in the second column if the production function has
increasing, constant, or decreasing returns to scale. Put an I, C, or D in the third column if the MPK is
increasing, constant, or decreasing as K is increased. Put an I, C, or D in the fourth column if the MPL is
increasing, constant, or decreasing as L is increased. YOU MUST SHOW YOUR WORK to get full credit:

Production Function Returns to MPK MPL

Scale

a) 2K + 3L

b) (2K + 3L)1/3

c) K2/3L2/3

d) K1/4L3/4

e) (K)0.5(L+1)0.5

f) (K1/2 + L1/2)2 (BONUS) (BONUS)

11. The production function of a firm is Q=100√KL, where Q is the output, k is the capital input and L is the
labor input. 

a) What type of returns to scale does this production function exhibit? Show the basis for your answer. 

b) Sketch the isoquant for Q=1000.

c) Find an expression for MRTS.

d) If k = 10 how much labor is required to produce 1000 units of output? What is the value of the APL
then? 
12. Tad's Baitshop currently uses no computers in determining inventory. The number of items that can be
inventoried in a day is given by y = 2L0.5 where L is the number of labor hours used. If Tad purchases a
computer to be used for inventory purposes, the number of items that can be inventoried in a day becomes y =
3L0.5. Use the information in the table below to sketch Tad's marginal product of labor curves before and after
the use of the computer for inventory purposes.
Old Quantity New Quantity Old MP of New MP of
L
Inventoried Inventoried labor labor

16

25

MPL

Labor hours