UNIVERSITY OF CALGARY

DEPARTMENT OF ECONOMICS
ECON 301 (L03), Fall 2019
Assignment 1-Solutions
1. Definitions
For all of the following pairs of terms, define each term and explain the relationship
between them.(12 points)

a. An indifference curve is the graphical representation of an indifference set. An

indifference set is defined for every possible consumption bundle x. It is the set of all
possible consumption bundles x0 such that x ∼ x0 . [1]
Utility function is an algebraic representation of a preference ordering such that if
x % x0 , then U (x) ≥ U (x0 ). [1]
Along an indifference curve all bundles have the same utility. [1]

b. The marginal rate of substitution of good x1 for good x2 , M RSx1 x2 , is the maximum
of good x1 that an individual will give up for a marginal increase in x2 . Any more
would leave the individual worse off, any less would make them better off. It is the
slope of an indifference curve at a point. [1]
Continuity is an assumption made about the willingness to substitute. If a preference
ordering is continuous then there exists some amount of x1 that an individual will
accept as compensation for a reduction in x2 (and vice versa). [1]
Continuity is a necessary condition for the M RSx1 x2 to be defined. [1]

c. Exogenous variables are external, independent variables having affect on a model,

but not affected by the model. The model builder specifies the exogenous variables
but set no qualitative characteristics or value generation method for them. [1]
Values of endogenous variables are based on a functional relationship in a model.
Basically, these are dependent variables generated within a model. [1]
Exogenous variables determine the values of endogenous variables. [1]

d. Preferences are perfect substitutes when they can be represented by a utility

function of the form U (x1 , x2 ) = ax1 + bx2 . The resulting indifference curves are
straight lines. Two goods are perfect substitutes when the marginal rate of substitution
of one good for the other is constant (ex. tea and coffee, orange juice and apple juice).
[1]
Preferences are perfect complements when they can be represented by a utility function
of the form U (x1 , x2 ) = min{ax1 , bx2 }. Two goods are perfect complements when the
indifference curves for the goods are shaped as right angles with the kink along the
line ax1 = bx2 (ex. if you have one left shoe and one right shoe, you are indifferent
between having more left shoes only). [1]
Perfect substitutes and perfect complements are polar opposites. If two goods are
perfect substitutes, price is the only difference between the two, however, however
complementary goods are always used together. [1]

2. True or False
Answer each of the following statements True/False. Give a full explanation of your
answer. Include clearly labelled graphs where appropriate. (9 points)

a. Consider the following consumption bundles of two goods: (x1 , x2 ) = (27, 10),
(x1 , x2 ) = (40, 18), and (x1 , x2 ) = (200, 7). Monotonicity implies that (40, 18) is
preferred to (27, 10), but does not imply that (200, 7) is preferred to (27, 10).
TRUE. Monotonicity implies that the bundle with more of at least one good and no
less of any good is preferred. [3]

b. If the marginal rate of substitution between two goods x1 and x2 is not equal to 1,
then it is possible for these two goods to be perfect substitutes.
TRUE. The marginal rate of substitution between perfect substitutes is constant (slope
of an indifference curve is constant when two goods are substitutes). Preferences are
perfect substitutes when they can be represented by a utility function of the form
U (x1 , x2 ) = ax1 + bx2 where a and b are positive numbers and M RSx1 x2 = a/b. If
a > b, M RSx1 x2 > 1. [3]

c. When the consumer maximizes his utility over two goods, x1 and x2 , the marginal
utilities of each good are always equal.
FALSE. At an optimal bundle relative marginal utilities are equal to the slope of the
budget constraint. [3]

3. Robin’s Preferences
Robin is an ambitious young knight living in the middle ages. He is in his early
career and wants to prove himself. He is detached from material things (he doesn’t
attend the lavish banquets or the evening entertainments in the castle) and prefers
to improve his skills in horsemanship instead. As he states in his preferences “I like
horses, I would always, rather always ride my horse, do more practice of it, and am
completely indifferent as to the consumption of material goods.” Denote by xr the
number of hours of horse riding, and by xc the quantity of material goods consumed.
We can translate these preferences as follows. When comparing two bundles x and
x0 , with x = (xr , xc ) and x0 = (x0r , x0c ), Robin’s preferences are such that x % x0 if and
only if xr ≥ x0r . (19 points)

a. Based on the information given about Robin’s preferences, sketch a two representative
indifference curves on a clearly labelled graph and indicate the direction of higher
utility. Explain your intuition.
Since Robin is indifferent with respect to the consumption of good c, in the space
(r, c), his indifference curves are vertical. [3]
Graph [4]

b. Are these preferences are monotonic? First define the term used, then explain your
answer.
Monotonic preferences are such that if x ≥ x0 , then x % x0 . For x ≥ x0 to apply, it
must be the case that xr ≥ x0r and xc ≥ x0c . [3]
The first inequality implies x % x0 , as desired. [3]
Extra info: Robin’s preferences however, are not strictly monotonic. Strict monotonicity
implies that if x ≥ x0 and xi > x0i for at least some i, then x  x0 . For example,
(4, 6) ≥ (4, 2) and clearly 6 > 2 but it is not the case for Robin that (4, 6)  (4, 2)
since he is indifferent between these two commodities.

c. Are these preferences are convex? First define the term used, then explain your
answer.
Preferences are convex if for every x and y such that x % z and y % z, then
tx + (1 − t)y % z for all t ∈ [0, 1]. [3] A (clearly labelled) graphical explanation
is also acceptable.
These preferences are convex. In Robin’s case, by definition of these preferences x % z
and y % z imply that xr ≥ zr and yr ≥ zr . Given that xr ≥ zr and yr ≥ zr , also
txr + (1 − t)yr ≥ zr also holds for all t ∈ [0, 1] and hence tx + (1 − t)y % z. [3]
4. Wendy’s Budget Set
Wendy spends her monthly income of $100 on two goods: steaks (xs ) and fries (xf ).
The price of each steak (ps ) is $5 and the price of a portion of fries (pf ) is $2. (20
points)

a. What is the maximum number of steaks that Wendy can consume? What is the
maximum portions of fries that she can consume?
xmax
s = 100/5 = 20 [2]
max
xf = 100/2 = 50 [2]

b. Draw Wendy’s budget line on a clearly labelled graph. Show all the affordable
bundles (the budget set) [1]. Where can we find the quantities you found in part a on
this graph [1]?

Wendy’s budget line is

5xs + 2xf = 100. [2]

c. What is the slope of the budget line? How do you interpret it?
Slope of the budget line is equal to the negative of the price ratio, −2.5 [2].
In a world of two goods, the absolute value of the slope represents the relative prices
of the two goods. Here, the slope is equal to −2.5 indicating that the relative price
of one unit of steak is 2.5 units of fries. In other words, to afford one extra portion of
steak, she’d consume 2.5 fewer portions of fries. [2]

d. Because of the Mad Cow Disease, local beef supply decreases and the price of steaks
increases to $10. Write down the new budget set. Does the slope change? Illustrate
on a graph how Wendy’s budget set is affected.
Wendy’s new budget line is
10xs + 2xf = 100. [1]
Slope of the budget line is equal to the negative of the price ratio, −5. [1]
Graph [2]

e. Due to the severe shortage of beef, the local government passes a legislation allowing
each consumer to purchase at most 5 steaks. How does the new legislation affect
Wendy’s budget set? Illustrate on a graph.
Graph [4]
The legislation prohibits Wendy from consuming any combination of (xs , xf ) with
xs > 5. Notice that this does not change the slope of the budget line, it rather forces
her to choose among only the affordable bundles for which xs ≤ 5.

5. Cobb-Douglas Preferences
Jane will celebrate her birthday alone this year. She has a total budget of m to
spend on wine (xw ) and snacks (xs ). Wine costs pw per bottle, and snacks cost
ps per unit. Her preferences over the two goods is given by the utility function
1/3 2/3
U (xw , xs ) = 6xw xs . (20 points)

a. What is Jane’s budget line?

pw xw + ps xs = m [5]

b. The marginal utility for wine is

2/3
M Uw (xw , xs ) = 2 xs2/3
xw

The marginal utility for snacks is

1/3
M Us (xw , xs ) = 4 xw1/3
xs

What is the marginal rate of substitution of wine for snacks? Is it a constant? What
is its interpretation?

M Us
M RSxw xs = − M Uw
= −2 xxws [3]

M RSxw xs is not a constant since it depends on the bundle (xw , xs ) it is evaluated at. [1]

MRS gives the slope of the indifference curve. In this case, it is non-linear, therefore
the slope changes at every point along the indifference curve. [1]
c. Draw a diagram which represents the choices available to Jane, her preferences over
those choices, and her optimum choice.
Graph [5]
Note: Notice that you can equivalently put xw along the x-axis and xs along the
y-axis.

d. Looking at the preceding diagram, what are the two conditions which must be
satisfied for utility maximization?

For any pw , ps and m, the optimum consumption bundle must satisfy the following
conditions:

• The tangency condition: M RSxw xs = − ppxs [2.5]

• The optimum consumption bundle must be on the budget line so that the
consumer exhausts all of her income: pw xw + ps xs = m [2.5]
6. Perfect Complements
Oliver is very specific about his business attire. He always buys three white shirts (xw )
for every pair of trousers (xt ). Oliver’s total budget for clothing is $200. The price of
each white shirt (pw ) is $5 and the price of each pair of trousers (pt ) is $25. (20 points)

a. Given Oliver’s preferences, what is his corresponding utility function?

U (xw , xt ) = min{xw , 3xt } or U (xw , xt ) = min{ 13 xw , xt } [5]

And the line along which all of the vertices of the L-shaped indifference curves lie is
xw = 3xt .

b. What is Oliver’s budget constraint?

p w xw + p t xt = m
5xw + 25xt = 200 [5]

c. What is Oliver’s optimum consumption bundle?

Oliver consumes only to optimal proportions along the line xw = 3xt .

15xt + 25xt = 200
40xt = 200
xt ∗ = 5
And, xw ∗ = 15 [5]

d. Draw the indifference curve and the budget constraint on a clearly labelled graph
to illustrate Oliver’s optimum consumption bundle.
Graph [5]