Fall 2018 14.

01 Problem Set 1-Solutions

1 Positive vs. Normative Statements (16 points)

Identify whether each of the following statements is positive or normative. Briefly
justify your answer.

1. (4 points) The government has a duty to provide basic healthcare and education
to every citizen.

2. (4 points) The cost of health insurance is too high.

3. (4 points) The median earnings of a full-time worker with a college degree are
almost twice as high as those of a high-school graduate with no college education.

4. (4 points) The current unemployment rate is 3.9%, the lowest it has been since
December 2000.

Solution: The first statement is normative as it provides an opinion about what

the role of the government should be. The second statement is also normative since
saying that it is “too high” is implicitly expressing that it should be lower. The last two
statements are positive as they are just describing facts about the US economy.

2 True or False (20 points)

For each of the following statements, indicate if they are True or False. Justify your
answer.

1. Bill is a football coach. He evaluates his players based on three criteria: height,
strength, and speed. Bill prefers one player over another if he is better in at
least two of these criteria. Assume that there are no players with the exact same
height, nor the exact same strength, nor the exact same speed.

(a) (4 points) Bill’s preferences are complete.

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 (b) (4 points) Bill’s preferences are transitive.

2. (4 points) Ann and Bob are utility maximizing consumers. Given their income
and market prices, Ann chooses a bundle that gives her a utility UAnn = 100,
while Bob chooses a bundle that gives him a utility UBob = 110. Therefore, we
know that Bob is happier than Ann.

3. (4 points) John’s utility function for food (f ) and clothes (c) is given by U (f, c) =
1
(f α + cα ) α , with α > 0. John’s preferences satisfy the principle of diminishing
marginal rate of substitution for any value of α.

4. (4 points) Ava has preferences over two goods that satisfy completeness, transitiv-
ity, non-satiation and the indifference curves have a strictly diminishing marginal
rate of substitution. Suppose that the price of one of these goods increases (and
the price of the other one remains the same). Claim: Ava’s utlity must be strictly
lower after the price increase. How does your answer depend on the composition
of the initial consumption bundle?

Solution:
1.a. True, if we are comparing two players based on three criteria, it must be that one is
better than the other in at least two of them, so we can always compare any two players.
1.b. False, consider the following counterexample. We have three players: A,B and C.

A B C
Height 2 1 3
Strength 3 2 1
Speed 1 3 2

so A is preferred to B, B is preferred to C, and C is preferred to A, thus violating

transitivity.
2. False, utility is ordinal so we can’t tell who is happier.
3. False, if α > 1 the indifference curves are concave, so they don’t satisfy the principle
of diminishing MRS.
4. False, the utility can’t be higher after the price increase, but it could stay the same
if in the initial bundle she was only consuming the good that didn’t change price. If
the initial bundle had strictly positive quantities of both goods, then we can tell that the
utility must be strictly lower after the price increase.

3 Demand for Video Games (16 points)

We have the following weekly demand data for the video game Grand Theft Auto in a
US town. We also have the price data for a Playstation at the same time.

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Price of Playstation (in $) Price of Grand Theft Auto (in $) Quantity of games demanded
300 10 100
310 10 95
320 10 90
300 11 99
310 9 96

1. (6 points) Write down the equation for the demand for Grand Theft Auto in the
following form:
QD
g = α + β g P g + β p Pp

where QD g and Pg are quantity demanded and price of Grand Theft Auto, Pp is
the price of Playstation, and α, β g , β p are constants.
Solution: Using the first two observations, we have that −5 = ΔQD g = β p ΔPp =
1
β p 10, so β p = − 2 . Using the first and fourth observation, we have that −1 =
ΔQD g = β g ΔPg = β g , so β g = −1. We can then use any observation to find the
constant, α = 260, so the demand curve is
1
QD
g = 260 − Pg − Pp
2

2. (4 points) Does the demand function that you found in part (1) satisfy the law
of demand? Explain.
Solution: Yes, we have that β g < 0 so it satisfies the law of demand.

3. (6 points) The supply curve for Grand Theft Auto in this town is

QSg = 2Pg

Solve for the equilibrium price and quantity, as a function of Pp . How does the
equilbrium price and quantity depend on Pp ? Briefly explain the intuition.
Solution: We find the intersection between the two curves and obtain
260 1
Pg = − Pp
3 6
520 1
Qg = − Pp
3 3
Both quantity and price depend negatively on Pp . The intuition is that the increase
in a complementary good (Playstation) shifts the demand for videogames curve
inwards, leading to a drop in the equilibrium price and quantities.

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4 Indifference Curves (18 points)
In each of the following examples, the consumer consumes only two goods, x and y.
Based on the information given in each statement, sketch a plausible set of indifference
curves (draw at least two curves on a set of labeled axes and indicate the direction of
higher utility). Then, write down a possible form of the utility function u(x, y) that is
consistent with your graph.

1. (6 points) Alan likes wearing both right shoes (x) and left shoes (y). He always
needs to wear them as a pair, having a right shoe is useless without the left one
and viceversa.
Solution: right shoes and left shoes are perfect complements, so a possible utility
function is u (x, y) = min {x, y} .

Figure 1:

2. (6 points) Emma likes pizza (x) but hates vegetables (y). She is only willing to
eat an extra unit of vegetables if she gets to eat an extra unit of pizza.
Solution: note that in this case the utility must be decreasing in y and increasing
in x. It must also satisfy that when we increase both pizza and vegetables by one
unit the utility stays the same. A possible utility function is u (x, y) = x − y.

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 Figure 2:

3. (6 points) Mary likes Coke (x) and Pepsi (y). She is indifferent between them as
she is unable to tell the difference between Coke and Pepsi.
Solution: Coke and Pepsi are perfect substitutes, so a possible utility function is
u (x, y) = x + y.

Figure 3:

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5 Utility Maximization (30 points)
Chloe consumes only books (x) and video games (y) . Her preferences can be represented
by the following utility function: U (x, y) = xy 2 . The price of books is px , the price of
video games is py , and Chloe has an income of m dollars.

1. (4 points) Write down Chloe’s budget constraint.

Solution: px x + py y ≤ m (it is also correct to right it as an equality).

2. (4 points) Calculate the Marginal Rate of Substitution (at an arbitrary bundle

(x, y)).
y
Solution: M RS = − M Ux
M Uy
= 2x .

3. (6 points) Find the equation that describes Chloe’s demand for books and videogames
for any possible value of px , py and m.
Solution: Setting M RS = M RT and using the budget constraint with equality we
get
m
x =
3px
2m
y =
3py

4. (6 points) Repeat part 3 when the utility function is U (x, y) = min {x, y} .
Solution: With these preferences, the consumer will always choose bundles such
that x = y. Replacing this condition in the budget constraint, we get that

px x + py y = (px + py ) x = m
m
⇒ x=y=
px + py

5. (4 points) Let us now go back to the original utility function U (x, y) = xy 2 .

Suppose that the government imposes a tax on videogames, such that if the price
of a videogame is py , the consumer must pay (1 + τ ) py . What is the new demand
function for videogames? Plot the demand before the tax and after the tax in the
same graph (you don’t need to assume any particular values for m, τ , it is enough
to provide a qualitative graph). Briefly explain the intuition.
2m
Solution: the new demand function is y = 3(1+τ )py
, so the new demand function is
down and to the left of the original one. The intuition is that for any given value
of py , Chloe now has to pay a higher price, so she will demand a lower quantity.

6. (6 points) Let’s go back to the case without taxes. Suppose that px = 2, py =

2, m = 30. Suppose that Chloe has one “buy-10-get-10-free” coupon for books
(that is, she will get 10 free books if she buys at least 10 books). How many

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 Figure 4:

books and how many videogames will Chloe consume? Carefully draw the bud-
get set and the highest attainable indifference curve on the same graph.
Solution: The highest indifference curve will be either tangent to the budget con-
straint or will pass through the kink at the bundle (20, 5) . The only tangency point
is at (5, 10) , and evaluating the utility function at these two points we find that
U (20, 5) = U (5, 10) = 500, so Chloe is indifferent between buying (x, y) = (5, 10)
or using the coupon and getting (x, y) = (20, 5) .

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Figure 5:

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14.01 Principles of Microeconomics

Fall 2018

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