ECON2011 Tutorial 2

1. For each of the following utility functions, what is the marginal utility of x? What is
the marginal utility of y? What is the marginal rate of substitution M RSxy ? What is
the equation for the indifference curve corresponding to 5 units of utility? What is the
equation for the indifference curve corresponding to 10 units of utility?

(a) U (x, y) = 5x + 7y
∂ ∂
Answer: M Ux = ∂x U (x, y) = 5, and M Uy = ∂y U (x, y) = 7. M RSxy =
M Ux /M Uy = 5/7. Indifference curves show which combinations of x and y lead
to equal utility, so for U = 5 the equation is 5x + 7y = 5 (or y = (5 − 5x)/7). For
U = 10 it is 5x + 7y = 10, or y = (10 − 5x)/7.
(b) U (x, y) = 2 log(x) + log(2y)
1
Answer: Similarly to part a, M Ux = 2/x, M Uy = 2 · 2y = 1/y, and M RSxy =
(2/x)/(1/y) = 2y/x. The indifference curves are given by 5 = 2 log(x) + log(2y)
and 10 = 2 log(x) + log(2y).
(c) U (x, y) = 5x0.3 y 0.7
Answer: Similarly to parts a and b, M Ux = 0.3 · 5x−0.7 y 0.7 = 1.5(y/x)0.7 , M Uy =
0.7 · 5x0.3 y −0.3 = 3.5(x/y)0.3 , and M RSxy = M Ux /M Uy = 1.5 3.5
(y/x)0.7 /(x/y)0.3 =
3y
7x
. The indifference curves are 5 = 5x0.3 y 0.7 ⇒ 1 = x0.3 y 0.7 and 2 = x0.3 y 0.7 .

2. Suppose milk can be bought for $1 per liter. Honey is $5 per liter if you buy up to
5 liters, $4 per liter if you purchase between 5 and 10 liters, and $3 per liter if you
purchase more than 10 liters.

(a) Bob earns $100 per month an spends all of it on milk and honey. Draw his budget
set.
Answer: See graph below.
(b) If Bob’s utility function is U (x, y) = xy, draw the indifference curve that corre-
sponds to his maximum utility.
Answer:
3. Alice has utility from hours of TV and hours of movies given by U (t, m) = 5t + 4m.

(a) Draw three indifference curves for Alice, and label the levels of utility that they
correspond to.
Answer:

(b) What is Alice’s marginal rate of substitution M RStm ?

Answer: M RStm = M Ut /M Um = 5/4.
(c) If Alice’s income is $50, and the price of movies is $2 per hour and the price of
TV is $1 per hour, how much of each will she consume?
Answer: See the graph below. The highest utility attainable, on the highest
 indifference curve, intersects with the budget set on the far right. Alice therefore
spends all of her money on TV (purchasing 50 hours) and none on movies. Note
that setting the M RS equal to the price ratio does not work in this case because
both values are constant and inequal. We are in a “corner solution” and must
look at the graph to determine what Alice does.

(d) What if the price of movies is $1 per hour and TV is $2 per hour?
Answer: See the graph below. The highest utility attainable, on the highest
indifference curve, intersects with the budget set on the far left. Alice therefore
spends all of her money on movies (purchasing 50 hours) and none on TV.

4. George has a fixed income and can afford at most 7 units of X if he spends his entire
income on X. Alternatively, if he spends all his income on Y, he can afford at most 6
units of Y.
 (a) Draw George’s budget line and an indifference curve such that George chooses to
buy 4 pieces of X.
Answer: See below.
(b) Martha has the same income and faces the same prices, yet she chooses to buy 2
pieces of X. Draw the indifference curve that contains her optimal choice.
Answer: See below.
(c) In equilibrium, what is George’s subjective value of X in terms of Y? What is
Martha’s?
Answer: The marginal rate of substitution at the optimal point must be equal
to the price ratio, because the indifference curve must be tangent to the budget
line. Therefore in equilibrium, one unit of X will be worth 6/7 units of Y for both
George and Martha.

5. Suppose that the government subsidizes housing expenditures of low-income families

by providing a dollar-for-dollar subsidy to a family’s housing expenditure. The Cun-
ninghams qualify for this subsidy and spend a total of $500 per month on housing:
they spend $250 of their own and receive a government subsidy of $250. Recently, a
new policy has been proposed that would provide each low income family with a lump
sum transfer of $250 which can be used for housing or other goods.

(a) What tradeoff is involved when the Cunninghams consider whether they prefer
the old or the new policy?
Answer: The tradeoff is between housing and all other goods. We can analyze
this as a two-good economy by putting money on one axis (used to buy everything
else) and housing on the other axis.
 (b) Graph the Cunninghams’ budget constraints under the old and the new policy.
Answer: See below.
(c) Show the Cunninghams’ consumption choice and an indifference curve that jus-
tifies that choice.
Answer: See below.
(d) Do the Cunninghams prefer the current policy, the new policy, or are they indif-
ferent between the two? Support you argument graphically.
Answer: See below. The Cunninghams prefer the new policy because the lump
sum payment will allow them to either purchase the same amount of housing as
they would under the housing subsidy (because the transfer they received was
also equal to $250 under the subsidy) or to use that cash for other goods.

6. Sally consumes two goods, X and Y . Her utility function is given by the expression
U (X, Y ) = 3XY 2 . The current market price for X is $10, while the market price for
Y is $5. Sally’s current income is $500.

(a) Sketch a set of two indifference curves for Sally in her consumption of X and Y.
Answer: See graph below. Indifference curves are places where utility is equal, so
we can draw two of them by choosing two different utility levels. Say U (X, Y ) =
30, 000. We then have the equation for the indifference curve as 30, 000 =
3XY 2 ⇔ X = 10, 000/Y 2 . If we instead choose a utility level of 300,000, we
have the indifference curve X = 100, 000/Y 2 . Here I am choosing to put X on
the vertical axis, but of course this is arbitrary. We must simply be careful to be
consistent.
(b) Write the expression for Sally’s budget constraint. Graph the budget constraint
and determine its slope.
Answer: Sally’s budget constraint is that the total amount she spends is less
than or equal to her total income. That is, 10X + 5Y ≤ 500. If we put X on the
vertical axis, this becomes X = 50 − Y /2. See graph below.
(c) What is Sally’s marginal utility of Y (as a function of X)? What is her marginal
utility of X (as a function of Y )?
Answer: The marginal utility of Y is the partial derivative of the utility function
with respect to Y . This is M Uy (X, Y ) = 6XY . As for X, we similarly have
M UX (X, Y ) = 3Y 2 .
(d) What combination of X and Y maximizes Sally’s utility under her budget con-
straint?
Answer: The condition for optimality is that the marginal rate of substitution of
Y for X is equal to the price ratio PY /PX . This is another way of saying that the
indifference curve must be tangent to the budget set (they must have the same
slope at the point that indifference curve just grazes the budget set).
One way to find the optimum is to use the fact that the marginal rate of substitu-
tion is the ratio of the marginal utilities: M RSY X = M UY (X, Y )/M UX (X, Y ) =
2X/Y . The price ratio, the negative of the slope of the budget line, is PY /PX =
1/2, so we must have that 2X/(Y ) = 1/2 ⇔ Y = 4X. This doesn’t tell us which
indifference curve Sally is on; to find a specific answer we must realize that the
budget constraint must simultaneously be satisfied. If we substitute Y = 4X into
the budget constraint, we have X = 50 − (4X)/2 ⇔ X = 50/3, which then yields
Y = 4X = 200/3.
Another way to find this optimum is to use unconstrained optimization
techniques. Sally wants to use up her entire budget purchasing X and Y , so
the budget constraint 10X + 5Y = 500 must hold. We can rewrite this as
Y = 100 − 2X. If we use this expression for Y in her utility function, we
have U (X) = 3X(100 − 2X)2 . Sally wants to maximize this quantity, so she
sets its derivative equal to zero: U 0 (X) = 6X(100 − 2X)(−2) + 3(100 − 2X)2 =
−1200X + 24X 2 + 30000 − 1200X + 12X 2 = 36X 2 − 2400X + 30000 = 0, so
X 2 − 200
3
X + 2500
3
= 0. This has two solutions: X = 50/3 and X = 50. The latter
corresponds to a Y value of 0, though, which definitely can’t be utility maximizing
since it leads to utility of 0. The former solutions corresponds to Y = 200/3.
Another way to find this optimum is to use constrained optimization techniques.
Sally maximizes her utility 3XY 2 subject to the budget constraint, so we can set
up the lagrangian

L(X, Y, λ) = 3XY 2 − λ(10X + 5Y − 500)

∂L ∂L
which has first order conditions ∂X = 3Y 2 − 10λ = 0, ∂Y = 6XY − 5λ = 0, and
∂L
∂λ
= 10X + 5Y − 500 = 0. The values that simultaneously satisfy these three
 equations are either (X, Y, λ) = (50/3, 200/3, 4000/3) or (50, 0, 0). The latter is
clearly not the utility-maximizing answer, so the former is the answer, just as
above.

(e) Illustrate her best attainable indifference curve and optimal consumption choice.
Answer:

(f) How does Sally’s optimal consumption change when the price of X increases to
$15? How does this price change affect her utility?
Answer: The MRS is still Y /2X, but now the price ratio is 15/5 = 3, so equating
the two yields 6X = Y . The new budget constraint is 15X + 5Y = 500. The
solution to these two equations is X = 100/9 and Y = 200/3.
200 2
Sally’s original utility is U (50/3, 200/3) = 3 · 50


3
· 3
= 222, 289. Her new
utility is U (100/9, 200/3) = 148, 148. Sally’s utility has fallen, so she is on a lower
indifference curve after the price change.