York University

Course: ECON 2300.03 A [F05]

Course Director: S. H. Chiang
Answers to Assignment#1♦

I. Budget constraint functions for the following cases:

a) An individual receives $100 from y

the Government. This results in a
parallel outward shift of the budget
line. m m + 100

0 -px/py -px/py x

b) P = P = 1. A subsidy is given in
terms of coupons. This allows the y
consumer to get 10 units of X free
of charge.
10

-px/py= -1 -px/py= -1 x

c) The recipient is able to sell his

coupons at $0.5. the results in ans. y
b) becomes: -py/px=-0.5
5
10

-px/py=-1 x

y
d) Rationing (x) is imposed on the
consumption of X. -px/py=-1

X0

x
♦
Prepared by TA, Simin Seury
e) Pizza Pizza had sales promotion – buy one at regular price, get the second one for
half a price:

f) Sales taxes are imposed on X:

Value tax: Quantity tax:

-px/py

-(1+Г)px/py

g) Sales taxes are imposed on X and Y:

II. The utility functions:
a. U = min[2x, y] : Perfect Complement [Leontief] Utility y
I. O. C.
Optimal: 2x = y
x* = y*/2 Slope = 2
plugging in: px.x + py.y = m yields:
4 U2
y* = 2m/(px + 2py)
2 U1
Effect of income on x and y: 1 2
x
dx*/dm>0; x is normal;
dy*/dm> 0; y is normal.
y U2
b. U = ax + by: Perfect Substitute [Linear] Utility slope = px/py
For the case: px/py < a/b:
x* = m/Px; ; y*= 0
U1
Effect of income on x and y:
dx*/dm > 0; x is normal; x
/
dy*/dm = 0; y is neutral. m/px m /px

c. U = x + √y : Quasilinear Utility y slope = -px/py

MUx = 1 ; MUy = 1/(2√y)
MRS = MUx / MUy = 2√y
Optimal: MRS = 2√y = px/py
y* = px2/4py2
I.O.C.
plugging in: px.x + py.y = m yields:
x* = m/px - px/4py
x
x1 x2 x3
Effect of income on x and y:
dy*/dm = 0; y is neutral;
dx*/dm = 1/px > 0; x is normal.
y
d. U = x y : Cobb-Douglas Utility
a b U2
Optimal: U1 I.O.C.
slope = -px/py
x* = am/Px; ; y* = bm/Py;

Effect of income on x and y:

dx*/dm = a/px > 0; x is normal;
dy*/dm = b/py > 0; x is normal. x
III. Engineering students face the following money prices for lab notebooks (N) and computer
diskettes (D) at the Bookstore: $5.00 per N and for D, $10.00 for the first 10 and a 10 percent
discount for the next 10. Thus, the cost is $19 for 20 diskettes, $27.1 for 30, etc.
a) Draw up the budget line of a student with $200.00 to spend.
b) What is the price of a lab book in terms of diskettes?
D
Maximum amount to spend on D:
=10 + 10 (0.9) + 10 (0.9) 2 + 10 (0.9) 3 + ... A
= 10/(1-0.9) = $100;
Minimum units of N that can be bought:
= ($200-$100)/$5 = 20;
.: Budget constraint is AB (not a straight line)

U
The slope of B.C approaches infinity as n≈20.

B
0 20 40 N

IV. (a) The money price of a bag of pretzels: Pp = $.50; the money price of a bottle of beer be Pb
= $1.00; the consumer have $5.00 to spend and only two hours in which to spend it. It takes
½ hour to eat a bag of pretzels and 15 minutes to down a brew. Therefore the two budget
lines and their slopes:
P p = $0.5 m = $5 t p = 0.5 hr; Budget constraint: 0.5p + 1.b = 5 => slope = -0.5
Pb =$1 H=2hrs t b =0.25 hr; Time constraint: 0.5p + 0.25.b = 2 => slope = -1
(b) Considering time can be bought and sold for $2.00 an hour. That is, you can take some of
your two hours and wash dishes, so that you have more cash to spend during the
remaining time, or you can pay someone to take your washing job, and have more time to
spend less cash. Draw up a new budget line in which you have combined your money and
time resources, where you start from $5.00 and add what you earn or deduct what you
spend, and in which time costs have a money value.
Optimal (using all money and time): p*
=2; b* = 4 b
(b) P hr = $2 8 Time constraint (slope =-2)
New Budget Constraint:
Point A (2, 4)
0.5+2(0.5)]p + [1+2(0.25)]b = 5+ 2x2
6
=> 1.5p +1.5b = 9
5
Slope = -P p /P b = -1.5/1.5 = -1. Utility
B BL(slope=-0.5)
increases as a result of trade if originally
the consumer was at B or C. No change
occurs if the consumer was at A. New BL(slope=-1)
C
p
0 4 6 10
V. Let U = x + lny.
a) What effect does higher px have on the demand for x and y.
b) What effect does higher income have on the demand for x and y? Discuss.
y

The consumer maximizes U = x + lny s.t. px.x + py.y = m -px/py

MUx = 1; MUy = 1/y
=> MRS = MUx/MUy = 1/1/y = y
Optimal condition: MRS = y = px/py, where px/py is fixed.

The direct demand for good y is:

y = px/py y =y0 I.O.C
The direct demand for good x [found from substituting x1 x
y = px/py in the budget constraint]: 0 x2
x = m/px - 1 x3

a) effect of higher px on the demand for x and y:

dx/dpx = - m/px < 0; demand curve for x is downward slopping.

dy/dpx = 1/px > 0; y is gross substitute.

b) effect of higher income on the demand for x and y:

dx/dm = 1/px > 0; x is normal

dy/dm = 0; y is neutral. The demand for y is independent of income in this example- i.e.
does NOT change as income changes [when a positive amount of each good is being
consumed].

When m < px , the optimal consumption of good x will be zero [since otherwise x = m/px –
1 < 0 is not possible, can not consume negative amount].

When m = px , the MU from spending additional income on good y is just equal to the
MU from spending additional income on x. after that point, the consumer spends all
additional income on good x.

VI. Bernice has the utility function U (x, y) = min[x, y]. The price of x used to be 3, but rose to
4. The price of y remained constant at 1. Her income is 12. The price increase was as bad for
her as a loss of 3 dollars in income, but she would need an income of 16 dollars to be able to
afford a bundle as good as her old one at the new price. True or false? Why?

Ans: False.
When, P x =3, P y =1, m=12, U(x, y) = min[x, y], optimal: x* = y*
=> 3.x + l.y = 12
=> (3 + 1)x* = 12
 => x* = 3; Y * = 3

When P x =4, P y =1, m=16, U(x, y) = min[x, y], optimal: x** = y**
=> 4.x + l.y = 16
=> (4 + 1)x* = 16
=> x* = 16/5 = 3.2; Y * = 3.2

Obviously, x* ≠ x**; y**y*≠ y**

VIII. Show that the utility function V = a + bxy gives the same demand functions as U = xy.

max U = xy s.t. P x .x + P y . y = m
optimal condition: MU x /MU y = P x /P y
M U x = y , M U y= x
=> y/x = P x /P y ….. (1)

max V = a + b(xy) s.t. Px.x+Py.y=m

optimal condition: MV x /MV y = P x /P y
MV x = b y , MVy = bx
=> by/bx = y/x = P x /P y ..… (2)

(1) = (2) ….. [proved]

VII. Suppose that individual’s utility for three goods, x, y, and z is given by u(x, y, z) = u1(x) +
u2(y) + u3(z), with u/i > 0 and u//i < 0. Show that none of the goods can be inferior.

The consumer maximizes u(x, y, z) = u1(x) + u2(y) + u3(z) s.t. px.x + py.y + pz.z = m

Mux/Muy = u1/(x)/u2/(y); Muy/Muz = u3/(z)/u2/(y)

Optimal condition: Mux/Muy = Muy/Muz= px/py= py/pz given px , py and pz

px/py = u1/(x)/u2/(y); and pz/py= u3/(z)/u2/(y)

Dividing px.x + py.y + pz.z = m through py:

y = m/py - px/py.x - pz/py.z

y = m/py – [u1/(x)x + u3/(z)z]/u2/(y)

dy/dm = 1/py + {u1/(x)x + u3/(z)z}/u2//(y) {dy/dm}

dy/dm[1- {u1/(x)x + u3/(z)z]/u2//(y)} = 1/py
dy/dm = 1/py{u//(y)}/[u//2(y) - u1/(x)x - u3/(z)z]
with u/i > 0 and u//i < 0, dy/dm is non-negative hence y is not inferior.

Similarly from dx/dm and dz/dm we can show that x and z are not inferior either.
Therefore none of the goods are inferior.
IX. Exercises from the text:
2: 1:
The consumer maximizes U = x + lny s.t.
Original budget line: p1.x + p2.x2 = m
New price: p1/ = 2p1 ; p2/ = 8p2 ;
New Income: m/ = 4m
Hence new budget line: 2p1.x1 + 8p2.x2 = 4m
p1.x1 + 4p2.x2 = 2m
2.6 Original budget line: p1.x + p2.y = m
Lump-sum tax = u;
Quantity tax on x1. = t
Quantity subsidy on x2 = s y
Hence new budget line: (p1+t)x1 + (p2-s)x2 = m

2.9 As price changes (say for example good x becomes

cheaper, the budget line rotates (become flatter) and
as income increases the budget line shifts outward.
So the old budget set is completely contained within
the old budget set. The consumers are at least as well
off as they were before; all the bundles they could x
afford before are still affordable at the new price and
income.
pepperoni
Since both good are bad, giving the consumer more
3.7
anchovies makes him worse off, so some amount of direction
pepperoni have to be taken away from him to put of utility ↑
him back on the same indifference curve.

3.9 MRS between of $1 bills for $5 bills is –5 or –1/5

anchovies
depending on which good is there in which axis.

y=$1bill y=$5bill

x =$5bill x=$1bill

3.10 If good 1 is neutral, MRS for good 2 will be zero; taking away some of good 1 needs zero
unit of good 2 to compensate his loss.
4.4 u(x1,x2) = √(x1 +x2) represents Perfect Substitute [Linear] Utility:
Mu1/Mu2 = u(x1)/u (x2) = 1
For the case: p1/p2 < 1:
x1* = m/P1; ; x2*= 0

v(x1,x2) = 13x1 +13x2 represents Perfect Substitute [Linear] Utility:

For the case: p1/p2 < 1:
x1* = m/P1; ; x2*= 0

Note: For perfect substitutes, all that matters to the consumer is the total number of goods.
Though the usual format is of U(x,y) = ax + by, any monotonic transformation of this, for
example logarithmic or square form V(x,y) = (ax + by)2 also represents perfect substitutes.

4.5 u(x1,x2) = x1 +√x2

MU1 = 1 ; MU2 = 1/(2√x2)
MRS = MU1 / MU2 = 2√x2
Optimal: MRSu = 2√x2 = p1/p2
x2* = p12/4p22
plugging in: px.x + py.y = m yields:
x1* = m/p1 – p1/4p2

v(x1,x2) = x12 +2x1√x2 + x2

Mv1 = 2x1 + 2√x2 ; Mv2 = 1 + 2x1/(2√x2)
MRS = Mv1 / Mv2 = 2√x2
Optimal: MRSv = 2√x2 = p1/p2
x2* = p12/4p22
plugging in: px.x + py.y = m yields:
x1* = m/p1 – p1/4p2
Since MRSu = MRSv, v(x1, x2) is the monotonic transformation of u(x1, x2).

4.6 U(x1,x2) = √(x1x2) = x1/2y1/2 represents Cobb-Douglas Utility:

MRSu = MU1 / MU2 = x2/x1
Optimal: x1* = m/2P1; ; x2* = m/2P2

v(x1, x2) = x12x2 is not a monotonic transformation of u(x1, x2):

MRSv = Mv1 / Mv2 = 2x2/x1; is not the same as MRSu

w(x1,x2) = x12x22 is a monotonic transformation of u(x1, x2):

MRSw = Mw1 / Mw2 = (2x22x1)/ (2x12x2) = x2/x1; is the same as MRSu

5.1 If two goods x1 and x2 are perfect substitutes,

for the case: p1/p2 < 1: x2*= 0;
for the case: p1/p2 > 1: x2* = m/P2; ;
for the case: p1 = p2: any amount between 0 and m/P2.
5.3 Let z be the number of cups of coffee the consumer buys. Then we know that 2z is the
number of teaspoon of sugar the consumer buys. The budget constraint therefore becomes:
2p1.z + p2.z = m
z = m/(2p1 + p2)

5.6 With quantity tax, the budget constraint is: (px + Г)x + py.y = m

With income tax, the budget constraint is: px.x + py.y = m – tx

With any kind of kinked preferences (graphically), where the equilibrium happens to be the
same point in both cases, the consumer will remain unaffected. For example with perfect
complements (in figure) we have such a case where the change in price does not induce any
change in demand.

y
slope
= -px/py

u2

u1
BL without tax

slope = -(1+Г)px/py x

6.1 If the consumer is consuming two goods only, and exactly exhausting the income, when
income increases, consumption of at least one of the good must increase as well. Hence both
of the goods cannot be inferior.

6.2 In case of homothetic preferences, the consumer’s preferences depend on the ratio of the
good 1 and good 2. For perfect substitutes, u(x1, x2) = x1 + x2 , we have (x1 + x2) > (y1, y2) if
u(x1, x2) > u(y1, y2).
Then, (tx1 + tx2) > (ty1, ty2)
u(tx1, tx2) > u(ty1, ty2).
Perfect substitutes are therefore an example of homothetic preferences

6.3 The Cobb-Douglas utility function has the property that

u(tx1, tx2) = (tx1)a(tx2)1-a = t(x1)a(x2)1-a = tu(tx1, tx2)
Hence if we have u(x1, x2) > u(y1, y2),
Then, (tx1 + tx2) > (ty1, ty2)
u(tx1, tx2) > u(ty1, ty2).
Cobb-Douglas preferences are therefore homothetic preferences.

7.2 m = p1.x1 + p2.x2 = 2(1) + 1(2) = 4

m/ = q1.y1 + q2.y2 = 1(2) + 2(1) = 4 = m.
 with {m , p1 , p2}, the bundle (y1 , y2) is not affordable:
p1.y1 + p2.y2 = 2(2) + 1(1) = 5 > m.
with {m , q1 , q2}, the bundle (x1 , x2) is not affordable:
q1.x1 + q2.x2 = 1(1) + 2(2) = 5 > m.
So there is no violation of WARP; this behavior is consistent with the model of maximizing
behavior.

7.4 If both prices change by the same amount, the base year bundle will still be optimum.

7.5 If the consumer utility function represents perfect complements, the consumer will remain
just as well off as the base year regardless of any price change.