Fulbright University Vietnam

Microeconomic Analysis (ECON 201)

Problem Set 1
[Due in class on February 18]

Instruction:
o Complete the problem set independently or in a group of maximum 4 students. The
score for the group submission will be the score that each group member receives.
o You can type or hand-write your responses. Please staple the additional pages to the
back of this document.

Student Name(s) and ID number(s):

1.__________________________________________________________________

2.__________________________________________________________________

3.__________________________________________________________________

4.__________________________________________________________________

Score:

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Exercise 1. Phone companies used to sell minutes of phone calls at the same price no matter how
many phone calls a customer made.
a. On a graph with “minutes of phone calls per month” on the horizontal axis and “dollars of other
consumption” on the vertical, draw a budget constraint assuming the price per minute of phone
calls is p and assuming the consumer has a monthly income I.
b. More recently, cell phone companies have become more creative in their pricing. Suppose a new
option is that you can pay $Px to buy into a phone plan that offers you x minutes of free calls per
month, with any calls beyond x costing p per minute. Assume that Px is sufficiently low such that
the new budget contains some bundles that were previously unavailable to our consumer.
Illustrate the your budget constraint going with this new option.

Suppose a phone company has 100,000 customers who currently buy phone minutes under the old
system that charges p per minute. Suppose it costs the company c to provide one additional minute
of phone service but the company also has fixed costs FC (that do not vary with how many minutes
are sold). Suppose a second identical phone company has 100,000 customers that have bought into
a calling plan that charges Px = kpx and gives customers x free minutes before charging p for minutes
above x.
c. If people on average use half their “free minutes” per month, what is the amount of k (as a
functions of FC, p,c and x) for the second company to break even (e.g., making zero profit)?
d. If there were no fixed costs (i.e., FC = 0) but everything else was still as stated above, what does c
have to be equal to in order for the first company to make zero profit? What is k in that case?

Exercise 2. Suppose you just won $10,000 in the lottery. You decide to put it all in a savings account.
Bank A offers you a 10% annual interest rate that compounds annually, while
Bank B offers you a 10% annual interest rate compounded every 6 months.
a. How much will you have in the bank at the end of the year if you go with Bank A?
b. How much will you have if you put your money into Bank B?
c. What annual interest rate would Bank A have to offer to make you indifferent between accepting
Bank B’s and Bank A’s offers over the coming year?
d. Would the interest rate you calculated in (c) be sufficient for you to be indifferent between Bank A
and Bank B if you planned to keep your money in the savings account for 2 years?
e. Generalization: Suppose you place x in a savings account and assume that the account gives an
annual interest rate of r compounded n times per year. Derive the formula for how much y you
will have accumulated 1 year from now in terms of x, n and the annual interest rate r.
(i) If you have to choose between an annual interest rate of 10% compounded monthly
versus one compounded weekly, which would you choose?
(ii) How about choosing between an annual interest rate of 10.5% compounded annually and
an annual interest rate of 10% compounded weekly?

Exercise 3. Suppose you are considering where to invest money for the future. Like most investors,
you care about the expected return on your investment as well as the risk associated with the
investment. But different investors are willing to make different kinds of tradeoffs relative to risk and
return.
a. On a graph, put risk on the horizontal axis and expected return on the vertical. (For purposes of
this exercise, don’t worry about the precise units in which these are expressed.) Where in your

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 graph would you locate “safe” investments like inflation indexed government bonds —
investments for which you can predict the rate of return with certainty?
b. Pick one of these “safe” investment bundles of risk and return and label it A. Then pick a riskier
investment bundle B that an investor could plausibly find equally attractive (given that risk is bad
in the eyes of investors while expected returns are good).
c. If your tastes are convex and you only have investments A and B to choose from, would you prefer
diversifying your investment portfolio by putting half of your investment in A and half in B?
d. If your tastes are non-convex, would you find such diversification attractive?

Suppose an investor has utility function 𝑢(𝑥1 , 𝑥2 ) = (𝑅 − 𝑥1 )𝑥2 where 𝑥1 represents the risk
associated with an investment, 𝑥2 is the expected return and R is a constant.
e. What is the MRS of risk for return for this investor?
f. Suppose A is a risk free investment, with 𝑥1𝐴 = 0, and suppose that B is risky but our investor is
indifferent between A and B. What must the return 𝑥2𝐴 on the risk-free investment be in terms of
𝑥1𝐵 and 𝑥2𝐵 ?
g. Do this investor’s tastes satisfy convexity? Illustrate by considering whether this investor would
be willing to switch from A or B in part (b) to putting half his investment in A and half in B.

Exercise 4. Suppose that you have an income of $100,000 now and you expect to have an income of
$300,000 10 years from now, and suppose that the interest rate for borrowing from the bank is twice
as high as the interest rate the bank offers for savings.
a. Begin by drawing your budget constraint with “consumption now” and “consumption in 10 years”
on the horizontal and vertical axes. (Assume for purposes of this problem that your consumption
in the intervening years is covered and not part of the analysis.)
b. Can you explain why, for a wide class of tastes, it is rational for someone in this position not to
save or borrow?
c. Now suppose that the interest rate for borrowing was half the interest rate for saving. Draw this
new budget constraint.
d. Illustrate a case where it might be rational for a consumer to flip a coin to determine whether to
borrow a lot or to save a lot (e.g., indifferent between saving and borrowing a lot).

Suppose that your incomes are as described in part A and that the annual interest rate for borrowing
is 20% and the annual interest rate for saving is 10%. Also, suppose that your tastes over current
consumption 𝑐1 and consumption 10 years from now 𝑐2 can be captured by the utility function 𝑢(𝑐1 ,
(1−𝛼)
𝑐2 ) = 𝑐1𝛼 𝑐2 .
e. Assuming that interest compounds annually, what are the slopes of the different segments of the
budget constraint that you drew in (a)? What are the intercepts?
f. For what ranges of 𝛼 is it rational to neither borrow nor save?

Exercise 5. Given the concerns about environmental damage from car pollution, many have
proposed increasing the tax on gasoline. Suppose a consumer has annual income of $50,000 and
suppose the price of a gallon of gasoline is currently $2.50.
a. Illustrate the consumer’s budget constraint with “gallons of gasoline” per year on the horizontal
axis and “dollars spent on other goods” on the vertical. Then illustrate how this changes if the
government imposes a tax on gasoline that raises the price per gallon to $5.00.

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b. Pick some bundle A on the after-tax budget constraint and assume that bundle is the optimal
bundle for our consumer. Illustrate in your graph how much in gasoline taxes this consumer is
paying and call this amount T.
c. One of the concerns about using gasoline taxes to combat pollution is that it will impose
hardship on consumers. Some have therefore suggested that the government simply rebate all
revenues from a gasoline tax to taxpayers. Suppose that our consumer receives a rebate of
exactly T. Illustrate how this alters the budget of our consumer.
d. Suppose our consumer’s tastes are quasilinear in gasoline. How much gasoline will she
consume after getting the rebate?
e. Can you tell whether the tax/rebate policy is successful at getting our consumer to consume less
gasoline than she would were there neither the tax nor the rebate?

Suppose our consumer’s tastes can be captured by the quasilinear utility function
𝑢(𝑥1 , 𝑥2 ) = 200𝑥1 2 + 𝑥2 , where 𝑥1 denotes gallons of gasoline and 𝑥2 denotes dollars of other
goods.
f. Calculate how much gasoline this consumer consumes as a function of the price of gasoline (𝑝1 )
and income I. Since other consumption is denominated in dollars, you can simply set its price
(𝑝2 ) to 1.
g. After the tax raises the price of gasoline to $5, how much gasoline does our consumer purchase
this year?
h. Can you verify that her gasoline consumption will not change when the government sends her a
rebate check equal to the tax payments she has made?
i. How does annual gasoline consumption for our consumer differ under the tax/rebate program
from what it would be in the absence of either a tax or rebate?
j. Illustrate that our consumer would prefer no tax/rebate program but, if there is to be a tax on
gasoline, she would prefer to have the rebate rather than no rebate.

Exercise 6. Consider a consumer who consumes two goods, X and Y. Initially, the prices of X and Y
are 𝑃𝑋 = 10 and 𝑃𝑌 = 20, respectively. The consumer’s initial income is 𝐼 = 200. The consumer
reaches an optimal consumption bundle at the prices and income given. Now, suppose the price of
good X decreases to 𝑃𝑋 = 5 while the price of good Y and the consumer’s income remain unchanged.
a. Write the budget constraint equations before and after the price change.
b. Assume that the utility function is 𝑈(𝑋, 𝑌) = 𝑋 × 𝑌. Calculate the initial and new optimal
quantities of goods X and Y consumed.
c. Compute the substitution effect by keeping utility constant at the initial level and changing the
price of X to 5. Compute the income effect by considering the change in real income due to same
price change.
d. Discuss how an understanding of income and substitution effects can be useful for
policymakers when designing tax policies or subsidies.

Exercise 7. Suppose you consume only beer and pizza (sold at prices 𝑝1 and 𝑝2 respectively) with an
exogenously set income I. With the number of beers on the horizontal axis and the number of pizzas
on the vertical, illustrate a budget constraint (clearly labeling intercepts and the slope) and some
initial optimal (interior) bundle A.
a. When your income goes up, I notice that you consume more beer and the same amount of pizza.
Can you tell whether beer is normal or inferior? What about pizza?

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b. When the price of beer goes up, I notice that you consume less beer. Present one bundle on the
graph that would make beer a normal good and one that makes beer an inferior good.
c. When the price of beer goes down, I notice you buy less pizza. What type(s) of good can pizza be?
Present one bundle on the graph to illustrate each case.
d. When the price of pizza goes down, I notice you buy more beer. Is beer an inferior good for you? Is
pizza?

Suppose that your tastes over beer (𝑥1 ) and pizza (𝑥2 ) can be summarized by the utility function 𝑢(𝑥1 ,
𝑥2 ) = 𝑥1 2 𝑥2 . Calculate the optimal quantity of beer and pizza consumption as a function of 𝑝1 , 𝑝2
and I.
e. Illustrate the optimal bundle A when 𝑝1 = 2 , 𝑝2 = 10 and weekly income I=180. What numerical
label does this utility function assign to the indifference curve that contains bundle A?
f. Using your answer above, show that both beer and pizza are normal goods when your tastes can
be summarized by this utility function.
g. Suppose the price of beer goes up to $4. Illustrate your new optimal bundle and label it C.
h. How much beer and pizza would you buy if you had received just enough of a raise to keep you
just as happy after the increase in the price of beer as you were before (at your original income of
$180)? Illustrate this as bundle B.
i. How large was your salary increase in (h)?

Exercise 8. Suppose that tastes can be represented by the Cobb-Douglas utility function
𝑢(𝑥1 , 𝑥2 ) = 𝑥1 𝛼 𝑥2 (1-𝛼) .
a. Derive the demand functionswhen income is exogenous and illustrate that own-price demand
curves slope down.
b. Now suppose that all income is derived from an endowment (𝑒1 , 𝑒2 ). If 𝑒2 = 0, what is the
shape/slope of the own price demand curve for 𝑥1 ?
c. Continuing with part (b),what is the shape/slope of the own price demand curve for 𝑥1 when 𝑒2 >
0?