ECO2001

Spring 2011

Problem Set #2
(Due Date: April 22, 2011)

True-False Questions (Total 40 pts)

Answer “True” or “False” to each statement, and verify your answers using 1-2 paragraphs or
graphs.

1. (10 pts) When markets fail, public policy can potentially remedy the problem and increase
economic efficiency.

2. (10 pts) The demand for bread is less elastic than the demand for donuts; hence, a tax on
bread will create a larger deadweight loss than will the same tax on donuts, other things equal.

3. (10 pts) If goods A and B are perfect substitutes, then the marginal rate of substitution of
good A for good B is constant.

4. (10 pts) All points on a demand curve are optimal consumption points.

Short Answer Questions (Total 30 pts)

5. (15 pts) Answer each of the following questions about demand and consumer surplus.

a. What is consumer surplus, and how is it measured?

b. What is the relationship between the demand curve and the willingness to pay?
c. Other things equal, what happens to consumer surplus if the price of a good falls? Why?
Illustrate using a demand curve.
d. In what way does the demand curve represent the benefit consumers receive from
participating in a market? In addition to the demand curve, what else must be considered to
determine consumer surplus?

6. (15 pts) Use the following graph shown to fill in the table that follows.

Price
P4
Supply
A
P3

B C

P2
D G

P1
F

Demand
Q2 Q1 Quantity

(Continued to the next page!)

1
ECO2001
Spring 2011

WITHOUT TAX WITH TAX CHANGE

Consumer surplus
Producer surplus
Tax revenue
Total surplus

Consumer’s Utility Maximization (Total 30 pts)

7. (15 pts) What are the optimal conditions under which consumers can maximize their total
utility in the two-good case? Graphically demonstrate the conditions associated with a
consumer optimum. Carefully label all curves and axes.

8. (15 pts) Assume that a person consumes two goods, Coke and Snickers. Use a graph to
demonstrate how the consumer adjusts his/her optimal consumption bundle when the price of
Coke decreases. Carefully label all curves and axes. (Also assume that two goods are normal
goods and that budget is constant.)