DARTMOUTH COLLEGE

Department of Economics
Economics 21 Professor Gustman
Microeconomics
Problem Set I
1. This question concerns rent subsidies. Suppose that under a rent subsidy the government will pay
some specified proportion of the total rental price. Using an indifference map for "housing" (e.g.
rooms of standard quality) and "all other commodities" analyze whether this approach to enhancing
domestic welfare is more or less effective than granting income tax reductions equal in dollar
amount to the amount of the rent subsidy? How do these compare to a lump sum $250 per month
subsidy which must be applied toward rent or it is taken away?
II. A. Mr. Jones has $15,000 per year of "pocket money." He buys 500 packs of cigarettes at $10.00 per
pack. Although he is a heavy smoker cigarettes are not necessary for his survival. Show his
budget line and his equilibrium position in a diagram utilizing indifference curves. (Measure
packages of cigarettes on the horizontal axis and "pocket money" on the vertical axis.)
B. The Anti-Tobacco Alliance threatens to win its fight to have smoking prohibited by law. Where
would Jones' equilibrium lie if this legislation were passed? Show on the diagram you have
drawn the maximum amount Jones would be willing to pay annually to avoid the ban on
smoking and explain briefly. (Assume that Jones would still pay $10.00 per pack). Show also the
minimum amount the U.S. Smokers Compensation Commission (set up to compensate smokers
for the loss of their right to smoke) would have to pay Mr. Jones to compensate him for the loss
of his opportunity to smoke.
III. 1. Derive a formula for the elasticity of supply so that the elasticity at point E is AX/OX. Use the
same approach to show that any straight line supply curve has unitary elasticity if it goes through
the origin, is inelastic if it intersects the X axis and is elastic if it intersects the Y axis.

2. Draw indifference curves between present consumption (this year) and future consumption (next
year) and justify the shape you gave them. (Assume that there is just one all purpose commodity
that is used for consumption, investment, etc. Be sure to measure present consumption on the X
axis.) What does the MRS indicate in this case? Is this related to anything you have learned in
other economics courses? Now draw a budget line of any slope. What is the significance of the
slope? Is it related to anything you have learned before? Illustrate the determination of

equilibrium and indicate the equilibrium amounts of present and future consumption with C
t
and
C
t+1
respectively. Would you expect the indifference curves to intersect, or to be asymptotic to one
or both axes?
3. Many consumers would buy the same quantity of a commodity such as hats, suits, desk lamps,
and automobiles even if the price of the commodity were raised or lowered by 30 percent or more.
Why then do the demand curves resulting from statistical studies typically show the quantity
demanded as a continuously varying function of price?
4. Suppose cattle raisers are observed to consume more meat when its price rises. Does this imply
that from their point of view, beef is an inferior good? Explain.
IV. For the utility function U=ln x + ln y, given a budget constraint m = xPx + yPy derive the demand
curve for x using
a. The equilibrium condition.
b. The Lagrangian maximization technique.
V. 1. Assume a society in which consumers partake of only two goods, bread (B) and wine (W). The
price of bread is 4 units per loaf and the price of wine is 2 units per glass. Mr. H, a typical consumer
with whom we shall be concerned, has a weekly income of 200 units; the government taxes away
entirely any part of that income which he does not spend. There is also a rationing scheme whereby
each consumer, Mr. H. included, receives 120 ration "points" each week and must turn in 2
"points" with the purchase of each loaf of bread and 6 "points" with the purchase of each glass of
wine. There is no way to buy or sell "points" for money.
a. On graph paper, shade in the region of all feasible combinations of consumption of loaves of
bread (B) and glasses of wine (W) for Mr. H.
b. Is it possible for Mr. H's preferred consumption pattern to be such that he exhausts both his
income and his "points"? If so draw in a possible highest indifference curve which would
bring about this situation; label it XX.
c. Is it possible for Mr. H's preferred consumption pattern to be such that he exhausts his
"points' but not his income (the rest of which is of course taxed)? If so, draw in a possible
highest indifference curve which would bring about this situation; label it YY.