PART 1

Exercise 1: Supply and Demand

price
demanded quantity

supplied quantity

24

20

16

12

12

16

20

24

1. Draw the appropriate supply-demand diagram.

P
Suppl
yy

6
5 6
4
3

2
1

1
2

Deman
d
Q
2
4

2. Calculate the equilibrium price and quantity?

P* = 3 & Q* = 12
3. Assuming that the price is 2, does an over-supply or under-supply thus prevail?

 Under supply
4. Assuming that wheat becomes scarce due to a storm. The following should apply:
Demanded
quantity

supplied
quantity

price

24

20

16

12

12

16

Map the new supply function in the diagram. What is the equilibrium price now?
P* = 2 & Q* = 8
P
Suppl
yy

3
2

Deman
d
Q
1
6

5. Explain, with the help of a diagram, why the equilibrium price for hotel prices on the
Adriatic would decrease if the weather from now on was very warm in Northern Germany
every summer.

=> Because Nothern Germany is so cold, thus when it is very warm now, the demand
of tourists to visit the place will increase; as a result the number of travellers to
Adriatic will fall and this leads to reducing prices of hotel too.

Exercise 2: Budget amounts

Show, by means of a sketch, how the budget amount changes with

1. A price increase of commodity 1.
C = (I/Pc) (Pf/Pc) * F
The budget line rotates inward to line 2 because the persons purchasing power has
diminished
C2

L2

L1
C1

2. A decrease in budget.
C2

L2

L1
C1

If the income decreases, the budget line shifts inward from L1 to L2

3. An introduction of quantity tax on commodity 1.

L2

L1
C1

Price on C1 increases a decrease in purchasing power

4. An introduction of value tax on all commodities.
C2

L2

L1
C1

Prices of two goods go up slopes or the ratio of 2 prices unchanged shifting the
budget line inward

5. Inflation
C2

L2

L1

C1

Prices of two goods increase at the same ratio with inflation, income is constant =>
purchasing power decreases ( slope unchanged, intercept shifted downward)

C2

C1

If both prices and income changed or rise proportionately will not affect to the budget
line or purchasing power

6. A rationing of commodity 1.
C2
A

L1

E
Q

C1
B

7. A minimum quantity of commodity 1 necessary for survival (should the consumer

consume
less than this minimum amount, then they must die).
A
A

L1
B

C1
Q
8. An introduction of value tax on the consumption of commodity 1 outside of a minimum

quantity.

A
I-Q

A
D

L1
L2
E

C1

Part II:
Exercise 1: Preferences
1. Explain the relationship between preferences and utility functions.
2. Explain the difference between cardinal and ordinal utilities.
3. Explain why any positive monotonous transformations of a utility function depict the same
preferences (deleted)

Exercise 2: Required optimality condition

Show graphically and mathematically (by using the Lagrange approach) that the slope in the
budget line is equal to that of the slope of the indifference curve at an optimum, that thus

u ( x1 , x2 )
p
x1
= 1
u ( x1 , x2 ) p2
x2
applies. Interpret the condition.
C2

Optim
al

C1
Q1

1. The method of Larange Multipliers

= U(x1, x2) (P1x1 + P1x2 I)
Where: P1x1 + P2x2 I = 0
2. Differentiating the Lagrangian

x 1

= MUx1(x1, x2) P1 = 0

x 2

= MUx2 (x1, x2) P2 = 0

x 1

= I P1x1- P2x2 = 0

3. Solving the resulting equations

MUx1(x1, x2) = P1
MUx1(x1, x2) = P1
I = P1x1+ P2x2

The equal marginal principle

MUx 1(x 1, x 2)
MUx 2( x 1, x 2)
=
=
P1
P2
MUx 1(x 1, x 2)
MUx 2(x 1, x 2)

P1
P2

u ( x1 , x2 )
x1
p
= 1
u ( x1 , x2 ) p2
x2

Exercise 3: Indifference curves and demand

Mr. K consumes two commodities: honey (commodity 1) and coffee (commodity 2). His utility
function is as follows:
U ( x1 , x2 ) = x1 x1 x2 x2

Utilize prices

p1 = 2

and

p2 = 1

for the drawings and income

E =5

1. What functional forms do the indifference lines have? Produce a sketch.

U ( x1 , x2 ) = x1 x1 x2 x2

With
U (x1, x2) = x1(1+x2) + x2
Or U (x1, x2) = x1 + x2(x1 +1)
U ( x 1, x 2 )x 2
x1 =
(1+ x 2)
x2 =

U ( x 1, x 2 )x 1
(x 1+1)

Taking 1st and 2nd derivatives

x 2 U +1
=
x
x 1 ( X 1+1 ) 2 < 0

2 x 2
= 2 (U + 1)(x1+1) -3 > 0 x 1
2
x 1

2. Name various utility functions with the help of which we can deduce these
preferences.
U(x1, x2) = A.U(x1, x2) = A(

U(x1, x2) = e

x1 x1 x2 x 2

x10 x20
3. Calculate the marginal rate of the substitution for any bundle of goods ( , ).
MUx 10( x 10, x 20)
U /x 10
Px 10
1+ x 20
MRSX10, X20 = MUx 20( x 10, x 20) = U /x 20 = Px 20 = 1+ x 10

x1 0 = 1
4. Assume that Mr K. has

x2 0 = 5
and

. He receives an offer to deliver a

x1

x2

(marginal) unit of
and in exchange receive two (marginal) units of . Does he agree?
Form an argument using the marginal rate of the substitution. What would be the case if he
received the offer at position (2,3)?
1+5
MRS = 1+1 = 3 > 2 DISAGREE
MRS =

1+3 4
= <2
AGREE
1+2 3

5. Define & calculate the demand functions. Are the demand functions homogeneous
in
(a) income?
(b) in income and prices?
U(x1, x2) = x1 + x1x2 + x2
E = P1x1 + P2x2 P1x1 + P2x2 E = 0
= U(x1, x2) (P1x1 + P2x2 E) (1)

x 1 = 1 + x2 P1 = 0

x 2

= 1 + x1 P2 = 0

x 1

= E - P1x1 - P2x2 = 0 (2)

=
X2 =

1+ x 2
1+ x 1
P1
P2

P1
P2

(1+X1) 1 (3)

Substituting (3) into (2)

P1
E P1x1 (P2 * ( P 2
X1 =

EP 1+ P 2
2P1

(4)

E 2P1x1 P1 + P2 = 0

(1+x1) 1)) = 0

So, x2 =

E+ P 1P 2
2P2

(5)

(b) income and prices?

f(x) = tf(x)
EP 1+ P2
x1(P1, P2, E) =
2 P1

x2(P1, P2, E) =

E+ P1P2
2 P2

x1(P1, P2, E) =

EP 1+ P 2
2 P1

EP 1+ P 2
2P1

The same to x2
=> Changes in income, the demand functions are not homogeneous
=> In contrast, when both income and price change, it gives rise to be homogeneous in the
functions
6. Define, calculate and draw the Engel curves.
Definition: Engel curve relating the quantity of a good consumed to income
E1= 2P1x1 + P1 P2 = 4x1 + 1
E

9
5

X1
1

E2 = 2P2x2 + P2 P1 = 2x2 -1

X2
1

7. Define, calculate and draw the income expansion path. (=income consumption
curve)
Income consumption curve: curve tracing the utility maximizing combinations of two
goods as a consumers income changes
(1) E1 = E2
4x1 + 1 = 2x2 1
4 x 1+2
X2 =
= 2x1 + 1 (*)
2
Maximizing utility (one of the properties of demand curve)
1+ X 2
P1
(2) MRS = P1/P2 1+ X 1 = P 2 = 2
1 + x2 = 2 + 2x1
=> x2 = 2x1 + 1 (**)
We have, (*) = (**) => optimal
X
21

X
1

X
2

X
1

8. Define normal and inferior commodities. Are we talking about normal or inferior
commodities here for both commodities?
Normal goods: consumers want to buy more of them as their incomes increase. When
the income- consumption curve has a positive slope, the quantity demanded increases
with income. As a result, the income elasticity of demand is positive
xi
E >0
Inferior: consumption falls when income rises. The income elasticity of demand is
negative
xi
E <0
x 1(P 1, P2, E)
E
x 2(P1, P 2, E)
E

1
2 P1

=> NORMAL COMMODITIES

1
2 P2 > 0

>0

PART III:
Exercise 1: Income and substitution effect

The Slutsky equation for "Cobb-Douglas" preferences:

A consumer has the utility function
p1 > 0

u ( x1 , x2 ) = x1 x 12

. The consumer's income is E and the prices

p2 > 0

of both goods are

and
. Sketch the indifference curve and solve the following
exercise graphically and mathematically.

1-

U = x1 x2

x2 =

x 2
x 1

2 x 2
2
x 1

1-

=> x2

U
x 1

1
)
1

(
)
1

X1

= U

1
1

x 1 1
1

x1

1
1

2 +

x 1 1
1

1
1

)
1

<0

>0

X
2

X
1

Max U (x1, x2) = x 1 x21-

P1x1 + P2x2 E P1x1 + P2x2 E 0
E - P1x1 - P2x2 0
1. Calculate the demand for commodity 1 and 2.
= u(x1, x2) (P1x1 + P2x2 E)
Or = u(x1, x2) (E - P1x1 - P2x2)
= x 1 x21- (P1x1 + P2x2 E)

-1
1-
x 1 = x 1 x2 - P1 = 0

x 1

= (1- ) x 1 x2 - P2 = 0

x 1

= E P1x1 - P2x2 = 0

x -11 x21- = P1
(1- ) x 1 x2- = P2
1

x 1 x 2
(1 )x 1 x 2

X2 =

P1
P2

P 1 X 1(1 )
P2

(*)

Substituting (*) into E - P1x1 - P2x2 = 0

E P1x1 P2

P1 x1

P 1 X 1(1 )
P2

= E => x1* (P1, P2, E) =

=0
E
P1

x2
x1

P1
P2

Replace x*1 into X*2 => X*2 =

E (1 )
P2

2. Assume the price of commodity 1 decreases from

What now is the demand for both commodities?
E
p1
X1( , p2, E) = > x (P1, P2, E)

p1

to

p1

X2(

p1

, p2, E) =

E (1 )
P2

= x2 (P1, P2, E)

3. How large would the corresponding income have to be for a consumer to just be
able to afford the original bundles of goods? Also produce a sketch.
P 1 E
P 2 E(1 )
E = P1X1 + P2X2 E =
+
P1
P2
( P 1 ( P 1P ' 1 ) )
=> E = E
P1
P1 P1 > 0
P 1P ' 1
0<
P1

<1

=> E < E
X2

C
A

X1