Multiple Choice Problems

1. e
The correct answer is e because elasticity is -0.5
Assume that the price of one hot tub is P, then an individual must have an income of at
least 100P in order to purchase a hot tub. Therefore, the quantity demanded at this price is
1000000/100P=10000/P. Supposing further that the price of a hot tub doubles, the price
now becomes 2P, therefore making the income required to be 200P. Quantity demanded
at this point decreases to 100000/200P=5000/P. Recall that the formula for price elasticity

of demand is

2. b
3. a
At a price of $100, the quantity of tickets demanded is 267+237=504
At the price of $110, the total quantity demanded is 127+127=254

4. b
Consumers problems
1.
a. Yes. Ray prefers more to less of each good. This can be confirmed by taking first
order derivatives of the utility function to show that the level of utility is
positively related to the amount of each good consumed.
(This value is positive)

(this value is positive)

b. When utility is , the function can be written as

Rewriting it in the form of y=mx+c

The intercepts for this line will be

X

Y
0
100

50
0

At a utility level of 1

Rewriting in the form y=mx+c

Intercept coordinates are

X

Y
0
100

100
0

When U=2, we can write the utility function as

Rewriting this function in the form y=mx+c

The intercept coordinates for this line will be
X

Y
0
100

200
0

Plotting the three curves in one graphs

c. For any bundle, the indifference curve is a line passing through point (100, 0).
The resultant indifference map is a star shaped ray of indifference curves all

passing through (100, 0). Yes, the utility is homothetic because each utility
function can be expressed as a function of the other.
d. If Rays income is less than $100, he will consume only good Y and nothing of
good X. But if his income is above $100, he will consume only good X and
nothing of good Y. Given the utility function and the prices of good X and good Y
(both $1), we can derive his demand for good X as a function of his income. For
all income levels above $100, Ray will consume 1 unit of good X for every
additional $1 of income. Therefore, X=I-100, where X is the quantity of X
consumed and I is Rays income

2.
a) The general form of a consumption leisure budget line is
Where C is consumption levels, w is the wage rate, L is hours of leisure, T is total
time available and M is the part of income that is independent of working hours.
Given total time T, wage rate w, and x1 hours of leisure, the agent faces a budget
constraint given by the equation.

b) to solve for utility maximizing levels of x1 and x2, we proceed as follows

Max
s.t

From this problem, we can derive the langrage as

L=

Differentiating this function with respect to

, and

=03

From 1 and 2, we can solve for the expansion paths of x1 and x2

From 1)

From 2)

Equating the two

Since

is common on both sides it cancels out, leaving

Obtaining reciprocals on both sides and then square roots results in

We can plug equivalents of

, and

into the budget constraint to obtain their optimal values.

Factoring out

Dividing both sides by

b) At first, increasing wage will cause an individual to work more and take less
hours of leisure. This is the case because substitution effect is higher than income
effect hence work is relatively more profitable than leisure. However, as wages
keep increasing, the substitution effect keeps declining while income effect
increases until a point where income effect is bigger than substitution effect. At
this point, an individual consumes more of leisure hours and less of work
True or False
1. False. Not all the sections of the ATC symbolize DRS. Only the upward sloping part of
the curve is associated with decreasing returns to scale. The downward sloping part is
associated with increasing returns to scale.
2. True. At MP1/w1>MP2/w2, the slope of the isoquant exceeds that of the isocost, implying
that the firm can maintain same level of output by increasing the use of input 1 and
decreasing the use of input 2 until equilibrium is reached.
3. True. Whenever the MC curve is below the ATC curve, it implies that an additional unit
of input will cost less than the previous unit, which means the average cost is also
declining. On the other hand, if MC the AC, then the AC is increasing because every
additional unit is costing more, which implies higher costs on average? Therefore, the
average cannot increase when MC is declining.
4. False. Average cost is minimized when y=10

Recall that

At minimum, the derivative of the AC function is equal to zero

Multiplying each term by

Taking the square root on both sides

y=10.
5. False. Given that the inputs in this production function are perfect substitutes, the optimal
solution is a corner solution, implying that the firm maximizes profit by using only one
input. Then, if the price of x1 doubles and that of x2 triples, then the firm is better off
producing using x1 only because it is cheaper. Therefore, the firms cost will only double.
6. False. Since the firm shows decreasing returns to scale, the effect of the tax and subsidy
do not cancel out. Essentially, the increase in inputs used due to the subsidy will result in
less than proportionate increase in output. This means that the overall impact is negative;
hence the optimal quantity has to change.
7. False. If the firm is in a competitive market, an increase in its output price must cause its
quantity to fall because buyers will shift to other firms.
Production problems
1.
(a) If the firm is experiencing a fixed proportions production function, the total
cost is equal to the sum of costs of both inputs.

(b) Given that the firms inputs are perfect substitutes, then the firm optimal
bundle is a corner solution, which means it can only produce with one input.

As such, it chooses the input which has a lower cost. However, the input costs
may be equal, in which case the firm is indifferent. Therefore, there are 3
possible cost functions.
If w1>w2, TC=w1y.
If w2>w1, TC=w2y
If w1=w2=w, TC=wy
2. Given the production function y=min(2x1, 3x2) then the conditional demand for x1
is:

When

, the production function becomes y=min(2x1, 12)

Since the proportions are fixed, 2x1=12

x1=6
TC=6w1+4w2

3. The total cost function is

Production function
This problem is a cost minimization problem which is solved as follows.
Min
s.t

Formulating Langrage

L=

Obtaining First order conditions

.ii

iii

We can solve expansion paths of x1 and x2 using equations 1 and 2

From 1,

..iv

From 2,

..v

Equating iv and v

Substituting these values into equation 3 one at a time

Introducing the exponent on both sides

Multiplying through by

Collecting like terms

The cost function will be

4.

Given that

a. Average variable cost

b. Marginal cost

c. Average cost is minimized when the derivative of AVC is put to zero

d. Use, the supply curve can be derived from the marginal cost curve by taking the
positively sloping part of the curve. To do that we need to determine the turning point of
MC to know where the supply curve begins by differentiating MC with respect to y and
putting it to zero.