ME Problem Set-1

1. Draw a set of indifference curves for the following pairs of goods:

a. Hamburgers and carrots for a vegetarian who neither likes nor dislikes meat. (Vegetarians
do not eat meat.)
b. Peanut butter and jelly for an individual that will not eat peanut butter sandwiches or jelly
sandwiches, but loves peanut butter and jelly sandwiches made with two parts peanut butter
and one part jelly.
c. Tickets for Knott's Berry Farm (KBF) and Universal Studios (US) for a tourist that
believes that KBF and US are perfect substitutes.
d. Ice cream and pie if these are goods that you like, but if you consume enough of either,
you get sick of them. If you are sick of a good, consuming more of it lowers your utility.

2. In the field of financial management it has been observed that there is a trade-off between
the rate of return that one earns on investments and the amount of risk that one must bear to
earn that return.

a. Draw a set of indifference curves between risk and return for a person that is risk averse
(a person that does not like risk).
b. Draw a set of indifference curves for a person that is risk neutral (a person that does not
care about risk one way or the other).
c. Draw a set of indifference curves for a person that likes risk.

3. An island economy produces only two goods, coconuts and pineapples. There are five
people (A, B, C, D, and E) living on the island with these preferences:

A has a strong preference for pineapples.

B has a strong preference for coconuts.
C doesn't care for pineapples (assigns no value to them).
D doesn't care for coconuts (assigns no value to them)
E will only consume pineapples and coconuts in the fixed proportion of
one pineapple to one coconut.

For each of these five individuals, construct a representative indifference curve with
pineapples on the vertical axis and coconuts on the horizontal axis. Discuss the shape of the
indifference curves and relate them to the MRS.

4. It is common for supermarkets to carry both generic (store-label) and brand-name

(producer-label) varieties of sugar and other products. Many consumers view these products
as perfect substitutes, meaning that consumers are always willing to substitute a constant
proportion of the store brand for the producer brand. Consider a consumer who is always
willing to substitute 4 pounds of a generic store-brand sugar for 2 pounds of brand-name
sugar. Do these preferences exhibit a diminishing marginal rate of substitution between store-
brand and producer-brand sugar?

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5. Consider the single-good utility function U(x) = 3x2, with a marginal utility given by MUx
= 6x. Plot the utility and marginal utility functions on two separate graphs. Does this utility
function satisfy the principle of diminishing marginal utility? Explain.

6. It is common for supermarkets to carry both generic (store-label) and brand-name

(producer-label) varieties of sugar and other products. Many consumers view these
products as perfect substitutes, meaning that consumers are always willing to
substitute a constant proportion of the store brand for the producer brand. Consider a
consumer who is always willing to substitute 4 pounds of a generic store-brand sugar
for 2 pounds of brand-name sugar.
(a) Do these preferences exhibit a diminishing marginal rate of substitution between
store-brand and producer-brand sugar?
(b) Assume that this consumer has $24 of income to spend on sugar, and the price of
store-brand sugar is $1 per pound and the price of producer-brand sugar is $3 per
pound. How much of each type of sugar will be purchased ?

7. Dr. Strangetaste buys only french fries (F) and hot dogs (H) out of his income. He has
positive marginal utilities for both goods, but his MRSH,F is increasing. The price of hot dogs
is PH, and the price of french fries is PF.
a) Draw several of Dr. Strangetastes indifference curves, including one that is tangent
to his budget line.
b) Show that the point of tangency does not represent a basket at which utility is
maximized, given the budget constraint. Using the indifference curves you have drawn,
indicate on your graph where the optimal basket is located.

8. A consumer has the utility function U = xy, with the marginal utilities MUx = y and
MUy = x. The price of x is 2, the price of y is Py, and his income is 40. When he
maximizes utility subject to his budget constraint, he purchases 5 units of y. What
must be the price of y and the amount of x consumed?

9. Consider a consumer with the utility function U(x, y) = min(3x, 5y), that is, the two
goods are perfect complements in the ratio 3:5. The prices of the two goods are Px =
Rs. 5 and Py = Rs.10, and the consumers income is Rs. 220. Determine the optimum
consumption basket.

10. Provide an intuitive explanation for why a buy one, get one free deal is not the
same as a half-price sale.