Answer Keys (ME Problem Set-1)

PGP 2019 - 21

1. (a)

(b)

1
(c)

(d)

2.
(a)

2
(b)

(c)

3.

3
Individual A has relatively flat indifference curves, since A requires relatively large numbers
of coconuts to compensate for the loss of pineapples that she values highly.

Individual B has relatively steep indifference curves, since B requires relatively few coconuts
to compensate for the loss of pineapples that he does not value highly.

C's indifference curves are vertical; the level of satisfaction is affected only by coconuts.

D's indifference curves are horizontal; the level of satisfaction is affected only by pineapples.

E's indifference curves are L-shaped.

MRS measures (at the margin) the maximum number of pineapples that the consumer will be
willing to give up in order to get one more unit of coconuts.

A's MRS is low. A is willing to relinquish few pineapples relative to coconuts since
pineapples are dear to A.

B's MRS is high, for the opposite reason.

C's MRS is infinite. Since C's utility is not affected by pineapples, she is willing to relinquish
all pineapples (an infinite number) to obtain additional coconuts.

D's MRS is zero. D is not willing to give up any pineapples to obtain additional coconuts.

E's MRS is infinite when Qp > Qc, zero when Qc > Qp, and undefined when Qc = Qp.

4. These preferences do not exhibit a diminishing marginal rate of substitution since

consumers are always willing to substitute the same amount of store-brand sugar for an
additional pound of producer-brand sugar.

5. The two graphs are shown below. It can be seen from both graphs that this function does
not satisfy the law of diminishing marginal utility. The first figure shows that utility increases
with x, and moreover, that it increases at an increasing rate. For example, an increase in x
from 2 to 3, increases utility from 12 to 27 (an increase of 15), while an increase in x from 3
to 4 induces an increase in utility from 27 to 48 (an increase of 21).
This fact is easier to see in the second figure. The marginal utility is an increasing function of
x. Higher values of x imply a greater marginal utility. Therefore this function exhibits
increasing marginal utility.

U(x) = 3x2

4
 MUx = 6x

6. Robinson’s initial budget constraint is BC1 on the diagram below. Since His
indifference curves are always flatter than her budget constraint, he will consume all
coconuts. Thus, he gathers and consumes 64 coconuts. When his neighbor arrives and
offers the exchange, his budget constraint becomes BC2. It is now optimal for him to
gather all bananas and exchange them 1 for 1 with his neighbor for coconuts. This gives
him 128 coconuts to consume. This brings him to the higher indifference curve I2.
Robinson is better off.

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7.

Without the gift certificate, Bobby's budget constraint is indicated by the line segment from
10 books and 0 pizza to 0 books and 50 pizzas (labelled BC1). With the gift certificate that
can only be used for book purchases, Bobby still cannot afford anymore than 50 pizzas.
However, she is guaranteed 6 books even if she spends all her money on pizza. Since the
price of books and pizza hasn't changed, the slope of her new budget constraint is the same as
the slope of the old budget constraint. The new budget constraint is drawn above as BC2.
Note that with the gift certificate, Bobby has an expanded opportunity set and is guaranteed
more of both goods no matter what her original consumption choice on BC1 was. This
implies that Bobby is strictly better-off with the gift certificate.

y
8. a) Using the tangency condition,  4 , and the budget constraint, 4 x  y  120 ,
x
your initial optimum is the basket (x, y) = (15, 60) with an utility of 900.

b) First we need the decomposition basket. This would satisfy the new tangency
y
condition,  3 and would give you as much utility as before, i.e. xy  900 . This gives
x
( x, y )  (10 3 ,30 3 ) or approximately (17.3,51.9). Now we need the final basket, which
satisfies the same tangency condition as the decomposition basket and also the new budget
constraint: 3x  y  120. Together, these conditions imply that (x, y) = (20, 60). The
substitution effect is therefore 17.3 – 15 = 2.3, and the income effect is 20 – 17.3 = 2.7.

9. Self-expnanatory !!! It is a normal good !