NTU SSS Economics HE1001

Tutorial 2 (Week 4): Consumption

1. Draw a budget line and an indifference curve to illustrate the satisfaction maximizing
choice associated with two products. Use your graph to answer the following questions.
a. Suppose that one of the products is rationed. Explain why the consumer is likely to
be worse off.

Answer:
When goods are not rationed, the consumer is able to choose the satisfaction-
maximizing bundle where the slope of the budget line is equal to the slope of the
indifference curve, or the price ratio is equal to the MRS. This is point A in the
graph below. If good 1 is now rationed the consumer will not be able to attain the
utility maximizing point. He or she will have to consume more of the other good
instead. This is point B below.

U2

U1

good 1

b. Suppose that one of the products is taxed. Explain why the consumer is likely to be
worse off.

Answer:

When the price of good 1 increases because it is taxed, the budget line will pivot
inwards. This will shrink the size of the budget set and the consumer will no longer
be able to afford his old bundle. His new optimal bundle is where the indifference
curve is tangent to his new budget line and this indifference curve is below his
original indifference curve.

U2
1 U1

good 1
2. Based on his preferences, John is willing to trade 4 movie tickets for 1 ticket to a
basketball game. If movie tickets cost $8 each and a ticket to the basketball game costs
$40, should John exchange movie ticket for basketball game ticket at the prevailing prices?
Why or why not?

Answer:

No, John should not make the trade. If he gives up the 4 movie tickets then he will save
$8 per ticket for a total of $32. However, this is not enough for a basketball ticket. He
would in fact have to give up 5 movie tickets if he wanted to buy another basketball
ticket.

Notice also, that the marginal utility per dollar is higher for movie tickets so John will be
better off if he consumes more movie tickets and fewer basketball tickets. To figure this
out recall that what John is willing to do define his MRS. His MRS is 4 so this means that
the marginal utility of a basketball game is 4 and the marginal utility of a movie is 1:
MUball 4
MRS = -4 = - =-
MUmovie 1

Now the marginal utility per dollar can be computed:

MU ball 4 1
= =
Pball 40 10
MU movi e 1
= .
Pmovi e 8

3. Bobby is a university student who has $500 of income to spend each semester on books
and pizzas. The price of a pizza is $10 and the price of a book is $50. Diagram Bobby’s
budget constraint. Now, suppose Bobby's parents buy him a $300 gift certificate each
semester that can only be used to buy books. Diagram Bobby's budget constraint when he
has the gift certificate in addition to his $500 income. Is Bobby better-off with the gift
certificates?

Answer:

2
 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 (labeled BC1). With the gift certificate
that can only be used for book purchases, Bobby still cannot afford any more than 50
pizzas. However, he is guaranteed 6 books even if he spends all his money on pizza.

Since the price of books and pizza hasn't changed, the slope of his 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 his
original consumption choice on BC1 was. This implies that Bobby is strictly better-off with
the gift certificate.

4. Janice consumes two goods, X and Y. Janice has a utility function given by the expression:
U = 4X0.5Y0.5
The current prices of X and Y are 25 and 50, respectively. Janice currently has an income
of 750 per time period.

a. Write an expression for Janice's budget constraint.

Answer:
I = Px X + Py Y
750 = 25X + 50Y

b. Calculate the optimal quantities of X and Y that Janice should choose, given her
budget constraint. Graph your answer.

Answer:
We can derive the marginal utility of X and Y:
2Y 0.5
MU X = 0.5
X
2 X 0.5
MUY = 0.5 .
Y
Then:
P
MRS = X
PY
Y 0.5
MUX 2 X 0.5
MRS = =
MUY 2 X 0.5
Y 0.5
Y
MRS =
X
PX 25 1
= =
PY 50 2

3
 PX
Equating MRS to :
PY
Y 1 1
= , Y= X
X 2 2

Janice should buy 1/2 as much Y as X.

Recall 750 = 25X + 50Y
Substitute (½) X for Y
750 = 25 X + 50 (1/2) X
750 = 25X + 25X
750 = 50X
X = 15
Y = (1/2) X
Y = (1/2) (15)
Y = 7.5
Janice should consume 7.5 units of Y and 15 units of X.