EC 203 - INTERMEDIATE MICROECONOMICS

Boğaziçi University - Department of Economics

Summer 2020
Problem Set 2 - Solutions

1. Consider a consumer who wants to consume only two commodities and has an income of $100. Assume
the price of good 1 is $10 per unit and the price of good 2 is $20 per unit. Now, inflation causes the price
of good 1 to increase to $20 per unit, while the price of good 2 increases to $25 per unit. On the other
hand, the consumer also gets a raise of $100 (so her new income is $200). Is she better off or worse off?
Solution: Originally, the consumer’s budget constraint is

10x1 + 20x2 ≤ 100.

m 100 m 100
The budget line has horizontal intercept p1 = 10 = 10 and vertical intercept p2 = 20 = 5. After the
change, her budget constraint becomes

20x1 + 25x2 ≤ 200,

m 200
and so the new budget line has horizontal intercept p1 = 20 = 10 (the same as before) and vertical
m 200
intercept p2 = 25 = 8 (higher than before), and so the consumer’s budget set has grown: she can
now afford bundles she previously could not, and she can still afford all bundles she previously could.
Therefore she is better off.

2. Suppose prices are Px = 2, Py = 1 and income is m = 100.

(a) Show the change in the budget set if price of x decreased and price of y increased such that Px0 = 1
and Py0 = 2.
Solution: The new budget line is shown as the blue line in the figure belove.
y

100

−2

50

−1/2

50 100

(b) Suppose that the government taxes (at the new set of prices Px0 = 1 and Py0 = 2) the consumer an
extra 0.50 dollar for each unit of x he buys beyond 70 units. That is, no tax is collected for units
x < 70, and 0.50 dollar tax for each x ≥ 70. Show the new budget set.

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 Solution: Pxnew = 1 for the first 70 units, there is no tax. For each additional good x purchased
after 70 units, consumers pay $0.50 per unit tax. There is no tax on the second good. This is shown
in the following figure.
y

100

50

slope −1/2

slope
−3/4 x

70 90

(c) Suppose that on top of part (b) government subsidizes the consumer with a 0.40 dollar for each unit
of y he buys beyond 40 units. That is, there is no subsidy for y > 40, and consumer pays 0.40 dollar
less for each y ≥ 40. Show the new budget set.
Solution: Pynew = 2 for the first 40 units, there is no subsidy. For each additional good y purchased
after 40 units, consumers pays $1.60. This is shown in the following figure.
y

100

52.5
slope −5/8

40
slope −1/2

slope
−3/4 x

20 70 90

3. Consider a consumer who is choosing how many of two goods to buy: Footballs and cricket balls. The
consumer has an income of $20, and the cost of a football is $4 and a cricket ball is $2.

(a) Write down the equation for the consumer’s budget constraint and graph it.
Solution: Let F be the amount of footballs and C be the amount of cricket balls. The budget is
4F + 2C = 20, that is 2F + C = 10.

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 C

10

− ppCF = −2

(b) The government decides that football is evil and needs to be taxed. They introduce a 50% tax on
each football sold. Rewrite and re-graph the budget constraint.
Solution: The new cost of buying a football is $6 after the tax. Here the budget line is 6F +2C = 20,
or 3F + C = 10.
C

10

− ppCF = −3

10/3

(c) A new government is elected that hates all sports. They now tax both footballs and cricket balls at
50%. What does the budget constraint look like now?
Solution: Now the cost of buying a cricket ball is $3. The budget line now is 6F + 3C = 20.

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 C

20/3

− ppCF = −2

10/3

(d) Due to a threat of revolt amongst sports fans, the government hands out a subsidy of $10 to the
consumer. What does their new budget constraint look like?
Solution: The budget now is 6F + 3C = 30.

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(e) Revolution comes, and all taxes and subsidies are abolished. Even better, the consumer finds a new
shop that offers bulk discounts. In this shop, footballs cost $4 each if you buy 3 or less. However,
the cost of any additional football after 3 is $2. What does the budget set look like now?
Solution: PF = $4 for the first 3 units. PFdiscount = $2 for any additional football after 3 units.

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 C

10

− ppCF = −2

− ppCF = −1
F

3 7

4. William has $300 to spend on food and clothing. The price of food is $2 per unit and the price of clothing
is $1 per unit.

(a) Write down the equation for William’s budget constraint and graph it.
Solution: Let F denote the amount of food, and C denote the amount of closing. The budget line
is 2F + C = 300.
C

300

− ppCF = −2

150

(b) Suppose that the government gives William 100 free coupons as food stamps (assuming that William
can get free unit of food for each coupon) and strictly enforce a rule which prohibits William from
selling his food stamps to someone. Draw the new budget set.
Solution: For the first 100 units of Food, William can use coupons, and resale is prohibited.

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 C

300

− ppCF = −2

100 250

(c) Suppose that the rule prohibiting the food stamps sale is difficult to enforce and William can trade
each food stamp in black market for $0.50. Draw his budget set.
Solution: Now he has 100 coupons for food, but he can sell it in the black market at $0.5 per
coupon.

350 − ppCF = −1/2

300

− ppCF = −2

100 250

(d) Suppose that in addition to 100 units of food stamps, government also gives 50 free coupons for
clothing (each coupon can be used for a free unit of clothing). Assume that trading both coupons
in black market can be prohibited. Draw the budget set.
Solution: He has coupon for both C and F (trading in black market is prohibited).

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 C

350

− ppCF = −2

50
F

100 250

√
5. Mark has preferences for guns and banjos represented by the utility function u(xg , xb ) = xg + xb .

(a) Write down the equation for an indifference curve, that is, for some utility level ū, write down the
number of guns as a function of the number of banjos.
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Solution: ū = xg + (xb ) 2 , that is xg = ū − (xb )1/2
(b) Find the marginal rate of substitution of banjos for guns.
−1/2 M Ub −1/2
Solution: We have M Ub = 12 xb and M Ug = 1, then we get M RSbg = M Ug = 21 xb .
(c) Determine whether these preferences are convex, that is, determine whether there is diminishing
MRS property.
Solution: Convexity of preferences is equivalent to the diminishing MRS property. You can check
whether MRS is decreasing, as xb increases and xg decreases: MRS is actually decreasing since
1 −1/2
2 xb is decreasing in xb . Alternatively, you can check the second order derivative of the indifference
dxg −1/2 d2 xg −3/2
curve you found: dxb = − 12 xb , then dx2b
= 14 xb . Second order derivative is positive, so the
indifference curve has a convex shape.
(d) Show that, for a budget constraint pb xb + pg xg = m, at any point of tangency between budget line
p
and indifference curves, it must be the case that xb = (1/4)( pgb )2 .
pb −1/2 pb 1/2 pg
Solution: Tangency is equivalent to M RSbg = pg . Then 12 xb = pg , that is, xb = 2pb , which
p
implies, xb = (1/4)( pgb )2 .
(e) What is the optimal consumption bundle, if pg = $2 , pb = $1 and m = $8?
Solution: Since this utility function is well behaved (it is monotone, represents convex preferences
since MRS is diminishing, and continuous and differentiable) at an interior solution tangency should
hold. From the tangency condition above, plugging prices, we get x∗b = (1/4)(2/1)2 = (1/4)4 = 1.
Then, from the budget equation, we get 1 · 1 + 2xg = 8, that is, x∗g = 7/2. Since both x∗b = 1 and
x∗g = 7/2 are positive, we have an interior solution at (x∗b = 1, x∗g = 7/2).
(f) What is the optimal consumption bundle if pg = $5 , pb = $1 and m = $4?

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 Solution: From the tangency condition, we get xb = 25/4. However, this together with budget
equation implies a negative amount of guns. Hence the best solution is to buy no guns and buy as
much banjos as possible. Mark spends all income on banjos: x∗b = m
pb = 4, and none spent on guns,
x∗g = 0.
M Ub M Ug −1/2
You can also see this through comparing pb and pg . We have M Ub = 12 xb and M Ug = 1,
1 −1/2
M Ub x
2 b 1/2 M Ug
that is, pb = 1 = 1/2 and pg = 1/5. When spending all income on banjos, the most he
xb
M Ub 1/2
can buy is xb = 4. With this amount pb = 41/2
= 1/4 which is larger than 1/5. Thus, he would
like to get more xb , but xb = 4 is the limit. Thus, this is the solution, x∗b = 4, together with no guns,
x∗g = 0.

6. Suppose a consumer has a utility function u(x1 , x2 ) = xa1 x1−a

2 , for goods x1 and x2 .

(a) Find her demand for x1 and x2 in terms of her income, m, prices, p1 , p2 , and the positive constant
0 < a < 1. (Although we derived this in class, I included this problem here, since it may be useful
for the rest of the problem set.)
Solution: This is a Cobb-Douglas utility function, which is well-behaved (it is increasing in x and y,
that is, it is monotone. It has DMRS, that is, it represents convex preferences. It is also continuous
and differentiable. You should be able to check monotonicity and DMRS). And the budget line is
p1 x1 + p2 x2 = m. We can directly use the tangency condition:
M U1 axa−1 x1−a a x2 p1
M RS = M U2 = 1
(1−a)xa
2
−a = 1−a x1 . And the price ratio is simply p2 . Thus, we get
1 x2

a x2 p1
=
1 − a x1 p2
p1
Then, we have x2 = x1 1−a
a p2 . Now plug this into the budget line and solve for x1 .

1 − a p1
p1 x1 + p2 x1 =m
a p2

that is, p1 x1 + x1 1−a

a p1 = m, which implies x1 [p1 +
1−a
a p1 ] = m, or x1 p1 [1 + 1−a
a ] = m, that is,
x1 p1 [ a1 ] = m. Thus, we get
m
x∗1 = a
p1
p1 m 1−a p1
Plugging this into the equation x2 = x1 1−a
a p2 , we get x2 = a p1 a p2 , that is,

m
x∗2 = (1 − a)
p2

(b) What share of her budget does she spend on x1 , and what share on x2 ?
p1 x∗1
Solution: The income share she is spending on good 1 is m = a, and the income share she is
p2 x∗2
spending on good 2 is m = (1 − a).

7. Suppose that the preferences of a typical household for quantities of electricity (E) and gasoline (G) are
given by u(E, G) = aln(E) + (1 − a)ln(G), where 0 < a < 1. Suppose the prices of gasoline and electricity
in the units provided are both $1/unit and the household has an income of $100. Suppose in addition, the

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 government has chosen to ration electricity by allowing a maximum consumption of 50 units of electricity,
that is, Emax = 50.

(a) If a = 1/4, find the optimal consumption bundle of gasoline and electricity.
Solution: The utility function is a positive monotonic transformation of V (E, G) = E a G1−a . Thus
the optimal choice bundle can be found through E ∗ = a pmE and G∗ = (1−a) pmG , which imply E ∗ = 25,
G∗ = 75 (you should be able to solve this without applying these formulas).
(b) If a = 3/4, find the optimal consumption bundle of gasoline and electricity.
Solution: Calculation gives E = .75 100
1 = 75, but this is not allowed. Thus consumers will consume
as much E as possible, that is the maximum possible: E ∗ = 50, and the rest will be spent on gasoline
G∗ = 50.

8. Suppose that a consumer consumes only food (f) and entertainment (e) where pf = $5, pe = $10 and
m = $600. Suppose that the consumer has to have a minimum of 50 units of f , and a maximum of 20
units of e.

(a) Draw the budget set.

Solution:
E

20

50 80 120 F

(b) Suppose the utility function is u(f, e) = f · e. Find the optimal consumption bundle.
Solution: This is a monotonic transformation of u(f, e) = f 1/2 · e1/2 . By Cobb-Douglas solution
m1 m1
above, e = pe 2 = 30 and f = pf 2 = 60. But, e = 30 is not allowed. Thus, the consumer will
consumer as much e as he can, the maximum allowed, that is, e∗ = 20. Then, from the budget
equation we get f ∗ = (600 − (10 · 20))/5 = 80. You can see the optimal bundle in the graph below.

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 E

20

50 80 120 F

9. Suppose that a consumer only consumes good 1 and good 2 under the following prices and income:
p1 = $2, p2 = $1 and m = $100. Consumer’s preferences can be represented by the utility function,
u(x1 , x2 ) = 3x1 + x2 .

(a) Find the optimal bundle.

Solution: This is a perfect substitutes case. M U1 = 3 and P1 = 2, and M U2 = 1 and P2 = 1. Thus
M U1 3 P1 2 M U1 M U2
M RS12 = M U2 = 1 =3> P2 = 1 = 2, that is, p1 > p2 . Thus, this consumer will spend all
income on good 1, which means x1 = 50, x∗2 =
∗ 0.
(b) Now suppose that the consumer receives a coupon of $20 which can be spent only in good 2. Draw
the new budget constraint and find the new optimal consumption bundle.
Solution: The budget set is drawn below. Since $20 coupon can only be spent on good 2, he will
use the coupon to buy good 2, and use all income to buy good 1, as the prices did not change, that
M U1 M U2
is p1 > p2 is still the case. Thus we get, x∗1 = 50, x∗2 = 20 as the optimal consumption bundle.

x2

120

20

50 x1

10. Pamir spends most of his time in Just Coffee shop. Pamir has $12 a week to spend on coffee and muffins.
Just Coffee sells muffins for $2 each and coffee for $1.2 per cup. Pamir consumes xc cups of coffee per
week and xm muffins per week. His utility function for coffee and muffins is u(xc , xm ) = xkc xkm , where
k > 0.

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 (a) Find Pamir’s optimal consumption bundle. Does it depend on k?
Solution:
1/2 1/2
A positive monotonic transformation of u(xc , xm ) = xkc xkm gives u(xc , xm ) = xc xm . Then, using
the solution we found for the Cobb-Douglas utility function, we get

1m 1 12
x∗c = = =5
2 pc 2 1.2
1m 1 12
x∗m = = =3
2 pm 2 2
The solution does not depend on k!
(b) Now Just Coffee has introduced a frequent-buyer card: For every five cups of coffee purchased at
the regular price of $1.2 per cup, Pamir receives a free sixth cup. Draw Pamir’s new budget set.
Solution:
xm

xc
5 6 11 12

(c) With frequent-buyer card, find the new optimal consumption bundle.
Solution: (5,3) is the optimal point without the frequent-buyer card. With the frequent-buyer
card, the upper portion of the budget line (the portion above (5,3)) cannot be optimal because, all
those bundles were affordable but Pamir chose (5,3), thus they all are on a lower indifference curve
than (5,3) is on. Thus, Pamir has two possibilities for optimal choice: it might be at the kink (6,3),
or it might be in the portion of the budget line to the right of the kink. Consider the modified m:
1 m 1 13.2
Pamir now has m = 1.2 · 6 + 3 · 2 = 13.2. The Cobb-Douglas solution implies xc = 2 Pc = 2 1.2 5.5,
1 m 1 13.2
and xm = 2 Pm = 2 2 = 3.3, however this is not feasible as this bundle lies above the flat portion
of the budget set. Thus the optimal point should be at the kink (6, 3). Then x∗c = 6 and x∗m = 3.

11. A consumer can buy two goods: good 1 denoted by x1 and good 2 denoted by x2 . Her utility function is
x1 x2
given by u(x1 , x2 ) = x1 +x2 , and p1 and p2 are the prices of good 1 and good 2, respectively, and m is the
consumer’s income level.

(a) Is this utility function well-behaved? (Hint: It is continuous and differentiable. How about mono-
tonicity and DMRS?)

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 x22 x21
Solution: Both marginal utilities are positive: M U1 = (x1 +x2 )2
, and M U2 = (x1 +x2 )2
. Thus,
u(x1 , x2 ) is increasing in both x1 and x2 . It is monotone. For DMRS, find MRS first: using
x22 x21 x22
M U1 = (x1 +x2 )2
and M U2 = (x1 +x2 )2
we get M RS12 = x21
= ( xx21 )2 . This is decreasing as x1
increases and x2 decreases, implying DMRS. Thus this is well-behaved.
(b) Solve for her demand for x1 and x2 both as a function of p1 , p2 and m, that is, x1 (p1 , p2 , m) and
x2 (p1 , p2 , m).
Solution: Since u(·) is well-behaved, at an interior solution
q tangency should hold. Equating MRS
to price ratio gives: M RS12 = ( x1 ) = p2 . Then x2 = x1 pp12 . Plugging this into the budget line,
x2 2 p1

p1 x1 + p2 x2 = m, and solving for x1 we get,

m
x∗1 (p1 , p2 , m) = √
p1 + p1 p2

Then solving for x2 , we get

m
x∗2 (p1 , p2 , m) = √
p2 + p1 p2

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