1. Comment on the shape of IC and nature of MRS for the following: a. Perfect Substitutes Ans: Shape of IC: straight line and MRS is Constant b. Perfect Complements Ans: Shape of IC: L- shaped and MRS will be zero or infinite 2. What happens to the MRS as you move alonga a. Convex indifference curve? Ans: Diminishes b. Alinear indifference curve? Ans: Remains constantQuestign 3: Mary's utility fimotion is u(y) = max{x, 2y} - (@) On a graph, draw and label the indifference curve where u(x.y)-10. Solution: Here the red line is the IC for U(x,y) = 10. Question 4; Ann has a utility fumction given by u(xl x2 Amn’s marginal rate of substitution, MRS(x1 function votl x2) = x2+x1 x1?-2x1x2x2? . (a) Compute » ¥2_). (b) Ann’s cousin, Andrew, has a utility Compute, Andrew’s MRS. Solution: MRS (X1,32) = MUy MUx Find MUx: and MU;o and substitute in the above formula, Both Ann's and Andrew's MRS jis 1 Ir rrrrnrnn3. Assume an economy in which John can spend his budgets (£M) on purchasing two goods X and Y. Use an appropriate diagram to explain your answer: a. How will John’s budget constraint be affected if his income increases permanently? Answer: Other things being constant, an increase in his income will result in a parallel shift of the budget constraint from Bo to Byb. How will John’s budget constraint be affected if the price of good X increases? Answer: The vertical axis represents the amount of good Y and the horizontal axis Tepresents the amount of good X. Other things being constant, an increase in the price of good X his income will result in a shift of the budget constraint from B, to B c. Assuming that John has smooth preferences, graphically define his equilibrium consumption of the two goods. Answer: John’s equilibrium consumption occurs at point E (shown below) where his indifference curve is tangent to his budget constraint. At this point, given his budget constraint, his utility from consumption of the two goods is maximised. U3 u2IU = X* YP is an individual's utility function for two goods. Taking p, and py as their fixed prices and also M as the individual fixed income. a. Find out the marginal utility of X and Y and its MRS(X.Y) b. Determine the generalized expression for X and Yin terms their prices and income. Ans: X = aM/{(otB) px]; X = BM/[(o+B) py] c. Deduce that elasticity of demand for either good with respect to income or its prices is always unity.N Using X as the number of CDs and Yas the number of video rentals, the Laseanyian equation is @ = 20XN + BOY ~— X° — 2¥? ~ ALN + 2Y—41). ‘To find the optimal consumption of each good, maximize the Lagrangian equation with respect to X, Y and A, which is the same as maximizing utility subject to the budget constraint, The necessary conditions for a maximum are ow OX od oY OD oa ste that in condition (3), both sides have been multiplied by (1) and (2) results in A= 20-2X = 40-2Y (4) 2¥ =204+2%, i » you have solved for X, you can Now substitute (4) into (3) and solve for X./ Once you have solved fan vn r te this value back into (4) and solve for Y-_ Note that algehmarcaly thers ore aeeentil ways to solve this type of problem, and that it dows ways yp a ‘Phe optimal bundle is X = 7 and Y = 17. 0O-2X—-A =O =8O- 4Y¥=2A=0 a) N+2Y¥-41=0. Combining conditionsnus prices 1s arways umty. NJ 5. The Utility function for two goods are given by UC&y) = x" ¥ goods are p, = 2 and p, = 5 and income (M) is 40 a. Set up the optimization problem and also determine the FOCs na ps Prices of two Ans: L(x,y,4) = x'3 y’? + 2 40-2x-Sy) and differentiate to get 3 FOCS b. Compute the utility maximizing consumption bundle and also maximized value of utility Ans: X = 8 ; Y = 120/25 and U = [120/25]'” [8]'°