PART B

Question 1: Use an indifference curve–budget line analysis to explain why Nigel buys and
operates a car while Bob chooses an SUV.

Indifference Curve - Budget Line

1.2

1
No: of cars bought in a decade

Indifference Curve
0.8
BLN
0.6

0.4

0.2

BLB
0
0 0.2 0.4 0.6 0.8 1 1.2
No: of SUVs bought in a decade

BLB – Budget Line for Bob, BLN – Budget Line for Nigel
For Nigel, who’s living in Britain, the relative cost of owning and operating a car is cheaper than
the cost of owning and maintaining a SUV. The reason includes both economic and cultural
reasons. Few reasons could be the environment consciousness in Europe, thinner streets, preference
towards the look of smaller cars, gasoline tax etc.
For Bob, who lives in America, the cost of owning and operating a SUV is not that high to make it
unaffordable. Americans generally have a preference towards larger cars. Bob is receiving a tax
break on SUV. Their wide roads and gasoline prices also make it easy to afford an SUV there.
 PART C
A. 3. Point Elasticity vs Arc Elasticity

Elasticity is the sensitivity of one variable to another. Elasticity helps us measure the percentage
change in an independent variable with respect to a one-percentage change in the dependent
variable.
Price elasticity of demand tell us the percentage change in the quantity demanded of a good as
a response to a one percentage change in its price.

Price Elasticity, Ep = (% ∆Q)/ (% ∆P);

where Q is the quantity demanded and P is the price.

Goods can be elastic, inelastic or unitary elastic to price changes.

Income elasticity tell us the percentage change in the quantity demanded of a good as a response
to a one percentage change in the consumer income.
Income Elasticity, Ei = (% ∆Q)/ (% ∆M) ;
where Q is the quantity demanded and M is the consumer income.
Cross-price elasticity tell us the percentage change in the quantity demanded of a good as a
response to a one percentage increase in another good.
Cross Price elasticity of Good X with Price Chage in Y, Exy = (% ∆Qx)/ (% ∆Py) ;
where Qx is the quantity demanded of X and Py is the price of a related good Y.

Elasticies can be measured either over an interval (or arc) or at a specific point on the demand
and supply curves. If the change in dependent variable (price, income etc.) is relatively small, a
point measure is suitable to measure elasticity of demand or supply. If the change in dependent
variable spans a sizeable arc in the curve, the arc or interval measurement provides a better
measure of consumer responsiveness. Let’s see point and arc elasticities with demand curve as
the basis.
Elasticities at a particular point on the demand curve are called point elasticities. Point
elasticity of demand at a particular point on the demand curve is represented using the equation
below:

Ep = [(∆Q/Q)/(∆P/P)] = [ (∆Q/∆P) x (P/Q) ]

When calculating price elasticity of demand, we multiply the slope of demand (∆Q/∆P)
computed at the point of measure by the ratio (P/Q) computed using the values of Price and
Quantity at the point of measure.
When elasticity is calculated over an interval of a demand curve, the curve is called an interval or
arc elasticity. Arc elasticity of demand at a particular point on the demand curve is represented
using the equation below:

Ep = [ (∆Q/∆P) x (Average P / Average Q) ]

A. 6. Diminishing Marginal Utility and Indifference Curve

Marginal utility (MU) is the additional or incremental satisfaction obtained by the consumer
from consuming one additional unit of a particular good.
Diminishing marginal utility is the principle that as more of a good is consumed, the
consumption of additional amounts will yield smaller additions to utility. For example, a Yankee
fan watching a game in the stadium may derive less and less satisfaction with the each number of
Cola he consumes while watching the game. The first Cola yields him more Marginal Utility as
compared to the 2nd, 3rd, 4th or all subsequent cups of Cola he is consuming.

An Indifference Curve is a graph tracing the curve that joins all set of points representing
different combinations of goods and services, each of which provides a consumer with the same
level of satisfaction or utility. Indifference curves are downward sloping as more of a good can
be added only after reducing some other good of the same consumption bundle to maintain the
same level of utility. Indifference curves are convex. An indifference map consists of two or
more indifference curves.

Indifference Curve (Example)

1.2

1
Quantity of Good Y

0.8

0.6

0.4

0.2

0
0 0.2 0.4 0.6 0.8 1 1.2
Quantity of Good X
B. Maximize the utility function U(X1, X2) = X1. X2 +2 X1 with respect to the budget
constraint P1X1+ P2X2=M where X1 and X2 are two normal goods facing the prices P1 and P2
with the total income as M. Explain the equilibrium condition and derive the demand function of
X2 . Calculate price elasticity of demand for X2 at P2=2 and X2=4, when M=20.

U (X1, X2) = X1X2 + 2X1

M = P1X1 + P2X2 ---- (a)

∂U/∂X1 = X2 + 2 --- (i)

∂U/∂X2 = X1 --- (ii)
∂U/∂X1 = MUX1 (marginal utility of X1)
∂U/∂X2 = MUX2 (marginal utility of X2)

Equilibrium condition is when (MUX1/ P1) = (MUX2/P2). Therefore:

[ (X2 + 2 )/ P1) ]= (X1 / P2) (from (i) and (ii))

X2P2 + 2P2 = X1P1 --- (iii)

Equating (a) and (iii):

M = P1X1 + P2X2
-2P2 = -P1X1 + P2X2
-----------------------------
2P2X2 = M – 2P2

Therefore: X2 = [ (M - 2P2)/ 2P2]

That is, demand function for X2 is : X2 = [ (M/2P2) – 1]

Elasticity of price = Ep = [(∆X2/X2)/(∆P2/P2)] = [ (∆X2/∆P2) x (P2/X2) ]

(∆X2/∆P2) = (dX2/dP2)

(dX2/dP2) = d/dP2 ((M/2P2) – 1)) = (-M/ 2P22)

Therefore, price elasticity Ep = (-M / 2P2X2)

When P2=2, and X2=4, and M=20:

Price Elasticity, Ep = -1.25