1.

Assume that a Utility function is given by:

U = 8q1q2

Where; q1, q2, and U > 0

(a) Verify whether diminishing marginal rate of Substitution hold for the utility

function.

Solution

Using;

U = q1q2 ∂U/∂q1 = Uq1 = q2 ∂U/∂q2 = Uq2 = q1

Thus;

∂U/∂q1 = Uq1 = 8q2

and

∂U/∂q2 = Uq2 = 8q1

Which implies that;

∂U/∂q1 = Uq1 = 8q2 = 0

∂U/∂q2 = Uq2 = 8q1 = 0

Substituting one into the other gives

8q1 = 8q2

Which implies that

q1 = q2

∂ U /∂ q 1
Recalling that MRSC = MUq1/MUq2 = ∂U /∂ q 2

the problem is reduced to solving the two simultaneous equations that leaves the

demand unchanged by positive monotonous transformations of the utility function.

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That is why the demand curve is the same as the standard Cobb-Douglas. Thus,

diminishing marginal rate of substitution holds for the utility function.

(b) Derive algebraically the ordinary demand functions for q1 and q2.

Solution

Assuming that the utility function of the consumer is

U = q1q2 …………………………………………………………………………………………………………………….eqn.1

And his budget constraint is:

y° = p1q1 + p2q2……………………………………………………………………………………………………….eqn.2

The relevant Lagrange function needed for deriving the conditions for utility

maximization is:

V = q1q2 + λ (y°− p1q1 – p2q2) …………………………………………………………………………………eqn.3

The first-order condition for constrained utility-maximisation is:

∂V
= q2 – λp1 = 0 …………………………………………………………………
∂q1

eqn.4

∂V
= q1 – λp2 = 0 …………………………………………………………………
∂q2

eqn.5

and,

∂V
= y° - p1q1 – p2p2 = 0 ………………………………………………………eqn.6
∂λ

Now solving equations (4) – (6) for obtaining the equilibrium values of q1 and q2.

From (4) and (5), we have:

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q1 p2
=
q2 p1

 p1q1 = p2q2 ……………………………………………………………. eqn.7

From (6) and (7), we have:

y° - p1q1 – p1q1 = 0

 2p1q1 = y°

y°
 q1 = 2 p 1

Similarly, we would have:

q2 = y°/2p2 ……………………………………………………………………….eqn.9

thus, eqn. 8 and eqn. 9 gives us the demand functions for the two goods, respectively.

(c) Compute the price and income elasticities of demand for q1 and q2.

(d) Is the demand function downwards sloping? Prove your answer.

2. Graph the following statement and explain the characteristics of each good,

X and Y.

(a) “In the plane of goods X and Y, indifference curves slope downward and the

nearer to the origin the curve is, the higher the amount of utility is”.

Solution

Indifference curves are downward sloping. If the quantity of one’s goods is

reduced, then you must have more of the other good to make up for the loss. The

indifference curves must slope down from left to right. This means that an

indifference curve is negatively sloped. It slopes downward because as the consumer

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increases the consumption of X cooking oil, he has to give up certain units of Y

wheat to maintain the same level of satisfaction.

In the above graph, two combinations of commodity cooking oil and commodity

wheat are shown by the points A and B on the same indifference curve. The

consumer is indifferent towards points A and B as they represent equal level of

satisfaction.

At point (a) on the indifference curve, the consumer is satisfied with OE units of

cooking oil and OD units of wheat. He is equally satisfied with OF units of cooking

oil and OK units of wheat shown by point B on the indifference curve. It is only on

the negatively sloped curve that different points representing different combinations

of goods X and Y give the same level of satisfaction to make the consumer

indifferent. Thus, indifference curve must slope downward to show that when the

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quantity of one good in a combination increases, the quantity of other good must fall,

so that the level of satisfaction remains unchanged.

(b) “In the plane of goods X and Y, indifference curves slope upward and the

nearer to the Y axis the curve is, the lower the amount of utility is”.

Solution

Higher indifference curves are preferred to lower ones, since more is preferred

to less (non-satiation). A higher indifference curve that lies above and to the right of

another indifference curve represents a higher level of satisfaction and combination

on a lower indifference curve yields a lower satisfaction. In other words, we can say

that the combination of goods, which lies on a higher indifference curve, will be

preferred by a consumer to the combination of goods, which lies on a lower

indifference curve.

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 In this diagram above, there are three indifference curves, IC1, IC2 and IC3,

which represents different levels of satisfaction. The indifference curve IC 3 shows

greater amount of satisfaction and it contains more of both goods than IC 2 and IC1

(IC3 > IC2 > IC1).

(c) Why must indifference curves be convex rather than concave?

Solution

Indifference curves are bowed inward (in most cases). The slopes of

indifference curves represent the MRS (rate at which consumers are willing to

substitute one good for the other). This is an important property of indifference

curves. They are convex to the origin (bowed inward). This is equivalent to saying

that as the consumer substitutes commodity X for commodity Y, the marginal rate of

substitution diminishes of X for Y along an indifference curve. People are usually

willing to trade away more of one good when they have a lot of it, and less willing to

trade away goods, which are in scarce supply. This implies that MRS must increase

as we get less of a good.

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 In the diagram above, as the consumer moves from A to B to C to D, the

willingness to substitute good X for good Y diminishes. This means that as the

amount of good X is increased by equal amounts, that of good Y diminishes by

smaller amounts. The marginal rate of substitution of X for Y is the quantity of Y

good that the consumer is willing to give up to gain a marginal unit of good X. The

slope of IC is negative. It is convex to the origin.

Thus, if the indifference curve is convex rather than concave, it implies that

MRS decreases and two goods are imperfect substitutes of each other. A convex

indifference curve implies that MRS of good X for the good Y falls as more quantity

of X is substituted for good Y.

If indifference curve is concave to the origin, it would mean that MRS xy

increases as more and more of goods X and Y are consumed. This leads to failure of

assumption that MRSxy diminishes. Thus, indifference curve must be convex to the

origin.

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(d) Logically explain why indifference curves cannot intersect.

Solution

The explanation is most easily achieved with the aid of a graph such as is

shown below, which shows two indifference curves intersecting at point A. We

know from the definition of an indifference curve that a consumer has the same

level of utility along any given curve. In this case, the consumer is indifferent

between bundles A and B because they both lie on indifference curve U1.

Similarly, the consumer is indifferent between bundles A and C because they

both lie on indifference curve U2. By the transitivity of preferences this

consumer should also be indifferent between C and B. However, we see from

the graph that C lies above B, so C must be preferred to B. Thus, the fact that

indifference curves cannot intersect is proven.

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We, therefore, conclude that indifference curves cannot cut each other.

(e) What is the implication of an upward sloping indifference curve?

Solution

A set of indifference curves can be upward sloping if we violate assumption

number three; more is preferred to less. When a set of indifference curves is upward

sloping, it means one of the goods is a “bad” in that the consumer prefers less of the

good rather than more of the good. The positive slope means that the consumer will

accept more of the bad good only if she also receives more of the other good in

return. As we move up along the indifference curve the consumer has more of the

good she likes, and also more of the good she does not like.

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 Thus, indifference curve must slope downward to show that when the quantity

of one good in a combination increases, the quantity of other good must fall, so that

the level of satisfaction remains unchanged.

3. (a) Based on the law of diminishing marginal utility of Classical economics, state

and briefly explain the conditions of consumer equilibrium.

Solution

i. Preferences are complete: this means that the consumer is able to compare

and rank all possible baskets;

ii. Preferences are transitive: this means that preferences are consistent, in that

if bundle A is preferred to bundle B and bundle B is preferred to bundle C,

then we should be able to conclude that bundle A is preferred to bundle C;

iii. More is preferred to less: this means that all goods are desirable, and that the

consumer will always prefer to have more of a good;

iv. Diminishing marginal rate of substitution: this means that indifference

curves are convex, and that the slope of the indifference curve increases

(becomes less negative) as we move down along the curve. As a consumer

moves down along her indifference curve she is willing to give up fewer units

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 of the good on the vertical axis in exchange for one more unit of the good on

the horizontal axis. This assumption also means that balanced market baskets

are preferred to baskets that have a lot of one good and very little of the other

good.

(b) Compare the law of diminishing marginal utility with the law of diminishing

marginal rate of substitution in relation to the consumer equilibrium.

Solution

The law of diminishing marginal utility is similar to the law of diminishing

returns which states that as the amount of one factor of production increases as all

other factors of production are held the same, the marginal return (extra output

gained by adding an extra unit) decreases.

As the rate of commodity acquisition increases, marginal utility decreases. If

commodity consumption continues to rise, marginal utility at some point may fall to

zero, reaching maximum total utility. Further increase in the consumption of units of

commodities causes the marginal utility to become negative; this signifies

dissatisfaction. For example,

 beyond some point, further doses of antibiotics would kill no pathogens

at all, and might even become harmful to the body.

 to satiate thirst a person drinks water but beyond a point, consumption of

more water might make the person vomit, hence leading to negative marginal and

thus diminished total utility

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  it takes a certain amount of food energy to sustain a population, yet

beyond a point, more calories cannot be consumed and are simply discarded

on the other hand, the marginal rate of substitution (MRS) is the rate at which a

consumer can give up some amount of one good in exchange for another good while

maintaining the same level of utility. At equilibrium consumption levels (assuming

no externalities), marginal rates of substitution are identical. The marginal rate of

substitution is one of the three factors from marginal productivity, the others being

marginal rates of transformation and marginal productivity of a factor.

(c) Write a succinct essay on (i) Demand (ii) Utility (iii) Preferences.

Distinguish among these three terms and discuss why economists have devoted

their time to investigation of these notions.

Solution

In every market, there are both buyers and sellers. The buyers' willingness to

buy a particular good (at various prices) is referred to as the buyers' demand for that

good. The sellers' willingness to supply a particular good (at various prices) is

referred to as the sellers' supply of that good.

The buyers' demand is represented by a demand schedule, which lists the

quantities of a good that buyers are willing to purchase at different prices. An

example of a demand schedule for a certain good X is when as the price of good X

increases, the quantity demanded of good X decreases. This kind of behaviour on the

part of buyers is in accordance with the law of demand. According to the law of

demand, an inverse relationship exists between the price of a good and the quantity
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demanded of that good. As the price of a good goes up, buyers demand less of that

good. This inverse relationship is more readily seen using the graphical device

known as the demand curve, which is nothing more than a graph of the demand

schedule.

Individuals consume goods and services because they derive pleasure or

satisfaction from doing so. Economists use the term utility to describe the pleasure or

satisfaction that a consumer obtains from his or her consumption of goods and

services. Utility is a subjective measure of pleasure or satisfaction that varies from

individual to individual according to each individual's preferences. For example, if an

individual's choices for a Saturday evening are to watch television, go out to dinner,

or go to a movie, then, depending on that individual's preferences, he or she will

attribute different levels of utility to each of these three activities. Of course, it is not

possible to measure utility, nor is it possible to claim that one individual's utility is

higher than another's. Utility is just a unit-less measure that economists have found

useful in their explanation of consumer choice.

Total and marginal utility. The utility that an individual receives from

consuming a certain amount of a particular good or service is referred to as that

individual's total utility. The marginal utility of a good or service is the addition to

total utility that an individual receives from consuming one more unit of that good or

service.

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