4.

14 A consumer has preferences between two goods, hamburgers (measured by H)

and milkshakes (measured by M). His preferences over the two goods are represented
by the utility function U = √H + √M. For this utility function MUH = 1/(2√H) and MUM
= 1/(2√M).

a) Determine if there is a diminishing MRSH,M for this utility function.

b) Draw a graph to illustrate the shape of a typical indifference curve. Label the curve
U1. Does the indifference curve intersect either axis? On the same graph, draw a second
indifference curve U2, with U2 > U1.
c) The consumer has an income of $24 per week. The price of a hamburger is $2 and the
price of a milkshake is $1. How many milkshakes and hamburgers will he buy each
week if he maximizes utility? Illustrate your answer on a graph.

𝑀𝑈 1/(2√𝐻) √𝑀
a) 𝑀𝑅𝑆𝐻,𝑀 = 𝑀𝑈 𝐻 = 1/(2√𝑀) =
𝑀 √𝐻
This utility function has a diminishing marginal rate of substitution since 𝑀𝑅𝑆𝐻,𝑀 declines
as H increases and M decreases.

Since it is possible to have U > 0 if either H = 0 (and M > 0) or M = 0 (and H > 0), the
indifference curves will intersect both axes.

c) We know from the tangency condition that

Substituting this into the budget line, 2𝐻 + 𝑀 = 24, yields

Finally, plugging this back into the tangency condition implies 𝑀 = 4(4) = 16. At the
optimum the consumer will choose 4 hamburgers and 16 milkshakes. This can be seen in
the graph above.

4.22 Samantha purchases food (F) and other goods (Y ) with the utility function U =
FY. Her income is 12. The price of a food is 2 and the price of other goods 1.

a) How many units of food does she consume when she maximizes utility?
b) The government has recently completed a study suggesting that, for a healthy diet,
every consumer should consume at least F = 8 units of food. The government is
considering giving a consumer like Samantha a cash subsidy that would induce her to
buy F = 8. How large would the cash subsidy need to be? Show her optimal basket with
the cash subsidy on an optimal choice diagram with F on the horizontal axis and Y on
the vertical axis.
c) As an alternative to the cash subsidy in part (b), the government is also considering
giving consumers like Samantha food stamps, that is, vouchers with a cash value that
can only be redeemed to purchase food. Verify that if the government gives her
vouchers worth $16, she will choose F = 8. Illustrate her optimal choice on an optimal
choice diagram. (You may use the same graph you drew in part (b).)

a) MUY = F and MUF = Y, so MRSF,Y = Y/F, which diminishes as F increases along an

indifference curve. Since the indifference curves do not intersect either axis, an optimal
basket will be interior. At such an optimum two conditions must be satisfied: (1) tangency:
MRSF,Y = PF / PY, or Y = 2F, and (2) budget line (“BL No subsidy” in the graph): 2F + Y =
12. This F = 3 and Y = 6. This optimum is depicted as point A in the graph.

b) We need to find an interior optimum with F = 8. As income increases, the consumer

chooses a basket along the Income Consumption Curve, which consists of the tangency
points Y = 2F. So Y = 2(8) = 16. Total expenditure will then be 2F + Y = 2(8) + 16 = 32. So
the consumer needs an income of 32 (“BL Cash” in the graph). Since the consumer has an
income of 12, she needs an additional income of 20 (=32 – 12). So the subsidy needed is 20.
This optimum is shown as point B in the graph.

c) From part (b) we see that, with no restrictions on how the government subsidy can be
spent, the consumer would like to buy 16 units of Y, more than her own budget (without
subsidy) would permit. So we expect that with food stamps, she will use the voucher to
purchase the required 8 units of food and spend all of her own unrestricted income (12) on Y.
In other words, this consumer will be at point C on the graph, at the kink on the budget
constraint RCS (labeled “BL Food Stamps”).

We can verify that (F = 8, Y = 12) is her optimal choice by looking at the “bang for the buck”
condition at C. MUF/price of food = Y/2 = 12/2 = 6. MUY/price of Y = F/1 = 8. So the
consumer would like to substitute more Y for F, but cannot do so because at basket C she has
purchased all the other goods she can, given her budget constraint.

4.31 Julie’s preferences for food (measured by F) and clothing (measured by C) are
described by the utility function U(F,C) = FC. Her marginal utilities are MUF = C and
MUC = F . Suppose food costs $1 per unit and clothing costs $2 per unit. She has an
income of $12 to spend on food and clothing.

a) With Julie’s utility function, is it possible that the utility-maximizing basket of food
and clothing will be at a corner point, with either F = 0 or C = 0? Do you expect the
budget constraint to be binding?
b) Using the method of Lagrange, find Julie’s optimal consumption basket (F,C) when
income is $12.
c) Find the numerical value of the Lagrange multiplier, λ, which measures Julie’s
∆𝑼
marginal utility of income (the rate of change ) when her income is exactly $12.
∆𝑰

d) Find Julie’s optimal consumption basket (F,C) and the value of λ if her income is
$13.
e) Show that the increase in Julie’s utility when her income rises from $12 to $13 is close
to the values of 𝝀 you found in parts (c) and (d).

a) Since Julie has a Cobb-Douglas utility function, we know that her optimal basket will be
interior, with F > 0 and C > 0. Since both marginal utilities are positive, we know that the
optimal basket will lie on the budget line. We therefore know that Julie would be able to
increase utility if she had a higher income, so the Lagrange multiplier 𝜆 will be positive at
the utility-maximizing basket.

b) For this problem the Lagrangian function is:

Ʌ(𝐹, 𝐶, 𝜆) = 𝐹𝐶 − 𝜆(𝑃𝐹 𝐹 + 𝑃𝐶 𝐶 − 𝐼) = 𝐹𝐶 − 𝜆(𝐹 + 2𝐶 − 𝐼)

Since the optimal basket will be interior, the necessary conditions are:

𝑀𝑈𝐹 − 𝜆𝑃𝐹 = 0 => 𝐶 − 𝜆 = 0

𝑀𝑈𝐶 − 𝜆𝑃𝐶 = 0 => 𝐹 − 2𝜆 = 0
𝑃𝐹 𝐹 + 𝑃𝐶 𝐶 − 𝐼 = 0 => 𝐹 + 2𝐶 − 12 = 0

We have three equations and three unknowns. When we combine the first two equations, we
find that Julie should equate the marginal utility per dollar spent on each good.

𝑀𝑈𝐹 𝑀𝑈𝐶 𝐶 𝐹
𝜆= = => 𝜆 = = 𝑎𝑛𝑑 𝐹 = 2𝐶 .
𝑃𝐹 𝑃𝐶 1 2

Substituting 𝐹 = 2𝐶 into the budget constraint, we find that

𝐹 + 2𝐶 − 12 = 0 => 2𝐶 + 2𝐶 − 12 = 0 => 𝐶 = 3 and 𝐹 = 6 .

𝐶 𝐹 3 6
c) In part (b) we found that 𝜆 = = => 𝜆 = 1 = 2 = 3. This is the rate of change
1 2

∆𝑈
when Julie’s income is exactly 12. If her income were to rise by a dollar, we would expect
∆𝐼

to see her utility increase by about 3.

d) The two conditions that must be satisfied when income is 13 are:

(1) The tangency condition, 𝐹 = 2𝐶, and the budget constraint 𝐹 + 2𝐶 − 13 = 0.

Together these conditions tell us that Julie’s optimal basket will now contain F = 6.5 and C =
3.25.

𝐶 𝐹 3.25 6.5
Also, 𝜆 = = = = = 3.25.
1 2 1 2

e) When Julie’s income is 12, she chooses C = 3 and F = 6. Her utility is U = FC =

(6)(3) = 18. When her income is 13, she chooses F = 6.5 and C = 3.25. Her utility is U =
FC = (6.5)(4.25) = 21.25.

Julie’s utility increased by 3.25 (from 18 to 21.25) when her income increased by 1 (from 12
to 13). This is close to the values of 𝜆 we found in parts (c) and (d), as we expected.

5.8 David has a quasi-linear utility function of the form U(x, y) = √x + y, with associated
marginal utility functions MUx = 1/(2√x) and MUy = 1.

a) Derive David’s demand curve for x as a function of the prices, Px and Py. Verify that
the demand for x is independent of the level of income at an interior optimum.
b) Derive David’s demand curve for y. Is y a normal good? What happens to the
demand for y as Px increases?

a) Denoting the level of income by I, the budget constraint implies that 𝑝𝑥 𝑥 + 𝑝𝑦 𝑦 = 𝐼 and
1 𝑝 𝑝𝑦 2
the tangency condition is = 𝑝𝑥 , which means that 𝑥 = 4𝑝 2. The demand for x does not
2√ 𝑥 𝑦 𝑥

depend on the level of income.

𝐼−𝑝𝑥 𝑥 𝐼 𝑝𝑦
b) From the budget constraint, the demand curve for y is, 𝑦 = = 𝑝 − 4𝑝 .
𝑝𝑦 𝑦 𝑥

You can see that the demand for y increases with an increase in the level of income,
indicating that y is a normal good. Moreover, when the price of x goes up, the demand for y
increases as well.

5.16 (This problem shows that an optimal consumption choice need not be interior
and may be at a corner point.) Suppose that a consumer’s utility function is U(x, y) = xy
+ 10y. The marginal utilities for this utility function are MUx = y and MUy = x + 10. The
price of x is Px and the price of y is Py, with both prices positive. The consumer has
income I.

a) Assume first that we are at an interior optimum. Show that the demand schedule for
x can be written as x = I/(2Px) − 5.
b) Suppose now that I = 100. Since x must never be negative, what is the maximum
value of Px for which this consumer would ever purchase any x?
c) Suppose Py = 20 and Px = 20. On a graph illustrating the optimal consumption bundle
of x and y, show that since Px exceeds the value you calculated in part (b), this
corresponds to a corner point at which the consumer purchases only y. (In fact, the
consumer would purchase y = I/Py = 5 units of y and no units of x.)
d) Compare the marginal rate of substitution of x for y with the ratio (Px/Py) at the
optimum in part (c). Does this verify that the consumer would reduce utility if she
purchased a positive amount of x?
e) Assuming income remains at 100, draw the demand schedule for x for all values of Px.
Does its location depend on the value of Py?

a) If we are at an interior optimum the tangency condition must hold:

Substituting into the budget line, 𝑃𝑥 𝑥 + 𝑃𝑦 𝑦 = 𝐼, yields

b) If 𝐼 = 100, then

Since we must have 𝑥 ≥ 0, we must have

So the consumer would only purchase 𝑥 for prices less than 10.

c)

Given 𝑃𝑥 = 𝑃𝑦 = 20, the slope of the budget line is –1. At the corner point optimum, the
slope of the indifference curve is

𝑀𝑈𝑥 𝑦 5 1
− =− =− =−
𝑀𝑈𝑦 𝑥 + 10 10 2

Because the indifference curve has a flatter slope than the budget line, the consumer would
like to substitute more 𝑦 for 𝑥, but has no more 𝑥 to give up at the corner point.

𝑀𝑈𝑥 5 10 𝑀𝑈𝑦
d) 𝑃𝑥
= 20 < 20 = 𝑃𝑦
. If the consumer were to purchase any 𝑥, since the “bang for the

buck” for 𝑥 is less than the “bang for the buck” for 𝑦, the consumer would reduce total
utility by increasing 𝑥 above zero.
 e)

As shown in part a), the demand for 𝑥 depends only on 𝐼 and 𝑃𝑥 . Therefore, the location of
the demand curve does not depend on 𝑃𝑦 .

5.24 There are two consumers on the market: Jim and Donna. Jim’s utility function
is U(x, y) = xy, with associated marginal utility functions MUx = y and MUy = x. Donna’s
utility function is U(x,y) = x2y, with associated marginal utility functions MUx = 2xy and
MUy = x2. Income of Jim is IJ = 100 and income of Donna is ID = 150.

a) Find optimal baskets of Jim and Donna when price of y is Py = 1 and price of x is P.
b) On separate graphs plot Jim’s and Donna’s demand schedule for x for all values of P.
c) Compute and plot aggregate demand when Jim and Donna are the only consumers.
d) Plot aggregate demand when there is one more consumer that has identical utility
function and income as Donna.

a) Jim’s optimal basket is a solution to equations

MUx / MUy = P / Py and P x + Py y = IJ.

Hence, we have 2xy / x2 = P and P x + y = 100
with solution x = 200 / (3P) and y = 100 / 3.
Analogous system of equations for Donna is
y / x = P and P x + y = 150 with solution x = 75 / P and y = 75.

b) Approximate shape of the demand curve for Jim and Donna is depicted below.

c) Aggregate demand is

Dx(P) = 200 / (3P) + 75 / P = 445 / (3P).

d) When there is one more consumer that has preferences identical to Donna’s then her
demand is also 75 / P and hence aggregate demand is

Dx(P) = 200 / (3P) + 75 / P + 75 / P = 650 / (3P).

Shape of the demand curve in this case is the same as in part b).

6.5. Are the following statements correct or incorrect?

a) If average product is increasing, marginal product must be less than average
product.
b) If marginal product is negative, average product must be negative.
c) If average product is positive, total product must be rising.
d) If total product is increasing, marginal product must also be increasing.

a) Incorrect. When 𝑀𝑃 > 𝐴𝑃 we know that 𝐴𝑃 is increasing. When 𝑀𝑃 < 𝐴𝑃 we know

that 𝐴𝑃 is decreasing.

b) Incorrect. If 𝑀𝑃 is negative, MP < 0. But𝐴𝑃 = Q / L can never be negative since total

product Q and the level of input L can never be negative. Thus, MP < 0 < AP, which only
implies that 𝐴𝑃 is falling.

c) Incorrect. Average product is always positive, so this tells us nothing about the change in
total product. Whether or not total product is rising depends on whether or not marginal
product is positive.

d) Incorrect. If total product is increasing we know that 𝑀𝑃 > 0. If diminishing marginal

returns have set in, however, marginal product will be positive but decreasing, but that does
not preclude MP > 0.

6.13. You might think that when a production function has a diminishing marginal rate
of technical substitution of labor for capital, it cannot have increasing marginal
products of capital and labor. Show that this is not true, using the production function
Q = K2L2, with the corresponding marginal products MPK = 2KL2 and MPL = 2K2L.

First, note that MRTSL,K = L/K, which diminishes as L increases and K falls as we move along
an isoquant. So MRTSL,K is diminishing. However, the marginal product of capital MPK is
increasing (not diminishing) as K increases (remember, the amount of labor is held fixed
when we measure MPK.) Similarly, the marginal product of labor is increasing as L grows
(again, because the amount of capital is held fixed when we measure MPL). This exercise
demonstrates that it is possible to have a diminishing marginal rate of technical substitution
even though both of the marginal products are increasing.

6.23. A firm’s production function is Q = 5L2/3K1/3 with MPK = (5/3)L2/3K−2/3 and MPL =
(10/3)L−1/3K1/3.
a) Does this production function exhibit constant, increasing, or decreasing returns to
scale?
b) What is the marginal rate of technical substitution of L for K for this production
function?
c) What is the elasticity of substitution for this production function?

a) Notice that (aK)1/3(aL)2/3 = a1/3a2/3 K1/3 L2/3 = a K1/3 L2/3 = aQ. This production function
exhibits constant returns to scale.
b) MRTSL,K = MPL / MPK = 2 K/L .

Because this is a Cobb-Douglas production function, its elasticity of substitution equals 1.