EC2066 Microeconomics

Problem Set 1

Section A

1. Maya consumes only two goods, chocolate and clothes. Her income consumption curve
for chocolate comes out as a vertical line when plotted with quantity of chocolate on the
horizontal axis and quantity of clothes on the vertical axis. This implies that chocolate
might be a Giffen good for Maya. Is this true or false? Explain carefully, defining
relevant economic terms.
2011, Zone A, Question 4

2. Consider an economy with two goods, Bread ( B ) and Milk ( M ). Jo likes both goods and
her marginal rate of substitution between the two goods is diminishing. The price of M
is 3 and the price of B is 1. At the current consumption basket, her marginal rate of
substitution of Milk for Bread ( MRS M , B ) is 2. Is Jo currently at her optimum
consumption? If your answer is yes, show why. If your answer is no, clarify how her
consumption basket should change to reach her optimum.
2011, Zone B, Question 1

3. Suppose that the government subsidises housing expenditures of low-income consumers

by providing a dollar-for-dollar subsidy to a consumer's housing expenditure - i.e. if a
consumer spends x of his own on housing, the government gives him x , making total
housing expenditure 2 x . Ariel qualifies for this subsidy and spends a total of 500 per
month on housing: he spends 250 of his own and receives a government subsidy of 250.
Recently, a new policy has been proposed that would provide each low income consumer
with a lump sum transfer of 250 which can be used for housing or other goods. Using a
graph, demonstrate whether Ariel would prefer the current program, the proposed
program, or would be indifferent between the two.
2011, Zone B, Question 2

4. Two indifference curves of an individual cannot cross. Is this true or false? Explain your
answer.
2012, Zone B, Question 1
5. Consumers drink both tea and coffee. Suppose that as the price of coffee rises, consumers
drink less tea. Hence the income elasticity of demand for tea is negative. Is this true or
false? Explain your answer.
2012, Zone B, Question 7

6. Andy purchases only two goods, apples ( A ) and oranges ( R ). The price of apples is 2
and the price of oranges is 4. Andy has an income of 40 and his utility function is
U ( A, R ) = 3 A + 5R . What bundle of apples and oranges should Andy purchase to
maximize utility?
2013, Zone A, Question 2

7. u(x, y) = x2 + y2. The price of x is 3 and the price of y is 2. The consumer’s income is 18.
What is the optimal consumption bundle? [Hint: Compare interior bundles to corner
solutions.]
2016, Zone B, Question 3

8. Consider an economy with two goods, x and y with prices 𝑝𝑥 and 𝑝𝑦 , respectively. We
observe the following choices made by Rob: if 𝑝𝑥 > 𝑝𝑦 he chooses to consume only y,
and if 𝑝𝑦 > 𝑝𝑥 he chooses to consume only x. Suggest a utility function for Rob that
represents preferences consistent with the given data.
2015, Zone A, Question 5

9. The figure below shows the inter-temporal budget constraint. The endowment point is
(Y0, Y1). As the rate of interest increases, the budget constraint pivots around the
endowment point as shown. Using the figure, explain that a saver cannot become a
borrower if the rate of interest rises.
2017, Zone A, Question 1
Section B

1. Rai spends her income on fuel for heating her house (H) and a composite of all other
goods (Y). Her preferences are represented by the utility function 𝑢(𝐻, 𝑌) = 𝐻 ∝ 𝑌1−∝ .
The price of the composite good is 1, and the price of heating fuel is p. Let M denote
Rai’s income.

(a) Derive Rai’s demand for H and Y. [5 marks]

(b) Suppose M = 300 and ∝ = 2/3. Also suppose currently the unit price of fuel is p =
20. The energy company offers Rai the option to switch to a different tariff. Under the
new tariff, Rai must pay a fixed fee of 100 and then she can buy fuel at a unit price of
10. Would Rai switch to the new tariff? Explain. [8 marks]

(c) The government decides to give Rai a heating fuel subsidy of s per unit. This
results in an increase in utility from 𝑢0 before the subsidy to 𝑢1 after the subsidy.
Could the government follow an alternative policy that would result in the same
increase in utility for Rai, but cost the government less? Explain using a suitable
diagram. [7 marks]
2014, Zone B, Question 13

2. Consider an economy with two goods: food (F) and music (M). The price of M is 4 and
the price of F is 1. Harvey has an income of 800. Suppose F and M are good substitutes
(but not perfect substitutes) for Harvey, and his preferences are such that he optimally
consumes 100 units of M.

(a) Suppose a new club opens which Harvey can join for a fee of 300. The advantage
is that once he joins the club, he can purchase M at a price of 1. Would Harvey join
the club? [10 marks]

(b) Suppose Carol has the same income as Harvey, but her preferences are represented
by the utility function 𝑈𝐶 (𝑀, 𝐹) = 𝑚𝑖𝑛(∝ 𝑀, 𝐹). For what values of ∝ would Carol
prefer to join the club? [10 marks]
2015, Zone A, Question 13
3. An agent spends her income on two goods, X and Y. Her preferences are represented by
the utility function 𝑢(𝑋, 𝑌) = 𝑚𝑖𝑛{2𝑋, 𝑌}. The price of good Y is 1, and the price of X is
p. Let M denote the agent’s income. Suppose M = 100.

(a) Derive the agent’s demand for X and Y as functions of p. [5 marks]

(b) Suppose initially p = 3, and then p rises to 8. How much of the change in demand
for X as a result of the price rise can be attributed to income effect and how much to
substitution effect? [5 marks]

(c) Consider the rise in p from 3 to 8. Calculate the compensating variation of the
price change. [5 marks]

(d) Consider the rise in p from 3 to 8. Calculate the equivalent variation of the price
change. [5 marks]
2016, Zone B, Question 13

4. Maya spends her income on chocolate (X) and a composite of all other goods (Y). Her
preferences are represented by the utility function 𝑢(𝑋, 𝑌) = 2√𝑋 + 𝑌. The price of the
composite good is 1, and the price of chocolate is p. Let M denote Maya’s income.

(a) Derive Maya’s demand for X and Y. [5 marks]

(b) Suppose M = 10. Suppose initially the price of X is 1/2, and then the price falls to
1/5. How much does Maya’s demand for X change? How much of this change in
demand can be attributed to income effect and how much to substitution effect? [5
marks]

(c) Consider the change in price of X from 1/2 to 1/5. Calculate the compensating
variation of the price change. [5 marks]

(d) For the change in price noted in part (c), is the equivalent variation greater than,
equal to or less than the compensating variation? [5 marks]
2014, Zone A, Question 12