OPMT 7701 Term Project 2015

Selected Answers

1. Analyzing di¤erent types of utility functions

Consider the case of a two-good world where both goods, x and y are consumed. Let the consumer,
Beaufort, have the utility function U = U (x; y). Beaufort has a …xed money budget of B and faces the
money prices Px and Py . Therefore Myrtle’s maximization problem is

Maximize
U = U (x; y)
Subject to
B = Px x + Py y

For EACH utility function listed below,

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i U = (xy)
1=2
ii U = (xy)
iii U = 2x + ln y
iv U = (x + 1) y

do the following:

(a) Find the slope of the indi¤erence curve (dy=dx) using the di¤erential approach (i.e. dU = Ux dx +
Uy dy = 0)
1=2 y
i U = (xy) dy=dx =
x
ii U = 2x + ln y dy=dx = 2y
y
iii U = (x + 1) y dy=dx =
x+1

(b) Set up the lagrange equation and …nd the optimal x and y expressed as functions of only B; px
and py
1=2 B B
i U = (xy) x = 2P x
y = 2Py
ii U = 2x + ln y x = 2B2PxPx Px
y = 2Py
iii U = (x + 1) y x = B2PPx x y = B+P
2Py
x

(c) Suppose the budget is initially B = 24, and Px = 6; Py = 6: Find the optimal x and y , value for
U
1=2
i U = (xy) =2 x=2 y=2
ii U = 2x + ln y = 6:3 x = 27 y = 12
iii U = (x + 1) y = 6:25 x = 23 y = 52
(d) Let B increase from 24 to 36. Find the NEW optimal x and y , value for U
1=2
i U = (xy) =3 x=3 y=3
ii U = 2x + ln y = 10:3 x = 11
2 y = 12
iii U = (x + 1) y = 12:25 x = 25 y = 72

(e) Let B again be 24, but now let the price of x (px ) rise from 6 to 12.Find the NEW optimal x and
y , value for U . In any case is there an unusual results?
1=2
i U = (xy) =3 x=1 y=2
ii U = 2x + ln y = 3 x = 32 y=1
iii U = (x + 1) y = 4:5 x = 12 y=3

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(f) GRAPH your answers for parts (b), (c), and (d). You will have one graph for EACH utility
function. These need to be very well done. Accuracy is the Key. is there any case where the
indi¤erence curves have vertical or horizontal intercepts?

Graph 1

graph 2

graph 3

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2. Willingness to Pay versus Equivalent Compensation
Skippy and Myrtle are friends who consume the same goods: yoga classes (X) and Timbits (Y ). Skippy
has the utility function u = 10xy and faces the budget constraint: M = px x + py y. where M is income,
and px ; py are prices. Myrtle has the same budget constraint as Skippy but her utility function is
v = xy 2 .

(a) Use the Lagrange Method to show that Skippy and Myrtles’demand functions for x and y, which
will be in the form:
L = 10xy + (M px x py y)
Lx = 10y px = 0
Ly = 10x py = 0
L = M px x py y = 0

10y px
=
10x py
y px
=
x py
Substitute into budget to …nd
M M 10M 2
xs = ys = u=
2px 2py 4px py
The expenditure function is r
4px py u
M =
10
Then, for Myrtle,
L = xy 2 + (M px x py y)
2
Lx = y px = 0
Ly = 2xy py = 0
L = M px x py y = 0

y2 px
=
2xy py
y px
=
2x py

M 2M
xm = ym =
3px 3py
2
M 2M 4M 3
v = =
3px 3py 27px p2y
and Myrtle‘s expenditure function is
r
3 27px p2y v
M =
4
(b) Suppose M = 120, Py = 1 and Px = 4: What is Skippy and Myrtles’ optimal x; y and utility
number? If the price of x was lowered to $2 what would be their x; y and utility numbers?
Using the formula‘s in part (a) At
Px = 4 Skippy M yrtle
x 15 10
y 60 80
U 9000 64000

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 Then
Px = 2 Skippy M yrtle
x 30 20
y 60 80
U 18000 128000

(c) If the price remains as $4, how much additional income would each one require to get the same
utility as they did when the price was $2
Use each person‘s expenditure function ((M ) shown in part (a)

Skippy M yrtle
u = 18000 v =q128000
q 2
4px py u 3 27px py v
M = 10 M = 4
M = 169:7 M = 151:2

(d) Draw a graph for Skippy and another for Myrtle. In each graph show the budget constraints,
indi¤erence curves and equilibrium values of x and y for both px = 4 and px = 2. Be ACCURATE
and NEAT. (minimum 1/2 page for each graph)
(e) Suppose that the Yoga Studio o¤ers two options: a drop-fee of $4, or a membership of $30 that
lets the member take Yoga classes for $2. What will be the Utility of Skippy and Myrtle if they
each buy a membership? Given the options (drop-in or member) which will each one choose?
Carefully add the new budget constraint, indi¤erence curve and equilibrium x and y to each girl’s
graph.

Skippy M yrtle
Drop in 9000 64000
M ember 10125 54000
Skippy will join, Myrtle will not join
(f) What is the membership fee that would make Skippy indi¤erent between drop at $4 and mem-
bership that charges $2 per yoga class? Add this to Skippy’s graph.

M embership = 120 84:5 = 35:5

(g) What is the membership fee that would make Myrtle indi¤erent between drop at $4 and mem-
bership that charges $2 per yoga class? Add this to Myrtle’s graph.

M embership = 120 95:4 = 24: 6

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 y

169.7

Skippy Question 2

120

35.15 90

84.5

60

18000

10125
9000
x

151.2
Myrtle

120

24.6

95.4
90

80

128000

64000

54000
x
10 20

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3. Skippy lives on an island where she produces two goods, x and y, according the the production possibil-
ity frontier 400 x2 + y 2 , and she consumes all the goods herself. Skippy also faces and environmental
constraint on her total output of both goods. The environmental constraint is given by x + y 28:
Her utility function is
u = x1=2 y 1=2

(a) Write down the Kuhn Tucker …rst order conditions.

Z = x1=2 y 1=2 + 1 (400 x2 y2 ) + 2 (28 x y)

The Kuhn-Tucker conditions are now

Zx = 21 x 1=2 y 1=2 2x 1 2 =0
Zy = 21 x1=2 y 1=2 2y 1 2 =0
Z 1 = 400 x2 y 2 0 1 0 1 Z 1
=0
Z 2 = 28 x y 0 2 0 2 Z 2 =0

(b) Find Skippy’s optimal x and y. Identify which constaints are binding.From the …rst two
equations, we get:
1 1=2 1=2
2x y 2x 1 + 2
1 1=2 =
2x y 1=2 2y 1 + 2
or
y 2x 1+ 2
=
x 2y 1+ 2

try 2 = 0 . then we get:

y 2x 1
=
x 2y 1
y2 = x2

Sub into the PPF constraint (400 x2 y 2 = 0) to get,

400 = 2x2
x2 = 200
x = 14:14
y = 14:14

But this violates the other constraint (x + y 28) so try 1 =0

y 2 1
= =
x 2 1
x = y
x = 14; y = 14

Environmental Constraint is Binding

(c) Graph your results.
(d) On the next island lives Sparky who has all the same constraints as Skippy but Sparky’s utility
function is u = ln x + 3 ln y. Redo a, b, and c for Sparky. The only di¤erence is that from the
…rst order conditions
y 2x 1 + 2
=
3x 2y 1 + 2
try 2 = 0 . then we get:
y 2x 1
=
3x 2y 1
y2 = 3x2

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 Sub into the PPF constraint (400 x2 y 2 = 0) to get,

400 = 4x2
2
x = 100
x = 10

and

y2 = 300
y = 17:3

which does NOt violate the other constraint (x + y 28)

(c)

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 y
The Gains From Trade
20

15.8
15
D
12.7

10
A u = 2341
u = 2000

(No trade) 8.i6

6.7 B
Px = 0.5
E
5.3
5
u = 1185
C

Px = 1
u*

6.3 10 13.3 20 21.1

x
(No trade) 11.5

4. International Trade: Solving the problem of Production and Exchange (Note: this is not a Kuhn-
Tucker multiple constraint problem).
The following graph is found in most economics texts and it illustrates how an economy can get outside
its PPF through free trade. Solving this problem is a straight forward application of Lagrange.
Figure 1:

(a) Skippy lives on an island full of resources that lets her produce two goods: x and y. Her production
possibility frontier (constraint) is given by

x2 + y 2 = 200

Skippy works alone to maximize her utility which is given by u = x2 y

(b) Set up the Lagrangian for Skippy and solve for x ; y .Use your solution to calculate u .

L = x2 y + 200 x2 y2
x = 11:5; y = 8:16; u = 1089

(c) Carefully graph and label the PPF and Indi¤erence Curve at the optimum.
(d) Now Skippy has the opportunity of to trade with Myrtle on a neighboring island. Skippy can
trade whatever x and y she has at prices px and py . To maximize her gains from trade, Skippy
needs to follow a 2-step process.

LE = px x + py y + (200 x2 y2 )
U 2
L = x y + (px XE + py YE px x py y)

(e) If px = py = 1, solve the Lagrangian that maximizes her endowments. Then use the endowment
values and prices given in the trading constraint and maximize her utility by the Lagrangian

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 method. Calculate her utility number.

L = x + y + (200 x2 y2 )
x = y = 10
L = x2 y + (20 x y)
x = 13:3; y = 6:7; u = 1185

(f) CAREFULLY construct a graph containing her PPF, Trading Line, and indi¤erence curve at the
optimum. Is her utility number greater than in part one?
(g) Now suppose the trading prices change such that px = 0:5. Using your endowment values (XE ; YE )
from before, calculate Skippy’s new utility maximizing bundle. Draw the new trading line and
indi¤erence curve on your graph in (b) above.

x = y = 10
L = x2 y + (15 0:5x y)
x = 20; y = 5; u = 2000

(h) Since the trading prices have changed, Skippy needs to adjust her production decision. Re-do (a)
and (b) with the new prices.

L = 0:5x + y + (200 x2 y2 )
x = 6:3; y = 12:7
L = x2 y + (15:8 0:5x y)
x = 21:1; y = 5:3; u = 2341

5. Suppose the market has two …rms, and Market demand is P = 200 3(q1 + q2 ) The cost functions for
all …rms are: C(qi ) = 675 + 20qi

(a) Derive each …rm’s Best Response functions and carefully graph both on the same graph. For …rm
1:

1 = 200q1 3q12 3q2 q1 675 20q1

d 1
= 200 6q1 3q2 20 = 0
dq1
1
q1 = 30 q2
2
for Firm 2:

2 = 200q2 3q22 3q2 q1 675 20q2

d 2
= 200 6q2 3q1 20 = 0
dq2
1
q2 = 30 q1
2

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 Graphically
q2

60
Firm 1's Best Response

30

Cournot
20 Stackelberg
15
Firm 1's Best Response

20 30 60 q1
(b) Solve for the Cournot Duopoly outputs, price and pro…ts.
q1 = 20 q2 = 20
1 = 525 2 = 525

(c) What would be each …rm’s pro…t if they colluded?

q1 = 15 q2 = 15
1 = 675 2 = 675

(d) Suppose …rm 1 got to choose output …rst, knowing what …rm 2’s best response function is, what
would be each …rm’s output and pro…ts (Stackelberg)
First substitute …rm 2’s best response function into …rm 1’s pro…t function and SIMPLIFY
1 = 200q1 3q12 3q2 q1 675 20q1
1
1 = 200q1 3q12 3 30 q1 q1 675 20q1
2
3 2
1 = 180q1 3q12 90q1 q 675
2 1
3
1 = 180q1 3q12 90q1 + q12 675
2
3 2
1 = 90q1q 675
2 1
Now …nd …rm 1’s pro…t maximizing quantity
d 1
= 90 3q1 = 0
dq1
q1 = 30
Substitute q1 = 30 into …rm 2’s best response to get q2
1 1
q2 = 30 q1 = 30 (30) = 15
2 2
q1 = 30 q2 = 15
1 = 675 2 =0

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