P ROBLEM SET 2

1. Suppose the demand curve of a good is given by P = 1200 − 3QD and the supply curve is
given by P = 7QS .

(a) What is the equilibrium quantity and the equilibrium price?

(b) What is the consumers’ surplus at the equilibrium?

(c) Suppose the government introduces a per unit tax of $2 on the sellers. Find the
equilibrium price and quantity after the tax is introduced.

(d) What is the tax revenue of the government?

(e) Will your answer to (d) change if instead the tax is levied on the buyers instead of the
sellers?

(f) Suppose that the government introduces a value added tax of 5%on the buyers. This
means if the price is P then a tax of 0.05P must be paid by the buyers as tax. How will
the demand and supply curves change?

2. Consider a lottery with three possible outcomes:

• $125 will be received with probability 0.2

• $100 will be received with probability 0.3

• $50 will be received with probability 0.5

(a) What is the expected value of the lottery?

(b) What is the variance of the outcomes?

(c) What is the maximum amount that a risk-neutral person will be willing to pay to play
the lottery?

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3. Suppose that Natasha’s utility function is given by u(I) = 10I, where I represents annual
income in thousands of dollars.

(a) Is Natasha risk loving, risk neutral, or risk averse? Explain.

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 (b) Suppose that Natasha is currently earning an income of $40000(I = 40) and can earn
that income next year with certainty. She is offered a chance to take a new job that offers
a 0.6 probability of earning $62500 and a 0.4 probability of earning $36100. Should she
take the new job?

(c) What is her expected income if she takes the job?

(d) Suppose she is offered an insurance that gives her the expected income with certainty.
How much will she be willing to pay for such an insurance?

4. Find the utility-maximizing bundle when the utility function is given by U (x, y, z) = x2 y 2 z 2
and Px = 20, Py = 30, Pz = 50 and M = 450. Find the compensating variation when the
price of x rises to Px′ = 50.