Problem Set 4

ECON 511

Fall 2019

Exercises 1-4 on this problem set appeared on the first midterm exam in Fall 2018.

Exercise 1: Optimal Bundles

Alex’s preferences can be represented by the utility function

u(x, y) = (x + 2)2 (y + 1).

In each part below, determine whether the listed bundle is an optimal choice subject to the budget.

1. Bundle (x∗1 , y1∗ ) = (3, 3) with prices (p1 , q1 ) = (3, 3) and income m1 = 18.

2. Bundle (x∗2 , y2∗ ) = (8, 9) with prices (p2 , q2 ) = (4, 2) and income m2 = 50.

3. Bundle (x∗3 , y3∗ ) = (3, 0) with prices (p3 , q3 ) = (1, 5) and income m3 = 3.

Exercise 2: Income and Substitution Effects

Bob has homothetic preferences with smooth indifference curves (no kinks) and strictly diminishing marginal
rate of substitution.
With income m = 1500 and prices (p, q) = (15, 5), Bob’s optimal bundle is (x∗ , y ∗ ) = (50, 150).
When the price of the first good increases to p′ = 20, Bob’s optimal bundle is (x∗∗ , y ∗∗ ) = (30, 80)

1. How much income m̃ is needed for the artificial budget that keeps the ”Slutsky real income” constant?
Explain/show your work.

2. What is Bob’s optimal bundle when faced with the artificial budget m̃? Explain/show your work.

3. Decompose the change in quantity demanded for the first good into income and substitution effects.

1
Exercise 3: Consumer Surplus

Holding income (m) and price of good two (q) fixed, Chiara’s demand for good one can be expressed as

⎧
⎨ 640 − 20p if p < 32
⎪
x(p) =
⎩ 0
⎪
if p ≥ 32

1. Suppose Chiara is able to purchase the good in a market. Would she be better or worse off if she faced
price p′ = 20 instead of p = 30? Provide a dollar measure of how much better or worse off she would
be. Show your work and explain.

Exercise 4: Labor-Leisure Choices

Consider four individuals who each have preferences over bundles of leisure (x) and money for consumption
(y), and are free to choose any number of hours they work.

• A has (generalized) perfect substitutes preferences,

• B has (generalized) perfect complements preferences,

• C has horizontal shift (linear in x) quasi-linear utility with smooth indifference curves,

• D has Cobb-Douglas utility (homothetic preferences).

They all have exactly the same endowment, E = (1, 200) consisting of 168 hours of leisure and $200 from
a dividend (everything is measured per week, x ∈ [0, 1] is the fraction of time spend on leisure).
When the wage rate is w = 20, all four individuals choose exactly the same (interior) optimal bundle
(x∗ , y ∗ ) with 0 < x∗ < 1.

1. How does the budget line change when wage changes from w = 20 to w′ = 18?

2. For each person, what can you say about the number of hours worked at wage w′ = 18 (i.e. 1 − x∗∗ )
in comparison to the number of hours they worked at w = 20 (i.e. 1 − x∗ )? Explain.

3. Who works more hours at wage w′ = 18? Try to rank the pairs:

(a) A versus B

(b) B versus C

(c) C versus D

(d) D versus A

ECON 511, Fall 2019 - B.Klose 2 Problem Set 4 - Sample Solutions

Exercise 5: Investment

Dan has endowment E = (1500, 5000) and access to a perfect capital market with interest rate r = 0.25 (i.e.
25%) p.a.
He also has access to a private investment opportunity. If he invests z in the private investment oppor-

tunity now, it will return ⎧

⎨ 250 · √z − 500
⎪
if z > 500
R(z) =
0 if z ≤ 500
⎪
⎩

next year.
Dan’s preferences can be represented by the utility function

u(x, y) = x · y 2 ,

where x is the number of dollars available to purchase goods now and y is the number of dollars available to
purchase goods next year.

1. What is the net present value, N P V (z), of the private investment opportunity?

Solution The NPV is the sum of the stream of inflows and outflows with future flows discounted
according to the interest rate r. For investments z > 500

1 √ √
N P V (z) = −z + · 250 · z − 500 = −z + 200 · z − 500.
1 + 0.25

For investments z ≤ 500, N P V (z) = −z.

2. Find the optimal investment z ∗ that maximizes N P V (z).

√
Solution If there exists a z ∗ > 500 that maximizes N P V (z) = −z + 200 · z − 500, then it must
satisfy the first-order condition

d 1 1 100
N P V (z ∗ ) = −1 + 200 · · √ ∗ = −1 + √ ∗ = 0,
dz 2 z − 500 z − 500

ECON 511, Fall 2019 - B.Klose 3 Problem Set 4

 d2 1 100 50
and the second-order condition N P V (z ∗ ) = − · √ 3 = −√ ∗ 3 < 0, which holds
dz 2 2 z − 500
∗ z − 500
for all z > 500.

d
N P V (z ∗ ) = 0
dz
100
⇔√ ∗ =1
z − 500
⇔ 10000 = z ∗ − 500

⇔ z ∗ = 10500

√
N P V (10500) = −10500 + 200 · 10000 = 9500 > 0 ≥ −z for all z. Therefore, z ∗ = 10500 is indeed the

NPV-maximizing investment amount.

3. What is Dan’s budget constraint?

Solution Without the investment opportunity, Dan’s budget was

1 1
x+ y = 1500 + · 5000 = 5500.
1.25 1.25

The investment opportunity adds a net-present-value of 9500 to his budget, i.e. his budget constraint

shifts to the right. Dan’s budget is

1
x+ y = 5500 + N P V (z ∗ ) = 15000.
1.25

4. What is Dan’s optimal consumption bundle (x∗ , y ∗ )?

Solution Dan has Cobb-Douglas utility u(x, y) = x · y 2 , therefore he will always choose an interior
bundle (i.e. strictly positive x and y) at which M RS(x∗ , y ∗ ) = 1 + r = 1.25. Here,

y2 y
M RS(x, y) = = ⇒ M RS(x∗ , y ∗ ) = 1.25 ⇔ y ∗ = 2.5x∗ .
x · 2y 2x

Substituting in the budget constraint yields

1
x∗ + 2.5x∗ = 3x∗ = 15000 ⇔ x∗ = 5000 ⇒ y ∗ = 12500.
1.25

5. How does he finance this consumption plan (i.e. how much does he borrow/save/invest in the first

ECON 511, Fall 2019 - B.Klose 4 Problem Set 4 - Sample Solutions

 period and payback/receive in the second period)?

Solution In the first period, Dan consumes x∗ = 5000 and invests z ∗ = 10500. His endowment in
the first period is 1500, therefore, he must borrow 5000 + 10500 − 1500 = 14000 dollars in the capital
market.

In the second period, Dan consumes y ∗ = 12500 and must repay 1.25 · 14000 = 17500 for his loan with
√
interest. He has endowment 5000 in period 2 and receives 250 · 10500 − 500 = 25000 as return from
his investment. In total, he receives 5000 + 25000 = 30000 and spends 12500 + 17500 = 30000.

ECON 511, Fall 2019 - B.Klose 5 Problem Set 4 - Sample Solutions