Problem Set 3 - Sample Solution

ECON 511

Fall 2019

Exercise 1 (Consumer’s Surplus) Holding income and the price of good 2 fixed, Alexa’s demand for

good 1 can be expressed as 8

>
< 2500 50p if p  50
x(p) = .
>
: 0 otherwise

Her income e↵ect for the good is zero.

1. What are 1500 units of the good worth to her?

Solution Alexa’s valuation of 1500 units of good 1 is the area under her inverse demand curve

between x = 0 and x = 1500. This can be computed as the sum of a rectangle, ’the price’, and a

triangle, the ’consumer’s surplus’. Graphically, her value of the 1500 units of good one is the blue area

below.

1
Thus, Alexa’s valuation is 20 · 1500 + 2 · 1500 · (50 20) = 12 (50 + 20) · 1500 = 30000 + 22500 = 52500.

1
 Alternatively, we can calculate the valuation via the integral of her inverse demand function, p(x) from

x = 0 to x = 1500.

8
>
>
<50 1
if x 2 [0, 2500]
50 x
p(x) =
>
>
:0 otherwise

Then the valuation of 1500 units, V (1500), is

Z 1500 ✓ ◆
1
V (1500) = 50 x dx
0 50
 1500
x2
= 50x
100 0

= 52500

Alternatively calculated via the area of the blue trapezoid

1
V (1500) = (20 + 50) · 1500 = 35 · 1500 = 52, 500.
2

2. How much better o↵ would Alexa be if she faced price p0 = 30 per unit instead of p = 40 per unit?

Solution This part asks how Alexa’s consumer surplus changes as the price changes from p = 40 to

p0 = 30. Graphically, it is the blue trapezoid in the next figure. Alexa demands x(40) = 500 units of

the good when p = 40 (corresponding to point A in the figure) and x(30) = 1000 when p0 = 30 (point

A0 ). Again, we can calculate the change in surplus in multiple ways. Firstly, using the formula for the
1 1 1
area of a trapezoid, it is 2 (1000 + 500) · (40 30) = 2 · (50 30) · 1000 2 · (50 40) · 500 = 7500.

This is the measure of how much better o↵ Alexa is at the lower price.

Alternatively, we compute the integral of Alexa’s demand function from p0 = 30 to p = 40.

Z 40
CS = (2500 50p)dp
30
h i40
= 2500p 25p2
30

= 7500

3. If Alexa were o↵ered a take-it-or-leave-it package of 800 units for a payment of $32000, would she

accept?

ECON 511, Fall 2019 - B.Klose 2 Problem Set 3 - Sample Solution

 Solution To determine whether to accept the o↵er, we need to know what Alexa’s valuation of 800

units. That is,

Z 800
1
V (800) = (50 x)dx
0 50
h x2 i800
= 50x
100 0
= 33600

Since the valuation is strictly greater than the payment, Alexa would take it and still appreciate

consumer surplus in the amount of 1600.

Exercise 2 (Consumer’s Surplus) Holding income and the price of good 2 fixed, Benjamin’s demand

for good 1 can be expressed as 8

>
< 3500 100p if p  35
x(p) = .
>
: 0 otherwise

His income e↵ect for the good is zero.

1. What are 1500 units of the good worth to him?

Solution Benjamin’s valuation of x = 1500 units of good 1 is the green area below the demand curve

and between x = 0 and x = 1500.

1
We can see that the ’price’ is 20 ⇥ 1500 = 30000 and the ’consumer’s surplus’ is 2 ⇥ 1500 ⇥ 15 = 11250.

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

 Thus, his valuation is V (1500) = 41250 = 30000 + 11250.

Again, alternatively, we can calculate his valuation using the inverse demand function:

8
>
> 1
<35 x if x 2 [0, 3500]
p(x) = 100
>
>
:0 otherwise

Then his valuation V (1500) is

Z 1500 ✓ ◆
1
V (1500) = 35 x dx
0 100
h x2 i1500
= 35x
200 0
= 41250

2. How much worse o↵ would Benjamin be if he faced price p0 = 30 per unit instead of p = 20 per unit?

Solution This part asks how Benjamin’s consumer surplus changes as the price changes. Graphically,

it is the green trapezoid in the following figure. Notice that Benjamin is “su↵ering” from a price increase

here. Again, we can calculate how much would Benjamin be worse o↵ in two ways. Using the formula

for the area of a trapezoid, it is CS = 12 (1500 + 500) · 10 = 10000.

The second way is using the demand function. Integrating the demand function from p = 20 to p0 = 30,

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

 we can obtain the same result:

Z 30
CS = (3500 100p)dp
20
h i40
= 3500p 50p2
30

= 10000

3. If Benjamin were o↵ered a take-it-or-leave-it package of 800 units for a payment of $32000, would he

accept?

Solution To determine whether to accept the o↵er, we need to know Benjamin’s valuation of 800

units. That is,

Z 800 ✓ ◆
1
V (800) = 35 x dx
0 100
h x2 i800
= 30x
200 0
= 24800

Since his valuation is strictly less than the payment, Benjamin would not take the deal.

Exercise 3 (Consumer’s Surplus) Suppose Alexa (from Exercise 1) were o↵ered a take-it-or-leave-it

package of the following type:

ECON 511, Fall 2019 - B.Klose 5 Problem Set 3 - Sample Solution

 By paying a lump-sum fee of $1000, she would be allowed to purchase as many units of the good as she

desires at an additional charge of $40 per unit.1 If she rejects the o↵er, she gets none of the good.

1. Does Alexa accept the o↵er?

Solution When does Alexa accept the take-it-or-leave-it package? We know that her value is max-

imized when she buys x = 500 units at the price of p = 40. Hence, she would accept the o↵er as

long as her net consumer surplus (after extracting the lump-sum fee) remains positive (or at least

non-negative). That is, whenever the maximum value she can obtain from the package is larger than

its cost, i.e. the price of purchasing the good and the lump-sum fee combined. Here, Alexa’s valuation

of 500 units of the good is, using the inverse function as we did in exercise 1,

Z 500 ✓ ◆
1
V (500) = 50 x dx
0 50
h x2 i500
= 50x
100 0
= 22500.

We also know that her consumer surplus is the di↵erence of her valuation V (500) and the price she
1 Alexa’s income e↵ect is zero, therefore, the lump sum fee does not a↵ect her demand function.

ECON 511, Fall 2019 - B.Klose 6 Problem Set 3 - Sample Solution

 needs to pay:

CS = V (500) | {z· 40} = 22, 500

500 20, 000 = 2, 500 > 1, 000
| {z }
price lump-sum fee

Therefore, Alexa would accept the o↵er and buy 500 units.

2. Suppose the lump sum fee were F . What is the largest value of F at which she would be willing to

accept the o↵er?

Solution In general, Alexa would accept the package deal whenever it creates non-negative net

surplus. She would still maximize the value of the package by purchasing x = 500 units. Therefore,

similar to part 1, Alexa would accept the o↵er if

CS(500) F

2500 F

Thus the largest value of F at which Alexa accepts the o↵er is 2500, the amount of the CS. For

F < 2500 she would be left with strictly positive net surplus, while F = 2500 extracts the entire

consumer surplus.2

Exercise 4 (Aggregate Demand and Consumers’ Surplus) If the only consumers of the commodity

were Alexa and Benjamin (from Exercises 1 & 2), what is the aggregate demand function?

1. What is the social value of 1500 units of the good? That is, what is the total value if the 1500 units

are distributed between Alexa and Benjamin in a total value maximizing way?

Solution For p  35, both consumers will purchase the commodity, if 35 < p  50 only Alexa will

purchase a positive quantity, and none will purchase any positive amount for prices p > 50. Adding up

Alexa’s and Benjamin’s individual demands in the relevant regions results in the following aggregate

(market) demand function X(p)

2 We will discuss such pricing schemes in more detail during the section of class concerned with monopolies and price

discrimination.

ECON 511, Fall 2019 - B.Klose 7 Problem Set 3 - Sample Solution

 8
>
>
>
> 6000 150p if p  35
>
>
<
X(p) = 2500 50p if 35 < p  50
>
>
>
>
>
>
:0 otherwise

In order to obtain the social value, we need to find the inverse aggregate demand function. To find the

relevant regions/cut-o↵s, note

X(0) = 6000 0 = 6000

X(35) = 6000 5250 = 750

X(50) = 2500 2500 = 0.

We obtain the inverse aggregate demand function P (x) by inverting the market demand piecewise:

1 1
x = 6000 150p , p = (6000 x) = x + 40 (1)
150 150
1 1
x = 2500 50p , p = (2500 x) = x + 50 (2)
50 50

Altogether, we obtain
8
>
> 0 if x 6000
>
>
<
P (x) = 1
> 150 x + 40 if 750  x < 6000
>
>
>
: 1
50 x + 50 if 0  x < 750

Now we can calculate the social value of 1500 units using P (x). It is the area below the inverse

aggregate demand function between x = 0 and x = 1500. Using integration, this is

Z 1500
SV (1500) = P (x)dx
0
Z 750 ✓ ◆ Z 1500 ✓ ◆
1 1
= x + 50 dx + x + 40 dx
0 50 750 150
h 1 2 i 750 h 1 2 i1500
= x + 50x + x + 40x
100 0 300 750

= 31, 875 + 24, 375

= 56, 250

ECON 511, Fall 2019 - B.Klose 8 Problem Set 3 - Sample Solution

 Alternatively, using the areas of two trapezoids

1 1
SV (1500) = (50 + 35) · (750 0) + (35 + 30) · (1500 750)
2 2
= 42.5 · 750 + 32.5 · 750

= 75 · 750

= 56, 250

2. In the total value maximizing allocation of the 1500 units, how much of the commodity does each of

the consumers obtain?

Solution An interior allocation qa , qB > 0 is efficient (i.e. total value maximizing) if and only if

M P VA (qA ) = pA (qA ) = pB (qB ) = M P VB (qB )

A corner solution qi = 0, qj = 1500, (i, j 2 {A, B}) is efficient if and only if

pi (qi = 0) < pj (qj = 1500).

ECON 511, Fall 2019 - B.Klose 9 Problem Set 3 - Sample Solution

 We can use the inverse aggregate demand function to find the efficient allocation. The price works as

the allocating device here. From the inverse aggregate demand function, we find

1
p⇤ = P (1500) = (6000 1500) = 30.
150

At p⇤ = 30 the total quantity demanded equals the quantity to be allocated Q = 1500. At p⇤ = 30

both consumers demand strictly positive quantities: xAlexa (30) = 1000 and xBenjamin (30) = 500.

Therefore, if we allocate qA = 1000 units to Alexa and qB = 500 units to Benjamin, aggregate (social)

value will be maximized, because M P VA (1000) = M P VB (500) = p⇤ .

3. Starting from 1500 units total, what is the marginal social value of an additional ”unit” of the com-

modity? (The term ”unit” means an infinitesimal unit, so point values or derivatives could be used.)

Solution The marginal private value of Alexa is 30. The one of Benjamin is 30 as well. Therefore,

no matter which consumer obtains the marginal ”unit”, the marginal social value is M SV (1500) =

30 = p⇤ .

4. Starting from the social value maximizing allocation of 1500 units, what is the marginal private value of

an additional ”unit” of the commodity to Alexa and what is the marginal private value of an additional

”unit” of the commodity to Benjamin?

Solution At the efficient allocation, the marginal private value for each of the two consumers is equal

to p⇤ = 30. The marginal private values must coincide because both consumers are allocated strictly

positive quantities in the efficient allocation.

Exercise 5 (Elasticity) One approach of measuring changes in one variable in response to changes in

another variable uses elasticities. The Elasticity of A with respect to B is defined as (absolute value of) the

percentage change in A divided by the percentage change in B, i.e.

A/A
✏A,B = .
B/B

Therefore, ✏A,B tells us the percentage change in A that results from a one percent change in B.

Economists are often interested in the (own-)price elasticity of demand

x p dx p⇤
✏x,p (x⇤ , p⇤ ) = ! ·
x⇤ p⇤ !0 dp x⇤

ECON 511, Fall 2019 - B.Klose 10 Problem Set 3 - Sample Solution

We call demand inelastic at (x⇤ , p⇤ ) if ✏x,p (x⇤ , p⇤ ) < 1 and elastic if ✏x,p (x⇤ , p⇤ ) > 1

1. Suppose a consumer’s demand curve is

8
>
< 100 p if p  100
x⇤ (p) =
>
: 0 otherwise

(a) What is her price elasticity of demand at a general point (x, p)?

Solution 8
>
< ( 1)
dx for p  100
= .
dp > : 0 otherwise

Therefore,

dx p⇤
✏x,p (x⇤ (p), p) u ·
dp x⇤
8
> p p
< ( 1) · = for p  100
x 100 p
=
>
: p
0· x =0 otherwise

(b) At which bundles is her demand elastic? Where is it inelastic?

Solution For p  100

✏x,p (x⇤ (p), p) = 1 , p = x⇤ (p)

, p = 100 p

, p = 50

Demand is elastic if and only if ✏x,p (x⇤ (p), p) > 1 , 50 < p < 100. Demand is inelastic if and

only if ✏x,p (x⇤ (p), p) < 1 , p < 50 or p 100.

2. The Expenditure function for good 1 is defined as E1 (p) = p · x⇤ (p).

dE1 (p)
What is ? How does it relate to the price elasticity of demand?
dp

ECON 511, Fall 2019 - B.Klose 11 Problem Set 3 - Sample Solution

 Solution

dE1 (p) d
= [p · x⇤ (p)]
dp dp
dx⇤ (p)
= x⇤ (p) + p ·
dp
✓ ◆
p dx⇤ (p)
= x⇤ (p) · 1 + ⇤
x (p) dp

= x⇤ (p) · (1 ✏x,p (x⇤ (p), p))

8
>
> < 0 if ✏x,p (x⇤ (p), p) > 1
>
>
dE1 (p) <
) = 0 if ✏x,p (x⇤ (p), p) = 1
dp > >
>
>
: > 0 if ✏x,p (x⇤ (p), p) < 1

Exercise 6 (Income and Substitution E↵ects) Emil has quasi-linear utility of the form u(x, y) =

f (x) + y (linear in the amount of the second good). With income m = 200 and prices p = 5, q = 2 his

optimal bundle is (x⇤ , y ⇤ ) = (20, 50). When the price of the first good increases to p0 = 10, his new optimal

bundle is (x⇤⇤ , y ⇤⇤ ) = (15, 25).

1. Follow the steps to decompose the change in quantity demanded into Income and Substitution E↵ects:

• How much income is needed for the artificial budget m̃ that keeps the Slutsky real income constant?

• What is the optimal bundle when faced with the artificial budget m̃?

• Decompose the change from (x⇤ , y ⇤ ) = (20, 50) to (x⇤⇤ , y ⇤⇤ ) = (15, 25) into income and substitu-

tion e↵ects.

2. How would your answers to part 1. change if Emil had quasi-linear utility that is linear in the amount

of the first good (rather than the second), i.e. u(x, y) = x + g(y)?

Solution

ECON 511, Fall 2019 - B.Klose 12 Problem Set 3 - Sample Solution

Exercise 7 (Labor-Leisure Choice) Freya has preferences over bundles of leisure (x), measured as

fraction of total time (i.e. x=1 corresponds to 100% of time - or 168 hours per week- spent on leisure) and

money for consumption of all other goods (y). She has an endowment consisting of both leisure time and a
1
dividend payment.Freya’s endowment is E = (1, 1) and her utility function is u(x, y) = x y. Assume that

she is absolutely free to choose the number of hours she works, 1 x 2 [0, 1].

1. For fixed wage rate w > 0 (per 168 hours) what is her budget?

2. Assume w > 1, what is her optimal consumption bundle (x⇤ , y ⇤ )?

3. Assume w 2 (0, 1], what is her optimal consumption bundle (x⇤ , y ⇤ )?

4. Find her labor supply function, i.e. how does the amount of time she works, 1 x, depend on the wage

rate w? Is her optimal choice of labor, 1 x⇤ (w) increasing in w?

Solution

ECON 511, Fall 2019 - B.Klose 13 Problem Set 3 - Sample Solution