All Past YeAR PAPERS

B.A.
(Hons) Economics 1 Year-2007

Introductory Microeconomics
(Modified According to the CBCS)
Q.1. Show how much will an

individual’s opportunity set increase if
the government gives food stamps
rather than selling food at subsidized
prices.
Sol. With a given money income and price of
food, is the budget line whose slope
represents the price of food. Before the
receipt of food stamps or subsidy, the
individual is in equilibrium at point on
indifference curve . Now, suppose the
individual is given food stamps of ₹ 100 per week which he can spend on food
alone. Suppose price of food is ₹ 5 per kg. He can therefore buy 20 kg of food
which is equal to at the given market price.
Since the consumer cannot use food stamps to buy non-food items (other goods)
he cannot spend more than his initial income on other goods. Thus above
the horizontal line the combinations of other goods and food are not
attainable when he is given the food stamps of ₹ 100. If the individual wants to
buy more food-grains than , then he will spend some part of his initial
income to purchase additional food. Since the food stamps are in addition to his
initial income his budget line with food stamps becomes a kinked line
.
At new equilibrium point he is purchasing quantity of food and of
other goods. Thus, as compared to the situation prior to food-stamp subsidy, he
is on higher indifference curve. Thus, food stamps subsidy has led him to buy
not only more food but also more of other
goods. This means that a part of food stamp
subsidy has been indirectly used for financing
the purchases of non-food commodities.
If instead, food is subsidized, budget line will
rotate to right as food is cheaper so that more
of it can be bought with same income. This
will lead to both substitution and income
effect as opposed to only income effect in food
stamps.
As shown in diagram, we reach a lower
indifference curve as compared to IC in food
stamps, and thus food stamps are better as compared to excise subsidy on food.
This is because in case of food stamps, the consumer can spend the left over
(1)
2 Intermediate Microeconomics
income in any way he likes while in the excise subsidy the consumer is forced to
buy more of food only.
Q.2. Let output be given by the following production function
= (, )
Where is capital and is labour. Let price of capital be ₹ 1 and cost of
per unit of labour be ₹ 3. If only 10 units of capital are employed, find
the short run total cost.
Sol. Given the production function, we know that capital and labour are perfect
complements here and are consumed always in the ratio 2:1 respectively.
Thus if 10 units of capital are being employed, that means 10 × 0.5 = 5 units of
labour are being employed.
Short run total cost () = + ,
Where,
• = wages i.e., per unit cost of labour and
• = rental cost of per unit of capital
Therefore, = 3(5) + 1(10) = 25
Q.3. Show that using indifference curve analysis that “lump sum”
subsidy makes the consumer better off compared to an “excise
subsidy” which costs the government the same amount.
Sol. When the government subsidizes the
consumption of a particular good by paying part
of the per-unit price of the good and the
consumer is free to buy as many units of the
subsidized good as he wants, it is known as
excise subsidy. Whereas a lump-sum subsidy is
a form of subsidy in which the government pays
a lump sum cash grant to the consumer without
lowering the price of any good. The consumer is
free to use this cash grant to buy any good he
likes.
Suppose a particular consumer’s income is given by ₹ . Given the price of as
₹ and the budget line , the consumer is in equilibrium at .
Now, let us suppose that the government subsidizes the individual’s
consumption of by paying half the price of . Then the budget line will rotate
to right because he can buy more of with same income. Now, the consumer is
in equilibrium at point !, where the budget line is tangent to the highest
possible indifference curve . The consumer is clearly better off as compared
to the no-subsidy position as he can now buy more units of X while still
spending the same amount of money on X i.e., he can reach a higher .
Now, let us suppose that instead of giving an excise subsidy, the govt.
gives the consumer the same amount of lump sum subsidy. In this case, the
price of will remain at the original level, but the consumer’s income will
Ecopedia 3
increase by so the budget line will have a parallel shift to " and will pass
through the point !. On the new budget line ", the consumer can still buy the
same market basket ! which she was buying when the excise subsidy was
granted. But now he can reach the highest possible indifference curve .
Thus, as compared to the excise subsidy, the consumer is on a higher
indifference curve when a lump sum subsidy is given and thus is better off. This
is because a lump sum subsidy will involve only income effect whereas giving
an excise subsidy reduces the price of the subsidized good, and will involve both
an income effect and a substitution effect. The consumer is also better off if
given a lump sum subsidy instead of an excise subsidy because with a lump
sum grant the consumer can spend the money in any way she likes while in the
excise subsidy the consumer is forced to buy more of the good which is being
subsidized.
Q.4. Let Mr. N have an income of ₹ 4, 000 this year and ₹ 2, 000 next
year. He can borrow and lend at the market rate of interest 20% per
annum. (Assuming no inflation and prices of consumer goods be ₹ 1 per
unit in both time periods).
The utility function of the individual Mr. N is # ($ , $% ) = $ $% , where $
and $% are consumption levels in current and next year respectively.
Find the Marginal Rate of Substitution between $ and $% and
equilibrium levels of $ and $% .
Sol. Marginal Rate of Substitution (MRS) between and
&'()*+', -.*,*./ 0(12 3114 (&-5 )
=
&'()*+', -.*,*./ 0(12 )114 (&-6 )
= 7( , ) =
We know,
7 = and 7 = .
85
Therefore, MRS =
86
Now, intertemporal budget constraint is given by

+ +
=
(1 + ) (1 + )
i.e.,
85 : 86 86
= 5,666.7 or = 5,666.7 −
. .
85
Also, MRS = Price Ratio = 1.2 i.e., = 1.2 or = 1.2
86
Therefore, budget constraint becomes 2 = 5,666.67 i.e., = ₹ 2833.33 and =

1.2(2833.33) = ₹ 3,400
•••
INTERMEDIATE MICROECONOMICS - I
2008
Q.1. Suppose that price of a good rises by 10%, while the income rises
by 5%. Show that a man who spends half of his income on this good
would become better off. Is there any exception?
Sol. Let this good be represented by A with price
B and the other good be C which represents
money spent on all other goods so that D = ₹ 1.
Let his income be represented by M.
Therefore his budget line will be B A + D C = as
represented in diagram by line E. He can
purchase maximum units of good by
represented by point E, and /B units of A
represented by point . Since consumer spends
half of his income on good A, his optimum will be
H H
point i.e., 0.5( ) units of A and units of C.
IJ
Now, new price is BK

= 1.1 B and new income K = 1.05, therefore new budget
line is B A + D C = ′ or 1.1B A + D C = 1.05 represented by line ", consumer
K
can now afford more C with a maximum of ′ units (point C) and lesser of A
with maximum units 0.95 /B (point D).
These budget lines will intersect at point since it satisfies both the lines. The
consumer still spends half of his income on good A, but he will now be able to
afford less of A i.e., K /2′B or 0.48(/B ) units of A and more C i.e., K /2 units
of C. Since this point F lies on a higher indifference curve, consumer will always
be better off with no exception.
Q.2. Suppose that chief selector of a football team says that given two
players A and B he would weakly prefer a richer player. Check if this
preference is reflexive, transitive and complete or not.
Sol. Reflexive. If a bundle is as good as itself then it follows axiom of
reflexiveness.
Completeness. Axiom of completeness states that two bundles can be
compared. Assume two bundles 1 and 2; both comprising of gods A and goods C.
(a) Either (A1, C1)would be preferred over (A2, C2): (A1, C1) > (A2, C2)
(b) Or (A2, C2) would be preferred over (A1, C1): (A2, C2) > (A1, C1)
(c) Or both, which means that consumer is indifferent between two
bundles.
Transitivity. If bundle 1 is preferred over bundle 2 and bundle 2 is preferred
over bundle 3, then by axiom of transitivity bundle 1 should be preferred over
bundle 3.
(4)
Ecopedia 5
Assume three individuals - A, B, C.

Richer than: Given relation satisfies only transitivity.
• A could be richer than, shorter than or of same status as of B. This
relation is not complete since in third case of same status this relation
can’t be used.
• It is not reflexive since A can’t be richer than him/herself.
• If A is richer than B & B is richer than C then it follows that A is richer
than C. So this relation is transitive.
Q.3.(a) Suppose Nikita’s utility function is # = Q + R% while that of
Ishant is # = Q + STU. Assume price of both commodities to be ₹ 1.
Derive the income offer curves and Engel offer curves for commodity x
for both of them.
Sol. We assume both A and C normal good for both the consumers. Let income
be represented by .
Income offer curve is a line that depicts the optimal choice of two goods at
different levels of income at fixed prices. Income offer curve for two normal
goods is upward sloping. Engel curve shows the demand for one good under a
set of fixed prices and changing income.
NIKITA
Max 7 = A + C with respect to budget constraint A + C = V (price of both
commodities is ₹ 1)
Using the constraint, 7 can be written as 7 = A + ( V − A)
To maximize, we equate W7/ WA = 0
W7/ WA = 1 − 2(V − A) i.e., V − A = 1/2
Or,
Q = XY − /% which is Engel curve of Q
Now,
C = V − A = V − (V − 1/2) i.e., R = /%
which is Engel curve ofR.
Income offer curve is obtained by equating Engel curves of A and C i.e., A − V +
1/2 = C − 1/2
Thus, income offer curve is A − C − V + 1 = 0, which is upward sloping
ISHANT
Max 7 = A + Z[\C with respect to budget constraint A + C = ] (price of both
commodities is ₹ 1)
Using the constraint, 7 can be written as 7 = A + Z[\ (]^B )
To maximize, we equate W7/WA = 0

W_/WA = 1 − = 0 i.e., ] − A = 1 or Q = Xa −
H–B
which is Engel curve of Q.
Now,
C = ] − A = ] − (] − 1)
i.e., R = which is Engel curve of R
Income offer curve is obtained by equating Engel curves of A and C i.e., A − ] +
1=C−1
Thus, income offer curve is A − C − ] + 2 = 0, which is upward sloping.
(b) Distinguish between returns to scale and economies of scale. Is it
possible to have constant returns to scale and economies of scale
together?
Sol. “Returns to scale” refers to the
percentage change in output achieved by a
particular production process when all
inputs are increased by the same percent.
A production process exhibits decreasing,
constant, or increasing returns to scale,
depending on whether the quantity of
output increases less than, the same as, or
more than proportionally when all the
inputs are increased by the same percent. It is a short run concept and explains
the relationship between the rates of output with increasing inputs of
production.
“Economies of Scale” is the situation experienced by a firm when the Average
Cost i.e., Cost per unit is decreasing. Economies of scale explains the
relationship between the long run average cost of producing a unit of good with
increasing level of output. In easy terms, it is a situation in which output can be
doubled for less than a doubling of cost.
The term economies of scale include increasing returns to scale as a
special case, but it is more general because it reflects input proportions that
change as the firm changes.
There are a number of sources including the ability to spread FCs over a large
volume and ability of large volume producers to utilize specialized employees
and equipment that are more productive than less specialized employees and
equipment. So, even when there are constant returns to scale (increase in
output is exactly equal to increase in inputs), there can be economies of scale
(increase in cost less than proportion to increase in inputs) because when a firm
produces at large scale it can acquire raw materials at cheaper rates or use
specialized employees and equipment as mentioned above.
Q.4. Farmer Sham owns farmland, which he wants to sell next year. In
years when it floods his land can be sold for ₹ 75,000 only, while it can
be sold for ₹ 75 lakhs in a normal year. Sham expects that the
probability of flooding next year is 0.1. His expected utility function is
given by
Ecopedia 7
#($b, $cb) = . d$b + . ed$cb

Where $b and $cbstands for possible consumption with floods and
without floods respectively. He can buy insurance against floods at a
premium of 10%.
(a) What would be his contingent consumption bundle if he does not
buy insurance?
(b) What amount of insurance will he buy and what will be his
contingent bundle in that case?
Sol.(a) If he does not buy insurance, he has 75,000 only when it floods, while
he gets ₹ 75 lakhs in a normal year.
So his contingent consumption bundle will be (75,000; 75, 00,000).
(b) Let B be the benefit from insurance that he will receive then according to
question, 10/100B = 0.1B is the premium of insurance. We know insurance is
actuarially fair when the premium rate must equal the probability of an
accident. Here also premium rate (10%) is equal to probability of flooding (10%),
therefore this insurance policy is actuarially fair.
Also, farmer’s expected utility function shows that he is risk averse, and when a
person is risk averse he always takes full insurance under fair insurance
irrespective of degree of aversion.
We know after buying full insurance, wealth in both the events is equal i.e.,
Wealth with flood = wealth with no flood
Wealth with flood without insurance – premium + benefit = wealth with no
flood - premium
75, 000 – 0.1B + B = 75, 00, 000 – 0.1B i.e., B = 74, 25, 000
Thus, the amount of insurance that he needs to buy to be fully insured is ₹ 74,
25, 000.
And his contingent consumption bundle will be (74, 25, 000; 74, 25, 000) since
he is taking full insurance, he will be on guaranteed consumption line i.e., he
will have same wealth in both the conditions and therefore no risk.
•••
2009
Q.1. Can the long run total cost curve of a firm be a positively sloped
straight line through the origin? What does it imply? What shapes will
the long run averages cost and long run marginal cost take in this
case? Can the short run average cost be U-shaped?
Sol. Yes, the long run total cost curve of a firm can be
a positively sloped straight line through the origin.
This implies that total cost is proportional to output.
For e.g. = fg. This happens when underlying
production function exhibits constant returns to scale.
In this case, long run averages cost (/g = f) and
long run marginal cost (W/Wg = f) will be equal and
constant for output levels and thus will be straight
lines parallel to x-axis.
Yes, the short run average cost (SAC) is generally U –
shaped. We know that, SAC = Average Fixed Cost
(AFC) + Average Variable Cost (AVC). Initially when
output increases both AFC and AVC falls, because of
operation of increasing returns or diminishing costs,
so that AC falls till it reaches the minimum point.
After this, any increase in output leads to increase in
AVC because of operation of law of diminishing return or increasing cost.
Although AFC keeps falling, the rise of AVC is more than fall of AFC, so that
their combined effect causes SAC to rise. Hence, the shape of SAC becomes ‘U’
shaped.
SAC being U-shaped can also be explained due to operation of law of variable
proportion. When there is increasing return in production SAC falls and when
there is diminishing return in production SAC rises.
Q.2. For two consumers with utility functions given by h = STUQ +
%STUR and h = Q/% + R/% respectively, find their demand functions for Q
and R.
Sol. We know, Marginal Rate of Substitution (MRS) between A and C =
Hijklmin oplnlpD qjrs trru (Ho5 )
Hijklmin oplnlpD qjrs trru (Ho6 )
Also, MRS = Price Ratio = B /D . Let the budget constraint of consumer be given
by A B + CD = , where is income of consumer.
For consumer 1, 7 = 1/A and 7 = 2/C.
D
Therefore !v = = B / D
B
(8)
Ecopedia 9
This implies C = (2A)B /D . Putting it in budget line, we get:

(2A)B
A B + w x D =
D
Or,
H
A B + (2A)B = i.e., Demand function for A = B
y
And thus demand function for C = 2 (B /D )(/3)
i.e., C = 2/3D
Similarly, for consumer 2,
7 = 1/2A /
and 7 = 1/2C /
.
5 5
Therefore !v = C 6 /A 6 = B /D
This implies C = (A)[B /D ] . Putting it in budget line, we get :

B
AB + }(A) w x ~ D =
D
Or,
(B)IJ6
AB + = i.e., Demand function for Q = XR /(Q R + %Q )
I
I
And thus demand function for C = D /(B + D + B )[ J ] i.e., C = B /
I
(B D + D )
Q.3. If a firm’s production function is given by = 5, where is
output, is labour and is capital (all per unit of time). If the price of
labour is ₹ 1 per unit and that of capital is ₹ 2 per unit, what
combination of inputs should be used to produce 20 units of output?
Sol. Let the cost function be = + , where is total cost, = per unit cost
of labour and = per unit cost of capital
According to question, = + 2
So we minimize = + 2 with respect to g = 20 or 5 = 20
i.e., = 20/5 = 4/, using this we get = + 8/
Min , we get W/W = 1 − 8/ .

Equating it to zero we get, 8/ = 1 i.e., = %(%% )

And thus = /% %% = %%
5
Thus to produce 20 units of output, %(%% ) units of labour and 26 units of capital
should be used.
Q.4.(i) An economic agent owns a business that generates income of ₹ 2,
00,000 per day. If there is a fire, he earns ₹ 2, 000. The probability that
there is a fire on the premises is 20%. What is his expected income? If
his Von Neumann Morgenstern utility function is given by h = dR (R is

income), what is the certainty equivalent of this business?
(ii) Given that the demand for some service (like electricity) is higher
during some periods than at others, and that it is non-storable, i.e., it
must be generated when it is needed, how would consumer welfare be
affected if different prices are charged for the service at these
different times rather than charging a constant price in both periods?
Why?
Sol.(i) Expected returns equal the outcome we will obtain on average
considering every possible event and its probability.
There are two events here fire ( ) and no fire ( ), with their probability 0.2
and 0.8 respectively.
Therefore expected returns = . ( ) + . ( ) = 2,000(0.2) + 2,00,000(0.8) =
400 + 1,60,000 = 1,60,400
The certainty equivalent () of any outcome is that amount of money, offered
for certain, which gives the consumer exactly the same utility as the outcome.
Utility from the given outcome is given by
(_) = dC = √2,00,00 × 0.8 + √2,000 × 0.2 = √20 × 80 + √20 × 2 = 82√20.
For certainty equivalent, we need income level that gives same utility as
(_) = 82√20 i.e., dC = 82√20 or y = 1, 34,480
Therefore, = 1,34,480 i.e., insurance must give ₹ 1, 34, 480 whether there is
fire or no fire to make the economic agent indifferent.
(ii) Electricity producers have extreme capacity
problem i.e., it is easy to produce up to capacity
but impossible to produce more. Since
increasing capacities is expensive, reducing the
use of electricity during peak demand is more
attractive. And thus setting up pricing system
so that people have incentives to reduce
consumption in peak demand can be beneficial.
One method can be Real Time Pricing (RTP). In
this, industrial users are equipped with special
meters and the price of electricity can vary
from minute to minute depending on the total demand of electricity. As demand
approaches capacity, company increases price to encourage consumers to use
less electricity. Along with charging high price at time of short supply, it also
offers rebate if consumers can manage to cut their electricity use below their
baseline amount.
As shown in the figure, when consumers maximize their utility subject to
budget constraint determined by baseline price of electricity, they get their
baseline consumption. If during high price time, consumer is able to reduce his
usage beyond the baseline, he gets rebate. Since this is a Slutsky pivot around
Ecopedia 11
baseline consumption, consumers will definitely reduce their usage because

they can end up on higher indifference curve i.e. they will be at least as well off
due to directly revealed preferences.
Thus if different prices are charged for electricity at different times rather
than charging a constant price in every period, consumer will be better off
(along with the company).
Q.5.(i) Suraj is indifferent between Coke and Pepsi. What do his
indifference curves between these two goods look like? What is his
demand function for Pepsi?
(ii) If the same person acts as a risk avoider (purchases fire insurance)
and also acts as a risk seeker (gambles) can one explain such
seemingly contradictory behavior?
(iii) In a two commodity world can both the goods be inferior? Can
both the goods be luxurious?
Sol. (i) if Suraj is indifferent between Coke and
Pepsi, this means that they are perfect substitutes
for him. If two goods are perfect substitutes, the
indifference curve is a straight line with negative
slope, as shown in the figure because the MRS is
constant. This is so because Suraj would be ready
to give up one Coke for one Pepsi every time since
he is indifferent between the two. Thus the value
of slope is throughout minus 1, and hence MRS =1. Suraj does not distinguish
between these two goods and regards them as the same commodity.
Demand function of Pepsi: Let price of Pepsi be given by B , price of Coke be
D and Suraj’s income be .
Suraj is just as happy with a unit of Coke as he is with a unit of Pepsi, and thus
he will spend all of his income on whichever good is cheaper because he can get
more in this way.
0, if B > D
Anywhere between 0 and /B , if
B = D
Thus, demand for Pepsi =
/B if B < D
(ii) There are certain risk averse persons who buy insurance coverage (e.g. –
fire insurance) and engage in gambling at casinos. This appears to be a
contradiction because this behavior suggests that people are risk averse and
risk loving at the same time. But there is no contradiction because such a
behavior depends on the nature and cost of insurance that can be bought and
on the type of gambling game.
When a person gets an insurance policy, he pays to escape or avoid risk. But
when he buys a lottery ticket, he gets a small chance of a large gain. Thus he
takes risk. Some people indulge both in buying insurance and gambling i.e.,
they both avoid and choose risks over different segments of wealth and different
choices and hence it is not irrational to do so.
(iii) When an increase in income causes a consumer to buy less of a good that
good is called an inferior good.
Using the general assumption that the income is fixed and that the consumer is
rational i.e., he spends his whole income on the two goods in a two – commodity
world, both good can’t be inferior goods because if both goods are inferior this
means that starting from an exhausted income when a consumers income goes
up he will consume less of both goods meaning he is no longer using all of his
income and assumption of rationality is breached. In other words, as income
decreases consumer buys more of an inferior good. This means in a two-
commodity world, if income decreases consumer will want to have more of both
the inferior goods which is not possible given the budget constraint.
A luxury good is a good for which demand increases more than proportionally
as income rises. Again using the general assumption that the income is fixed
and that the consumer is rational i.e. he spends his whole income on the two
goods in a two – commodity world, both good can’t be luxury goods because say
if income increases by 20%, then consumer will like to spend more than 20% on
both the luxury goods i.e. he will end up spending more than his increased
income, which is not possible given the budget constraint.
Q.6. What does it mean to be risk averse? A person is offered the
following choice: a payment of ₹ 800, or to play a game in which he
draws a ball from bag containing 60 red and 40 white balls. If he draws
a red ball he gets ₹ 1,000 while if he draws a white ball he gets ₹ 500. If
he is risk averse what would be his choice? What is his choice between
the same game and
(a) Getting a payment of ₹ 780?
(b) Getting a payment of ₹ 850?
Sol. A person who prefers a certain given income to a-risky outcome with the
same expected income is known as risk-averse i.e. a person who seeks to
minimize risk even if he has to choose a lower level of ‘certain’ income or pay
insurance premium to reduce risk. Given two choices with same expected
profits, he will choose the one with lower risk.
According to question, a risk averse person has the choice of ₹ 800 with
certainty or choice of playing the game in which he gets a return of 1,000 × 0.6
+ 500 × 0.4 = 600 + 200 = 800
Thus, both choices have same returns but first choice has certainty i.e., no risk
and therefore he will choose not to play the game which has high risk and take
payment of ₹ 800 instead.
(a) We cannot say with surety which option will the person choose, it
depends on the shape of his indifference curve or in other words degree
of his risk aversion. Higher the risk aversion, more chances that he will
Ecopedia 13
choose the payment of ₹ 780 even if it means a lower return because it

comes with no risk.
But if the person is not very risk averse, he might choose to play the
game as well if he gets a higher expected utility from the outcome i.e.,
he is on a higher indifference curve.
(b) He will definitely choose the payment because he is getting higher
return and with zero risk as opposed to high risk and lower return in
playing the game.
•••
2010
Q.1. Aman consumes two goods, peanuts and juice. He prefers to

consume a bundle that has more peanuts if he can have the same
number of glasses of juice, otherwise he would have a bundle that has
more juice even if it has fewer peanuts. What sort of indifference
curves will he have between peanuts and juice?
Sol. Aman has lexicographic preferences. In this
an economic agent prefers any amount of one good (here
juice) to any amount of another (peanuts). Specifically,
if offered several bundles of goods, the agent will choose
the bundle that offers the most (juice), no matter how
much (peanuts) there is. Only when there is a tie
between bundles with regard to the number of units of
(juice), will the agent start comparing the number of
units of (peanuts) across bundles. A distinctive feature of lexicographic
preferences is that an agent's preferences cannot be mapped as an indifference
curve that is, there is no δreal-valued representation of a utility function.
The indifference sets contain only one element, i.e., given any bundle all the
other bundles are either more desirable or less desirable. Thus every point on
indifference map is a different indifference curve.
Q.2. Why is the maximization of expected utility not a valid criterion in
a decision making subject to risk?
Sol. When a project or decision making is subject to risk, maximizing expected
utility alone is not sufficient because two projects may have same expected
utility but highly different risks and thus risk should also be taken into
account.
Only when risks of projects are totally identical, maximizing expected utility
will give best result. Risk as a numerical value can be measured through
mathematical formula of variance which is square of standard deviation.
For e.g.,: Let there be two projects and and two events E and such that
Event Probability of event Project X returns Project Y returns
A ½ 150 50
B ½ - 50 0
Expected returns from = 1/2 × 150 + 1/2 × (-50) = 50
Expected returns from = 1/2 × 50 + 1/2 × 0 = 25
From this analysis, project seems to be a better choice but this analysis is
incomplete without calculating variance.
(14)
Ecopedia 15

Variance of = 1/2 (150) + (−50) = 11,250 + 1,250 = 12,500

Variance of = 1/2 (50) + (0) = 1,250

Thus we see, decision of choosing might not be reliable because it is highly
risky as compared to . Thus both expected utility and variance should be
analyzed when decision making is subject to risk.
Q.3. Give two examples of production function (assuming two inputs)
that exhibit diminishing returns to variable proportions but
increasing returns to scale.
Sol. The law of diminishing returns to variable proportions states that as the
quantity of one factor is increased, keeping the other factor fixed (assuming two
inputs), the marginal product of that factor will eventually decline.
While, increasing returns to scale means the output increases by a larger
proportion than the increase in inputs during the production process i.e., if
g = (Z, ) represents the production functions where Z is labour input and is
capital input then increasing returns implies g < (Z, )
(a) g = (Z, ) = Z/y y
Keeping constant, marginal product of labour factor declines as it is
increased.
1 6
= n = Z ^ y
Z 3
n /Z = −2.9 Z ^/y , which is negative and hence n falls as Z increases or
there are diminishing returns to variable proportions.
5 5
Also, λ, λ = (λ)/y (λ)y = λ  y > λg, and hence increasing returns to
scale.
y
Thus, g = (Z, ) =  y exhibits diminishing returns to variable proportions
and increasing returns to scale simultaneously.

(b) Similarly, g = (Z, ) =  / exhibits diminishing returns to capital and
increasing returns to scale simultaneously.
Q.4. What is the slope of a consumer’s intertemporal budget line? What
is its shape if the consumer can borrow at a higher interest rate than
the one at which he can lend?
Sol. Equation of inter-temporal budget line
is :
+ /(1 + ) = + /(1 + )
And thus slope of a consumer’s intertemporal

budget line = 5 = 1 + .
5
Since there are different rates for borrowing

and lending, there will be kink in our budget
line at endowment point representing the
two different rates. Higher interest rate means higher slope and thus a steeper
line.
Borrowing means consumer is spending more than his endowment income in
period 1, and thus will be represented by a point to the right of endowment
point M. Since borrowing rate is higher than lending rate, line to the right of
will be steeper than the line to the left of it as shown in the adjacent figure.
Q.5. The owner of an egg firm produces 300 eggs a week. Initially the
price of eggs is ₹ 4 per egg. Her demand functions for eggs, for her own
consumption is
Q = + /
Where x is the number of eggs she consumes per week. is the price of
an egg and m is the income. The price of eggs then falls to ₹ 3 per egg.
How many eggs does she consume before and after the fall in the price
of eggs? How much is the endowment income effect on her
consumption of eggs?
Sol. Case 1: Price = ₹ 4
She has an endowment of 300 eggs, thus his income will be 300 × 4 = ₹ 1,200
According to her demand function, she will consume
A = 180 + 1,200/10 × 4 = 180 + 30 = 210
Case 2: Price falls to ₹ 3
Now with her endowment of 300 eggs, she will have an income of ₹ 300 × 3 = ₹
900
According to her demand function, she will now consume
A = 180 + 900/10 × 3 = 180 + 30 = 210
So, she consumes 210 eggs both before and after the fall in prices.
The movement from the optimal consumption bundle E(x’, y’) on the new budget
line that has fixed income but changed prices to the new optimal consumption
bundle (A ∗ , C ∗ ) with changed income and prices is the endowment income
effect.
To calculate the endowment income effect, we will keep the income same as
before i.e., ₹ 1200
With income ₹ 1,200 and price ₹ 3, she will consume A = 180 + 1,200/10 × 3 =
180 + 40 = 220
Thus, endowment income effect on good A = (A ∗ , C ∗ ) − E(A K , C K ) = 210 – 220 = –
10
And therefore, endowment income effect on eggs is negative here.
•••
2011
Q.1. Answer the three questions.

(a) Is the following statement true or false: “If both current and future
consumption are normal goods, an increase in the interest rate will
necessarily make a saver save more.” Explain.
Sol. FALSE. If both current and future consumption are normal goods, an
increase in the interest rate will not necessarily make a saver save more i.e. he
may choose to save less.
Suppose initially the consumer is a saver and
then the rate of interest increases. This increase
in interest rate will make the budget line
steeper. Now the new budget line is ′′ but
this new budget line will pivot around point
because – i.e., endowment will always be
available to the consumer. Say initially he was
in equilibrium at (to the left of because he
is a saver).
When the interest rate increases, current
consumption becomes relatively more expensive
thus the individual will tend to substitute away from current consumption,
known as the substitution effect. However, since present and future
consumption are both normal goods, an increase in the interest rate will
increase relative income leading to what is known as the income effect. For a
net-saver this increase in relative income will thus induce him to "buy" more
current consumption.
The substitution and income effects work in opposite directions for the net-
saver. Therefore, the effect of changes in the interest rate on savings behavior
depends on the relative size of the two effects. If the income effect is greater
than the substitution effect then an increase in the interest rate will lead to an
increase in current consumption and a reduction in savings. If the income effect
is less than the substitution effect, he will save more.
Also from the figure we can see that after the increase in the interest rate the
portion of the new budget line to the right of the endowment point is lying
below the initial budget line. All these consumption points were earlier
available to the consumer but were not preferred by the consumer in the
beginning. So according to the Revealed Preference Hypothesis in this new
situation consumer cannot prefer these points. Thus he can choose any point to
the left of M on the new budget line ′′, and may end up saving either more or
less.
(17)
(b) What is meant by a fair bet? Suppose a person has preferences

represented by #() = √. Is the person likely to accept a fair bet?
Sol. If someone offers you a lottery with an expected value of zero, this is called
a fair bet.

7() = √, we know 7 K () =
√

And 7" () = − <0
()/6
Since given utility function is concave, we know that person is risk averse.
In essence, a fair gamble allows you receive the same amount of money through
two distinct ways: Gambling or not gambling. A risk averse person will never
accept a fair gamble because he has a choice between earning the same amount
of money through a gamble or through certainty and being risk averse he will
opt for certainty and not the fair bet.
(c) Suppose coffee and sushi has the same quality: the more you
consume, the more you want. What kind of preferences are these? For
a given budget, should you diversify if you have these kinds of
preferences?
Sol. Preference indicated by quality. More you consume, the more you
want represents increasing marginal utility i.e. an additional unit of coffee or
sushi always gives him a higher marginal utility. Increasing marginal utility
generally leads to concave preferences since Marginal Rate of Substitution will
also be increasing (on average) and thus for a given budget the consumer will
diversify that is he will consume either only coffee or only sushi. This is because
for concave preferences, optimum occurs at corners.
Q.2.(a) There is a government subsidy program that lowers the price of
food for consumers from ₹ 3 to ₹ 2. The price of all other goods (AOG) is
₹ 1. Both food and AOG are normal goods and there is diminishing
marginal rate of substitution between them.
(i) Graphically show the change in food consumption from the
program.
(ii) Graphically show the change in food consumption due to
income effect and substitution effect.
(iii) Graphically show how much the program costs to the
government.
(iv) An economist claims she can make the consumer better off
without costing the government more money. How is this
possible?
Sol.(i) and (ii) A fall in the price of food (good ), given the price of AOG (good
), increases its demand as shown in the figure. This is the price effect which
has dual effects: a substitution effect and an income effect. Given the price of
two goods and income represented by the budget line PQ, the consumer will be
in equilibrium at ! on indifference curve . If price of food falls from ₹ 3 to ₹ 2,
Ecopedia 19
price of AOG and his money income remaining unchanged so that budget line
now shifts to g .
The consumer will now be in equilibrium at a
point on the new budget line g . In case of
normal goods the new equilibrium point lie on
budget line such that the quantity
demanded of the food will increase as its price
falls.
For normal goods, the income effect is positive;
it will work towards increasing the quantity
demanded of food when its price falls because
purchasing power of the consumer has increased. The substitution effect which
is always negative and operates so as to raise the quantity demanded of food
when its price falls. The substitution effect relates to the increase in the
quantity demanded of when its price falls while keeping the real income of
the consumer constant. When we keep real income constant we get
compensated budget line MN parallel to g , which shows the substitution
effect. Thus, in case of normal goods both the income effect and negative
substitution effect work in the same direction and cause increase in the
quantity purchased of food whose price has fallen. Substitution effect causes "
increase in quantity demanded. Income effect which is positive here also leads
to the increase in quantity demand by ". Each
effect therefore reinforces the other.
As a result, the total effect of a fall in price of food
from ₹ 3 to ₹ 2 is the rise in quantity demanded
from OB to OE, that is, quantity demanded
increases by (price effect) which is equal to
"(substitution effect) + " (income effect).
(iii) Costs of the program to government will be equal to the increase in
consumption possibilities for the consumer due to subsidy. It means the
increase in budget constraint represented by the shaded area.
(iv) This is possible if government gives a lump sum subsidy rather than an
excise subsidy on food. If both the subsidies cost the same, lump sum subsidy
will make the consumer better off without costing the government any more
amount. Refer Q.3. of 2007 for explanation.
(b) A consumer has the following utility function :

#(Q, R) = (Q + %)% R% , Q, R > 0. Find the optimal consumption of Q and R
given prices = ₹ 6, % = ₹ 1 and income = ₹ 10
Sol. We have to maximize his utility with respect to his budget constraint given
by 6A + C = 10. We also at equilibrium, Marginal Rate of Substitution (MRS) =
Price ratio
Hijklmin plnlpD qjrs krru B
MRS =
sijklmin plnlpD qjrs krru D
Marginal utility from good A = 1/2(A + 2)^/ C/

5 5
And similarly marginal utility from good C = 1/2(A + 2)6 C ^6
/(B : )5/6 D 5/6 D
Therefore MRS = = and,
/(B:D)5/6 D 5/6 (B : )
8r qql¡l mp rq B ¢
Price ratio = = =6
8r qql¡l mp rq D
D
Thus, ( = 6 or C = 6A + 12
(B:)
Putting value of C in budget constraint, we get : 6A + 6A + 12 = 10

i.e., A = −1/6
Since consumption of a good can’t be in negative, we take the lowest possible
£
value i.e., A = 0 and hence consumer only consumes C = = 10. Thus, the

optimal consumption of A = 0and C = 10, given prices and income.
Q.3. Dinesh is risk averse. His utility function is given as h = $/% ,
where $ is his wealth. Dinesh has ₹ 50,000 in bank deposits and he also
owns a house that is located in an area where a lot of forest fires occur.
If his house burns down, the remains of his house would be worth ₹
40,000 giving his total wealth of ₹ 90,000. If his house does not burn it
will be worth ₹ 2,00,000 and his total wealth will be ₹ 2,50,000. The
probability that his house will burn = 0.01.
(i) Calculate his expected utility if he doesn’t buy fire insurance
(ii) Calculate the certainty equivalent of the lottery he faces if he
doesn’t buy fire insurance.
(iii) Suppose that he can buy insurance at a price of ₹ 1 per ₹ 100 of
insurance. Calculate the amount of insurance that he must buy
to be fully insured and the amount of wealth that he will have
after buying full insurance.
Sol.(i) Expected utility is the sum of utilities over all the possible events. Here
there are two events fire and no fire.
Therefore,
Expected Utility = Probability of Fire × (2,50,000)1/2 + Probability of no. Fire ×
(90,000)1/2
= 0.99(500) + 0.01(300) = 495 + 3 = 498
(ii) Certainty equivalent bundle lies on guaranteed consumption line where
consumption of both the events is equal, therefore let the bundle be given by
(, ).
Certainty equivalent bundle means it has the same expected utility as the
given outcome,
Thus,
498 = 0.01()/ + 0.99 ()/ = ()/ and thus = 2,48,004 which is the
certainty equivalent of lottery he faces if he doesn’t buy fire insurance.
Ecopedia 21
(iii) Let B be the benefit from insurance that Dinesh will receive then
according to question, 1/100B = 0.01B is the premium of insurance.
We know after buying full insurance, wealth in both the events is equal i.e.,
Wealth with fire = Wealth with no fire
Wealth with fire without insurance – Premium + Benefit = Wealth with no Fire
– Premium
90,000 – 0.01B + B = 2,50,000 – 0.01B i.e., B = 1,60,000
Thus, the amount of insurance that he needs to buy to be fully insured is
1,60,000.
And amount of wealth after buying full insurance = wealth with fire or no fire
after full insurance (since they will be equal)
= 2,50,000 – 0.01B = 2,50,000 – 0.01(1,60,000)
= 2,50,000 – 1,600 = 2,48,400.
•••
2012
Q.1. Let u (Q, R) = (%Q, R) and assume that the price of both the
commodities is 1. Derive the income offer curve and Engel curve for
the commodity Q.
Sol. We assume both A and C normal good for both the
consumers. Let income be represented by . Income
offer curve is a line that depicts the optimal choice of
two goods at different levels of income at fixed
prices. Income offer curve for two normal goods is
upward sloping. Since _(A, C) = min(2A, C), we know
that all the optimum point will lie on the diagonal
C = 2A as shown in diagram, thus income offer curve is straight line passing
through origin C = 2A.
Engel curve shows the demand for one good under a set of fixed prices and
changing income. fA _(A , C) = min(2A , C) with respect to budget constraint
A + C = (price of both commodities is 1).We already know at all optimal
point; C must be equal to 2A. Putting this in budget constraint, we get :
A + 2A = i.e., 3A = or A = /3 which is the Engel curve of commodity A.
Q.2. Abdul has utility function defined over food (b) and leisure (§). He
has 80 hours a week to allocate between labour and leisure. The price
of food is 1 per unit and wage per hour is 5. Any wage income above
100 is subject to tax of 50%. What is his budget constraint? Draw his
budget constraint in the (§ , b) plane by specifying the slope of each
segment of the budget constraint and the coordinates of the intercepts.
Sol. Let Abdul spend () hours on leisure and () hours on work. And thus
= 5 if < 20 (i.e., ¨f\© ª«[¬© < 20 × 5 = 100) and putting = 80 −
We get budget constraint as + 5 < 80 × 5 =
400 with slope −5 since price of = 1 and
opportunity cost of = 5.
But if > 20, wage income is greater than 100
and thus income is subject to 50% tax. So =

100 + ( − 20)5 × = 100 + 2.5 − 50 = 50 +

2.5 and putting = 80 − , we get budget
constraint as + 2.5 = 250[(20 × 5) + (60 × 2.5)]
with slope −2.5.
Thus, budget constraint is:
+ 5 = 400, < 20 or > 60
+ 2.5 = 250, > 20 or < 60
(22)
Ecopedia 23
Q.3. Let a production function be represented by (, ) = ® ^® ,

where ® is a constant less than one. Calculate the elasticity of
substitution. What would be the elasticity of substitution if =
¯c (°, ±) where ° and ± are positive constants.
Sol. For a production function = b(², S), the elasticity of substitution (³)
measures the proportionate change in ²/S relative to proportionate change in
the rate of technical substitution (RTS) along an isoquant.
¹
% ¡µimk lm ¶/n u( ) V·¸
i.e., © = = º
.
% ¡µimk lm V·¸ u V·¸ ¶/n
RTS = » /¼

» = ½ ¾^ ^¾ and ¼ = (1 − ½)¾ ¾
¾¼ ¾ ¼
Thus, !¿v = ½¾^ ^¾ /(1 − ½)¾ ^¾ = (^¾) = (^¾) .
»
À À Â À À Â À
u (Á) V·¸ u (Á) . u (Á) .
©= . . .
(5Â) Á (5Â) Á
= Â À = Â À =1
u V·¸ ¼/» u (5Â) . ¼/» u( ) ¼/»
Á (5Â) Á
Thus, elasticity of substitution for a production function Ã(, ) = ¾ ^¾ is

one.
If Ã = min(f, Ä), and are always used in fixed proportions and elasticity of
substitution is zero, because the optimum always lie on the diagonal line since
firm will always produce at the corner of L-shaped isoquant i.e., f = Ä. Hence
¼ i ¼
the ratio = remains fixed and numerator W becomes zero, which leads to
» Å »
© = 0. This is true because and can’t be substituted for each other in case of
fixed proportions i.e., perfect complements.

Q.4. For a production function of the form (, ) = % + , diminishing
marginal productivities of labour and capital constitutes a sufficient
condition for diminishing marginal rate of technical substitution.
Why?
HIÁ
Sol. Marginal Rate of Technical Substitution (MRTS) =
HIÀ
For diminishing marginal rate of technical substitution, !¿v/ < 0

Here, » = 1/2^/ and » = 1/2^/ and ¼ = 1,
Thus, !¿v = 1/2^/ , which is purely a function of .
We know, marginal productivity of labour is diminishing here as
uHIÁ
= −1/4^y/ < 0
u»
ÆHV·¸ uHV·¸ uHIÁ
And = = = −1/4 ^y/ , which is also diminishing.
Æ» u» un
Therefore for this particular function, diminishing marginal productivities of
labour and capital constitutes a sufficient condition for diminishing marginal
rate of technical substitution.
Q.5.(a) Let the production function of a firm be represented by

(, ) = % + /% . Assume that the firm buys and sells at a perfectly
competitive market at price p, w and v.
(i) Derive the firm's short run and long run cost functions.
(ii) What would be the impact of conditional demand for capital of an
increase in?
(iii) By treating output as the choice variable of the firm, derive its
profit function by using its cost function obtained in part (i). Show
that it is homogeneous of degree 1 in , and Ç.
Sol.(i) In short run, one of the input can’t be altered and hence is kept
constant, here let capital be constant in short run at = ′
Therefore,
5 5
Ã − ′6 = 6
5
i.e., = (Ã − ′6 )
Let cost function be represented by = + È
5
In short run, it will be = (Ã − ′6 ) + È′
For long run cost function, we minimize cost constrained by production function
using Lagrangian and equate the derivatives to zero.
5 5
⇒ = + È + λ(Ã − ′6 − 6 )
ÆH
= 5/6 = 0
λ
⇒
Æ» »
⇒ / = È − =0
λ
¼ 5/6
5 5
Æ»
⇒ = Ã − ′ − = 06 6
Æλ
Dividing the first two equation gives,
¼ 5/6 ¼ 5/6
⇒ /È =
λ
. =
» 5/6 λ » 5/6
or
⇒ = (/È)
Putting in production function obtained by third derivative gives:
5 5
:É É6
g = / + 6 = 6 or = Ã
É É (É:)6
Putting back in , we get

È
= Ã = Ã
È (È + ) (È + )
É6 6
Therefore long run cost function = + È = Ã (É:)6 + ÈÃ (É:)6 =
É É
Ã (É:)6 ( + È) = Ã (É:)
Ecopedia 25
(ii)Conditional demand function of (Ã, È, ) demand of as a function of the

output level (Ã) and the input costs (È, ). This means that the function is
conditional on a given level of output.
6
Conditional demand function of = Ã
(É:)6
Ê 6 (É:)6 ^Ê 6 6 (É:)
= / (É:)Ë
ÌÊ 6 (É:) Í(É:^) Ê 6 É
= (É:)Ë
= (É:)
>0
This means, as wages increase, more capital is employed (due to the fact that
labour is costly now)
(iii) Let profit function be Î = ¿! − ¿,
Where ¿! is total revenue = ÏÃ and ¿ is total cost as calculated in part (i)
É
(Ã) = ÏÃ − Ã
Profit function with output as choice variable is Î(Ã
É:
Now to show that profit function is homogenous of degree 1 in Ï,
and È, we need to show that
Ð(λÏ, λ, λÈ) = λÎ(Ï(Ï, , È)
λλÈ
Ð(λÏ, λ, λÈ) = λÏÃ − Ã
λ(È + )
È
= λÏÃ − λÃ = λÎ(Ï Ï, , È)
(È + )
Thus, profit function is homogenous of degree 1 in Ï,Ï
and È.
(b) Consider consumption in two possible states of the world-
world a
booming stock market and a plummeting stock market. Use a diagram
to explain that for a risk lover, certainty equivalent exceeds the
expected level of consumption and that the risk premium is negative.
nega
Explain the terms used.
Sol. The certainty equivalent of a risky bundle is the guaranteed amount of
consumption that will make an individual equally well off as with risky bundle.
Expected consumption equal the consumption
consumer will obtain on average considering every
possible event and its probability.
Risk premium is the minimum amount of money by
which the expected return on a risky asset must
exceed the known return on a risk-free free asset in
order to induce an individual to hold the risky asset
rather than the risk-free
free asset. It is the minimum
willingness to accept compensation for the risk. It is
the difference between expected consumption and
certainty equivalent.
For a risk loving person, his utility function is convex curve which represents
increasing marginal utility of income. Let there be a 50-50 chance of winning:
getting income $150 and utility U (150) represented by point A or losing:
getting income $50 and utility Y (50) represented by point B. Now, taking
weighted averages of the 150 and 50, where probabilities are being used as
weights so we get level of expected consumption (income) = 100 and expected
utility EU (100) represented by point C. Thus, this point lies on the straight
line that connects points A and B.
Now we take a point with same level of expected consumption but no risk
represented by point D. It has the same horizontal coordinate as C but since
utility function is bowed inward, D’s vertical coordinate is smaller than C
(representing risk lover person likes the risky bundle more). Now to calculate
certainty equivalent, we need a point with same utility as point C represented
by point E, and its horizontal coordinate gives the certainty equivalent.
As seen in figure, horizontal coordinate of E is greater than C, and thus
certainty equivalent exceeds the expected level of consumption. And the
difference between them is negative which is nothing but the risk premium.
The risk premium is the difference between the certain income of $118 and the
risky income of $100. This risk loving person is willing to pay up to $18 in order
to engage in the 50-50 wager of winning or losing $50. Or in other terms this
risk loving person would need to be paid $18 not to engage in the wager.
Q.6. Show that the cost function is concave in input prices for any
level of output.
Sol. To demonstrate concavity let (, È) and ( K , È K ) be two cost minimizing
price factor combinations and let " = + (1 − )′ for any
0 < < 1. Concavity implies that (" C) > (, C) + (1 − ) (′, C). We can
prove this by a diagram. Given figure shows total costs for various values of an
input price, say , holding Ã and È constant.
Suppose that initially a wage rate of w’
prevails. If the firm did not change its input
mix in response to changes in wages to w,
then its total cost curve would be linear as
reflected by the straight line in the figure
called pseudo cost line = È + Z. But a cost-
minimizing firm probably would change the
input mix it uses to produce Ã when wages
change, and these actual costs (È, , Ã )
would fall below the “pseudo” costs. Hence, the total cost function must have
the concave shape shown in figure. Costs are higher along this line than along
the cost function because we are not adjusting inputs. Along the cost function,
as the price of input Ñ increase, we probably use less of input Ñ and more of other
inputs.
This means costs will be lower when a firm faces input prices that fluctuate
around a given level than when they remain constant at that level. With
Ecopedia 27
fluctuating input prices, the firm can adapt its input mix to take advantage of
such fluctuations by using a lot of, say, labor when its price is low and
economizing on that input when its price is high.
•••
2012
PART-A
Q.1.(a) Consider the following binary relations defined over Ò where Ò
is the set of human beings:
(i) At least as tall as
(ii) Taller than
(iii) Is the sister of
Check if each of these relations satisfies reflexivity, completeness and
transitivity.
Sol. Reflexive. If a bundle is as good as itself then it follows axiom of
reflexiveness.
compared. Assume two bundles 1 and 2; both comprising of goods A and goods
C.
(a) Either (A , C ) would be preferred over (A , C ) ∶ (A , C ) > (A , C )
(b) Or (A , C ) would be preferred over (A , C ) ∶ (A , C ) > (A , C )
(c) Or both, which means that consumer is indifferent between two
bundles.
Transitivity. If bundle 1 is preferred over bundle 2 and bundle 2 is preferred
over bundle 3, then by axiom of transitivity bundle 1 should be preferred over
bundle 3.
Assume three individuals - A, B, C.
(i) At least as tall as. Given relation satisfies all reflexivity, completeness and
transitivity. A could be taller than, shorter than or of same height as of, B. A is
at least as tall as B could be used in first & third instance or B is at least as tall
as A can be used is second & third instance. Since, this relation helps is
comparing A & B every time, this relation is complete.
• A is at least as tall as A also makes sense hence this relation is
reflexive.
• If A is at least as tall as B, & B is at least as tall as C then A is at least
as tall as C. Even if three would of same height this statement would
still hold. Hence, this relation is transitive.
(ii) Taller than. Given relation satisfies only transitivity.
• A could be taller than, shorter than or of same height as of B. This
relation is not complete since in third case of same height this relation
can’t be used.
• It is not reflexive since A can’t be taller than him/herself.
(28)
Ecopedia 29
• If A is taller than B & B is taller than C then it follows that A is taller

than C. So this relation is transitive.
(iii) Is the sister of: Given relation satisfies only transitivity.
• A could be sister, brother or none of the two of B. This relation is not
complete since all cases can’t be covered.
• It is not reflexive since A can’t be sister of him/herself.
• If A is sister of B & B is sister of C then it follows that A is sister of C.
So this relation is transitive.
(b) Ajay likes oats (Q) and fruit juice (R) and has concave preferences
between them. Price per kilogram of oats is Q and price per liter of
fruit juice is R . His monthly budget for the two commodities is X.
(i) Draw his indifference map and comment on the behavior of the
marginal rate of substitution between oats and fruit juice
(XYÔQR ) as he increases his consumption of oats. Indicate the
possible optimum choices for Ajay in a representative diagram.
(ii) Specifically, if Ajay’s utility function is # = b(Q, R) = Q% + QR +
R% , Q = , R = and X = 1,000, find his optimum
consumption choice.
Sol.(i) If Ajay’s preferences are concave between
fruit juice and oats then his indifference curves
will be bowed towards origin or concave as shown
in given figure, the consumer will buy and
consume only one good.
Marginal rate of substitution (MRS) is
the rate at which a consumer is ready to give up
one good in exchange for another good while
maintaining the same level of utility. Usually
MRS is diminishing but since here Ajay has concave preferences MRS will
increase. That is, as he increases his consumption of oats, the marginal rate of
substitution between oats and fruit juice will increase – he will be willing to
give up more and more of fruit juice to consume more oats and vice versa.
Optimal choices occur where we reach the highest indifference curve that can
be attained within our budget In case of concave preference, utility maximizing
bundle will be located where the indifference curve and the budget line meet
one of the axes—at a corner and hence they are called corner solutions.
(ii) We know that it will be a corner solution since utility function is concave.
To find the optimum solution, we will just see at which of the two corner points
Ajay gets a higher utility i.e., he reaches the highest .
Corner points are (0, 1,000/80) i.e., (0, 12.5) and (1,000/100, 0) i.e., (10, 0)
Now, 7(0, 12.5) = 0 + 0 (12.5) + 12.52 = 156.25
And 7(10, 0) = 102 + 10 (0) + 0 = 100
Since first point provides higher utility to Ajay, optimum consumption choice is
(0, 12.5).
(c) Using a revealed preference argument, show that the change in
demand for a commodity due to substitution effect is always non-
positive. Does this also hold true for non-convex preferences?
Sol. The substitution effect is always negative
for all goods. When the relative price of a good
increases, consumers substitute away from that
good until they reach a new optimal trade-off
between the price ratio and the marginal rate
of substitution and similarly when price of a
good decreases, a consumer will substitute that
good for the other costlier good. To prove that
substitution effect is always negative consider
the given figure. Say price of good falls, as a
result budget line rotates toward right from GH to GH”. We draw a line K ′
parallel to ′′ to show substitution effect (keeping income constant). Now
where will the consumer remain on the compensated budget line K K ? All the
points on the line K ′ left to the initial equilibrium point . These bundles
were all affordable at old prices but were not purchased. Instead the bundle at
was purchased. So the bundle at is preferred to all the bundles that lies
inside the original budget line . And thus by revealed preference theory, he
cannot go to the left of on line K ′ as well and hence the optimal bundle
must be either at E1 or some point to the right of . All points to the right of
on the line K ′ involves consuming at least as much of good X as originally.
Here we get the optimal bundle at point which certainly involves consuming
more of good than at the original equilibrium . Therefore the substitution
effect always moves opposite to the price movement. So we say that the
Substitution effect is always negative.
No, it does not hold true for non-convex preferences.
Q.2.(a) “If an individual consumes two goods Ò and Õ that are perfect
substitutes, the change in demand for Ò as its price changes, is entirely
due to the substitution effect.” Is this always the case? Substantiate
with suitable exposition.
Sol. Usually, in case of perfect substitutes, change
in demand of as its price changes is entirely due to
substitution effect. When goods are perfect
substitutes, the indifference curves are straight lines
and the optimum solution is possible only at the
corner.
Say initially (B , D , ) = (2, 1, 10), so that maximum
£ £
= = 5 and = = 10 as shown by budget line E with slope = −1/2. Now

say utility function is given by 7(, ) = + , so that Ö are straight lines
Ecopedia 31
with slope = −1 as shown in figure. So, optimum consumption point is E i.e., he

consumes only because consumer can reach highest at E.
£
Now say price of falls to ½, so that maximum = = 20 while = 10 (same
£.
as before). Now new budget line is E with slope = 2, since higher can be
attained at axis i.e., point , consumer will consume only now. This is
entirely due to substitution effect.
But this is not always the case, say price of falls only
£
to 1.5, so that maximum = = 6.67 while = 10
.
(same as before). Now new budget line is E" with
slope= 0.67, since higher is still being attained at
axis i.e. point E, consumer will still consume only .
Now, according to substitution effect, demand of
should increase when its price falls. Since change in
= 0 here even if its prices fall, there is no substitution effect, and hence given
statement is incorrect.
(b) Sheela and her family consume wheat flour and sugar. Six years
back, price per kg of wheat flour was 14, while price per kg of sugar
was 20. Sheela purchased 10 kg of wheat flour and 7.5kg of sugar.
Current prices of the wheat flour and sugar have risen to 20 and 35
per kg respectively. Sheela’s preferences have not changed though her
budget set increased to 500. Is she better off or worse off now?
Explain.
Sol. Since Sheela optimized earlier at flour ( ) = 10kg and sugar (v) = 7.5kg,
she must have exhausted her entire income assuming she is rational. Thus
earlier she had an income of (14 × 10) + (20 × 7.5) = 140 + 150 = 290. Her new
income is 500 which is higher but prices have also increased.
If she purchased original bundle at new prices, she
would spend 20 × 10 + 35 × 7.5 = 462.5 < 500, so she
will still be left will some income to purchase more
goods and hence she is better off now as she will be
able to reach a higher indifference curve.
This can also be shown through diagram, her old
budget line E was 14 + 20v = 290.
And new budget line " is 20 + 35v = 500.
On solving the two equations, we get their intersection point = 1.67 and v =
13.33.
As shown in diagram, initial consumption bundle represented by point E lies
below the new budget line ", hence original bundle is affordable with new
budget and hence she is better off.
(c) Assume that a store offers two schemes of discount on purchase of
cashew (Ò) during the festival season:
(i) Buy one get one free offer. When a consumer buys the first kg at
price = Q per kg, he gets the second kg of cashew free.
Thereafter, cashew is purchased at a price = Q per kg.
(ii) Cash back offer. When a consumer buys the first kg at price ,
he gets back cash = Q . Thereafter, cashew is purchased at a
price = Q per kg.
Draw the budget set for consumer with money income under the two
discount schemes on offer. If a consumer likes cashew and always buys
some during the festival season, which discount scheme is likely to be
more beneficial for him? Explain with the help of a representative
diagram.
Sol. Let good be money spent on all other goods so that D = 1.
Thus, budget line of consumer with income is B + =
Scheme 1: Buy One Get One Free
Say his earlier budget line was the line ", but when
he gets scheme 1, after he buys the 1st unit, he gets
the 2nd unit free, hence the budget line will be flat
between unit 1 and 2 since price is zero and budget
line shifts after the link to point . This happens
because earlier maximum units of cashews that could
be bought were /B but now he can buy 1 + /B
units and hence the shift.
Scheme 2: Cash Back Offer
Say, his initial budget line was dotted line from E, if
he gets scheme 2, after buying 1st unit of he will get
cash back of B , thus his income which would have
been reduced to − B , returns to and thus we get
a shift to line , so our new budget set will be E"
and then . As in the previous case, earlier
maximum units of cashews that could be bought were
/B but now he can buy 1 + /B units and hence the shift.
The increase in maximum number of units of cashews that can be bought in two
schemes is same, but in scheme 2 we have a larger budget set, because with the
cash back, the consumer can either buy one more unit of cashews () or more
good as opposed in scheme 1, where he will necessarily get only 1 more unit of
. Since he has a greater set of possible consumption bundles under this
scheme, he will be better off with scheme 2.
Q.3. Varun lives in a small city with only one bank that provides the
facilities of borrowing and lending at an interest rate of 6% per annum.
Varun has a job that ensures an income of 1,04,000 this year and
1,06,000 the next year. His utility function over the two years is
# = b($ , $ ) = $ $ , where £ and represents the value of
Ecopedia 33
consumption in the current and next year respectively. Assume that

prices do not change over the two year period.
(i) Draw the inter-temporal budget line that he faces and
determine his optimum consumption bundle ($∗ , $∗ ). Does he
lend or borrow in the current period?
(ii) After the government announced a deregulation of the savings
bank deposit rate, the bank now provides the facilities of
borrowing and lending at a higher interest rate. Depict and
explain with the help of a representative diagram how this
increase in the interest rate affects Varun’s choice of being a
borrower or lender, and how does his welfare change.
(iii) Suppose the bank now decides to give an interest of 8% per
annum on deposits and charge an interest rate of 10% per
annum for borrowers. Draw Varun’s inter-temporal budget
line. Find his optimum consumption mix ($K , $K ). Compare ($K ,
$K ) and ($∗ , $∗ ) in terms of welfare implication.
Sol.(i) Equation of inter-temporal budget line is:
£ + / (1 + ) = £ + /(1 + )
According to question, it becomes
£ + /1.06 = 1,04,000 +(1,06,000)/ 1.06 =
2,04,000 with slope = 1 + = 1.06
Now, utility function is 7 = (£ , ) = £
which is convex to origin and hence it will be an
interior solution. ¨ is the endowment point in
diagram.
At equilibrium, Marginal rate of substitution
(MRS) = Price ratio
Hijklmin oplnlpD qjrs ¡rm×sØplrm lm Ø jlru 85
!v = =
Hijklmin plnlpD qjrs ¡rm×sØplrm lm Ø jlru 8
85
And price ratio = 1 + /1 = 1.06 =
8
This means, = 1.06£. Putting this in inter-temporal budget constraint, we

get;
8 :(.£¢8 )
= 2,04,000
.£¢
i.e., 2£ = 2,04,000
i.e., £∗ = 1,02,000
And thus ∗ = 1,08,120 as shown in diagram. His optimum consumption bundle
(£∗ , ∗ ) = (1,02,000; 1,08,120)
Since, £∗ < £ , Varun lends in the current period.
(ii) Initially Varun is a lender and now the rate of interest is increased. This
increase in interest rate will make the budget line steeper. The new budget line
will pivot around point ¨ because ¨ i.e., endowment will always be available
to him. Initially he was in equilibrium at A (to the left of W because he is a

lender).
consumption becomes relatively more
expensive thus he will tend to substitute
away from current consumption, known as
the substitution effect. However, since
present and future consumption are both
normal goods, an increase in the interest rate
will increase relative income leading to what
is known as the income effect. For a net-
saver this increase in relative income will
thus induce him to "buy" more current
consumption.
From the figure we can see that after the increase in the interest rate, the
portion of the new budget line to the right of the endowment point W is lying
available to Varun but were not preferred by him in the beginning. So according
to the Revealed Preference Hypothesis in this new situation he cannot prefer
these points. Thus he can only choose a point to the left of W on the new budget
line for e.g. B, and thus will remain a lender. Also, any optimal point to the left
of W will lie on a higher indifference curve (e.g. B) and hence, Varun’s welfare
is increased.
(iii) Since now there are different rates for borrowing and lending, there will be
kink in our budget line representing the two different rates. If Varun chooses a
point to right of ¨, he will be borrower and hence ¨E represents borrowing
rate of 10% and similarly If Varun chooses a point to left of W, he will be lender
and hence ¨ represents lending rate of 8% (and hence flatter).
If Varun decides to be a borrower, his inter-temporal budget constraint will be:
C0 + C1 / 1.1 = 1, 04,000 + (1,06,000)/ 1.1 = 2,00,363.636 with slope = 1+r = 1.1
At equilibrium, Marginal rate of substitution (MRS) = Price ratio i.e. 1.1 = C1 /
C0
This means, C1 = 1.1 C0. Putting this in
inter-temporal budget constraint, we
get:
C0 + (1.1 C0) / 1.1 = 2,00,363.636 i.e., 2
C0 = 2,00,363.636 i.e., C0 = 1,00,181.818.
And thus C1 = 1,10,200. Since C0 < M0,
he cannot be a borrower and hence this
case is not possible
If Varun decides to be a lender, his
inter-temporal budget constraint will
be:
Ecopedia 35
C0 + C1 / 1.08 = 1,04,000 + (1,06,000)/1.08 = 2,02,148.148 with slope = 1+r = 1.08

At equilibrium, Marginal rate of substitution (MRS) = Price ratio i.e., 1.08 = C1 /
C0
This means, C1 = 1.08 C0. Putting this in inter-temporal budget constraint, we
get:
C0 + (1.08 C0) / 1.08 = 2,02,148.148 i.e., 2 C0 = 2,02,148.148 i.e., C0 =
1,01,074.074
And thus C1 = 1,09,160 as shown by point E in diagram.
Since C0 < M0, Varun can be a lender and his optimum consumption mix (C0’,
C1’) = (1,01,074.074; 1,09,160)
Comparing (C0’, C1’) and (C0*, C1*) in terms of utility:
U (C0’, C1’) = U (1,01,074.074; 1,09,160) = 11,033, 245,917.84
U (C0*, C1*) = U (1,02,000; 1,08,120) = 11,028, 240,000
Since U (C0’, C1’) > U (C0*, C1*), Varun is better off now being a lender at 8%
interest rate with optimum consumption bundle (C0’, C1’).
Q.4. (a) What do you mean by an actuarially fair insurance policy? How
is the practice of Hedging used as a strategy for managing risk?
Explain how ‘insurance’ is a form of hedging?
Sol.(a) For insurance policy to be actuarially fair, its net expected payoff must
be zero. In other words for insurance to be actuarially fair, the premium rate
must equal the probability of an accident.
• For e.g.: If a person with a current wealth of $ 100,000 faces a 25%
chance of losing his automobile worth $ 20,000, then in this situation a
fair insurance premium would be $ 5,000 (25% of $ 20,000)
From a consumer's point of view, insurance is actuarially fair if the premiums
paid are equal to the expected value of the compensation received where
expected value is the probability of the insured-against event occurring
multiplied by the compensation received in the event of a loss.
Hedging is the practice of taking two activities with negatively correlated
financial payoffs, where negatively correlated activities mean they tend to move
in opposite directions. Hedging has many techniques but, mainly, involves
taking opposite positions in two different markets (e.g., Cash and futures
markets), so that they don’t lose everything in case they invested in only one
market.
Insurance is a form of hedging. Many people buy insurance to hedge against
risks such as the risk of property damage, risk of fire, the risk of theft, etc.
When a person buys the insurance, it pays a premium to shift the risks to the
insurance company. In other words, benefit received in case of loss is perfectly
negatively related with the possibility of loss not occurring, thus by taking
insurance a person manages risk through hedging.
(b) A farmer who grows corn expects a good harvest under normal
conditions resulting in consumption CN worth 25, 600. There is
however a 25% possibility of pest attacks in which case consumption
drop to CA worth 6,400. His utility function is # = C1/2, where $
denotes the value of consumption.
(i) Compute the farmer’s expected consumption, expected utility, the
certainty equivalent and the risk premium of the risky outcome.
(ii) If an insurance company offers crop insurance at a price of 40 for
every 100 worth of insurance, what will be the farmer’s demand for
insurance? Does he buy full/partial/no insurance? Explain.
(b)(i) Expected Consumption (EC) equal the outcome we will obtain on average
considering consumption in every possible event and its probability. There are
two events here pest attack (A) and no pest attack (N), with their probability
0.25 and 0.75 respectively. Therefore expected consumption = A.P (A) + N.P (N)
= 6,400 (0.25) + 25,600 (0.75) = 1,600 + 19,200 = 20,800
Similarly, expected utility equal the outcome we will obtain on average
considering utility obtained in every possible event and its probability. Utility
from the given outcome is given by E (u) = E (C1/2) = √6,400 × 0.25 + d25,600 ×
0.75 = 80 × 0.25 + 160 × 0.75 = 20 + 120 = 140
The Certainty Equivalent (CE) of any outcome is that amount of money, offered
for certain, which gives the consumer exactly the same utility as the outcome.
For certainty equivalent, we need consumption level that gives same utility as
(_) = 140 i.e., √C = 140 or = 19,600. Therefore, = 19,600 i.e., insurance
must give 19,600 whether there is fire or no fire to make the economic agent
indifferent.
Risk premium of a risky outcome is the maximum amount that a person is
willing to pay to remove the risk associated with outcome. Since a risk averse
person does not want risk, in this case risk premium is positive. Thus risk
premium of any risky outcome is the difference between the expected value of
the outcome and its certainty equivalent, i.e.,: − = 20,800 – 19,600 =
1,200.
(ii) If an insurance company offers crop insurance at a price of 40 for every
100 worth of insurance, this means premium rate is 40/100 = 0.4 = R. Let B be
the benefit from insurance that the farmer will receive then according to
question, 40/100B = 0.4B is the premium of insurance.
Since premium rate (0.4) > probability of loss (0.25), the given insurance policy
is actuarially unfair.
If he increases B by 1, his consumption falls by R if pest attack does not
happen and rises by (1−R) if pest attack happens. Therefore, by purchasing
insurance, he can obtain on a straight line through point A (initial bundle) with
a slope of – (1−R) / R = −0.6/0.4 = −1.5.
Ecopedia 37
Therefore his budget line is AD with slope −1.5,

where D is point reached if he takes full
insurance.
We know that slope of expected constant
consumption line is – 0.75/0.25 = −3, so it’s
steeper than the budget line and indifference
curve that is tangent to this line at D cannot be
tangent to line AD as well. Therefore he cannot
buy full insurance.
The Von Neumann Morgenstern utility function associated with question is U =
0.25 CA½ + 0.75 CN ½
At equilibrium, MRS = Slope of budget line i.e., (dU/dCN ) / (dU/dCA ) = –
(1−R)/R
This means, 0.75 CA ½ / 0.25 CN ½ = 1.5 i.e., 3 CA ½ / CN ½ = 1.5 or CA ½ / CN ½ =½
i.e., CA /CN = ¼
Thus, CN = 4CA, putting this in budget constraint we get
CA – 6,400 = −1.5(CN – 25,600) i.e., CA – 6,400 = −1.5(4CA – 25,600) or CA – 6,400
= −6CA + 38,400
Which means, 7CA = 44,800 or CA = 6,400 and thus CN = 25,600, which is the
same bundle as earlier, thus he maximizes at point A itself and will not take
any insurance.
PART-B
Q.5.(a) Does declining marginal productivity of inputs guarantee

diminishing marginal rate of technical substitution? Explain. Which of
the following production functions depict diminishing marginal rate of
technical substitution between the two inputs labour (S) and capital
(²)?
(i) = ².% S.
(ii) = %² + S
Sol. Marginal Rate of technical substitution (MRTS) is the rate at which labor
can be substituted for capital while holding output constant along an isoquant.
MRTS (Z for ) = −W/WZ = » / ¼
No, declining marginal productivity () of inputs does not alone guarantee
diminishing marginal rate of technical substitution. Assume Ã = (Z, ) and
that ¼ and » are positive and ¼¶ and »» are negative (so that of inputs in
diminishing). To show that MRTS is diminishing, we have to prove W!¿v/
WZ < 0.
qÁ
W!¿v W qÀ
u¼ u¼
¼ »» + »¼ . − » ¼» + ¼¼ .
= = un un
WZ WZ (¼ )
u¼ qÁ
We know, = − and »¼ = ¼» (using Young’s theorem)
un qÀ
We get,
W!¿v
= { »» – 2¼ » ¼» + ¼¼ } / ()y
WZ
Because ¼ > 0 (by assumption), the denominator is positive. Also ¼¼ and »»
are negative; therefore numerator will be definitely negative if ¼» is positive. In
case ¼» is negative and large such that numerator becomes positive, MRTS will
be increasing even if MPs are declining. Thus only declining marginal
productivity (MP) of inputs might not result into diminishing marginal rate of
technical substitution due to presence of ¼» .
(i) g = 100 £. Z £.Ü
!¿v = » / ¼ = −W/WZ
» = .8 (100 £. ^£. )
Z and ¼ = 0.2(100 ^£.Ü Z £.Ü )
Therefore,
!¿v = [.8 (100 £. Z ^£. ) / 0.2(100 ^£.Ü Z £.Ü )] = 4/Z
We know, !¿v = − W/WZ, thus to show that MRTS is diminishing, we must
show W!¿v/WZ must be negative or W2 /WZ2 must be positive W / WZ = −4/Z
n u¶ ¶
W − 4 4Z − − 4
= − un
= n
WZ Z Z
−16 − 4 20
=− = >0
Z Z
Hence, MRTS is diminishing.
(ii) 20 + 5Z
!¿v = −» /¼
» = 5 and ¼ = 20. Therefore, MRTS = −5/20 = −1/4 = W/WZ
And thus W /WZ = 0, as W/WZ or MRTS is constant i.e., neither diminishing
nor increasing.
(b) Given the production function = b(², S) = ²S ( − ²S), with
b > 0, b > 0 for all S > 0 and ² > 0, determine the range of positive
values of ² and S over which
(i) marginal productivities of S and ² are diminishing and
(ii) cross productivity effect is positive.
Sol. Marginal productivity of Z = » = Wg/WZ = Z (−) + (800 − Z) =
− Z + 800 – Z = 800 − 3 Z
Given » > 0, we get 800 − 3 Z > 0 i.e., 800 > 3Z( > 0 i.e. can’t be 0)
or Z < 800/3
Similarly, Marginal productivity of = ¼ = Wg/W = Z (−Z) + (800 −
Z) Z = −Z + 800Z – Z = 800Z − 3Z
Ecopedia 39
Given ¼ > 0, we get 800Z − 3Z > 0 i.e., 800 > 3Z (Z > 0 i.e. Z can’t be 0)

or Z < 800/3
(i) For Marginal productivity of Z to be diminishing, W g/WZ should be negative.
W g/WZ = − 3 < 0 i.e., 3 > 0 or > 0
Similarly, for Marginal productivity of to be diminishing W g/W should be
negative.
W g/W = − 3Z < 0 i.e., 3Z > 0 or Z > 0
Thus, for Z < 800/3 such that Z > 0 and > 0, productivities of Z and are
diminishing.
(ii) Cross productivity effect being positive means W(» )/W > 0 and W(¼ )/
WZ > 0
W(» )/W = 800 − 6Z > 0 i.e., 800 > 6Z or Z < 800/6
And W(¼ )/WZ = – 6Z > 0 i.e. 800 > 6Z or Z < 800/6
Thus for Z < 800/6 such that Z > 0 and > 0, cross productivity effect is
positive.
(c) A firm’s long run cost function is $ = b( ) = Ý − % + %Þ ,
where is output produced by the firm per period. Find the firm’s
minimum efficient scale (MES) of production. Find the average cost
and marginal cost of production at the MES of production.
Sol. Minimum efficient scale (MES) is the lowest production point at which
long-run average costs (LRAC) are minimized.
!E = /g = g − 100g + 2700
Minimizing Yß$ ∶ W(!E)/Wg = 2g – 100
Putting it equal to zero, we get 2g – 100 = 0 i.e., g = 50
For !E to be minimum at g = 50, W (!E)/Wg must be positive
W (!E)/Wg = 2 > 0, thus !E is minimum at g = 50 and therefore v is
g ∗ = 50.
Average cost at v = !E(50) = 50 − 100(50) + 2,700
= 2,500 − 5,000 + 2,700 = 200
Marginal cost of production (MC) = W/Wg = 3g − 200g + 2,700
Marginal cost at MES = (50) = 3(50) − 200(50) + 2,700
= 7,500 − 10,000 + 2,700 = 200
We know, AC = MC at MES, which is true in this case AC(50) = MC (50) = 200
Q.6.(a) A firm’s production technology is given by = b (S/²) =
¯c(S, %²) where S and ² are measures of labour and capital input. Price
of one unit of S and ² are denoted by ‘’ and ‘Ç’ respectively.
(i) If = Ç = , find the equation of the firm’s long run expansion
path, conditional input demand function and the cost function.
(ii) If the price of l becomes 1.5 times that of k, find the equation of
the firm’s long run expansion path, the conditional input
demand functions and the cost function.
Sol.(i) A firm’s long run expansion path shows the equilibrium input
combination for every level of fixed output.
When production technology is given by Ã = min(Z, 2), each equilibrium
combination of inputs lie on the diagonal where vertex of each L-shaped
isoquant lies i.e., Z = 2. Thus firm’s long run expansion path will be Z = 2.
Conditional input demand function is the cost-minimizing level of an input
which is required to produce a given level of output for given unit costs of the
input factors. Here, = È = 1.
Say, firm wants to produce q’ level of output at = È = 1.
We know Ã’ = Z = 2.
Thus, conditional input demand functions are Z = Ã’ and
= Ã’/2
Assuming cost function to be = Z + È i.e., Z + = Ã’ +
Ã’/2 = 3Ã’/2, which is a linear cost function.
(ii) If the price of Z becomes 1.5 times that of , this means = 1.5È. Long run
expansion path of the firm remains same because here optimal input
combination does not depend on input prices, it will always be Z = 2. Thus
firm’s long run expansion path remains Z = 2.
Similarly, conditional input demand functions remain same as Z = Ã’ and
= Ã’/2 because Ã’ = Z = 2 if we want to produce Ã’ even when = 1.5È
Cost function will change due to change in input costs.
= Z + È = 1.5ÈZ + È = 1.5ÈÃ’ + ÈÃ’/2 = 2ÈÃ’, which is also a linear cost
function.
(b) Draw and briefly explain the shape of total, average and marginal
cost curves of a firm facing constant input prices and has a production
function depicting
(i) Constant Returns to Scale and
(ii) Increasing Returns to Scale.
Sol. Total cost (TC) function shows the minimum total cost incurred by firm to
produce any level of output at any set of input costs. It is represented by
= (È, , Ã), where v is cost of capital input, is cost of labour input and Ã is
the level of output to be produced.
Average cost (AC) function shows the total cost per unit of output i.e.
(È, , Ã)
E(È, , Ã) =
Ã
Marginal cost (MC) function shows change in TC for a unit change in output
produced i.e..
Ecopedia 41
δ (È, , Ã)
(È, , Ã) =
δÃ
(i) Constant Returns to Scale. If output increases by same proportional
change as the change in all inputs then there are constant returns to scale.
Say we have solved the cost minimization problem for 1
unit of output, which gives (È; ; 1). Given this, under
CRS, we can produce C units of output by using C times as
much of every input. It must be the cheapest way to
produce C units of output; otherwise, the production of each
individual unit was not done using the cost-minimizing
method. Thus, the minimal cost to produce y units of output is (È; ; 1)C
So, the cost function is linear in output, i.e., it equals a specific number
multiplied by output, and that number is (È; ; 1) i.e., (C) = (È; ; 1)C.
The total cost curve of a firm will be a positively sloped straight line through
the origin as in diagram.
Now, E(C) = (È; ; C)/C. Since the technology has CRS, then (È; ; C) =
(È; ; 1)C. This means E(C) = (È; ; 1)C/C = (È; ; 1), which is a
constant.
Similarly, due to CRS: (È, , C)
δ8 (É,,D) δ8 (É,,) D
= = = (È, , 1) which is same as AC
δD δD
In this case, average cost and marginal cost are equal and constant for output
levels and thus will be straight lines parallel to x-axis.
(ii) Increasing Returns to Scale. If output increases
by more than the proportional change as the change in all
inputs then there are increasing returns to scale.
We again calculate the minimum cost of producing one
unit say (È; ; 1). Now, we know that multiplying all
inputs by C will produce more than C units of output due
to IRS; so, to produce C units, we must add less inputs,
and that means that costs to produce C units must
increase less than one-for-one with output C. This means
costs increase at a decreasing rate and thus will be
concave.
Since the total cost increases at decreasing rate, both AC
and MC declines. Since AC is falling, it can happen only
when < E, and thus AC and MC are downward sloping as shown in figure
with MC curve below AC curve.
(c) State the condition for profit maximization by a firm operating
under perfect competition. What is the relevance of returns to scale to
the profit-maximizing model?
Sol. Profit () = Total Revenue (!) – Total Costs (). Therefore, and thus profit
maximization occurs at the biggest gap between Total revenue and total costs.
A firm maximize profits where Marginal revenue (MR) = Marginal cost (MC)
uI uV u8
i.e., = − = 0.
uâ uâ uâ
Hence first order condition for maximization is

W!/Wg = W/Wg which gives optimal output g ∗ .
But this is only a necessary condition. For sufficiency,
second order condition must also be satisfied which is
W /Wg |g ∗ < 0. This means marginal profit must
decrease at optimal level g∗ i.e. for g < g∗ , profit
must increase and for g > g ∗ , profits must decrease.
We know, marginal profit decreasing in gmeans
marginal cost increasing in g.
For a perfectly competitively firm, MR = price = a
constant because they are price takers.
So for a perfectly competitive firm, profit maximizing conditions are:
(i) MC = Price (ii) MC is rising after optimal level of output
Thus even though MR = MC at point L in diagram, it is not profit maximizing
level of output because MC decreases after that level not increase. Instead,
point J is profit maximizing level of output because both conditions are being
satisfied: (i) MC = Price (ii) Marginal cost decreases after this level of output.
Marginal revenue increases or marginal cost decreases only when there are
increasing costs or decreasing returns to scale. And thus for a profit maximizing
model, decreasing returns to scale are required.
Q.7.(a) ‘Input demand functions are unambiguously downward
sloping’. Explain in terms of the substitution and output effects using
the graphical approach.
Sol.(a) Let us take ‘labour’ (Z) as the input for our analysis here. Thus to show
that it is unambiguously downward sloping, δZ/δ, where is wage rate should
be negative at all times.
We get the unconditional labour input demand function: Z = Z(, È, ), where
is price of output and È is rental cost of capital (); through profit
maximization. Suppose falls, there will be two effects on labour when this
happens: substitution effect and output effect.
Substitution effect. When falls and output (Ã)
is fixed at say Ã ∗ , firm will try to substitute Z for
because it is comparatively cheaper now which is
shown in figure 1. Since minimizing cost of
production of Ã ∗ requires Rate of technical
Substitution (RTS) = /È, a fall in will
necessitate a movement from input combination A
to B i.e., since /È falls, RTS must also be less at
optimum. And because isoquants exhibit a
diminishing RTS, it is clear from figure that
Ecopedia 43
substitution effect must be negative. This means a fall in w will increase the
labour if output is held constant due to substitution effect.
Output effect. In reality although output is not held
constant, so we consider output effect (change in Ã) to
reach the final optimum. As long as firm has demand for
its output, it can produce any quantity it wants depending
on its profit maximizing decision. When falls, firm’s
expansion path will change due to change in relative input
costs. Thus, all the firm’s cost curves will shift and some
output level other than Ã ∗ might be chosen. As shown in figure, a fall in most
probably causes MC to shift downward to MC’ and thus profit maximizing
output level rises from Ã ∗ to Ã K . This increase in output will cause even more
labour to be hired (assuming Z to be normal good) as shown in figure 1.
Thus both substitution and output effect result in higher Z when falls and
thus δZ/δ ≤ 0 always. Same analysis will hold for capital and rental cost È.
Hence, input demand functions are unambiguously downward sloping.
(b) A firm is in the business of assembling personal computers (PCs)
and has the following production function: = b(S, ²) = S/Ý ²/% , where S
and ² are measures of labour and capital used to produce number of
PCs that are sold in the market at a fixed price = per PC. Cost of one
unit of S and ² are ′′ and ′Ç′ respectively.
(i) Does this production function exhibit increasing, decreasing or
constant returns of scale?
(ii) Find the firm’s conditional demand for labour in the short run
when capital is fixed at ′= 81.
(iii) Find the firm’s unconditional demand functions for labour and
capital in the long run.
(iv) Find also the long run profit maximizing level of output.
Sol.(i) Ã = (Z, ) = Z/y /
To check whether production function exhibits increasing, decreasing or
constant returns of scale, we increase each input by
(λZ, λ ) = (λZ)/y (λ)/ = λ/y Z/y λ/ /
= λ/¢ Z/y / < λZ /y / i.e., λ (Z, )
Thus there are decreasing returns of scale in this production function.
(ii) Ã = Z/y /
Given ′ = 81
Ã’ = 9Z/y i.e., Z = Ã’y/åæ , which is conditional remain for labour in short run
when ′ = 81.
(iii) Let the cost function be = Z + È
We set up the profit function
= ÏÃ– = ÏZ/y / − (Z + È– )
We find the unconstrained maximum of G with respect to l and k by finding the

values of l and k such that the partial derivatives of G are equal to zero.
δ/δZ = 1/3Z ^/y / − = 0
i.e., 1/3Z ^/y / =
¶ 5/6 I
i.e., Z /y =
y
δ/δ = 1/2Z/y ^/ − È = 0
i.e., 1/2Z
/y ^/
=È
5/
n I
i.e., / =
É
Putting value of ²/% in first constraint, we get;
n6/ I

Z /y
= É
3
I6 Iç
i.e. Z /y
= or Z (Ï, È, ) =
∗
¢É ¢É
Putting S /Ý
in second constraint, we get;
I6
y
/ = ¢É
=
2È 12È
Or,
¢
∗ (Ï, È, ) =
144È
(iv) Since Z and are optimum levels of Z and , putting them in given
∗ ∗
production function will fetch us the profit maximizing level of output directly.
y
g∗ (Ï, È, ) = Z/y / = × =
6È 12È 72È y
•••
INTERMEDIATE MICROECONOMICS – I
2013
Q.1.(i) In a two commodity world (Q, R), specify utility functions where
(a) Q and R are perfect substitutes with one unit of Q equivalent to 3
units of R.
(b) Q and R are perfect compliments and one units of Q is always used
with four units of R.
Sol.(a) Two goods are substitutes if the consumer is
willing to substitute one good for another at a Constant
rate. Constant marginal rate of substitution means that
indifference curves are straight lines. If ′f′ units of C
gives same utility as ′Ä′ units of A then utility function
becomes: 7 = fA + ÄC. Here since Ä: f is 3:1, utility
function is _ = 3A + C with slope = −3.
(b) Perfect complements are goods that are consumed

together in fixed proportions. Any extra of either of these
from the fixed proportion would not be useful & hence,
no utility is gained. Indifference curves for perfect
complements are hence L–shaped with kink at a
diagonal line through origin. Slope at vertical portions is
infinity & slope at horizontal portion is zero.
For a general case, where ′f′ units of A are consumed
with & ′Ä′ units of C, the utility function is written as follows: 7 = min(ÄA, fC).
Since here f: Ä is 1:4, utility function is 7 = min (4A, C).
(ii) Consider the utility function h(Q, R) = Q% + éR, and examine
whether the assumption of ‘more is better’ is satisfied for each good.
Sol. Assumption of ‘more is better’ means monotonic preferences. An agent's
preferences are said to be monotonic in a two- world commodity if, given a
consumption bundle, he always prefers a consumption bundle that has more of
both goods, or more of one good and same quantity of second good. It means
that a rational consumer always prefers more of a commodity as it offers him a
higher level of satisfaction.
If preferences are monotonic, this means marginal utility should be positive.
Here, _(A, C) = 4A + 6C
δ_/δA = 8A ≥ 0 for all A ≥ 0 and δ_/δC = 6 > 0 for all C ≥ 0
Since, A, C ≥ 0 for any good, ‘more is better’ for both goods.
(iii) A consumer spends all his money on coffee and sugar. He only
drinks his coffee with two spoons of sugar and only consumes sugar if
he drinks coffee.
(45)
(a) Write his utility function.

(b) Graph his indifference curves.
(c) What is his demand function for coffee?
(d) Write the equation for his Engel curve.
Sol.(iii)(a) When goods are consumed together in fixed
proportions, they are called perfect complements. Any
extra of either of these from the fixed proportion would
not be useful & hence, no utility is gained. For a general
case, where ′f′ units of A are consumed with & ′Ä′ units of
C, the utility function is written as follows: 7 =
min(ÄA, fC). Since here f: Ä is 1:2, utility function is
7 = min (2A, C)
(b) Indifference curves for perfect complements are L–shaped with kink at a
diagonal line through origin. Here equation for diagonal is C = 2A. Slope at
vertical portions is infinity & slope at horizontal portion is zero.
(c) Let income be represented by , price of A be B and D . So his budget
constraint will be AB + CD = . We know that at optimum, C = 2A will always
be true because equilibrium always lie at the kink.
Hence,
H
AB + 2AD = i.e., A(B + 2D ) = or A = , which is the demand
(IB : ID)
function for coffee where and D are constants.
(d) Engel curve shows the demand for one good under a set of fixed prices and
changing income. So B and D are constants now and is variable, thus his
Engel curve will be same as before
H
A= , where B and D are constants.
(IB : ID)
(iv) Suppose the Government levies tax on petrol and also undertakes
equivalent money transfers to the consumer in order not to make
people worse off. Using indifference curves illustrate the effects of the
entire proposal. Will the consumers be better or worse off after the tax
and transfer program?
Sol. Government undertook this proposal
because of income and substitution
effects can alter consumption patterns by
selective tax and rebate programs and it
wants to reduce consumption of petrol
without trying to make consumers worse
off at large.
Suppose the consumer starts out at point
A consuming gë units of petrol and has a
utility level of 7 . After the tax , which rotates the budget line downward since
petrol is costlier now (Ï + ) as shown by the dashed budget constraint, the
Ecopedia 47
consumer say moves to point which is on a lower indifference curve 7 , and

consumption falls to gÜ . Finally, after the rebate the budget line shifts outward
and will intersect previous budget line at ". This is because say price of C is 1
and point E be (A, C), so original budget will be ÏA + C = ¬, and let consumption
bundle after the program be represented by (A’C’), so budget now will be
(Ï + ) A’ + C’ = ¬ + A’, where A’ is rebate given to consumer. On cancelling A’
from both sides we get ÏA’ + C’ = ¬, this means (A’, C’) was also available earlier
and hence the intersection. But the consumer chose to consume at point E when
" was affordable so if he chooses say point ", he will be worse off now.
On average, the consumption of petrol will fall, as intended, and the consumer
is worse off because the level of utility attainable at point " is below the level
7 at point E. Even though the money comes back to consumers in the form of a
rebate, the reason consumption falls from E to " is because the substitution
effect will dominate the income effect in general in this case.
Q.2.(i) For a change in income, diagrammatically illustrate how the
income consumption curve would look like for the following utility
functions:
(a) h(Q, R) = Q + Ç(R), where h is non-linear in R
(b) h(Q, R) = (Q, R)
Sol. Income consumption/offer curve is a line that
depicts the optimal choice of two goods at different levels
of income at fixed prices.
(a) Utility function which in non-linear in one variable
represents quasi-linear preferences. The indifference
curves are just horizontally shifted versions of one
indifference curve.
Income offer curve (IOC) will be straight horizontal line parallel to x axis
because y is independent of changes in income.
We know at optimal,
7B /7D = B /D
i.e., 1/È′(C) = B /D or È′(C) = D /B , hence C will be independent of income.
(b) This kind of utility function represents perfect
complements. Perfect complements are goods that are
consumed together in fixed proportions. Indifference curves
will be L–shaped with kink at 45 ̊ line (because of 1:1 ratio).
We know, at optimal A = C always. So when income
changes, and even if budget line shifts equilibrium will still
be at x = y line and thus this is the income offer curve.
(ii) Consider a consumer who buys two goods, x and y with utility
function h(Q, R) = %√Q + R. The consumer’s income is 20 and price of y is
4.
(a) Compute the optimal consumption bundle when the price of Q is

equal to 1.
(b) If the price of x rises to 4, what is the new optimal bundle?
(c) Determine the Hicksian substitution effect and income effect
for the change in consumption of Q from part (a) to part (b).
Sol.(a) _(A, C) = 2√A + C
= 20, D = 4 and B = 1.
Budget constraint will be AB + CD =
7B = 2/2√A = 1/√A and 7D = 1.
We know at equilibrium,
HoJ IJ
!v = =
Ho I
That means,
1/√A = 1/4 or A ∗ = 16
H BIJ
And thus from the budget constraint, C ∗ = −
I I
= 20/4 – 16(1/4) = 5 – 4 = 1
Thus the optimal consumption bundle is (A ∗ , C ∗ ) = (16, 1)
(b) B ′ = 4
At equilibrium, MRS = 7B /7D = B /D
That means, 1/√A = 4/4 = 1 or A′ = 1
And thus from the budget constraint, C K = /D − AB /D = 20/4 – 16(1) = 5 – 16
= −11 < 0.
Since consumption of a good can’t be negative, C′ = 0 and A′ = /B = 20/4 = 5
Thus the new optimal consumption bundle is (A K C K ) = (5, 0)
(c) To calculate Hicksian substitution effect, we must keep utility constant at
original level at new prices.
7(16, 1) = 2√16 + 1 = 2(4) + 1 = 9
We calculate new income ¬′ at which utility = 9 for new optimal bundle (A y")
at new prices.

At optimum, = B / D i.e., A” = (D /B )
√B
Hence A does not depend in on change in income so A" = 1 even at compensated
income.
Hicksian substitution effect = A” – A ∗ = 1 − 1
(iii) In the context of inter-temporal choice, diagrammatically analyze
the impact of a rise in interest rate for a person who is initially a
lender of capital.
Ecopedia 49
Sol. If both current and future consumption are normal goods, an increase in
the interest rate can make a lender lend more or less but he will remain a
lender.
Suppose initially the consumer is a lender and
then the rate of interest increases. This
increase in interest rate will make the budget
line GH steeper. Now the new budget line is
′′ but this new budget line will pivot around
point because i.e., endowment will
always be available to the consumer. Say
initially he was in equilibrium at (to the
left of because he is a lender).
consumption becomes relatively more
expensive thus the individual will tend to
substitute away from current consumption,
known as the substitution effect. However, since present and future
consumption are both normal goods, an increase in the interest rate will
increase relative income leading to what is known as the income effect. For a
net-lender this increase in relative income will thus induce him to "buy" more
current consumption.
Also from the figure we can see that after the increase in the interest rate the
portion of the new budget line to the right of the endowment point is lying
available to the consumer but were not preferred by the consumer in the
beginning. So according to the Revealed Preference Hypothesis in this new
situation consumer cannot prefer these points. Thus he can choose any point to
the left of on the new budget line ′′, and may end up lending either more
or less.
The substitution and income effects work in opposite directions for the net-
lender Therefore, the effect of changes in the interest rate on lending behavior
depends on the relative size of the two effects. If the income effect is greater
than the substitution effect then an increase in the interest rate will lead to an
increase in current consumption and a reduction in lending. If the income effect
is less than the substitution effect, he will lend more.
Q.3.(i) Assuming the wage rate in labour market to be ′′,
diagrammatically illustrate the effect of the following on supply of
labour:
(a) Introduction of an overtime wage rate ′, such that ’ > .
(b) Increase in the wage rate itself to ’
Sol.(a) Consider a worker who has chosen to supply a certain amount of labor
∗ = !K − !∗ when faced with the wage rate . Now suppose that the firm offers
him a higher wage, ′ > , for extra time beyond ∗ , known as overtime wage.
This will make the budget line steeper as shown in the diagram.
But we know labor supply will increase unambiguously due to revealed

preference theory (all other points right to !∗ i.e., working less than ∗ were
available earlier too, but were rejected and hence must not be chosen now too).
This is because it is pure substitution effect (wage only rises from extra hours
worked) i.e., change in optimal choice resulting from ‘pivoting’ the budget line
around a chosen point.
(b) Now suppose wage rate itself increases to ’. The effect on labour supply is
ambiguous here because it involves both substitution and income effects. When
wage rate increases for all the hours, opportunity cost of leisure rises and we
will prefer less of leisure and thus more of work. But our real income rises with
increase in w and thus assuming leisure as normal good; it will increase and
thus fall in working hours. Thus the final impact on labour supply depends on
the relative strength of the two effects and result remains ambiguous as
opposed to overtime wages.
(ii) A worker’s utility function for leisure (Y) and consumption (Õ) is
h(Y, Õ) = √Y + √Õ. If the price of consumption is 1 and wage rate is ‘’,
can his labour supply curve be backward bending?
Sol. Labour supply curve will be backward bending if labour initially increases
as wages rises but after a limit, labour starts declining as wage increases. So
we need to calculate labour function and evaluate W/W.
_(!, ) = √! + √
Budget constraint: = (24 − !) i.e., + ! = 24
Since, given utility function is convex, we know at equilibrium,
7V /7î = V /î = /1 =

1 1
7V = and 7V = , =
√V
2√! 2√

√î
√î î
Or, = i.e., =
i.e., = !
√V V
Putting this in budget constraint we get,

! + ! = 24 i.e., ! + ! = 24 i.e., ! (1 + ) = 24 or ! =
(:)
Let labour supply be represented by , then ! = 24 −

(:)^
So, 24 − = or = 24 − (:)
= (:)
=
(:) (:)

Thus, labour supply function is = (:)
u» (:)^
Now, = (:) 6
= (:)6
> 0 for all .
u
Thus, labour strictly increases whenever rises and labour supply curve
cannot be backward bending.
(iii) A consumer has the utility function #($ , $% ) = $ $% , where $ and
$% are consumption levels in current and next year respectively. He
Ecopedia 51
earns an income of 1,00,000 this year and 1,29,600 next year. If the
objective is to maximize the consumption over time, work out the
required consumption in each period and determine whether he would
borrow or lend? Assume that the rate of interest is 8% per annum and
there is no inflation.
Sol. Marginal Rate of Substitution (MRS) between and = Marginal Utility
from good 1 (7 ) / Marginal Utility from good 2(7 )
7 ( , ) =
We know, 7 = and 7 = .
Therefore, MRS = /
85 :86 H5 :H6
Now, intertemporal budget constraint is given by (:j)
=
:j
i.e.,
86
+ /1.08 = 2,20,000 or [ = 2,20,000 −
.£Ü
Also, MRS = price ratio = (1 + ) = 1.08 i.e. / = 1.08 or = 1.08
Therefore, budget constraint becomes 2 = 2,20,000 i.e., = 1,10,000 and,
= 1.08(1,10,000) = 1,18,000. Since > , he is a borrower.
Q.4.(i) An individual consumes three goods Q , Q% and QÝ at respective
prices , % and Ý . His month wise consumption amounts of xi at
prices pi in three different months are given in each rows of the
following table:
Q Q% QÝ % Ý
Month 1 3 2 4 2 3 6
Month 2 4 2 3 4 1 7
Month 3 3 7 2 3 2 1
Check if this price and consumption data is consistent with:
(a) Weak axiom of revealed preference
(b) Strong axiom of revealed preference
Sol.(a)Weak Axiom Of Revealed Preference (WARP). States that if a
consumption bundle E(A , C ) is preferred over another consumption bundle
(A , C ) and E(A , C ) ≠ (A , C ), then there can be no budget set containing
both alternative choices E(A , C ) and (A , C ), where (A , C )is preferred over
E(A , C ).
In other words, if bundle E is directly revealed preferred to bundle , then
cannot be directly revealed preferred to bundle E. or if the bundle is
affordable when the bundle E is purchased, then when the bundle is
purchased, the bundle E must not be affordable.
Mathematically, if E(A , C ) is chosen at prices (ÏB , ÏD ) and (A , C ) is chosen
at prices (ÏB , ÏD ),
Then if: ÏB × A + ÏD × C ≥ ÏB × A + ÏD × C ,

Then, the following is not possible: ÏB × A + ÏD × C ≥ ÏB × A + ÏD × C
We make a table with cost of each bundle at each set of prices to do the analysis
quickly
Bundle I Bundle II Bundle III
Price set I 36 23* 39
Price set II 42 39 33*
Price set III 17* 19* 25
Since bundle 2 was affordable when bundle 1 was purchased, bundle 1 is
revealed preferred to bundle 2 (represented by star in row 1 coloumn2).
Similarly bundle 2 is revealed preferred to bundle 3 (represented by star in
row2 coloumn3). But bundle 3 is revealed preferred to bundle 1 as well as 2,
which is a contradiction, and hence Weak axiom of revealed preference fails.
(b) Strong Axiom of Revealed Preference (SARP). If a consumption
bundle E(A , C ) is directly or indirectly revealed preferred to (Ay , Cy ), then
(Ay , Cy ) cannot be directly or indirectly revealed preferred to E(A , C ), if
E(A , C ) is affordable/available.
WARP is a required condition for SARP as well as it includes direct revealed
preferences. Since WARP is not satisfies, SARP cannot hold true here.
(ii) A person has a wealth () equal to 1,000 and will lose 600 if his
investment in a risky bond is unsuccessful and will gain 600 if it is
successful. The probability that the investment is successful is 0.25 and
his utility function is h() = . .
(a) What is the expected value of his wealth?
(b) What is his expected utility?
(c) What is the certainty equivalent of this investment?
Sol.(a) The expected value of his wealth is his wealth in each event multiplied
by the probability of event.
Let event of success be v and not success be
Thus, () = vÏ(v) + Ï( )
= 1,600(0.25) + 400(0.75) =400 + 300 = 700
(b) Expected utility is the summation of his utility in each event multiplied by
the probability of event.
Thus, [_()] = 16000.5(0.25) + 4000.5(0.75)
= 40(0.25) + 20(0.75) = 10 + 15 = 25
(c) The Certainty Equivalent (CE) of any outcome is that amount of money,
offered for certain, which gives the consumer exactly the same utility as the
outcome.
Ecopedia 53
For certainty equivalent, we need wealth level that gives same utility as (_) =
25 i.e. √w = 25 or = 625.
(iii) Diagrammatically illustrate how the strategy of hedging by
making two risky investments with negatively correlated payoffs can
expand the expected consumption level while making choices under
uncertainty.
Sol. Hedging is the practice of taking two activities with negatively correlated
financial payoffs, where negatively correlated activities mean they tend to move
in opposite directions. Hedging has many techniques but, mainly, involves
taking opposite positions in two different markets (e.g., cash and futures
markets), so that they don’t lose everything in case they invested in only one
market.
Assume there are two events sunny (2/3 probability) and hurricane (1/3
probability) and X initially has a riskless consumption bundle A (600, 600)
which lies on constant expected consumption line ($ 600). She can invest $300
separately in sunscreen investment with which she can reach point B (1200,
300) i.e. gain $ 600(300 + 300 profit) if it’s sunny and net loss $ 300 if hurricane
occurs. She gets a higher expected consumption from B. She has another
investment opportunity of generator distribution in which she can again invest
$ 300 and reach point E(300, 1,200) i.e., net gain $600 (300 + 300 profit) if
hurricane occurs and net loss $ 300 if it’s sunny. She gets same expected
consumption from E as A. Taken individually both these investments lie on
lower ICs since they are risky and X will not prefer them.
But if she invests simultaneously in both,
she needs $ 600 for investment ($ 300 in
each) but will get $ 900 with guarantee in
both periods i.e., $ 600 + (600 from
successful business – 300 from unsuccessful
business) = 600 + 300 = $ 900 and thus
point F lies on guaranteed consumption line
and at a higher IC with higher expected
consumption.
Thus, the strategy of hedging by making
two risky investments with negatively
correlated payoffs can expand the expected
consumption level while making choices
under uncertainty.
Q.5.(i)(a)Distinguish between accounting cost and economic cost of
using an input.
(b) Vijay gives up his small time business to undertake professional
training for one year. He would have made a net profit of 5 lakhs
from the business by the end year. The training program costs 2
lakhs, which is paid in the beginning of the program. If the market
rate of interest is constant at 10% per annum, and Vijay finishes the
training program, what is the economic cost of undertaking the
program?
Sol.(a) Accounting cost is the measurement of the cost of an input at which the
expense (actual cost incurred/ cash outflow) will be recorded in books of
accounts for the transaction. It includes only the explicit cost. Whereas,
economic cost takes into consideration both implicit cost (opportunity cost) and
explicit cost. And thus economic costs are higher than accounting costs.
For e.g., Economic costs will also include, then, the opportunity cost of wages
that you could have been getting if you had gone to work instead of opening a
business but not in accounting cost.
(b) Economic costs = implicit cost (opportunity cost) + explicit cost Here,
implicit costs = opportunity cost of interest rate foregone on cost of training
program + profits foregone by leaving the business
= 2,00,000(.1) + 5,00,000 = 5,20,000
And explicit cost = Payment made for training = 2,00,000
Thus, economic cost = 5,20,000 + 2,00,000 = 7,20,000
(ii) Is it possible to have diminishing returns to a single factor of
production and constant returns to scale at the same time? Discuss.
Sol. Yes, diminishing returns to a single factor of production and constant
returns to scale are possible at the same time. The law of diminishing returns
to variable proportions states that as the quantity of one factor is increased,
keeping the other factor fixed (assuming two inputs), the marginal product of
that factor will eventually decline.
While, constant returns to scale means the output increases by the same
proportion as the increase in inputs during the production process i.e., if
g = (Z, ) represents the production functions where Z is labour input and is
capital input then increasing returns implies g = (Z, )
Production functions with diminishing returns to variable proportions and
constant returns to scale:
g = (Z, ) = Z/y /y
Keeping constant, marginal product of labour factor declines as it is
increased.
δg
= » = 1/3Z ^/y /y
δZ
HIn
δ = −2/9Z ^/y /y , which is negative and hence» falls as Z increases or
δn
Also, (λZ, λ) = (λZ)/y (λ)/y = λZ/y /y = λg, and hence constant returns to
scale.
Thus, g = (Z, ) = Z/y /y exhibits diminishing returns to variable proportions
and constant returns to scale simultaneously.
Ecopedia 55
(iii) Do the following production function exhibit increasing,

decreasing or constant returns to scale? In each case, find if returns to
labour (S) are increasing, decreasing or constant as capital (²) is held
constant.
(a) = ÝS + Ý√²

(b) = (S% + ²% )%
(c) = S. ²
(a) To check returns to scale, we compare (λZ, λ ) and λÃ
(λZ, λ) = 3λZ + 3√λ , we cannot take λ common, hence this function is non-
homogenous and we can’t know the return to scale.
To check, returns to capital, we check the sign of δ» /δZ
Marginal product of labour = δg/δZ = » = 3
δ» /δZ = 0
Hence returns to labour (Z) are constant as capital () is held constant.
(b) To check returns to scale, we compare (λZ, λ ) and λÃ
(λZ, λ) = (λ Z + λ )/ = λ(Z + )/ = λÃ.
Thus, there are constant returns to scale.
To check, returns to capital, we check the sign of δ» /δZ
5
δâ
Marginal product of labour = = » = 1/2(Z + )^6 (2Z) = Z[(Z + )^/ ]
δn
δ» ó 1Ì(Z + )/ Í– ZÌ−1/2(Z + )^y/ 2ZÍô
=
δZ (Z + )
ó(Z + )/ + Z (Z + )^y/ ô
= >0
(Z + )
And hence returns to labour (Z) are increasing as capital () is held constant.
(c) To check returns to scale, we compare (λZ, λ ) and λÃ
(λZ, λ) = λ£.Ü Z £.Ü λ = λ.Ü (Z £.Ü ) > λÃ.
Thus, there are increasing returns to scale.
To check, returns to capital, we check the sign of δZ/δZ
δâ
Marginal product of labour = = » = 0.8(Z ^£. )
δn
δZ
= −0.16 (Z ^£. ) < 0
δZ
And hence returns to labour (Z) are decreasing as capital () is held constant.
Q.6.(i) You are an employer seeking to fill an additional position on as
assembly line in order to increase output. If you observe that the
average product of workers is just beginning to decline, should you
hire any more workers? Explain. What does this situation imply about
the marginal product of your last worker hired?
Sol. Marginal product is the change in total product divided by the change in
quantity of resources (or inputs). Average product is the total product divided
by the quantity of economic resources (or inputs).
As seen in the diagram, as long as marginal product
is greater than average product, average product
curve increases then they both intersect each other
at maximum of average product and then average
product curve decreases as marginal product
becomes less than average product.
But even when average product is decreasing,
marginal product is positive for a long stretch. And hence, we can hire more
firms because it increases total product of the firm.
In fact, marginal product of the last worker hired is equal to the marginal cost
of hiring the workers i.e., his wage. This means when = , firm should no
longer hire workers because additional cost will be greater than additional
benefit.
(ii) A firm’s production technology is given by = S², where S and ² are
labour and capital input. Price of one unit of S and ² are denoted by ′′
and ′Ç′ respectively.
(a) Find the equation of the firm’s long run expansion path, the
contingent input demand functions and the long run total cost
function.
(b) Show that the long run total cost function derived in the first part
is (i) homogeneous in input prices (ii) concave in input prices.
Sol.(a) Let the cost function be = Z + È
Firm’s long run expansion path is the locus of all optimal points or cost
minimization points i.e., it shows how input increase as output increases
assuming fixed input prices.
We know at equilibrium, !¿v = /È i.e.,
n /¶ = /È i.e., /Z = /È
So we know all optimal points will lie on this line, firm’s long run expansion
path is = (/È) Z.
Now for contingent input demand function, we need to keep one input as fixed
for short run, let it be = ′
Thus, Z = Ã/′
And short run cost function SC(È, , Ã, ’) = Z + È = Ã/′ + È′
According to Shepherds’ lemma, contingent input demand function for labour is
given by δv/δ
So Z(È, , Ã, K ) = δv/δ = Ã/′
To derive long run total cost function, we minimize total costs by choosing
optimum .
Ecopedia 57
Ê
δv/δ = È– Ã/ = 0 i.e., = √
É
Putting it back in short run cost function, we get
dÃ dÃ
(, È, Ã) = Ã/ + È = 2dÈÃ
È È
(b)(i) Homogeneous in input prices
(λ, λÈ, Ã) = 2dλÈλÃ = λ2dÈÃ = λ(, È, Ã)
Hence, it is homogeneous in input prices.
(ii) Concave in input prices
δ8 Ê δ6 8 √Ê
= dÃ = √É and δÉ6 = −
√
<0
δÉ √É É /6
6
δ8 √ÉÊ δ 8 √ÉÊ
= dÈÃ = and =− <0
δ √ √ δÉ 6 /6
Hence, it is concave in input prices
(iii) Show that the extent of markup of price over marginal cost
depends on price elasticity of demand. What is the price markup for a
price taking firm?
Sol. We define marginal revenue as
W¿! W[(Ã). Ã] W[(Ã)]
!(Ã) = = = . Ã + (Ã)
WÃ WÃ WÃ
uÊ I
We know elasticity of demand © = õ ö ∗
uI Ê
Also, at equilibrium, MR = Marginal Cost (MC)
Thus,
W[(Ã)]
. Ã + (Ã) =
WÃ
i.e.,
W[(Ã)] Ã
÷ . + 1ø =
WÃ Ï

+ 1 = or = ( )
:
Thus, the extent of markup of price over marginal cost depends on price
elasticity of demand.
For a price taking firm, equilibrium exists at =
Hence there is no markup, this is because elasticity of demand is ∞ i.e., price
does not change as quantity increases WÏ/WÃ = 0 (i.e., WÃ/W is ∞ and hence e
tends to ∞), marginal revenue will be equal to price equal to marginal cost.
Q.7.(i) A price taking firm's short run total cost function is
Ý
$( ) = – . % % + +
Ý
Where is output per period
(a) Find the firm's shutdown price.

(b) Find the firm's short run supply curve.
Sol.(a) Shut down price is the price below which firm does not operates. A firm
to continue producing in the short run it must earn sufficient revenue to cover
only its variable costs because by shutting down a firm avoids all variable costs.
However, it must still pay fixed costs. Thus, in determining whether to shut
down a firm should compare total revenue (TR) to total variable costs (TVC)
and not total costs (TFC +TVC)
The rule is conventionally stated in terms of
price (average revenue) and average variable
costs.
Firm shuts down if, TR < min TVC
Dividing by Q on both sides, we get
Firm shuts down if AR = Price (P) < min AVC
In the given cost function however there are no fixed costs.
So TVC = TC and AVC = AC

gy − 0.2g + 4g + 10
Eú = E = = y££
g g
1
= g − 0.2g + 4
300
Minimizing AVC/AC = WEú/Wg = 0
5
uâ6 ^£.â:
i.e.
uâ

= g − 0.2 = 0 or g = 2 ∗ 300/10 ∗ 2 Or g ∗ = 30
y££

W Eú/Wg = > 0, therefore AVC is minimum at g = 30
y££
Now,

At Q* = 30, min AVC = (30)2 – 0.2(30) + 4 = 3 – 6 + 4 = 1
y££
Thus whenever < 1, firm shuts down and 1 is the shutdown price.
(b) Firm’s short run supply curve is MC curve above min AVC point.
y
MC = dTC/dQ = Q2 – 0.4Q + 4
y££

Hence supply curve is P = Q2 – 0.4Q + 4, when > 1.
££
(ii) A firm has the following production function = √S + √², where S

and ² in input used to produce . Price of , S and ² and , and Ç
respectively.
(a) Find the firm's long run unconditional demand function for
labour and capital.
(b) Find the firm's long run profit maximizing output and
maximum profit.
Ecopedia 59
Sol.(a) Unconditional demand function for labour is Z(, È, Ï) and capital is

(, È, Ï) i.e., they are unconstrained on output level or any input level.
And these can be derived by partial differentiation of profit function wrt Z and
respectively and equating them to zero.
Profit (Î) = Revenue – Cost = ÏÃ– (Z + È) = Ï√Z + √ − Z − È
δû
= 1/2ÏZ ^/ − = 0
δn
Ø6
i.e., 1/2Ï Z ^/ = i.e. Z ^/ = 2/Ï or Z ∗ (, È, Ï) =
6
δÎ/δ = 1/2Ï ^/
− È=0
Ø6
i.e.,1/2Ï ^/ = È i.e., ^/ = 2È/Ï or ∗ (, È, Ï) =
É 6
(b) Since Z ∗ and ∗ are optimum levels of Z and , putting them in given
production function will fetch us the profit maximizing level of output directly.
1 1
g ∗ (Ï, È, ) = √Z + √ = + = ( + )
2 2È 2 È
Putting Z ∗ and ∗ in profit function to get maximum profit, we get:
1 1 Ï Ï
Ð∗ = Ï√Z + √ – Z– È = ü + ý− −
2 È 4 4È
1 1 1 1 1 1
= ü + ý− ü + ý= ( + )
2 È 4 È 4 È
+ È
= ( )
2 È
(iii)(a) Define elasticity of substitution.
(b) Find elasticity of substitution for the following production
function.
(i) (, ) = ° ±
(ii) = (°², ±S) where < f, Ä < 1, Z and ² are inputs used to
produce .
(c) What complications arise when one generalizes the elasticity of
substitution to many input case?
Sol.(a) For a production function
Ã = (, Z), the elasticity of
substitution (©) measures the
proportionate change in /Z
relative to proportionate change in
the rate of technical substitution
(RTS) along an isoquant. That is,
¹
% ¡µimk lm ¶/n u( ) V·¸
© = = º
.
(b)(i) Ã (, Z) = i Å
RTS = » /¼
» = Ä Å^
and ¼ = f
i Å i^
,
Thus,
Ä
RTS = ÄÅ^ i / fÅ i^ = Ä/f = .
f
¼ ¼ Å ¼
W !¿v W .
© = »
. = Å »¼ . i ¼ »
W!¿v / W . » i »
¼ Å ¼
W( ) .
= »
.i » = 1
) /
Å ¼
W(
i »
Thus, elasticity of substitution for a production function Ã(, ) = i Å is one.
(ii)If Ã = min(f, Ä), and are always used in fixed proportions and
elasticity of substitution is zero, because the optimum always lie on the
diagonal line since firm will always produce at the corner of L-shaped isoquant
¼
i.e., f = Ä. Hence the ratio / = f/Ä remains fixed and numerator W
»
becomes zero, which leads to © = 0. This is true because and can’t be
substituted for each other in case of fixed proportions i.e. perfect complements.
(c) Generalizing the elasticity of substitution to the many-input case raises
several complications. If we define the elasticity of substitution between two
inputs to be the proportionate change in the ratio of the two inputs to the
proportionate change in RTS, we need to hold output and the levels of other
inputs constant. However, this latter requirement (which is not relevant when
there are only two inputs) restricts the value of this potential definition. In
real-world production processes, it is likely that any change in the ratio of two
inputs will also be accompanied by changes in the levels of other inputs. Some
of these other inputs may be complementary with the ones being changed,
whereas others may be substitutes, and to hold them constant creates a rather
artificial restriction.
•••
2014
PART - A
Q.1.(i) What are the standard assumptions about consumer preferences

and under what conditions are preferences said to be ‘well-behaved’?
Sol. We say a consumer is rational and consumer’s preferences are consistent if
the following assumptions also called axioms of consumer theory are met:
Reflexive.If a bundle is as good as itself then it follows axiom of reflexiveness
i.e., Q ≥ Q.
compared. Assume two bundles 1 and 2; both comprising of goods A and goods
C.
(a) Either (A1, C1) would be preferred over (A2, C2): (A1, C1) ≥ (A2, C2)
(b) Or (A2, C2) would be preferred over (A1, C1): (A2, C2) ≥ (A1, C1)
(c) Or both, which means that consumer is indifferent between two bundles.
Having a complete ordering of bundles is very important for consumer analysis.
Transitivity. Following conditions come under axiom of transitivity:
• If bundle 1 is preferred over bundle 2 and bundle 2 is preferred over bundle
3, then by axiom of transitivity bundle 1 should be preferred over bundle 3
i.e., if Ò ≥ Õand Õ ≥ ࢆ, then Ò ≥ ࢆ.
• Second, if Ò ∼ Õ and Õ ∼ ࢆ, then Ò ∼ ࢆ.
• Third, if Ò ≥ Õ and Õ ∼ ࢆ, then Ò ≥ ࢆ.
• Fourth, if Ò ∼ Õ and Õ ≥ ࢆ, then Ò ≥ ࢆ.
The transitivity of preference assumption rules out irrational preferences.
If above three assumptions are satisfied, then consumer preferences are said to
be rational. But preferences are well behaved, only when it satisfies following
two assumptions:
Monotonicity. We assume that both the goods are desirable i.e. goods are
‘goods’ which means the consumer prefers consuming more of a good to
consuming less. That is, suppose A and B are two bundles of goods such that A
has more of one good (or both) than B does or has at least as much of both
goods as B has. Then, ß ≥ ࡮.
In other words, it is assumed that the consumer does not reach the point of
saturation. Consumer always prefers more of both commodities, i.e. he always
tries to move to a higher indifference curve if he can. Due to monotonicity,
indifference curves representing preferences over two desirable goods cannot be
thick, upward sloping, vertical or horizontal. Another implication of the
(61)
assumptions of transitivity (of indifference) and monotonicity is that two

distinct indifference curves cannot cross.
Convexity. This assumption means that averages
of consumption bundles are preferred to extremes.
Consider two distinct points on one indifference
curve. The assumption of convexity for indifference
curves means the line segment connecting them
(excepting its end points) lies above the indifference
curve. If we take a weighted average of two bundles,
between which the consumer is indifferent, she
prefers the weighted average to the original bundle. Convexity occurs due to
diminishing marginal rate of substitution.
Also, tangency can be achieved only when preferences are well-behaved because
of the linear nature of a budget constraint. Thus, we call preferences well
behaved when indifference curves are downward sloping and convex.
(ii) A person wants to join a swimming pool that charges 10 per visit
to non-members and 5 per visit to a member with an annual
membership fee of 20. If his income is 100 and price of other goods
is 1, then-
(a) Draw the budget lines with appropriate intercepts under both
situations as member and non-member.
(b) Calculate the number of visits on which amount spent is same
under both situations.
Sol.(a) Let the number of visits be represented by A, other goods by C and
income by . Therefore, D = 1 and = 100
Budget line when he is a member:
Annual membership fee of 20 is levied on a member,
which is like a deduction from his income, and thus his
new income become ’ = 80 and B = 5.
ୡ1ୣ0ϐ*ୡ*ୣ+. 10 B
Slope of budget line = − = −5/1 = −5
ୡ1ୣ0ϐ*ୡ*ୣ+. 10 D
And intercepts: axis = 80/5 = 16 and Y axis = 80/1 = 80.

Budget line will be 5A + C = 80.
Budget line when he is a non- member:
There is no annual membership fee here so = 100 but B
increases to 10.
ୡ1ୣ0ϐ*ୡ*ୣ+. 10 B
Slope of budget line = − = −10/1 = −10, and
ୡ1ୣ0ϐ*ୡ*ୣ+. 10 D
thus it will be steeper.
And intercepts: X axis = 100/10 = 10 and Y axis = 100/1 =
100.
Budget line will be 10A + C = 100.
Ecopedia 63
(b) Let the number of visits be A.

Amount spent on A visits when he is a member = 5A + 20
Amount spent on A visits when he is a non-member = 10A
Number of visits on which amount spent is same under both situations is when:
5A + 20 = 10A i.e., 5A = 20 or A = 4
Thus, when the person makes 4 visits, he will spend equal amounts under both
situations.
(iii) If utility function is #(Q, R) = Q, where Q and R are the amounts of
two goods consumed, then what would be the shape of indifference
curves? Find the optimal consumption bundle if income is 200, price
of Q is 10 and price of R is 20.
Sol. When utility function is 7(A, C) = 4A, indifference
curves will be straight vertical lines parallel to y-axis
a shown in adjacent figure. This means, for any level
of good y, his utility remains same when A is fixed.
This means his utility does not depends on C and only
on A and will increase in right direction as
consumption of good A increases.
Since consumer’s utility depends only on good A, he
will spend all his income on A independent of amount
of his income, price of A or price of C i.e., C = 0 always.
Thus, he consumes A = 200/10 = 20 and C = 0
His consumption bundle is (20, 0)
Q.2.(i) Consider a consumer who buys two goods Q and R with utility
function #(Q, R) = QR. The consumer’s income is 40 and prices of Q and
R are 2 and 1 respectively.
(a) Compute the optimal consumption bundle.
(b) If the price of Q falls to 1, what is the new optimal
consumption bundle?
(c) Using Slutsky’s equation, compute the substitution effect and
income effect for the change in consumption of x from part (a)
to part (b).
Sol.(a) Consumer’s budget line will be 2A + C = 40. His function 7(A, C) = AC is
convex to origin and thus will have an interior solution at tangency i.e., where
Marginal Rate of Substitution (MRS) = Price Ratio(B /D )
&'()*+', -.*,*./ 0(12 )114 B (&-) D
MRS = =
&'()*+', -.*,*./ 0(12 )114 D (&-) B
Price ratio = 2/1 = 2

D
Thus, at equilibrium: = 2 or C = 2A
B
Putting y in budget line, we get
2A + 2A = 40 i.e., 4A = 40 or A ∗ = 10
And thus C = 2A = 20
∗ ∗
Therefore, the optimal consumption bundle is (10, 20).

(b) When price of A falls to 1, MRS remains same but budget line and thus
price ratio changes
New budget line: A + C = 40
And Price ratio = 1/1 = 1
D
At equilibrium, = 1or C = A
B
Putting C in budget line, we get
A + A = 40 or 2A = 40 i.e., A’ = 20
And thus C’ = A’ = 20
Therefore, new optimum consumption bundle is (20, 20).
(c) When price of A falls from 2 to 1 = ′B
we need to adjust the money income to
enable the consumer to afford the old bundle.
The change in income is given by: ∆ =
A∆B = 10(1 − 2) = −10. New income ′ = 30
The new income which enables the
consumer to afford the old bundle is given by
A + C = 40 − 10 = 30
D
Now at equilibrium, = 1 or C = A still
B
Putting y in budget line, we get
A + A = 30 or 2A = 30 i.e., A = 15
The Slutsky equation says that the Price Effect (PE) is the sum total of the
Substitution Effect (SE) and Income Effect (IE) i.e., PE = SE+IE
SE = A(K A, K ) − A(A, ) = 15 – 10 = 5 shown by AC
IE = A(’A, ) − A(’A, ’) = 20 – 15 = 5 shown by CD
Hence it can be shown, that (10) PE = (5) SE + (5)IE
(ii) An individual always consumes one cheese slice with two bread
slices and the price of a cheese slice and a bread slice are 3 and 1
respectively.
(a) How much of the two commodities will he consume under
alternative incomes of 30 and 60?
(b) State whether the utility function is homothetic.
Sol. Since consumer always consumes cheese slice (Say A) and bread slice (say
C) in fixed proportion 1:2, they are perfect substitutes and utility function will
be 7(A, C) = min(2A, C)
(a) When his income is 30, his budget line will be 3A + C = 30
Also, we know that optimal will always lie on the diagonal line 2A = C. Putting
value of C in budget line, we get,
Ecopedia 65
3A + 2A = 30 i.e., 5A = 30 or A = 6 and thus C = 2(6) = 12

∗ ∗
Thus, optimum consumption bundle is (6, 12)

When his income is 60, his budget line will be 3A + C = 60
Putting value of C in budget line, we get,
3A + 2A = 60 i.e., 5A = 60 or A ∗ = 12 and thus C ∗ = 2(12) = 24
Thus, optimum consumption bundle is (12, 24)
(b) Homothetic preferences can be represented by a utility function with the
following property: for any constant ½, _(½A, ½C) = ½_(A, C).
Here _(½A, ½C) = min(2½A, ½C) = ½min(2A, C)
And ½_(A, C) = ½min(2A, C)
Since _(½A, ½C) = ½_(A, C); given utility function is homothetic.
(iii) The government is deciding to launch one of the two welfare
schemes. While scheme 1 provides a subsidy of s per unit of good x,
scheme 2 involves a cash grant to the consumer. If both the schemes
cost same to the government, determine which scheme would make the
consumers better off?
Sol. Refer Q.3, 2007 [page no- ?????? ]
Q.3.(i) A worker with a daily non-labour income of 50 can work any
number of hours at an hourly wage of 25. He has 18 hours in a day for
wither work or leisure and has utility function #(Y, $) = Y$, where Y
and $ are number of leisure hours and consumption expenditure
respectively.
(a) What would be his optimal choice of leisure hours?
(b) What would be his work hours if wage rate rises to 30 per day?
(c) What would be his work hours if wage rate remains at 25 per
hour, but the non-labour income rises to 100?
(d) Is leisure an inferior good to this worker?
Sol.(a) If the worker takes leisure for ! hours, his maximum total consumption
expenditure can be
= 25(18 − !) + 50
And thus budget line is
+ 25! = 500
At the optimum, Marginal Rate of Substitution (MRS) = Price Ratio (¡ /V )
&'()*+', -.*,*./ 0(12 8 (Ho) V
MRS = =
&'()*+', -.*,*./ 0(12 V (Ho) 8
Now, ¡ = 1 as it is consumption expenditure and V = 25 in terms of

opportunity cost
V
Thus, = i.e., = 25!, putting this in budget line we get:
8
25R + 25R = 500 i.e. 50R = 500 or R* = 10 hours and thus C* = 250. Thus his
optimal choice of leisure hours is 10 hours.
(b) If wage rate rises to R.30 per day, MRS remains same but budget line
becomes steeper as price ratio increases.
New budget line is: C + 30R = 30*18 + 50 = 590 and new price ratio = 1/30
V
Thus, = i.e. C = 30R, putting this in budget line we get:
8 y£
30!+30!=590 i.e., 60!=590 or !∗ = 9.84 hours and ∗ = 295.
Thus, now his optimal choice of leisure hours decreases to 9.84 hours.
(c) If wage rate remains at 25, both his MRS and price ratio remains same as
part (a) but his budget line will shift to right due to increase in non-labour
income.
New budget line will be: C + 25! = 25 × 18 + 100 = 550. We know at optimum,
= 25!, putting this in budget line we get:
25R + 25R = 550 i.e. 50! = 550 or !∗ = 11 hours and thus ∗ = 275. Thus his
optimal choice of leisure hours increases to 11 hours.
(d) No, leisure is a normal good here. This is because when non- labour income
increased without any change in prices, total labour hours increased. Since
there was no price change, substitution effect must be zero here and any change
is due to income effect. Since leisure hour increases as income increase, income
effect is positive and thus leisure is a normal good.
The fall in leisure hours when wage rate increases must have occurred due to a
stronger negative substitution effect (SE) over positive income effect. When
wage rate increases, leisure becomes costlier and thus worker substitutes away
from it (negative SE) but since income of consumer is increased he will try to
increase leisure hours through income effect (as it a normal good). Final result
depends on the relative strength of two effects even when leisure is a normal
good.
(ii) Assume that a consumer, who is initially a borrower, remains a
borrower after a rise in interest rate. Determine whether the
consumer becomes better or worse off in the framework of inter-
temporal choice. Will he be better off if he turns into a lender?
Sol. If a consumer is initially a borrower, then at
equilibrium he must be to the right of the point
(endowment point) say point . He is consuming
more than his current year income and chooses to
borrow an amount at the interest rate.
Suppose initially the rate of interest is Ñ1 and it
increases to Ñ2. This increase in interest rate will
make the budget line AB steeper. Now the new
budget line is E’’ but this new budget line will
pivot around point because it will always be
available to the consumer.
As shown in the diagrams, when the interest rate increases- the borrower may
remain a borrower or he can switch to become a lender. Revealed Preference
Ecopedia 67
Hypothesis is not able to predict his behavior in this

case. There is no violation of revealed preferences in
either case so there is no definite result.
Although if he chooses to remain a borrower, he will
definitely be worse off as shown in second diagram
as he will be on a lower indifference curve. This is
because if he remains a borrower, he must operate
at a point left to on new budget line A’B’ and all
those points were affordable under the old budget
but were rejected, which means he must be worse off.
But, if he switches to become a lender, nothing can be said about the change in
his welfare, without his knowing his utility function.
(iii) A person purchased a 10-year bond on January 1, 2007 with the
face value 1,000 that promises to give a return of 200 per year till
the maturity date when he gets back the face value. What is the
present value of this bond as on January 1, 2014, if returns are
received on December 31 every year? Assume rate of interest as 10%
per annum.
Sol. As on January 1, 2014, 7 interest payments must have been received and
been accounted for, we have to calculate present value of 3 interest payments
up till 31 December, 2016 and the face value to be received at maturity.
££ ££ ££
So, present value = + (.)6 + (.) = 181.82 + 165.29 + 901.58 = 1, 248.69
(.)
Q.4.(i) Derive the relationship between insurance premium and

benefits in cases when the insurance market is
(a) actuarially fair
(b) actuarially unfair.
Sol. Insurance premium () is the amount of money the insured need to pay
for the insurance policy. An insurance benefit () is the amount of money the
insured receive in case of specific loss covered under the policy.
(a) Actuarially fair insurance- as the name suggests, in this insurance net
expected pay off is zero i.e., if λ is probability of loss not being occurred and
(1 − λ) is probability of loss being occurred, then:
λ ∗ (−) + (1 − λ) ∗ (– ) = 0 which means = (1 − λ), that is under
actuarially fair insurance, insurance premium equals the insurance benefit
times the probability of loss.
(b) Actuarially unfair insurance – in this, insurance company tries to cover its
costs of operations and thus net expected payoff is less than zero for insured
(consumer) and he loses money on average i.e., > (1 − λ), that is under
actuarially unfair insurance, insurance premium exceeds the insurance benefit
times the probability of loss.
(ii) A risk-averse person has 100 that he can invest in company A, or
in company B, or in both and each of the two companies has equal
chances of success and failure. He gets double the money if the

investment is successful and completely loses his money if it fails. He is
considering two investment options (a) investing half of his money in
each company (b) investing all of his money in one company?
Determine which investment he should undertake if the pay-offs from
two companies are uncorrelated.
Sol. Equal chances of success and failure imply:
Probability of success = probability of failure =1/2 for both companies.
Since pay-offs from two companies are uncorrelated, diversification helps in
reducing the risk, let’s see how.
Suppose, he invests 100 in Company A and 100 in Company B. Since, the
pay-offs are uncorrelated, expected returns will be as follows
Return Probability
Success in both (100 + 100) ½+½=¼
Success in A, failure in B (100 +0) ½+½=¼
Failure in A, success in B (0 + 100) ½+½=¼
Failure in both ( 0 + 0) ½+½=¼
Therefore, total expected returns = 200 ×¼ + 100 × ¼ + 100 × ¼ + 0 × ¼ = 50 +
25 + 25 +0 = 100
Risk depends on variance of an event, so variance = (200)2 × ¼ + (100)2 × ¼ +
(100)2 × ¼ + (0)2 × ¼ = 40,000/4 + 10,000/4 + 10,000/4 = 15,000
Now, let’s assume he invests 200 in one company only; his returns will be as
follows:
Return Probability
Success (200) ½
Failure (0) ½
Thus, total expected return = 200 × ½ + 0 × ½ = 100
Expected returns are same as previous case but risk depends on variance.
Variance = (200)2 × ½ + (0)2 × ½ = 20,000
Since variance is greater in this case, this situation is more risky even if he will
get same expected returns. So investing equally in both companies is a better
choice as it reduces risk due to uncorrelated pay-offs.
(iii) Diagrammatically illustrate how a risk-averse individual can
benefit through risk sharing.
Sol. We can make a risky investment more attractive through risk sharing by
dividing it among several people. For e.g., Companies can expand the
opportunities for risk sharing by issuing equity shares. As long as an
Ecopedia 69
investment's expected payoff is positive, even an extremely risk-averse person

will benefit from taking a small share of it.
• Suppose X has 600 regardless of
weather, which he can spend on
food which is represented by
bundle A - his initial bundle, and
he is risk free at A.
• Say he is offered an opportunity to
invest 300. If it’s sunny, he
makes 600 (net of investment)
which means he has now 1, 200
if it’s sunny and 300 if there is a
hurricane. By investing, consumer
can move to B with higher
expected consumption (assuming expected return from investment is
positive) but which is also risky.
• Since consumer is risk averse, he will prefer to avoid risk associated with B
as shown by diagram because B will lie on a lower indifference curve which
means higher expected consumption is not enough to offset the risk.
• Now let’s say he shares his risk with Y where in both invest 150, then
each of them will have 900 (300 + 600) if it’s sunny and 450 (600 –
150) if there is hurricane represented by point C, which also lies on a higher
indifference curve. With partners to split investment and profits, X will
reach C which is preferred over A and be willing to take the risk even if he
is risk averse.
• D is most preferred bundle with risk sharing, which can be attained by
bringing in more partners i.e., more risk sharing. Thus, a risk averse person
can also benefit from a risky investment through risk sharing.
PART – B
Q.5.(i) Given the production function = ß® ^® , where is the

amount of output, is the amount of capital input, and is the amount
of labour input. The firm’s cost is $ = + §, where is the wage and
§ is he rental on capital. Set up a Lagrangian function for cost
minimization and solve for optimum levels of capital and labour.
Sol. We set up the Lagrangian = E ¾ ^¾ − λ( + – )
We find the unconstrained maximum of with respect to and for a fixed
value of ߣ by finding the values of and such that the partial derivatives
of are equal to zero.
δ/δ = (1 − ½) E ¾ ^¾ − λ = 0
i.e., (1 − ½)E ¾ ^¾ = λ
δ/δ = (½)E ¾ ^¾

− λ = 0 i.e., ½E ¾ ^¾
= λ
Dividing the two statements we get,
(1 − ½)E ¾ ^¾ λ
=
½E ¾^ ^¾ λ
(^¾) ¼
i.e., =
¾» j
¾ »
or =
(^¾)j
Putting value of in constraint, we get:

¾ »
+ =
(^¾)j
or (1 − ½) + ½ = (1 − ½)

i.e., (1 − α + α) = (1 − ½)
(^஑)
This means, optimum level of labour input ∗ =

Putting the value of in , we get:
(5Â)
¾ 8 ¾
Optimum level of capital input ∗ = ೢ
= C
(^¾)j j
%
(ii) A firm’s total cost function is TC = 4,000+5 + 10 then:
(a) Write an expression and also draw a rough sketch of average
fixed cost, average variable cost, average total cost and
marginal cost.
(b) Determine the quantity that minimizes average total cost.
(c) Show that the average total cost is minimized where MC is
equal to average total cost.
Sol.(a) Average Fixed Cost (AFC) is the Fixed Costs
(FC) of production divided by the total quantity of
output produced. Fixed costs are the costs that must be
incurred in a fixed quantity regardless of the level of
output being produced e.g. rent, salaries of permanent
staff, etc. Thus, here FC = 4,000, as it is independent
of g.
AFC = FC/Q = 4,000/Q. Since AFC keeps on falling due
to FC being constant and rising g, it will be downward
sloping as shown in diagram.
Average Variable Cost (AVC) is a firm's variable
costs (VC) divided by the quantity of output
produced. Variable costs are the costs which vary with
output e.g. wages of labor, electricity, etc. Here, VC =
5Q + 10Q2 as it depends on Q.
AVC = ú/g = 5g + 10 % / Q = 5 + 10g. Since AVC,
rises as output increases, it will be upward sloping
straight line.
Ecopedia 71
Average Total Cost (ATC) is equal to total cost

(TC) divided by the total quantity of produced. It is also
equal to the sum of average variable
costs and average fixed costs. ATC = TC/Q = AFC +
AVC
TC/Q = 4,000 + 5g + 10g /g = 4,000/g + 5 + 10g = AFC
+ AVC. ATC first falls as g increases, and after a
minimum starts rising and thus it will be U-shaped.
Marginal Cost (MC) is the addition to total cost when
an additional unit of output is produced
i.e., MC = W¿/Wg = W(4000 + 5g + 10g )/Wg = 5 + 20g.
MC increases as g increases and thus will be upward
sloping straight line.
uë·8
(b) Minimizing ATC. =0
uâ
uë·8
= W(4,000/g + 5 + 10g)/Wg = −4000/g + 10
uâ
Putting it equal to zero, we get: 4000/g = 10 i.e., g = 400 or g = 20

represented by point in diagram. Now, W E¿/Wg = 8,000/g which is positive
for g = 20. Thus output (g) =20 minimize average total cost.
(c) To show ATC = MC at g = 20 (i.e., where ATC is minimum)
ATC (20) = 4000/20 + 5 + 10 (20) = 200 + 5 + 200 = 405
MC (20) = 5 + 20 (20) = 5 + 400 = 405
Thus, the average total cost is minimized where MC is equal to average total
cost.
Q.6.(i) A driving institute teaches students to drive cars. The number
of students that the institute can teach per week is given by =
(, ), where is the number of cars the institute rents per week,
is the number of teachers hired each week. Derive the firm’s total
cost function.
Sol. Let the cost function be defined = + , where is per unit cost of
labour and is per unit cost of capital.
We know at optimum, =
So, for a particular quantity, say g’,
At equilibrium g’ = 10 i.e., = g’/10
And similarly, = g’/10
Thus cost function = g’/10 + g’/10 = g’/10 ( + )
(ii) The total cost function of a price-taking firm is ࢀ$( ) = Ý – . % +
– Þ. If the price of its output is 12 per unit, then set up the firm’s
profit function. Also calculate the profit maximizing level of output.
Sol. Profit (Î) = Revenue – Cost
= 12g − (g − 4.5g + 18g − 7)

y
Max Î ∶ W Î/Wg = 0
W(12g − gy + 4.5g − 18g + 7 )
= 12 − 3g + 9g − 18 = 0
Wg
3g − 9g + 6 = 0 or g − 3g + 2 = 0
g – g– 2g + 2 = 0 or g(g − 1)– 2(g– 1) = 0
(g – 2)(g – 1) = 0
This means, g = 2 or g = 1. For profits to be maximum, W Î/Wg < 0 at
optimal.
Now, W Î/Wg = −6g + 9
At g = 1, W Î/Wg = −6(1) + 9 = 3 > 0
At g = 2, W Î/Wg = −6(2) + 9 = −12 + 9 = −3 < 0
Thus, profits get maximized at g = 2
(iii) Do you agree that a firm in the short run will always use optimal
input combinations? Explain with the help of a diagram.
Sol. No, we disagree. We know that optimal input combination is obtained
when firm minimizes its costs such that: Rate of Technical Substitution (RTS) =
/È, where is per unit cost of labour input and v is per unit cost of capital
input. That means when isoquant is tangent to isocost line whose slope is –/È
i.e., input price ratio.
But in short run there are fixed costs and variable
costs, and say capital is fixed in short run so capital
costs are fixed costs here. Thus, firm does not have
flexibility of input choice for cost minimization, and
more than often firm has to use ‘non-optimal’ input
combinations in short run. In other words RTS
might not be equal to input price ratio in short run.
As shown in the diagram, let the firm be
constrained to use ∗ amount of capital in short run.
If it wants to produce q0 output level, it will have to
use £ amount of labour, but this is not optimal since isoquant is not tangent to
iso cost line £ , in fact firm has to use “ too much” capital in this case. Cost
minimization would occur with a southeasterly movement along isoquant Ã£
where labour will substituted for ‘extra’ capital in production. Similarly if it
wants to produce Ã output level, it will have to use amount of labour, but this
is not optimal since isoquant is not tangent to iso-cost line , in fact firm has to
use “ too little” capital in this case. Cost minimization would occur when capital
will substituted for labour in production. Only when firm wants to produce Ã
output level, it will use amount of labour and it will result in optimal input
combination since RTS = /È at this point.
Ecopedia 73
For the other two situations, substitution is not possible in short run and only
in long run will the firm be able to move to the optimum point. And hence, firm
may not be able to use optimal input combinations in the short run always.
Q.7.(i) A short run production function is = ࡲ() = √ where is
labour input. The market wage rate is 12 an hour and the production
involves a fixed cost of 250. What is their short run cost function?
Sol. Cost = Fixed cost + Variable Cost
Therefore, cost function = = 250 + 12
Also, in short run g = √ i.e., = g ,
Thus, short run cost function is = 250 + 12g
(ii) The cost function of a price taking firm is $( ) = Ý
–% %
+ .
Determine the firm’s shut down price.
Sol. Shut down price is the price below which firm does not operates. A firm to
continue producing in the short run it must earn sufficient revenue to cover
only its variable costs because by shutting down a firm avoids all variable costs.
However, it must still pay fixed costs. Thus, in determining whether to shut
down a firm should compare total revenue (TR) to total variable costs (TVC)
and not total costs (TFC +TVC).
The rule is conventionally stated in terms of price (average revenue) and
average variable costs.
Firm shuts down if, TR < minTVC
Dividing by g on both sides, we get
Firm shuts down if AR = Price () <
minAVC
In the given cost function however there
are no fixed costs, so TVC = TC and
AVC = AC
8
AVC = AC = = (gy − 2g + 4g)/g =
â
g2 − 2g + 4
ë௏8 uë௏8 uâ6 ^â:
Minimizing = = 0 i.e.,
ë8 uâ uâ
= 2g − 2 = 0
Or g ∗ = 1W Eú/Wg = 2 > 0,
Therefore AVC is minimum at g = 1
Now at g ∗ = 1, minAVC = 12 – 2(1) + 4 = 3
Thus whenever P<3, firm shuts down and 3 is the shut-down price.
(iii) Construct an appropriate profit function and state its necessary
properties.
Sol. Any appropriate profit (Ð) function shows a firm’s maximal profits as a
function of the prices that it faces:
Ð(, È, ) = ¬fA Ð(, Z) = ¬fA[ (, Z)– È– Z]

Where is the price of output, is per unit cost of labour input (Z) and È is per
unit cost of capital input (). Only variables and Z are under firm’s control
and firm chooses them to maximize profits treating , È, as fixed parameters.
Properties of profit function:
(a) Homogeneity. Profit function is homogeneous of degree one in prices i.e., if
all the prices (Ï, È, ) double, the profits will also exactly double. Although
profits might double but profit maximizing quantity remains same because
revenue and costs also doubles.
π(Ï) = π(Ï) for all ≥ 0
Hence, inflation does not change quantities of inputs used and output
produced, but profit will increase at the rate of inflation.
(b) Non-decreasing in output price . If the firm does not change input use
and output produced, profit will rise as p increases. If the firm changes
input use or output in response to the increase in Ï, it must be doing so to
make even more profit. Therefore, if p increases, profit remains the same or
increases; it cannot decrease for a profit-maximizing firm because then it
would not be maximizing profits.
(c) Non-increasing in input prices Ç and . Similarly when profit is
maximized, a firm cannot reallocate input use without reducing profit. If È
increases, the firm cannot reallocate resources to achieve higher profit or it
would not have been maximizing profits earlier at lower È.
(d) Convex in output prices. Average profits obtainable from two different
output prices will be at least as high as profit obtained from the average of
two output prices i.e.,
Ð(Ï , È, ) + Ð(Ï , È, ) Ï + Ï
≥ Ð÷ , È, ø
2 2
•••
2015
PART A
Q.1.(i) What are the assumptions of ‘monotonicity’ and ‘averages are

preferred to extremes’ with respect to a consumer’s preferences?
What do these imply about the shape of indifference curves?
Sol. ‘Monotonicity’ implies increase in the
consumption of one good increases overall
utility, and a decrease in the consumption of
one good decrease overall utility. That is more
of a good is always preferred. But we know
utility is constant along an indifference curve.
And thus assumption of monotonicity leads to
downward sloping indifference curve.
A downward sloping indifferent curve mean that as we move down the
indifference curve it would mean more of goods A with less of goods C to keep
utility constant.
‘Averages are preferred to extremes’ means that consumer prefers a convex
combination of two goods rather than corner points (all of one good and none of
other). This assumption leads to indifference curve being convex to origin.
(ii) Suppose a consumer spends his entire income of 5,000 on
electricity consumption and other goods. The electricity company
charges 5 per unit of electricity consumption. How does the
consumer’s budget line change if the government gives full subsidy on
electricity consumption up to 100 units, a subsidy of 4 per unit on
consumption of more than 100 units and up to 500 units and a 2
subsidy on consumption of more than 500 units and up to 700 units and
no subsidy on electricity consumption more than 700 units? Assume
that the price of other goods is 1 per unit.
Sol. Let electricity be represented by A and other goods by C.
Without any subsidy his budget constraint will be 5A + C = 5,000 represented by
line AB.
Subsidy:
Up to 100 units, B =0, hence his budget constraint till 100 units will be
100 × 0 + C = 5,000 i.e., C = 5,000
For 100 < A < 500, budget line will be 100 × 0 + (5 − 4)A + C = 5,000 i.e., A + C =
5,000
For 500 < A < 700, budget line will be 100 × 0 + 400 × 1 + (5 − 2)A + C = 5,000
i.e., 3A + C = 4,600
(75)
For A > 700, budget line will be 100 × 0 + 400 × 1 + 200 × 3 + 5A + C = 5,000
i.e., 5A + C = 4,000
It is represented by AC in given diagram. X intercept of AC is 1,500 (700 +

4000/5 = 700 + 800)
(iii) Suppose a consumer consumes two goods Q and R and his
preferences are described by the utility function h(Q, R) = ScQ + R. the
consumer’s income is 120 per month and the price of R is 12 per
unit.
(a) Find the optimal consumption bundle when the price of Q is 3
per unit.
(b) Find his optimal consumption bundle if the price of Q increases
to 6 per unit.
Sol. His budget constraint will be 3A + 12C = 120 and Utility function is
_(A, C) = ZªA + C
We know, Marginal Rate of Substitution (MRS) between A and C
f\ÑªfZ 7ÑZÑC [¬ \[[W 1(7 )
=
f\ÑªfZ 7ÑZÑC [¬ \[[W 2(7 )
Also, MRS = Price Ratio = B /D
7 = 1/A and 7 = 1.
Therefore MRS = 1/A = B /D
This implies A ∗ = D /B . Putting it in budget line, we get:
(D /B )B + CD = or D + CD =
i.e.,Demand function for R = (X − R )/R
And demand function for Q = D /B
(a) D = 12 and B = 3
Thus, A = 12/3 = 4 and C = (120 − 12)/12 = 9
Thus, optimum consumption bundle when the price of
A is 3 per unit is (4, 9).
(b) D = 12 and B = 6
Ecopedia 77
Thus, A = 12/6 = 2 and C = 120 − 12/12 = 9

Thus, optimum consumption bundle when the price of A is 6 per unit is (2, 9).
Q.2.(i) A consumer who always consumes two teaspoons of sugar with
each cup of tea, after heeding his doctor’s advice he now consumes one
teaspoon of sugar with each cup of tea. How does this change in his
utility function and his indifference curves between sugar and cups of
tea?
Sol. Let sugar be represented by A and cups of tea by C.
Before doctor’s advice, his utility function was 7 =
min(A, 2C). His optimal will always lie on the line A ∗ 2C ∗
and his difference curves will be as shown in diagram 1.
After doctor’s advice, he will consume one unit of each
good and thus his utility function is 7 = min(A, C). His
optimal will always lie on the line A ∗ = C ∗ . And his
difference curves will be as shown in diagram 2.
(ii) Suppose a consumer’s preferences are described by the utility
function h = (Q, R) = Q + R. What is his demand function for Q? Draw h is
demand curve for Q.
Sol. A utility function given by _ = (A, C) = A + C
represents perfect substitutes preferences.
In such a case, he is equally happy with A and C and
thus will buy all of the good which is cheaper. In case
prices are equal, he can buy quantities of two goods as
long as budget constraint is satisfied. Using this we get
the demand curve for A as:
And demand curve is represented by :
(iii) Over a three-month period an individual exhibits the following

consumption behavior:
Q R Ò Õ
Month 1 6 6 14 8
Month 2 8 4 12 12
Month 3 10 2 14 6
Is the consumer’s behavior consistent with the weak axiom of revealed
preference?
Sol. Weak axiom of revealed preference (WARP) states that if a consumption

bundle E(A1, C1) is preferred over another consumption bundle (A2, C2) and
E(A1, C1) ≠ (A2, C2), then there can be no budget set containing both
alternative choices E(A1, C1) and (A2, C2), where (A2, C2) is preferred over
E(A1, C1).
In other words, if bundle E is directly revealed preferred to bundle , then
cannot be directly revealed preferred to bundle E. Or if the bundle is
affordable when the bundle E is purchased, then when the bundle is
purchased, the bundle E must not be affordable.
Mathematically, if E(A , C ) is chosen at prices (ÏA , ÏC ) and (A , C ) is chosen
at prices (ÏA , ÏC )
Then if: ÏA × A + ÏC × C ≥ ÏA × A + ÏC × C
Then, the following is not possible: ÏA × A + ÏC × C ≥ ÏA × A + ÏC × C
We make a table with cost of each bundle at each set of prices to do the analysis
quickly:
Price set I 132 144 120*
Price set II 144* 144 136*
Price set III 156 144* 152
Since bundle 3 was affordable when bundle 1 was purchased, bundle 1 is
revealed preferred to bundle 3 (represented by star in row1 coloumn3).
Similarly bundle 2 is revealed preferred to bundle 1 as well as 3(represented by
star in row2 coloumn1 and row2 coloumn3). But bundle 3 is revealed preferred
to bundle 2, which is a contradiction (bundle 2 is also revealed preferred to 3,
and hence Weak axiom of revealed preference fails.
Q.3.(i) Two workers A and B work in private company. Worker A gets
40 per hours for the first 40 hours that he works and 60 per hours for
every hour he works beyond 40 hours a week. Worker B gets 50 per
hour no matter how many hours he works. Each has 80 hours a week
to allocate between work and leisure and neither has any income from
sources other than labour. Each has a utility function # = $Y, where $
is consumption in rupees and Y is leisure in hours. Each can choose
the number of hours to work.
(a) How many hours will A choose to work?
(b) How many hours will B choose to work?
Sol.(a) If the worker E takes leisure for ! hours, his maximum total
consumption expenditure can be
= 40(80 − !) i.e., = 3,200 – 40!, if 80 – ! ≤ 40
And = 40 × 40 + 60 (40 − !) i.e., = 4,000 – 60!, if 80 – ! ≥ 40
At the optimum, Marginal Rate of Substitution (MRS) = price ratio (8 /V )
Ecopedia 79
&'()*+', -.*,*./ 0(12 8 (Ho) V
MRS = =
&'()*+', -.*,*./ 0(12 V (Ho) 8
Consider the first constraint,

⇒ 8 = 1 as it is consumption expenditure and
⇒ V = 40 in terms of opportunity cost
V
8 £
40! = 3200 – 40! i.e., 80! = 3,200 or ! ∗ = 40 hours and thus ∗ = 1,600. Hence
his utility will be 64,000.
For second constraint,
V
8 ¢£
60! = 4,000 – 60! i.e., 120! = 4,000 or ! ∗ = 100/3 hours and ∗ = 2,000.
Thus, now his utility increases to 66666.7.
Thus, we maximize his utility at (100/3, 2000)
(b) If the worker takes leisure for ! hours, his maximum total consumption
expenditure can be
= 50 (80 − !) i.e. = 4,000 – 50!
8 = 1 and V = 50 in terms of opportunity cost
V
8 £
50! = 4,000 – 50! i.e., 100! =4,000 or !∗ = 40 hours and thus ∗ = 2,000
(ii) Suppose a farmer has a piece of land where he grows potatoes and
tomatoes in every season. One season his land yielded 50kg Potatoes
and80kg tomatoes. He consumes both and his preferences can be
described by the utility function #(, ࢀ) = ࢀ.
(a) If prices of both goods in his season are 10 per kg, find his
optimal consumption level. Is he a net buyer or a net seller of
potatoes?
(b) If the price of potatoes increased to 20 before he makes any
transactions, find his optimal level of consumption of potatoes.
(c) Decompose the price effect into the substitution effect, the
ordinary income effect and the endowment income effect.
Sol. Let be quantity of potatoes consumed and ¿ be quantity of tomatoes
consumed. His endowments are (¨I , ¨· ) = (50, 80)
(a) His budget constraint will be 10 + 10¿ = 50 × 10 + 80 × 10
= 1,300 or + ¿ = 130
At the optimum, Marginal Rate of Substitution (MRS) = Price Ratio (I /· )
&'()*+', -.*,*./ 0(12 I (Ho) ·
MRS = =
&'()*+', -.*,*./ 0(12 · (Ho) I
·
Thus, = 1 i.e., ¿ = , putting this in budget line we get:
I
+ = 130 i.e., 2 = 130 or ∗ = 65 and thus ¿ ∗ = 65.
Since > ¨, he is a net buyer of potatoes.

∗
(b) Now I = 20, his budget constraint will be 20 + 10¿ = 50 × 20 + 80 × 10 =

1,800 or 2 + ¿ = 180
·
Thus, = 2 i.e., ¿ = 2, putting this in budget line we get:
I
2 + 2 = 180 i.e., 4= 180 or ∗ = 45 and thus ¿ ∗ = 90.
(c) For substitution effect P (P’P, PT, m’), we keep the purchasing power
constant.
Thus required changes in income will be ߂¬ = ߂Ï( ∗ ) = 10(65) = 650
His new income ¬’ will be 1,300 + 650 = 1,950.
At this income, he will buy 4 = 195 i.e., (′I , · , ¬’) = 48.75
Now, for ordinary income effect (′I , · , ¬), we will calculate when nominal
endowment income remains same even at new prices.
His new income ¬ will be 1,300
At this income, he will buy 4 = 130 i.e., (′I , · , ¬) = 32.5
For endowment income effect (K I , · , ¬′′), we will calculate when we take
into account changes in endowment income.
His new income ¬′′ will be 1,800
At this income, he will buy 4 = 180 i.e., (K I , · , ¬′′) = 45
We know,
Total Price Effect = Substitution Effect + Ordinary Income Effect + Endowment
Income Effect
⇒ Total Price Effect = (K I , · , ¬′′) − (′I , · , ¬) = 45 − 65 = −20
⇒ Substitution Effect = (K I , · , ¬′) − (K I , · , ¬) = 48.75 − 65 = −16.25
⇒ Ordinary Income Effect = (K I , · , ¬) − (K I , · , ¬′) = 32.5 − 48.75 =
−16.25
⇒ Endowment Income Effect = (K I , · , ¬′′) − (K I , · , ¬) = 45 − 32.5 =
12.5
(−20 = −16.25 − 16.25 + 12.5)
Q.4.(i) Suppose Ram will have 10, 000 kg of corn this year and 5,000 kg
or corn next year. He consumes only corn and his utility function is
#($, $%) = $. $%, where $ is consumption of corn this year and $% is
consumption of corn next year. If he stores this year’s corn to consume
next year 20% of it will be eaten by rats. He can borrow corn from his
friend this year with the promise to return next year 10% more corn
than he has borrowed. Find his optimal consumption plan.
Sol. If Ram saves his corn this year to consume next year, his rate or return
will be –0.2
We know, intertemporal budget constraint is given by 1 + 2/(1 + ) = 1 +
2/(1 + )
Consider the first constraint,
Ecopedia 81
1 + 2/0.8 = 16,250 or 2/0.8 = 16,250 – 1

At the optimum, Marginal Rate of
Substitution (MRS) = Price Ratio =
(1 + ) = .8
i.e., 1/2 = .8 or 2 = .81
Therefore, budget constraint becomes
21 = 16,250 i.e., 1 = 8,125 and
2 = .8(8125) = 6,500. Since 1 < 1,
we are sure he is a saver.
For second constraint,
1 + 2/1.1 = 14,545.45 or 2/1.1 =
14,545.45 – 1
At the optimum, Marginal Rate of Substitution (MRS) = Price Ratio = (1 + ) =
1.1
i.e., 1/2 = 1.1 or 2 = 1.1 C1
Therefore, budget constraint becomes 21 = 14,545.45 i.e., 1 = 7272,72 and
2 = 1.1(7272,72) = 8,000. Since 1 < 1, he cannot be a saver.
Thus, he maximize his utility at (8125, 6500)
(ii) A person expects his future earnings to be worth 225. If he falls
ill, his expected future earnings will be 36. The probability of falling
ill is 2/3 while the probability of remaining in good health is 1/3. His
expected utility function is h() = /% . Suppose that an insurance
company offers to insure the person against loss of earnings caused by
illness for an actuarially fair premium.
(a) Will the person accept the insurance? Explain.
(b) How much premium does he pay for insurance?
Sol. Let be the benefit from insurance that he will receive then since it is
actuarially fair premium, 2/3 is the premium of insurance.
We know after buying full insurance, earnings in both the events is equal i.e.,
Earning with sickness = Earning without sickness
Earning with sickness without insurance – premium + benefit = Earning
without sickness – premium
36 – 2/3 + = 225 – 2/3 i.e., = 189
Thus, the amount of insurance that he needs to buy to be fully insured is 189
for which he will pay premium of 2/3(189) = 126.
(a) His utility function / is concave since W_/W = 1/2 ^/ and W _/W =
−1/4 ^y/
Thus he is a risk averse person and will accept the insurance.
Alternatively, his expected utility without taking insurance will be 1/3(225)1/2 +
2/3(36)1/2 = 5 + 4 = 9
And expected utility after taking insurance will be 1/3(225 − 126)1/2 + 2/3(225 −
126)1/2 = 9.95.
And thus he will accept the insurance.
(b) As already calculated he will pay a premium of 126.
PART B
Q.5.(i) What do you understand by homogeneous production function?

Examine each of the following production function for homogeneity
and determine the degree of homogeneity for those which are
homogeneous.
(a) = /Ý %/Ý

(b) = (% + + % )%
(c) = ß® ^® + , where < ½ < 1
Sol. A production function is said to be homogeneous of degree if it can be
written in form
(λ, λZ) = λ¶ (, Z)
(a) (λ, λZ) = 5(λ)/y (λ)/y = λ5 /y /y = λ(, Z)
Thus it is homogeneous of degree 1.
(b) (λ, λZ) = (λ(λ) + λλ + (λ ) )/ = (λy + λ + λ )/
We can’t take λ common and this production function is not homogeneous.
(c) (λ, λZ) = E(λ)¾ (λ)^¾ + λ = λE ¾ ^¾ + = λ (, Z)
Thus it is homogeneous of degree 1.
(ii) What do you understand by elasticity of substitution? What is the
elasticity of substitution between and for each of the following
production function?
(a) = + + %()/%
(b) = /% /%
(c) = ° + ±
Sol. For a production function Ã = (, Z), the elasticity of substitution (©)
measures the proportionate change in /Z relative to proportionate change in
the rate of technical substitution (RTS) along an isoquant. That is, © =
¹
% ¡µimk lm ¶/n u( ) V·¸
= º
.
(a) Ã(, Z) = + + 2()/

RTS = » /¼
¼ »
» = 1 + (¼»)6 and ¼ = 1 + (¼»)6,
¼ » ¼ 5/6
Thus, RTS = 1 + (¼»)6/ 1 + (¼»)6= (on taking LCM)
» 5/6
Ecopedia 83
À À À5/6
u( ) V·¸ u( ) ¼ /
©= . = .Á =5 . [WC/WA = /{WA/WC}]
Á Á 5/6
À5/6 À 5/6
=2
u V·¸ ¼/» u 5/6 ¼/» »

Á 6 Á
Thus, elasticity of substitution is two.

(b) Ã(, Z) = / /
RTS = » /¼
» = 1/2 ^/ / and ¼ = 1/2/ ^/ ,
¼
Thus, RTS = 1/2^/ / /1/2/ ^/ = Ä/f =
»
¼ ¼ ¼
W( )!¿v W ( » )
©= .
»
= ¼ . / = 1
»
W !¿v / W
»
Thus, elasticity of substitution is one.
(c) g = f + Ä
MRTS = −» /¼
» = Ä and ¼ = f.
Therefore, MRTS = −Ä/f = W/WZ
And thus W /WZ = 0, as W/WZ or MRTS is constant i.e., neither diminishing
nor increasing.
Now, since RTS is constant along this straight line linear production function,
denominator in definition of elasticity of substitution is 0 (% «ℎfª\© Ñª !¿v = 0)
and hence © tends to ∞.
Q.6.(i) Show that the cost minimizing input ratio for output level T for
the CES production function,
= (Q࣋ + Q%࣋ )ϒ/࣋ is independent of the absolute level of production.
ࢱ ≤ , ࣋ ≠ , ϒ > 0.
Sol.(i) Minimize 1A1 + 2A2
Subject to: g£ = (A1ఘ + A2ఘ )ϒ/࣋
Form the Lagrangian
(A1, A2, ߣ; 1, 2, g£ ) = 1A1 + 2A2 + ߣ[g£ − (A1ఘ + A2ఘ )ϒ/஡ ]
The first-order conditions are
1 = ߲/߲A1 = 1 − ߣϒ/ߩ(A1ఘ + A2ఘ )(ϒ–ఘ)/ఘ ߩA1ఘ^ = 0
2 = ߲/߲A2 = 2 − ߣϒ/ߩ(A1ఘ + A2ߩ)(ϒ – ఘ)/ఘ ߩA2ఘ^ = 0
ߣ = ߲/߲ߣ = g£ − (A1ߩ + A2ߩ)ϒ/ఘ = 0.
Solve the first equation for 1, the second equation for 2 and divide 1 by 2
to obtain the condition that :

1/2 = A1ఘ^ /A2ఘ^ or (A1/A2) ∗ = ( )/ ஡^

Thus the cost minimizing input ratio for output level g£ for the CES production
function is independent of the absolute level of production.
(ii) What are the properties if cost functions?

Sol. Properties of Cost function:
(a) Homogeneity. The total cost functions are homogeneous of degree 1 in the
input prices. That is, a doubling of input prices will precisely double the
cost of producing any given output level. When all input prices double (or
are increased by any uniform proportion), the ratio of any two input prices
will not change. Because cost minimization requires that the ratio of input
prices be set equal to the RTS along a given isoquant, the cost-minimizing
input combination also will not change. Hence, the firm will buy exactly the
same set of inputs and pay precisely twice as much for them. One
implication of this result is that a pure, uniform inflation in all input costs
will not change a firm’s input decisions. Its cost curves will shift upward in
precise correspondence to the rate of inflation
i.e., (Ï) = (Ï) for all ≥ 0
(b) Non-decreasing in , Ç and . Because cost functions are derived from a
cost minimization process, any decline in costs from an increase in one of
the function’s arguments would lead to a contradiction. For example, if an
increase in output from Ã1 to Ã2 caused total costs to decline, it must be the
case that the firm was not minimizing costs in the first place. It should
have produced Ã2 and thrown away an output of Ã2 − Ã1, thereby
producing Ã1 at a lower cost. Similarly, if an increase in the price of an
input ever reduced total cost, the firm could not have been minimizing its
costs in the first place.
(c) Average and marginal costs. Some, but not all, of these properties of
total cost functions carry over to their related average and marginal cost
functions. Homogeneity is one property that carries over directly.
The effects of changes in Ã, È, and on average and marginal costs are
sometimes ambiguous, however. Average and marginal cost curves may
have negatively sloped segments, so neither AC nor MC is non-decreasing
in Ã. Because total costs must not decrease when an input price rises, it is
clear that average cost is increasing in w and v. But the case of marginal
cost is more complex. The main complication arises because of the
possibility of input inferiority. In that (admittedly rare) case, an increase in
an inferior input’s price will actually cause marginal cost to decline. Still, in
most cases, it seems clear that the increase in the price of an input will
increase marginal cost as well.
(d) Concave in output prices. – Refer Q6, 2012
(iii) Consider a production function = /% /% where is output
level, is the amount of capital and is the amount of labour. The
price of capital is 3 per unit and price of labour is 12 per unit. What
input combination will minimize the cost of producing = .
Sol. Let the cost function be 3+12
Minimize this with respect to 40 = / /
Ecopedia 85
Setting up the Lagrangian G,

(, , λ) = 3 + 12 + λ(40 − / / )
First order conditions
δt
= 3– λ1/2 ^/ / = 0 i.e., 3/λ = 1/2 ^/ /
δ¼
δt
= 12 – λ1/2 / ^/ 2 = 0 i.e., 12/λ − 1/2 / ^/
δ»
δ/δλ = 40 − / / = 0
Dividing first by second we get
1/4 = / i.e., = 4
Putting this in third condition, we get
40 − / (4)/ = 0 i.e., 40 = 2 or ∗ = 20 and thus ∗ = 80
Q.7.(i) A price taking firm has a cubic total cost function given by:
ࢀ$( ) = . Ý – . e % + +
(a) If the price of its output is 4 per unit, what is the profit
maximizing level of output?
(b) What is the firm’s profit at this price?
(c) What would be its loss if discontinued production?
Sol. Profit (Î) = Revenue – Cost = 4g – (0. 04g y – 0. 9g + 10g + 5)
Max : WÎ/Wg = 0
W(4g– 0. 04gy – 0. 9g + 10g + 5)/Wg
= 4 – 0.12 g + 1.8g − 10 = 0
0.12g − 1.8g + 6 = 0 or g − 15g + 50 = 0
g – 10g – 5g + 50 = 0 or g(g − 10) – 5(g – 10) = 0
(g – 10) (g – 5) = 0
This means, g = 5 or g = 10.
For profits to be maximum, W Î/Wg < 0 at optimal
Now, W Î/Wg = − 0.24g + 1.8
At g = 5, W Î/Wg = −0.24(5) + 1.8 = 0.6 > 0
At g = 10, W Î/Wg = −0.24(10) + 1.8 = −0.6 < 0
Thus, profits get maximized at g ∗ = 10
(b) Î(10) = 4(10) – (0.04(10)3 – 0.9(10)2 + 10(10) + 5)
= 40 – 40 + 90 – 100 – 5 = −15
Firm’s loss is 15.
(c) If firm discontinues the production, its variable costs will be saved but it
will still have to bear fixed costs. Hence its loss will be 5.
(ii)(a) What do you understand by producer’s surplus?
(b) If a firm with fixed cost equal to 10 has a producer surplus of 40,
how much profit is it earning?
(c) A competitive firm has the following short run cost function
$( ) = Ý – % + Ý + , find the firm’s shut down price.
Sol.(a) Producer Surplus (PS) is the extra return that producers earn by
making transactions at the market price over and above what they would earn
if nothing were produced. It is illustrated by the size of the area below the
market price and above the supply curve.
(b) From the above definition, we can conclude that
v = Î(Ï) − Î(0) = Î(Ï)– (−È) = Î(Ï) + È
Here, 40 = Î(Ï) + 10 and thus firm is earning profit of 30.
(c) In the short run a firm should continue to operate if price exceeds average
variable costs i.e. to produce in the short run a firm must earn sufficient
revenue to cover its Variable Costs (VC). So shut down price is any price below
minimum average variable costs AVC.
¿ú = gy – 8g + 30g
Eú = ¿ú/g = g − 8g + 30
Minimizing AVC : W(Eú)/Wg = 2g– 8
Putting it equal to zero, we get 2g – 8 = 0 i.e., g = 4
For AVC to be minimum at g = 4, W (Eú)/Wg must be non-negative
W (!E)/Wg = 2,
Thus, AVC is minimum at g = 4 and AVC(4) = 16 – 32 + 30 = 14
Therefore shut down price is 14
•••
2016
Q.1.(i) Abdul's consumption bundle consists of food (ࡲ) and leisure ().
He has 80 hours a week to allocate between labour and leisure. The
price of food is 1 per unit and his wage rate is 5 per hour. Any wage
income above 100 is subject to a tax of 50%. Write and depict
graphically the budget constraint by specifying the slope of each of it
segment and also mention coordinates of the intercepts.
Sol. Let Abdul spend ‘’ hours on leisure and ‘’ hours on work. And thus
= 5 if ≤ 20 (i.e., Wage income ≤ 20 ×5 = 100) and putting = 80 –, we
get budget constraint as + 5 ≤ 80 × 5 = 400 with slope −5 since price of = 1
and opportunity cost of = 5.
But if > 20, wage income is greater than 100
and thus income is subject to 50% tax. So = 100 +
( −20)5 × 1/2 = 100 +2.5 – 50 = 50 + 2.5 and
putting = 80 –, we get budget constraint as
+ 2.5 = 250[(20 × 5) + (60 × 2.5)] with slope −2.5.
Thus, budget constraint is:
+ 5 = 400, ≤ 20 or ≥ 60
+ 2.5 = 250, > 20 or < 60
(ii) Vinita likes both tennis shoes and racket and would like to
consume both. At the moment, she has many of both and her marginal
rate of substitution (MRS) of rackets for shoes is 3. Unused rackets and
shoes may be returned to the store for a refund. The current price for a
racket is 200 and the price for a pair of shoes is 100. Is her present
consumption bundle an optimum? Suggest a way for Vinita to make
herself better off.
Sol. Let rackets be represented by A and shoes by C.
Present consumption bundle will be optimum if it satisfies the equilibrium
condition i.e., MRS(slope of indifference curve) = B /D (slope of budget line) i.e.,
her psychological rate of substitution between rackets and shoes is same as
market rate of exchange so that no more benefits can be exhausted.
MRS at her present bundle is 3, and price ratio is 200/100 = 2
This means MRS (her psychological rate of substitution between rackets and
shoes) > price ratio (rate of exchange) so some benefits can still be exhausted
and her present consumption bundle is not optimum.
Hijklmin oplnlpD qjrs B HoJ
We know MRS = =
Hijklmin plnlpD qjrs D Ho
(87)
Here, 7B /7D > B /D or 7B /B > 7D /D i.e., marginal utility from last dollar
spent on A is greater than marginal utility from last dollar spent on y so she can
make herself better off by purchasing more of x or giving up some y for refund
from store.
(iii) Mala is very flexible. She consumes Q and R. She says, "Give me Q or
give me R, I don't care, I can't tell the difference between them." She is
currently endowed with 8 units of Q and 17 units of R. The price of Q is 3
times the price of R. Mala can trade Q and R at the ongoing prices but
has no other source of income. How many units of R will Mala
consume?
Sol. Since Mala is indifferent between A or C, these goods are perfect
substitutes for her and thus her utility function will be 7(A, C) = A + C and her
indifference curve will be straight downward sloping lines with slope = −1.
Also, B = 3D . Since she is indifferent between the two goods, she will buy
whatever is cheaper i.e., she will buy all of C and none of A. In other words her
Marginal Rate of Substitution (MRS) = Marginal Utility from A/Marginal utility
from C = 7B /7D = 1, while price ratio = 3C/C = 3
Since, 7B /7D < B /D , she will buy all C and no A.
Now, her income is = AB + CD = 8(3D ) + 17D = 41D .
So, C* = M/D = 41D /D = 41 and A* = 0
Thus, she consumes 41 units of C.
(iv) For a consumer, the utility function for two goods Q and R is given
by #(Q, R) = %Q + %R + (QR)/% . He earns an income of 1,000 while Q = 50
and R = 50. Find his optimal consumption choice.
Sol. We first need to know whether our utility function is quasi-concave or not.
Only if it is, there will be an interior solution and we can use the equilibrium
condition: Marginal Rate of Substitution (!v) = 7B /7D = B /D
A utility function is quasi-concave if:
7AA7 A − 27A7C7AC + 7CC 7 C < 0
Here Ux = 2 + ½ (xy)-1/2y and Uy = 2 + ½ (xy)-1/2x
Uxx = -1/4 (xy)-3/2y2, Uyy = -1/4 (xy)-3/2x2 and Uxy = -1/4 (xy)-3/2yx + ½ (xy)-1/2 = -
1/4 (xy)-1/2 + ½ (xy)-1/2 = 1/4 (xy)-1/2
Thus, Uxx U2x – 2UxUyUxy + Uyy U2y = -1/4 (xy)-3/2y2 [2 + ½ (xy)-1/2y]2 – 2[2 + ½
(xy)-1/2y][ 2 + ½ (xy)-1/2x][ 1/4 (xy)-1/2] + -1/4 (xy)-3/2x2[2 + ½ (xy)-1/2x]2 which are all
negative terms hence < 0 and given utility function is quasi concave.
Now, MRS = UX/ Uy = 2 + ½ (xy)-1/2y / 2 + ½ (xy)-1/2x = 50/50 = 1
Thus, 2 + ½ (xy)-1/2y = 2 + ½ (xy)-1/2x or ½ (xy)-1/2y = ½ (xy)-1/2x or y = x
His budget constraint will be 50x + 50y = 1000, putting y = x we get
100x = 1000 or x* = 10 and y* = 10. His optimal consumption bundle is (x*, y*)
= (10, 10)
Ecopedia 89
Q.2 (i) Which of the following utility functions satisfies strict

convexity?
(a) U (x, y) = 3x2 + (1/3) y2
(b) U (x, y) = min (2x + 3, y)
Also, draw the indifference map for each of the above case.
Sol. Utility function U(x, y) satisfies strict convexity
when Uy 2Uxx – 2 Ux Uy Uxy + Ux 2 Uyy < 0
(a) Ux = 6x and Uxx = 6
Similarly Uy =2/3 y and Uyy = 2/3. Also Uxy = 0
Thus, Uy 2Uxx – 2 Ux Uy Uxy + Ux 2 Uyy
= (4/9) y2 (6) – 2 (6x) (2/3y) (0) + 36x2 (2/3)
= 8/3y2 – 0 +24x2
= 8/3y2 + 24x2 ≥ 0 for all x and y.
And thus the given function does not satisfy strict
convexity. It can also be seen from the diagram that
function is rather concave.
(b) The given function is non-differentiable. But it is
clear from the diagram that it is flat at various points
so when we join two points on the flat curve the line
will lie on the curve itself and thus does not satisfy
strict convexity. Rather it is convex.
(ii) There are two goods X and Y. In the current year, prices of these
goods are (5, 10). Bela's consumption bundle in the current year is (25,
25) while her consumption bundle in the base year was (20, 30). Has
she become better off in the current year or not? Explain.
Sol. If Bela’s current consumption bundle in the current year is (25, 25) this
means she must be maximizing at this point and exhausting her income. Thus
her current income is 25*5+ 25*10 = 125 + 250 = Rs.375
If she purchases her consumption bundle in the base year (20, 30) at current
prices it will cost her 20*5 + 30*10 = 100 + 300 = 400
She is unable to afford her base year consumption bundle at current prices and
thus we cannot tell whether she has become better off in current period or not
through revealed preferences because no comparison can be made. Since this
bundle is not a part of her budget set in current period, it can give her a higher
or lower utility depending on her utility function.
(iii) Derive the income offer curves and Engel curves for commodity X
for the following utility functions, assuming Px = Py =1.
(a) u (x, y) = max (2x, 3y)
(b) u (x, y) = x – y
Sol. We assume both x and y normal good for both the consumers. Let income
be represented by M.
Income offer curve is a line that depicts the optimal choice of two goods at
different levels of income at fixed prices. Income offer curve for two normal
goods is upward sloping. Engel curve shows the demand for one good under a
set of fixed prices and changing income.
(a) u (x, y) = max (2x, 3y)
As shown in the diagram, given utility function is
concave and thus optimal will occur at a corner.
Also, let consumer’s income be m, thus his budget
line will be a straight line with slope = -1 (Px / Py
=1/1) with intercepts m for both axes. We can see
that he can reach a higher utility function by
consuming all y. And thus Engel curve for
commodity x = 0 and for y = m
i.e. x = 0 and y-m = 0, equating both these we get income offer curve as y –
m = x or y – x = m.
(b) u (x, y) = x – y
As shown in the diagram, given utility function is
upward sloping and utility increases in southeast
decision and thus optimal will occur always at x-
axis. We are implicitly assuming that x is a ‘good’
and y is a ‘bad’
Also, let consumer’s income be m, thus his budget
line will be a straight line with slope = -1 (Px / Py
=1/1) with intercepts m for both axes. We can see
that he can reach a higher utility function by
consuming all x. And thus Engel curve for
commodity x = m and for y = 0
i.e. x - m= 0 and y = 0, equating both these we get income offer curve as x –
m = y or x – y = m.
Q.3.(i) Is strong Axiom of Revealed Preferences (SARP) a necessary
and sufficient condition for well-behaved consumer preferences?
Explain your answer.
Sol. STRONG AXIOM OF REVEALED PREFERENCE (SARP): If a
consumption bundle A(x1, y1) is directly or indirectly revealed preferred to
C(x3, y3), then C(x3, y3) cannot be directly or indirectly revealed preferred to
A(x1, y1), if A(x1, y1) is affordable/available.
This clearly says that preferences must be transitive, which is a condition for
well-behaved preferences. Thus SARP is a necessary implication of optimizing
behavior i.e. if a consumer is always choosing the best things that he can afford,
then his observed behavior must satisfy SARP. SARP is also a sufficient
Ecopedia 91
condition for optimizing behavior i.e. if the observed choices satisfy SARP, then
it is always possible to find preferences for which the observed behavior is
optimizing behavior. Thus SARP is both a necessary and a sufficient condition
for observed choices to be compatible with the economic model of consumer
choice.
To check SARP: we take a numerical 3X3 matrix of expenditures. We need 3 set
of prices (px, py) with 3 consumption bundles of x and y bought at each set of
prices. The matrix is as follows:
Price set I 40 20* 44**
Price set II 42 40 30*
Price set III 24 30 20
We can observe that bundle I is directly revealed preferred to bundle II as
bundle II is affordable but still consumer has chosen bundle I (indicated by *
sign). in the second state, consumer chooses bundle II because bundle I is not
affordable. Similarly, bundle II is directly revealed preferred to bundle III
(indicated by * sign). In the third state, the consumer chooses bundle III as
bundle II is not affordable. All this implies that bundle I is indirectly revealed
preferred to bundle III. This can be indicated by double star sign **. Now
testing for SARP requires that we should check whether bundle III is revealed
preferred to bundle I or not in any way, when both are affordable. We find that
bundle III is purchased in state III when bundle I is not available (not
affordable). If bundle I would be affordable and still bundle III was chosen, then
this would be a violation of SARP.
(ii) Show how indexing of social security payments for inflation
increases the welfare of senior citizens receiving these social security
payments.
Sol. Since social security payments are the main source of income for majority
of senior citizens, so government tries to adjust them to keep the purchasing
power constant even when prices change (inflation) to maximize their welfare.
This is called indexing.
Say in base year ‘b’, there is an optimal
consumption bundle of senior citizens shown by
point X on line AB. Say prices have increased so
that budget line shifts and rotates downwards.
Now social security system strives to adjust
payments in current year so that they are just able
to afford the same consumption bundle as shown in
figure where new budget line CD after indexing
intersects old budget line at base year optimal
bundle X.
The result is that senior citizen will always be better off than he was in base
year ‘b’ because new budget line cuts the indifference curve through X and thus
there will be some other bundle on new budget line that would be strictly
preferred to X (If he chooses a point left to X on CD it will lead to violation of
revealed preference). Thus he will able to choose a better bundle than X and
will be on a higher indifference curve.
(iii) A consumer has the utility function U (C1, C2) =C1C2, where C1 and
C2 are consumption levels in current and next year respectively. He
earns an income of Rs.1, 00, 000 this year and 1, 29, 600 next year. If
the objective is to maximize the consumption over time, work out the
required consumption in each period and determine whether he would
borrow or lend? Assume that the rate of interest is 8% per annum and
there is no inflation.
Sol. Marginal Rate of Substitution (MRS) between C1 and C2 = Marginal Utility
from good 1 (MU1) / Marginal Utility from good 2(MU2)
U (C1,C2) =C1C2. We know, MU1 = C1 and MU2 = C2. Therefore, MRS = C1/C2
Now, intertemporal budget constraint is given by C1 + C2/ (1+r) = M1 + M2/ (1+r)
i.e. C1 + C2/ 1.08 = 2,20,000 or C2/ 1.08 = 2,20,000 - C1
Also, MRS = price ratio = (1+r) = 1.08 i.e. C1/C2 = 1.08 or C2 = 1.08 C1
Therefore, budget constraint becomes 2C1 = 2,20,000 i.e. C1 = Rs.1,10,000 and
C2 = 1.08(1,10,000) = Rs.1,18,000. Since C1 > M1, he is a borrower.
Q.4.(i) Why might it make sense for a risk averse person to purchase
insurance on the one hand and invest in the stock market,
undertaking risk, on the other hand?
Sol. There are certain risk averse persons who buy insurance coverage (e.g. –
fire insurance) and engage in investing in the stock market too. This appears to
be a contradiction because this behavior suggests that people are risk averse
and risk loving at the same time. But there is no contradiction because such a
behavior depends on the nature and cost of insurance that can be bought and
on the type of investment.
When a person gets an insurance policy, he pays to escape or avoid risk. But
when he invests in the stock market, he gets a small chance of a large gain.
Thus he takes risk. Some people indulge both in buying insurance and
gambling i.e. they both avoid and choose risks over different segments of wealth
and different choices and hence it is not irrational to do so.
(ii) A person expects his future earnings (W) to be worth 441, when
he is healthy. If he falls sick, his expected future earnings will be 36.
The probability of falling sick is 2/3. His utility function is U (W) = W1/2.
Suppose that an insurance company offers to insure the person against
loss of earnings caused by illness for an actuarially fair premium.
(a) Will the person accept the insurance? Explain in terms of changes
in the expected earnings and expected utility.
Ecopedia 93
(b) What will be the value of fair insurance if he chooses to buy full
insurance?
(c) If the price of the insurance is 75 paisa for each rupee of promised
benefits. How much insurance will he purchase?
Sol. Let B be the benefit from insurance that he will receive then since it is
actuarially fair premium, 2/3 B is the premium of insurance.
We know after buying full insurance, earnings in both the events is equal i.e.
Earning with sickness = Earning without sickness
Earning with sickness without insurance – premium + benefit = Earning
without sickness - premium
36 – 2/3B + B = 441 – 2/3B i.e. B = 405
He will pay a premium of 270
(a) His utility function w1/2 is concave since du/dw = 1/2 w-1/2 and d2u/dw2 = -1/4
w-3/2
Thus he is a risk averse person and will accept the insurance.
Alternatively, his expected earnings before taking insurance will be 1/3(441) +
2/3(36) = 147 + 24 = 171
And expected earnings after taking insurance will be 1/3(441 - 270) + 2/3(441 -
270) = 171
Similarly, his expected utility without taking insurance will be 1/3(441)1/2 +
2/3(36)1/2 = 7 + 4 = 11
And expected utility after taking insurance will be 1/3(441 - 270)1/2 + 2/3(441 -
270)1/2 = 13.08.
He gets the same expected earnings but a higher expected utility after
insurance and thus he will accept the insurance.
(b) The amount of insurance that he needs to buy to be fully insured is 405.
(c) If B is the benefit from insurance that he will receive then according to
question, 75/100B = 0.75B is the premium of insurance while probability of loss
is 0.67 and premium rate is 75/100 = 0.75 = R
Since premium > probability of loss, it is actuarially unfair insurance.
If he increases B by Re.1, his consumption falls by R if sickness does not
happen and rises by (1-R) if sickness happens. Therefore, by purchasing
insurance, he can obtain on a straight line through point A (initial bundle) with
a slope of – (1-R) / R = - 0.25/0.75= -0.33
Therefore his budget line is AD with slope -0.33, where D is point reached if he
takes full insurance.
/y
We know that slope of expected constant consumption line is – = -0.5, so it’s
/y
steeper than the budget line and indifference curve that is tangent to this line
at D cannot be tangent to line AD as well. Therefore he cannot buy full
insurance.
The Von Neumann Morgenstern

utility function associated with
question is U = 1/3 WH ½ + 2/3 wS ½
At equilibrium, MRS = slope of
budget line i.e. (dU/dWH ) / (dU/dWS )
= – (1-R) / R
This means, 1/3 WS ½ / 2/3 WH ½ =
0.33 i.e. WS ½ / 2WH ½ = 0.33 or WS ½ /
WH ½ = 0.66 i.e. WS / WH = 0.43
Thus, WS = 0.43 WH, putting this in
budget constraint we get
WS – 36 = -0.33 (WH – 441) i.e. 0.43 WH – 36 = -0.33 (WH – 441) or 0.76 WH =
181.53
Which means, WH = 238.85 and thus WS = 102.7, which is the between A and D,
thus he takes partial insurance. And insurance premium purchased is 441 –
238.85 = Rs.192.15
Q.5. (i) Is it possible to have diminishing returns to a factor of
production and increasing returns to scale at the same time? Discuss.
Sol. The law of diminishing returns to variable proportions states that as the
quantity of one factor is increased, keeping the other factor fixed (assuming two
inputs), the marginal product of that factor will eventually decline.
While, increasing returns to scale means the output increases by a larger
proportion than the increase in inputs during the production process i.e. if Q =
F (l, k) represents the production functions where l is labour input and k is
capital input then increasing returns implies tQ < F (tl, tk)
Production function with diminishing returns to variable proportions and
increasing returns to scale: Q = f (l, k) = l1/3k3
Keeping k constant, marginal product of labour factor declines as it is
increased.
δQ/δl = MPl = 1/3 l-2/3k3
δ MPl / δl = -2/9 l-5/3k3, which is negative and hence MPl falls as l increases or
Also, f (λl,λ k) = (λl)1/3 (λk)3 = λ10/3 l1/3k3 > λQ, and hence increasing returns to
scale.
Thus, Q = f (l, k) = l1/3k3 exhibits diminishing returns to variable proportions
and increasing returns to scale simultaneously.
(ii) Which of the following production functions depict diminishing
rate of technical substitution between two inputs labour (L) and
capital (K)? How does it affect the elasticity of substitution between
these inputs in each case?
(a) Q = 100 K0.2 L0.8
Ecopedia 95
(b) Q = 20 K + 5L
Sol. Marginal Rate of technical substitution (MRTS) is the rate at which labor
can be substituted for capital while holding output constant along an isoquant.
MRTS (l for k) = -dk/dl = MPL / MPK
(a) Q = 100K0.2 L0.8
MRTS = MPL / MPK = -dK/dL
MPL = .8 (100K0.2 L-0.2) and MPK = 0.2(100K-0.8 L0.8)
Therefore, MRTS = [.8 (100K0.2 L-0.2) / 0.2(100K-0.8 L0.8)] = 4K/L
We know, MRTS = - dk/dl, thus to show that MRTS is diminishing, we must
show dMRTS/dl must be negative or d2 k/dl2 must be positive
dK / dL = -4K/L
Ëº ೏¹ Ë¹
^ ¶ n (^ )^ ¶ ^¢¶^ ¶ £¶
೏º º
d2 K/dL2 = - = - = - = > 0, hence MRTS is
n^ n^ n^ n^
diminishing.
For a production function q = f(k, l), the elasticity of substitution (e) measures
the proportionate change in k/l relative to proportionate change in the rate of
% ¡µimk lm ¶/n
technical substitution (RTS) along an isoquant. That is, e = =
% ¡µimk lm V·¸
¹
u( ) V·¸
º
.
u V·¸ ¶/n
À À À
u (Á) ¼/» u (Á) .Á
e= . = À . =1
u ¼/» ¼/» u( ) ¼/»
Á
Thus, elasticity of substitution for a production function q (L, K) is one and is

not affected by diminishing MRTS.
(b) Q = 20 K + 5L
MRTS = -MPL / MPK
MPL = 5 and MPK = 20. Therefore, MRTS = - 5/20 = -1/4 = dk/dl
And thus d2 k/dl2 = 0, as dk/dl or MRTS is constant i.e. neither diminishing nor
increasing.
Now, since RTS is constant along this straight line linear production function,
denominator in definition of elasticity of substitution is 0 (% «ℎfª\© Ñª !¿v = 0)
and hence e tends to ∞.
(iii) For the production function given by q =e0.3t K0.5 L0.5, where the
technical coefficient is denoted by e0.3t:
(a) Without actually calculating, find the elasticity of output with
respect to capital and labour respectively.
(b) Both capital and labour grow at the rate of 1% per annum each,
compute the annual growth rate of output. Explain your answer.
Sol. Technical coefficient represents technical progress which shows that the
same level of output can be produced with fewer inputs.
(a) ∂q/∂k (k/ q) = elasticity of output with respect to capital input = eq, k and ∂q/∂l
(l/q) = elasticity of output with respect to labor input = eq, l
But for a Cobb Douglas function q = AKaL1-a, we can find them by actually
calculating because
eq, k = a = 0.5and eq, l = 1-a = 0.5
(b) Let annual growth rate be represented by Gq
For q =e0.3t K0.5 L0.5, a particularly easy way to study the properties of this type
of function over time is to use “logarithmic differentiation”:
డ nm Ê డ nm Ê డÊ డÊ/δp £.yp: £. nm ¶: £. nm n డ nm ¼ డ nm Ê
Gq = = . = = = 0.3 + 0.5 + 0.5 = 0.3 + 0.5
డp డÊ డp Ê డp డp డÊ
Gk + 0.5 Gl
= 0.3 + 0.5 (1) + 0.5 (1) = 0.3 + 0.5 + 0.5 = 1.3%
Thus annual growth rate of output is 1.3%.
Q.6.(i) Is it possible for the input demand to fall if the price of that
input falls? Explain your answer.
Sol. Let us take ‘labour’ (l) as the input for our
analysis here. It is impossible for labour demand to
fall if the price of labour falls i.e. its demand curve is
unambiguously downward sloping. Thus to show that
it is unambiguously downward sloping, δl/δw, where
w is wage rate should be negative at all times.
We get the unconditional labour input demand
function: l = l (P, v, w), where P is price of output and
v is rental cost of capital (k); through profit
maximization. Suppose w falls, there will be two effects on labour when this
happens: substitution effect and output effect.
Substitution effect: when w falls and output (q) is fixed at say q*, firm will
try to substitute l for k because it is comparatively cheaper now which is shown
in figure 1. Since minimizing cost of production of q* requires Rate of technical
Substitution (RTS) = w/v, a fall in w will necessitate a movement from input
combination A to B i.e. since w/v falls, RTS must also be less at optimum. And
because isoquants exhibit a diminishing RTS, it is clear from figure that
substitution effect must be negative. This means a fall in w will increase the
labour if output is held constant due to substitution effect.
Output effect: in reality although output is not
held constant, so we consider output effect
(change in q) to reach the final optimum. As long
as firm has demand for its output, it can produce
any quantity it wants depending on its profit
maximizing decision. When w falls, firm’s
expansion path will change due to change in
relative input costs. Thus, all the firm’s cost
curves will shift and some output level other than
Ecopedia 97
q* might be chosen. As shown in figure 2, a fall in w most probably causes MC

to shift downward to MC’ and thus profit maximizing output level rises from q*
to q’. This increase in output will cause even more labour to be hired (assuming
l to be normal good) as shown in figure 1.
Thus both substitution and output effect result in higher l when w falls and
thus δl/δw ≤ 0 always. Same analysis will hold for capital and rental cost v.
Hence, input demand functions are unambiguously downward sloping.
(ii) The cost function of a firm is given by C (v, w, q) = q1/β (vx + wx)1/x
Where q represents the quantity of output and prices of labour and
capital inputs are w and v respectively.
(a) Find the contingent (constant output) demand for labour and
capital.
(b) Use the results in part (a) to find the underlying production
function
Sol. (a) When we hold quantity produced constant, the demand for inputs will
be “contingent” on the quantity being produced. Shephard’s lemma states that
the contingent demand function for any input is given by the partial derivative
of the total cost function with respect to that input’s price.
డ8(É,,Ê) డ8(É,,Ê)
Thus, = kc (v,w, q) and = lc (v,w, q)
డÉ డ
So, kc (v,w, q) = δC/δv = q1/β (1/x)(vx + wx)(1-x)/x (xvx-1) = q1/β (vx + wx)(1-x)/x (vx-1)
And lc (v,w, q) = δC/δw = q1/β (1/x)(vx + wx)(1-x)/x (xwx-1) = q1/β (vx + wx)(1-x)/x (wx-1)
(b) We know this type of contingent demand functions occur for a constant
elasticity production function. More precisely, for a CES production function: q
= f (k, l) = (kρ + lρ) γ/ρ . For this case, the total cost function is:
C (v,w, q) = vk + wl = q1/γ (v1-σ + w1-σ) 1/(1-σ) and underlying contingent demand
functions are
kc (v,w, q) = δC/δv = q1/ γ (v1-σ + w1-σ) σ/(1-σ) (v-σ)
And lc (v,w, q) = δC/δw = q1/ γ (v1-σ + w1-σ) σ/(1-σ) (w-σ)
On comparing we get, β = γ and x = 1-σ i.e. σ = 1-x, and σ = 1/ (1- ρ) i.e. 1-x = 1/
(1- ρ) or ρ = -x/(1-x) thus production function is q = f (k, l) = (k-x/(1-x) + l-x/(1-x)) –
β(1-x)/ x
(iii) Let a firm's production function be represented by q =√ + .

Assume that in perfectly competitive markets, firm buys labour input
at price 'w', capital input at 'v' and sells the output at price 'p'.
(a) If the market price of labour (w) is higher than the market price of
capital (v), then find the equation of expansion path and graphically
represent it.
(b) Now if market price of capital (v) is higher than the market price of
labour (w), then find the equation of expansion path and graphically
represent it.
(c) Find the cost function if v = w.

Sol. q =√ + is a monotonic transformation of
linear production function q = L + K.
Monotonic transformation preserves the ordinal
preferences of the production function and thus
MRTS remains same and so does thus the
analysis.
(a) Since in this case, capital and labor can be
thought of as perfect substitutes for each other,
so we can use only capital or only labor,
depending on these inputs’ prices. Since MRTS
= 1, we will use all of the cheaper input.
Since w > v, capital is cheaper and we use only
capital and equation of expansion path is y axis
i.e. L = 0.
(b) Since w < v, labour is cheaper and we use
only labour and equation of expansion path is x
axis i.e. K = 0.
(c) w = v, we can use any combination of L and K to produce q quantity of
output. Thus cost function will be C = wq (w=v)
Q.7. (i) A firm has the following production function q = f (K, L) =
L2/3K1/3, where L and K are the labour and capital inputs per time
period respectively. Take p, v and w as the prices of the product,
capital and labour respectively.
(a) Find the firm's profit function.
(b) Using the Hotelling's Lemma, find the short run supply function.
(c) If v = 10, K is fixed at 100 and shutdown price is 5, find the
producer's surplus and the profit at this price.
Sol. (a) Profit (π) = Revenue – Cost = pq – (wL + vK) = p (L2/3K1/3) – wL – vK
Ø¼ 5/
δπ /δl = 2/3p L-1/3K1/3 - w = 0 i.e. 2/3p L-1/3K1/3 = w i.e. L1/3 =
y
Ø¼ 6/
δπ /δk = 1/3p L2/3K-2/3 - v = 0 i.e. 1/3p L2/3K-2/3 = v i.e. L2/3 =
y
We cannot determine long run L* and K* and thus the long run profit function
from these two equations, but we can find the short run profit function π (p, w,
v, K’) by keeping K constant at K’.
Ø¼ ᇲ5/ ÜØ ¼ ᇲ
Thus, L1/3 = i.e. L =
y å
Putting L and K’ in profit function we get,
Ø6 ¼ ᇲ6/ ÜØ ¼ ᇲ Ø ¼K ÜØ ¼ ᇲ Ø ¼ ᇲ
p K’1/3 – w – vK’ = – – vK’ = – vK’ = π (p, w, v, K’)
æ6 å æ 6 å 6 å6
Ecopedia 99
(b) Using the Hotelling's Lemma, the short run supply function can be derived
by δ π / δp
Ø6 ¼K Ø6
Thus, short run supply function q (p, w, v, K’) = = (K’) = S (p)
å6 æ 6
Ø∗
(c) Producer surplus (at p = p* and q = q*) = ‫׬‬£ v(Ï) dp
Here, v = 10, K’ = 100 and p* = 5.
Ø∗ ¼’ ¼’ Ü.Ü
‫׬‬£ v(Ï) dp = æ6 ‫׬‬£ 4Ï dp = å6 (5)y = å6 (4*100) 125 = 6
Ü.Ü
Hence the producer surplus is at shut down price.
6
££££
Also, the profit will be – 1000.
å6
(ii) For a firm, the cost function is given by: C = Q3 – 3Q2 + 3Q + 1
(a) If the market price is 3, then find the profit maximizing level of
output.
(b) Find the minimum efficient scale of production.
Sol. (a) Profit (π) = Revenue – Cost = 3Q – (Q3 – 3Q2 + 3Q + 1)
Max π: d π/dQ = 0
d (3Q – Q3 + 3Q2 - 3Q - 7 ) / dQ = 3 - 3 Q2 + 6Q – 3 = 0
3 Q2 - 6Q = 0 or Q2 - 2Q = 0
Q (Q - 2) = 0
This means, Q = 2 or Q = 0. For profits to be maximum, d2 π/dQ2 < 0 at optimal.
Now, d2 π/dQ2 = -6Q + 6
At Q = 0, d2 π/dQ2 = -6(0) + 6 = 6 > 0
At Q = 2, d2 π/dQ2 = -6(2) + 6 = -6 < 0
Thus, profits get maximized at Q = 2
(b) Minimum efficient scale (MES) is the lowest production point at which long-
run average costs (LRAC) are minimized.
LRAC = C/Q = Q2-3Q + 3
Minimizing LRAC: d (LRAC)/dQ = 2Q – 3
Putting it equal to zero, we get 2Q – 3 = 0 i.e. Q = 3/2
For LRAC to be minimum at Q = 3/2, d2 (LRAC)/dQ2 must be non-negative.
d2 (LRAC)/dQ2 = 2, thus LRAC is minimum at Q = 3/2 and therefore MES is Q*
= 3/2.
(iii) For a firm, the short run supply function is given by q =
20p2/5k13/5w-2/5, where p represents the price of the output, k1 represents
the level of capital input that is held constant in the short run and w
represents the wage rate.
(a) Find the short run marginal cost equation.
(b) Find the short run total cost function, if the total fixed cost is 100.
Sol. (a) A firm's short-run supply function is the increasing part of its short run
marginal cost curve above the minimum of its average variable cost. The short
run supply function of the firm is given by q = 20p2/5k13/5w-2/5 and thus short run
marginal cost curve will be precisely
Ê Ê6/ఱ .Ê ఱ/6
p2/5 = = or p =
£¶/ఱ 6/ఱ £¶/ఱ åÜæ¶/6
(b) We now integrate the marginal cost curve to derive Total Variable cost
function.
.Ê ళ/6
And thus TVC = . (2/7) = 0.0016 q7/5k13/2w
åÜæ¶/6
To derive total cost function, we add fixed costs to TVC.
Thus, TC = 0.0016 q7/5k13/2w + 100
•••
Unique paper code : 12271301
Name of course : Intermediate Microeconomics –I
Name of Course B.A.(H) Economics (CBCS)
Semester – III
Attempt any three in part A
Part –A
Q.1.(i) Joan like chocolate cake and ice-cream but after having 10 slices of cake, eating more cake
makes her less happy. Joan always wants more ice-cream to less. Draw and explain the shape of the
indifference curve depicting her preferences. Take ice-cream on the horizontal axis.
Sol.(i) Diagram
When Joan consumes less than 10 slices of cake, both chocolate cake and ice-cream give utility to her
and both are goods. After Joan consumes 10 slices of cake, cake gives disutility to her. Hence, after
10 slices chocolate cake becomes a bad for Joan that gives her disutility.
(ii) A consumer always purchases at least 4 units of good X. He pays a price 𝑷 up till 17 units of X. if
he purchases more than 17 units, then he must pay 10% more on each additional units. Taking the
other good as the numeraire.
(a) Set up the equation of the budget constraint.

(b) Graphically show the budget set.
Sol.(ii)(a) When 𝑥 < 17
𝑝𝑥 + 𝑦 = 𝑚
When 𝑥 > 17
(𝑝 + 0.1)𝑥 + 𝑦 = 𝑚
𝑦 ∶ All other goods, 𝑦 is a numeric good and price of 𝑦 = 1
Diagram
(iii) What are the properties of well-behaved indifferences curves? Check which properties are
violated in the following indifferences curves for two goods X and Y?
(a) Good X is a neutral good

(b) Goods X and Y are perfect complements. (4+6+5=15)
Sol.(iii) There are two properties of well-behaved indifference curves convexity and monotonicity.
According to the assumptions of monotonicity, more is better that is if (𝑥 , 𝑥 ) is a bundle of goods
and (𝑦 , 𝑦 ) is a bundle of goods with at least as much of both goods and more of one, then
(𝑦 , 𝑦 ? ? ? ? (𝑥 , 𝑥 ) or (𝑦 , 𝑦 ) is preferred to (𝑥 , 𝑥 ). According to the assumptions of convexity,
averages are preferred to extremes. That is, if there are two bundles of goods (𝑥 , 𝑥 ) and (𝑦 , 𝑦 )on
the some differences curve and take a weighted average of the two bundles such as
𝑡𝑥 + (1 − 𝑡)𝑦 , 𝑡𝑥 + (1 − 𝑡)𝑦 > (𝑥 , 𝑥 )
For t???????????? [0,1]
i.e., the average bundle will be atleast as goods as the two extreme bundles. Also, if (𝑥 , 𝑥 ) and
(𝑦 , 𝑦 ) are on the same indifferences curve and t ????? (0,1) i.e., 0 < 𝑡 < 1 then
𝑡𝑥 + (1 − 𝑡)𝑦 , 𝑡𝑥 + (1 − 𝑡)𝑦 > (𝑥 , 𝑥 )
For 𝑡 ? ? ? ? ? ? ? (0,1)
That is if 𝑡 ? ? ? ? (0,1) then the average bundle will be strictly preferred to the two extreme bundles.
(a) Good X is a natural good
A good is a neutral good if the consumers doesn’t care about it one way or the other i.e., the
consumer doesn’t care about the units of neutral good. In this case if the consumer has a bundle
(𝑥, 𝑦) and (𝑥 , 𝑦 ) is a bundle of goods with atleast as much of both goods and more of good 𝑦 then
(𝑥 , 𝑦 ) is strictly preferred to (𝑥, 𝑦). But if the common has a bundle (𝑥, 𝑦) and (𝑥 , 𝑦 ) is a bundle of
goods with atleast as much of both goods and more of the good 1 then, (𝑥 , 𝑦 ) will not be strictly
preferred to (𝑥, 𝑦).
(𝑥 , 𝑦 ) will be atleast as goods as (𝑥, 𝑦).
For example, it there are two bundles (1,1) and (4,1) because 𝑥 is a neutral good and consumer
doesn’t care about the unit of good 𝑥, (1,1) will be atleast as good as (4,1) and (1,1); and (4,1) will lie
on the same indifference curve.
So, monotonicity is violated in case of neutral goods.
When X is a normal good then strictly convexity is also violated.
For example if there are two bundles and let 𝑡 = ? ? ? ? ? (0,1)
𝑡𝑥 + (1 − 𝑡)𝑦 , 𝑡𝑥 + (1 − 𝑡)𝑦 > (𝑥 , 𝑥 )
1( ) 1( ) 1( ) 1( )
(𝑡𝑥 + (1 − 𝑡)𝑦 , 𝑡𝑥 + (1 − 𝑡)𝑦 ) = ( + , + )
2 2 2 2
???????????
Now, (2.5,1) ??????(1,1)
(2.5,1) ???? (4,1)
i.e., (2.5,1) is not strictly preferred to any of the extreme bundle (2.5,1) lies on the same indifferences
curve as (1,1) and (4,1). Thus, when X is a neutral good that strict convexity is violated.
(b) Good X and Y are perfect compliments
If X and Y are perfect compliments the equilibrium occurs at the ???. let say the equilibrium occurs
when quantity of good X = quantity of good Y then the utility function is given as :
𝑈(𝑥, 𝑦) = min(𝑥, 𝑦)
Now, in this case property of monotonicity will be violated.
For example if there are two consumption bundles-
(1,1) and (1,4) then by monotonicity (1,4) must be strictly preferred over (1,1) since there is atleast as
much of both goods and there is more of good Y but given the consumer difference more of good Y is
unnecessary for the consumer as he always prefers equal quantities of both goods.
Perfect complements also violate strict convexity
Let, the two bundles be (1,1) and (1,4) also let 𝑡 =
1( ) 1( ) 1 ( ) 1 ( )
𝑡𝑥 + (1 − 𝑡)𝑦 , 𝑡𝑥 + (1 − 𝑡)𝑦 ) = ( + , + )
2 2 2 2
= (1,2.5)
Now, (1,2.5) is not strictly preferred to either of the two bundle. (1,2.5) lies on the same indifference
curve as (1,1) and (1,4).
Q.2.(i) Check if the law of demand holds for good 𝒙𝟏 in case of the following utility function :
𝒖(𝒙𝟏 , 𝒙𝟐 ) = 𝒙𝟏 + 𝒙𝟐
(ii) Jaya’s consumption bundle consists of two goods 𝒙and 𝒚. Prices of these goods are rupee 5 and 10
per unit respectively. Her income increases from ₹ 100 per month to ₹ 200 per month. Drive her
income consumption curve and represent it graphically, if she has the following utility functions :
(a) 𝑼(𝒙, 𝒚) = 𝟐𝒙 + 𝒚𝟐
(b) 𝑼(𝒙, 𝒚) = 𝐦𝐢𝐧(𝟐𝒙, 𝟑𝒚)
(iii) Over a three month period, an individual exhibits following consumption behaviour :
Price of Good Price of Good X Y

X Y
Month 1 6 6 14 8
Month 2 8 4 12 12
Month 3 10 2 14 6
State the Weak Axiom of revealed preferences and check if the above behaviour is consistent with
this Axiom.
Sol.(i) 𝑢(𝑥 , 𝑥 ) = √𝑥 + 𝑥
In the above utility function, the two goods are perfect substitutes. Utility function is a monotonic
transformation of the utility function given as : 𝑢(𝑥 , 𝑥 ) = 𝑥 + 𝑥
Demand function for good 1 is given as :
?????????????????????????????
??????????????????????????
According to law of demand quantity demanded of a good falls when price of a good increases
assuming all other factors to be constant.
In this case, holding the price of other good constant quantity demanded of the good falls to 0. When
𝑃 > 𝑃 . Therefore, the law of demand holds in this case.
(ii)(a) 𝑈(𝑥, 𝑦)2𝑥 + 𝑦
𝑀𝑈 = 2, 𝑀𝑈 = 2𝑦
−2 −1
𝑀𝑅𝑆 = =
2𝑦 𝑦
In the above case, consumer has concave preferences. Indifference curves are level curves or contours
of the utility function.
If 𝑈(𝑥, 𝑦) = 𝐶, 𝐶 > 0
This level curve will consists of points satisfying this equation.
So, 2𝑥 + 𝑦 = 𝐶
Let 𝐶 = 4
(0,2); (1,1.41); (2,0) are points that will lie on this level curve. The indifference curve will touch the 𝑥
axis and 𝑦 axis.
Since the consumer has concave preferences, the optimum will occur at the boundary point. The
consumer will consume only one of the two goods. Whichever is cheaper since, price of good 𝑥 ( 5) is
less than price of good 𝑦( 10). Consumer will consume only good 𝑥.
Diagram
Diagram
(b) 𝑼(𝒙, 𝒚) = 𝐦𝐢𝐧(𝟐𝒙, 𝟑𝒚)
Price of good 𝑥 = 5, Price of good 𝑦 = 10
At the optimum level of consumption ratio of two goods = slope of ray from origin
 =
 3𝑦 ∗ =2𝑥 ∗ ………①
Original budget constraint of the consumer
 5𝑥 + 104 = 100
 5𝑥 ∗ + 10 𝑥 ∗ = 100 (using ①)
 15𝑥 ∗ + 20𝑥 ∗ = 300
 35𝑥 ∗ = 300
 𝑥∗ = = 8.5
 𝑦∗ = × = = = 5.7
New budget constraint after change in income
 5𝑥 + 10𝑦 = 200
 5𝑥 ∗ + 10 𝑥 ∗ = 200 (using ………..①)
 35𝑥 ∗ = 600
 𝑥∗ = = = 17.1
 𝑦 =∗
= = 11.4
Diagram
Diagram
(iii) The consumer choose consumption bundle (14,6) at prices (10,2) and he chooses consumption
bundle (12,12) at price (8,4)
According to the weak axiom of reveled preference if (𝑥 , 𝑥 ) is directly reveled preferred to (𝑦 , 𝑦 )

and the two bundles are not the same, then it cannot happen that (𝑦 , 𝑦 ) is directly reveled
preferred to (𝑥 , 𝑥 ).
It means that is a bundle (𝑥 , 𝑥 ) is purchased at prices (𝑝 , 𝑝 ) and a different bundle (𝑦 , 𝑦 ) is

purchased at prices (𝑞 , 𝑞 ) then if;
𝑝 𝑥 +𝑝 𝑥 > 𝑝 𝑦 +𝑝 𝑦
Then it must not be the case that –
𝑞 𝑦 +𝑞 𝑦 > 𝑞 𝑥 +𝑞 𝑥
We can say that the above consumers behaviour violates weak axiom of revealed preference. Since
when the consumer chose (14,6) at price (10,2) bundle (12,12) was available and when the consumer
case (12,12) at prices (8,4) bundle (14,60 was available. That is
10 × 14 + 2 × 6 = 152 > 10 × 12 + 2 × 12
= 152 > 144
And 8 × 12 + 4 × 12 = 144 > 8 × 14 + 4 × 6
= 144 > 136

Q.3.(i) A consumer is endowed with 300 and 100 units of goods 𝑿 and 𝒀 respectively. His utility
function is given by 𝒖(𝒙, 𝒚) = 𝟐𝒙(𝒚 + 𝟑). The prices of per unit of these goods, are ₹ 10 each initially,
and then the price of each unit of good 𝑿 rises to ₹ 15 thereafter. Calculate the change in the
optimum consumption of good 𝑿 due to substitution effect, ordinary income effect and endowment
income effect, using Slutsky’s decomposition.
Sol.(i) Endowment of Good 𝑋 = 300
Endowment of Good 𝑌 = 100
𝑢(𝑥, 𝑦) = 2𝑥(𝑦 + 3), price of each good = 10
Budget constraint of the consumer is given as ;
10𝑥 + 104 = 10 × 300 + 10 × 100
10𝑥 + 104 = 4,000
At the equilibrium
 𝑀𝑅𝑆𝑋𝑌 = −
 𝑀𝑈 = 2𝑦 + 6 = 2(𝑦 + 3)
 𝑀𝑈 = 2𝑥
( )
 𝑀𝑅𝑆𝑋𝑌 = − =−
 − = −1
 𝑦 + 3 = 𝑥∗
∗
Or, 𝑥 ∗ − 3 = 𝑦 ∗ ……….①
Putting back ① into the budget constraint ;
 10𝑥 + 10𝑦 = 400

 10𝑥 ∗ + 10(𝑥 ∗ − 3) = 4,000 (using ①)
 10𝑥 ∗ + 10𝑥 ∗ − 30 = 4,000
 20𝑥 ∗ = 4,030
 𝑥 ∗ = 201.5
Now price of good 1 increases to 15
 =
 2𝑦 + 6 = 3𝑥
 𝑦∗ =
 1.5𝑥 − 2 ……….②
New budget constraint of the consumers (assuming no change in income for ordinary income
effect) is given as
 15𝑥 ∗ + 10(1.5𝑥 ∗ − 2) = 4,000

 15𝑥 ∗ + 15𝑥 ∗ − 20 = 4,000
 30𝑥 ∗ = 4,020
 𝑥 ∗ = 134
(ii)A worker’s utility function for leisure (𝑹) and consumption (𝒀) is 𝑼(𝑹, 𝒀) = 𝑹 + √𝒀. He has 18
hours in a day, which he can spend on work or leisure. If the price of consumption is ₹ 1 and wage
rate is 𝒘. derive his labor supply function and check if labor supply curve is backward bending.
(iii) In the context of intertemporal choice, analyze the impact of a rise in interest rate for a person
who is initially a lender, with respect to his optimal choice and welfare.
(6+5+4=15)
Q.4.(i) Explain how a risk averse individual can benefit through risk sharing.
(ii) Amar, initially has a wealth (𝑾) equal to 2,000 and will lose 1,200 if his investment in a risky
bond is unsuccessful and will gain 1,200 if it is successful. The probability that the investment is
successful is 0.75 and his utility function is given by 𝑼(𝑾) = 𝑾𝟎.𝟓 .
(a) Is this bond a fair bond?

(b) What is Amar’s expected utility?
(c) Suppose, there is a secured non-risky gold bond. How much return should this gold bond
offer. So, that Amar chooses the gold bond instead of the risky bond.
(iii) Suppose, for a consumer, consumption when it is sunny and consumption when there is a
hurricane are perfect complements. Using a suitable graph, explain why this implies infinite risk
aversion. (4+6+5=15)
Part –B
(Attempt any two question in part B)
Q.5.(i) A computer institute teaches student to create software programs. The number of students
that the institute can teach per week is given by 𝑸 = 𝟏𝟎. 𝐦𝐢𝐧(𝑲, 𝑳), where 𝑲is the number of
computers the institute rents per week and 𝑳 is the number of teachers hired per week. Assume
𝑲 = 𝑲∗ in short run. Will the firm’s total cost function be different in the short-run and long-run?
(ii) For each of the following product function, find if returns to labor (𝑳) are increasing, decreasing
or constant as capital (𝑲) is held constant :
(a) 𝑸 = [𝜶. 𝑲𝑷 + (𝟏 − 𝒂). 𝑳𝑷 ]𝒃/𝑷 where, 𝟎 < 𝜶 < 𝟏

(b) 𝑸 = 𝑲𝑳 − 𝟎. 𝟖𝑲 − 𝟎. 𝟐𝑳
(c) The total cost function for a firm is given by
𝟏 𝟏 𝟐
𝑪= 𝜶𝒗𝟑 𝒘𝟑
𝟓
Where 𝒗 and 𝒘 are the prices of capital and labor respectively and 𝒒 represents the quantity
of output produced in this firm.
a. Use shepherd’s Lemma to compute the contingent input demand function for the labor
input (𝑳) and capital input (𝑲).
b. Use the results to calculate the underlying production function for 𝒒. (4+4+7=15)
Q.6.(i)(a) What are the necessary and sufficient conditions to ensure that a well behaved production
function is characterized by a diminishing rate of technical substitution?
(b) If a production function is given as :

𝟏 𝟏
𝒒(𝑳, 𝑲) = 𝑳𝟐 + 𝑲𝟑 ,
Check if there rate of technical substitution is diminishing. If yes, then check if diminishing
marginal productivities of labor and capital constitute a sufficient condition for diminishing rate of
technical substitution.
(ii) Find the long-run cost function and elasticity of substitution for the following production
functions :
(a) 𝒒 = 𝒇(𝑲, 𝑳) = 𝟐𝑲 + 𝑳
𝟏
(b) 𝒒 = 𝒇(𝑲, 𝑳) = 𝑲 + 𝑳 + 𝟐(𝑲𝑳)𝟐
(c) 𝒒 = 𝒇(𝑲, 𝑳) = 𝟎. 𝟓𝑲𝟐 (𝑳 + 𝟑)
Where 𝑲 and 𝑳 are inputs available at price ′𝒗′ and ′𝒘′ respectively. (6+9=15)
Q.7.(i) Explain why a producer is unable to minimize total costs in the short-run while he can do so
in the long-run ?
(ii) A firm has the following production function :
𝟏 𝟐
𝒒(𝑳, 𝑲) = 𝟎. 𝟓𝑲𝟑 𝑳𝟑
Where 𝑳 and 𝑲 are the inputs used to produce 𝒒 .
Prices of 𝒒, 𝑳 and 𝑲 are p , 𝒘 and 𝒗 respectively.
(a) Find the firms long-run unconditional demand for labor and capital.
(b) Find the firms long run profit maximizing output as a function of 𝑳.
(iii) A competitive firm has the following short-run cost function :
𝑪 = 𝑸𝟑 − 𝟖𝑸𝟐 + 𝟑𝟎𝑸 + 𝟓
Find the firms shut down prices and the minimum efficient scale of production. (5+6+4=15)
Intermediate Microeconomics 2018
Unique Paper Code. 12271301
Name of Course. B.A.(Hons.) Economics (CBCS)
Name of Paper. Intermediate Microeconomics – I
Semester – III
Time. 03 hours Maximum Marks. 75
Attempt five questions in all, selecting three questions from Section-A and two questions from
Section – B
Section – A
Q.1.(a) Consumer’s consumption bundle is described by (𝒙𝟏 , 𝒙𝟐 ). His money income is 100 and price
of good 1(𝒑𝟏 ) is 10 and price of good 2(𝒑𝟐 ) is 10.
(i) How does his budget constraint change when government gives lump-sum subsidy of 50
regardless his consumption behaviour?
(ii) How does his original budget constraint change when the government gives subsidy of 5 per unit
on good 1.
(iii) Compare his utility levels in case (i) and (ii) if his utility function is 𝒖(𝒙𝟏 , 𝒙𝟐 ) = (𝒙𝟏 , 𝒙𝟐 ). (3)
Sol. (a)(i) Given : Money income (m) = ₹100
Price of good 1 (𝑝 ) = ₹10
Price of good 2 (𝑝 ) = ₹10
Original budget constraints of the consumer
𝑝 𝑥 + 𝑝 𝑥 = 100 or 10𝑥 + 10𝑥 = 100
Amount of lump sum subsidy (s) = ₹50
New budget constraints of the consumer after consumption subsidy :
 𝑝 𝑥 + 𝑝 𝑥 = 𝑚 + 50
 10𝑥 + 10𝑥 = 100 + 50
 10𝑥 + 10𝑥 = 150
(ii) If the consumer is given quantity subsidy of ₹5. His budget constraints will be :
(𝑝 −5)𝑥 + 𝑝 𝑥 = 𝑚
(10−5)𝑥 + 10𝑥 = 100
5𝑥 + 10𝑥 = 100  New Budget Constraints.

(iii) 𝑈(𝑥 , 𝑥 ) = 𝑥 𝑥
𝑑𝑈(𝑥 , 𝑥 )
𝑀𝑈 = =𝑥
𝑑𝑥
𝑑𝑈(𝑥 , 𝑥 )
𝑀𝑈 = =𝑥
𝑑𝑥
𝑀𝑈 𝑥
𝑀𝑅𝑆 = − =−
𝑀𝑈 𝑥
Slope of the budget line in (i) = − = −1
Equilibrium level of consumption in case of (i)
𝑥
− = −1
𝑥
𝑥∗ = 𝑥∗
Putting this result back into the equation of the budget line (i) i.e.
10𝑥 + 10𝑥 = 150
At the equilibrium level
10𝑥 ∗ + 10𝑥 ∗ = 150
20𝑥 ∗ = 150 = 𝑥 ∗ = 7.5 = 𝑥 ∗
𝑈(𝑥 ∗ , 𝑥 ∗ ) = (7.5) = 56.25
Utility level in case of (ii)
5𝑥 + 10𝑥 = 100
Slope of budget line = − =−
At the equilibrium
𝑝𝑥
𝑀𝑅𝑆 =
𝑝𝑦
𝑥 1
− = − = 2𝑥 ∗ = 𝑥 ∗
𝑥 2
Putting this result back into the equation of the budget line (ii) i.e.
5𝑥 + 10𝑥 = 100
At the equilibrium
5(2𝑥 ∗ ) + 10𝑥 ∗ = 100
10𝑥 ∗ + 10𝑥 ∗ = 100

𝑥 ∗ = 5 = 𝑥 ∗ = 10
𝑈(𝑥 ∗ , 𝑥 ∗ ) = 50 utility is higher in (i) than in (ii)
(b) A Consumer always consumes one unit of good 𝑿 with 2 units of good 𝒀.
(i) Write her utility function. (1)
(ii) If price of good X is 5 and price of good Y is 10. He has to spend all his money income of 200
on Goods X and Y only. Find the optimal consumption of X and Y. illustrate diagrammatically. (4)
(c) What do assumptions of monotonicity and convexity imply about the shape of indifferences
curves? Does the utility function 𝒖(𝒙, 𝒚) = 𝒙 + 𝒚𝟐 satisfy these assumptions? (2+3)
Sol. (b) Consumer always consumes one unit of good X with 2 units of good Y.
(i) 𝑈(𝑋, 𝑌) = min(2𝑋, 𝑌)
(ii) Price of good X = ₹5
Price of good Y = ₹10
Money income (m) = ₹200
At the optimum level of consumption, ratio of two goods = slope of ray from origin.
=2
 𝑌 ∗ = 2𝑋 ∗ ----------- (i)
Budget constraints of the consumer is given as :
5𝑋 + 10𝑌 = 200
At the equilibrium
5𝑋 ∗ + 10(2𝑋 ∗ ) = 200 (using (i))
5𝑋 ∗ + 20𝑋 ∗ = 200
25𝑋 ∗ = 200 = 𝑋 ∗ = 8, 𝑌 ∗ = 16
(c) Monotonicity. According to the assumption of monotonicity, more is better that is if (𝑥 , 𝑥 ) is a

bundle of goods and (𝑦 , 𝑦 ) is a bundle of goods with at least as much of both goods and more of one,
then (𝑦 , 𝑦 ) ∝ (𝑥 , 𝑥 )or (𝑦 , 𝑦 ) is preferred to (𝑥 , 𝑥 ). Monotonicity implies that indifference curves
will have a negative slope. Starting from a bundle (𝑥 , 𝑥 ), if the consumer moves to a bundle which
is anywhere up and to the right, then he is moving to a preferred position. If the consumer chooses a
bundle which is down and to the left then he is moving to a worse position. If the consumer moves to
a bundle which is either left and up or right and down then he is moving to an indifferent position.
Thus, the indifference curves must have a negative slope.
Convexity. According to this assumption, averages are preferred to extremes. That is, if there are
two bundle of goods (𝑥 , 𝑥 ) and (𝑦 , 𝑦 ) on the same indifference curve and take a weighted average
of the two bundles such as
1 1 1 1
𝑥 + 𝑦 , 𝑥 + 𝑦
2 2 2 2
Then the average bundle will be at least as good as or strictly preferred to each of the two extreme
bundles. Convexity implies that indifference curves will be convex to the origin.
Now, if the utility function is given as :-
𝑈(𝑥, 𝑦) = 𝑥 + 𝑦
𝑀𝑈 = 1
𝑀𝑈 = 2𝑦
1
𝑀𝑅𝑆 =−
2𝑦
In the above case, consumer has concave preferences. Indifference curves are level curves or contours
of the utility function.
If 𝑈(𝑥, 𝑦) = 𝐶, 𝐶 ≥ 0
This level curve will consists of points satisfying this equation.
So, 𝑥 + 𝑦 = 𝐶
Let 𝐶 = 3
(0,1.73) ; (1,1,41) ; (2,1) and (3,0) are points that will lies on this level curve. The indifference curve
will touch both the x and y-axis.
Utility function satisfies monotonicity but not convexity.
Q.2.(a) A consumer consumes two goods X and Y and her preferences are described by the utility
function 𝒖(𝒙, 𝒚) = √𝒙 + 𝒚. The consumer’s money income is M. Price of good X is 𝑷𝒙 and price of Y is
𝑷𝒚 .
(i) Derive the inverse demand function for goods X and Y.
(ii) Graph the Engel curves for goods X and Y.
Sol. (a) Utility function of the consumer
𝑈(𝑥, 𝑦) = √𝑥 + 𝑦
Consumer’s money income is M, price of good X is 𝑝 and price of good Y is 𝑝 .
(i) Inverse demand for good X and Y.
Considering the utility maximization problem of the consumer.

max √𝑥 + 𝑦
,
Such that 𝑃 𝑥 + 𝑃 𝑦 = 𝑀
Solving the budget constraints for y we get,
𝑃 𝑦=𝑀−𝑃𝑥
𝑦= − ……….①
Putting the value of y in the objective function,
max 𝑥 √𝑥 + − ……….①
Differentiating the objective function w.r.t x,
− = 0  first order condition

√
= = 𝑃 (𝑥) = ……….②
√ √
Inverse demand function for good x is independent of income.
From (i) we have

𝑦= −
 𝑦𝑝 = 𝑀 − 𝑝 𝑥 ……….③
Substituting the value of 𝑃 ② into ③ we get,
𝑃
𝑦𝑃 = 𝑀 − ,𝑥
2√ 𝑥
𝑃
𝑦𝑃 = 𝑀 − √𝑥
2
√𝑥
𝑦𝑃 + 𝑃 =𝑀
2
2𝑦𝑃 + √𝑥𝑃 = 2𝑀
(2𝑦 + 𝑥)𝑝 = 2𝑀
2𝑀
𝑃 (𝑦) =
2𝑦 + √𝑥
 The inverse demand function for y is given as :
2𝑀
𝑃 (𝑦) =
2𝑦 + √𝑥
(ii) **********diagram**********
*************diagram*********
(b) Price and consumption of three goods in 2015 and 2017 are given as under :
Prices Quantity
Goods 2015 2017 2015 2017
A 10 15 100 110
B 5 20 50 80
C 15 10 150 120
Calculate the Laspeyres quantity index and show consumer is better off or worse of in 2017 as
compared to 2015.
∑ 𝒑𝒐 𝒙𝟏
Sol. (b) Laspeyres quantity index = ∑
𝒑𝒐 𝒙𝟎
𝑥 : current year quantity of the good.

𝑥 : base year quantity of the good.
𝑝 : base year quantity of the good.
In this question base year = 2015
Current year = 2017
Laspeyres quantity index =
𝑝 : base year price of good A
𝑝 : base year price of good B
𝑝 : base year price of good C
𝑥 : current year quantity of good A
𝑥 : current year quantity of good B
𝑥 : current year quantity of good C
𝑥 : base year quantity of good A
𝑥 : base year quantity of good B
𝑥 : base year quantity of good C
× × ×
Laspeyres quantity index =
× × ×
1,100 + 400 + 1800

1000 + 250 + 2250
3300 33
= = = 0.9428 < 1
3500 35
 The consumer’s welfare has gone down in the current period as when the consumer choose the
current year bundle of gods. Base year bundle was not affordable.
(c) Draw and explain the shape of indifference curves when;
(i) one of the two goods is neutral good,
(ii) one of the two goods is a bad and
(iii) consumer has a satiation point. (2+2+1)
Sol.(c)(i) One of the two goods is a neutral good.
When x is a good and y is a neutral when x is a neutral and y is a good
**diagram************** ******diagram*********
(ii) One of the two goods is a bad.
When x is a good and y is a bad. When x is a bad and y is a good.
******diagram****** ******diagram********
(iii) Consumer has a satiation point.
***********diagram***********
Q.3. If a consumer’s utility function is 𝒖(𝒙, 𝒚) = 𝒙𝟐 + 𝒚𝟐 and his money income is 400 has to spend
on only two goods X and Y, the price of X is 20. Using diagrams :
(i) Find the optimal choice when price of Y (𝑷𝒚 ) is 25. (2)
(ii) Find the optimal choice when price of Y (𝑷𝒚 ) is 16. (2)
(iii) Calculate substitution and income effects for good Y when 𝑷𝒚 decreases from 25 to 16. (2)
Sol. (a) Consumer’s utility function is given as :-
𝑈(𝑥, 𝑦) = 𝑥 + 𝑦
Money income = M, price of good X = ₹20
(i) From the consumer’s utility function, it can be observed that the consumer has concave
preference. For instance, indifference curves are level curves or contours of the utility function.
If 𝑈(𝑥, 𝑦) = 𝐶, 𝐶 ≥ 0
This level curve will consists of pints satisfying this equation.
So, 𝑥 + 𝑦 = 𝐶
Level curve of this equation are circles in the x-y plane centered at the origin with the radius √𝑐.
******************diagram************
The above graph shows that the consumer has concave preferences between good X and Y. So, he will
buy only one of the two goods i.e. the good which is cheaper.
Since the consumer preferences, optimal choice occurs at the boundary point. The consumer will
purchase one of the two gods that is, the consumer will consume the good which is cheaper. If price of
good Y is ₹25 and price of good X is ₹20; the consumer will consume only good X. The consumer will
spend his entire income on good X.
(ii) Now, when price of good Y has fallen, good Y has become cheaper than good X. therefore, now the
consumer will spend his entire income On good Y. the consumer will consume only good Y.
(iii) In this case, since consumer will buy one of the two goods there is no Income effect, there is only
substitution effect. Entire total effect in the quantity of good Y is due to substitution effect.
Therefore, magnitude of substitution effect in this case is 9 units i.e.(25 – 16)
(b) “As wage rate increase, supply of labor may increase or decrease. But, when ‘overtime’ wage rate
increases, labor supply always increase”. Explain with suitable diagrams. (4)
Sol. (b) Considering the budget constraints of the consumer who takes R amount of leisure and earns
wage rate equal to w.
Let 𝑐̅ be consumer’s endowment of consumption
Let 𝑝 be the price of consumer’s consumption
Let 𝑐 be the amount of consumption that the consumer has.
Budget constraints of the consumer is given as :
𝑃𝐶 + 𝑊𝑅 = 𝑃𝐶̅ + 𝑊𝑅
Now, if the wage rate increases, (assuming leisure is a normal good) demand for leisure will go
down by ordinary Income effect. Also, since leisure has become expensive, consumer would want
to buy less of it as a result demand for leisure will go down by substitution effect. But if the wage
rate increases, then money income must change as well. The change in demand resulting from a
change in money income is an extra income effect-endowment income effect. Sp, when the wage
rate increases, the value of endowment also increases and with this extra income, the consumer
may decide to take extra leisure.
Describing the change in labour supply wage rate changes for all hours :
∆𝑅 ∆𝑅
= 𝑠𝑢𝑏𝑠𝑡𝑖𝑡𝑢𝑡𝑖𝑜𝑛 𝑒𝑓𝑓𝑒𝑐𝑡 + (𝑅 ̅ − 𝑅)
∆𝑤 ∆𝑀
(+)
When wage rate increases for all hours, demand for leisure will fall by substitution effect. Since
leisure is a normal good, demand for leisure will fall by ordinary Income effect. But since (𝑅 − 𝑅)is
positive, the sign of the whole expression is ambiguous i.e. labour supply may increase or decrease
when wage rate increases for all hours.
But if wages increases for the extra work i.e. a firm offers the individual 𝑊 > 𝑊for the extra time
that he chooses to work then the labour supply increases unambiguously. The reason is that the
response to an overtime wage is essentially a pure substitution effect whereas increase in the wage
rate for all hours involves both substitution and income effect.
***************diagram****************
(c) What is Hicksian compensated demand curve? Why does the utility remain the same at every
point of this compensated demand curve in contrast to ordinary demand curve? (5)
Sol. (c) The Hicksian demand curve, in which the utility is held constant is called the compensated
demand curve. Hicksian demand curve show the relationship between the price of a good and the
quantity demanded of it, holding utility and prices of other goods constant. Hicksian demand curves
only show substitution effect, which means demand varies with only price. Because, the Hicksian
demand curve shows only substitution effect, utility along the Hicksian demand curve remains
constant. Ordinary demand curve involves both Income and Substitution effect. Hence, the utility
along an ordinary demand curve is not constant.
Q.4.(a) Suppose that a consumer has the utility function 𝒖(𝒄𝟏 , 𝒄𝟐 ) = 𝒄𝟏 𝒄𝟐 ; where 𝒄𝟏 is consumption in
period and 𝒄𝟐 is consumption in period 2. His income is 1,000 in period 1 and 1,200 in the period
2. He can borrow and lend at the market rate of interest. If the objective is to optimize utility by
choice of consumption over time.
(i) Determine whether the consumer would need to borrow or lend money if rate of interest is 20%
and there is no inflation. (2)
(ii) How his choice of consumption over time will change when rate of interest increase to 40% and
there is no inflation. (2)
(iii) Calculate the substitution effect, ordinary income effect and endowment income effect of change
in the rate of interest on 𝒄𝟏 .
Sol.(a) Utility function of the consumer:
𝑈(𝐶 , 𝐶 ) = 𝐶 𝐶
𝐶 : Consumption in period 1
𝐶 : Consumption in period 2
𝑀 : Income in period 1, 𝑀 = 1000
𝑀 : Income in period 2, 𝑀 = 1200
(i) The budget constraints of the consumer in terms of future value is given by :
(1 + 𝑟)𝐶 + 𝐶 = (1 + 𝑟)𝑀 + 𝑀
Or (1 + 𝑟)𝐶 + 𝐶 = (1 + 𝑟)1000 + 1200
If the interest rate is 20%

Equilibrium level of consumption occurs at the point where,
𝑀𝑈 𝐶
𝑀𝑅𝑆 =− =−
𝑀𝑈 𝐶
𝐶
− = −(1 + 𝑟)
𝐶
Putting 𝑟 = 0.2
𝐶
= 1.2
𝐶
𝐶 ∗ = 1.2𝐶 ∗ ………①
Substituting (i) into the budget constraints of the consumer
(1 + 0.2)𝐶 + 𝐶 = (1 + 0.2)1000 + 1200
1.2𝐶 + 𝐶 = 1.2(1000) + 1200
1.2𝐶 + 𝐶 = 1200 + 1200 = 2400
At the equilibrium
1.2𝐶 ∗ + 1.2𝐶 ∗ = 2400 (using ①)
2.4𝐶 ∗ = 2400
2400 × 10
𝐶∗ = = 1000
24
𝐶 ∗ = 1200 (using ①)
 When rate of interest is 20%, the consumer will neither be a borrower nor a lender. The
consumer at this rate of interest, will consume his Income in both the periods.
(ii) When the rate of interest is 40% and there is no inflation.
At the equilibrium level of consumption,

𝑀𝑅𝑆 = −(1 + 𝑟)
(1 + 𝑟) = 1 + 0.4 = 1.4
𝐶
𝑀𝑅𝑆 = −
𝐶
− = −1.4
𝐶 ∗ = 1.4𝐶 ∗ ……….②
Budget constraints of the consumer is given by :
1.4𝐶 + 𝐶 = 1.4(1000) + 1200

1.4𝐶 + 𝐶 = 1400 + 1200 = 2600
Substituting ② we get,
1.4𝐶 ∗ + 1.4𝐶 ∗ = 2600
2.8𝐶 ∗ = 2600 = 𝐶 ∗ = 928.57
𝐶 ∗ = ₹1300 (using (iii))
(iii) Budget constraints of the consumer in terms of future value is given by:
(1 + 𝑟)𝐶 + 𝐶 = (1 + 𝑟)𝑀 + 𝑀
Now using slutsky equation to describe the change in current consumption, when interest rate
changes
∆𝐶 ∆𝐶 ∆𝐶
= + (𝑀 − 𝐶 )
∆ℎ ∆𝑃 ∆𝑀
(−) (+)
If the interest rate rises then :
The substitution effect works in the opposite direction of price. The substitution effect has a negative
sign. Its current consumption is a normal good then the last term that is how consumption changes
as income changes will be positive. Hence, it has a positive sign below it. The sign of the whole
expression depends on the sign of (𝑀 − 𝐶 ). If the person was a borrower , then this term will be
negative and the whole expression will be unambiguously negative. If the person was a lender, then
this term will be positive and the total effect will be ambiguous.
In the given question, when the interest rate was 20% the consumer was consuming only his Income
in both the periods. He was neither a borrower nor a lender. When the interest rate increases to
40%, he becomes a lender. Therefore in this case, 𝑀 − 𝐶 will be equal to 0. As initially he was
consuming only his Income in the first period. Thus, the Income effect will be 0 in this case and total
effect in consumption of periods 1 will be equal to the substitution effect.
 Total effect = substitution effect = 1000 − 928.57 = 71.43
(b) An individual has three investment options X, Y and Z;
(i) return from option X is of 1,000 with certainty;
(ii) return from option Y is 1,500 with the probability 1/3 and 600 with probability 2/3 and
(iii) return from option Z is 1,000 with probability 1/4 and return of 1,000 with probability 3/4.
Calculate the expected return of these investment options. (2)
Sol.(b)(i) Expected return from option × is ₹1,000
(ii) Expected return from option 4 is

1 2
× 1500 + × 600 = 500 + 400 = 900
3 3
(iii) Expected return from option 2 is
1 3 1 3
× 1000 + 1000 × = 1000 +
4 4 4 4
= ₹1000
(c) Graphically explain any one method managing risk other than insurance. (5)
Sol. (c) Hedging refers to the practice of taking on two risky activities with negatively correlated
financial payoffs.
For example, if there is an Individual ‘A’ who is uncertain about the weather. There are only two
positive states of nature, “Sun” and “Hurricane”. Assuming probability of Sun 2/3, and probability of
Hurricane is 1/3. Individual ‘A’ earns $600 and consumes only one good ‘food’. Regardless of the
weather, individual ‘A’ can invest his money in two activities. Individual ‘A’ can buy sunscreen
concession at the local beach for an investment of $300. Expected pay off of individual ‘A’ from this
activity is :
Expected pay off = . 600 + (−300) = $300
That is, individual ‘A’ earns a profit of $600 if it is sunny but in case of hurricane, she sells nothing
and loses his investment. If it’s sunny, A makes $600 which means he can spend $1200 on food (his
earnings $600 plus her net profit $600) in this case A reaches point B on the indifference curves.
On the other hand Individual ‘A’ can invest $300 in a portable generator distributorship. Individual
‘A’ earns a profit of $600 if there is a hurricane. In case of a sun, he loses his investment. Expected
pay off of individual ‘A’ from this activity is :
If its hurricane A makes $1200 which means he can spend $1200 on food. In this case A reaches
point E on the Indifference curve.
If A invests only in one of the two activities, he is faced with substantial risk premium. But id A
invests in both the activities, then the net profit is positive.
Net profit = . (600 − 300) + (600 − 300)
2 1
= . 300 + . 300 = $300
3 3
In this case, regardless of the weather , A can spend $900 on food ($600 that he earns plus $300 in
net profit). In this case A reaches point E on the indifference curve. Thus, taken together these
investments are riskless.
********************diagram***********
Section – B
𝟏 𝟏
Q.5.(a) Let a production function be 𝑭(𝑳, 𝑲) = (𝑳𝟐 + 𝑲𝟐 )𝟐 and let 𝑭(𝑳, 𝑲) = [𝑭(𝑳, 𝑲)]𝟑 . Here 𝑳 is labour
and 𝑲 is capital.
(i) Does 𝑭(𝑳, 𝑲) exhibits constant return to scale, decreasing returns to scale or increasing returns to
scale? (2)
(ii) Does 𝑭(𝑳, 𝑲) exhibits constant returns to scale, decreasing returns to scale or increasing returns
to scale? (2)
(iii) What does this functional transformation teach you about the shape of isoquants and RTS
(return to scale) (2)
Sol. (a) Production function of the firm is given as :
/ /
𝐹(𝐿, 𝐾) = (𝐿 +𝐾 )
Let 𝐹(𝐿, 𝐾) = [𝑓(𝐿, 𝐾)]
(i) For any 𝑡 > 1

/ /
𝑓(𝑡𝐿, 𝑡𝐾) = (𝑡𝐿) + (𝑡𝐾)
/ / / /
= 𝑡 𝐿 +𝑡 𝐾
/ / /
= 𝑡 (𝐿 +𝐾 )
/ /
=𝑡 𝐿 +𝐾
 𝑓(𝐿, 𝐾) has constant returns to scale.

(ii) 𝐹(𝐿, 𝐾) = [𝑓(𝐿, 𝐾)]
/ /
𝐹(𝐿, 𝐾) = 𝐿 +𝐾
= 𝐿 +𝐾
For any 𝑡 > 1
𝐹(𝑡𝐿, 𝑡𝐾) = 𝑡𝐿 + 𝑡𝐾
/ / / /
= 𝑡 𝐿 +𝑡 𝐾
/ / /
= 𝑡 (𝐿 +𝐾 )
/ /
= 𝑡 (𝐿 +𝐾 )
 𝐹(𝑡𝐿, 𝑡𝐾) > 𝑡𝐹(𝐿, 𝐾) for 𝑡 > 1

 𝐹(𝐿, 𝐾) has increasing returns to scale.
(iii) Any constant returns to scale production function will be homothetic i.e. its isoquants
will be radial expansions of one another. Along any ray through the origin (where the
K/L ratio does not change), the slopes of successively higher isoquants are identical.
𝐹(𝐿, 𝐾) is a monotonic transformation of 𝑓(𝐿, 𝐾), hence 𝐹(𝐿, 𝐾) is a isoquant function.
The property of homotheticity is retained by any monotonic transformation of a
homogeneous function. Hence increasing or decreasing returns to scale can be
incorporated into a constant returns to scale function through an appropriate
transformation. Changes in returns to scale will just change the labels on the isoquants
rather than their shapes. Therefore, 𝐹(𝐿, 𝐾) has increasing returns to scale but its
isoquants will have the same shape as the isoqaunts of the production function 𝑓(𝐿, 𝐾).
(b) Let 𝒇(𝑳, 𝑲) = 𝑲 + 𝑳 + 𝟐√𝑲𝑳, here 𝑳 is labour and 𝑲 is capital.
(i) Deriving the slope of isoquants test for the convexity/concavity of the curves. (3)
(ii) Compute the cross partial derivatives and comment. (2)
Sol.(b) 𝑓(𝐿, 𝐾) = 𝐾 + 𝐿 + 2√𝐾𝐿
Slope of the isoquants = MRTS or marginal rate of technical substitution.
𝑀𝑃
𝑀𝑅𝑇𝑆 =
𝑀𝑃
𝑑𝑓(𝐿, 𝐾) 1
𝑀𝑃 = =1+ ×𝐾×2
𝑑𝐿 2√𝐾𝐿
𝐾
= 1+
𝐿
𝑑𝑓(𝐿, 𝐾) 1
𝑀𝑃 = = 1+ ×𝐿×2
𝑑𝐾 2√𝐾𝐿
𝐿
= 1+
𝐾
1 + √𝐾√𝐿 √𝐿 + √𝐾
𝑀𝑅𝑇𝑆 = =
1 + √𝐿/√𝐾 √𝐾 + √𝐿
= √𝐾/√𝐿
As 𝐾/𝐿 ratio falls. MRTS falls. Therefore, isoquants have a convex shape.
(ii) 𝑓 = 1 +
1 1 1
𝑓 = × =
√𝐿 2√𝐾 2√𝐿𝐾
𝐿
𝑓 = 1+
𝐾
1 1 1
𝑓 = × =
√𝐾 2√𝐿 2√𝐿𝐾
𝑓 =𝑓 also both 𝑓 and 𝑓 are positive
𝑑𝑅𝑇𝑆 𝑓 𝑓 − 2𝑓 𝑓 𝑓 ∓𝑓 𝑓
=
𝑑𝐿 (𝑓 )
𝑓 , 𝑓 > 0, 𝑓 , 𝑓 < 0, 𝑓 =𝑓 >0= < 0, isoquants are convex.
(c) Let 𝒒 = 𝑲𝑳𝟐 − 𝑳𝟑 , 𝒒 ≥ 𝟎, where 𝒒 is the quantity of output, 𝑲 = units of capital and 𝑳 = units of
labour. Sketch the 𝑨𝑷𝑳 and 𝑴𝑷𝑳 curves carefully noting, slope and convexity/concavity. (4)
Sol. (c) Production function is given by :
𝑞 = 𝐾𝐿 − 𝐿 , 𝑞 ≥ 0
To construct the marginal ad average productivity functions of labour (L) for this function, we must
assume a particular value for other input, capital (K). let us assume K=15. Then the production
function is given by :
𝑞 = 15𝐿 − 𝐿
𝑀𝑃 = = 30𝐿 − 3𝐿 ……….①
𝑞 reaches maximum value when 𝑀𝑃 = 0
Putting ①equal to 0
30𝐿 − 3𝐿 = 0 = 𝐿(30 − 3𝐿) = 0 = 30 = 3𝐿
𝐿∗ = 10 is the value at which q reaches its maximum.
Taking second derivative of q.
= 30 − 6𝐿 = 30 = 6𝐿 = 𝐿 = 5 is the point where 𝑀𝑃 reaches its maximum.
Taking second order derivative of 𝑀𝑃
( / )
= −6 < 0 = 𝑀𝑃 is concave and has a maximum at 𝐿 = 5.
For 𝐿 > 5, or slope of 𝑀𝑃 is positive.
For 𝐿 = 5 slope of 𝑀𝑃 is 0.
For 𝐿 > 5 slope of 𝑀𝑃 is negative.
Now, 𝐴𝑃 = = 15𝐿 − 𝐿
Differentiating w.r.t L
𝑑𝐴𝑃
= 15 − 2𝐿
𝑑𝐿
𝑑𝐴𝑃
= 0 = 15 − 2𝐿 = 0 = 𝐿 = 7.5
𝑑𝐿
 𝐴𝑃 reaches its maximum at 𝐿 = 7.5

Taking second order derivative of 𝐴𝑃
( / )
= −2 < 0 = 𝐴𝑃 is concave and has a maximum at 𝐿 = 7.5.
Slope of 𝐴𝑃 is positive for 𝐿 < 7.5

Slope of 𝐴𝑃 is equal to 0 for 𝐿 = 7.5
Slope of 𝐴𝑃 is negative for 𝐿 > 7.5
When 𝐴𝑃 reaches its maximum, average and marginal productivities of labour are equal.
At 𝐿 = 7.5
𝐴𝑃 = 15𝐿 − 𝐿 = 15(7.5) − (7.5) = 56.25
𝑀𝑃 = 30(7.5) − 3(7.5) = 225 − 168.75

= 56.25
******************diagram**********
Q.6. Let total cost be given by 𝑪 = 𝒒𝒘𝟏/𝟐 𝒗𝟏/𝟐 (there 𝒒 is output, 𝒘 is price of labour nd 𝒗 is rental
price of capital).
(i) Use Shepard’s Lemma to arrive at the contingent demand function for labour and capital with ′𝒘′
as wage rate and ′𝒗′ as rental cost of capital. (2)
(ii) Use these contingent demand functions to arrive at the production function. (4)
Sol.(a) Total cost is given by :
/ /
𝐶 = 𝑞𝑤 𝑣
𝑞 : output, 𝑤 : price of labour, 𝑣 : price of capital
(i) The process of cost minimization creates implicit demand for inputs. Because the process of cost
minimization holds quantity produced constant, demand for inputs is contingent on the quantity
being produced. The contingent demand function for any input can be derived by taking partial
derivative of the total cost function with respect to that input’s price. This process of deriving
contingent demand function for any input through the total cost function is called Shephard’s
Lemma.
𝑑𝐶(𝑣 𝑤 𝑞) 1 / /
= 𝑞𝑤 𝑣 = 𝐿 (𝑣 𝑤 𝑞)
𝑑𝑤 2
𝑑𝐶(𝑣 𝑤 𝑞) 1 / /
= 𝑞𝑤 𝑣 = 𝐾 (𝑣 𝑤 𝑞)
𝑑𝑤 2
Now,
/
(ii) 𝐿 (𝑣 𝑤 𝑞) = 𝑞𝑤 /
𝑣 /
= 𝑞
1 1 𝑣 /
/ /
𝐾 (𝑣 𝑤 𝑞) = 𝑞𝑤 𝑣 = 𝑞
2 2 𝑤
Let 𝑇 =
 𝐿 = 𝑞𝑇 /
, 𝐾 = 𝑞𝑇 /
 𝐿 = 𝑞𝑇
 𝐿= = √𝑇 = ……….①
√
𝑞√𝑇
∵ 𝐾=
2
Substituting ①
𝑞 𝑞
𝐾= . = 𝑞 = 4𝐾𝐿 = 𝑞 = 2√𝐾𝐿
2𝐿 2
(b) Discuss the following properties of total cost function: (2+2)
(i) Total cost is non-decreasing in output and input prices.
(ii) Total cost is concave in input prices.
Sol. (b)(i) Total cost is non-decreasing in output and input prices.
According to this property of total cost function, cost functions are derived from a cost minimization.
Therefore, any decrease in costs from an increase in one of the cost function’s arguments would
mean, the firm was not minimizing its costs earlier. For example, if an increase in output from 𝑞 to
𝑞 caused total costs to decrease, it must be the case that the firm was not minimizing input reduces
cost, it implies that the firm was using the input combination 𝐿 , 𝐾 and wages increases. Increase
in wages will increase the cost of the initial bundle of inputs. But if changes in input choices caused
total cost to decrease, that must imply there was a lower cost input mix than 𝐿 , 𝐾 initially. Hence,
there is a contradiction.
(ii) Total cost is concave in input prices.
According to this property of total cost function, a firm will change its input mix in response to
changes in input prices in order to minimize its costs, as a result the cost function will have a
concave shape. In this figure below, total costs is shown for various values of 𝑤 holding 𝑞 and 𝑣
constant .suppose that initially input prices were 𝑤 and 𝑣 and total output 𝑞 was produced at total
cost 𝐶(𝑣 , 𝑤 , 𝑞 ) = 𝑣 𝐾 + 𝑤𝐿
But a cost minimizing firm would change the input mix it uses to produce 𝑞 when wages change,
and the actual cost C(𝑣 , 𝑤 , 𝑞 ) would fall below the “pseudo” costs. Hence, the total cost function will
have a concave shape.
**************diagram************
If the firm produces y units of output
 cost function for the firm is given as :
𝑤𝑦 𝑖𝑓 𝑤 < 𝑣
𝑇𝐶(𝑦, 𝑤, 𝑣) 𝑣𝑦 𝑖𝑓 𝑣 < 𝑤
𝑡𝑦 𝑖𝑓 𝑣 = 𝑤 = 𝑡
(c) Let 𝒒 = (𝑳 + 𝑲)𝟏/𝟑 (where 𝒒 is quantity of output, 𝑲 = units of capital and 𝑳= units of labour).
(i) Derive the input demand function (contingent) for labour. (2)
(ii) Use the input demand (contingent) so derived to arrive at the total cost function. (3)
Sol. (c) 𝑞 = (𝐿 + 𝐾) /
(i) Input demand function for labour

Production function is given as:
/
𝑞 = 𝑓(𝐿 + 𝐾)
Constant elasticity of substitution (CES) production function is given as :
/
𝑞 = 𝑓(𝐾, 𝐿) = [𝐾 + 𝐿 ]
For 𝑇 ≤ 1, 𝑇 ≠ 0 and 𝑟 > 0
In the given production function
𝑞 = (𝐿 + 𝐾 )
 𝑇 = 1 and 𝑟 = 1/3
When 𝑇 = 1 in case of the CES we get a linear production function. The given production function is
a homothetic function. It is a monotonic transformation of a linear production function. Because in
linear production, labour and capital are perfect substitutes. Thus, firm will use either labour or
capital depending on the input prices.
Firm will use the input which is cheaper.
Now, if the firm has to produce y units of output then 𝑦 = (𝐿 + 𝐾)
0 𝑖𝑓 𝑤 > 𝑣
 𝐿(𝑤, 𝑣, 𝑞) = 𝐿/ 𝑖𝑓 𝑤 < 𝑣
/
[0, 𝐿 𝑖𝑓 𝑤 = 𝑣
(ii) Since the firm will use only one of the two inputs
 if the firm uses only labour then
𝑦=𝐿 /
or 𝐿 = 𝑦
& if the firm uses only capital then
𝑦=𝐾 /
or 𝐾 = 𝑦
Q.7. Let demand function be 𝒒 = 𝒂𝒑𝒃 ; where 𝒒 is output and 𝑷 is price of output.
(i) What is the economic interpretation of 𝒃? Verify using the demand curve. (2)
(ii) When MR positive and/or negative? Relate this to ′𝒃 .
(iii) If a firm is maximizing its profits, where will it produce? Explain in terms of elasticity of
demand. (3)
Sol.
(a) Demand function is given as :
𝑞 = 𝑎𝑝
∆
(i) Elasticity of demand = − .
∆
∆
 = −𝑎𝑏𝑝
∆
𝑝
𝑒 = −𝑎𝑏𝑝 .
= −𝑏𝑝 (𝑝 )
𝑎𝑝
= −𝑏𝑝( )
= −𝑏. 1 = −𝑏
 𝑏 is the elasticity of demand.
(ii) 𝑇𝑅 = 𝑞. 𝑝
𝑞 /
𝑝=
𝑎
 𝑇𝑅 = 𝑞.
/
 𝑇𝑅 = 𝑞 /
 𝑀𝑅 = . 1+ 𝑞
 𝑀𝑅 = 1+
 𝑀𝑅 = 1 +
 MR is proportional to price. For example if 𝑏 = −2 then 𝑀𝑅 = 0.5𝑝. and if 𝑏 = −∞ then 𝑀𝑅 = 𝑝,

that is in this case of infinitely elastic demand, the firm is a price taker, in general, MR curve
approaches the demand curve as demand becomes more elastic. For inelastic demand curve, MR is
negative (and maximization would be impossible).
(iii) Any profit maximizing firm will produce output upto the pint where,
𝑀𝑅 = 𝑀𝐶
 𝑀𝐶 = 1 + 𝑝
 𝑀𝐶 = 𝑝 +
 = or =− ………..①
This equation gives mark up of price over marginal cost. The markup depends on the elasticity of
demand facing the firm. It is important that demand facing the firm must be elastic. Because if
the demand is inelastic, then the ratio in (i) would be greater than 1, which is impossible if a
positive MC is subtracted from a positive 𝑝 in the numerator. This simply reflects that when
demand is inelastic, marginal revenue is negative and cannot be equated to a positive marginal
cost.
Equation ①implies that the percentage markup over marginal cost will be higher the closer 𝑒
is to −1. If the demand facing the firm is infinitely elastic (because there are many other firms
producing the same good), then 𝑏 = −∞ and there is no markup i.e. 𝑃 = 𝑀𝐶. On the other hand,
with an elasticity of demand of say 𝑏 = −2, the markup over marginal cost will be 50% of price
i.e. =−
(b) Let 𝒒 = 𝑨𝑲𝟐/𝟓 𝑳𝟐/𝟓 ; (where 𝒒 is quantity of output, 𝑲 = units of capital and 𝑳 = units of labour).
Derive the input demand function in terms of price of output (𝑷), price of labour (𝒘) and price of
capital (𝒗).
Sol. (b) Production function is given as:
/ /
𝑞 = 𝐴𝐾 𝐿
𝐾 = units of capital ; 𝐿 = units o labour
Firm’s profit function is given as:
𝜋(𝑃, 𝑉, 𝑊) = max [𝑃𝑓(𝐾, 𝐿) − 𝑉𝐾 − 𝑊𝐿]

,
Firm’s profit are given as:
/ /
𝜋 = 𝑃 𝐴𝐾 𝐿 − 𝑉𝐾 − 𝑊𝐿
Calculating the first order conditions:
= 𝑃𝐴𝐾 /
𝐿 /
−𝑊 …………①
= 𝑃𝐴𝐾 /
𝐿 /
−𝑉 …………②
Using ②
2 / /
𝑃𝐴𝐾 𝐿 −𝑉 =0
5
/ /
𝑃𝐴𝐾 𝐿 −𝑉
𝑉
𝐿 =
2
𝑃𝐴𝐾
5
/
𝑉 /
𝐿 = .𝐾
2
𝑃𝐴
5
𝑉 ×
𝐿= .𝐾
2
𝑃𝐴
5
𝐿= .𝐾 /
…………③
Substituting ③ in ①
 𝑃𝐴𝐾 𝐿 −𝑊 =0
/
 𝑃𝐴𝐾 /
.𝐾 /
=𝑊
/
 𝑃𝐴𝐾 / (𝑣) /
𝑃𝐴 .𝐾 /
=𝑊
/
 𝑃𝐴 .𝐾 / /
.𝑣 /
=𝑊
/
 𝑃𝐴 .𝐾 /
.𝑣 /
=𝑊
Squaring both sides
 𝑃𝐴 .𝐾 .𝑣 =𝑊
 𝐾 =
.
 𝐾 =
( / )
 𝐾= …………④
Putting ④ in ③ we get,
/
𝑉 (2/5𝑃𝐴)
𝐿= .
2 𝑣 𝑊
𝑃𝐴
5
/
2
𝑉 / 𝑃𝐴
𝐿= /
. 5 /
2 𝑣 𝑊
𝑃𝐴
5
/ /
/ /
2
𝐿=𝑉 . 𝑃𝐴 .𝑊
5
/
/
𝐿=𝑉 . 𝑃𝐴 .𝑊
2
𝑃𝐴
𝐿= 5
𝑉 𝑊
 𝐿(𝑃, 𝑉, 𝑊) =
 𝐾(𝑃, 𝑉, 𝑊) =

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B.A.

(Hons) Economics 1 Year-2007

Q.1. Show how much will an

Now, intertemporal budget constraint is given by

Therefore, budget constraint becomes 2 = 5,666.67 i.e.,  = ₹ 2833.33 and  =

Now, new price is BK

Assume three individuals - A, B, C.

#($b, $cb) = . d$b + . ed$cb

This implies C = (2A)B /D . Putting it in budget line, we get:

his Von Neumann Morgenstern utility function is given by h = dR (R is

baseline consumption, consumers will definitely reduce their usage because

choose the payment of ₹ 780 even if it means a lower return because it

Q.1. Aman consumes two goods, peanuts and juice. He prefers to

Since there are different rates for borrowing

Q.1. Answer the three questions.

(b) What is meant by a fair bet? Suppose a person has preferences

Marginal utility from good A = 1/2(A + 2)^/ C/

Putting value of C in budget constraint, we get : 6A + 6A + 12 = 10

Q.3. Let a production function be represented by ­(, ) = ® ^® ,

RTS = » /¼

Thus, elasticity of substitution for a production function Ã(, ) = ¾  ^¾ is

For diminishing marginal rate of technical substitution, !¿v/ < 0

Q.5.(a) Let the production function of a firm be represented by

Putting back in , we get

(ii)Conditional demand function of (Ã, È, ) demand of  as a function of the

• If A is taller than B & B is taller than C then it follows that A is taller

with slope = −1 as shown in figure. So, optimum consumption point is E i.e., he

consumption in the current and next year respectively. Assume that

This means,  = 1.06£. Putting this in inter-temporal budget constraint, we

to him. Initially he was in equilibrium at A (to the left of W because he is a

C0 + C1 / 1.08 = 1,04,000 + (1,06,000)/1.08 = 2,02,148.148 with slope = 1+r = 1.08

Therefore his budget line is AD with slope −1.5,

Q.5.(a) Does declining marginal productivity of inputs guarantee

Hence first order condition for maximization is

We find the unconstrained maximum of G with respect to l and k by finding the

(b) Perfect complements are goods that are consumed

(a) Write his utility function.

consumer say moves to point which is on a lower indifference curve 7 , and

(a) Compute the optimal consumption bundle when the price of Q is

But we know labor supply will increase unambiguously due to revealed

Let labour supply be represented by , then ! = 24 −

Then if: ÏB × A + ÏD × C ≥ ÏB × A + ÏD × C ,

(iii) Do the following production function exhibit increasing,

(a) Find the firm's shutdown price.

(ii) A firm has the following production function ­ = √S + √², where S

Sol.(a) Unconditional demand function for labour is Z(, È, Ï) and capital is

Q.1.(i) What are the standard assumptions about consumer preferences

assumptions of transitivity (of indifference) and monotonicity is that two

And intercepts:  axis = 80/5 = 16 and Y axis = 80/1 = 80.

(b) Let the number of visits be A.

Price ratio = 2/1 = 2

Therefore, the optimal consumption bundle is (10, 20).

3A + 2A = 30 i.e., 5A = 30 or A = 6 and thus C = 2(6) = 12

Thus, optimum consumption bundle is (6, 12)

Now, ¡ = 1 as it is consumption expenditure and V = 25 in terms of

Hypothesis is not able to predict his behavior in this

Q.4.(i) Derive the relationship between insurance premium and

chances of success and failure. He gets double the money if the

investment's expected payoff is positive, even an extremely risk-averse person

Q.5.(i) Given the production function = ß® ^® , where is the

δ/δ = (½)E ¾ ^¾

Putting value of  in constraint, we get:

or (1 − ½) + ½ = (1 − ½)

Average Total Cost (ATC) is equal to total cost

Therefore, budget constraint becomes 2 = 5,666.67 i.e., = ₹ 2833.33 and =

Now, new price is BK

#($b, $cb) = . d$b + . ed$cb

This implies C = (2A)B /D . Putting it in budget line, we get:

Marginal utility from good A = 1/2(A + 2)^/ C/

Q.3. Let a production function be represented by (, ) = ® ^® ,

RTS = » /¼

Thus, elasticity of substitution for a production function Ã(, ) = ¾ ^¾ is

For diminishing marginal rate of technical substitution, !¿v/ < 0

Putting back in , we get

(ii)Conditional demand function of (Ã, È, ) demand of as a function of the

This means, = 1.06£. Putting this in inter-temporal budget constraint, we

Then if: ÏB × A + ÏD × C ≥ ÏB × A + ÏD × C ,

(ii) A firm has the following production function = √S + √², where S

Sol.(a) Unconditional demand function for labour is Z(, È, Ï) and capital is

And intercepts: axis = 80/5 = 16 and Y axis = 80/1 = 80.

Now, ¡ = 1 as it is consumption expenditure and V = 25 in terms of

Q.5.(i) Given the production function = ß® ^® , where is the

δ/δ = (½)E ¾ ^¾

Putting value of in constraint, we get:

or (1 − ½) + ½ = (1 − ½)

Putting it equal to zero, we get: 4000/g = 10 i.e., g = 400 or g = 20

Ð(, È, ) = ¬fA Ð(, Z) = ¬fA[ (, Z)– È– Z]

Since > ¨, he is a net buyer of potatoes.

(b) Now I = 20, his budget constraint will be 20 + 10¿ = 50 × 20 + 80 × 10 =

1 + 2/0.8 = 16,250 or 2/0.8 = 16,250 – 1

(a) Ã(, Z) = + + 2()/

(iii) Let a firm's production function be represented by q =√ + .