ECON 201 (Fall 2020) Department of Economics, SFU

Prof. Christoph Lülfesmann

Assignment # 1

I. Short Problems - Explain! No credit will be given without a

justification of your answer (8 pts each)
1. The optimal choice for the consumer is always given by the point of
tangency between budget line and an indifference curve. Discuss.
2. Consider an economy with two people (Jerry and Jen) and just one
good, roses. Both of them like roses, and the economy wide endowment of
roses is 100. Consider two different allocations: allocation 1 where Tom has
all 100 roses, and allocation 2 in which each of them has 50 roses. A politician
says that the first allocation is ‘Pareto-inefficient’. Does he have a point?
3. Suppose the optimal demand for two goods 1 and 2 is characterized
by the relation x∗1 = 2x∗2 , no matter what the person’s income. Give a utility
function compatible with these preferences! What is the demand function
for each good?
4. Consider an economy with two goods which are perfect substitutes (on
a one-to-one basis), blue and red pencils. At original prices, Franny is just
indifferent between buying red and blue pencils. Now suppose that the price
of blue pencils goes up by 1 unit while the price of red pencils goes down by
1/2 units. Is Franny now worse off than before?

II. Long Problems

Problem 1 (20 pts.) (Explain your answers!)

√
Tom’s preferences are given by the utility function U = 4 x1 + x2 , where x1
represents his consumption of pop tarts, and x2 the consumption of fitness
classes. A box of pop tarts costs him 6, and one fitness class 12 dollars.

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 a) What is Tom’s optimal choice if his income m is 60? What if it is 108?
What if it is 228? Compute Tom’s demand function for both goods!

b) Graph Tom’s indifference curves and his budget sets for the three in-
come levels given in a). Also graph his optimal choices in all three
situations, and explain.

c) After a while Tom thinks about enrolling as a regular member of his

fitness club. The member fee is 24 dollars but gives him free access to
fitness classes (since he studies at University, he won’t be able to attend
more than 10 fitness classes though). Should he enrol if his income is
24? Explain.

Problem 2 (20 pts.) (Explain your answers!)

Shirley has an income of 100. Her preferences are given by the (Cobb-
Douglas) utility function U (x1 , x2 ) = a ln x1 + (1 − a) ln x2 . Let x1 be the
consumption of shiny red shoes, x2 her consumption of cowboy boots, and let
a = 1/2. Both types of shoes cost 2 per pair (ok ok, this is a cheap country
but remember her income is also pretty low!). The government needs money
and plans to raise an amount of 20 dollars from Shirley. Remark: To answer
this question, it is very useful to first read ch. 5.6 in Varian.

a) Suppose first there is no government. Derive the bundle which Shirley

will demand.

b) Suppose now the government imposes a quantity tax t on red shoes to

raise the 20 dollars of tax revenue. Which unit tax t will the government
impose? Which quantities of both goods will Shirley demand? What
is her utility?

c) On second thought, the government considers an alternative lump-sum

tax (a head tax T = 20) to raise the 20 dollars. How much would

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 Shirley now consume of both goods? What about her utility in this
situation? Is she doing better or worse than in b)? (To answer the
last question, you can either use a calculator, or - even better - give an
intuitive economic explanation.)

Problem 3 (20 pts.) (Explain your answers!)

Consider a consumer’s problem of optimal choice in a two-goods situation.

a) Argue precisely why the optimal bundle (x∗1 , x∗2 ) must be some point
on the budget line.

b) Argue precisely why it can’t be on an indifference curve which cuts

through the budget line.

c) Consider two alternative preferences: quasilinear preferences, and Cobb-

Douglas preferences. Are these preferences convex? Can corner solu-
tions (also called boundary solutions) occur? Argue precisely!

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Some important rules of differentiation:
1. Constant function rule
Consider the function f (x) = k, where k is a constant number.
The derivative is df (x)/dx = 0.
2. Power function rule.
Let f (x) = axn with a, k being some constant numbers.
Then, df (x)/dx = naxn−1 .
(Example: f (x) = 3x2 → df (x)/dx = 6x).
3. Sum-difference rule
Let g(x) = f (x) + (−)h(x).
Then, dg(x)/dx = df (x)/dx + (−)dh(x)/dx.
4. Product rule
Let g(x) = f (x)h(x).
Then, dg(x)/dx = dfdx
(x)
h(x) + dh(x)
dx
f (x).
(Example: g(x) = x1 (1 − x1 ) → dg(x)/dx = (1 − x1 ) − x1 = 1 − 2x1 ).
5. Quotient rule
Let g(x) = f (x)/h(x).
Then,
dg(x)
df (x)
h(x) − dh(x) f (x)
= dx dx
.
dx [h(x)]2
(Example: g(x) = 2x/(4+x2 ) → dg(x)/dx = [2(4+x2 )−2x(2x)]/(4+x2 )2
or dg(x) dx = (8 − 2x2 )/(4 + x2 )2 ).
6. Logarithm rule
Let g(x) = aln x with a being a constant number.
Then, dg(x)/dx = a/x
7. Chain rule
Let g(x) = f (h(x)).
dg dh(x)
Then, dg/dx = dh(x) dx
.
(Example: g(x) = alnf (x) → dg(x)/dx = a df (x)
f (x) dx
.)