MICROECONOMICS I (TSUNG-SHENG TSAI) FALL 2020

Midterm Exam
2020.11.9

1. [20%] In the following questions, there are only two goods, 𝑥1 and 𝑥2 , whose prices are 𝑝1 and
𝑝2 , respectively. Determine whether each of the following statements is TRUE or FALSE.
a. [5%] If a preference satisfies strict monotonicity, then its indifference curve is negatively sloping,
and vice versa.
b. [5%] Suppose that both 𝑥1 and 𝑥2 are ordinary goods, and the preference satisfies strict
monotonicity. Then if the own-price elasticity for 𝑥1 is always elastic (i.e., |𝜀1 | > 1), then 𝑥1
and 𝑥2 are substitutes. (Hint: find the sign of 𝜀21 )
c. [5%] The preference represented by the utility function, 𝑢(𝑥1 , 𝑥2 ) = 𝑓(𝑥1 ) + 𝑓(𝑥2 ), where
𝜕𝑓 𝜕2 𝑓
> 0 and < 0, satisfies strict convexity.
𝜕𝑥 𝜕𝑥 2

d. [5%] Currently, the optimal consumption bundle satisfies |𝑀𝑅𝑆| = 𝑝1 /𝑝2. Now suppose that
𝑝1 and 𝑝2 will increase in the same proportion, while income will remain the same. Then since
the relative price 𝑝1 /𝑝2 will not change, the new optimal consumption bundle will still satisfy
|𝑀𝑅𝑆| = 𝑝1 /𝑝2.

2. [30%] Jeff got a gift of 𝐼 dollars from his grandma recently. He plans to spend it on video games
(𝑥1 ) and new clothes (𝑥2 ). His preference can be represented by the following utility function:
1
𝑢(𝑥1 , 𝑥2 ) = 𝑥1 − .
𝑥2
Suppose that the prices of 𝑥1 and 𝑥2 are 𝑝1 and 𝑝2 , respectively.
a. [4%] Draw some of the indifference curves. Find the marginal rate of substitution (MRS).
b. [4%] Determine whether or not the preference represented by this utility function satisfies strict
monotonicity and strict convexity.
c. [6%] Set up his maximization problem. Find the demand function for each good.
d. [4%] Given 𝑝2 and 𝐼, draw his demand curve for video games. Does it always satisfy the “law
of demand”? Explain why or why not.
e. [8%] Suppose that currently, 𝑝1 = 1, 𝑝2 = 4 and 𝐼 = 40. However, the price of video games
is about to increase to 𝑝1′ = 4. Other things remain the same. Find the substitution effect and
income effect caused by the price change in terms of 𝑥1 . Draw a picture to show them. (Note:
you need to compute the accurate numbers in this question)
f. [4%] Consider the following situation under the current conditions, 𝑝1 = 1, 𝑝2 = 4 and 𝐼 =
40. Knowing that Jeff will use the money on buying video games, his grandma worries that he
might spend too much time on playing them. She then gives him two options:
Option 1: If Jeff can control his consumption of 𝑥1 within 20 units, i.e., 𝑥1 ≤ 20, then he can
still have the 40 dollars; otherwise, the money has to be returned to his grandma.
Option 2: The amount of the gift is cut by 10 dollars, i.e., 𝐼 = 30.
Which option would he choose? Explain your finding.

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MICROECONOMICS I (TSUNG-SHENG TSAI) FALL 2020

3. [25%] Josephine spends her money on two goods: food (𝑥1 ) and travel goods (𝑥2 ). Her utility
function is:
𝑢(𝑥1 , 𝑥2 ) = √𝑥1 + √𝑥2 .
Suppose that the prices of 𝑥1 and 𝑥2 are 𝑝1 and 𝑝2 , respectively. She currently has a fixed
income with an amount of 𝐼.
a. [5%] Does the following utility function 𝑣 represent the same preference as 𝑢? Explain why
or why not.
𝑣(𝑥1 , 𝑥2 ) = 𝑥1 + 𝑥2 + √𝑥1 𝑥2 .
b. [7%] Set up her maximization problem under the utility function 𝑢. Find the demand functions
for 𝑥1 and 𝑥2 . Draw their demand curves.

Now consider the following new situation under the utility function 𝑢. Josephine considers taking a
part-time job in a convenience store, from which she can earn more income. By working 𝑥3 hours,
her income becomes 𝐼 + 𝑤 ⋅ 𝑥3 , where 𝑤 is the wage rate. However, it also causes her some
“disutility” because it is time consuming and exhausting. Her utility becomes:
𝑢(𝑥1 , 𝑥2 , 𝑥3 ) = √𝑥1 + √𝑥2 − 𝑥3 ,
c. [8%] Find the optimal 𝑥1 , 𝑥2 , and 𝑥3 . Let 𝑥3 = 0 represent the case where she does not take
the part-time job. Then when will she work for the job (i.e., 𝑥3 > 0)? If so, find out the condition
such that 𝑥3 > 0. Explain the condition, particularly by focusing on the effect of the fixed
income 𝐼 and the wage rate 𝑤.
d. [5%] Compared to b., how will the demand for 𝑥1 and 𝑥2 be affected when the part-time job
is available? Explain your finding.

4. [25%] Joel is planning his consumption schedule, (𝑐1 , 𝑐2 ), in the next two periods, 1 and 2. He has
the following utility function:
𝑢(𝑐1 , 𝑐2 ) = ln 𝑐1 + 𝛽 ln 𝑐2 ,
where 𝛽 > 0 measures the importance of the second period. He already has some income in each
period, 𝐼1 = 2100 and 𝐼2 = 2121, respectively. He can borrow and save his money at the same
interest rate, which is currently 𝑟 = 1%.
a. [8%] Set up his maximization problem. Find the optimal (𝑐1∗ , 𝑐2∗ ). Is he a saver or a borrower?
By separating two cases: 𝛽 > 1 and 𝛽 < 1, draw the figure to show the choice of being a saver
or a borrower in each case. Explain your finding.

For the following questions b.-d., it is expected that the interest rate will increase to 5%.
b. [7%] Find the new optimal (𝑐1′ , 𝑐2′ ) after the change. Compared to a., discuss how this change
will affect his consumption behavior in each period and the role of being a borrower or a savor.
c. [7%] Suppose that 𝛽 = 1. Provide the economic reasoning for the income effect and the
substitution effect caused by the change in terms of 𝑐1. Draw a figure to show them. (Note: in
the figure, you do not need to compute the accurate amount of the income effect and the
substitution effect.)
d. [3%] Following c., will he be better off or worse off due to this change? Explain your answer.
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MICROECONOMICS I (TSUNG-SHENG TSAI) FALL 2020

Answer Key to Midterm Exam

1. a. 𝑥2 False. (⟹) It is true that if a preference satisfies strict monotonicity (SM),
𝑥 the indifference curves (ICs) are negatively sloping. To see this, consider an
𝑦 IC that is positively sloping. Then two consumption bundles like 𝑥 and 𝑦
in the first figure are indifferent. However, [SM] implies that 𝑥 ≻ 𝑦, which
𝑥2 𝑥1 leads to a contradiction. That is, [SM] implies that ICs are negatively sloping
(⟸) The reverse statement is, however, false. When the IC is negatively
𝑦 sloping, it does not necessarily imply [SM]. As shown in the second figure,
𝑥 when 𝑥 ≻ 𝑦, it does not satisfy [SM] even though ICs are negatively sloping.
𝑥1
b. True. If a preference satisfies [SM], the budget constraint holds as an equality, i.e., 𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝐼.
𝜕𝑥 𝜕𝑥 𝜕𝑥 𝑝
By taking the derivative with respect to 𝑝1, we have 𝑥1 + 𝜕𝑝1 𝑝1 + 𝜕𝑝2 𝑝2 = 0 ⟹ 𝑥1 + 𝜕𝑝1 𝑥1 𝑥1 =
1 1 1 1

𝜕𝑥 𝑝 𝑥 𝑥 𝑝 𝑥
− 𝜕𝑝2 𝑥1 𝑝2 𝑝2 ⟹ 𝑥1 (1 − |𝜀1 |) = −𝜀21 𝑝2 𝑝2 ⟹ 1 − |𝜀1 | = −𝜀21 (𝑝2 𝑥2). Then if |𝜀1 | > 1, 𝜀21 > 0,
1 2 1 1 1 1

which means that 𝑥1 and 𝑥2 are substitutes.

The intuition behind this result is the following. When both goods are ordinary goods (so the demand
curves satisfy the law of demand), 𝑥1 decreases when 𝑝1 increases. Moreover, |𝜀1 | > 1 means
that 𝑝1 𝑥1 (the expenditure on good 1) decreases in 𝑝1 (or increases in 𝑥1 ). Since the budget
constraint must hold, the expenditure on good 2, 𝑝2 𝑥2 , must increase when 𝑝1 increases under a
given income 𝐼. Given the same 𝑝2 , this means that 𝑥2 must increase when 𝑝1 increases. Thus,
𝑥1 and 𝑥2 are substitutes.
c. True. First of all, since 𝑓 ′ > 0 , both 𝑀𝑈1 > 0 and 𝑀𝑈2 > 0 , that is, [SM] holds. Second,
𝑀𝑈 𝑓′(𝑥 )
|𝑀𝑅𝑆12 | = 𝑀𝑈1 = 𝑓′(𝑥1 ). Then when 𝑥1 increases, the numerator decreases because 𝑓 ′′ (𝑥1 ) < 0,
2 2

which means that |𝑀𝑅𝑆12 | is decreasing in 𝑥1 . Similarly, when 𝑥2 increases, the denominator
decreases because 𝑓 ′′ (𝑥2 ) < 0, which means that |𝑀𝑅𝑆12 | is increasing in 𝑥2 . Thus, the ICs are
convex to the origin. Combining this with [SM], we know that the preference satisfies [SC].
d. 𝑥2 False. When 𝑝1 and 𝑝2 increase in the same proportion, the relative price
𝑒 𝑝1 /𝑝2 does not change. This is equivalent to a reduction in the real income
𝑒 ∗ (even though the nominal income remains the same). If the new optimum
𝑒′ is interior (內解), it is true that |𝑀𝑅𝑆| = 𝑝1 /𝑝2 still holds. However, if the
new optimum is at the corner, it can violate |𝑀𝑅𝑆| = 𝑝1 /𝑝2 . Since
𝑥1 consumption cannot be negative, a solution like 𝑒 ∗ is not feasible, so that
the consumer has to choose another consumption bundle at the corner like
𝑒 ′ , in which case |𝑀𝑅𝑆| ≠ 𝑝1 /𝑝2.

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MICROECONOMICS I (TSUNG-SHENG TSAI) FALL 2020

2. a. 𝑥2
1 𝑀𝑈 1
For 𝑢(𝑥1 , 𝑥2 ) = 𝑥1 − 𝑥 , 𝑀𝑅𝑆12 = − 𝑀𝑈1 = − 1/(𝑥 2
= −(𝑥2 )2 .
2 2 2)

Since |𝑀𝑅𝑆12 | is increasing in 𝑥2 , the indifference curves are

convex to the origin, as shown in the figure.

𝑥1
b. Since 𝑀𝑈1 = 1 > 0 and 𝑀𝑈2 = 1/(𝑥2 )2 > 0 for any 𝑥1 , 𝑥2 > 0, the more 𝑥1 and/or 𝑥2 that
he consumes, the higher the utility is. Thus, the preference satisfies [SM].
Moreover, since the indifference curves are convex to the origin, and the preference satisfies [SM],
it also satisfies [SC].
1
c. His maximization problem is: max 𝑥1 − 𝑥 , 𝑠. 𝑡. 𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝐼.
𝑥1 , 𝑥2 2

1
The Lagrange is max ℒ = 𝑥1 − 𝑥 + 𝜆(𝐼 − 𝑝1 𝑥1 − 𝑝2 𝑥2 ).
𝑥1 , 𝑥2 2

𝑝1 𝑝1
By the FOCs, we obtain (𝑥2 )2 = or 𝑥2∗ = √ . By substituting this into the budget constraint,
𝑝2 𝑝2

𝑝1 𝐼2
𝐼 𝑝2 √𝑝 𝑖𝑓 𝑝1 < 𝑝 ,
− √𝑝
the demand functions are 𝑥1∗ (𝑝1 , 𝑝2 , 𝐼) = {𝑝1 1 , 𝑥2∗ (𝑝1 , 𝑝2 , 𝐼) = { 2 2

𝐼 𝐼2
0 𝑖𝑓 𝑝1 ≥ 𝑝 .
𝑝2 2

In other words, when 𝑝1 ≥ 𝐼 2 /𝑝2 , he will spend all the money on 𝑥2 but nothing on 𝑥1 .
d. 𝑝1
The demand curve for 𝑥1 is shown in the figure.
The law of demand holds only when 𝑝1 < 𝐼 2 /𝑝2 . When 𝑝1 ≥ 𝐼 2 /𝑝2, the
2
𝐼 /𝑝2
price is so high that he won’t consume any 𝑥1 . Therefore, even when 𝑥1
becomes cheaper, the quantity demanded does not increase.
𝐷1
𝑥1
e. Under the current status, 𝑝1 = 1, 𝑝2 = 4 and 𝐼 = 40, the optimal choice is (𝑥1∗ , 𝑥2∗ ) = (38, 1/2),
where he obtains utility of 𝑢 = 38 − 1/0.5 = 36 . On the other hand, when the price of 𝑥1
increases to 𝑝1′ = 4, the new optimal choice is (𝑥1′ , 𝑥2′ ) = (9, 1).
To separate the substitution effect from the income effect, we solve the following minimization
problem:
𝑥2 auxiliary line 1
10 min 4𝑥1 + 4𝑥2 , 𝑠. 𝑡. 𝑥1 − 𝑥 = 36.
𝑥1 , 𝑥2 2

The solution is 𝑥2′′ = √𝑝1′ /𝑝2 = 1, 𝑥1′′ = 37. Thus, in terms of 𝑥1 :

Total effect = 𝑥1′ − 𝑥1∗ = 9 − 38 = −29.
𝒆′ 𝒆′′
1 𝒆 Substitution effect = 𝑥1′′ − 𝑥1∗ = 37 − 38 = −1.
9 3738 𝑥1 Income effect = 𝑥1′ − 𝑥1′′ = 9 − 37 = −28.
𝑥′1 𝑥′′1 𝑥1∗

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MICROECONOMICS I (TSUNG-SHENG TSAI) FALL 2020

f. 𝑥2 Option 1: Since it is restricted to 𝑥1 ≤ 20, the optimal choice

under this option is 𝑥1𝑜𝑝𝑡1 = 20 and 𝑥2𝑜𝑝𝑡1 = 5. His utility in
this case is 𝑢𝑜𝑝𝑡1 = 20 − 1/5 = 19.8.
Option 2: the new income level is 𝐼′ = 30. Then according to the
solution obtained before, 𝑥1𝑜𝑝𝑡2 = 28 and so 𝑥2𝑜𝑝𝑡2 = 0.5. His
20 28 38 𝑥1 utility is 𝑢𝑜𝑝𝑡2 = 28 − 1/0.5 = 26.
𝑥1𝑜𝑝𝑡1 𝑥1𝑜𝑝𝑡2 Thus, he prefers Option 2.

3. a. Check the MRS under different utility functions:

1⁄2 𝑥 𝑥 1+ 𝑥 ⁄2 𝑥 𝑥 (2√𝑥1 +√𝑥2 )
Under 𝑢, 𝑀𝑅𝑆|𝑢 = − 1⁄2√𝑥1 = − √𝑥2; under 𝑣, 𝑀𝑅𝑆|𝑣 = − 1+√𝑥2⁄2√𝑥1 = − √𝑥2 ( .
√ 2 √ 1 √ 1 √ 2 √ 1 √𝑥1 +2√𝑥2 )

In general, 𝑀𝑅𝑆|𝑢 ≠ 𝑀𝑅𝑆|𝑣 , which means that 𝑣 is NOT a monotonic transformation of 𝑢, and
so they represent different preferences.

b. Her maximization problem is: max 𝑢(𝑥1 , 𝑥2 ) = √𝑥1 + √𝑥2 , 𝑠. 𝑡. 𝑝𝑥1 + 𝑝2 𝑥2 = 𝐼.

𝑥1 , 𝑥2

The Lagrange is max ℒ = √𝑥1 + √𝑥2 + 𝜆(𝐼 − 𝑝1 𝑥1 − 𝑥2 ).

𝑥 ,𝑥 1 2

𝑥2 𝑝 2
𝑝1 𝑝2 By the FOCs, we obtain = (𝑝1 ) .
𝑥1 2

Substituting this into the budget constraint, we obtain

𝐷1 𝐷2 𝑥1∗ = 𝑝2 𝐼 𝑝 𝐼
and 𝑥2∗ = 𝑝 (𝑝1+𝑝 ). Both demand
𝑝1 (𝑝1 +𝑝2 ) 2 1 2
𝑥1 𝑥2
curves satisfy the law of demand.

c. The maximization problem becomes: max 𝑢(𝑥1 , 𝑥2 ) = √𝑥1 + √𝑥2 − 𝑥3 , 𝑠. 𝑡. 𝑝𝑥1 + 𝑝2 𝑥2 =

𝑥1 , 𝑥2 , 𝑥3

𝐼 + 𝑤𝑥3 . The Lagrange is max ℒ = √𝑥1 + √𝑥2 − 𝑥3 + 𝜆(𝐼 − 𝑝1 𝑥1 − 𝑥2 + 𝑤𝑥3 ).

𝑥1 , 𝑥2 , 𝑥3

1 1 1
FOCs: = 𝜆𝑝1 … ① , = 𝜆𝑝2 … ②, and 1 = 𝜆𝑤 … ③. From ③, we know that 𝜆 = 𝑤 .
2√𝑥1 2√𝑥2

𝑤2 𝑤2 𝑤
Substituting this into ① and ②, we have 𝑥1∗∗ = 4(𝑝 2
and 𝑥2∗∗ = 4(𝑝 2
, and so 𝑥3∗∗ = 4𝑝 +
1) 2) 1

𝑤 𝐼
− 𝑤 by the budget constraint.
4𝑝2

𝑝 +𝑝2 4𝑝 𝑝 𝐼
In particular, 𝑥3∗∗ > 0 if 𝑤 2 ( 4𝑝1 ) > 𝐼 or 𝑤 > √ 𝑝 1+𝑝2 . The intuition is, since the part-time job
1 𝑝2 1 2

is time consuming and exhausting, she will take the job only if her fixed income 𝐼 is too low, or the
wage of the part-time job 𝑤 is high enough to compensate the disutility. On the other hand, if she
already has an enough high income, or the wage is too low, she won’t take the job, i.e., 𝑥3∗∗ = 0.
𝑤2 𝑝2 𝐼 𝑤2 𝑝1 𝐼 𝑝 +𝑝2
d. Note that 𝑥1∗∗ = 4(𝑝 > 𝑥1∗ = 𝑝 and 𝑥2∗∗ = 4(𝑝 > 𝑥2∗ = 𝑝 if 𝑤 2 ( 4𝑝1 ) > 𝐼, i.e.,
1 )2 1 (𝑝1 +𝑝2 ) 2)
2
2 (𝑝1 +𝑝2 ) 1 𝑝2

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MICROECONOMICS I (TSUNG-SHENG TSAI) FALL 2020

𝑥3∗∗ > 0. This means that when she decides to take the part-time job, she will consume more 𝑥1 and
𝑥2 compared to the no job case. This is due to the income effect caused by the more money that she
earns from the part-time job.

2 2 𝑐 𝐼
4. a. Her maximization problem is: max ln 𝑐1 + 𝛽 ln 𝑐2 , 𝑠. 𝑡. 𝑐1 + 1+𝑟 = 𝐼1 + 1+𝑟 .
𝑐1 , 𝑐2

2 2 𝐼 𝑐
The Lagrange is max ℒ = ln 𝑐1 + 𝛽 ln 𝑐2 + 𝜆 [𝐼1 + 1+𝑟 − 𝑐1 − 1+𝑟 ].
𝑐1 , 𝑐2

The FOCs yield 𝑐2 = 𝛽(1 + 𝑟)𝑐1 . By substituting this into the budget constraint, we obtain the
1 𝐼 𝛽(1+𝑟) 𝐼
optimal solution (𝑐1∗ , 𝑐2∗ ) = (1+𝛽 (𝐼1 + 1+𝑟
2
), 2
(𝐼1 + 1+𝑟 )).
1+𝛽

4200 4242𝛽
Thus, when 𝐼1 = 2100, 𝐼2 = 2121, and 𝑟 = 1%, (𝑐1∗ , 𝑐2∗ ) = ( , ).
1+𝛽 1+𝛽

𝑐2 𝑐2 There are two cases to consider:

4200
(1) When 𝑐1∗ = < 𝐼1 = 2100, or equivalently, 𝛽 >
1+𝛽

1, he is a saver.
𝑐1∗
𝐼 𝑐1 𝐼 𝑐1∗ 𝑐1 (2) When 𝑐1∗ > 𝐼1 , or equivalently, 𝛽 < 1 , he is a
𝛽>1 𝛽<1 borrower.
1/𝑐 𝑐
Note that |MRS12| = 𝛽/𝑐1 = 𝛽𝑐2 . When 𝛽 > 1, the future consumption is more important (which
2 1

means that |MRS12 | is smaller, or the indifference curves are flatter), and so he tends to save. On
the other hand, when 𝛽 < 1 (i. e., the indifference curves are steeper), the current consumption is
more important, and so he tends to borrow so that he can consume more in the first period.
b. When the interest rate increases to 𝑟′ = 5%, the maximization problem is:
2 𝑐 2121
max ln 𝑐1 + 𝛽 ln 𝑐2 , 𝑠. 𝑡. 𝑐1 + 1.05 = 2100 + = 4120.
𝑐1 , 𝑐2 1.05

4120 4326𝛽
By the same approach, the new optimal solution is (𝑐1′ , 𝑐2′ ) = ( 1+𝛽 , ).
1+𝛽

4120 2020
Again, when 𝑐1′ = < 𝐼1 = 2100, or equivalently, 𝛽 > 2100 ≈ 0.96, he is a saver; when 𝛽 <
1+𝛽

0.96, 𝑐1′ > 𝐼1 , and so he is a borrower.

Compared to a., one can see how the change in 𝑟 affects his role in terms of saving and borrowing:
(1) when 𝛽 > 1, he is a saver before and after the change;
(2) when 𝛽 < 0.96, he is a borrower before and after the change;
(3) when 0.96 < 𝛽 < 1, he becomes a saver after the change, while he used to be a borrower.
c. When 𝛽 = 1, the optimal choice under 𝑟 = 1% is (𝑐1∗ , 𝑐2∗ ) = (2100, 2121), while the optimal
choice under 𝑟 = 5% is (𝑐1′ , 𝑐2′ ) = (2060, 2163). That is, he does not save nor borrow before the
change while he becomes a saver after the change.

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MICROECONOMICS I (TSUNG-SHENG TSAI) FALL 2020

𝑐2 When 𝑟 = 1% increases to 𝑟 ′ = 5% , the budget line

𝑠𝑙𝑜𝑝𝑒: −1.05 becomes steeper.
auxiliary line Substitution effect (SE): as 𝑟 increases, the opportunity
cost of 𝑐1 increases. Thus, she will consume fewer 𝑐1
𝒆′ and more 𝑐2 . In this case, SE = 𝑐1′′ −𝑐1∗ < 0.
𝒆′′ 𝒆 Income effect (IE): since she becomes a saver, an increase
𝐼2 𝑠𝑙𝑜𝑝𝑒: −1.01 in 𝑟 means more interest revenue, which gives her a
higher real income. Since 𝑐1 is a normal goods, she will
consume more 𝑐1. Thus, IE = 𝑐1′ −𝑐1′′ > 0.
𝑐1′′ 𝒄′𝟏 𝑐1∗ = 𝐼1 𝑐1
Total effect: 𝑐1′ −𝑐1∗ = −40 < 0.

d. The utility will increase due to the following reasoning. We know that 𝑒′ ≻ 𝑒′′ because both 𝑐1 and
𝑐2 are normal goods, and there is a raise in the real income for a saver. On the other hand, 𝑒 ∼ 𝑒′′
since they are on the same indifference curve. Thus, 𝑒′ ≻ 𝑒, which means that her utility will increase
after the change.