EconS301REVIEWEXERCISESFORMIDTERM#1

Chapter2ReviewQuestions
2.12.Consideralineardemandcurve,Q=3507P
a)Derivetheinversedemandcurvecorrespondingtothisdemandcurve.

Q = 350 7 P

7 P = 350 Q (Remember,theinversedemandcurveisthedemandcurvesolvedforP)
P = 50 17 Q

b)Whatisthechokeprice?

The choke price occurs at the point where Q = 0 . Setting Q = 0 in the inverse demand
equation above yields P = 50 . That is, the choke price shows us the price at which
consumers will not demand any quantity of the good.
c)WhatisthepriceelasticityofdemandatP=50?
At P = 50 ,thechokeprice,theelasticitywillapproachnegativeinfinity.Sinceelasticityequals
thepercentagechangeinQuantityoverthepercentagechangeinprice,atQ=0,theelasticity
willapproachnegativeinfinity.
2.16.Considerthefollowingdemandandsupplyrelationshipsinthemarketforgolfballs:Qd=902P
2TandQS=9+5P2.5R,whereTisthepriceoftitanium,ametalusedtomakegolfclubs,andRisthe
priceofrubber.
a)IfR=2andT=10,calculatetheequilibriumpriceandquantityofgolfballs.

Substituting the values of R and T, we get

Demand : Q d = 70 2 P
Supply : Q s = 14 + 5P

Inequilibrium,702P=14+5P,whichimpliesthatP=12.Substitutingthisvalueback,Q=46.
b)Attheequilibriumvalues,calculatethepriceelasticityofdemandandthepriceelasticityofsupply.

Elasticity of Demand = 2(12/46), or 0.52. Elasticity of Supply = 5(12/46) = 1.30.

Notice that -2 is simply the (Q/P), or derivative with respect to P of the demand
function.

c)Attheequilibriumvalues,calculatethecrosspriceelasticityofdemandforgolfballswithrespectto
thepriceoftitanium.Whatdoesthesignofthiselasticitytellyouaboutwhethergolfballsandtitanium
aresubstitutesorcomplements?

10
) = 0.43 . The negative sign indicates that titanium and golf balls are
46
complements, i.e., when the price of titanium goes up the demand for golf balls
decreases. Remember that people like to consumer complements together so the increase
in the price of one is essentially like an increase in the price of the other, and therefore,
the demand will decrease.

golf ,ti tan ium = 2(

2.20.SupposethatthemarketforairtravelbetweenChicagoandDallasisservedbyjusttwoairlinesm
UnitedandAmerican.Aneconomisthasstudiedthismarketandhasestimatedthatthedemandcurves
forroundtripticketsforeachairlineareasfollows:
=10,000100PU+99PA(Unitedsdemand)
=10,000100PA+99PA(Americansdemand)
WherePUisthepricechargedbyUnited,andPAisthepricechargedbyAmerican.
a) SupposethatbothAmericanandUnitedchargeapriceof$300eachforaroundtripticketbetween
ChicagoandDallas.WhatisthepriceelasticityofdemandforUnitedflightsbetweenChicagoand
Dallas?

QUd = 10000 100(300) + 99(300)

QUd = 9700

Using PU = 300 and QUd = 9700 gives

300
= 3.09 (Simplyplugnumbersintothepriceelasticityofdemand
9700

Q , P = 100
equation)

b) WhatisthemarketlevelpriceelasticityofdemandforairtravelbetweenChicagoandDallaswhen
bothairlineschargeapriceof$300?(Hint:BecauseUnitedandAmericanaretheonlytwoairlines
servingtheChicagoDallasmarket,whatistheequationforthetotaldemandforairtravelbetween
ChicagoandDallas,assumingthattheairlineschargethesameprice?)

Market demand is given by Q d = QUd + QAd . Assuming the airlines charge the same price
we have
2

Q d = 10000 100 PU + 99 PA + 10000 100 PA + 99 PU

Q d = 20000 100 P + 99 P 100 P + 99 P

(PAandPUsimplybecomeP)

Q = 20000 2 P
d

When P = 300 , Q d = 19400 .Thisimpliesanelasticityequalto

300
= .0309
19400

Q , P = 2

Chapter3ReviewQuestions
3.4.ConsidertheutilityfunctionU(x,y)=y withthemarginalutilitiesMUx=y/(2 )andMUy= .
a)Doestheconsumerbelievethatmoreisbetterforeachgood?
SinceUincreaseswheneverxoryincreases,moreofeachgoodisbetter.Thisisalsoconfirmed
bynotingthatMUxandMUyarebothpositiveforanypositivevaluesof x and y .
b)Dotheconsumerspreferencesexhibitadiminishingmarginalutilityofx?Isthemarginalutilityofy
diminishing?

b)

Since MU x =

y
2 x

, as x increases (holding y constant), MU x falls. Therefore

the marginal utility of x is diminishing. However, MU y = x . As y increases, MUy does

not change. Therefore the preferences exhibit a constant, not diminishing, marginal
utility of y.

3.13.Drawindifferencecurvestorepresentthefollowingtypesofconsumerpreferences.
a)Ilikebothpeanutbutterandjelly,andalwaysgetthesameadditionalsatisfactionfromanounceof
peanutbutterasIdofrom2ouncesofjelly.
Inthefollowingpictures,U2>U1.

Jelly
4
2
U1

U2

Peanut Butter

b)Ilikepeanutbutter,butneitherlikenordislikejelly.

Jelly

U1

U2

Peanut Butter

c)Ilikepeanutbutter,butdislikejelly.
Jelly

U1
U2

Peanut Butter

d)Ilikepeanutbutterandjelly,butIonlywant2ouncesofpeanutbutterforeveryounceofjelly.

Jelly
U1

U2

2
1
2

Peanut Butter

3.15.ConsidertheutilityfunctionU(x,y)=3x+y,withMUx=3amdMUy=1.
a)Istheassumptionthatmoreisbettersatisfiedforbothgoods?

2.
Yes, the more is better assumption is satisfied for both goods since both
marginal utilities are always positive. As you add more of either x or y, the total utility
increases.
b)Doesthemarginalutilityofxdiminish,remainconstant,orincreaseastheconsumerbuysmoreofx?
Explain.
Themarginalutilityof x remainsconstantat3forallvaluesofx.TheMUxequationissimplya
constantof3,sothechangeinxorydoesntchangeMUx.
c)WhatisMRSx,y?

b)

MRS x , y = 3 (because MUx/MUy=3/1=3)

d)IstheMRSdiminishing,constant,orincreasingastheconsumersubstitutesxforyalongan
indifferencecurve?
The MRS x , y remainsconstantmovingalongtheindifferencecurve(lookataboveequation).
e)Onagraphwithxonthehorizontalaxisandyontheverticalaxis,drawatypicalindifferencecurve(it
neednotbeexactlytoscale,butitneedstoreflectaccuratelywhetherthereisadiminishingMRSx,y).
Alsoindicateonyourgraphwhethertheindifferencecurvewillintersecteitherorbothaxis.Labelthe
curveU1.

U1 U2

f)OnthesamegraphdrawasecondindifferencecurveU2,withU2>U1.

(Seeabovegraph)

3.21.SupposeaconsumerspreferencesfortwogoodscanberepresentedbytheCobbDouglasutility
functionU=Axy,whereA,,andarepositiveconstants.ThemarginalutilitiesareMUx=Ax1y
andMUy=Axy1.AnswerallpartsofProblem3.15forthisutilityfunction.
a)Yes,themoreisbetterassumptionissatisfiedforbothgoodssincebothmarginalutilitiesare
alwayspositive.

b) Since we do not know the value of , only that it is positive, we need to specify three
possible cases:
When < 1 ,themarginalutilityof x diminishesas x increases.
When = 1 ,themarginalutilityof x remainsconstantas x increases.
When > 1 ,themarginalutilityof x increasesas x increases.
c) MRS x , y =

Ax 1 y y
=

Ax y 1 x

d)Astheconsumersubstitutes x for y ,the MRS x , y willdiminishbecausexisinthedenominatorand

drivesdowntheentirefraction.
e&f)Thegraphbelowdepictsindifferencecurvesforthecasewhere A = 1 and = = 0.5. Thus

U ( x, y ) = x 0.5 y 0.5 .Regardless,theindifferencecurveswillneverintersecteitheraxis.

450

U2

400
350

300
250
200
150

U1

100
50
0
0

10

15

20

25

30

35

3.24.OnetypeofCobbDouglasutilityfunctionisgivenbyU(x,y)=xy1,whereMUx=x1y1andMUy
=(1)xy.SupposethatyouaretoldthatapersonwithCobbDouglaspreferenceshasanMRSx,yof4
whenx=4andy=8.Whatisthenumericalvalueof?

First, the expression for MRSx,y is

MRS x , y =

MU x
MU y

x 1 y1
=
(plugging in the MUs and then rearranging)
(1 )x y
y
=
1 x

c)

Since we know that MRSx,y = 4 when x = 4 and y = 8,

8
1 4

2=
1 (we set MRS equal to 4 and then plug in x,y values and solve for
2 2 =
4=

d)

2
3
)

Chapter4ReviewQuestions
4.2.TheutilityfunctionthatAnnreceivesbyconsumingfoodFandclothingCisgivenbyU(F,C)=FC+F.
ThemarginalutilitiesoffoodandclothingareMUF=C+1andMUC=F.Foodcosts$1aunit,and
clothingcosts$2aunit.Annsincomeis$22.
a)Anniscurrentlyspendingallofherincome.Sheisbuying8unitsoffood.Howmanyunitsofclothing
issheconsuming?

3.

If Ann is spending all of her income then

F + 2C = 22
8 + 2C = 22
(SimplyplugginginwhatweknowtotheBudgetLine)
2C = 14
C=7

b)Graphherbudgetline.Placethenumberofunitsofclothingontheverticalaxisandthenumberof
unitsoffoodonthehorizontalaxis.Plothercurrentconsumptionbasket.
Remember:UsetheBudgetLineandsetPytozerotofindhorizontalinterceptandPxequalto
zerotofindtheverticalintercept.
12

Clothing

10
8
6
4
2
0
0

10

15

20

25

30

35

Food

c)Drawtheindifferencecurveassociatedwithautilitylevelof36andtheindifferencecurveassociated
withautilityof72.Aretheindifferencecurvesbowedintowardtheorigin?

Yes, the indifference curves are convex, i.e., bowed in toward the origin. Also, note that
they intersect the F-axis.

80
70

U=72

Clothing

60
50
40

U=36

30
20
10
0
0

10

15

20

25

30

35

Food

d)Usingagraph(andnoalgebra),findtheutilitymaximizingchoiceoffoodandclothing.Thatis,find
theintersectionofthebudgetlineandtheindifferencecurves.
80
70

U=72

Clothing

60
50
40

U=36

30

Optimum at F=12, C=5

20
10
0
0

10

15

20

25

30

35

Food

e)Usingalgebra,findtheutilitymaximizingchoiceoffoodandclothing.

The tangency condition requires that

MU F PF
(whereslopeofBLequalsslopeofIC)
=
MU C PC
Pluggingintheknowninformationyields

C +1 1
=
F
2
2C + 2 = F
Substitutingthisresultintothebudgetline, F + 2C = 22 resultsin

(2C + 2) + 2C = 22
4C = 20
C =5

Finally,pluggingthisresultbackintothetangencyconditionimpliesthat F = 2(5) + 2 = 12 .Atthe

optimumtheconsumerchooses5unitsofclothingand12unitsoffood.

f)Whatisthemarginalrateofsubstitutionoffoodforclothingwhenutilityismaximized?Showthis
graphicallyandalgebraically.

MRS F ,C =

C +1 5 +1 1
=
= Themarginalrateofsubstitutionisequaltothepriceratio.
12
2
F

g)DoesAnnhaveadiminishingmarginalrateofsubstitutionoffoodforclothing?Showthisgraphically
andalgebraically.

Yes, the indifference curves do exhibit diminishing MRS F ,C . We can see this in the
graph in part c) because the indifference curves are bowed in toward the origin.
Algebraically, MRS F ,C = C +1 F . As F increases and C decreases along an isoquant,
MRS F ,C diminishes.

4.3.ConsideraconsumerwiththeutilityfunctionU(x,y)=min(3x,5y),thatis,thetwogoodsareperfect
complementsintheratio3:5.ThepricesofthetwogoodsarePx=$5andPy=$10,andtheconsumers
incomeis$220.Determinetheoptimumconsumptionbasket.

This question cannot be solved using the usual tangency condition. However, you can see
from the graph below that the optimum basket will necessarily lie on the elbow of
some indifference curve, such as (5, 3), (10, 6) etc. If the consumer were at some other
point, he could always move to such a point, keeping utility constant and decreasing his
expenditure. The equation of all these elbow points is 3x = 5y, or y = 0.6x. Therefore
the optimum point must be such that 3x = 5y.
The usual budget constraint must hold of course. That is, 5 x + 10 y = 220 . Combining
these two conditions, that is, plugging y into the budget line, we get (x, y) = (20, 12).
10

(20,12)
(10,6)
(5,3)

x
4.7.HelenspreferencesoverCDs(C)andsandwiches(S)aregivenbyU(S,C)=SC+10(S+C),withMUC=
S+10andMUS=C+10.IfthepriceofaCDis$9andthepriceofasandwichis$3,andHelencanspend
acombinedtotalof$30eachdayonthesegoods,findHelensoptimalconsumptionbasket.

See the graph below. The fact that Helens indifference curves touch the axes should
immediately make you want to check for a corner point solution.
To see the corner point optimum algebraically, notice if there was an interior solution, the
tangency condition implies (S + 10)/(C +10) = 3, or S = 3C + 20. Combining this with the
budget constraint, 9C + 3S = 30, we find that the optimal number of CDs would be given
by 18C = 30 which implies a negative number of CDs. Since its impossible to
purchase a negative amount of something, our assumption that there was an interior
solution must be false. Instead, the optimum will consist of C = 0 and Helen spending all
her income on sandwiches: S = 10.
Graphically, the corner optimum is reflected in the fact that the slope of the budget line is
steeper than that of the indifference curve, even when C = 0. Specifically, note that at
(C, S) = (0, 10) we have PC / PS = 3 > MRSC,S = 2. Thus, even at the corner point, the
marginal utility per dollar spent on CDs is lower than on sandwiches. However, since
she is already at a corner point with C = 0, she cannot give up any more CDs. Therefore
the best Helen can do is to spend all her income on sandwiches: (C, S) = (0, 10). [Note:
At the other corner with S = 0 and C = 3.3, PC / PS = 3 > MRSC,S = 0.75. Thus, Helen
would prefer to buy more sandwiches and less CDs, which is of course entirely feasible at
this corner point. Thus the S = 0 corner cannot be an optimum.]

11


4.15.Paulconsumesonlytwogoods,pizza(P)andhamburgers(H)andconsidersthemtobeperfect
substitutes,asshownbyhisutilityfunction:U(P,H)=P+4H.Thepriceofpizzais$3andthepriceof
hamburgersis$6,andPaulsmonthlyincomeis$300.Knowingthathelikespizza,Paulsgrandmother
giveshimabirthdaygiftcertificateof$60redeemableonlyatPizzaHut.ThoughPaulishappytogetthis
gift,hisgrandmotherdidnotrealizethatshecouldhavemadehimexactlyashappybyspendingfarless
thanshedid.Howmuchwouldshehaveneededtogivehimincashtomakehimjustaswelloffaswith
thegiftcertificate?
PaulsinitialbudgetconstraintisthelineAC,allowinghimtopurchaseatmost50hamburgers
oratmost100pizzas.The$60cashcertificateshiftsouthisbudgetconstraintwithoutchanging
themaximumnumberofhamburgersthathecanbuy.ThenewbudgetconstraintisABDandhe
cannowbuyamaximumof120pizzas.

Hamburgers

60
55
50

B
A

20

C
100

D
120

Pizza

Initially, Pauls optimal basket contains all hamburgers and no pizza, at point A where (P,
H) = (0, 50), because MUH /PH = 4/6 > MUP / PP = 1/3. His utility level at point A is U(0,
50) = 200. When he gets the gift certificate, Pauls optimal basket is at point B, spending
12

all of his regular income on hamburgers and the $60 gift certificate on pizza. So point B
is where (P, H) = (20, 50) with a utility of U(20, 50) = 220.
However, Paul could also achieve a utility of 220 by consuming 220/4 = 55 hamburgers.
To buy the extra 5 hamburgers he would require 5*6 = $30. So, if he had received a cash
gift of $30 it would have made Paul exactly as well off as the $60 gift certificate for
pizzas.

4.22.Darrelhasamonthlyincomeof$60.Hespendsthismoneymakingtelephonecallshome
(measuredinminutesofcalls)andnoothergoods.Hemobilephonecompanyoffershimtwoplans:

PlanA:paynomonthlyfeeandmakecallsfor$0.50perminute.
PlanB:Paya$20monthlyfeeandmakecallsfor$0.20perminute.

GraphDarrellsbudgetconstraintundereachofthetwoplans.IfPlanAisbetterforhim,whatistheset
ofbasketshemaypurchaseifhisbehaviorisconsistentwithutilitymaximization?Whatbasketsmight
hepurchaseifPlanBisbetterforhim?
Letxdenotethenumberofphonecalls,andydenotespendingonothergoods.UnderPlanA,
DarrellsbudgetlineisJLM.UnderPlanB,itisJKLN.ThesebudgetlinesintersectatpointL,or
aboutx=67.

y
60
40

L
M
67

N
120

200

If we know that Darrell chooses Plan A, his optimal bundle must lie on the line segment
JL. No point between L and M would be optimal under this plan because then Darrell
could have chosen a point under Plan B, between L and N, that would have given him
more minutes, and left him with more money to buy other goods. However, we cannot
exclude point L itself (Darrell could, for instance, have perfect complements preferences
with an elbow at point L). Thus, if Darrell chooses Plan A his optimal basket could be
anywhere between J and L, including either of these points.
Similarly, if he chose Plan B then his optimal basket must lie between L and N. Any
point between L and K (but not including point L) would be dominated by a point under

13

Plan A between L and J. Thus, if Darrell chooses Plan B his optimal basket could be
anywhere between L and N, including either of these points.

Chapter5ReviewQuestions
5.7

Davidhasaquasilinearutilityfunctionoftheform U(x, y) =

utilityfunctions MU x =

1
2 x

x + y ,withassociatedmarginal

and MU y = 1.

a)DeriveDavidsdemandcurveforxasafunctionoftheprices,PxandPy.Verifythatthedemandforx
isindependentofthelevelofincomeataninterioroptimum.
DenotingthelevelofincomebyI,thebudgetconstraintimpliesthat p x x + p y y = I andthe

py2
px
,whichmeansthat x =
.Thedemandforxdoesnot
tangencyconditionis
=
2 x py
4 px2

dependonthelevelofincome.

b)DeriveDavidsdemandcurvefory.Isyanormalgood?WhathappenstothedemandforyasPx
increases?

From the budget constraint, the demand curve for y is, y =

py
I px x
I
=

.
py
p y 4 px

You can see that the demand for y increases with an increase in the level of income,
indicating that y is a normal good. Moreover, when the price of x goes up, the
demand for y increases as well.

5.19 Louspreferencesoverpizza(x)andothergoods(y)aregivenbyU(x,y)=xy,withassociated
marginalutilitiesMUx=yandMUy=x.Hisincomeis$120.
a)CalculatehisoptimalbasketwhenPx=4andPy=1.
Usingthetangencycondition,

y
= 4 ,andthebudgetconstraint, 4 x + y = 120 ,
x

y = 4 x Insert int o budget constraint

4 x + 4 x = 120
8x = 120

4(15) + y = 120

y = 60

x = 15
Lousinitialoptimumisthebasket(x,y)=(15,60)withautilityof900.
14

b)Calculatehisincomeandsubstitutioneffectsofadecreaseinthepriceoffoodto$3.
Firstweneedthedecompositionbasket.Thiswouldsatisfythenewtangencycondition,
wouldgivehimasmuchutilityasbefore,i.e. xy = 900 .

y
= 3 and
x

y = 3x
x(3x) = 900
x 2 = 300
x = 17.32

17.32y = 900

y = 51.9

Thisgives ( x, y ) = (10 3 ,30 3 ) orapproximately(17.3,51.9).Nowweneedthefinalbasket,which

satisfiesthesametangencyconditionasthedecompositionbasketandalsothenewbudgetconstraint:
3x + y = 120.

y
=3
x
y = 3x
3x + 3x = 120
6x = 120
x = 20

3(20) + y = 120

y = 60

Together,theseconditionsimplythat(x,y)=(20,60).Thesubstitutioneffectistherefore17.315=
2.3,andtheincomeeffectis2017.3=2.7.

c)Calculatethecompensatingvariationofthepricechange.
ThecompensatingvariationistheamountofincomeLouwouldbewillingtogiveupaftertheprice
changetomaintainthelevelofutilityhehadbeforethepricechange.Thisequalsthedifference
betweentheconsumersactualincome,$120,andtheincomeneededtobuythedecompositionbasket
atthenewprices.Thislatterincomeequals:3*17.3+1*51.9=103.8.Thecompensatingvariationthus
equals120103.8=$16.2.

d)Calculatetheequivalentvariationofthepricechange.
TheequivalentvariationistheamountofincomethatLouwouldneedtobegivenbeforetheprice
changeinordertoleavehimaswelloffashewouldbeafterthepricechange.Afterthepricechangehis
utilitylevelis20(60)=1200.ThereforetheadditionalincomeshouldbesuchthatitallowsLouto
purchaseabundle(x,y)satisfyingtheinitialtangencycondition,

y
= 4 ,andalsosuchthat xy = 1200.
x

Thisimpliesthat ( x, y ) = (10 3 ,40 3 ) orapproximately(17.3,69.2).HowmuchincomewouldLou

needtopurchasethisbundleundertheoriginalprices?Hewouldneed4(17.3)+69.2=138.4.Thatishe
15

wouldneedtoincreasehisincomeby(138.4120)dollarsinordertobeaswelloffasifthepriceof
pizzaweretodecreaseinstead.Thereforehisequivalentvariationis$18.4.

5.20 Carinabuystwogoods,foodFandclothingC,withtheUtilityfunctionU=FC+F.Hermarginal
utilityoffoodisMUf=C+1andhermarginalutilityofclothingisMUc=F.Shehasanincomeof$20.The
priceofclothingis$4.
a)DerivetheequationrepresentingCarinasdemandforfood,anddrawthisdemandcurveforpricesof
foodbetween1and6.
MUF=C+1MUC=F
Tangency:MUF/MUC=PF/PC.(C+1)/F=PF/4=>4C+4=PFF.(Eq1)
BudgetLine:PFF+PCC=I.PFF+4C=20.(Eq2)
Substituting(Eq1)into(Eq2):4C+4+4C=20.ThusC=2,independentofPF.

Fromthebudgetline,weseethatPFF+4(2)=20,sothedemandforFisF=12/PF

6
Demand for food

PF5
4

3
2
1

3 4

12

b)CalculatetheincomeandsubstitutioneffectsonCarinasconsumptionoffoodwhenthepricerises
from1to4,anddrawagraphillustratingtheseeffects.Yourgraphdoesnotneedtobetoscale,butit
shouldbeconsistentwiththedata.
InitialBasket:Fromthedemandforfoodin(a),F=12/1=12,andC=2.
Also,theinitiallevelofutilityisU=FC+F=12(2)+12=36.
FinalBasket:Fromthedemandforfoodin(a),weknowthatF=12/4=3,andC=2.(Also,U=3(2)+3=
9.)
DecompositionBasket:Mustbeoninitialindifferencecurve,withU=FC+F=36(Eq5)
Tangencyconditionsatisfiedwithfinalprice:MUF/MUC=PF/PC.(C+1)/F=4/4=>C+1=F.(Eq3)
Eq5canbewrittenasF(C+1)=36.UsingEq3,(C+1)2=36,andthus,C=5.Also,byEq3,F=6.
SothedecompositionbasketisF=6,C=5.

IncomeeffectonF:FfinalbasketFdecompositionbasket=36=3.
SubstitutioneffectonF:FdecompositionbasketFinitialbasket=612=6.

16

c)Determinethenumericalsizeofthecompensatingvariation(inmonetaryterms)associatedwiththe
increaseinthepriceofthegoodfrom1to4.
PFF+PCC=4(6)+4(5)=44.Soshewouldneedanadditionalincomeof24(plusheractualincomeof20).
Thecompensatingvariationassociatedwiththeincreaseinthepriceoffoodis
24.

Clothing11

10
9

Initial U

8
7

Final U

6
Decomp Basket
5

4
Final BL
3
Final

Initial Basket
Decomp BL

1
0

Initial BL
0

2 3 4 5

10 11 12 13 14 15 16 17 18 19 20

Food
Inc
Effect

Subst Effect = -6

5.22 Therearetwoconsumersonthemarket:JimandDonna.JimsutilityfunctionisU(x,y)=xy,with
associatedmarginalutilitiesMUx=yandMUy=x.DonnasutilityfunctionisU(x,y)=x2y,withassociated
marginalutilityfunctionsMUx=2xyandMUy=x2.IncomeofJimofIJ=100andincomeofDonnaisID=150.
a)FindoptimalbasketsofJimandDonnawhenthepriceofyisPy=1andpriceofpisx.
Jimsoptimalbasketisasolutiontoequations
MUx/MUy=P/PyandPx+Pyy=IJ.
Hence,wehave2xy/x2=PandPx+y=100
withsolutionx=200/(3P)andy=100/3.
AnalogoussystemofequationsforDonnais
y/x=PandPx+y=150withsolutionx=75/Pandy=75.

b)OnseparategraphsplotJimsandDonnasdemandscheduleforxforallvaluesofP.
ApproximateshapeofthedemandcurveforJimandDonnaisdepictedbelow.

17

Px

c)ComputeandplotaggregatedemandwhenJimandDonnaaretheonlyconsumers.
AggregateDemand:
Dx(P)=200/(3P)+75/P=445/(3P).

d)Plotaggregatedemandwhenthereisonemoreconsumerthathasidenticalutilityfunctionand
incomeasDonna.
WhenthereisonemoreconsumerthathaspreferencesidenticaltoDonnasthenherdemandis
also75/Pandhenceaggregatedemandis
Dx(P)=200/(3P)+75/P+75/P=650/(3P).
Shapeofthedemandcurveinthiscaseisthesameasinpartb).

18

5.28

ConsiderNoahspreferenceforleisure(L)andothergoods(Y), U(L,Y ) =

associatedmarginalutilitiesare MU L =

2 L

and

L + Y .The
1
MUY =
.SupposethatPY=$1.IsNoahs
2 Y

supplyoflaborbackwardbending?
IfNoahswagerateisw,thentheincomeheearnsfromworkingis(24L)w.SincePY=1,thenumberof
unitsofothergoodshepurchasesisY=(24L)w.Also,thetangencyconditiongivesus
Combiningthetwoconditions, w 2 L = (24 L) w ,or L =

Y
= w .
L

24
.Clearly,theamountofleisurethat
w +1

Noahconsumesdecreaseswithanincreaseinthewagerate,andthisistruenomatterwhatthewage
rateis.SincetheamountoflaborthatNoahsuppliesequals(24L),weseethathissupplyoflabor
alwaysincreaseswithanincreaseinthewagerate.So,hislaborsupplycurveisalwayspositivelysloped
thatis,itisnotbackwardbending.

Chapter6ReviewQuestions
6.4
SupposethattheproductionfunctionforDVDsisgivenbyQ=KL2L3,whereQisthenumberof
disksproducedperyear,Kismachinehoursofcapital,andLismanhoursoflabor.
a)SupposeK=600.FindthetotalproductfunctionandgraphitovertherangeL=0andL=500.Then
sketchthegraphsoftheaverageandmarginalproductfunctions.AtwhatleveloflaborLdoesthe
averageproductcurveappeartoreachitsmaximum?Atwhatleveldoesthemarginalproductcurve
appeartoreachitsmaximum?

Total Product

Total Product with K=600

35,000,000
30,000,000
25,000,000
20,000,000
15,000,000
10,000,000
5,000,000
0

100

200

300

400

500

600

700

Labor

19

AP and MP with K=600

200000

AP/MP

100000

AP

-100000 0

100

200

300

400

500

600

700

-200000
-300000
MP

-400000
Labor

BasedonthefigureaboveitappearsthattheaverageproductreachesitsmaximumatL=300.The
marginalproductcurveappearstoreachitsmaximumatL=200

b)Replicatetheanalysisin(a)forthecaseinwhichK=1200

Total Product

Total Product with K=1200

300,000,000
250,000,000
200,000,000
150,000,000
100,000,000
50,000,000
0

500

1000

1500

Labor

20

AP and MP with K=1200

1000000
500000

AP

AP/MP

-500000 0

200

400

600

800

1000

1200

1400

-1000000
-1500000

MP

-2000000
Labor

BasedonthefigureaboveitappearsthattheaverageproductcurvereachesitsmaximumatL=
600.ThemarginalproductcurveappearstoreachitsmaximumatL=400.

c)WheneitherK=600orK=1200,doesthetotalproductfunctionhavearegionofincreasingmarginal
returns?
Inbothinstances,forlowvaluesof L thetotalproductcurveincreasesatanincreasingrate.ForK=
600,thishappensforL<200.ForK=1200,ithappensforL<400.

6.9
Supposetheproductionfunctionisgivenbytheequation Q = L K .Graphtheisoquants
correspondingtoQ=10,Q=20,Q=50.Dotheseisoquantsexhibitdiminishingmarginalrateoftechnical
substitution?
7.0

Q=50

6.0
Capital

5.0

Q=10

4.0

Q=20

3.0
2.0
1.0
0.0
0

20

40

60

80

Labor

21

Becausetheseisoquantsareconvextotheorigintheydoexhibitdiminishingmarginalrateof
technicalsubstitution.

6.11 Supposetheproductionfunctionisgivenbythefollowingequation(whereaandbarepositive
constants):Q=aL+bK.Whatisthemarginalrateoftechnicalsubstitutionoflaborforcapital(MRTSL,K)at
anypointalonganisoquant?

For this production function MPL = a and MPK = b . The MRTS L , K is therefore

MRTS L , K =

MPL a
=
MPK b

6.12 Youmightthinkthatwhenaproductionfunctionhasadiminishingmarginalrateoftechnical
substitutionoflaborforcapital,itcannothaveincreasingmarginalproductsofcapitalandlabor.Show
thatthisisnottrue,usingtheproductionfunctionQ=K2L2,withthecorrespondingmarginalproducts
MPK=2KL2andMPL=2K2L.

First, note that MRTSL,K = L/K, which diminishes as L increases and K falls as we move
along an isoquant. So MRTSL,K is diminishing. However, the marginal product of capital
MPK is increasing (not diminishing) as K increases (remember, the amount of labor is
held fixed when we measure MPK.) Similarly, the marginal product of labor is increasing
as L grows (again, because the amount of capital is held fixed when we measure MPL).
This exercise demonstrates that it is possible to have a diminishing marginal rate of
technical substitution even though both of the marginal products are increasing.

6.17 WhatcanyousayaboutreturnstoscaleofthelinearproductionfunctionQ=aK+bL,whereaand
barepositiveconstants.

Q = aK + bL
= aK + bL

= [ aK + bL
= [Q]
Thereforealinearproductionfunctionhasconstantreturnstoscale.

6.18 WhatcanyousayaboutthereturnstoscaleoftheLeontiefproductionfunctionQ=min(aK,bL),
whereaandbarepositiveconstants?
Ageneralfixedproportionsproductionfunctionisoftheform Q = min(aK , bL ) .

22

Q = min(aK , bL)
= min(aK , bL)

= min(aK , bL)
= [Q]
Thereforetheproductionfunctionhasconstantreturnstoscale.

6.19 AfirmproducesaquantityQofbreakfastcerealusinglaborLandmaterialMwiththe
productionfunction Q = 50 ML + M + L .Themarginalproductfunctionsforthisproductionfunction

MPL = 25
are

M
+1
L

L
MPM = 25
+1
M
a)Arethereturnstoscaleincreasing,constant,ordecreasingforthisproductionfunction?

To determine the nature of returns to scale, increase all inputs by some factor
and determine if output goes up by a factor more than, less than, or the same as

Q = 50 M L + M + L
Q = 50 ML + M + L
Q = 50 ML + M + L
Q = Q

Byincreasingtheinputsbyafactorof outputgoesupbyafactorof .Sinceoutputgoesupby

thesamefactorastheinputs,thisproductionfunctionexhibitsconstantreturnstoscale.

b)Isthemarginalproductoflaboreverdiminishingforthisproductionfunction?Ifso,when?Isitever
negative,andifso,when?

The marginal product of labor is

M
+1
L
Suppose M > 0 .Holding M fixed,increasing L willhavetheeffectofdecreasing MPL .The
marginalproductoflaborisdecreasingforalllevelsof L .The MPL ,however,willneverbe
MPL = 25

negativesincebothcomponentsoftheequationabovewillalwaysbegreaterthanorequalto
zero.Infact,forthisproductionfunction, MPL 1 .

23

6.25

Afirmsproductionfunctionisinitially Q = KL ,with

L
K
MPK = 0.5
and MPL = 0.5
.Overtime,theproductionfunctionchangesto
K
L
K
Q = K L, with MPK = L and MPL = 0.5
.
L

a)Verifythatthischangerepresentstechnologicalprogress.
WithanypositiveamountsofKandL, KL < K L somoreQcanbeproducedwiththefinal
productionfunction.Sothereisindeedtechnologicalprogress.

b)Isthischangelaborsaving,capitalsaving,orneutral?

With the initial production function

With the final production function

MRTS L , K =

MPL 0.5 K
=
.
MPK
L

For any ratio of capital to labor, MRTSL,K is lower with the second production function.
Thus, the technological progress is labor-saving.

24