PROBLEM SET 2*

Tutor: Matthew Polissona

1. Fresher is a first-year PPEist. On Friday of Week 2, Fresher defines her budget
for the evening. She is given income m > 0 to spend at The Bar on two continuous commodities: Beer and Juice. The quantities of Beer and Juice are denoted
by x1 0 and x2 0, respectively. The prices of Beer and Juice are denoted
by p1 > 0 and p2 > 0, respectively, where p1 , p2 < m. In order to encourage safe
drinking and to discourage drunkenness, The Bar imposes a tax t > 0 per unit
of consumption of Beer after x1 > 0 units have been consumed. Draw Freshers
budget set with and without the tax.
2. What is the effect on a consumers budget set when all prices are doubled?
What if her income is doubled simultaneously?
3. Consider two commodities in a world of many: 5 notes and 10 notes. Imagine
that these commodities are continuous rather than discrete. Draw indifference
curves for a consumer with rational (complete, transitive), well-behaved (locally
non-satiated, convex), and continuous preferences over money, and indicate
with small arrows the direction of preferred consumption bundles.1 What is the
consumers marginal rate of substitution (MRS )?
4. Explain why strictly convex preferences have indifference curves that are rotund
(or without flat spots).
5. A consumer has rational (complete, transitive), well-behaved (locally non-satiated,
convex), and continuous preferences represented by
u(x1 , x2 ) =

x1 x2 ,

where x1 0 and x2 0 denote quantities of Goods 1 and 2, respectively,

and where (x1 , x2 ) denotes a consumption bundle.2 Denote the marginal utility
from an infinitesimal increase in x1 as M U1 and the marginal utility from an
*
a

This problem set corresponds to the 20092010 paper. All errors are my own.
Department of Economics, University of Oxford

matthew.polisson@economics.ox.ac.uk
1
Note that we only assume that a consumer prefers more money to less.
2
1 2
Cobb-Douglas preferences are generally represented by u(x1 , x2 ) = x
1 x2 , where 1 , 2 > 0 and

M. POLISSON

infinitesimal increase in x2 as M U2 . Let u(x1 , x2 ) = 6 and graph the corresponding indifference curve. Mark and label (4, 9) on the indifference curve. What is
the MRS at (4, 9), where M U1 = 3/4 and M U2 = 1/3? Why is M U1 > M U2
at this bundle? Now mark and label (9, 4) on the indifference curve. What is
the MRS at (9, 4), where M U1 = 1/3 and M U2 = 3/4? Why is M U2 > M U1
at this bundle? Why is the MRS at (4, 9) different from the MRS at (9, 4)?
6. Since u() in the previous problem represents an ordering, a consumers preferences are equivalently represented by any monotonic transformation of u().
Consider the transformation
v(x1 , x2 ) = ln(u(x1 , x2 )).
What is the functional form for v()? What can you say about the MRS at
(4, 9) and the MRS at (9, 4) relative to those from the previous problem? What
can you say about M U1 and M U2 at (4, 9) and (9, 4) relative to those from the
previous problem? Explain the intuition behind this result.
7. What is the difference between ordinal and cardinal utility?
8. Graph indifference curves for perfect substitutes and perfect complements. Suggest a utility function for each.
9. A consumer has rational (complete, transitive), well-behaved (locally non-satiated,
convex), and continuous preferences represented by
u(x1 , x2 ) = x1 x2 ,
where x1 0 and x2 0 denote quantities of Goods 1 and 2, respectively. If
the consumer has income m > 0 and faces prices p1 , p2 > 0 for Goods 1 and 2,
respectively, calculate demand functions for Goods 1 and 2.3
10. Briefly explain why a consumers optimal choice in a world of two goods is
found where the MRS equals the relative price ratio between these two goods.
REFERENCES
Varian, H. R. (2006): Intermediate Microeconomics: A Modern Approach, 7th edn. New York: W.
W. Norton.
often where 1 +2 = 1. This form is commonly used in economics because it produces well-behaved
indifference curves and because it is analytically tractable.
3
The mathematical techniques used to solve this problem are not formally introduced until later.
See Varian (2006), p. 9094.