1

Econ 200 Elements of Economic Analysis I

Spring 2010
Section 04

MIDTERM EXAM Suggested Solutions

Part I: True, False or Uncertain Questions (20 points, 5 points each)

Take the non-underlined statements as given. State whether the underlined statements are TRUE, FALSE, or
UNCERTAIN. Explain your answer. No credit will be given for answers without explanation. Feel free to
use graphs or equations to illustrate your point.

1. In a stunning development, the Surgeon General announces that studying economics reduces heart
disease. The salaries of economics professors will rise. The salary increase will be larger at the end of
one year than at the end of 10 years.

TRUE. The announcement will increase the demand for economics professors. As the demand for
economics professors shifts out, the salaries of economics professors will increase. This should
happen fairly quickly. As students see the higher salaries paid to economics professors, more will
choose to teach economics. Over time, the increase the supply of economics professors will bid
down the salaries of economics professors. At the end of ten years, once a few cohorts of graduate
students have been wooed, the increase in economics professors salaries will be smaller than it
was at the end of one year.

2. If a law were passed requiring all cars sold in Europe to get at least 40 miles per gallon of gasoline,
Europeans would surely use less gasoline.

False. It is not certain that Europeans would use less gasoline. Here is a way to think about it: the
true good that consumers want to consume is not really gas, it is miles of driving. The price of
driving a mile is the price of the gas that it takes to drive that mile, plus the wear and tear on one's
car, plus the cost of one's time. So suppose an individual purchases one of these new cars. If this
person drives the same number of miles that he drove with his old car, then he will consume less
gasoline overall. However, now that the price of driving a mile has fallen, he is likely to drive
more.

3. Revealed preference analysis allows rankings of goods only within a given budget set.

False. Indirectly revealed preferred can compare bundles not within same budget set.

4. Suppose that at a wage of $20 per hour, the workers in your company choose to work 8 hours per day. If
you pay $30 per hour for hours in excess of 8 per day, employees will voluntarily choose to work more
than 8 hours per day.

True. At the optimal point MRS =
MU
|
MU
c
=
p
|
p
c
= w. When w increases, we have that MRS < w'.
Hence the MRS will increase until it equals the relative prices. This means that leisure will
decrease and consumption will increase; hence, workers will choose to work more than 8 hours
per day.



2

Part II: Long Questions

1. (20 points) Suppose Andrew only cares about consumption and leisure and has the utility function:
u(c, l ) = a ln c+(1 a) ln l
where his consumption, c, costs $1 per unit, and leisure is l = 24 L, where L is the number of hours of labor
Andrew supplies to the labor market. Suppose that Andrew can work at the hourly wage w and that his labor
income is subject to the constant tax rate t. Andrew also has some non-labor income, which we will assume is
untaxed, equal to y.
a. (5) Write out Andrews budget constraint over c and l. What is the "price" of leisure?
Andrews budget constraint is:
p
c
c = w(1 -t)L +y
Noting that p
c
= 1 and L = 24 - |, we can rewrite his budget constraint as:
c +w(1 - t)| = w(1 -t)24 + y
Andrew spends c dollars on market goods (consumption) and w(1 -t)| dollars on leisure. So the
after-tax price of an hour of leisure is w(1 -t).
b. (5) Solve for Andrews ordinary demand functions (hint: you can use any method you want).
Andrews ordinary demand functions can be derived by observing that with Cobb-Douglas
preferences, expenditure on a good is always a constant share of income, with the share equal to the
goods Cobb-Douglas preference parameter (if you didnt remember this fact, you could use either the
usual MRS-price ratio relationship or a Lagrange maximization).
Hence, we have that expenditure on c is given by:
p
c
c = a |w(1 - t)24 + y]
since a is the preference parameter for consumption and p
c
is the price of consumption. Solving for c
and using the fact that p
c
= 1, we get Andrews consumption demand function:
c
-
= a |w(1 - t)24 + y]
Similarly, we have that expenditure on l is given by:
(1 - t)w| = (1 - a)|w(1 - t)24 + y]
since (1-a) is the preference parameter for leisure and (1-t)w is the price of leisure. Dividing both sides
of this equation by (1 t)w, we get Andrews leisure demand function:
|
-
=
(1 - a)|w(1 - t)24 + y]
(1 - t)w

c. (5) Derive Andrews labor supply function (keeping in mind that Andrew will never supply negative
hours of labor) as a function of the tax rate, the wage, the non-labor income, and the preference
parameter a (hint: find L(t,w,y,a)).
Using the fact that L= 24 l, we get her labor supply function:
L
-
(t, w, y, a) = 24 -
(1 - a)|24(1 - t)w + y]
(1 - t)w


3

L
-
(t, w, y, a) = 24a -
(1 - a)y
(1 - t)w

Note that this equation is valid only if the right-hand side is positive, since Andrew cannot work
negative hours. Thus Andrews true labor supply function is the equation above if the RHS is non-
negative and zero otherwise.
d. (5) For what values of y will Andrew supply positive hours of labor to the labor market?
We want to find the level of y such that L* > 0. That is,

L
-
(t, w, y, a) = 24a -
(1 -a)y
(1 -t)w
> u
Hence, the maximum non-labor income Andrew can have if labor supply is to be positive is:
y < 24[
a
1 -a
(1 - t)w

In other words, if Andrews non-labor income is not less than 24[
a
1-a
times his after-tax wage,
Andrew will not choose to work for labor income.

2. (30 points) Amanda lives on an isolated apple orchard. She consumes only two goods, leisure (x
1
) and apples
(x
2
). Her utility function is u(x
1
, x
2
) = x
1
+ 2

x
2
. She has access to an unlimited amount of apples in her
orchard, but it takes time to pick each apple. In particular, she is able to pick 2 apples per hour. Suppose she has
a total of 24 hours available (to be divided between leisure and apple-picking). Then, her "income" will simply
be 24p
1
, so her budget constraint will be: p
1
x
1
+ p
2
x
2
= 24p
1
.
a. (5) Assuming p
2
= 1, determine p
1
(to get the price of leisure, think about how many apples must be
given up for 1 hour of leisure). Write out her budget constraint.
Since Amanda can exchange apples for leisure at the rate of 2 apples to 1 hours, it must be that p
1
=2.
Her budget constraint is:
2x
1
+ x
2
= 48

b. (10) State Amandas maximization problem and use the Lagranges method to solve for her ordinary
demands x
1
-
and x
2
-
.
Amandas maximization problem is:
max
x
1
,x
2
x
1
+ 2x
2

x. t. 2x
1
+ x
2
= 48
The Lagrange function is:
L = x
1
+ 2x
2
+2(48 - 2x
1
- x
2
)

The FOCs are:
0L
0x
1
= = 1 = 22
4

0L
0x
2
= =
1

x
2
= 2
0L
02
= = 48 = 2x
1
+x
2

Combining the first two conditions, we get:
x
2
-
= 2 = x
2
-
= 4
Plugging this into the third condition, we get:
48 = 2x
1
-
+ 4 = x
1
-
= 22

c. (5) Now suppose Amandas neighbor offers her an apple picking machine, which allows her to pick 4
apples per hour (instead of 2). Continue to assume p
2
=1. Adjust p
1
and her budget constraint
accordingly, and determine the new values of x
1
-
and x
2
-
. (Hint: you can use any method you want).
Now, p
1
= 4. So, the budget constraint is:
4x
1
+ x
2
= 9
Using the MRS-Price ratio relationship we have:
MRS =
MU
x
1
MU
x
2
=
P
x1
P
x
2
=
1
1
x
2
-
=
4
1

= x
2
-
= 4
= x
2
-
= 1
Plugging this into the budget constraint:
9 = 4x
1
-
+ 1 = x
1
-
= 2

d. (5) Instead of giving Amanda the apple picking machine for free, the neighbor decides to charge for it.
In particular, Amanda will have to pay a fraction t of the apples she ends up picking (in other words, an
hour of apple picking will leave her with only 4 (1 t) apples). Continue to assume p
2
= 1, and rewrite
the budget constraint. Solve Amandas maximization problem leaving t as an unknown. Note: Fractions
are OK. (Hint: you can use any method you want).
Now, p
1
=4(1-t). So, the budget constraint is:
4(1 -t)x
1
+ x
2
= 9(1 -t)
Using the MRS-Price ratio relationship we have:
MRS =
MU
x
1
MU
x
2
=
P
x1
P
x
2
=
1
1
x
2
-
=
4(1 - t)
1

= x
2
-
= 4(1 - t)
= x
2
-
= 1 (1 - t)
2


5

Plugging this into the budget constraint:

9(1 -t) = 4(1 -t)x
1
-
+1(1 -t)
2
= x
1
-
=
9(1 -t) - 1(1 -t)
2
4(1 - t)

= x
1
-
= 24 - 4(1 - t)

e. (5) What is the largest possible t Amanda is willing to pay for the apple picking machine?
You can answer this using your intuition by observing that, as t gets larger, her budget line gets flatter
until it converges to her original budget line at t =
1
2
.
You could also solve this out. The original utility level is 22 + 24 = 2. Solve:

2 = x
1
-
+ 2x
2
-

2 = 24 - 4(1 -t) + 21(1 - t)
2


= t =
1
2


3. (20 points) Patty spends all of her income on shirts (S) and jeans (J). Pattys preferences can be represented
by the utility function u(S, [) = min ]
1
2
S, [.
a. (5) Draw some indifference curves. What is his MRS at any given bundle?



What can we say about the MRS at any given bundle?
- If J>0.5 S then the MRS is equal to infinity.
- If J=0.5 S then the MRS is undefined.
- If J<0.5 S then the MRS is equal to zero.


S
J
2 4 6
3
2
1
J=0.5S
6

b. (5) Derive the ordinary demand functions for shirts and jeans in terms of the price of shirts (P
S
), the
price of jeans (P
J
), and income (m).

With perfect complements, we solve for the demand function using two different equations. The first
equation is the budget line (P
J
J + P
S
S = m), and the second equation is the optimal relationship
between the amounts of shirts and jeans consumed (J=0.5S).

Plugging J=
1
2
S into the budget constraint:
P
J
(0.5S
*
) + P
S
S
*
= m
S
*
(0.5P
J
+ P
S
) = m
S
-
=
m
. 5P
]
+ P
S

S
-
=
2m
P
]
+ 2P
S

Hence,
]
-
=
1
2
_
2m
P
]
+ 2P
S
_
]
-
=
m
P
]
+ 2P
S


c. (5) Suppose the price of a shirt is $2, the price of a pair of jeans is $6, and Patty has $100 income. What
bundle of shirts and jeans (S, [) maximizes Pattys utility?
Plugging the prices of shirts and jeans and Pattys income into the ordinary demands:

S
-
=
2m
P
]
+ 2P
S
=
2 - 1
+2 - 2
=
2
1
= 2

]
-
=
m
P
]
+ 2P
S
=
1
1
= 1

Now suppose the price of a shirt increases to $7. What bundle of shirts and jeans does Patty demand
now?
Similarly,
S
-
=
2m
P
]
+ 2P
S
=
2 - 1
+2 - 7
=
2
2
= 1

]
-
=
m
P
]
+ 2P
S
=
1
2
= 5


7

d. (5) On a clearly marked graph (with shirts on the horizontal axis), depict the old and new budget lines,
optimal bundles, and optimal indifference curves. Split up this change into a substitution effect and an
income effect. Compute the substitution and income effect in terms of Pattys consumption of shirts.
Explain briefly.

The following graph shows the original budget line (black line) and the new budget line (blue line).
Point A represents the original choice, while point C represents the final choice. The total effect of the
price change on the demand of shirts is -10. We can break up this effect into the substitution effect (A
to B) and the ordinary income effect (B to C). Given that we are analyzing perfect complements, we
have that the substitution effect is 0 and the income effect is 10 20 = -10 shirts.


- Income effect -










S
J
10 14.2 20 50
10
5
J=0.5S
A
C
B
33.3