ECON 310-1: Microeconomic Theory Professors James A. Hornsten and Ronald R.

Braeutigam

Northwestern University, Winter 2013

Problem Set #1: Supply and Demand, Preferences and Utility -- SOLUTIONS Answer to 1. a) P
50 44.44 40 S D when Y = 100 D when Y = 400

200 222.2

1000

2000

When Y = 100, the horizontal intercept is Q d = [100 2(0)] 100 = 1000 When Y = 100, the horizontal intercept is Q d = [100 2(0)] 400 = 2000 . The choke price will be the price at which the quantity demanded becomes zero. Setting Qd=0 for the demand curve, then at the choke price 0 = (100 2P) Y . When income is positive, the choke price (the vertical intercept of the demand curve) is always 50. In other words, the choke price is the same for all levels of positive income. b) The income elasticity of demand at any price and income is EQ.Y = The derivative of Q with respect to Y is: Thus EQ.Y =

dQ Y . dY Q

dQ 100 2P = . dY 2 Y

Y dQ Y 100 2P ( ) = 0.5 . So the income elasticity of demand is a constant = dY Q 2 Y (100 2P) Y (0.5), for all levels of P and Y. Interpretation: Given any price, when income rises by 1%, the quantity demanded increases by 0.5%.
Answer to 2. a) In equilibrium, QS=Qd. When Y=100, 5P = (100 2P) 100 . Thus, 5P=1000 20P, which tells us that the equilibrium price is P=40. Using the supply curve, we find the equilibrium quantity by Q*=5P =5(40) = 200. b) EQ.P =

dQ P dP Q

The derivative of Q with respect to P is:

dQ = 2 Y . Therefore, dP

dQ P P 40 = (2 Y ) = (2 100 ) = 4 dP Q Q 200 Interpretation: Moving along the demand curve, an increase in price of 1% will lead to a decrease in quantity of about 4%. EQ.P =
c) In equilibrium, QS=Qd. When Y=400, 5P = (100 2P) 400 . Thus, 5P=2000 40P, which tells us that the equilibrium price is P=44.44. Using the supply curve, we find the equilibrium quantity by Q*=5P =5(44.44) = 222.2.

Answer to 3. a) To find the reduced form, use the equilibrium condition QS=Qd. 5P = (100 2P) Y Solving this to see how the endogenous variable P depends on the exogenous variable Y, we find that 100 Y P= . 5+ 2 Y b) When Y = 100 (as in 2(a)), we see that P = When Y = 400 (as in 2(c)), we see that P =

100 100 1000 = = 40 , the same as in 2(a). 25 5 + 2 100

100 400 2000 = = 44.44 , the same as in 2(c). 45 5 + 2 400

c) One way to see how the equilibrium price changes as income rises is to divide the numerator and denominator of the reduced form by Y .

100 Y 100 = . 5 5+ 2 Y +2 Y As Y increases, the denominator decreases, and thus P always increases. Note: Asymptotically the price approaches the choke price of 50 as income becomes very large. P=

Answer to 4. a)

Orange Juice (J) U3=3 utils (3 mocktails) 8 6 4 U1=1 util (1 mocktail) 2 0 0 2 4 6 8 10 Lemon-Lime Soda (S) U2=2 utils (2 mocktails)

b) One possible function is U = min {S/2, J/3}. The function might also have a multiplicative constant, so that U = K[min {S/2, J/3}], where K is a positive constant.

Answer to 5. a) If UKervey[X,Y] =XY =12, then the indifference curve passes through (X=1, Y=12), (2,6), (3,4), (4,3), (6,2), (12,1), (24, 0.5), etc. This is a Cobb-Douglas function that exhibits diminishing MRSX,Y and is bowed-in. If ULynne[X,Y] = X + Y =12, then the indifference curve is a straight line that passes through (X=0, Y=12), (1,11), (2,10), (3,9), (4,8), (5,7), (6,6), etc. In this utility function, X and Y are perfect substitutes. b) Kervey and Lynne will have the same ordinal ranking of different baskets if, when basket A is preferred to basket B by one of the functions, it is also preferred by the other. NO, Kervey and Lynne will not always have the same ordinal ranking of different baskets of X and Y. For example, Kervey prefers (2,10) to (1,12) because 20>12; however, Lynne prefers (1,12) to (2,10) because 13>12. IF we could show that the two consumers have the same marginal rate of substitution at any basket, the slopes of their indifference curves through that basket will always be the same. In other words, their willingness to trade off one good for the other will be identical at any basket. So their indifference curves will all have the same shape and their ordinal ranking for all baskets will be the same. BUT this doesnt happen because Kerveys MRSX,Y differs from Lynnes MRSX,Y, as we show below: U U MU X Y Kervey : MU X = = Y and MUY = = X so MRSX,Y = = . X Y MUY X

Lynne : MU X =

U U MU X 1 = 1 and MUY = = 1 so MRSX,Y = = = 1. X Y MUY 1

When X = Y, the two MRSX,Y terms are the same, but when X Y, they differ.