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University of Toronto | Department of Economics | ECO 204 | 2012 2013 | Ajaz Hussain
TEST 1 SOLUTIONS

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Question Maximum Possible Points Score
1 15
2 15
3 20
4 30
5 20
Total Points = 100

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Question 1 [15 POINTS]
Please answer the questions following this excerpt from a Wall Street Journal blog article (October 30
th
, 2012):
Apples iPad Mini Faces Stiff Competition in India
When Apple Inc. last week launched the iPad mini, a tablet computer priced at $329, it
was seen as an attempt by the worlds most valuable company to target price-sensitive
audiences in emerging markets like China, Brazil and India. The Cupertino, Calif.
company said the iPad mini will go on sale in its major markets starting Friday.
However, like most other Apple products, analysts predict the 7.9-inches long iPad mini
to arrive in India a little late, perhaps by the end of this year.
The cheaper tablet could be key for Apple to build a larger following in India, where
customers are notoriously sensitive to price. But the advent of a number of even-cheaper
tablets, produced by Indian companies, is likely to give Apple some stiff rivalry. The tablet
market in India is small but growing and until recently Apple led the pack. But in the
April-June quarter local company Micromax Informatics Ltd. overtook Apple as the
leading supplier of tablets. The company held a 23% share of the tablet market in the
period versus Apples 18%, according to research firm IDC Inc. The 7-inch category of
tablets also includes products made by Indian firms HCL Info systems Ltd., which makes
ME tablets, and United Telelinks Ltd. that sells the Karbonn brand of smartphones and tablets.
The shipment of tablet computers to India jumped three-fold in the quarter from the previous three months to
about 341,000, IDC says. More than half of those tablets, including Micromaxs best-selling Funbook, were priced
between 6,000 rupees ($111) and 8,000 rupees ($149).
The local versions of the tablets lack the iPads high-quality responsive touch interface, analysts say. The iPad also
offers superior memory, better processing speed and has thousands of applications available on its app store, they
add.
But consumers appear willing to give up some of the iPads benefits to save money. Local companies have also
been successful in improving their products, analysts say.
In this question, good 1 is Apples iPad mini and good 2 is Micromaxs Funbook.
If the last digit of your ID # is 1, 3, 5, 7, 9 then use $111 as the price of a Micromax Funbook.
If the last digit of your ID # is 0, 2, 4, 6, 8 then use $149 as the price of a Micromax Funbook.

Apples iPad Mini displayed at an
event in San Jose, California, Oct. 23.
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(1.1) [3 Points] Calculate, explain, and interpret the budget line slope in economic terms. State all assumptions and
show all calculations.






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(1.2) [3 Points] Is there any evidence in the article that Indian consumers perceive mini iPads and Funbooks as perfect
substitutes? Please give a one or two sentence answer.


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(1.3) [3 Points] Give two utility function equations which model the fact that price sensitive Indian consumers are
buying Funbooks instead of mini iPads. State all assumptions, show all calculations and give a brief explanation.
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(1.4) [3 Points] Give at least two recommendations for how Apple can boost sales of the iPad mini. State all
assumptions, show all calculations, and give a brief explanation.
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(1.5) [3 Points] What will happen to the budget line slope and the indifference curve slope if Apple runs an effective,
persuasive, advertising campaign for the Apple iPad mini? Give a brief explanation.






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Question 2 [15 POINTS]
A consumer has a differentiable utility function

defined over the consumption set {

}.
Assume all pecuniary parameters are strictly positive.
(2.1) [5 Points] Write down all first order conditions and (any) Kuhn-Tucker conditions for the general UMP. Do NOT
solve this UMP and do NOT assume the consumer has monotone preferences. Show all steps in setting up the UMP.

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(2.2) [5 Points] Use your answer to the previous part to prove that if a consumer has monotone preferences then her
marginal utility of income must be strictly positive; at the optimal choice, expenditure must equal income. State all
assumptions and show all calculations.
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(2.3) [5 Points] Assuming a consumer has monotone preferences which of the following two tax schemes will have the
larger impact on consumer utility: a small flat-income tax or a tax revenue equivalent quantity tax on good 2? State all
assumptions and show all calculations.
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Question 3 [20 POINTS]
The following utility function for the representative broadband consumers preferences over some characteristics of
broadband service was published in Household Demand for Broadband Internet in 2010, BE Journal of Public Economics
(2011):

Here: Cost; Fast speed internet service; Very fast speed internet service; Reliable internet
service; Priority of download service; Tele-health connectivity; Mobile laptop connectivity;
Video phone capabilities; Movie rentals
Assume all pecuniary parameters are strictly positive.
(3.1) [10 Points] Suppose that the broadband provider Hell decides to charge customers $5 more for broadband
services. As a result, how much additional Very fast speed internet service must Hell provide to stop customers from
switching to other broadband providers? State all assumptions and show all calculations.
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(3.2) [10 Points] Suppose that customers of Raw-jerks, a broadband provider, have been clamoring for more reliable
internet service. If Raw-jerks agrees to increase reliability by 2 units for an additional cost of $10 then will current
customers stay with Raw-jerks or switch to another provider? If you claim that theyll stay with Raw-jerk then prove
your answer; otherwise calculate the cost increase that will trigger customers switching to other providers. State all
assumptions and show all calculations.













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Question 4 [30 POINTS]
Consider a consumer with the following utility function defined over the consumption set {

}:

Assume the consumer is a price taker, her income is exogenously given, and

.
(4.1) [5 Points] List (but do not perform) the positive monotonic transformations required to:

[This part is independent of all other parts in this question]
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(4.2) [5 Points] Check whether the consumer has monotone preferences in each of these four cases:
At the bundle

At any boundary bundle where:

At any boundary bundle where:

At any interior bundle
In any of these cases, if the consumer doesnt have monotone preferences then characterize the nature of her non-
monotone preferences. State all assumptions and show all calculations.

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(4.3) [5 Points] Derive and interpret in economic terms slope of the indifference curve at any interior bundle in the
consumption set and indicate whether she has imperfect substitutes preferences. State all assumptions and show all
calculations.







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(4.4) [10 Points] Solve this consumers UMP. State all assumptions and show all calculations. You are expected to use the
appropriate constrained optimization method.
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(4.5) [5 POINTS] Suppose the consumers budget constraint changes from

to

Use your answer for the interior solution in part (4.4) to calculate the total price
effect (PE), the total substitution effect (SE) and the total income effect (IE). State all assumptions and show all
calculations.
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Question 5 [20 POINTS]
The following demand model for a particular brand of soda sold at a large supermarket chain was estimated using actual
supermarket scanner data
1
:

Here gallons of soda sold per store per week and price ($/gallon). The average price of soda in the data set was:

.
(5.1) [2 Points] What is the price elasticity of demand at the average price? Show all calculations.




1
Source: INSEAD case Measuring Price Promotion Effects
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(5.2) [10 Points] Suppose that each individual store has a capacity of 200 gallons per week. Calculate the revenue
maximizing price and quantity subject to the constraint that the quantity sold is less than or equal to capacity. You are
expected to use the appropriate constrained optimization method. Show all calculations.

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(5.3) [5 Points] Assume all customers can be modeled by a single representative consumer. Derive this consumers
utility function over soda and all other goods and calculate the marginal utility at the optimal (constrained revenue
maximization) price that you calculated above. State all assumptions and show all calculations.



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(5.4) [3 Points] Without re-solving the problem calculate the change in optimal revenues due to a 1 gallon increase in
capacity. Show all calculations.