P ROBLEM SET 1: S OLUTION

1. Explain what happens to the demand curve for air transportation between New York City
and Washington, D.C., as a result of the following events:

(a) The income of households in metropolitan New York and Washington, D.C., increases.
The demand curve shifts to the right.

(b) The cost of a train ticket between New York City and Washington, D.C., is reduced.
The price of a substitute good falls. This means some people will prefer to travel via
trains. So, the demand curve for air transportation will shift to the left.

(c) The price of an airline ticket decreases.

This will cause a movement along the demand curve. So, the demand curve will be
unaffected.

2. The coconut oil demand function is Q = 1, 200 − 9.5p + 10.4pp + 0.2Y , where Q is the quantity
of coconut oil demanded in thousands of metric tons per year, p is the price of coconut oil
in cents per pound, pp is the price of palm oil in cents per pound, and Y is the income of
consumers. Assume that p is initially Rs 45 per pound, pp is Rs 31 per pound, and Q is 1,275
thousand metric tons per year. Calculate the income elasticity and cross-price elasticity of
demand for coconut oil.
Q = 1, 200 − 9.5p + 10.4pp + 0.2Y
dQ
= 0.2
dY
Putting p = 45, pp = 31 and Q = 1275 in Q = 1, 200 − 9.5p + 10.4pp + 0.2Y .
1275 = 1200 − 9.5 × 45 + 10.4 × 31 + 0.2Y
=⇒ Y = 900.5.
dQ Y 900.5
Income elasticity = × = 0.2 × = 0.141
dY Q 1275

Q = 1, 200 − 9.5p + 10.4pp + 0.2Y

dQ
= 10.4
dpp
dQ pp 31
Cross-price elasticity = × = 10.4 × = 0.253
dpp Q 1275

3. Paula is currently maximizing her utility by purchasing 10 TV dinners (T) and 8 Lean
Cuisine meals (L) each week.

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 (a) Graph Paula’s initial utility-maximizing choice.

(b) Suppose that the price of T rises by $1 and the price of L falls by $1.25. Can Paula still
afford to buy her initial consumption choice?
Let PT and PL be the initial prices of T and L respectively. Let M be her income. Since
she consumes 10 units of T and 8 units of L, it means that 10PT + 8PL ≤ M .
Let PT′ and PL′ be the new prices of T and L respectively. Therefore, PT′ = PT + 1 and
PL′ = PL − 1.25.
The cost of her initial consumption bundle after the price change is 10PT′ + 8PL′ =
10(PT + 1) + 8(PL − 1.25) = 10PT + 10 + 8PL − 10 = 10PT + 8PL ≤ M . Hence, even
after the price change Paula can afford to buy her initial consumption change.

(c) Do you think Paula’s utility after the price change will not be lower than before the
price change?
Paula was maximizing her utility by purchasing 10 TV dinners and 8 Lean Cuisine
meals, and she can still afford it after the price change. This means her utility after the
price change will not be lower than before the price change. After the price change she
can now purchase some bundles which she could not purchase before and in case she
prefers any of these bundles to 10 TV dinners and 8 Lean Cuisine meals her utility will
increase but even in the worst case scenario she can always buy 10 TV dinners and 8
Lean Cuisine meals and get the utility she had before the prices changed.

4. Edmund Stench consumes two commodities, namely garbage and punk rock video cassettes.
He doesn’t actually eat the former but keeps it in his backyard where it is eaten by cows
and goats. The reason that he accepts the garbage is that people pay him $2 per sack for
taking it. Edmund can accept as much garbage as he wishes at that price. He has no other
source of income. Video cassettes cost him $6 each. What is the equation of his budget line?
What is his budget constraint? Show graphically. How will your answer change if he can
only accept 75 sacks of garbage?
Let G be the number of sacks of garbage and C be the number of cassesttes. If he accepts G
amount of garbage, his income is 2G. The equation of the budget line is 6C = 2G
=⇒ 3C = G.
The budget constraint is the set of all consumption bundles (C, G) such that 3C ≤ G.

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 If he can only accept 75 sacks of garbage, his budget constraint changes to the set of all
consumption bundles (C, G) that satisfy 3C ≤ G and G ≤ 75

5. Suppose your utility function is U (x, y) = x2 y. Suppose your income is Rs 900, the price of
x is Rs 20 and the price of y is Rs 30.

(a) Give an expression of your budget set and show it in a graph.

The budget set is the set of all consumption bundles (x, y) that satisfies 20x + 30y = 900.

(b) What will be your utility maximizing consumption bundle?

2xy 2y
M RSxy = 2 = .
x x
dM RSxy −6y
= 2 ≤0
dx x
Hence, the marginal rate of substitution is declining. So, at the utility maximizing
Px 2y 20
bundle, M RSxy = . =
Py x 30
=⇒ 60y = 20x.
Putting in the budget line 20x + 30y = 900
=⇒ y = 10.
x = 30
The utility-maximizing consumption bundle is (x = 30, y = 10).

(c) Suppose your income is M. When the price of x is Px and price of y is Py what is your
utility maximizing consumption bundle?
Px
The budget line is Px x + Py y = M . At the utility maximizing bundle, M RSxy = .
Py
2y Px
=⇒ =
x Py
=⇒ 2Py y = Px x
Putting this in the budget line, 3Py y = M
M
=⇒ y = .
3Py
2M
x= .
3Px
(d) What is your demand function of x and y?
2M M
The demand functions are x = and y = .
3Px 3Py
(e) Is x a normal good or an inferior good?
dx 2
Yes x is a normal good because = > 0. So, when income rises, the demand for
dM 3Px
good x also rises.

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6. Suppose the countries of Lilliput and Blefuscu have a population of 2000 each. Each of the
residents have an income of 500 units and consume only rice (R) and bread (B). Each resident
of Lilliput has the following utility function U=R+2B while each resident of Blefuscu has
the following utility function U=2R+B. Find the market demand for bread.
Let PR be the price of rice and let PB be the price of bread. Each resident’s budget line is
given by PB B + PR R = 500. Consider the country of Lilliput first. Consider a representative
resident.
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M RSRB = = 0.5.
2
PR M UB M UR
If > 0.5, then > . So, to maximize utility, he will only consume B. Hence,
PB PB PR
500
utility maximizing bundle will be .
PB
PR
If = 0.5, then he will consume any (R, B) satisfying PB B + PR R = 500. Hence, amount
PB
500
of B consumed will be 0 ≤ B ≤ .
PB
PR
If < 0.5, then at the utility maximizing bundle B = 0.
PB
So, the demand for bread of this individual is

B = 0 if PB > 2PR
500
0≤B≤ if PB = 2PR
PB
500
B= if PB < 2PR
PB

Since there are 2000 such individuals, the demand will be

B = 0 if PB > 2PR
1000000
0≤B≤ if PB = 2PR
PB
1000000
B= if PB < 2PR
PB

By same logic as above, we can derive the demand for bread of the residents of Blefuscu as

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follows:

B = 0 if PB > 0.5PR
1000000
0≤B≤ if PB = 0.5PR
PB
1000000
B= if PB < 0.5PR
PB

Combining the demands from both the countries, we get the market demand. The market
demand is given by:

B = 0 if PB > 2PR
1000000
0≤B≤ if PB = 2PR
PB
1000000
B= if 0.5PR < PB < 2PR
PB
1000000 2000000
≤B≤ if PB = 0.5PR
PB PB
2000000
B= if PB < 0.5PR
PB