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ECO 201 Problem Set 2 Solutions Guide

The document contains solutions to an economics problem set, detailing budget constraints and utility functions for various individuals. It includes calculations for Mushfiq's housing and entertainment budget, Sarah's fruit consumption, Asma's food and clothing utility, and Jamal's utility function. Each section provides mathematical representations of budget constraints and optimal consumption points based on given prices and incomes.

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10 views5 pages

ECO 201 Problem Set 2 Solutions Guide

The document contains solutions to an economics problem set, detailing budget constraints and utility functions for various individuals. It includes calculations for Mushfiq's housing and entertainment budget, Sarah's fruit consumption, Asma's food and clothing utility, and Jamal's utility function. Each section provides mathematical representations of budget constraints and optimal consumption points based on given prices and incomes.

Uploaded by

r5y8jcd426
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

ECO 201 Problem Set 2 Solutions

1. Mushfiq works at a bank and has a monthly income of $1,000. He uses this income only to pay rent for

housing and to go to the movies (assume that somehow all of his other expenses are already paid for). In the

town where Mushfiq lives, each square foot of rental housing costs $2 per month. Each movie he attends costs

$10. Let x denote the number of square feet of housing he rents, and let y denote the number of movies he

attends per month.

(a) Mushfiq’s budget constraint is 2x + 10y ≤ 1000.

(b) The budget constraint graphically is represented by the green budget line below:

(c) 500.

(d) 100.

2. Sarah consumes apples and oranges (these are the only fruits she eats). She has decided that her monthly

budget for fruit will be $50. Suppose that one apple costs $0.25, while one orange costs $0.50.

(a) Sarah’s budget constraint is 0.25x + 0.50y ≤ 50, where x and y are numbers of apples and oranges, in

that order.

1
(b)

(c)

(d)

(e) It goes back to being the original budget constraint, as in part (b).

M UH PH M UH M UM
3. Currently, M RSH,M = M UM =2<3= PM . So we can see that PH < PM , this tells us that the marginal

utility of spending one more dollar on H is smaller than that of M , so she should consume fewer H and more

M.

2
4. The utility that Asma receives by consuming food F and clothing C is given by U (F, C) = F C + F . Food

costs $1 a unit, and clothing costs $2 a unit. Asma’s income is $22.

(a) Her budget constraint is F + 2C ≤ 22, if she is spending all her income and F = 8, then 8 + 2C = 22,

which gives us C = 7.

(b) Her budget line is graphed below, the red dot is her current consumption bundle.

(c) The optimal consumption may be graphically represented as the point where one of her indifference

curves are tangent to her budget line, for example as the blue node below:

M UF C+1
(d) We first compute her M RSF,C = M UC = F , and see that it is decreasing as F increases. Let us try
p1
the M RS = p2 trick.

PF
M RSF,C =
PC
C +1 1
=
F 2
F = 2 (C + 1)

3
Plugging this into her budget constraint (which holds with equality at optimum), we get

2 (C + 1) + 2C = 22

2C + 2 + 2C = 22

4C = 20

∴C = 5

F = 2 (5 + 1) = 12

C+1 5+1
(e) At the optimal level, M RSF,C = F = 12 = 12 , which is equal to the price ratio. Graphically, we can

refer back to the diagram in part (c) to say that at the optimal level, the (negative valued) M RSF,C ,

which is the slope of her indifference curves, must be equal to the slope of her budget line, which is − 12 .

C+1
(f) Asma has diminishing M RSF,C , which can be seen by the equation, M RSF,C = F , where as F

increases, M RS decreases. Graphically, this is represented as convex (bowed towards the origin) indif-

ference curves, where the slope becomes closer to 0 as F increases (indifference curves get flatter).

5. Because he has positive marginl utilities for both goods, his indifference curves will still be downward sloping,

and bundles in the north-east direction are preferred. However, increasing MRS means the curves are bowed

away from the origin (gets steeper as we move towards right), and the shape of the curves are concave.

We can clearly see that the point where we have a tangency is not the highest indifference curve Dr. Strange-

taste can get to. In fact, in the whole budget line, the tangency point is the bundle which gives him the

lowest level of utility. This is because for concave (bowed away from the origin) indifference curves, the utility

function is such that the FOC (which gives us the tangency point) gives us a minimum, not a maximum (the

second order condition fails in such cases). When indifference curves have this shape, preferences are not

convex, so the consumer does not prefer average bundles, instead they prefer extreme bundles. Based on the

relative prices, Dr. Strangetaste will either spend all his money on hot dogs, or on french fries. In the diagram

I drew it in a way which makes him only buy hot dogs.

4
6. Jamal has the utility function U = xy. Now, we can see clearly that Jamal will buy positive amounts of both
p1
goods, because otherwise his utility is 0. Because we must have an interior solution, the M RS = p2 equation

will give us the optimal solution. His budget constraint must also hold with equality at the optimal bundle,

so we have

px x + py y = m

2x + py (5) = 40

2x + 5py = 40
2
py = 8− x
5

The M RS = price ratio condition gives us

M Ux 2
=
M Uy py
y 2
=
x 8 − 52 x
5 2
= 40−2x
x 5
5 10
=
x 40 − 2x
10x = 200 − 10x

20x = 200

∴x = 10
2
∴ py = 8− (10) = 4
5

Common questions

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The diminishing MRS, indicated by MRSF,C = (C+1)/F, affects Asma's consumption choices by indicating that as she consumes more food relative to clothing, the additional satisfaction (marginal utility) she receives from an extra unit of food decreases . This concept ensures that Asma will consume a balanced mix of food and clothing where her indifference curve, representing equal levels of satisfaction, is tangent to her budget line, demonstrating optimal choice based on maximum utility .

The diminishing MRS, which Asma experiences, plays a critical role in utility maximization as it reflects her decreasing marginal willingness to substitute food for clothing as the quantity of food consumed increases . This principle guides Asma to distribute her income across food and clothing optimally, reaching a point where any additional allocation would result in lower utility, commonly achieved at the tangency between her indifference curve and budget line, fulfilling the condition MRSF,C = PF/PC .

Jamal's utility function, U = xy, represents his satisfaction from consuming two goods x and y, showing multiplicative utility dependence . His consumption decisions are influenced by a need to maximize this utility while satisfying his budget constraint 2x + py = 40. At equilibrium, Jamal distributes consumption such that the marginal rate of substitution equals the price ratio, ensuring no better utility combination exists within his income constraint .

Mushfiq's budget allocation is determined by the price ratio between goods—housing and movies—and his total income, constrained by the equation 2x + 10y ≤ 1000 . If the price of movies were to decrease or the cost of housing were to increase, Mushfiq would potentially afford more movies and fewer square feet of housing, respectively. This shift occurs because Mushfiq would reallocate his spending to maximize utility within his fixed income, based on the relative price of the goods.

Dr. Strange-taste should choose extreme consumption bundles because his concave indifference curves suggest that average bundles provide him with less utility than extremes . Concave curves indicate increasing marginal rates of substitution, which means he values additional units of one good more highly, the more he already consumes of it, leading to aggregate utility maximization by purchasing only hot dogs when contrasted with the relative price and given his income .

Asma's optimal bundle occurs where MRSF,C = PF/PC because that's where her marginal valuation of food relative to clothing equals their market price ratio . This ensures that Asma receives maximum utility from her spending. By equating MRS to the price ratio, she ensures that reallocating expenditure wouldn't increase satisfaction, reflecting a balance of marginal utility benefits between goods at cost ratio parity .

Price changes alter Sarah's budget constraint 0.25x + 0.50y ≤ 50. A decrease in the price of either good shifts the constraint, allowing more consumption. For example, reduced apple prices would enable Sarah to consume more apples without sacrificing oranges, reflecting a pivot of the budget line that leads to new utility maximizing consumption points .

Indifference curve shapes significantly affect consumer preferences, as concave curves suggest a preference for extreme bundles rather than average combinations . For instance, Dr. Strange-taste, who shares this preference, will either spend all his income on one good or the other rather than a mix. This is due to the increasing marginal rate of substitution of such curves, which indicates a rising willingness to substitute one good for another as the consumer acquires more of it, leading to choices that maximize utility given their convex indifference preferences .

Asma should adjust her consumption between food and clothing because the marginal utility of each additional unit gives her different levels of satisfaction relative to their prices. Her marginal rate of substitution, MRSF,C = (C+1)/F, shows how she perceives the trade-off between food and clothing . When the marginal utility per price of one good exceeds the other, Asma should adjust her consumption to equalize this marginal utility per price, thereby maximizing her total utility given her budget constraint F + 2C ≤ 22 .

Sarah's budget constraint, 0.25x + 0.50y ≤ 50, dictates her consumption of apples and oranges. If the price of apples or oranges changes, her budget line pivots. For example, a decrease in the price of apples allows her to purchase more apples without reducing the number of oranges, shifting her consumption bundle along the line where she gains maximum utility from consuming both fruits .

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