PROBLEM SET #2: CONSUMER CHOICE AND DEMAND

Microeconomics I
TO BE SOLVED FOR SEMINAR 2 ON APRIL 25/26, 2024.
THE PROBLEMS MARKED WITH AN ASTERISK (∗) WILL BE GIVEN HIGHER PRIORITY IN THE SEMINARS.

Consumer Choice and Demand.

1. (∗) Consider the utility functions in Problem Set #1, Question 5 (a)-(h). In
each case, find the optimal consumption bundle when p1 = 3, p2 = 4, and m =
12.
We need to find the optimal consumption bundle ( x 1 , x 2 )for each utility function from
Problem Set 1, question 5(a)-(h). The general approach is to maximize the utility function
subject to the budget constraint 3 x 1+ 4 x 2=12

2
a) u ( x 1 , x 2 )=x 1 +3
12
Utility depends only on x 1, so spend all income on x 1 : x 1= =4 , x 2=0
3

b) u ( x 1 , x 2 )=−x 1 +4 x2
M U 1 −1 M U2 4
Liner utility: compare = and = =1
p1 3 p2 4
M U2 M U1 12
Since > , spend al on x 2 : x 2= =3 , x 1=0
p2 p1 4

2
c) u ( x 1 , x 2 )=x 1 + x 2
2 x1 3
Solve using MRS = price ratio MRS= =
1 4
3 3
2 x1 =  x 1=
4 8
Budget constraint 3 ( 38 )+ 4 x =12 → x = 8732
2 2

2 2
d) u ( x 1 , x 2 )=x 1 + x 2
2 x1 3 x1 3
MRS: = → =
2 x2 4 x2 4
12
Let x 1=3 k , x 2=4 k : 3 ( 3 k )+ 4 ( 4 k )=12→ k =
25
36 48
x 1= , x 2=
25 25

2
e) u ( x 1 , x 2 )=( x 1 +4 x2 )
1 4
Perfect substitutes: compare and =1
3 4
1
Spend all on x 2 : x 2=3 , x 1=0

2 2
f) u ( x 1 , x 2 )=−( x 1−2 ) −( x 2−3 )
Optimal bundle is at the bliss point: x 1=2 , x 2=3
Check if affordable: 3 ( 2 ) +4 ( 3 )=18>12. Not affordable, so corner solution.

g) u ( x 1 , x 2 )=mi n [ x 1 +2 x2 , x1 + x 2 ]
Set x 1+ 2 x 2=2 x 1+ x 2 → x 1=x 2
12 12
Budget: 3 x 1+ 4 x 1=12 → x 1= , x 2=
7 7

h) u ( x 1 , x 2 )=max [ x1 +2 x 2 , x 1+ x 2 ]
Compare utility on budget line for corner solutions:
x 1=4 , x 2=0:u=max [ 4 , 8 ] =8
x 1=0 , x 2=3 :u=max [ 6 ,3 ]=6
Optimal: x 1=4 , x 2=0

2. Felix likes tea, especially since it keeps him concentrated when studying. His
neigh- borhood supermarket sells boxes with 20 teabags of black tea (x1) at the
price p1, boxes with 20 teabags of green tea (x2) at the price p2 = 2€. As black
tea has twice as much caffeine as green tea, his preferences are represented by the
following utility function: u(x1, x2) = 2x1 + x2. Felix has 12€ to spend on tea.

(a) Compute and interpret Felix’s MRS. At which quantity of boxes of green tea
will he be willing to forego an additional box of black tea? At which quantity
of boxes of black tea will he be willing to forego an additional box of green
tea?
−M U 1 −2
MRS= = =−2
M U2 1
Felix is willing to give up 2 boxes of green tea for 1 additional box of black tea, or
0,5 boxes of black tea for 1 additional box of green tea.

(b) Suppose p1 = 6€. What is the opportunity cost of a box of black tea (in terms
of boxes of green tea)? How many boxes of black tea and how many boxes of
green tea will Felix buy?
6
Opportunity cost of black tea: =3 boxes of green tea
2
M U1 2 M U2 1
Compare = ≈ 0 , 33 and = =0 , 5
p1 3 p2 2
12
Spend all on green tea: x 2= =6 , x 1=0
2

(c) Suppose p1 = 5€. What is the opportunity cost of a box of black tea (in terms
of boxes of green tea) now? How many boxes of black tea and how many
2
 boxes of green tea will Felix buy now?
5
Opportunity cost: =2 ,5 boxes of green tea
2
2 1
Compare =0 , 4 and =0 ,5
5 2
Spend all on green tea: x 2=6 , x 1=0

(d) Suppose p1 = 2€. What is the opportunity cost of a box of black tea (in terms
of boxes of green tea) now? How many boxes of black tea and how many
boxes of green tea will Felix buy now?
2
Opportunity cost =1 box of green tea
2
2 1
Compare =1 and =0 ,5
2 2
12
Spend all on black tea: x 1= =6 , x 2=0
2

3. (∗) Esther never drinks neither vodka nor orange juice by themselves, but she
really likes screwdrivers, which are cocktail drinks prepared with one third of
vodka and two thirds of orange juice.
3
Vodka ( x 1), orange juice( x 2), u ( x 1 , x 2 )=min [3 x 1 , x 2 ] budget = 30
2

(a) Derive a utility function that represents Esther’s preferences for vodka and
orange juice. Draw her preference map. Which is the equation that defines
the “vertices” of the indifference curves?

[ ]3
u ( x 1 , x 2 )=mi n 3 x 1 , x 2
2
3
Vertices: 3 x 1= x 2 → x2 =2 x 1
2

(b) Suppose she has 30€ to spend on drinks, the price of a 1 liter bottle of vodka
is 12€ and the price of a 1 liter pack of orange juice is 1,50€. What is Esther’s
optimal consumption bundle?
p1=12 , p 2=1 ,5 , m=30
Set x 2=2 x1 , budget: 12 x1 +1 , 5 ( 2 x 1 )=30 → x 1=2 , x 2=4

(c) Suppose that the price of a 1 liter bottle of vodka decreases from 12€ to 7€.
How many bottles of vodka and packs of orange juice will Esther buy?
Budget: 7 x ! +1 ,5 ( x 1 ) =30→ x 1=3 , x2 =6

3
 (d) Write down Esther’s general demand function for vodka as a function of the
price of vodka, the price of orange juice and her income. Do the same for
packs of orange juice.
x 2=2 x1 p1 x + p2 x =m
1 2

m 2m
General: x 1= , x 2=
p 1+3 p2 p 1+ 3 p 2

This reflects no substitution effect, due to perfect complement.

Engel Curve  If income increases, demand for both goods increases
proportionally (normal goods).
Cross – price effects: if p_2 (orange juice price) rises, demand for both goods falls
(complements)

4. (∗) Charles’s preferences for detergent (x1) and remaining commodities (the nu-
meraire, x2) are represented by the following utility function u(x1, x2) = 20x1 1/2 +x2.
A box of detergent costs p1 = 5€, while the price of x2 is p2 = 1€ (such that units
in which we measure good 2 are ‘Euros to be spent on other products’).
1
Given u ( x , x )=20 x 2 + x , p =5 , p =1
1 2 1 2 1 2

(a) Suppose Charles has 100€ to spend on detergent and the remaining commodi-
ties. How many boxes of detergent will Charles buy?How much does he
spend on other products?
∂ u 10
M U 1= =
∂ x1 √ x1
∂u
M U 2= =1
∂ x2

−1
2
Marginal Rate Substitution: 10 x 1 = 5 → x =4
1
1 1
Budget constraint  5 x 1+ x 2=100 : 5 ( 4 ) + x 2=100 → x 2=80
Detergent (x_1):4boxes
Other goods 80 euros

(b) Suppose now that Charles’s income increases from 100€ to 200€. How many
boxes of detergent will Charles buy now? How much will he spend of the
remaining commodities?
Same MRS condition: x 1=4
Budget constraint x 2=200−20=180
Detergent(x_1)=4 boxes
Other goods (x_2)=180
4
5. Nuria has received 100 euros to spend on books (x1) and music CD’s (x2). Her
utility function is given by: u(x1, x2) = ln x1 + ln x2.
Given: u ( x 1 , x 2 )=ln x 1 +ln x 2 ,m=100

(a) Compute Nuria’s demand for music CD’s and books as a function of p1, p2 and
m.
m m
x 1= , x 2=
2 p1 2 p2

(b) What combination of goods maximize her preferences when p1 = p2 = 10?

100
x 1=x 2= =5
20

(c) Radilux is a shop with discounts for second-hand CD’s with the following
pricing policy. There is an entrance fee of 20 euros with which each CD
can then be bought at 4 euros. (Nuria does not care whether a CD is new
or old). Do you think Nuria would like to buy in the second-hand shop if the
remaining shops charge p1 = p2 = 10? Explain.
Entrance fee 20, then p2=4, remaining m=80
80 80
x 1= =4 , x 2= =10
2· 10 2·4
Utility comparison: Original u=ln 5+ln 5, Radilux u=ln 4 +ln 10
ln 4+ ln10> ln 5+ln 5, so prefer Radilux

(d) Julia, Nuria’s friend, also receives 100 euros. Her utility function is different
from Nuria’s and is given by: u(x1, x2) = 8 ln x1 + ln x2. (Julia also does not
care whether the CD’s are new or old) Would Julia like to buy in Radilux?
Explain and interpret your answer.
u ( x 1 , x 2 )=8 ln x 1 +ln x 2
8m m
Demand: x 1= , x 2=
9 p1 9 p2
640 80
Radilux: x 1= ≈ 7 , 11, x 2= ≈ 2 ,22
90 36
Utility comparison: Original u=8 ln 5+ln 5, Radilux u=8 ln 7 , 11+ln 2 , 22
Calculate numerically to compare

5
 6. Rafael has the following utility function: u(x1, x2) = x2 + 2x2.
1 2

2 2
Given:u ( x 1 , x 2 )=x 1 + x 2 , p1=1 , p 2=2 , m=6

(a) Draw the indifference curve map.

Convex and symmetric around origin

(b) Compute Rafael’s optimal choice is p1 = 1, p2 = 2 and m = 6.

2 x1 1 x1
MRS: = → =1
4 x2 2 x2
Budget: x 1+ 2 x 2=6 , x 1=x 2 → x 1=2 , x 2=2

(c) Are his preferences homothetic? Are they convex?

Yes, homothetic. Yes, convex.

7. Daniela has 150€ to spend on yoga classes (x1) and other products (the numeraire,
x2) each month. Her utility function is u(x1, x2) = x1/5x4/5. The price of a yoga
1 2
class in her neighborhood yoga club is 4€ for members and 10€ for non-members.
The membership fee is 30€ per month.

(a) What is Daniela’s optimal choice.

' 120 480
Member:m =120 , x1 = =6 , x 2= =96
5·4 5· 1
150 600
Non-member: x 1= =3 , x 2= =120
5· 10 5 ·1
Compare utilities

(b) Will she choose to become a member of the yoga club? [Hint: Solve the prob-
lem for each segment of the budget constraint separately, and then compare
utility levels.]
Calculate utilities for both scenarios and compare.

6
 8. Hector has a budget of 60€ to spend on beef (x1, in kilos) and chicken (x2, in kilos)
each month. Suppose this utility function u(x1, x2) = 2x1/2 + x1/2 represents his
1 2
preferences. The price of chicken is 4€/kg.
1 1
Given: u ( x , x )=2 x 2 + x 2 , p =4 ,m=60
1 2 1 2 2

(a) Suppose that the price for a kilo of beef is also 4€. Find Hector’s optimal
consumption bundle.
−1
x 12 8 x1
MRS: −1
= → x 2=
2
4 4
0 ,5 x 2

Budget:8 x 1+ 4 ( x4 )=60 → x =12 , x =3

1
1 2

(b) Suppose now that the price of beef increases to 8€/kg. Find Hector’s optimal
consumption bundle.
−1
2
x 1 8 x1
MRS: −1
= → x 2=
2
4 16
0 ,5 x 2

Budget:8 x 1+ 4 ( 16x )=60 → x =7 , 5 , x =0,46875

1
1 2

(c) Is beef an ordinary good or a Giffen good for Hector? Why?

As price increases, quantity decreases: ordinary.

(d) Is beef a complement or a substitute for chicken? Why?

Check cross-price elasticity. Higher beef price leads to more chicken consumption-
Substitutes.

(e) Suppose the price of beef remains at 8€/kg. Find the equation that defines
Hector’s Engel curve for beef, and draw it on a graph with x1 on the horizontal
and m on the vertical axis. How many kilos of beef would Hector buy if his
monthly income was 24€? And if it was 120€? Mark these points on your
graph.
Derive x 1as a function of m
m
x !=
p1 + p2
( )
p1
4 p22
m
p1=8 , x !=
12
If m = 24, x1=2
7
 If m=120, x1=10

(f) Is beef a normal or an inferior for Hector? Why?

Check income elasticity. As income increases, beef consumption increases, beef is
a normal good.

9. Joan, Albert, Sonia and Clara are 4 friends who all like beer and French fries. Each
one values the goods as follows. Let x1 denote the quantity of beer and x2 the
quantity of French fries, we can write their utility functions as follows:
for Joan: u(x1, x2) = x1/4x3/4;
1 2

for Albert: u(x1, x2) = min(3x1, x2);

√
for Sonia: u(x1, x2) = x1 + x2;
and for Clara: u(x1, x2) = 3x1 + x2.
For each one of the four friends, answer the following questions:

(a) Compute the demand function for beer and french fries (as a function of the
price of beer p1, the price of french fries p2 and income m).
1. Joan (Cobb-Douglas)
m
Demand for beer: x !=
4 p1
3m
Demand for fries: x 2=
4 p2
2. Albert (perfect complements)
Optimal ratio: 3 x 1=x 2
Budget constraint: p 1x + p2 (3 x1 )=m
1

m
Demand for beer: x 1=
p 1+3 p2
3m
Demand for fries: x 2=
p 1+3 p2
3. Sonia (quasi-linear)
1 P1
MRS= =2 √ X 2=
Interior solution: 1 P2
X √ X2
Solve x_2, substitute into budget constraint
If m is large enough
2
m+ p p
( 2p )
( )
2 1
2
p
x 2= 1 . x ! =
2

2 p2 p1
8
 m
If m is small, corner solution (x2=0,x_! )
p1
4. Clara (perfect substitutes)
M U1 3 M U2 1
Compare = and =
p1 p1 P2 p2
3 1
If > spened all on beer. X1=m/p_1, x2=0
p1 p2
3 1
If < spened all on beer. X1=0, x2=m/p2
p1 p2
(b) If each one has a budget of 100 euros per month to spend on beer and French
fries, and if the prices are p1 = p2 = 2, what is the optimal choice of beer and
French fries for each of the four friends?
p1= p2=2, m=100
JOAN
100 300
x 1= =12 ,5 , x 2= =37 ,5
8 8
ALBERT
100
x 1= =12 ,5 , x 2=37 , 5
8
SONIA
( 100−2 ( 0 , 25 ) )
x 2=()
2 2
4
=0 , 25 , x 1=
2
=49 , 75

CLARA
3 1
> → x 1=50 , x 2=0
2 2

(c) Draw the demand curves for beer and French fries.
Plot quantity as a function of price.
Ploys c_1 and x_2 as funcions of p_1 and p_2

(d) Draw the Engel curves for beer and French fries.
Plot quantity as a function of income.
Plot x_1 and x_2 as functions of m

(e) Show whether the goods are substitutes or complements.

Joan and albert are complements (fixed ratio)
Sonia and clara are susbtitues (trade-of between goods).