Preparatory work for Microeconomics EC202

Most of the undergraduate students taking Microeconomics 2 have done a full year of micro
before. You will find it greatly beneficial to read key chapters of an introductory textbook to
familiarise yourself with key concepts. We suggest you read about the following topics:

 Consumer and producer theory

Suggested Reading:

“Microeconomics” by Michael Katz and Harvey Rosen (Irwin). This is a textbook used by first
year economics undergraduates.

The following readings and exercises are useful if you are able to get hold of the
relevant books, but they are not essential:

“Microeconomics and Behavior” by Robert Frank (eighth edition, McGraw Hill Publishing) for
Exercise 3 Q5 and Exercise 4 Q5 and Q6.

Review of Chapter 2 (page 19 to 32; 36 to 42 and 45 to 55) and Chapter 3 (pages 87 to 105)
from book "Microeconomic theory: Basic Principles and Extensions" Tenth edition by Snyder
and Nicholson.

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PLEASE BRING YOUR SOLUTIONS TO YOUR PRE-SESSIONAL CLASSES AT THE
START OF TERM.

Exercise 1

(1) Adam likes apples, but does not care about pears. If apples and pears are the only two
goods available, draw his indifference curves.

(2) If Amanda spent her entire allowance, she could afford 8 candy bars and 8 comic books
per week. She could also afford 10 candy bars and 4 comic books per week. The
price of candy bars is 50 cents.
(a) Graph her budget constraint and find her weekly allowance.
(b) If it is the case that when Amanda buys more than 10 candy bars, the price of
additional candy bars (beyond 10) drops to 25 cents each, graph her new budget
constraint.

(3) At your high-school’s fund raising picnic, you pay for soft drinks with tickets purchased in
advance – one ticket per bottle of soft drink. Tickets are available in sets of three
types:
Small: £3 for 3 tickets
Medium: £4 for 5 tickets
Large: £5 for 8 tickets.
The total amount you have to spend is £12. If fractional sets of tickets cannot be
bought (and no resale of tickets is possible), graph your budget constraint for soft
drinks and the composite good.

(4) If an indifference curve is convex from above (bowed outward), which of the following
statements would be true?
(a) The more you have of a good, the less you desire additional units of the good.
(b) The less you have of a good, the more intense your desire for more of it.
(c) The more you have of a good, the more intense your desire for more of it.
(d) This type of indifference curve violates the more-is-better-than-less assumption
underlying indifference curves.

(5) Fatima, a college professor, derives satisfaction from her teaching performance (T) and
her research output (R). Suppose that she can work up to 60 hours per week. Every
hour spent on preparing the lecture notes improves T by 1 unit whereas every hour
spent in the lab improves R by 2 units.
(a) Draw Fatima’s budget set in the T-R space.
(b) Suppose that the college has acquired new lab equipment worth £1000 that
increases Fatima’s research productivity to 3 units per hour. Redraw her budget
set.
(c) Consider the original scenario (no equipment). Now suppose that Fatima gets a
grant for £1000. She could use it to buy the above-mentioned equipment or she
could hire a teaching assistant who would improve her teaching productivity up
to 1.5 units per hour. Redraw her budget set.
(d) If the lab is not open for more than 40 hours per week, re-draw Fatima’s budget
set in part (a) above.

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Exercise 2

Show all your work clearly.

(1) Fiona requires a minimum level of consumption, to derive additional utility. For Fiona,
U(X,Y) = 0 if X+Y<5
= X+Y otherwise.
Which of our usual assumptions about well-behaved preferences are violated in
Fiona’s case?

(2) Consider the following utility functions over goods A and B. U = AB, and V = A2B.
Compute the MRS for each of these functions, and evaluate these at the point (3,4).
Explain whether these functions represent the same preference ordering. (Think about
what the MRS at (3,4) represents in economic terms.) In other words, is V a
monotonic transformation of U?

(3) Mr. J. Bond, a retired movie actor, consumes only grapes and the composite good Y
(i.e. price of Y is £1). His income consists of £10000 a year from his investment fund
plus the proceeds of whatever he sells of the 2000 bushels of grapes he harvests
annually from his vineyard in Tuscany. Last year, grapes sold at £2 per bushel and
Bond consumed all 2000 bushels of his grapes, in addition to 10,000 units of Y.

This year, the price of grapes is £3 per bushel (and the price of the composite good Y
is the same as before). If Bond has well-behaved preferences, will his consumption of
grapes this year be greater than, less than or the same as last year’s? How about his
consumption of the composite good? (Hint: Graph both years’ budget constraints and
think about whether last year’s bundle is affordable to Mr. R).

(4) Shirley Sixpack and Lorraine Quiche are friends. Shirley thinks a 16-ounce can of beer
is just as good as two 8-ounce cans. Lorraine only drinks 8 ounces at a time and hates
stale beer, so she thinks a 16-ounce can is no better or worse than an 8-ounce can.

(a) Write a utility function that represents Shirley's preferences between commodity
bundles comprised of 8-ounce cans and 16-ounce cans of beer. Let X stand for
the number of 8-ounce cans and Y stand for the number of 16-ounce cans.
(b) Write down a utility function to represent Lorraine’s preferences.
(c) Would the function utility U(X, Y ) = 100X+200Y represent Shirley's preferences?
How about U(X,Y) = X + 3Y?

(5) Suppose Carmela’s income is £100 per week, which she allocates between
sandwiches and books. Sandwiches cost £2 each. Books cost £10 each if she
purchases between 1 and 5 books. If she purchases more than 5 books in a week, the
price falls to £5 for the 6th book and all subsequent books. Draw the budget constraint.
Is it possible that Carmela might have more than one utility-maximizing solution?

(6) Suppose that a typical research student at the University of Warwick lives in a two
good world, books ( x ) and beer ( y ), with utility function u(x, y) = x1/5 y4/5 .
The price of book and beer are £50 and £10, respectively.
(a) If a research student gets £1000 as a scholarship, then find his demand for book
and beer.
(b) Show that the expenditure on beer is 4 times as much as that on book.
(c) Suppose the University is considering the following scheme: £750 is paid as
fellowship and additional £250 as book grant. Naturally, a book grant can only be
spent on books. Draw a research student’s budget constraint under the new
scheme.
(d) Find his optimal consumption bundle under this new scheme.

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(7) Kinko spends all his money on whips and leather jackets. Kinko’s utility function is U
(x, y) = min{4x, 2x + y}, where x is his consumption of whips and y is his consumption
of leather jackets. Kinko is consuming 15 whips and 10 leather jackets. The price of
whips is $10. You are to find Kinko’s income. To do so, you may proceed in the
following sequence:

(a) Draw Kinko’s indifference curve through his current consumption point (15,10) –
remember that the utility level on an indifference curve is a fixed number at all
points on the curve.
(b) Find the slope of the indifference curve at his current consumption bundle. Then
arrive at your answer.

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Exercise 3

(1) Jenny, a sports buff, enjoys playing golf (G) and tennis (T) each week and derives
enjoyment according to the utility function:

U(G, T) = G1/2 T1/2

(a) If she has £24 a week to spend on these two activities, and the price of a round
of golf, like that of a game of tennis, equals £4, how will Jenny pursue her
athletic activities in order to maximize utility?
(b) Being a businesswoman with a heavy schedule, however, Jenny has only a
limited amount of time — 16 hours — to devote to athletic activities each week.
If a round of golf takes 4 hours and a game of tennis 2 hours, how should she
allocate her time between these two activities? If she maximizes her utility
subject to her time constraint, does this outcome also satisfy her budget
constraint?

(2) Paul eats lunch at school each day. He likes only Twinkies(T) and Orange Slice(S),
and these provide him a utility of .
(a) If Twinkies cost £.10 each and Slice costs £.25 per cup, how should Paul spend
the £1 that his mother gives him in order to maximize his utility.
(b) The price of Twinkies rises to £.40 each. If Paul’s mother wanted to keep him as
satisfied as he was before the price increase, what should she do? How would
Paul’s consumption be altered after the price and allowance change? (Hint: You
need to write down Paul’s optimization problem in terms of the minimum
expenditure needed to generate the same level of utility as that attained in (a)).

(3)
(a) You have 24 hours of time in a day. You get utility from a composite good (C)
and leisure (L), the number of hours you don’t work. Your hourly wage rate (the
‘price’ of leisure) is w per hour and the price per unit of the composite good, p=
1. Write down the equation for your budget constraint in terms of C and L. (Hint:
First write it down only in terms of C, and then introduce L).
(b) Explain in words, using the budget equation from (b) how a change in the wage
rate has income and substitution effects going in opposite directions.

(4) Sarah allocates her income of £5.00 between the consumption of donuts and coffee.
Her tastes and preferences are indicated by the indifference curves shown below.
The price of donuts is £0.50 each. Initially the price of coffee is £1.00 per cup.
Subsequently, the price of coffee falls to £0.50 per cup. On the graph below, show
the initial utility-maximizing position, the new utility-maximizing position, and separate
the income and substitution effects. For Sarah, is coffee a normal or inferior good?

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(5)
(a) Question 2 – Appendix to Chapter 3, Frank book.
(b) Suppose the price of good X becomes P x = 5. Calculate the size of the Income
effect and the Substitution effect of this price change for Tom. (Hint: First figure
out what the original optimal bundle will cost Tom under the new prices. Then
proceed using the logic spelt out in class).
(c) Calculate Tom’s price elasticity of demand for good Y at the current price.

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Exercise 4

(1) Suppose that the demand function of beer is given by p = 20 – 0.25q.

(2) Consider a consumer with utility function U=x2y. Let Px, Py and M denote the prices of
x,y and the consumer’s income, respectively. (a) Find the consumer’s demand function
for x and y, in terms of Px, Py and M. (Assume an interior solution.) (b) Compute the
price elasticity of x at Px=10. (c) Find the income elasticity of x at Px=10.

(3) The demand function for football tickets for a typical game at a large university is D(p)
= 200,000 −10,000p. The university has a clever and avaricious athletic director who
sets his ticket prices so as to maximize revenue. The university’s football stadium
holds 100,000 spectators.
(a) Write expressions for total revenue and marginal revenue as a function of the
number of tickets sold and compute the profit-maximizing quantity of tickets.
Find the marginal revenue and price elasticity of demand at this quantity. (Hint:
First write down the inverse demand function, i.e. price as a function of quantity
demanded).
(b) A series of winning seasons caused the demand curve for football tickets to shift
upward. The new demand function is q(p) = 300,000 −10,000p. Write a new
expression for marginal revenue as a function of tickets sold. Given the
constraint imposed by the stadium capacity, find the price that would maximize
the stadium revenue (and profit). Also find the price elasticity of demand. (Note:
The marginal revenue at the maximum number of available seats is positive).

(4) Government offers a subsidy s per kilogram of corn that farmers produce, over and
above the market price. Use a diagram to depict the following in the corn market (a)
Consumer surplus (b) Producer Surplus (c) Government revenue and (d) Dead-weight
loss from the subsidy. Use alphabets to label the relevant points to clearly depict
these different areas.

(5) Q8, Appendix to Chapter 2, Frank book (Hint: The tax structure is like a VAT ( (1+t)p
where p was the original old price, instead of a fixed increase p+t. Everything else is
as before.)

(6) Q10, Appendix to Chapter 2 – Frank book. How much will buyers benefit if the tax is
removed?