Answer Keys

(Problem Set-II)
1. (a)
F
Preference
Directions

A
B
C
H

(b) At point A, Dr. Strangetastes indifference curve, which is bowed out from the origin,
is tangent to his budget line. This point is not an optimum because, for example, Dr.
Strangetaste could move to point B on his budget line and achieve a higher level of total
utility. Point B, though, is not an optimum either because Dr. Strangetaste could move to
point C, a corner point, to achieve an even higher level of total utility. When the MRS is
increasing, a corner point optimum will occur (with F = 0 in this picture, though it could
equivalently be with H = 0 for another set of indifference curves).

2. When the consumer maximizes utility, his optimal consumption basket will be on the
budget constraint and satisfy the tangency condition.
Any basket on the budget line will satisfy pxx + pyy = I, or 2x + 5py = 40.
The tangency condition requires that MUx / px = MUy / py, or that 5 / 2 = x / py. This implies
that 5py = 2x.
Putting these two equations together reveals that 5py + 5py = 40; thus py = 4.

3. This question cannot be solved using the usual tangency condition. However, you can see
from the graph below that the optimum basket will necessarily lie on the elbow of some
indifference curve, such as (5, 3), (10, 6) etc. If the consumer were at some other point, he
could always move to such a point, keeping utility constant and decreasing his expenditure.
The equation of all these elbow points is 3x = 5y, or y = 0.6x. Therefore the optimum point
must be such that 3x = 5y.
 5 x 10 y 220
The usual budget constraint must hold of course. That is, . Combining these
two conditions, we get (x, y) = (20, 12).

(20,12)

(10,6)
(5,3)

4. A half-price sale cuts the price of each and every unit in half. In contrast, a buy-one,
get-one-free deal does not change the relative price of any units between 0 and 1 unit.
Furthermore, it makes the price of units purchased between 1 and 2 units purchased
zero.

5. Gift cards are not merely a fad. Retailers experience significant benefits from gift
cards since they minimize product returns; independent of whether the good is normal
or inferior. Gift cards can also benefit consumers. A gift card does not impact the
amount purchased for one good (say the good on the Y axis), but shifts out the budget
constraint for the other good (the good on the X axis) by the face value of the gift
card. The expanded budget constraint permits the consumer to reach a higher
indifference curve; resulting in greater utility.

6. Robinsons initial budget constraint is BC1 on the diagram below. Since His
indifference curves are always flatter than her budget constraint, he will consume all
coconuts. Thus, he gathers and consumes 64 coconuts. When his neighbor arrives
and offers the exchange, his budget constraint becomes BC2. It is now optimal for
him to gather all bananas and exchange them 1 for 1 with his neighbor for coconuts.
This gives him 128 coconuts to consume. This brings him to the higher indifference
curve I2. Robinson is better off.
 7.

Without the gift certificate, Bobby's budget constraint is indicated by the line segment from
10 books and 0 pizza to 0 books and 50 pizzas (labelled BC1). With the gift certificate that
can only be used for book purchases, Bobby still cannot afford anymore than 50 pizzas.
However, she is guaranteed 6 books even if she spends all her money on pizza. Since the
price of books and pizza hasn't changed, the slope of her new budget constraint is the same as
the slope of the old budget constraint. The new budget constraint is drawn above as BC2.
Note that with the gift certificate, Bobby has an expanded opportunity set and is guaranteed
more of both goods no matter what her original consumption choice on BC1 was. This
implies that Bobby is strictly better-off with the gift certificate.
 y
4
x 4 x y 120
8. a) Using the tangency condition, , and the budget constraint, ,
your initial optimum is the basket (x, y) = (15, 60) with an utility of 900.

b) First we need the decomposition basket. This would satisfy the new tangency
y
3
x xy 900
condition, and would give you as much utility as before, i.e. . This gives
( x, y ) (10 3 ,30 3 )
or approximately (17.3,51.9). Now we need the final basket, which
satisfies the same tangency condition as the decomposition basket and also the new budget
3 x y 120.
constraint: Together, these conditions imply that (x, y) = (20, 60). The
substitution effect is therefore 17.3 15 = 2.3, and the income effect is 20 17.3 = 2.7.

9. Self-expnanatory !!! It is a normal good !