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University of Toronto | Department of Economics | ECO 204 | 2011 - 2012 | Ajaz Hussain
TEST 2
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Question 1 [5 Points]
The following graphs are reproduced from Tella and MacCullochs article Some Uses of Happiness Data in Economics.
According to the graph on the left: despite income per capita rising, happiness levels are more or less the same
According to the graph on the right: happiness levels rise with income per capita
1975 1980 1985 1995 1990
Real Household Income/capita
0 10k 20k 30k 40k 50k
Cross Section of Americans (1995)
Longitudinal Survey of Americans
1975, 1980, 1985, 1990, 1995

Please give a short explanation below for these seemingly contradictory conclusions.
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Question 2 [10 Points]
(a) [5 Points] If a good has a downward sloping demand curve (i.e. it is ordinary good), then it may be a normal good or
an inferior good -- true or false? Explain your answer, clearly stating any assumptions.











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(b) [5 Points] A normal good must be an ordinary good (i.e. has a downward sloping demand) -- true or false? Explain
your answer, clearly stating any assumptions.
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Question 3 [20 points]
Suppose the representative consumer has the following utility function over food (good 1) and everything else (good 2):

Assume and that the consumption set is {(

) }.
(a) [5 points] Solve the consumers UMP for the optimal amounts of goods 1 and 2 and the optimal level of utility and
indicate whether goods 1 and 2 are ordinary goods, and whether goods 1 and 2 are normal/inferior goods.
Assume all pecuniary parameters are and show all calculations.



















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(b) [5 points] Suppose the representative consumers utility function is:

Currently, the representative consumers budget constraint is (

) ( ) where is the
net income (i.e. income tax has been deducted at source). Now, suppose the government gives this consumer an
additional net income in cash. Calculate the change in the optimal amounts of goods 1 and 2 and the change in
optimal utility due to this income in cash program. Show all calculations.



















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(c) [5 points] Once again, consider the consumer in part (b) who had the utility function:

From part (b) recall that the consumers budget constraint is (

) ( ) where is the net

income (i.e. income tax has been deducted at source). Now suppose that instead of giving the consumer income in
cash, the government gives the consumer income in kind as food stamps (i.e. the food stamps can only be used to
buy food). Calculate the change in optimal amounts of goods 1 and 2 and the change in optimal utility due to this
income in kind program. Show all calculations.


















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(d) [5 points] Given your answers to parts (b) and (c), does the consumer prefer receiving as income in cash or
as income in kind? What about the government does it prefer giving the consumer as income in cash or as
income in kind? Show all calculations.





















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Question 4 [20 points]
Consider the two different consumers in part (a) and part (b) below with utility functions defined over {

}
Suppose each consumers budget constraint is initially

) ( ) and then changes to

) ( ). For each consumer below calculate the price effect, substitution effect and income
effect of good 1. Show the effects graphically and show all calculations.
(a) [10 points] (

)




















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(b) [10 points] (

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Question 5 [20 points]
(a) [10 points] Youre interested in the impact on consumer welfare from a proposed 5% excise tax on toothpaste. You
do not have the representative consumers utility function over toothpaste and everything else, but you do have the
demand curve equation for toothpaste:

Given that the representative toothpaste consumer buys 5 tubes of toothpaste a year on average, calculate the impact
on consumer welfare due to a 5% tax on toothpaste (i.e. calculate the change in utility due to the excise tax on
toothpaste). State all necessary assumptions and show all calculations.

















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(b) [10 points] Use the demand curve equation for toothpaste in part (a) to calculate the representative toothpaste
users utility function over toothpaste and everything else. Use this utility function to compute the impact on utility from
a 5% excise tax on toothpaste. Assume the representative toothpaste user has . State all necessary assumptions





















and show all calculations.

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S. Ajaz Hussain, Dept. of Economics, University of Toronto
Question 6 [5 Points]
Please answer the question following this article from the New York Times (please focus on the bolded sentences
below):

November 7, 2011
Soda Bans in Schools Have Limited Impact
By ANAHAD O'CONNOR
State laws that ban soda in schools but not other sweetened beverages have virtually no impact on the amount of sugary drinks
middle school students buy and consume at school, a new study shows.
The study, which looked at thousands of public school students across 40 states, found that removing soda from cafeterias and school
vending machines only prompted students to buy sports drinks, sweetened fruit drinks and other sugar-laden beverages instead. In
states that banned only soda, students bought and consumed sugary drinks just as frequently at school as their peers in states where
there were no bans at all.
The study is among the first to directly examine the extent to which state policies on soda in schools influence students behavior.
With obesity on the rise and teenagers getting about 15 percent of their daily calories from beverages, health groups like the Institute
of Medicine have pushed for the removal of all sweetened beverages from schools, and some states have put in place all-out bans on
sweetened drinks. California, for example, became the first state to ban the sale of soft drinks in grade schools, in 2003, and one city,
Boston, moved earlier this year to forbid the sale and promotion of sugar-sweetened beverages and sodas on all city property.
But the sale of soft drinks in schools has become a lucrative revenue source for many school districts, and a number of states have
been reluctant to eliminate them from schools. Some states have instituted only partial bans that remove sodas from schools but not
Snapple, Gatorade and other sugary drinks.
In the latest study, published this week in The Archives of Pediatrics and Adolescent Medicine, researchers looked at soda and
sweetened beverage consumption among roughly 7,000 fifth and eighth grade students across 40 states. The students were followed
between 2004 and 2007, a time when many states and school districts were beginning to enact bans.
The researchers found that the proportion of students who purchased sugary drinks at schools in states that removed only soda 28.9
percent was similar to the proportion in states that had no bans against any sugary drinks at all 26 percent. Both groups also
reported having identical levels of access to sugary beverages at school: about 67 percent in each category.
I think definitely the biggest message is that laws need to be comprehensive to have any positive effect at all, said Daniel R. Taber,
an author of the study and postdoctoral research associate at the University of Illinois at Chicago. The most unequivocal finding was
that laws that focus on soda are just not getting it done. If you really want to create a healthier school environment, you need more
comprehensive laws.
But the study, which was funded by the National Institutes of Health and the Robert Wood Johnson Foundation, had another
surprising finding. In states with policies banning all sugary drinks in schools, students had less access to them on campus, but
their overall consumption of the drinks did not fall, suggesting they were getting the drinks elsewhere. Dr. Taber said that
finding indicated that removing sugary drinks from school campuses, while effective, could only go so far. He said more
initiatives that target sweetened beverage consumption outside of schools like beverage taxes and regulations on their
marketing to children were needed.
The laws did exactly what they were designed to do, he said. They were designed to reduce kids access to sweetened beverages in
schools, but you cant expect schools to do it all on their own.
Dr. Taber said it made sense for some school districts to focus on soda at first, since it accounts for about two thirds of the calories
teenagers get from sugary drinks. But that could also give some students the wrong idea about which drinks are best.
ECO 204, 2011 - 2012, Test 2
This test is copyright material and cannot be used for commercial purposes or posted anywhere without prior permission. Report violations to economics204@gmail.com


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Soda is definitely the most popular choice among kids, he said. But theres a lot of misconceptions about which beverages are
healthy. Many kids think beverages like Gatorade are a healthy alternative to soda.
According to the article:
In states with policies banning all sugary drinks in schools, students had less access to them on campus, but their overall
consumption of the drinks did not fall, suggesting they were getting the drinks elsewhere.
Please model this effect of banning soda at school graphically. Show the before and after soda ban budget constraints and
indifference curves (choose the utility function wisely). Be sure to label the axes and give a brief explanation below.



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Question 7 [10 Points]
Consider a 2 period economy ( ) with a single good (say, corn). Each consumer receives real income

(in
units of corn) at the beginning of respectively. Denote the real interest rate by (assume a common at
).
Suppose a consumer has the following utility function defined over the consumption set {(

) }:
(

) (

)

Assume all pecuniary variables .

(a) [5 points] Derive an expression for

the of (Future Value of Total Lifetime Income), and the of

(Present Value of Total Lifetime Income). State all assumptions and show all calculations.


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(b) [5 points] Under what conditions will the consumer save corn at ? Characterize:
The relationship between

and The relationship between

and
Show all calculations.

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Question 8 [10 Points]
Consider a 3 period economy ( ) with a single good (say, corn). Each consumer receives real income

(in units of corn) at the beginning of respectively. Denote the real interest rate by (assume a
common at ).
Suppose a consumer has the following utility function defined over the consumption set {(

) }:
(

) (

)

That is, the consumer perceives consumption at and as complements, and consumption at
versus literally as perfect substitutes. Under what conditions will

and

? State all assumptions and

show all calculations. Assume all pecuniary variables .
















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