UNIVERSITY OF TORONTO SCARBOROUGH

DEPARTMENT OF MANAGEMENT

MGEB02: Price Theory: A Mathematical Approach

Instructor: A. Mazaheri
Midterm-1 (Solutions)

Instructions: This is a closed book test.

You have 2 Hours.

Good Luck!
Last
Name:

First
Name:

ID

FOR MARKERS ONLY:

Q1 Q2 Q3 Q4 Q5 Total
Marks
Earned
Maximum
Marks 36 15 15 18 16 100
Possible

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Answer all following 5 questions:

Question-1 [36 Points] Answer the following Short Questions:

a) [4 points] You are analyzing the market for Crude oil in the last decade or so, you know that
the price has risen from $20 or so to $100+ during this period. Show what must have happened to
the demand and supply to lead to such an equilibrium.

Demand shifts right, P & Q increase

b) [5 Points] In the following, the initial equilibrium is given. Suppose price of X declines.
Assuming X is Giffen, draw the new equilibrium. On the same graph show the income and the
substitution effects.

SE
IE

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 c) [5 Points] Draw representative indifference curves for the followings:

i) Sandra has a strange habit and she insists on it; she likes to eat an apple and two bananas
together.

Perfect complement:
Apple

Banana
2

ii) Adam does not care about orange juice or apple juice as long as he has juice.

Perfect Substitute:

Orange Juice

Apple Juice

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d) [5 Points] Assume you have a fixed budget of $10. Further assume that you spend your entire
budget. Both good X and good Y cost $1 each. You are spending all your money on X. At this
bundle, your marginal utility of X is 10 while your marginal utility of Y is 5.

Are you optimizing your utility? Why or why not? Using a graph explain your answer.

Solution:

(1) spend your entire income because you are on the budget line
(2) The MRS = 10/5=2 > 1, or (MUx/ Px) > (MUy/ Py).

That is, the marginal utility of X per dollar spent is higher than that of Y. However, you
already gave away all Y and cannot get more X. Therefore your optimal consumption
bundle is a corner solution where you consume no Y.

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 e) [7 Points] Assume a utility function that is given by U(X,Y) = X0.5Y0.5. Further assume a
budget of $50. When the prices where PX=1 and PY=1, you consumed X= 25 and Y = 25, while
when the prices changed to PX=2 and PY=1, you consumed X= 12.5 and Y = 25. With the help of
the following graph decompose the total effect of the price change into the substitution and
income effects.

Solution:

We know TE = 25-12.5. We need to find the SE. Having SE we can solve for IE as
TE=SE+IE. SE is the change in the quantity of x demanded, if (1) the individual remains at
the same indifference curve and (2) if MRS is equal to the new price ration.

1 : U = 25 0.5  25 0.5 = 25 = X 0.5Y 0.5

Y 2
2 : MRS = = = Y = 2 X
X 1
(1), (2) = 25 = X 0.5 (2 X ) 0.5 = X = 17.68
SE = 17.68 − 25 = −7.32
IE = 12.5 − 17.68 = −5.18

Graphically:

50

25

SE
IE

12.5 17.68 25 50
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f) [5 Points] You have 5 spent on two products, a composite product (Y) with a price of p y = 1
and coffee (X) with a price of px = 1. If you purchase three cups of coffee, you will be offered one
coffee for free and a 50% discount on each additional cup of coffee purchased. Show graphically
how this affects your budget line.

x
3 4 8

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g)(8 Points) There are 50 consumers in the economy. Half of them live in city A and demand
Orange according to the individual inverse demand curve P = 2− Q. The other half live in city B
and demand Orange according to the individual inverse demand curve P = 6−3Q. Suppose that
the market-clearing price for Orange is $1.

Write down the market demand for Orange in this economy and then graph it?
Suppose the price increases from $1 to $2, how does the consumer surplus change?

Solution:

But demand seize to exist in city A when the P >= 2 while in city B the demand is zero when
P>=6 therefore the demand will be kinked at P=2 or:

25P
QM = 50 − ( P  2)
3
QM = 100 − 33.33P( P  2)

33.33 100

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Page 8 of 17
Question-2 [15 Points] As a manufacturer you are interested in obtaining quick estimates of the
supply and demand curves for your product. You have done some research and you know that for
your product the elasticity of supply is 2, the elasticity of demand is -1.5. You also know that the
current price and quantity are $50 and 1,000, respectively. Assume that both demand and supply
are linear.

a) [6 Points] What is the supply and demand curves at the current price and quantity.
b) [4 Points] What impact would a 10% decline in demand have on the equilibrium price and
quantity?
d) [5 Points] Ignore part (b). Suppose the government subsidizes your product by 5 dollars per
unit. What would be the new equilibrium price? Use a graph to show your answer.

Solution:
a) Demand curve

Q = a0 + b0P
Ed = b0 × P/Q = -1.5 = b0 × 50/1000

b0 = - 30 => 1000 = a0 - 30(50) => a0 = 2500

Qd = 2500 - 30P

Next, we estimate the supply curve

Q = a1 + b1P

E1 = b1 × P/Q = 2 = b1 × 50/1000
b1 = 40 => 1000 = a1 + 40(50) => a1 = -1000

Qs = -1000 + 40P

b) Multiply demand equation by 0.9

Qdʹ = 0.9 (2500 - 30P)
Qdʹ = Qs and solve

2250 - 27P = -1000 + 40P

P = 48.51, => Qdʹ = 2250 - 27(48.5) Qdʹ = 940.3

c) PD = PS -5, QD =QS = Q
Qd = 2500 - 30P => PD = 2500/30-(1/30)Q
Qs = -1000 + 40P => PS = 25 +(1/40)Q
PD = PS -5 => 2500/30-(1/30)Q = 25 +(1/40)Q –5 => Q =1085.7=> PD = 47.14

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Question-3 [15 Points] Suppose your preferences for Gasoline (X) and a composite good
(Y) is set in accordance to U(X,Y) = 2X0.25 + Y0.25. You have an annual income of
$30,000 and that the price of the composite good is $1.
a) [5 Points] If the government introduces a rationing system such that you can only
consume 15,000 liters a year at $1 a liter. What would be your optimal consumption
bundle?
b) [6 Points] If the government removes the rationing system and the free market price of
gasoline jumps to $2. What would be your new optimal consumption bundle? Are you
better off with or without the rationing?
c) [4 Points] Illustrate your solution in a clearly labeled graph.

a)
0.5 X −0.75 1 2Y 0.75
MRS = = =
0.25Y −0.75 1 X 0.75
= Y 0.75 = 0.5 X 0.75 = Y = 0.3969 X
= X + 0.3969 X = 30,000
= X = 21476.89
= Y = 8523.11
But cannot consume more than 15000 L, therefore corner solution:
X + Y = 30,000
X = 15,000
= Y = 15,000
b) Without the rationing and with the new price:
2Y 0.75
MRS = =2
X 0.75
= Y = X
= 2 X + X = 30,000
= X = 10,000
= Y = 10,000

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You are better off with the rationing because:

U Ration = 2  1,5000 0.25 + 15,000 0.25 = 33.20

U without = 2  10,000 0.25 + 10,000 0.25 = 30
U Ration  U without

c)

15
30

10
15 30
0

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 0.5
Question-4 [18 Points] Mary has the following utility function: U(x, y) = 4y + 2x . Let px and
py be the corresponding prices and I her income.

a) [6 Points] Setup the Lagrangian function and find the first order conditions (FOCs). Use these
FOCs to find the expression for the marginal rate of substitution (MRS). Use the MRS to graph
the indifference map. What is “special” about these indifference curves?

L = 4 y + 2 x 0. 5 −  ( p x X + p y Y − I )
L
= x − 0. 5 − p x  = 0
x
L
= 4 − py = 0
y
L
= − ( p x X + p yY − I ) = 0

x − 0. 5
MRS =
4

The indifference curve can cross the horizontal line since MRS does not depend on y.

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b) [6 Points] Find the demand functions for x and y. Graph the Engle curve for x.

2
x −1 / 2 p x  py 
= = x * =  
4 py  4 px 
2
 py 
2 I − p x  
 py  I − p x  4 p  = I − py
x =   if PX x *  I = y = x
= x

 4 px  py py p y 16 p x
I
x= if (Px x *  I ) = y = 0
Px
I

Slope = Px

(Py/4Px)2

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c) [6 Points] Suppose Mary lives in a city where px = 1, py = 4 and her job offers her I = 0.5.
Find the optimal consumption levels for x and y? Graph your solution.

2
 py 
2
4
x =   = x =   = 1
 4 px  4

cannot afford this so hr consumption will be 0.5 X and no y.

0.5

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 Question-2 [16 Points] A consumer has the following utility function U = I where I is the
3/ 4

income. He is currently employed with an annual wage of $80,000. However, he might lose his
job and if so he will have to find a second job that pays only $20,000 a year. The probability of
him losing his job is 25%. (p= 0.25)

Note: Round to two digits.

a) [4 Points] Graph the utility of this consumer on the following diagram. Calculate the expected
utility for this consumer and identify it on the graph. Use the difference between his utility of
expected and his expected utility to comment on his risk aversion.

4756.83
4070.85

3988.07

16811.79

20000 65000 80000

E ( I ) = 0.75  80000 + 0.25  20000 = 65,000

U ( E ( I )) = 65000 3 / 4 = 4070.85
EU = 0.75  80000 3 / 4 + 0.25  20000 3 / 4 = 3988.07

His utility of expected is higher than his expected utility (for the same risky proposition),
therefore he must dislike risk – i.e. he must be risk averse.

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b) [4 Points] An insurance company is offering full insurance in the case of him losing his job.
What is the maximum that the consumer will pay for the insurance?

Solution:

EU = 0.75  800003 / 4 + 0.25  200003 / 4 = 3988.07

3988.07 = CE 3 / 4 = CE = 63243.66
RP = 80,000 − 63243.66 = 16756.34

Note: Since all the lost wage is paid by the insurance company the expected income will be
80,000.

c) [4 Points] Now suppose that the insurance company is offering 50% coverage – if the worker
loses his job he will get 30,000 from the insurance company - for a premium of $10,000. Would
the consumer insure himself?

Solution:

EU with = 0.75  (80,000 − 10,000) 3 / 4 + 0.25  ( 20,000 + 30,000 − 10000) 3 / 4 = 3934.75

EU without = 3988.07
EU with  EU without

Better off without the insurance. => Will not take the insurance.

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d) [4 Points] So far we have assumed that the probability of losing the job is 25%. Now suppose
that is not necessarily the case. What would be the maximum probability such that he is
indifferent between insuring and not insuring himself if he is offered the insurance as described in
part (c).

Solution:

EU with = (1 − p )  (80,000 − 10,000) 3 / 4 + p  ( 20,000 + 30,000 − 10,000) 3 / 4 = 4303.5 − 4303.5 p + 2828.43 p = 4303.5 − 1475.09 p

EU without = (1 − p )  (80,000) 3 / 4 + p  ( 20,000) 3 / 4 = 4756.83 − 4756.83 p + 1681.79 p = 4756.83 − 3075.04 p

EU with = EU withou
4303.5 − 1475.09 p = 4756.83 − 3075.04 p
p = 0.2833

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