PPOL 608:

Assignment 1 Example Answers (Fall 2024)

G. Kent Fellows

October 13, 2024

These Example Answers are intended to help you understand where you may have made

errors on your assignment. The answers provided here do not represent the type of responses I

expect to these questions. For the true/false/uncertain questions I have provided less detail than

expected from you (in particular my Example Answers often do not include graphs, however

you should always include a well labelled graph in a response if you can).

For Questions 2 and 3 I have provided more detail than I expect from you.

1
Contents

1 True/False/Uncertain 3

1.a . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

1.b . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

1.c . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

1.d . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

1.e . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

1.f . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

2 The Consumer Choice Problem and Taxation 7

2.a . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

2.b . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

2.c . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

2.d . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

2.e . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

2.f . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

3 Income and Substitution Effects 21

3.a . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

3.b . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

3.c . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

3.d . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

3.e . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

3.f . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

2
1 True/False/Uncertain

1.a

A higher tax rate always means more government revenue.

This is False. As the Laffer Curve demonstrates, beyond a certain level tax increases may

generate less government revenue. This is because taxation introduces a deadweight loss into a

market. The larger the tax, the larger the deadweight loss.

As the tax increases, the quantity demanded falls (since the purchaser’s price is increasing

along with the tax) and the quantity supplied falls (since the producer’s price is falling along with

the tax). Eventually the proportional decrease in quantity becomes larger than the proportional

increase in tax. The result of this shrinking tax base is a reduced overall tax revenue.

(Draw a graph)

1.b

An individual’s Marginal Rate of substitution is the same at every point along his

or her income consumption path.

This is True, Uncertain or False (depending on your reasoning). Note that these responses

should include a graph depicting two or more points of tangency between indifference countours

and multiple budget constraints (where prices remain fixed, but income changes).
P1
True: For the typical case of an interior solution, we know that M RS = P2 at every point

along the income consumption path. (See Question 2 Part B for more information on this). So,

for a given price ratio, the MRS must be fixed all along the income consumption path.

(Draw a graph)

Uncertain or False: If we consider a corner solution, the MRS won’t be equal to the price

ratio for the optimal (corner) bundle. So we can’t be sure that the MRS isthe same at every

point along the ICP.

(Draw a graph)

3
1.c

A consumer’s price consumption path is always upward sloping.

This is Uncertain or False

For any good that obey’s the law of demand, as we reduce (increase) the price of any good,

a consumer will consume more (less) of that good. The only exceptions are Veblin or Giffen

goods. However: if we reduce the price of one good in a two good model, the consumer could

increase or decrease their consumption of the other good.

Because the substitution effect always pushes a consumer away from the relativly higher

priced good and towards the relativly lower priced good, the only way to get an upward sloping

price consumption path is for the income effect to dominate (be larger than) the substitution

effect for the second good.

(Draw two graphs, one showing an upward sloping price consumption path, the other showing

a downward sloping price consumption path.)

1.d

The Laffer Curve Tells us something very important about economic efficiency.

This is True.

Consider that the Laffer Curve shows us that for any attainable level of government revenue,

there are two different tax rates we can use to generate that revenue, a high rate and a low rate.

We can also use a simple supply and demand graph to show that as we increase a tax rate,

we also increase deadweight loss.

We can therefore conclude that there is no reason to use a higher tax rate then necessary

when generating government revenue. Moving to the lower rate allows us to reduce deadweight

loss which is more economically efficient. In fact, any time we can reduce deadweight loss

without sacrificing government reveue, it is economically efficient to do so, as the addition to

total surplus is a potential pareto improvement (and may be a pareto improvement).

(Draw a graph)

4
1.e

Price Caps are often a good idea because they leave all consumers better off.

This is False

With reference to Figure 1. Absent a price cap in a well functioning market, the market

equilibrium would occur at (P ∗ , Q∗ ) which would maximize total surplus (see Question 1 F).

Imposing a price cap reduces the quantity supplied into the market from Q∗ down to Q.
b This

means that fewer consumers are able to purchase the good since there is less quantity supplied.1

This directly harms any consumer who would be able to find supply at the (higher) market price

but is unable to find supply at the new (lower) capped price.

From Figure 1, consumers who are unable to secure the good following the imposition of the

price cap lose their entire consumer surplus (area D) which becomes part of deadweight loss.

However, consumers that are able to purchase the good at the new (lower) price benefit from

the lower price (area B).

Summarizing:

ˆ With no price cap, Total Surplus is: A + B + C + D + E. This is made up of:

– Consumer Surplus: A + D and

– Producer Surplus: B + C + E

ˆ Following the imposition of the price cap:

– Total Surplus is: A + B + C. This is made up of:

* Consumer Surplus: A + B and

* Producer Surplus: C

– Deadweight loss is: D + E

1
As an aside, the quantity demanded also increases. However, we are less concerned about that here, since
the question is asking about consumers being made better off. A consumer who is enticed to demand a good
because of a price cap is not actually harmed by the cap since they go from not being interested in purchasing
the good, to being intereasted in purchasing the good but being unable to find a supplier. More concerning are
the consumers who would be willing and able to purchase the good at a market rate but are unable to find a
seller following imposition of a the price cap.

5
While some consumers gain (as depicted by the movement of area B out of producer surplus

into consumer surplus), some consumers also lose (as depicted by the movement of area D out

of consumer surplus into deadweight loss).

Figure 1: Price Cap and Deadweight Loss

Supply

A D

P∗
B E

P P rice Cap
C

Demand

Q
b Q∗ Q

1.f

A functioning and competitive free market is economically efficient.

True.

Review the first welfare theorem of economics.

(Draw a graph showing how a competitive equilibrium maximizes total surplus.)

6
2 The Consumer Choice Problem and Taxation
1 1
Consider a consumer with the Utility function: U = X12 X22 and facing the budget

constraint: M = P1 X1 + P2 X2

2.a

Solve for the Marginal Rate of Substitution between X1 and X2 .

Recall that the Marginal Rate of Substitution is the ratio between marginal utilities for the

two goods in question. Specifically:

Marginal Utility of X1
M RS = (1)
Marginal Utility of X2

Marginal Utility is defined as the change in utility for a marginal (small) change in either X1

(for M UX1 )or X2 (for M UX2 ). For this question, the marginal utilities are given as:

 1
1 X2 2
M UX1 = (2a)
2 X1

 1
1 X1 2
M UX2 = (2b)
2 X2

We can solve for a specific M RS by substituing equations (2a) and (2b) into equation (1):

 1
1 X2 2
Marginal Utility of X1 2 X1
M RS = =⇒ M RS = 1
Marginal Utility of X2 1

X1 2
2 X2

Which simplifies to:

X2
M RS = (3)
X1

Recall that the M RS represents the absolute value of the slope of the indifference curve at

any point (X1 , X2 ).2

2
If we pick a random bundle (5, 15) (i.e. where X1 = 5 and X2 = 15 ), the slope of the only indifference curve
X2
that runs through that point is −M RS = − X 1
= − 15
5
= −3 at that point.

7
2.b

Using the Marginal Rate of Substitution and the Budget Constraint, derive demand

functions for good X1 and good X2 using the equilibrium conditions for an interior

solution.

Solving the demand functions for X1 and X2 requires that we identify the consumer’s optimal

bundle. For an interior solution, this requires that the equilibrium bundle satisfy two conditions:

i. The consumer has chosen a bundle on the highest possible indifference curve such that the

slope of the indifference curve is tangent to (equals) the slope of the budget constraint and

ii. The bundle lies on the budget constraint (this is implied by non-satiation for equilibrium

outcomes in all consumer choice problems) such that:

M = P1 X1 + P2 X2 (4)

To explain condition i: If we consider this graphically (as per Figure 2), consider that any
0
point on the (red) indifference curve labelled U cannot be an optimal bundle. This is because we

can reach a higher indifference curve. There exists a tradeoff the consumer can make (moving

either up or down along the budget constraint) that is better than the tradeoff they are willing to

make (moving up or down along the indifference curve). Additionally, any point on the (orange)
00
indifference curve labelled U cannot be an optimal bundle. This is because the consumer does
00
not have sufficient budget to reach any bundle that lies on the U curve.

As a result, we conclude that the optimal bundle must lie on the (black) indifference curve
∗
labelled U . The consumer has sufficient budget to reach this curve (at point A), but the consumer

cannot reach a higher indifference curve. This implies that for an (interior) solution, the optimal

bundle must occur at a point where an indifference curve is tangent to the budget constraint.

The tangency condition implied at point A on Figure 2 (as well as the condition indicated in

i above) implies that, for the optimal bundle, the slope of the indifference curve is equal to the

slope of the budget constraint. Recall from part a above, the slope of the indifference curve for

any bundle (point) represented by (X1 , X2 ) is the Marginal Rate of Substitution. Defined (in

8
Figure 2: Visualizing the Optimal Bundle using an Indifference Curve Map in X1 , X2 space.

X2

X2∗ A

U 00
U∗
U0
M = P1 X1 + P2 X2
0 X1∗ X1

this case) by equation (3) above. To find the slope of the budget constraint, we can re-arrange

the equation to put it in the form of a straight line (in X1 , X2 space) as it appears on Figure 2.

Solving/rearranging Equation (4) for X2 as a function of X1 :

M P1
X2 = − X1 (5)
P2 P2

−P1
By inspection of equation 5 the budget constraint’s slope is P2 . (Also see Figure 3, which

shows this graphically).3

Therefor, the tangency condition implies:

P1
M RS = (6)
P2

Substituting the specific form for MRS (from equation (3) into equation 6:

X2 P1
= (7)
X1 P2
3
This is always true for a standard budget constraint.

9
Figure 3: Slope of the Budget Constraint

X2

M
P2

−P1
P2

M P1
X2 = P2 − P2 X1
0 M X1
P1

It follows that any optimal bundle of goods must satisfy Equation (7). This is the mathamatical

representation of Condition i.

Recall that Condition ii imples that any optimal bundle of goods must also satisfy the budget

constraint at equality.

Taken together, Conditions i and ii comprise two equations in two unknowns. Solving this

algebraic system will result in demand functions (optimal quantities) of X1 and X2 as functions

of M, P1 and P2 .

There are multiple ways to solve this system, but the most straightforward way is to solve

Equation (7) for X2 , substitute that into Equation (4), and then solve the resulting Equation

for X1.

Solving Equation (7) for X2 results in:

P1
X2 = X1 (8)
P2

Substituting Equation (8) into Equation (4) results in:

 
P1
M = P1 X1 + P2 X1 (9)
P2

10
 Solving this for X1 results in:
M
X1 = (10)
2P1

Then, to find the optimal value of X2 we can repeat the above (solving Equation (7) for

X1 , substituting that into Equation (4), and then solve the resulting Equation for X2) or we

can substitute Equation (11) into either Equation (4) or Equation (7) and solve the resulting

equation for X2 . All of the methods result in a demand curve for X2 of the form:

M
X2 = (11)
2P2

11
2.c

Graph and fully label the Demand Curve for good X1 (assume income is M = 100)

There are multiple methods to answer this question. As a starting point, we should re-state

our demand function substituing in the assumed value for income. Substituting M = 100 into

equation (11) and simplifying results in a more specific demand function of the form:

50
X1 = (12)
P1

We typically deal with inverse demand functions rather than demand functions, so we will

rearrange equation (12) to isolate P1 on the left side:

50
P1 = (13)
X1

To graph this, we can either determine the shape via a computer assisted graphing application

(google, or a graphing calculator) or we can choose some random values for X1 and solve for the

corresponding values of P1 .
M
Figure 4: A Demand Curve For X1 = 2P2 Assuming M=100

50

25

12.5

5 50
P1 = X1

0 1 2 4 10 X1

12
2.d

Assume the inverse supply curve for X1 can be given as: P1 = 20 + 2X1

There’s no question here. We simply assume the supply curve takes the form:

P1 = 20 + 2X1 (14)

2.e

Solve for equilibrium price and quantity.

Mathamatically, we are solving two equations (the inverse demand curve as represented by

Equation (13) and the inverse supply function as represented by Equation (14)) in two unknowns

(P1 and X1 ). There are multiple ways to do this, but the most straightforward is to set P1

from the inverse supply function (Equation (14)) equal to P1 from the inverse demand function

(Equation (13)).

Formally we set the following equal to each others:

P1Supply = P1Demand

From Equations (13) and (14), this implies:

50
20 + 2X1 = (15)
X1

Equation (15) can be rearranged as:

X12 + 10X1 − 25 = 0 (16)

Unfortunately, because this equation is nonlinear (we have a variable raised to an exponent)

a reduced form solution requires the use of the Quadratic formula. Applying the quadratic

13
formula4 and taking the positive root yields the following solution:

X1 = 2.07

Then, to find price, we can substitute this value of X1 into either the inverse demand

(Equation (13)) or inverse supply (Equation (14)) functions.

Using the inverse demand function Equation (13):

50
P1 =
X1
50
P1 =
2.07
P1 = 24.14

Using the inverse supply function Equation (14):

P1 = 20 + 2X1

P1 = 20 + 2 (2.07)

P1 = 24.14

Graphically, this equilibrium outcome can be depicted as:

4
Excel’s “goal seek” function is also sufficient for this task.

14
Figure 5: Supply and Demand Equilibrium

P1 = 20 + 2X1

24.14

50
P1 = X1

0 2.07 X1

15
2.f

Show what happens to the following items if the government places a $5 per unit

tax on X1

There are two ways to apply the tax in this question. You can apply the tax by shifting the

inverse supply curve, or the inverse demand curve. Shifting the inverse supply curve is more

straightforward, so that’s the method I cover here. But in either case, you will get the same

answer (since the economic incidence of the tax is independant of whether the tax is applied to

buyer or seller.

Applying the tax to the seller implies adjusting the inverse supply function (Equation (14))

to include the tax. If the tax is $5, then sellers will require $5 more per unit to sell any specific

quantity of the good. Adjusting for this, the new supply function is:

P1 = 20 + tax + 2X1 (17)

P1 = 25 + 2X1 (18)

Using this new inverse supply function, we solve for the equilibrium price and quantity exactly

the same way as before. Formally we set the following equal to each other:

P1Supply = P1Demand

From Equations (13) and (18), this implies:

50
25 + 2X1 = (19)
X1

Equation (19) can be rearranged as:

2X12 + 25X1 − 50 = 0 (20)

Unfortunately, because this equation is nonlinear (we have a variable raised to an exponent)

a reduced form solution again requires the use of the Quadratic formula, which will yield the

16
following:

X1 = 1.75

Then, to find price, we can substitute this value of X1 into either the inverse demand

(Equation (13)) or inverse supply (Equation (14)) functions.

Using the inverse demand function Equation (13):

50
P1 =
X1
50
P1 =
1.75
P1 = 28.51

Using the inverse supply function Equation (14):

P1 = 25 + 2X1

P1 = 25 + 2 (1.75)

P1 = 28.51

Graphically, the old and new equilibrium outcomes can be depicted as in Figure 6.

17
Figure 6: Supply and Demand Equilibrium before and after tax

P1 = 25 + 2X1

P1 = 20 + 2X1
28.51

23.51

50
P1 = X1

0 1.75 X1

18
 I. Producer’s price The Producer’s price is the price the producer recieves, net of the

payable tax. Because we applied the tax to the supply function, the purchaser recieves the

equilibrium price less the $5 tax. Formally:

Producer’s Price = P1 − 5 = 28.51 − 5 = 23.51

II. Purcahser’s price The Purcahser’s (or consumer’s) price is the price the consumer pays,

gross of the payable tax. Because we applied the tax to the supply function, the purchaser

pays the equilibrium price (which already includes the tax). Formally:

Purchaser’s Price = P1 = 28.51

III. Equilibrium price We solved this above:

P1 = 28.51

IV. Total Surplus

The Total Surplus Shrinks by the amount of the tax revenue and the introduced deadweight

loss as depicted in Figure 7. It’s interesting to note that the consumer faces a much larger

tax burden compared to the producer. That is to say, consumers are paying the majoirity

of this tax. The purchaser’s price increased by $4.37 ($28.51-$24.14) while the producer’s

price only fell by $0.63 ($24.14-$23.51). This is because demand is considerably more elastic

compared to supply around the point of equilibrium. This also means the consumer’s share

of deadweight loss is greater than the producers (although we cannot calculate specific

values for deadwieight loss or consumer suplus without using calculus).

19
Figure 7: Change In Total Surplus

(a) Before Tax Change

P1 = 25 + 2X1
28.51 P1 = 20 + 2X1

23.51

50
P1 = X1

0 1.75 X1
(b) After Tax Change

P1 = 20 + 2X1

50
P1 = X1

0 X1
Blue = Consumer Surplus
Green = Producer Surplus
Red = Deadweight Loss
Gray = Tax Revenue

20
3 Income and Substitution Effects

3.a

Graphically illustrate the budget set: M = P1 X1 + P2 X2 When M = 500, P1 = 5 ,

P2 = 1

Recall from question 2 that we can rearranging a Budget Constraint to solve for X2 as a

function of X1 (see Equation (5)). Graphically (repeating figure 3):

Figure 8: Slope of the Budget Constraint (restated)

X2

M
P2

M P1
X2 = P2 − P2 X1
0 M X1
P1

If we substitute in values for M , P1 and P2 we can label the figure numerically.

Figure 9: Slope of the Budget Constraint with Numerical Values

X2

500

X2 = 500 − 5X1
0 100 X1

21
3.b

Graph the change in the budget set if the price of good one changes to P1 = 2.5

Here, we simply substitute in the new values and re-plot the new budget constraint:

Figure 10: Rotation in the Budget Constraint

X2

500

X2 = 500 − 5X1 X2 = 500 − 2.5X1

0 200 X1

22
3.c

Using convex indifference curves to indicate the location of optimal bundle for each

budget constraint show the income and substitution effects resulting from the price

change. (Assume that good 1 is a Normal Good.)

As the price falls, the budget constraint rotates from it’s original position to it’s new position

(blue). This results in a movement from the initial optimal equilibrium bundle at Point A:

X1A , X2A to a new optimal equilibrium bundle at Point C: X1C , X2C . This movement can be

decomposed into:

ˆ The Substitution Effect: X1A , X2A → X1B , X2B , and

ˆ The Income Effect: X1B , X2B → X1C , X2C

Figure 11: Rotation in the Budget Constraint Resulting from a Reduction in the Price of X1
Assuming X1 is a Normal Good

X2

500

A
X2A
C
X2C

B
X2B

New U
Old U
0 X1A X1B 100 X1C 200 X1

23
3.d

Explain the income and substitution effects of this price change.

The income and substition effects are two components of the overall impact on quantity

demanded for a good as a result of a change in it’s price. As a good becomes cheaper (more

expensive) consumers will substitute towards (away from) that good. Specifically, they will buy

more of the cheaper good, and they will buy less of the more expensive good. However, any

change in price also changes a consumers real income or purchasing power. A reduction in any

price (holding other prices constant) leaves the consumer with more effective income. This will

lead the consumer to purchase more of any normal good and less of any inferior good. If we are

dealing with a two good model, and if both goods are normal, the income effect will lead the

consumer to purchase more of both goods.

To summarize:

ˆ Substitution effect means more of one good and less of the other as consumers substitute

from relativly more expensive goods to relativly less expensive goods.

ˆ Income effect means more of both goods (for a price decrease) if both goods are normal,

since the consumer will use their higher effective income to purchase more of both goods.

The overall impact of a price decrease in a two good model is then for the consumer to purchase

more of the good for which the price falls and more or less of the other good (depending on

whether the income effect is larger or smaller than the substition effect).

From Figure 12:

ˆ We represent the substitution effect as in the top panel. Specifically, the movement from

A to B represents the consumer substituting away from good X2 (since it has become

relativly more expensive) and towards good X1 (since it has become relativly cheaper).

This can also be thought of as a rotation in the income consumption path, since the price

ratio change means that the consumer will move allong their indifference curve until the

MRS matches the new price ratio.

24
 ˆ We represent the income effect as in the bottom panel. Specifically, the movement from

B to C represents the consumer expanding consumption of both good X1 and good X2 in

order to use their entire budget (which has expanded in real terms because of the reduction

in P1 ).

Figure 12: Decomposing the Income and Subustitution Effects

X2

500 Old ICP: M RS = 5

1

2.5
New ICP: M RS = 1
A
X2A

B
X2B

Old U
0 X1A X1B 100 200 X1
X2

500

2.5
New ICP: M RS = 1

C
X2C
B
X2B

New U
Old U
0 X1B X1C 200 X1

25
3.e

How would your answer to Part D change if good 1 were an Inferior good.

If good X1 is inferior, then the income effect would lead to a reduction in the quantity

demanded for X1. Specifically, this means that X1C < X1B which is contrary to the relationship

indicated in part D.

Figure 13: Rotation in the Budget Constraint Resulting from a Reduction in the Price of X1
Assuming X1 is an Inferior Good

X2

500

C
X2C A
X2A

B
X2B
New U

Old U
0 X1A X1C X1B 100 200 X1

26
3.f

Consider a price change in an important good (like housing or gasoline). Using what

you know about income and substitution effects, what are two policies a government

could use to compensate consumers for this price change. (Hint: consider what

the government would need to do to keep consumers on their original indifference

curve.) What advantages would each policy have? What might happen to the

demand for other related goods.

There are numerous ways to answer this question. It should be viewed as a prompt for you

to indicate you understand and can apply the concepts of income and substitution effects. The

most common response (and the most straightforward one) is to discuss:

ˆ Direct Price Subsidies (which would return consumption back to the original bundle fol-

lowing a price shock), or

ˆ Direct Cash Transfers (which would allow the consumer to make a substitiution choice,

but would offset any income effect).

27