Microeconomics

Midterm Exam

Time: 90 minutes

SOLUTIONS

October 26, 2022

1. (25 points) Tim buys two types of candy for Halloween, Reese's peanut butter cups (good 1) and Twix
(good 2). You are given the following information about Tim’s purchases in 2021 and 2022:

2021 2022
Quantity Price, $ Quantity Price, $
Reese’s (Good 1) 100 1 120 1
Twix (Good 2) 100 1 x 0.8
Assume that Walras’ Law holds in both years.
A. (10 points) Over what range of quantities of good 2 (x) would Tim’s behavior be in violation of the
WARP? Show your work (you should always show your work, that is, explain your answers!).
Solution: Tim chooses (100,100) at prices (1,1) and wealth 200 in 2021. He chooses (120,x) at prices
(1,0.8) and wealth (120+0.8x) in 2022. A violation entails that both choices are affordable with the
other year’s budget.
120*1 + x*1 ≤ 200 and 100*1+100*0.8 ≤ 120+0.8x. 75 ≤ x ≤ 80.

B. (5 points) Over what range of quantities of good 2 (x) would Tim’s choices satisfy WARP and reveal
preference for the consumption bundle of year 2021 over the consumption bundle of year 2022?
Solution: Consumption bundle of year 2021 is not affordable at prices (1,0.8) and wealth (120+0.8x) in
2022: 100*1+100*0.8 >120+0.8x, so x < 75.

C. (5 points) Over what range of quantities of good 2 (x) would Tim’s choices satisfy WARP and reveal
preference for the consumption bundle of year 2022 over the consumption bundle of year 2021?
Solution: Consumption bundle of year 2022 is not affordable at prices (1,1) and wealth 200 in 2021:
120*1 + x*1 > 200, so x > 80.

D. (5 points) Suppose x=100 and Tim’s choices are consistent with preference maximization. Is good 2
inferior or normal? What can you say about the substitution and income effects of the price change from
year 2021 to 2022?
Solution: Note that when x=100 the wealth in both years is the same = $200. Thus, the decrease in
price of good 2 is the only factor that impacts Tim’s purchasing decisions. The substitution effect of
own price change is always negative: decrease in price results in increase in consumption. Here
consumption of good 2 stays the same, but consumption of good 1 increases. Thus, the wealth effect is
negative for good 2. Good 2 (Twix) is inferior and good 1 (Reese’s cups) is normal.

2. (15 points) Zmei Gorynic only eats nonnegative quantities of beautiful maidens (good 1) and valiant
knights (good 2). His preference relation is defined as follows: 𝑥 ≿y if 𝑥1 ≥ 𝑦1 for any 𝑥2 and 𝑦2 . That is,
Zmei prefers bundle 𝑥 over bundle y if and only if 𝑥 contains (weakly) more of maidens.
Can Zmei’s preferences be represented by a utility function? If yes, suggest such a utility function. If not,
show why not.

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Solution: Only rational preferences can be represented by a utility function. We need to check that
Zmei’s preferences are rational: complete and transitive. It is obvious that they are complete, as for
any quantity of good 2, either bundle x has more of good 1 or bundle y has more of good 1 or both.
They are transitive for the same reasoning. Any non-decreasing in the quantity of good 1 utility
function would represent these preferences (and independent of quantity of good 2): 𝒖(𝒙𝟏 , 𝒙𝟐 ) = 𝒙𝟏 .

3. (25 points total) Dexter consumes only cleaver knives (k) and plastic bags (b). He purchases these at
respective market prices 𝑝𝑘 > 0 and 𝑝𝑏 > 0 and has wealth w>0 to spend on both goods. Dexter’s
preferences are described by the following utility function:
𝑢(𝑘, 𝑏) = 2√100 + ln 𝑘 + ln 𝑏

A. (5 points) Set up Dexter’s utility maximization problem

B. (10 points) Solve Dexter’s utility maximization problem. Find both the Walrasian demand and the
indirect utility function.
Solution:
Note that Dexter’s utility function is a monotonic (several monotonic transformations) of a Cobb
Douglas function. Monotonically transform it to
𝐮(𝐤, 𝐛) = 𝐥𝐧 𝐤 + 𝐥𝐧 𝐛
and solve
𝐦𝐚𝐱 {𝐥𝐧 𝐤 + 𝐥𝐧 𝐛},
𝐤,𝐛
such that 𝐤 ≥ 𝟎,
𝐛 ≥ 𝟎,
𝐩𝐤 𝐤 + 𝐩𝐛 𝐛 ≤ 𝐰.
Write down the Lagrangian and take the first order necessary conditions:
𝐋(𝐤, 𝐛, 𝛍𝐤 , 𝛍𝐛 , 𝛌) = 𝐥𝐧 𝐤 + 𝐥𝐧 𝐛 + 𝛌(𝐰 − 𝐩𝐤 𝐤 − 𝐩𝐛 𝐛) + 𝛍𝐤 𝐤 + 𝛍𝐛 𝐛
F.O.C.s:
𝛛𝐋(𝐤,𝐛,𝛍𝐤 ,𝛍𝐛 ,𝛌) 𝟏
1) = 𝐤 − 𝛌𝐩𝐤 + 𝛍𝐤 = 𝟎,
𝛛𝐤
𝛛𝐋(𝐤,𝐛,𝛍𝐤 ,𝛍𝐛 ,𝛌) 𝟏
2) = 𝐛 − 𝛌𝐩𝐛 + 𝛍𝐛 = 𝟎,
𝛛𝐛
𝛛𝐋(𝐤,𝐛,𝛍𝐤 ,𝛍𝐛 ,𝛌)
3) = 𝐰 − 𝐩𝐤 𝐤 − 𝐩𝐛 𝐛 ≥ 𝟎, 𝛌 ≥ 𝟎, 𝛌(𝐰 − 𝐩𝐤 𝐤 − 𝐩𝐛 𝐛) = 𝟎,
𝛛𝛌
𝛛𝐋(𝐤,𝐛,𝛍𝐤 ,𝛍𝐛 ,𝛌)
4) = 𝐤, 𝛍𝐤 ≥ 𝟎, 𝛍𝐤 𝐤 = 𝟎,
𝛛𝛍𝐤
𝛛𝐋(𝐤,𝐛,𝛍𝐤 ,𝛍𝐛 ,𝛌)
5) = 𝐛, 𝛍𝐛 ≥ 𝟎, 𝛍𝐛 𝐛 = 𝟎.
𝛛𝛍𝐛
Note that logarithm is not defined at zero, so 𝐤 > 𝟎 and 𝐛 > 𝟎. From 4) and 5) 𝛍𝐤 = 𝛍𝐛 = 𝟎, and
from 1) and 2)
𝟏 𝟏
𝛌 = 𝐩 𝐤 = 𝐩 𝐛 > 𝟎 and
𝐤 𝐛

𝐛 𝐩
= 𝐩𝐤 .
𝐤 𝐛
From 3) and 𝛌 > 𝟎 obtain 𝐩𝐤 𝐤 + 𝐩𝐛 𝐛 = 𝐰. Using the last two equations with two unknowns
obtain the Walrasian demands:
𝐰
𝐤( 𝐩𝐤 , 𝐩𝐛 , 𝐰) = 𝟐 𝐩 ,
𝐤
𝐰
𝐛( 𝐩𝐤 , 𝐩𝐛 , 𝐰) = 𝟐 𝐩 .
𝐛

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 These are, indeed, the Walrasian demand functions since the second order conditions are satisfied.
The utility function is concave because the sum of two concave functions is concave.
While the Walrasian demand is invariant to the monotonic transformations of the utility function,
the indirect utility function itself is not.
Substitute the solution into the original utility function to find the indirect utility function:
𝐰 𝐰
𝐯( 𝐩𝐤 , 𝐩𝐛 , 𝐰) = 𝟐√𝟏𝟎𝟎 + 𝐥𝐧 (𝟐 𝐩 ) + 𝐥𝐧 (𝟐 𝐩 ).
𝐤 𝐛

C. (10 points) Suppose Dexter has w=$100, the price of cleaver knives pk = $50 and the price of plastic
bags pb = $10. Suppose the store offers him the frequent buyer discount on cleaver knives: 75% off
regular price. Find the equivalent variation of this price discount.
Solution:
Need to find 𝐰 ′ = 𝐰 + 𝐄𝐕, such that
𝐯( 𝟎. 𝟐𝟓𝐩𝐤 , 𝐩𝐛 , 𝐰) = 𝐯( 𝐩𝐤 , 𝐩𝐛 , 𝐰′).
I.e., such that
𝐰 𝐰 𝐰′ 𝐰′
𝟐√𝟏𝟎𝟎 + 𝐥𝐧 (𝟐∗𝟎.𝟐𝟓∗𝐩 ) + 𝐥𝐧 (𝟐 𝐩 ) = 𝟐√𝟏𝟎𝟎 + 𝐥𝐧 (𝟐 𝐩 ) + 𝐥𝐧 (𝟐 𝐩 ).
𝐤 𝐛 𝐤 𝐛
Simplify to obtain:
𝐰 ′ = 𝟐𝐰.
With w=$100, obtain 𝐰 ′ = $𝟐𝟎𝟎.
Thus, EV=$100.

4. (35 points total) Jack Torrance is offered a job of the winter caretaker at the isolated Overlook Hotel in
Colorado. This job would pay him $𝑤 per hour after tax. Assume that he has no other income and can work
up to 24 hours per day, so that his total time endowment is 𝑇 = 24.
Jack’s utility function is 𝑢(𝑐, 𝑙) = √𝑐 + √𝑙, where 𝑙 denotes leisure and 𝑐 denotes consumption. Normalize
the price of consumption to 1.
A. (5 points) Write down Jack’s daily budget constraint.
Solution:
𝒄 + 𝒘𝒍 ≤ 𝟐𝟒𝒘.

B. (15 points) Set up and solve Jack’s utility maximization problem to find his Walrasian demand for
consumption, leisure, and his labor supply.
Solution:
𝐦𝐚𝐱 √𝒄 + √𝒍,
𝒄,𝒍
such that 𝒄 ≥ 𝟎,
𝒍 ≥ 𝟎, 𝒍 ≤ 𝟐𝟒,
𝒄 + 𝒘𝒍 ≤ 𝟐𝟒𝒘.
𝝏𝒖(𝒄,𝒍) 𝟏 𝝏𝒖(𝒄,𝒍) 𝟏
Note that due to inada conditions 𝐥𝐢𝐦 𝝏𝒄 = 𝐥𝐢𝐦 𝟐 𝒄 = ∞ and 𝐥𝐢𝐦 𝝏𝒍 = 𝐥𝐢𝐦 𝟐√𝒍 = ∞, in the
𝒄→𝟎 𝒄→𝟎 √ 𝒍→𝟎 𝒍→𝟎
solution 𝒄 > 𝟎 and 𝒍 > 𝟎. Also, since the utility function is strictly increasing in both arguments,
the budget constraint binds.
Thus, use the budget constraint with equality and the following MRS equal to price ratio
condition:
𝒄
√ 𝒍 = 𝒘.
The utility function is concave as it is the sum of two concave functions. Thus, the SOC holds and
the solution will be Jack’s Walrasian demands for consumption and leisure:
𝟐𝟒𝒘𝟐
𝒄(𝒘) = ,
𝒘+𝟏
𝟐𝟒
𝒍(𝒘) = 𝒘+𝟏.
Labor supply:

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 𝟐𝟒𝒘
𝟐𝟒 − 𝒍(𝒘) = 𝒘+𝟏.
Note also that 𝒍 ≤ 𝟐𝟒 if 𝒘 ≥ 𝟎.

C. (5 points) Suppose Jack is offered a wage of $5 per hour. His wife Wendy has a bad feeling about Jack
accepting this job. She worries he’d be working too much and not getting enough sleep (less than 8
hours per day), and "All work and no play makes Jack a dull boy". Is she correct to worry?
Solution:
𝟐𝟒
𝒍(𝟓) = 𝟔 = 𝟒. Indeed, less than 8 hours.

D. (10 points) Suppose Jack has different preferences for consumption and leisure: 𝑢(𝑐, 𝑙) = 𝑚𝑖𝑛{𝑐, 𝑙}. If
his employer wanted him to work more, should he raise or cut his wage? Explain.
Solution:
Consumption and leisure are perfect complements. Thus, increases in wage would result in both more
consumption and more leisure (less work). If Jack’s employer wants him to work more, he should
decrease his wage.