ECC2000/ECC5900/BEX5900

Intermediate microeconomics

Problem Set 2

Submission procedure:
• You can submit a scanned copy of your handwritten solutions if you like.

• Late submissions may be penalised.

1 Budget
A consumer buys water and gasoline. His income is $100. Water costs $1 per gallon, while
gasoline costs $2 per gallon.
1. With water on the vertical axis and gasoline on the horizontal axis, sketch the consumer’s
budget line. Label the intercepts.
2. Illustrate the impact of a subsidy that reduces gasoline prices.
3. Illustrate the impact of an income tax that reduces the consumer’s income.

2 Budget Lines
On the graph below, draw a budget line for each case.

q2
20

15

10

q1
0 5 10 15 20 25

1. p1 = 1, p2 = 1, m = 15 (use blue ink. m is the income.)

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3 Three Goods
In a small country near the Narrow Sea, there are only three commodities: potatoes, meatballs,
and jam. Prices have been remarkably stable for the last 50 years or so. Potatoes cost 2 dragons
per sack, meatballs cost 4 dragons per crock, and jam costs 6 dragons per jar.

1. Write down a budget equation for a citizen named Gendry who has an income of 360
dragons per year. Let P stand for the number of sacks of potatoes, M for the number of
crocks of meatballs, and J for the number of jars of jam consumed by Gendry in a year.

2. The citizens of this country are in general very clever people, but they are not good
at multiplying by 2. This made shopping for potatoes excruciatingly difficult for many
citizens. Therefore it was decided to introduce a new unit of currency, stags, such that
potatoes would be the numeraire. A sack of potatoes costs one unit of the new currency
while the same relative prices apply as in the past. In terms of the new currency, what is
the price of meatballs?

3. In terms of the new currency, what is the price of jam?

4. What would Gendry’s income in the new currency have to be for him to be exactly able
to afford the same commodity bundles that he could afford before the change?

5. Write down Gendry’s new budget equation.

6. Is Gendry’s budget set any different than it was before the change? Why?

4 Advertisement
Petyr has $5,000 to spend on advertising a new kind of dehydrated sushi. Market research
shows that the people most likely to buy this new product are recent recipients of M.B.A.
degrees and lawyers who own hot tubs. Petyr is considering advertising in two publications, a
boring business magazine and a trendy consumer publication for people who wish they lived in
Melbourne.
Fact 1: Ads in the boring business magazine cost $500 each and ads in the consumer magazine
cost $250 each.
Fact 2: Each ad in the business magazine will be read by 1,000 recent M.B.A.’s and 300 lawyers
with hot tubs.
Fact 3: Each ad in the consumer publication will be read by 300 recent M.B.A.’s and 250
lawyers who own hot tubs.
Fact 4: Nobody reads more than one ad, and nobody who reads one magazine reads the other.

1. If Petyr spends his entire advertising budget on the business publication, his ad will be
read by recent M.B.A.’s and by lawyers with hot tubs.

2. If he spends his entire advertising budget on the consumer publication, his ad will be read
by recent M.B.A.’s and by lawyers with hot tubs.

3. Suppose he spent half of his advertising budget on each publication. His ad would be
read by recent M.B.A.’s and by lawyers with hot tubs.

4. Draw a “budget line” showing the combinations of number of readings by recent M.B.A.’s
and by lawyers with hot tubs that he can obtain if he spends his entire advertising budget.
Does this line extend all the way to the axes? Sketch, shade in, and label the budget

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 set, which includes all the combinations of MBA’s and lawyers he can reach if he spends
no more than his budget. Assume free disposal.

5. Let M stand for the number of instances of an ad being read by an M.B.A. and L stand
for the number of instances of an ad being read by a lawyer. This budget line is a line
segment that lies on the line with equation . With a fixed advertising budget,
how many readings by M.B.A.’s must he sacrifice to get an additional reading by a lawyer
with a hot tub?

MBA x1000
12
10
8
6
4
2
Lawyers x1000
0 2 4 6 8 10 12

5 Marginal utility
A consumer’s marginal utility from a DVD is 10 and his marginal utility from a CD is 5. How
should he reallocate his expenditures if the price of a DVD is $15 and the price of a CD is $10?

6 Perfect substitute
Tywin wants to buy some toilet paper. He has $6 to spend on either Kleenex (represented by
K) or Sorbent (represented by S). His utility can be approximated by U (K, S) = 2K + S.

1. Draw and label Tywin’s indifference curves for U = 4 and U = 6.

2. Assume the price per roll is $3 for Kleenex and $2 for Sorbent. Draw Tywin’s budget
constraint and determine the optimal quantity of K and S.

3. Now assume the Sorbent is on sale, offering 50% off. Draw Tywin’s new budget constraint
and determine the optimal quantity of K and S.

4. Following Sorbent’s promotion, Kleenex offers one-third off, lowering the price to $2 per
roll. What is Tywin’s optimal quantity of K and S now?