UNIVERSITY OF TORONTO SCARBOROUGH

DEPARTMENT OF MANAGEMENT

MGEB02: Price Theory: A Mathematical Approach

Winter 2023

Instructor: A. Mazaheri
Test-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 44 10 15 15 11 95
Possible
 Answer all following 5 questions:

Question-1 [44 Points] Answer the following Short Questions:

a) [5 points] Over the last two years the price of canola oil has almost doubled while the overall
consumption has remained more or less constant. Using the following graph, identify possible
shifts in demand and/or supply that can lead to this change. In two sentences explain these
changes.

Price

Quantity
Demand is slowly shifting out due increase in population etc. supply has shifted in due to
weather related issues. Since both supply and demand are extremely inelastic in the short
run, the price has increased dramatically while the overall consumption has remained more
or less the same.

b) [5 Points] You are currently consuming at point A. Suppose the price of potato has increased
and that you view potato as an inferior but not a Giffen good. Graph your hypothetical final
bundle and show the substitution and income effects.

Y
B: Terminal Bundle
A-B Total Effect

Potato

SE IE

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c) [6 Points] Graph the indifference map (at least two indifference curves) for the following
individuals. (Make sure to label your graph)

i) Lisa is willing to exchange one cup of coffee for three cups of tea no matter what.

This the example of Perfect Substitute:

Coffee

Tea
3 6

ii) Lucie likes coffee but gets sick when she drinks more than five cups a day.

Everything else

Coffee

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d) [5 Points] Use graph to show that if you believe in non-satiation then crossing indifferences
curves will violate the transitivity condition.

Answer: If two indifference curves did cross, then by choosing three points, A, B, and C
in the following way. A lies on the first indifference curve, B is the intersection point, C
lies on the second curve, and A lies to the left and below point C. By non-satiation

C>A

But

B = C (same indifference curve)

B = A (same indifference curve)
But since non-satiation holds w cannot say C = A => Transitivity is violated.

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 e) [7 Points] Assume a utility function that is given by U(x,y) = 20x1/3 y1/3. Furthermore, assume
a budget of $100. When the prices where Px = 1 and Py = 1, you consumed x= 50 and y = 50,
while when the prices changed to Px = 2 and Py = 1, you consumed x = 25 and y = 50. 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 = 25-50 = -2.5. 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 = 20  501 / 3  501 / 3 = 271.44 = 20 x 1 / 3 y 1 / 3

y 2
2 : MRS = = = y = 2 x
x 1
(1), (2) = 271.44 = 20 x 1 / 3 (21 / 3 x 1 / 3 ) = x = 35.36
SE = 35.36 − 50 = −14.44
IE = 25.5 − 35.36 = −10.36

Graphically:

100
IE SE

50

25 50 100
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 f) [6 Points] You have $50. You spend it on two products. A composite product (y) with a price
of py = 1 and apple with a price of px = 1. You currently buy four apples. A store offers a new
special, if you purchase five apples, you will be offered two apples for free and a 40% discount
for any extra unit you purchase. Show graphically how this affects your budget line.

As a result of this new offer, do you purchase the same, more, or less than 4 apples? Show your
answer on the graph?

You can purchase the same or more depending on your utility function but you will not
purchase less. (2 Points)

50

Apple
4 5 7 50 82

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g) [5 Points] Asif is very picky; he always drinks his 2 Sugar (X) with 3 Creams (Y) in his coffee. Any
extra sugar or creamoutside that perfect combination will be discarded. Write down his utility function.
Find her demand function for X and Y.

Solution:

2Y = 3X or 1.5X = Y

U = min(3X, 2Y) U = min(1.5X, Y)

Y= 1.5X

PxX + PyY = I => PxX +Py (1.5X) = I

X = I/(Px+1.5Py)
Y = 1.5I/(Px+1.5Py)

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g) [5 Points] Consider a consumer and two goods: x, y. The Consumer utility function is:

U(x,y) = 2x + 3y

Write the demand functions for X and Y.

Solution:

Perfect substitute:

𝟐
𝑴𝑹𝑺 =
𝟑

Demand for X is kinked:

 X=0 if MRS = 2/3 < (Px/Py)

 X = I/Px if MRS = 2/3 > (Px/Py)
Demand for Y is kinked:

 Y = I/Py if MRS = 2/3 < (Px/Py)

 Y=0 if MRS = 2/3 > (Px/Py)

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Question-2 [10 Points] In Mars, the equilibrium price for a liter of gasoline is $1.00, and
the number of liters consumed each day is 30,000. The short-run price elasticity of
demand is -0.75, and the short-run elasticity of supply is 1.0.

a) [6 Points] Estimate supply and demand curves at the current price and quantity.
b) [4 Points] Suppose the government offers a subsidy of 0.30 for each liter of gasoline
sold, what would be the new equilibrium price and quantity?

Solution:

a)

Demand curve

Q = a0 – b0 P
Ed = - b0 × P/Q = -0.75 = - b0 × 1/30,000
b0 = 22,500 => 30,000 = a0 – 22,500(1) => a0 = 52,500
Qd = 52,500 – 22,500P => Pd = 2.33 – (1/22,500)Qd

Next, we estimate the supply curve

Q = a1 + b1 P
E1 = b1 × P/Q = 1 = b1 × 1/30,000
b1 = 30,000 => 30,000 = a1 + 30,000(1) => a1 = 0
Qs = 30,000P => Pd = (1/30,000)Qd

b)

PD = 2.33 – (1/22,500)Q
PS = (1/30,000)Q
PD = PS -0.3
2.33 – (1/22,500)Q = (1/30,000)Q – 0.30
Q = 33,814.29
P = 0.8271

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Question-3 [15 Points] Consider your preferences for Gasoline (X) and a composite good (Y).
Your utility function is U(X,Y) = 2X0.5 + 2Y0.5. You have an annual income of $20,000. Suppose
the price of the composite good is $1.

a) [5 Points] Due to shortages, the government has introduced a rationing system such that you
can only consume 8,000 liters a year at $1 a liter. What would be your optimal consumption
bundle?

b) [6 Points] 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? Show by finding the utility levels.

c) [4 Points] Illustrate your solution in a clearly labeled graph.

a)

X −0.5 1 Y 0.5
MRS = −0.5 = = 0.5
Y 1 X
= Y = X
= X + X = 20,000
= X = 10,000
= Y = 10,000
Not possible => X = 8,000, Y = 12000
b)
Without the rationing and with the new price:

X −0.5 2 Y 0.5
MRS = = =
Y −0.5 1 X 0.5
= Y = 4 X
= 2 X + 4 X = 20,000
= X = 3,333
= Y = 13,333.3

Page 10 of 16
You are better off with the rationing because:

U Ration = 2 * sqrt(5000) + 2 * sqrt(15000) = 386.37

U without = 2 * sqrt(3,333.3) + 2 * sqrt(13,333.3) = 346.41
U Ration  U without

c) The graph is not up to scale

20,000

3333 8000 10000 20000

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Question-4 [15 Points] Blinda has the following utility function: U(x, y) = 2y + 4x0.75. Let px and
py be the corresponding prices and I her income.

a) [5 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). Graph a representative
indifference curve. In no more than two sentences explain what is special about this indifference
curve.

Solution:

L = 2 y + 4 x 0.75 −  ( p x X + p yY − I )
L
= 3x −0.25 − p x  = 0
x
L
= 2 − py = 0
y
L
= − ( p x X + p yY − I ) = 0

MRS = 1.5 x −0.25

Since Y does not appear on MRS, it does not restrict the value of Y. Therefore, Y can be
zero or even negative, which may lead to a corner solution.

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b) [5 Points] Find the demand functions for x and y. Explain what it means

Solution:

px
1.5 x −0.25 =
py
4
 3p 
= x =  y  if p x x*  I
*

 2 px 
I
= x = if p x x*  I
px
4
 3p 
I − p x  y 
I − px x  2 p x  if p x*  I
y= = x
py py
y = 0if p x x*  I

Page 13 of 16
c) [5 Points] Blinda currently live in a city where prices are px =1, py = 2, with a job that pays
her $30. Suppose Blinda is offered a new job that offers her an income of 100 (I = 100) but the
job is in another city with px = 4, py = 4. Should she take the job?

4
 3 py   6 
4

x =   =   = 81
 2 px   2 
But 1×81> 30
 Corner solution. Demand for X will be 30 and demand for y will be zero.

Her utility in the old job is:

U = 2 * 0 + 4(30) 0.75 = 51.2744

In the new job her consumption is:

4
 3* 4 
x=  = 5.0625
 2*4 
y = (100 − 4 * 5.0625) / 4 = 19.9375

Her utility in the new job is:

U = 2 *19.9375 + 4(5.0625) 0.75 = 53.375

Better with the new job.

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Question-5 [11 Points] There are 500 consumers in the economy. Half of them live in city A and
demand gooseberry according to the individual inverse demand curve P = 12− 4Q. The other half
live in city B and demand gooseberry according to the individual inverse demand curve P =
18−2Q. Suppose that the market-clearing price for blue berry is $4.

a) [6 Points] Write down the market demand for gooseberry in this economy and then graph it? Is
the market demand function linear? If not, where is the kink?
b) [5 Points] If the price increases from $4 to $12, how does the consumer surplus change? Graph
the demand curve with quantity on the horizontal axis and price on the vertical axis and show the
change in consumer surplus.

Solution:

 P 250P
250Q A = 2503 −  = 750 −
 4 4
 P
250Q B = 2509 −  = 2250 − 125P
 2
QM = 3000 − 187.5P

But demand seizes to exist in city B when the P >= 18 while in city A the demand is zero when
P>=12 therefore the demand will be kinked at P = 12 or:

QM = 2250 − 125P( P  12)

QM = 3000 − 187.5P( P  12)

18

12

750 3000

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b) Change to new numbers:

City A: The change in the consumer Surplus is:

CS A = (0 − [(8  2) / 2])  250 = −2000

City B: The change in the consumer Surplus is:

CS B = [6  3) / 2 − (14  7) / 2]  250 = −10,000

TS = −2000 − 10,000 = −12000

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