Study Questions
1) Mr. and Mrs. Brauer owned their own home. There was a real estate boom in their town
and the price of houses doubled. Their income and other prices stayed constant. The Brauers
complained that “we are being driven from our home; we can’t afford to live here any more.”
a. Draw a diagram that illustrates what happened to the Brauers’ budget constraint.
b. Could they have been made worse off by the change? Could they have been made better
off? Explain why.
ANS:
a. A good diagram would show their budget line between housing and other goods pivoting
around their current consumption.
b. They can’t be made worse off because they can still afford their old consumption bundle.
They might be made better off because they might choose to consume less housing and
more other goods.
2) Harvey’s net demands for goods 1 and 2 are (2, –3) and his endowment is (6, 5).
a. What are his gross demands?
b. Draw a diagram illustrating his budget line, his endowment, and his consumption. (Put
good 1 on the horizontal axis.)
c. Draw a dotted line to show what his budget line would be if the price of good 1 doubled
and the price of good 2 stayed the same.
ANS:
(a) Harvey’s gross demands are (8, 2). (b) and (c) The graph is pretty straightforward.
Check the text for similar graphs.
3) Peter has an endowment of 3 units of good x and 5 units of good y. He can buy and sell x at
a price of $100 and y at a price of $200. He receives an income of $700 as alimony from a
former spouse.
a. Draw Peter’s budget line for x and y. Show his initial endowment of x and y on your
diagram.
b. Calculate the amount of x that he could afford if he bought only x and the amount of y he
could afford if he bought only y.
c. Write an equation for Peter’s budget.
ANS:
a. Check your class notes for the diagram.
b. He could afford 20 units of x and no y or 10 units of y and no x.
c. His budget is 100x + 200y = 2,000.
4) Ernie’s wage rate is $10 an hour. He has no earnings other than his labor income. His
utility function is U(C, L) = CR2, where C is the amount of money he spends on consumption,
and R is the number of hours a day he spends not working.
a. Write an equation that describes Ernie’s budget constraint.
b. How many hours does Ernie choose to work per day?
c. How much money does he spend on consumption per day?
ANS:
a. C + 10R = 240.
b. 8.
c. 80.
5) Leo thinks leisure and consuming goods are perfect complements. Goods cost $1 per unit.
Leo wants to consume 5 units of goods per hour of leisure. Leo can work as much as he wants
to at the wage rate of $15 an hour. He has no other source of income.
a. How many hours a day will Leo choose to spend at leisure?
b. Draw a diagram showing Leo’s budget and his choice of goods and leisure.
c. Will Leo work more or less if his wage rate increases?
ANS:
a. 18 hours a day.
b. Less.
6) Demand for potatoes is given by Qd = 10 –P with Q measured in tons. The supply of
potatoes is given by QS = P2
(a) Find the equilibrium price and quantity.
P=1
q=1
(b) Find the elasticity of demand and the elasticity of supply, evaluated at the
equilibrium price and quantity. Is demand elastic, inelastic, or unit elastic? Is
supply elastic, inelastic, or unit elastic?
Both are elastic
(c) Suppose a (small) sales tax is imposed on potatoes. Would the burden of the
tax fall mostly on consumers, mostly on producers, approximately equally, or
is it impossible to tell from the information above? Explain
More on producers
7) Assume there are two types of consumers: type A consumers have a demand
Q= 10 –P for widgets, and consumers of type B have a demand Q=5-P Assume
that there are 10 consumers of each type.
(a) Calculate the market demand.
Q=15 – 2P
(b) Assume that the market price for the good is $4 due to perfectly elastic industry supply. Using the market demand function, calculate the total consumers
surplus.
CS=18.5
(c) Calculate the total consumers surplus using individual demand functions.
CS=18.5
8) Suppose you are the manager of a firm and the demand function for your product is X=204P. At the moment the price of the product is 2. Your boss wants you to increase the total
revenue. What would you do to the price in order to increase the total revenue.
As the demand is inelastic at the current condition you would increase the price.
9) Hollywood screenwriters negotiate a new agreement with movie producers stipulating that
they will receive 10% of the revenue from every video rental of a movie they authored. They
have no such agreement for movies shown on pay-per-view television.
a. When the new writers’ agreement comes into effect, what will happen in the market for
video rentals—that is, will supply or demand shift, and how? As a result, how will consumer
surplus in the market for video rentals change? Illustrate with a diagram. Do youthink the
writers’ agreement will be popular with consumers who rent videos?
Answer: The payment to writers will increase the cost of providing video rentals.The supply
curve shifts leftward, the equilibrium price of video rentals rises, and the quantity of video
rentals bought and sold falls. As a result, consumer surplus will decrease. The writers’
agreement will not be popular with consumers. (look at your class notes for the diagram)
b. Consumers consider video rentals and pay-per-view movies substitutable to some extent.
When the new writers’ agreement comes into effect, what will happen in the market for payper-view movies—
that is, will supply or demand shift, and how? As a result, how will producer surplus in the
market for pay-per-view movies change? Illustrate with a diagram. Do you think the writers’
agreement will be popular with cable television companies that show pay-per-view movies?
Answer: The higher price of video rentals will make pay-per-view movies more popular.
They are substitute goods, and the demand for them will increase when the price of video
rentals rises. The demand curve shifts rightward , the price rises,and the equilibrium quantity
rises. Producer surplus will increase This change will be popular with the cable television
companies that show pay per -view movies. (look at your class notes for the diagram)