Instructor’s Manual
Intermediate Microeconomics
Eighth Edition
Instructor’s Manual
Intermediate Microeconomics
Eighth Edition
Instructor’s Manual
by
Hal R. Varian
Answers to Workouts
by
Hal R. Varian and Theodore C. Bergstrom
W. W. Norton & Company • New York • London
c 2010, 2002, 1999, 1996, 1993, 1990, 1988 by W. W. Norton & Company
Copyright All rights reserved
Printed in the United States of America
Typeset in TEX by Hal R. Varian
EIGHTH EDITION
ISBN 78-0-393-93544-8
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CONTENTS
Part I Chapter Highlights
1. The Market
1
2. Budget Constraint
4
3. Preferences
7
4. Utility
10
5. Choice
13
6. Demand
16
7. Revealed Preference
18
8. Slutsky Equation
21
9. Buying and Selling
23
10. Intertemporal Choice
26
11. Asset Markets
29
12. Uncertainty
31
13. Risky Assets
33
14. Consumer’s Surplus
35
15. Market Demand
37
16. Equilibrium
39
17. Auctions
42
18. Technology
44
19. Profit Maximization
46
20. Cost Minimization
48
21. Cost Curves
50
22. Firm Supply
52
23. Industry Supply
54
24. Monopoly
57
25. Monopoly Behavior
59
26. Factor Markets
61
27. Oligopoly
63
28. Game Theory
66
29. Game Applications
69
30. Exchange
73
31. Production
76
32. Welfare
78
33. Externalities
80
34. Information Technology
83
35. Public Goods
87
36. Information
90
Part II Answers to Workouts
1. The Market
1
2. Budget Constraint
5
3. Preferences
17
4. Utility
33
5. Choice
49
6. Demand
67
7. Revealed Preference
81
8. Slutsky Equation
97
9. Buying and Selling
111
10. Intertemporal Choice
131
11. Asset Markets
147
12. Uncertainty
161
13. Risky Assets
175
14. Consumer’s Surplus
181
15. Market Demand
191
16. Equilibrium
201
17. Auctions
219
18. Technology
237
19. Profit Maximization
249
20. Cost Minimization
265
21. Cost Curves
277
22. Firm Supply
283
23. Industry Supply
293
24. Monopoly
309
25. Monopoly Behavior
315
26. Factor Markets
329
27. Oligopoly
333
28. Game Theory
349
29. Game Applications
363
30. Behavioral Economics
379
31. Exchange
389
32. Production
405
33. Welfare
415
34. Externalities
425
35. Information Technology
437
36. Public Goods
453
37. Asymmetric Information
467
Chapter 1 1
Chapter 1
The Market
This chapter was written so I would have something to talk about on the first
day of class. I wanted to give students an idea of what economics was all about,
and what my lectures would be like, and yet not have anything that was really
critical for the course. (At Michigan, students are still shopping around on the
first day, and a good number of them won’t necessarily be at the lecture.)
I chose to discuss a housing market since it gives a way to describe a number
of economic ideas in very simple language and gives a good guide to what lies
ahead. In this chapter I was deliberately looking for surprising results—analytic
insights that wouldn’t arise from “just thinking” about a problem. The two
most surprising results that I presented are the condominium example and the
tax example in Section 1.6. It is worth emphasizing in class just why these results
are true, and how they illustrate the power of economic modeling.
It also makes sense to describe their limitations. Suppose that every condominium conversion involved knocking out the walls and creating two apartments. Then what would happen to the price of apartments? Suppose that the
condominiums attracted suburbanites who wouldn’t otherwise consider renting
an apartment. In each of these cases, the price of remaining apartments would
rise when condominium conversion took place.
The point of a simple economic model of the sort considered here is to focus
our thoughts on what the relevant effects are, not to come to a once-and-for-all
conclusion about the urban housing market. The real insight that is offered by
these examples is that you have to consider both the supply and the demand
side of the apartment market when you analyze the impact of this particular
policy.
The only concept that the students seem to have trouble with in this chapter
is the idea of Pareto efficiency. I usually talk about the idea a little more than
is in the book and rephrase it a few times. But then I tell them not to worry
about it too much, since we’ll look at it in great detail later in the course.
The workbook problems here are pretty straightforward. The biggest problem
is getting the students to draw the true (discontinuous) demand curve, as in
Figure 1.1, rather than just to sketch in a downward-sloping curve as in Figure
1.2. This is a good time to emphasize to the students that when they are given
numbers describing a curve, they have to use the numbers—they can’t just sketch
in any old shape.
2 Chapter Highlights
The Market
A. Example of an economic model — the market for apartments
1. models are simplifications of reality
2. for example, assume all apartments are identical
3. some are close to the university, others are far away
4. price of outer-ring apartments is exogenous — determined outside the
model
5. price of inner-ring apartments is endogenous — determined within the
model
B. Two principles of economics
1. optimization principle — people choose actions that are in their interest
2. equilibrium principle — people’s actions must eventually be consistent
with each other
C. Constructing the demand curve
1. line up the people by willingness-to-pay. See Figure 1.1.
2. for large numbers of people, this is essentially a smooth curve as in Figure
1.2.
D. Supply curve
1. depends on time frame
2. but we’ll look at the short run — when supply of apartments is fixed.
E. Equilibrium
1. when demand equals supply
2. price that clears the market
F. Comparative statics
1. how does equilibrium adjust when economic conditions change?
2. “comparative” — compare two equilibria
3. “statics” — only look at equilibria, not at adjustment
4. example — increase in supply lowers price; see Figure 1.5.
5. example — create condos which are purchased by renters; no effect on
price; see Figure 1.6.
G. Other ways to allocate apartments
1. discriminating monopolist
2. ordinary monopolist
3. rent control
H. Comparing different institutions
1. need a criterion to compare how efficient these different allocation methods
are.
2. an allocation is Pareto efficient if there is no way to make some group
of people better off without making someone else worse off.
3. if something is not Pareto efficient, then there is some way to make some
people better off without making someone else worse off.
4. if something is not Pareto efficient, then there is some kind of “waste” in
the system.
I. Checking efficiency of different methods
1. free market — efficient
2. discriminating monopolist — efficient
3. ordinary monopolist — not efficient
4. rent control — not efficient
Chapter 1 3
J. Equilibrium in long run
1. supply will change
2. can examine efficiency in this context as well
4 Chapter Highlights
Chapter 2
Budget Constraint
Most of the material here is pretty straightforward. Drive home the formula
for the slope of the budget line, emphasizing the derivation on page 23. Try
some different notation to make sure that they see the idea of the budget line,
and don’t just memorize the formulas. In the workbook, we use a number of
different choices of notation for precisely this reason. It is also worth pointing
out that the slope of a line depends on the (arbitrary) choice of which variable
is plotted on the vertical axis. It is surprising how often confusion arises on this
point.
Students sometimes have problems with the idea of a numeraire good. They
understand the algebra, but they don’t understand when it would be used. One
nice example is in foreign currency exchange. If you have English pounds and
American dollars, then you can measure the total wealth that you have in either
dollars or pounds by choosing one or the other of the two goods as numeraire.
In the workbook, students sometimes get thrown in exercises where one of
the goods has a negative price, so the budget line has a positive slope. This
comes from trying to memorize formulas and figures rather than thinking about
the problem. This is a good exercise to go over in order to warn students about
the dangers of rote learning!
Budget Constraint
A. Consumer theory: consumers choose the best bundles of goods they can
afford.
1. this is virtually the entire theory in a nutshell
2. but this theory has many surprising consequences
B. Two parts to theory
1. “can afford” — budget constraint
2. “best” — according to consumers’ preferences
Chapter 2 5
C. What do we want to do with the theory?
1. test it — see if it is adequate to describe consumer behavior
2. predict how behavior changes as economic environment changes
3. use observed behavior to estimate underlying values
a) cost-benefit analysis
b) predicting impact of some policy
D. Consumption bundle
1. (x1 , x2 ) — how much of each good is consumed
2. (p1 , p2 ) — prices of the two goods
3. m — money the consumer has to spend
4. budget constraint: p1 x1 + p2 x2 ≤ m
5. all (x1 , x2 ) that satisfy this constraint make up the budget set of the
consumer. See Figure 2.1.
E. Two goods
1. theory works with more than two goods, but can’t draw pictures.
2. often think of good 2 (say) as a composite good, representing money to
spend on other goods.
3. budget constraint becomes p1 x1 + x2 ≤ m.
4. money spent on good 1 (p1 x1 ) plus the money spent on good 2 (x2 ) has
to be less than or equal to the amount available (m).
F. Budget line
1. p1 x1 + p2 x2 = m
2. also written as x2 = m/p2 − (p1 /p2 )x1 .
3. budget line has slope of −p1 /p2 and vertical intercept of m/p2 .
4. set x1 = 0 to find vertical intercept (m/p2 ); set x2 = 0 to find horizontal
intercept (m/p1 ).
5. slope of budget line measures opportunity cost of good 1 — how much of
good 2 you must give up in order to consume more of good 1.
G. Changes in budget line
1. increasing m makes parallel shift out. See Figure 2.2.
2. increasing p1 makes budget line steeper. See Figure 2.3.
3. increasing p2 makes budget line flatter
4. just see how intercepts change
5. multiplying all prices by t is just like dividing income by t
6. multiplying all prices and income by t doesn’t change budget line
a) “a perfectly balanced inflation doesn’t change consumption possibilities”
H. The numeraire
1. can arbitrarily assign one price a value of 1 and measure other price relative
to that
2. useful when measuring relative prices; e.g., English pounds per dollar, 1987
dollars versus 1974 dollars, etc.
I. Taxes, subsidies, and rationing
1. quantity tax — tax levied on units bought: p1 + t
2. value tax — tax levied on dollars spent: p1 + τ p1 . Also known as ad
valorem tax
3. subsidies — opposite of a tax
a) p1 − s
b) (1 − σ)p1
6 Chapter Highlights
4. lump sum tax or subsidy — amount of tax or subsidy is independent of
the consumer’s choices. Also called a head tax or a poll tax
5. rationing — can’t consume more than a certain amount of some good
J. Example — food stamps
1. before 1979 was an ad valorem subsidy on food
a) paid a certain amount of money to get food stamps which were worth
more than they cost
b) some rationing component — could only buy a maximum amount of
food stamps
2. after 1979 got a straight lump-sum grant of food coupons. Not the same
as a pure lump-sum grant since could only spend the coupons on food.
Chapter 3 7
Chapter 3
Preferences
This chapter is more abstract and therefore needs somewhat more motivation
than the previous chapters. It might be a good idea to talk about relations in
general before introducing the particular idea of preference relations. Try the
relations of “taller,” and “heavier,” and “taller and heavier.” Point out that
“taller and heavier” isn’t a complete relation, while the other two are. This
general discussion can motivate the general idea of preference relations.
Make sure that the students learn the specific examples of preferences such
as perfect substitutes, perfect complements, etc. They will use these examples
many, many times in the next few weeks!
When describing the ideas of perfect substitutes, emphasize that the defining
characteristic is that the slope of the indifference curves is constant, not that it
is −1. In the text, I always stick with the case where the slope is −1, but in
the workbook, we often treat the general case. The same warning goes with the
perfect complements case. I work out the symmetric case in the text and try to
get the students to do the asymmetric case in the workbook.
The definition of the marginal rate of substitution is fraught with “sign
confusion.” Should the M RS be defined as a negative or a positive number? I’ve
chosen to give the M RS its natural sign in the book, but I warn the students that
many economists tend to speak of the M RS in terms of absolute value. Example:
diminishing marginal rate of substitution refers to a situation where the absolute
value of the M RS decreases as we move along an indifference curve. The actual
value of the M RS (a negative number) is increasing in this movement!
Students often begin to have problems with the workbook exercises here.
The first confusion they have is that they get mixed up about the idea that
indifference curves measure the directions where preferences are constant, and
instead draw lines that indicate the directions that preferences are increasing.
The second problem that they have is in knowing when to draw just arbitrary
curves that qualitatively depict some behavior or other, and when to draw exact
shapes.
Try asking your students to draw their indifference curves between five dollar
bills and one dollar bills. Offer to trade with them based on what they draw. In
addition to getting them to think, this is a good way to supplement your faculty
salary.
8 Chapter Highlights
Preferences
A. Preferences are relationships between bundles.
1. if a consumer would choose bundle (x1 , x2 ) when (y1 , y2 ) is available, then
it is natural to say that bundle (x1 , x2 ) is preferred to (y1 , y2 ) by this
consumer.
2. preferences have to do with the entire bundle of goods, not with individual
goods.
B. Notation
1. (x1 , x2 ) (y1 , y2 ) means the x-bundle is strictly preferred to the ybundle
2. (x1 , x2 ) ∼ (y1 , y2 ) means that the x-bundle is regarded as indifferent to
the y-bundle
3. (x1 , x2 ) (y1 , y2 ) means the x-bundle is at least as good as (preferred
to or indifferent to) the y-bundle
C. Assumptions about preferences
1. complete — any two bundles can be compared
2. reflexive — any bundle is at least as good as itself
3. transitive — if X Y and Y Z, then X Z
a) transitivity necessary for theory of optimal choice
D. Indifference curves
1. graph the set of bundles that are indifferent to some bundle. See Figure
3.1.
2. indifference curves are like contour lines on a map
3. note that indifference curves describing two distinct levels of preference
cannot cross. See Figure 3.2.
a) proof — use transitivity
E. Examples of preferences
1. perfect substitutes. Figure 3.3.
a) red pencils and blue pencils; pints and quarts
b) constant rate of trade-off between the two goods
2. perfect complements. Figure 3.4.
a) always consumed together
b) right shoes and left shoes; coffee and cream
3. bads. Figure 3.5.
4. neutrals. Figure 3.6.
5. satiation or bliss point Figure 3.7.
F. Well-behaved preferences
1. monotonicity — more of either good is better
a) implies indifference curves have negative slope. Figure 3.9.
2. convexity — averages are preferred to extremes. Figure 3.10.
a) slope gets flatter as you move further to right
b) example of non-convex preferences
G. Marginal rate of substitution
1. slope of the indifference curve
2. M RS = Δx2 /Δx1 along an indifference curve. Figure 3.11.
3. sign problem — natural sign is negative, since indifference curves will
generally have negative slope
4. measures how the consumer is willing to trade off consumption of good 1
for consumption of good 2. Figure 3.12.
Chapter 3 9
5. measures marginal willingness to pay (give up)
a) not the same as how much you have to pay
b) but how much you would be willing to pay
10 Chapter Highlights
Chapter 4
Utility
In this chapter, the level of abstraction kicks up another notch. Students often
have trouble with the idea of utility. It is sometimes hard for trained economists
to sympathize with them sufficiently, since it seems like such an obvious notion
to us.
Here is a way to approach the subject. Suppose that we return to the idea of
the “heavier than” relation discussed in the last chapter. Think of having a big
balance scale with two trays. You can put someone on each side of the balance
scale and see which person is heavier, but you don’t have any standardized
weights. Nevertheless you have a way to determine whether x is heavier than y.
Now suppose that you decide to establish a scale. You get a bunch of
stones, check that they are all the same weight, and then measure the weight of
individuals in stones. It is clear that x is heavier than y if x’s weight in stones
is heavier than y’s weight in stones.
Somebody else might use different units of measurements—kilograms, pounds,
or whatever. It doesn’t make any difference in terms of deciding who is heavier.
At this point it is easy to draw the analogy with utility—just as pounds give
a way to represent the “heavier than” order numerically, utility gives a way
to represent the preference order numerically. Just as the units of weight are
arbitrary, so are the units of utility.
This analogy can also be used to explore the concept of a positive monotonic
transformation, a concept that students have great trouble with. Tell them that
a monotonic transformation is just like changing units of measurement in the
weight example.
However, it is also important for students to understand that nonlinear
changes of units are possible. Here is a nice example to illustrate this. Suppose
that wood is always sold in piles shaped like cubes. Think of the relation “one
pile has more wood than another.” Then you can represent this relation by
looking at the measure of the sides of the piles, the surface area of the piles, or
the volume of the piles. That is, x, x2 , or x3 gives exactly the same comparison
between the piles. Each of these numbers is a different representation of the
utility of a cube of wood.
Be sure to go over carefully the examples here. The Cobb-Douglas example
is an important one, since we use it so much in the workbook. Emphasize that
it is just a nice functional form that gives convenient expressions. Be sure to
Chapter 1
NAME
The Market
Introduction. The problems in this chapter examine some variations on
the apartment market described in the text. In most of the problems we
work with the true demand curve constructed from the reservation prices
of the consumers rather than the “smoothed” demand curve that we used
in the text.
Remember that the reservation price of a consumer is that price
where he is just indifferent between renting or not renting the apartment.
At any price below the reservation price the consumer will demand one
apartment, at any price above the reservation price the consumer will demand zero apartments, and exactly at the reservation price the consumer
will be indifferent between having zero or one apartment.
You should also observe that when demand curves have the “staircase” shape used here, there will typically be a range of prices where
supply equals demand. Thus we will ask for the the highest and lowest
price in the range.
1.1 (3) Suppose that we have 8 people who want to rent an apartment.
Their reservation prices are given below. (To keep the numbers small,
think of these numbers as being daily rent payments.)
Person
Price
= A
= 40
B
25
C D
30 35
E
10
F
18
G
15
H
5
(a) Plot the market demand curve in the following graph. (Hint: When
the market price is equal to some consumer i’s reservation price, there
will be two different quantities of apartments demanded, since consumer
i will be indifferent between having or not having an apartment.)
2
THE MARKET
(Ch. 1)
Price
60
50
40
30
20
10
0
1
2
3
4
5
6 7
8
Apartments
(b) Suppose the supply of apartments is fixed at 5 units. In this case
there is a whole range of prices that will be equilibrium prices. What is
the highest price that would make the demand for apartments equal to 5
units?
$18.
(c) What is the lowest price that would make the market demand equal
to 5 units?
$15.
(d) With a supply of 4 apartments, which of the people A–H end up
getting apartments?
A, B, C, D.
(e) What if the supply of apartments increases to 6 units. What is the
range of equilibrium prices?
$10 to $15.
1.2 (3) Suppose that there are originally 5 units in the market and that
1 of them is turned into a condominium.
(a) Suppose that person A decides to buy the condominium. What will
be the highest price at which the demand for apartments will equal the
supply of apartments? What will be the lowest price? Enter your answers in column A, in the table. Then calculate the equilibrium prices of
apartments if B, C, . . . , decide to buy the condominium.
NAME
3
Person
A
B
C
D
E
F
G
H
High price
18
18
18
18
25
25
25
25
Low price
15
15
15
15
18
15
18
18
(b) Suppose that there were two people at each reservation price and 10
apartments. What is the highest price at which demand equals supply?
18.
Suppose that one of the apartments was turned into a condo-
minium. Is that price still an equilibrium price?
Yes.
1.3 (2) Suppose now that a monopolist owns all the apartments and that
he is trying to determine which price and quantity maximize his revenues.
(a) Fill in the box with the maximum price and revenue that the monopolist can make if he rents 1, 2, . . ., 8 apartments. (Assume that he must
charge one price for all apartments.)
Number
1
2
3
4
5
6
7
8
Price
40
35
30
25
18
15
10
5
Revenue
40
70
90
100
90
90
70
40
(b) Which of the people A–F would get apartments?
A, B, C, D.
(c) If the monopolist were required by law to rent exactly 5 apartments,
what price would he charge to maximize his revenue?
(d) Who would get apartments?
$18.
A, B, C, D, F.
(e) If this landlord could charge each individual a different price, and he
knew the reservation prices of all the individuals, what is the maximum
revenue he could make if he rented all 5 apartments?
$148.
(f ) If 5 apartments were rented, which individuals would get the apartments?
A, B, C, D, F.
1.4 (2) Suppose that there are 5 apartments to be rented and that the
city rent-control board sets a maximum rent of $9. Further suppose that
people A, B, C, D, and E manage to get an apartment, while F, G, and
H are frozen out.
4
THE MARKET
(Ch. 1)
(a) If subletting is legal—or, at least, practiced—who will sublet to whom
in equilibrium? (Assume that people who sublet can evade the city rentcontrol restrictions.)
E, who is willing to pay only
$10 for an apartment would sublet to
F,
who is willing to pay $18.
(b) What will be the maximum amount that can be charged for the sublet
payment?
$18.
(c) If you have rent control with unlimited subletting allowed, which of
the consumers described above will end up in the 5 apartments?
A,
B, C, D, F.
(d) How does this compare to the market outcome?
It’s the
same.
1.5 (2) In the text we argued that a tax on landlords would not get
passed along to the renters. What would happen if instead the tax was
imposed on renters?
(a) To answer this question, consider the group of people in Problem 1.1.
What is the maximum that they would be willing to pay to the landlord
if they each had to pay a $5 tax on apartments to the city? Fill in the
box below with these reservation prices.
Person
A
B
C
D
E
F
G
H
Reservation Price
35
20
25
30
5
13
10
0
(b) Using this information determine the maximum equilibrium price if
there are 5 apartments to be rented.
$13.
(c) Of course, the total price a renter pays consists of his or her rent plus
the tax. This amount is
$18.
(d) How does this compare to what happens if the tax is levied on the
landlords?
It’s the same.
Chapter 2
NAME
Budget Constraint
Introduction. These workouts are designed to build your skills in describing economic situations with graphs and algebra. Budget sets are a
good place to start, because both the algebra and the graphing are very
easy. Where there are just two goods, a consumer who consumes x1 units
of good 1 and x2 units of good 2 is said to consume the consumption bundle, (x1 , x2 ). Any consumption bundle can be represented by a point on
a two-dimensional graph with quantities of good 1 on the horizontal axis
and quantities of good 2 on the vertical axis. If the prices are p1 for good 1
and p2 for good 2, and if the consumer has income m, then she can afford
any consumption bundle, (x1 , x2 ), such that p1 x1 +p2 x2 ≤ m. On a graph,
the budget line is just the line segment with equation p1 x1 + p2 x2 = m
and with x1 and x2 both nonnegative. The budget line is the boundary
of the budget set. All of the points that the consumer can afford lie on
one side of the line and all of the points that the consumer cannot afford
lie on the other.
If you know prices and income, you can construct a consumer’s budget line by finding two commodity bundles that she can “just afford” and
drawing the straight line that runs through both points.
Example: Myrtle has 50 dollars to spend. She consumes only apples and
bananas. Apples cost 2 dollars each and bananas cost 1 dollar each. You
are to graph her budget line, where apples are measured on the horizontal
axis and bananas on the vertical axis. Notice that if she spends all of her
income on apples, she can afford 25 apples and no bananas. Therefore
her budget line goes through the point (25, 0) on the horizontal axis. If
she spends all of her income on bananas, she can afford 50 bananas and
no apples. Therfore her budget line also passes throught the point (0, 50)
on the vertical axis. Mark these two points on your graph. Then draw a
straight line between them. This is Myrtle’s budget line.
What if you are not told prices or income, but you know two commodity bundles that the consumer can just afford? Then, if there are just
two commodities, you know that a unique line can be drawn through two
points, so you have enough information to draw the budget line.
Example: Laurel consumes only ale and bread. If she spends all of her
income, she can just afford 20 bottles of ale and 5 loaves of bread. Another
commodity bundle that she can afford if she spends her entire income is
10 bottles of ale and 10 loaves of bread. If the price of ale is 1 dollar per
bottle, how much money does she have to spend? You could solve this
problem graphically. Measure ale on the horizontal axis and bread on the
vertical axis. Plot the two points, (20, 5) and (10, 10), that you know to
be on the budget line. Draw the straight line between these points and
extend the line to the horizontal axis. This point denotes the amount of
6
BUDGET CONSTRAINT
(Ch. 2)
ale Laurel can afford if she spends all of her money on ale. Since ale costs
1 dollar a bottle, her income in dollars is equal to the largest number of
bottles she can afford. Alternatively, you can reason as follows. Since
the bundles (20, 5) and (10, 10) cost the same, it must be that giving up
10 bottles of ale makes her able to afford an extra 5 loaves of bread. So
bread costs twice as much as ale. The price of ale is 1 dollar, so the price
of bread is 2 dollars. The bundle (20, 5) costs as much as her income.
Therefore her income must be 20 × 1 + 5 × 2 = 30.
When you have completed this workout, we hope that you will be
able to do the following:
• Write an equation for the budget line and draw the budget set on a
graph when you are given prices and income or when you are given
two points on the budget line.
• Graph the effects of changes in prices and income on budget sets.
• Understand the concept of numeraire and know what happens to the
budget set when income and all prices are multiplied by the same
positive amount.
• Know what the budget set looks like if one or more of the prices is
negative.
• See that the idea of a “budget set” can be applied to constrained
choices where there are other constraints on what you can have, in
addition to a constraint on money expenditure.
NAME
7
2.1 (0) You have an income of $40 to spend on two commodities. Commodity 1 costs $10 per unit, and commodity 2 costs $5 per unit.
(a) Write down your budget equation.
10x1 + 5x2 = 40.
(b) If you spent all your income on commodity 1, how much could you
4.
buy?
(c) If you spent all of your income on commodity 2, how much could
you buy?
below.
8.
Use blue ink to draw your budget line in the graph
x2
8
6
4
2
0
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Blue Line
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Red Line
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Black Shading
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Black Line
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Blue
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Shading
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2
4
6
8
x1
(d) Suppose that the price of commodity 1 falls to $5 while everything else
stays the same. Write down your new budget equation.
40.
5x1 +5x2 =
On the graph above, use red ink to draw your new budget line.
(e) Suppose that the amount you are allowed to spend falls to $30, while
the prices of both commodities remain at $5. Write down your budget
equation.
line.
5x1 + 5x2 = 30.
Use black ink to draw this budget
(f ) On your diagram, use blue ink to shade in the area representing commodity bundles that you can afford with the budget in Part (e) but could
not afford to buy with the budget in Part (a). Use black ink or pencil to
shade in the area representing commodity bundles that you could afford
with the budget in Part (a) but cannot afford with the budget in Part
(e).
2.2 (0) On the graph below, draw a budget line for each case.
8
BUDGET CONSTRAINT
(Ch. 2)
(a) p1 = 1, p2 = 1, m = 15. (Use blue ink.)
(b) p1 = 1, p2 = 2, m = 20. (Use red ink.)
(c) p1 = 0, p2 = 1, m = 10. (Use black ink.)
(d) p1 = p2 , m = 15p1 . (Use pencil or black ink. Hint: How much of
good 1 could you afford if you spend your entire budget on good 1?)
x2
20
15
Blue Line = Pencil Line
Black Line
10
5
Red Line
5
0
10
15
20
x1
2.3 (0) Your budget is such that if you spend your entire income, you
can afford either 4 units of good x and 6 units of good y or 12 units of x
and 2 units of y.
(a) Mark these two consumption bundles and draw the budget line in the
graph below.
y
16
12
8
4
0
4
8
12
16
x
NAME
9
(b) What is the ratio of the price of x to the price of y?
1/2.
(c) If you spent all of your income on x, how much x could you buy?
16.
(d) If you spent all of your income on y, how much y could you buy?
8.
(e) Write a budget equation that gives you this budget line, where the
x + 2y = 16.
price of x is 1.
(f ) Write another budget equation that gives you the same budget line,
but where the price of x is 3.
3x + 6y = 48.
2.4 (1) Murphy was consuming 100 units of X and 50 units of Y . The
price of X rose from 2 to 3. The price of Y remained at 4.
(a) How much would Murphy’s income have to rise so that he can still
exactly afford 100 units of X and 50 units of Y ?
$100.
2.5 (1) If Amy spent her entire allowance, she could afford 8 candy bars
and 8 comic books a week. She could also just afford 10 candy bars and
4 comic books a week. The price of a candy bar is 50 cents. Draw her
budget line in the box below. What is Amy’s weekly allowance?
Comic books
32
24
16
8
0
8
12
16
24
32
Candy bars
$6.
10
BUDGET CONSTRAINT
(Ch. 2)
2.6 (0) In a small country near the Baltic 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 crowns per sack,
meatballs cost 4 crowns per crock, and jam costs 6 crowns per jar.
(a) Write down a budget equation for a citizen named Gunnar who has
an income of 360 crowns 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 Gunnar in a year.
2P + 4M + 6J =
360.
(b) 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, 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?
2 crowns.
(c) In terms of the new currency, what is the price of jam?
3
crowns.
(d) What would Gunnar’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?
180 crowns.
(e) Write down Gunnar’s new budget equation.
180.
P + 2M + 3J =
Is Gunnar’s budget set any different than it was before the change?
No.
2.7 (0) Edmund Stench consumes two commodities, namely garbage and
punk rock video cassettes. He doesn’t actually eat the former but keeps
it in his backyard where it is eaten by billy goats and assorted vermin.
The reason that he accepts the garbage is that people pay him $2 per
sack for taking it. Edmund can accept as much garbage as he wishes at
that price. He has no other source of income. Video cassettes cost him
$6 each.
(a) If Edmund accepts zero sacks of garbage, how many video cassettes
can he buy?
0.
NAME
11
(b) If he accepts 15 sacks of garbage, how many video cassettes can he
5.
buy?
(c) Write down an equation for his budget line.
6C − 2G = 0.
(d) Draw Edmund’s budget line and shade in his budget set.
Garbage
20
15
10
5
0
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Budget Line
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Budget Set
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5
10
15
20
Video cassettes
2.8 (0) If you think Edmund is odd, consider his brother Emmett.
Emmett consumes speeches by politicians and university administrators.
He is paid $1 per hour for listening to politicians and $2 per hour for
listening to university administrators. (Emmett is in great demand to help
fill empty chairs at public lectures because of his distinguished appearance
and his ability to refrain from making rude noises.) Emmett consumes
one good for which he must pay. We have agreed not to disclose what
that good is, but we can tell you that it costs $15 per unit and we shall
call it Good X. In addition to what he is paid for consuming speeches,
Emmett receives a pension of $50 per week.
Administrator speeches
100
75
50
25
0
25
50
75
100
Politician speeches
12
BUDGET CONSTRAINT
(Ch. 2)
(a) Write down a budget equation stating those combinations of the three
commodities, Good X, hours of speeches by politicians (P ), and hours of
speeches by university administrators (A) that Emmett could afford to
consume per week.
15X − 1P − 2A = 50.
(b) On the graph above, draw a two-dimensional diagram showing the
locus of consumptions of the two kinds of speeches that would be possible
for Emmett if he consumed 10 units of Good X per week.
2.9 (0) Jonathan Livingstone Yuppie is a prosperous lawyer. He
has, in his own words, “outgrown those confining two-commodity limits.” Jonathan consumes three goods, unblended Scotch whiskey, designer tennis shoes, and meals in French gourmet restaurants. The price
of Jonathan’s brand of whiskey is $20 per bottle, the price of designer
tennis shoes is $80 per pair, and the price of gourmet restaurant meals
is $50 per meal. After he has paid his taxes and alimony, Jonathan has
$400 a week to spend.
(a) Write down a budget equation for Jonathan, where W stands for
the number of bottles of whiskey, T stands for the number of pairs of
tennis shoes, and M for the number of gourmet restaurant meals that he
consumes.
20W + 80T + 50M = 400.
(b) Draw a three-dimensional diagram to show his budget set. Label the
intersections of the budget set with each axis.
M
8
5
20
T
W
(c) Suppose that he determines that he will buy one pair of designer tennis
shoes per week. What equation must be satisfied by the combinations of
restaurant meals and whiskey that he could afford?
20W +50M =
320.
2.10 (0) Martha is preparing for exams in economics and sociology. She
has time to read 40 pages of economics and 30 pages of sociology. In the
same amount of time she could also read 30 pages of economics and 60
pages of sociology.
NAME
13
(a) Assuming that the number of pages per hour that she can read of
either subject does not depend on how she allocates her time, how many
pages of sociology could she read if she decided to spend all of her time
on sociology and none on economics?
150 pages. (Hint: You
have two points on her budget line, so you should be able to determine
the entire line.)
(b) How many pages of economics could she read if she decided to spend
50 pages.
all of her time reading economics?
2.11 (1) Harry Hype 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. Harry is considering advertising in two publications,
a boring business magazine and a trendy consumer publication for people
who wish they lived in California.
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.
(a) If Harry spends his entire advertising budget on the business publication, his ad will be read by
3,000
10,000
recent M.B.A.’s and by
lawyers with hot tubs.
(b) If he spends his entire advertising budget on the consumer publication,
his ad will be read by
lawyers with hot tubs.
6,000
recent M.B.A.’s and by
5,000
(c) Suppose he spent half of his advertising budget on each publication.
His ad would be read by
lawyers with hot tubs.
8,000
recent M.B.A.’s and by
4,000
(d) 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? No. Sketch, shade in, and label the budget set, which
includes all the combinations of MBA’s and lawyers he can reach if he
spends no more than his budget.
14
BUDGET CONSTRAINT
(Ch. 2)
(e) 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 M + 2L = 16. With a fixed advertising budget, how
many readings by M.B.A.’s must he sacrifice to get an additional reading
2.
by a lawyer with a hot tub?
MBA's x 1000
16
12
10
8
6
4
0
Budget line
a
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c
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3
5
2
4
8
12
16
Lawyers x 1000
2.12 (0) On the planet Mungo, they have two kinds of money, blue
money and red money. Every commodity has two prices—a red-money
price and a blue-money price. Every Mungoan has two incomes—a red
income and a blue income.
In order to buy an object, a Mungoan has to pay that object’s redmoney price in red money and its blue-money price in blue money. (The
shops simply have two cash registers, and you have to pay at both registers
to buy an object.) It is forbidden to trade one kind of money for the other,
and this prohibition is strictly enforced by Mungo’s ruthless and efficient
monetary police.
• There are just two consumer goods on Mungo, ambrosia and bubble
gum. All Mungoans prefer more of each good to less.
• The blue prices are 1 bcu (bcu stands for blue currency unit) per
unit of ambrosia and 1 bcu per unit of bubble gum.
• The red prices are 2 rcus (red currency units) per unit of ambrosia
and 6 rcus per unit of bubble gum.
(a) On the graph below, draw the red budget (with red ink) and the
blue budget (with blue ink) for a Mungoan named Harold whose blue
income is 10 and whose red income is 30. Shade in the “budget set”
containing all of the commodity bundles that Harold can afford, given
NAME
15
its∗ two budget constraints. Remember, Harold has to have enough blue
money and enough red money to pay both the blue-money cost and the
red-money cost of a bundle of goods.
Gum
20
15
10
5
Blue Lines
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0
5
10
Red Line
15
20
Ambrosia
(b) Another Mungoan, Gladys, faces the same prices that Harold faces
and has the same red income as Harold, but Gladys has a blue income of
20. Explain how it is that Gladys will not spend its entire blue income
no matter what its tastes may be. (Hint: Draw Gladys’s budget lines.)
The blue budget line lies strictly outside
the red budget line, so to satisfy both
budgets, one must be strictly inside the
red budget line.
(c) A group of radical economic reformers on Mungo believe that the
currency rules are unfair. “Why should everyone have to pay two prices
for everything?” they ask. They propose the following scheme. Mungo
will continue to have two currencies, every good will have a blue price and
a red price, and every Mungoan will have a blue income and a red income.
But nobody has to pay both prices. Instead, everyone on Mungo must
declare itself to be either a Blue-Money Purchaser (a “Blue”) or a RedMoney Purchaser (a “Red”) before it buys anything at all. Blues must
make all of their purchases in blue money at the blue prices, spending
only their blue incomes. Reds must make all of their purchases in red
money, spending only their red incomes.
Suppose that Harold has the same income after this reform, and that
prices do not change. Before declaring which kind of purchaser it will be,
∗
We refer to all Mungoans by the gender-neutral pronoun, “it.” Although Mungo has two sexes, neither of them is remotely like either of
ours.
16
BUDGET CONSTRAINT
(Ch. 2)
Harold contemplates the set of commodity bundles that it could afford
by making one declaration or the other. Let us call a commodity bundle
“attainable” if Harold can afford it by declaring itself to be a “Blue” and
buying the bundle with blue money or if Harold can afford the bundle
by declaring itself to be a “Red” and buying it with red money. On the
diagram below, shade in all of the attainable bundles.
Gum
20
15
10
5
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Blue Line
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Red Line
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0
5
10
15
20
Ambrosia
2.13 (0) Are Mungoan budgets really so fanciful? Can you think of situations on earth where people must simultaneously satisfy more than one
budget constraint? Is money the only scarce resource that people use up
when consuming?
Consumption of many commodities
takes time as well as money. People have
to simultaneously satisfy a time budget
and a money budget. Other examples--people
may have a calorie budget or a cholesterol
budget or an alcohol-intake budget.