Problem Set 2
Econ 201
Beomsoo Kim
1. The ABX Corporation determines that at current prices the demand for its computer
chips has a price elasticity of 2 in the short run, while the price elasticity for its disk
drive is 0.8.
a. If the corporation decides to raise the price of both products by 10%, what will
happen to its sales? To its sales revenue? (Find the changes of sales and sales
revenue in percentages and separately for the products.)
b. Can you tell from the available information which product will generate the most
revenue for the firm? If yes, why? If not, what additional information would you
need?
(Hint: use the definition of elasticity. To get the percentage change of sales revenue
(P2*Q2- P1*Q1)/ P1*Q1, try to represent P2*Q2 by P1*Q1)
2. Catherine has a monthly income of $500, which she spends on pizzas and a
composite of all other goods. The price of a pizza is $5.
a. Draw Catherine’s budget constraint. Label your values of the intercepts and the
slope of the budget constraint. (Place pizza on the horizontal axis).
b. Assume Catherine maximizes her utility by spending $200 on pizzas and the rest
of income on AOG. Show the bundle that maximizes her utility and the
indifference curve through this bundle.
c. Due to a flour shortage, the price of pizzas increases to $10. Show her new budget
constraint and the substitution effect of this price change. Label your diagram
appropriately.
d. Assume pizzas and all other goods are both normal goods, show the income effect
of the price change. Indicate Catherine’s new utility level (indifference curve)
after the price change.
e. How much additional income would Catherine need to be as well off as she was
at her initial optimal bundle? (This requires a graphical answer, not a numeric
answer.) What is the special name that is given to this additional income?
3. Anna has $200 in income, which she spends on paying her phone bill and all other
goods (AOG). The price of AOG is $1 per unit and she is billed $0.25 per minute for
phone calls.
a. Draw Anna’s budget constraint between AOG and minutes of phone calls,
placing the latter on the horizontal axis. Label the values for the intercepts and
the slope of the budget constraint.
Problem Set 2
Econ 201
Beomsoo Kim
b. Assume that Anna maximizes her utility by making 200 minutes of phone
calls. Draw Anna’s indifference curve passing through this bundle.
c. Suppose that phone calls now become cheaper and cost only $0.10 per minute.
Draw her new budget constraint. Show her “possible” new optimal bundle.
d. Indicate on your diagram how much income in lieu of a price decrease would
make her as well off as she would be at her “possible” new optimum. What is
the special name that is given to this additional income?