Problem Set 2 (Solution)

Managerial Economics - MGE(BJ21-1)

XLRI - Xavier School of Management

1. 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 .
(b) What is the ratio of the price of x to the price of y?
(c) If you spent all of your income on x, how much x could you buy?
(d) If you spent all of your income on y,how much y could you buy?
(e) Write a budget equation that gives you this budget line, where the 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.

2. Mr. Sunil has 5,000 to spend on advertising a new dish ‘Kababi’ in his restaurant
which is located in Delhi. His customers order it online. Market research shows that
the people most likely to buy this new dish are recent recipients of M.B.A. degrees and
lawyers. Mr. Sunil is considering advertising in two publications, a business magazine
and a consumer publication for people residing in Delhi.

Fact 1: Ads in the business magazine cost Rs. 500 each and ads in the consumer
magazine cost Rs. 250 each.
Fact 2: Each ad in the business magazine will be read by 1,000 recent M.B.A.’s and
300 lawyers.
Fact 3: Each ad in the consumer publication will be read by 300 recent M.B.A.’s and
250 lawyers.
Fact 4: Nobody reads more than one ad, and nobody who reads one magazine reads
the other.

(a) If Sunil spends his entire advertising budget on the business publication, How
many recent M.B.A.’s and how many lawyers will read his ad?
(b) If Sunil spends his entire advertising budget on the consumer publication, How
many recent M.B.A.’s and how many lawyers will read his ad?
(c) Suppose he spent half of his advertising budget on each publication. How many
recent M.B.A.’s and how many lawyers will read his ad?

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 (d) Draw a “budget line” showing the combinations of number of readings by recent
M.B.A.’s and by lawyers that he can obtain if he spends his entire advertising
budget. Does this line extend all the way to the axes?
(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. What is the
equation for budget line?

3. Suppose the price of goods x1 and x2 are p1 and p2 , respectively. The income of the
consumer is given by m. Derive the demand functions in terms of p1 , p2 and m of the
following utility functions:

(a) u(x1 , x2 ) = xα1 1 xα2 2 where α1 , α2 > 0 and α1 + α2 = 1.

(b) u(x1 , x2 ) = max{ax1 , bx2 } + min{x1 , x2 }.
(c) u(x1 , x2 ) = x21 + x22 .
(d) u(x1 , x2 ) = ax1 + bx2 .
(e) u(x1 , x2 ) = x1 x2 + x1 + x2 .

4. Consider the following three consumers:

The utility function of consumer 1, 2, and, 3 are given by u1 (x1 , x2 ) = x21 x82 , u2 (x1 , x2 ) =
x1 x2 , and , u3 (x1 , x2 ) = x81 x22 respectively.

(a) For each consumer calculate the marginal rate of substitution (MRS) of good x1
for good x2 .
Solution: Let M RSi is the marginal rate of substitution of good x1 fpr good x2
for i = 1, 2, 3.
M U x1 x2
M RS1 = =
M U x2 4x1
M U x1 x2
M RS2 = =
M U x2 x1
M U x1 4x2
M RS3 = =
M U x2 x1
(b) What are the marginal rate of substitution (MRS) of all 3 consumers at consump-
tion bundle (3, 3)? Which consumer like more good x1 ?
Solution: Let M RSi is the marginal rate of substitution of good x1 for good x2
for i = 1, 2, 3.
1
M RS1 =
4
M RS2 = 1
M RS3 = 4

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 (c) Assume these consumers face the same price p1 = 10 and p2 = 5. Also assume
consumer 1 has income m1 = 50, consumer 2 has income m2 = 100 and con-
sumer 3 has income m3 = 400. Find the optimal consumption bundle of all three
consumers.
Solution: Budget line is 10x1 + 5x2 = 50 for each consumer.
x2
Consumer 1 : =2 =⇒ x2 = 8x1 . Substituting this into budget line we get
4x1
x1 = 1, x2 = 8
x2
Consumer 2 : =2 =⇒ x2 = x1 . Substituting this into budget line we get
x1
x1 = 2.5, x2 = 5
4x2
Consumer 3 : =2 =⇒ x1 = 2x2 . Substituting this into budget line we get
x1
x1 = 4, x2 = 2

5. Hari’s utility function is U (x; y) = (x + 2)(y + 6), where x is the number of cookies
and y is the number of glasses of milk that he consumes.

(a) What is the slope of Hari’s indifference curve at the point where he is consuming
the bundle (4; 6)?
Solution:
y+6
Slope of indifference curve = − M Ux
M Uy
= − x+2 = −2
(b) The indifference curve through the point (4; 6) passes through the points (· · · · · · , 0),
(7, · · · · · · ), and (2, · · · · · · ).
Solution: We know that the utility levet at (4, 6) is u = 72. Now we get the
following equation:
72
72 = (x + 2)(y + 6) =⇒ y = −6
x+2

The indifference curve through the point (4; 6) passes through the points (10, 0),
(7, 2), and (2, 12).
(c) Hari currently has the bundle (4; 6). Sarita offers to give Hari 9 glasses of milk
if Hari will give Sarita 3 cookies. If Hari makes this trade, what would be his
consumption bundle after the trade? However, Hari refuses to trade. Was this a
wise decision?
Solution: Hari’s new consumtion bundle after trade is (1, 15). Yes, it is a wise
decision because Hari enjoys lower utility after trade.

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6. Nasia’s utility function is U (x, y) = min{x, y 2 }.
The king will occur at x = y 2 . Thus, the graph will look like

u = 16

u=4

u=1

(a) If Nasia consumes 4 units of x and 3 units of y, what is her utility?

Solution: u = 4
(b) If Nasia consumes 4 units of x and 2 units of y, what is her utility?
Solution: u = 4
(c) If Nasia consumes 5 units of x and 2 units of y, what is her utility?
Solution: u = 4
(d) Suppose the price of x is 1, the price of y is 2, and her income is 8. What bundle
does Nasia choose in this situation?
Solution: We know that x = y 2 . Substituting this into budget line x + 2y = 8,
we get

y 2 + 2y = 8 =⇒ (y + 4)(y − 2) = 0, =⇒ y = 2 and x = 4.

(e) Suppose that the price of x is 10 and the price of y is 15 and Nasia buys 100 units
of x. What is Nasia’s income?
Solution: 10x + 15y = m. Since she buys x = 100, then y = 10. Now her income
is
m = 10 × 100 + 15 × 10 = 1150

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7. Nargis likes to consume fine wine. When the prices of all other goods are fixed at
current levels, Nargis’s demand function for high-quality wine is q = .002m − 0.02p,
where m is her income, p is the price of wine, and q is the number of bottles of wine that
she demands. Nargis’s income is 75, 000 rupees, and the price of a bottle of suitable
wine is 3000 rupees.

(a) How many bottles of wine will Nargis buy?

Solution:
q = 0.002 × 75000 − 0.02 × 3000 = 90
(b) If the price of wine rose to 4000 rupees, how much income would Nargis have to
have in order to be exactly able to afford the amount of wine and the amount of
other goods that she bought before the price change? At this income, and a price
of 4000 rupees, how many bottles would Nargis buy?
Solution:
∆m = 90 × ∆p = 9000
Thus, she requires 84,000 to main old consumtion. She will buy 88 bottles.
(c) At her original income of 75,000 rupees and a price of 4000 rupees, how much
wine would Nargis demand?
Solution: She will demand 70 bottles.
(d) What are the substitution and income effects?
Solution:
When the price of wine rose from 3000 to 4000, the number of bottles that Nargis
demanded decreased by 20. The substitution effect reduced his demand by 2
bottles and the income effect reduced his demand by 18 bottles.

8. Shu buys two goods, food F and clothing C, with the utility function U = F C + F .
She has an income of 20. The price of clothing is 4.

(a) Derive the equation representing Shu’s demand for food, and draw this demand
curve for prices of food ranging between 1 and 6.
Solution:
12
F =
pF
(b) Calculate the income and substitution effects on Shu’s consumption of food when
the price of food rises from 1 to 4, and draw a graph illustrating these effects.
Your graph need not be exactly to scale, but it should be consistent with the data.
Solution: Shu’s consumtion of food and clothing when price is pC = 4 and pF = 1
is C = 2 and F = 12.

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 After price change shu’s consmtion of food and clothing is C = 2 and F = 3.
At intital price Shu’s utility is u = 2×12+12 = 36. For intermediate consumption
bundle she has to maintain utility 36 at indermediate budget line with slope
4/4 = 1. Thus, the intermediate solution is F = 6 and C = 5
The substitution effect is 6 and income effect is 3.
(c) Determine the numerical size of the compensating variation (in monetary terms)
associated with the increase in the price of food from 1 to 4.
Solution: CV = 24

9. (Challenging) A consumer’s preferences are captured by the utility function

u(x1 , x2 ) = xα1 x21−α (0 < α < 1)

where x1 is the amount (in Rupees) she spends on her own needs and x2 is the amount
she donates to charity. The consumer’s (before-tax) income m is subject to a propor-
tional income tax at rate t (0 < t < 1).

(a) Derive the optimal choice of own consumption and charitable donations as func-
tions of t and other parameters of the model. How does a tax cut (reduction in
t) affect the size of charitable donations?
Solution: The budget constraint is: x1 + x2 = (1 − t)m. The tangency condition:
M Ux αx2 (1 − α)
= =1 =⇒ x2 = x1
M Uy (1 − α)x1 α
Substituting this in the budget constrain and solving for x1 and x2
(1 − α)
x1 + x1 = (1 − t)m =⇒ x1 = α(1 − t)m, x2 = (1 − α)(1 − t)m
α
(b) Now suppose charitable donations are tax deductible, i.e., for every rupee given to
charity, the individual can claim a refund of Rs t from the Income tax department,
which she can spend on her own needs. Once again, set up the optimization
problem and derive the choices of x1 and x2 as functions of t and other parameters.
What is the effect of a tax cut (reduction in t) on charitable donations in this
scenario?
Solution: Since you get a tax rebate, the budget constraint is:

x1 + x2 = (1 − t)m + tx2 =⇒ x1 + (1 − t)x2 = (1 − t)m

Now the tangency condition implies that
αx2 1 (1 − α)
= =⇒ (1 − t)x2 = x1
(1 − α)x1 1−t α

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 Substituting this in the budget constrain and solving for x1 and x2

(1 − α)
x1 + x1 = (1 − t)m =⇒ x1 = α(1 − t)m, x2 = (1 − α)m
α

(c) Give an interpretation of the difference in results between parts (a) and (b) in
terms of income and substitution effects.
Solution: A tax cut makes own consumption cheaper and hence the substitution
e¤ect tends to increase selfish spending and reduce donations. However, the tax
cut also leaves more disposable income in the agent’s pocket and so the income ef-
fect tends to increase donations. For Cobb-Douglas utility, the two effects exactly
cancel each other out.

10. A firm is required to produce 100 units of output using quantities of labor and capital
(L, K) = (7, 6). For each of the following production functions, state whether it is
possible to produce the required output with the given input combination. If it is
possible, state whether the input combination is technically efficient or inefficient.

(a) Q = 7L + 8K
√
(b) Q = 20 KL
(c) Q = min(16L, 20K)
(d) Q = 2(KL + L + 1)

11. A firm’s production function is Q = 5L2/3 K 1/3

(a) Does this production function exhibit constant, increasing, or decreasing returns
to scale?
(b) What is the marginal rate of technical substitution of L for K for this production
function?
(c) What is the elasticity of substitution for this production function?