Chapter 6 Solutions

S O L U T I O N S
6
Doing the “Best” We Can
Solutions for Microeconomics: An Intuitive

Approach with Calculus (International Ed.)
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Doing the “Best” We Can 134
6.1 Grits and Cereal: In end-of-chapter exercise 4.4, I described my dislike for grits and my fondness for
Coco Puffs Cereal.
A: In part A of exercise 4.4, you were asked to assume that my tastes satisfy convexity and continuity
and then to illustrate indifference curves on a graph with grits on the horizontal axis and cereal on
the vertical.
(a) Now add a budget constraint (with some positive prices for grits and cereal and some exoge-
nous income I for me). Illustrate my optimal choice given my tastes.
Answer: This is depicted in panel (a) of Graph 6.1 where higher indifference curves occur
to the northwest with fewer grits and more cereal. The highest indifference curve that still
contains a bundle within the budget set is then a corner solution at point A. This should
make sense — if I don’t like grits but do like cereal, I should spend no money on grits.
Graph 6.1: Grits and Cereal
(b) Does your answer change if my tastes are non-convex (as in part (b) of exercise 4.4A)?
Answer: No — the same corner solution would arise since I still don’t like grits and therefore
won’t buy any at positive prices. This is illustrated in panel (b) of the graph.
(c) In part (c) of exercise 4.4A, you were asked to imagine that I hate cereal as well and that my
tastes are again convex. Illustrate my optimal choice under this assumption.
Answer: Panel (c) of the graph illustrates optimization in this case where higher indifference
curves lie further to the southwest with fewer grits and less cereal. The optimum would be
at (0,0) — I would not spend any money since I dislike consuming both cereal and grits.
(d) Does your answer change when my tastes are not convex (as in part (d) of exercise 4.4A)?
Answer: No, it would not change — moving southwest would still be optimal until one gets
to (0,0) since I still dislike both cereal and grits.
B: In part B of exercise 4.4 you derived a utility function that was consistent with my dislike for grits.
(a) Can you explain why the Lagrange method will not work if you used it to try to solve the
optimization problem using this utility function?
Answer: The Lagrange method identifies points at which indifference curves are tangent to
budget lines. But the solution in this case is a corner solution where there is no tangency.
Thus, the Lagrange method cannot be employed to solve this problem.
(b) What would the Lagrange method offer as the optimal solution if you used a utility function
that captured a dislike for both grits and cereal when tastes are non-convex? Illustrate your
answer using u(x 1 , x 2 ) = −x 1 x 2 and graph your insights.
Answer: The Lagrange function for this problem is
L (x 1 , x 2 ,λ) = −x 1 x 2 + λ(I − p 1 x 1 − p 2 x 2 ), (6.1)
which gives as its first two first order conditions

135 Doing the “Best” We Can
−x 2 = λp 1 and − x 1 = λp 2 . (6.2)
Dividing these by each other, we get x 2 /x 1 = p 1 /p 2 or x 2 = (p 1 /p 2 )x 1 . Substituting this
into the budget constraint, we get p 1 x 1 + p 2 x 2 = p 1 x 1 + p 2 (p 1 /p 2 )x 1 = 2p 1 x 1 = I which
solves to x 1 = I /(2p 1 ). Substituting back into x 2 = (p 1 /p 2 )x 1 , we also get x 2 = I /(2p 2 ).
This is exactly the same solution that we would get if we had maximized the utility func-
tion u(x 1 , x 2 ) = x 1 x 2 where both goods are “goods” rather than “bads”. That is because the
Lagrange method simply looks for tangencies — and we have not changed the map of in-
difference curves by multiplying the utility function by −1 — all we have done is change the
ordering.
Put differently, the Lagrange method finds a bundle like A in panel (a) of graph 6.2 — but
that is not an optimum because I can jump to higher indifference curves by moving south-
west in the graph toward the origin. In fact, the Lagrange method has found the lowest
possible utility I can get while still being in the choice set.
Graph 6.2: Grits and Cereal: Part 2
(c) What would the Lagrange method offer as a solution if a utility function that captures a dis-
like for both grits and cereal represented convex tastes? Illustrate your answer using the func-
tion u(x 1 , x 2 ) = −x 12 − x 22 and show what happens graphically.
Answer: The method would again identify tangencies — and thus would find a bundle like B
in panel (b) of Graph 6.2. Of course that is again not an optimum because better bundles lie
to the southwest. For the utility function u(x 1 , x 2 ) = −x 12 − x 22 , the Lagrange function would
be
L (x 1 , x 2 ,λ) = −x 12 − x 22 + λ(I − p 1 x 1 − p 2 x 2 ) (6.3)

with the first two first order conditions giving
−2x 1 = λp 1 and − 2x 2 = λp 2 . (6.4)

Dividing these by each other, we get x 1 /x 2 = p 1 /p 2 or x 1 = p 1 x 2 /p 2 . Substituting into the
budget constraint and solving for x 2 (and then substituting back into x 1 = p 1 x 2 /p 2 ) we get
I p2 I p1
x2 = and x 1 = . (6.5)
p 12 + p 22 p 12 + p 22
Thus, the math gives us an interior solution on the budget constraint where an indifference
curve is tangent — but the real solution is to consume nothing (which gives utility of zero as
opposed to negative utility from positive consumption.)
6.2 Coffee, Milk and Sugar: Suppose there are three different goods: cups of coffee (x 1 ), ounces of milk (x 2 )
and packets of sugar (x 3 ).
A: Suppose each of these goods costs 25 cents and you have an exogenous income of $15.
(a) Illustrate your budget constraint in three dimensions and carefully label all intercepts.
Answer: At 25 cents a piece, I can buy as much as 60 of any one of the goods with $15
assuming I don’t buy anything else. Thus, panel (a) in Graph 6.3 has intercept of 60 on each
axis (which makes all the slopes equal to −1.)
Graph 6.3: Coffee, Milk and Sugar
(b) Suppose that the only way you get enjoyment from a cup of coffee is to have at least one ounce
of milk and one packet of sugar in the coffee, the only way you get enjoyment from an ounce
of milk is to have at least one cup of coffee and one packet of sugar, and the only way you get
enjoyment from a packet of sugar is to have at least one cup of coffee and one ounce of milk.
What is the optimal consumption bundle on your budget constraint.
Answer: The three goods are therefore perfect complements. This would mean that you
would want to consume equal amounts of all three goods — which, given the prices and
income, you would do when x 1 = x 2 = x 3 = 20. Put differently, you would want to consume
20 perfectly balanced cups of coffee (with an ounce of milk and a packet of sugar in each).
(c) What does your optimal indifference curve look like?
Answer: The indifference curve has a corner along the ray from the origin on which all goods
are represented in identical quantities. The rest of the indifference “curve” is composed of
planes parallel to each of the planes formed by the axes in the graph but ending at the cor-
ner. Panel (b) of Graph 6.3 is an attempt to graph this. Essentially, the indifference “curve”
is like three sides of a box with the corner of the box pointing toward the origin and located
along the ray that holds all goods equal to one another.
(d) If your income falls to $10 — what will be your optimal consumption bundle?
Answer: You would still want to consume the three goods in equal amounts — which means
now you could consume 2/3 of what you did before. Before, you were able to consume 20
cups of coffee (with milk and sugar). Now you can only consume 40/3=13.33 cups (with milk
and sugar).
(e) If instead of a drop in income the price of coffee goes to 50 cents,how does your optimal bundle
change?
Answer: Because the goods are perfect complements, it would still need to be the case that
you buy the same quantity of each of the goods. Thus, 0.5x 1 + 0.25x 2 + 0.25x 3 = 15 but
x 1 = x 2 = x 3 at any optimum. Thus, letting x denote the quantity of each of the goods,
0.5x + 0.25x + 0.25x = 15 or x = 15. Thus, you would drink 15 cups of coffee with milk and
sugar.
(f) Suppose your tastes are less extreme and you are willing to substitute some coffee for milk,
some milk for sugar and some sugar for coffee. Suppose that the optimal consumption bundle
you identified in (b) is still optimal under these less extreme tastes. Can you picture what the
optimal indifference curve might look like in your picture of the budget constraint?
Answer: The indifference “curve” would still point toward the origin but would now be more
“bowl-shaped” rather than “box-shaped” since the corner on the indifference curve would
become smooth.
(g) If tastes are still homothetic (but of the less extreme variety discussed in (f)), would your an-
swers to (d) or (e) change?
Answer: If 20 cups of coffee with 20 ounces of milk and 20 packets of sugar is optimal under
the original income of $15, and if tastes are homothetic, then the ratio of the goods will
remains the same if income changes. Thus, the answer to (d) does not change — you would
consume 13.33 cups of coffee with as many sugars and ounces of milk when income falls
to $10. But when opportunity costs change — as in (e) where the price of a cup of coffee
doubles, you will now substitute away from coffee and toward milk and sugar. Thus, you
would drink fewer cups of coffee than we concluded in (e), but the coffee would be lighter
(because of more milk) and sweeter (because of more sugar).
B: Continue with the assumption of an income of $15 and prices for coffee, milk and sugar of 25
cents each.
(a) Write down the budget constraint.
Answer: 0.25x 1 + 0.25x 2 + 0.25x 3 = 15.
(b) Write down a utility function that represents the tastes described in A(b).
Answer: u(x 1 , x 2 , x 3 ) = min{x 1 , x 2 , x 3 }.
(c) Suppose that instead your tastes are less extreme and can be represented by the utility function
β
u(x 1 , x 2 , x 3 ) = x 1α x 2 x 3 . Calculate your optimal consumption of x 1 , x 2 and x 3 when your
economic circumstances are described by the prices p 1 , p 2 and p 3 and income is given by I .
Answer: It becomes notationally a bit easier to just take the log of the utility function before
doing this problem. Thus, we can use the function v(x 1 , x 2 , x 3 ) = α ln x 1 +βln x 2 +ln x 3 . This
gives us an optimization problem that can be written as
max α ln x 1 + βln x 2 + ln x 3 subject to p 1 x 1 + p 2 x 2 + p 3 x 3 = I . (6.6)

x 1 ,x 2 ,x 3
The Lagrange function for this problem is
L (x 1 , x 2 , x 3 ,λ) = α ln x 1 + βln x 2 + ln x 3 + λ(I − p 1 x 1 + p 2 x 2 + p 3 x 3 ), (6.7)
which gives us first order conditions of
α
= λp 1
x1
β
= λp 2
x2 (6.8)
1
= λp 3
x3
p1 x1 + p2 x2 + p3 x3 = I .
Solving the third equation for λ and substituting this into the first and second equations, we
can solve for x 1 and x 2 to get
αp 3 x 3 βp 3 x 3
x1 = and x 2 = . (6.9)
p1 p2
We can then substitute these into the final first order condition (which is equal to the budget
constraint) to get
αp 3 x 3 βp 3 x 3
p1 x1 + p2 x2 + p3 x3 = p1 + p2 + p 3 x 3 = (α + β + 1)p 3 x 3 = I . (6.10)
p1 p2
Solving for x 3 , and then using this to plug into equations (6.9), gives
αI βI I
x1 = , x2 = and x 3 = . (6.11)
(α + β + 1)p 1 (α + β + 1)p 2 (α + β + 1)p 3
(d) What values must α and β take in order for the optimum you identified in A(b) to remain the
optimum under these less extreme tastes?
Answer: In A(b), p 1 = p 2 = p 3 = 0.25 and I = 15. Thus, the solutions in (6.11) become
60α 60β 60
x1 = , x2 = and x 3 = . (6.12)
(α + β + 1) (α + β + 1) (α + β + 1)
In order for the solution to be x 1 = x 2 = x 3 = 20 as in A(b), this implies that α = β = 1.
(e) Suppose α and β are as you concluded in part B(d). How does your optimal consumption
bundle under these less extreme tastes change if income falls to $10 or if the price of coffee
increases to 50 cents? Compare your answers to your answer for the more extreme tastes in
A(d) and (e).
Answer: Using α = β = 1 as we have just concluded, the expressions become x 1 = I /(3p 1 ),
x 2 = I /(3p 2 ) and x 3 = I /(3p 3 ). Substituting p 1 = p 2 = p 3 = 0.25 and I = 10, we get x 1 =
x 2 = x 3 = 13.33 which is identical to what we concluded in A(d) under the more extreme
tastes. Substituting p 1 = 0.50, p 2 = p 3 = 0.25 and I = 15, on the other hand, we get x 1 = 10,
x 2 = 20 and x 3 = 20. This differs from the answer in A(e) where no substitutability between
the goods was permitted — now you end up drinking less coffee but with more milk and
sugar in each cup.
(f) True or False: Just as the usual shapes of indifference curves represent two dimensional “slices”
of a 3-dimensional utility function, 3-dimensional “indifference bowls” emerge when there
are three goods — and these “bowls” represent slices of a 4-dimensional utility function.
Answer: This is true. The utility function with three goods can be plotted in 4 dimensions
— one for each good and one to indicate the utility level of each bundle — but the indiffer-
ence “curves” hold utility fixed and can therefore be represented in 3 dimensions. This is
analogous to slicing a 3 dimensional utility function with two goods to get two dimensional
indifference curves.
6.3 Coffee, Coke and Pepsi: Suppose there are three different goods: cans of Coke (x 1 ), cups of coffee (x 2 )
and cans of Pepsi (x 3 ).
A: Suppose each of these goods costs the same price p and you have an exogenous income I .
(a) Illustrate your budget constraint in three dimensions and carefully label all intercepts and
slopes.
Answer: Panel (a) of Graph 6.4 illustrates the budget constraint. Each intercept is simply I
divided by the price p which is the same for all three goods. All slopes are −1.
Graph 6.4: Coffee, Coke and Pepsi
(b) Suppose each of the three drinks has the same caffeine content, and suppose caffeine is the
only characteristic of a drink you care about. What do “indifference curves” look like?
Answer: This implies that all three goods are perfect substitutes for one another — which
means the MRS between any two of them (holding the third fixed) is always exactly −1.
Thus, the indifference curves would be planes that look very much like the budget con-
straint graphed in panel (a). In fact, there is one indifference curve that lies exactly on this
budget constraint, with all other indifference curves parallel to that plane.
(c) What bundles on your budget constraint would be optimal?
Answer: Since, when all three goods have the same prices, the slopes of the budget con-
straint are exactly identical to the slopes of the indifference planes, all bundles on the bud-
get constraint are optimal. In other words, there is an indifference plane that lies exactly on
top of the budget plane. This should make sense — if the three goods are perfect substitutes
and they all cost the same, then it does not matter which combination you buy because they
are all the same to you.
(d) Suppose that Coke and Pepsi become more expensive. How does your answer change? Are you
now better or worse off than you were before the price change?
Answer: Panel (b) illustrates the new budget with the plane created by the dashed lines. The
new budget shares one point in common with the original budget — the point at which all
income is spent on coffee (since the price of coffee has not changed). Since the indifference
planes look like the budgets before the price change, the plane formed by the solid lines
is both the original budget (before the price change) and the highest possible indifference
plane you can get to and still have it contain a point in your new (dashed) budget. That
optimal point contains only coffee — and it gives you the same utility as you had before the
price change (since it appears on the same indifference curve). Again, that should make
sense — when coffee is cheaper than Coke and Pepsi but is perfectly substitutable for Coke
and Pepsi, you should spend all your income on coffee. And when all three are initially
equally priced and then two become more expensive, you do not become worse off because
you can still consume the same quantity of a good that is perfectly substitutable for the ones
whose price has gone up.
B: Assume again that the three goods cost the same price p.
(a) Write down the equation of the budget constraint you drew in part A(a).
Answer: px 1 + px 2 + px 3 = I .
(b) Write down a utility function that represents the tastes described in A(b).
Answer: u(x 1 , x 2 , x 3 ) = x 1 + x 2 + x 3 .
(c) Can you extend our notion of homotheticity to tastes over three goods? Are the tastes repre-
sented by the utility function you derived in (b) homothetic?
Answer: Homotheticity would now mean that, along any ray from the origin (where that ray
can be along any plane where one of the goods is held at zero or it can vary all three goods at
the same time), the MRS’s in all direction (i.e. always holding one of the goods fixed) are the
same along that ray. This clearly holds for perfect substitutes where all MRS’s between any
two goods at all bundles is always identical. The tastes represented by our utility function
in (b) are therefore homothetic.
6.4 Inferring Tastes for Roses (and Love) from Behavior: I express my undying love for my wife through
weekly purchases of roses that cost $5 each.
A: Suppose you have known me for a long time and you have seen my economic circumstances
change with time. For instance, you knew me in graduate school when I managed to have $125
per week in disposable income that I could choose to allocate between purchases of roses and “other
consumption” denominated in dollars. Every week I brought 25 roses home to my wife.
(a) Illustrate my budget as a graduate student — with roses on the horizontal and “dollars of
other consumption” on the vertical axis. Indicate my optimal bundle on that budget as A.
Can you conclude whether either good is not “essential”?
Answer: Graph 6.5 illustrates a number of different budget constraints for this problem,
including the one described in this part — which starts at $125 on the vertical axis and ends
at 25 roses on the horizontal axis. Thus, I am spending all my income on roses — which
implies other goods are not essential for me.
Graph 6.5: Love and Roses
(b) When I became an assistant professor, my disposable income rose to $500 per week, and the
roses I bought for my wife continued to sell for $5 each. You observed that I still bought 25
roses each week. Illustrate my new budget constraint and optimal bundle B on your graph.
From this information, can you conclude whether my tastes might be quasilinear in roses?
Might they not be quasilinear?
Answer: The new budget constraint is the one starting at $500 on the vertical axis and ending
at 100 roses on the horizontal. The new optimal B lies exactly above the original optimal A.
These tastes could be quasilinear — it is possible that the MRS at A is exactly equal to the
MRS at B . But tastes might also not be quasilinear because the MRS at A could in fact be
larger in absolute value (i.e. the slope could be steeper) at A than at B — which would still
make the corner solution at A optimal.
(c) Suppose for the rest of the problem that my tastes in fact are quasilinear in roses. One day
while I was an assistant professor, the price of roses suddenly dropped to $2.50. Can you
predict whether I then purchased more or fewer roses?
Answer: The new budget line is the one beginning at $500 on the vertical axis and ending
at 200 roses on the horizontal. The bundle that lies on this budget line and directly above
B must have an MRS that is the same as the MRS that goes through B if tastes are indeed
quasilinear. But that implies that the indifference curve through that point cuts the budget
line from above — making bundles to the right more preferred. Thus, I can conclude I will
consume more roses when the price of roses falls.
(d) Suppose I had not gotten tenure — and the best I could do was rely on a weekly allowance of
$50 from my wife. Suppose further that the price of roses goes back up to $5. How many roses
will I buy for my wife per week?
Answer: This budget constraint begins at $50 on the vertical axis and ends at 10 roses on
the horizontal. If tastes are indeed quasilinear, the MRS at the corner bundle C is larger
in absolute value (i.e. the slope is steeper) than it is at A or B . Thus, if A was an optimum
under the higher budget, C must be an optimum under the lower income. I will therefore
buy 10 roses per week.
(e) True or False: Consumption of quasilinear goods always stays the same as income changes.
Answer: This is almost true but not quite. As we have shown, once we reach the corner so-
lution where we are only consuming the quasilinear good, we will reduce our consumption
of that good as income falls (because we just don’t have enough income to keep buying the
same amount).
(f) True or False: Over the range of prices and incomes where corner solutions are not involved,
a decrease in price will result in increased consumption of quasilinear goods but an increase
in income will not.
Answer: This is true. We have demonstrated in part (c) that decreases in prices will lead to
increased consumption of the quasilinear good. We also know that, for quasilinear goods,
the MRS stays constant along any consumption level of the other good — which implies
that the tangency of the budget line and the optimal indifference curve remains at the
same level of the quasilinear good as income increases (because increases in income do
not change the slope of budget constraints and thus don’t change the slope of the optimal
indifference curve at the optimum so long as we are not at corner solutions).
B: Suppose my tastes for roses (x 1) and other goods (x 2 ) can be represented by utility function u(x 1 , x 2 ) =
βx 1α + x 2 .
(a) Letting the price of roses be denoted by p 1 , the price of other goods by 1, and my weekly income
by I , determine my optimal weekly consumption of roses and other goods as a function of p 1
and I .
Answer: The Lagrange function for this optimization problem is
L (x 1 , x 2 ,λ) = βx 1α + x 2 + λ(I − p 1 x 1 − x 2 ). (6.13)

The first two first order conditions are
αβx 1α−1 = λp 1
(6.14)
1 = λ.
Replacing λ with 1 in the first equation and solving for x 1 , we get

µ ¶ µ ¶
p 1 1/(α−1) αβ 1/(1−α)
x1 = = (6.15)
αβ p1
and substituting this into the budget constraint and solving for x 2 , we get
µ ¶
αβ 1/(1−α) αβ 1/(1−α)
x2 = I − p1 =I− α . (6.16)
p1 p1
Note that x 1 is not a function of I — the optimal level of the quasilinear good is indepen-
dent of I (so long as the Lagrange method applies — i.e. so long as we are not at a corner
solution).
(b) Suppose β = 50 and α = 0.5. How many roses do I purchase when I = 125 and p 1 = 5? What
if my income rises to $500?
Answer: Substituting β = 50, α = 0.5, I = 125 and p 1 = 5 into equations (6.15) and (6.16), we
get x 1 = 25 and x 2 = 0, exactly like point A in our graph. When we replace income by $500,
we get x 1 = 25 and x 2 = 375, again exactly as in our graph.
(c) Comparing your answers to your graph from part A, could the actions observed in part A(b)
be rationalized by tastes represented by the utility function u(x 1 , x 2 )? Give an example of
another utility function that can rationalize the behavior described in part A(b).
Answer: Yes, as we just showed, the utility function gives us the same optimal consumption
levels as those graphed in Graph 6.5. Any order preserving transformation of the utility
¡ ¢2
function will similarly rationalize this behavior — as, for instance, v(x 1 , x 2 ) = βx 1α + x 2 .
(d) What happens when the price of roses falls to $2.50? Is this consistent with your answer to
part A(c)?
Substituting β = 50, α = 0.5, I = 500 and p 1 = 2.5 into equations (6.15) and (6.16), we get
x 1 = 100 and x 2 = 250 — which is consistent with the answer we gave in A(c), i.e. the answer
that I will buy more roses when the price falls.
(e) What happens when my income falls to $50 and the price of roses increases back to $5? Is
this consistent with your answer to part A(d)? Can you illustrate in a graph how the math is
giving an answer that is incorrect?
Graph 6.6: Love and Roses: Part 2
Answer: Substituting β = 50, α = 0.5, I = 50 and p 1 = 5 into equations (6.15) and (6.16), we
get x 1 = 25 and x 2 = −75. This can’t be a true optimum because it would involve a negative
consumption level for other goods. Graph 6.6 illustrates what is happening — that math
picks out bundle A in the graph because that is where an indifference curve extended into
the negative “other goods” quadrant is tangent to a budget line that is similarly extended.
The negative value for “other goods” suggests that there is a corner solution that is missed
by the math because there is no tangency at that solution. This solution, we know from our
intuition, is the bundle B =(10,0). The indifference curve through that bundle has a steeper
slope than the budget constraint as we can see by calculating the MRS for this utility func-
tion. Applying our formula for MRS, we get MRS = −αβx 1α−1 which, when α = 0.5, β = 50
and x 1 = 10 is substituted into it, implies that the MRS at x 1 = 10 is −7.91 while we know the
budget constraint has a slope of just −5. Thus, the answer given by the math is just wrong
because there is a corner solution, but the corner solution it points us to is exactly the one
we arrived at in part A(d).
6.5 Everyday Application: Different Interest Rates for Borrowing and Lending: You first analyzed in-
tertemporal budget constraints with different interest rates for borrowing and saving (or lending) in end-
of-chapter exercise 3.7.
A: Suppose that you have an income of $100,000 now and you expect to have an income of $300,000
10 years from now, and suppose that the interest rate for borrowing from the bank is twice as high as
the interest rate the bank offers for savings.
(a) Begin by drawing your budget constraint with “consumption now” and “consumption in 10
years” on the horizontal and vertical axes. (Assume for purposes of this problem that your
consumption in the intervening years is covered and not part of the analysis.)
Answer: Suppose that the interest rate for savings is r S while the interest rate for borrowing
is r B — with r S < r B . Panel (a) of Graph 6.7 then illustrates that this results in an outward
kink of the intertemporal budget constraint at point E.
Graph 6.7: Different Interest Rates for Borrowing and Lending
(b) Can you explain why, for a wide class of tastes, it is rational for someone in this position not
to save or borrow?
Answer: The larger the difference between r S and r B , the sharper the kink at point E in panel
(a) of the graph. And the sharper the kink, the greater the range of slopes of the indifference
curves at E that would make it optimal to consume at E — which is equivalent to neither
borrowing nor lending. Panel (b) of the graph illustrates two such indifference curves —
with very different slopes — that are both consistent with this.
(c) Now suppose that the interest rate for borrowing was half the interest rate for saving. Draw
this new budget constraint.
Answer: Panel (a) of Graph 6.8 (next page) illustrates that the kink at E would now point
inward.
(d) Illustrate a case where it might be rational for a consumer to flip a coin to determine whether
to borrow a lot or to save a lot.
Answer: If the consumer flips a coin, she must be indifferent between borrowing and saving.
Thus, she has two optimal bundles — as illustrated in panel (b) of Graph 6.8. At A, she saves
a large fraction of her current income and consumes it in the future; at B she borrows a large
fraction of future income and consumes it now.
B: Suppose that your incomes are as described in part A and that the annual interest rate for borrow-
ing is 20% and the annual interest rate for saving is 10%. Also, suppose that your tastes over current
consumption c 1 and consumption 10 years from now c 2 can be captured by the utility function
u(c 1 ,c 2 ) = c 1α c 2(1−α) .
(a) Assuming that interest compounds annually, what are the slopes of the different segments of
the budget constraint that you drew in A(a)? What are the intercepts?
Graph 6.8: Different Interest Rates for Borrowing and Lending
Answer: The slope of the line segment above E is −(1+0.1)10 = −2.594 while the slope of the
line segment below E is −(1+0.2)10 = −6.192. If you save $100,000 for 10 years at an interest
rate of 10% compounded annually, then you will have $100,000(1 + 0.1)10 = $259,374 in
the bank 10 years from now. Added to the $300,000 you will earn in 10 years, this makes
for an intercept of $559,374 on the c 2 axis. If you borrow on $300,000 expected income 10
years from now at a 20% interest rate, on the other hand, you can only borrow $300,000/(1+
0.2)10 ) = $48,452. Added to the $100,000 in current income, that makes for a c 1 intercept of
$148,452.
(b) For what ranges of α is it rational to neither borrow nor save?
Answer: The marginal rate of substitution for these tastes is
αc 2
MRS = − . (6.17)
(1 − α)c 1
At the kink point E = (100000,300000), this reduces to
300000α 3α
MRS(100000,300000) = − =− . (6.18)
100000(1 − α) (1 − α)
In order for E to be optimal, it must be that the MRS at E falls between the shallower slope
of the budget constraint above E and the steeper slope below E. In part (a), we concluded
that the former is −2.594 and the latter is −6.192. The MRS at bundle E then falls between
these values so long as 0.4637 < α < 0.6736.
6.6 Pizza and Beer: Sometimes we can infer something about tastes from observing only two choices un-
der two different economic circumstances.
A: Suppose we consume only beer and pizza (sold at prices p 1 and p 2 respectively) with an exoge-
nously set income I .
(a) With the number of beers on the horizontal axis and the number of pizzas on the vertical,
illustrate a budget constraint (clearly labeling intercepts and the slope) and some initial op-
timal (interior) bundle A.
Answer: Panel (a) of Graph 6.9 illustrates the original budget line containing the optimal
bundle A.
Graph 6.9: Beer and Pizza
(b) When your income goes up, I notice that you consume more beer and the same amount of
pizza. Can you tell whether my tastes might be homothetic? Can you tell whether they might
be quasilinear in either pizza or beer?
Answer: The shift in income is also indicated in panel (a), with the new optimal bundle
B containing more beer but the same amount of pizza. Since the two indifference curves
have the same MRS along the horizontal line that holds pizza fixed at its original quantity,
the tastes might indeed be quasilinear in pizza. But the tastes could not be homothetic —
because, on the ray that passes through A from the origin, the MRS is greater in absolute
value along the higher indifference curve than along the lower. The only way this would
not be the case is if pizza and beer were perfect substitutes and the price of pizza is the
same as the price of beer. In that case, all points on both budgets are optimal — including
A initially and B after the income change. This would be the one case where tastes are both
quasilinear and homothetic.
(c) How would your answers change if I had observed you decreasing your beer consumption
when income goes up?
Answer: If I simply would have observed a decrease in your beer consumption, I could say
for sure that your tastes are not quasilinear in beer (unless beer and pizza are perfect substi-
tutes and prices happen to be such that the slopes of the budget constraints are equal to the
MRS everywhere). I could similarly conclude that your tastes are not quasilinear in pizza
— because, if you consume less beer with an increase in income, you must be consuming
more pizza (if pizza and beer is all you consume). Finally, I could also say for sure that your
tastes are not homothetic — because under homothetic tastes, consumption of all goods
goes up with increases in income. Again, the one exception is the case where pizza and beer
are perfect substitutes with MRS equal to the slopes of the budgets. In that case, we would
again have tastes that are both quasilinear and homothetic.
(d) How would your answers change if both beer and pizza consumption increased by the same
proportion as income?
Answer: This case is graphed in the second panel of Graph 6.9. The original bundle A and
the new optimal bundle B lie on the same ray from the origin — with the indifference curves
at both bundles tangent to the same slope. Thus, along this ray, the two indifference curves
we know about have the same slope — which is consistent with tastes being homothetic.
But the vertical and horizontal lines through A will contain bundles along u B where the
MRS differs from that at A — which implies that the tastes are not quasilinear, at least so
long as we rule out the special case that the goods are perfect substitutes and the ratio of
prices happens to be such that the budget lines have the same slope as the indifference
curves everywhere.
B: Suppose your tastes over beer (x 1) and pizza (x 2 ) can be summarize by the utility function u(x 1 , x 2 ) =
x 12 x 2 and that p 1 =2, p 2 =10 and weekly income I =180.
(a) Calculate your optimal bundle A of weekly beer and pizza consumption by simply using the
fact that, at any interior solution, MRS = −p 1 /p 2 .
Answer: Using the fact that we know MRS = −p 1 /p 2 = −2/10 = −1/5 at the optimum, we
can write
∂u/∂x 1 2x 1 x 2 2x 2 1
MRS = − =− =− =− , (6.19)
∂u/∂x 2 x2 1
x1 5
and the last equality can be written as x 2 = x 1 /10. Plugging this into the budget constraint
180 = 2x 1 + 10x 2 , we get
x1
180 = 2x 1 + 10 = 3x 1 , (6.20)
10
which solves to x 1 = 60. Plugging this back into x 2 = x 1 /10, we also get x 2 = 6.
(b) What numerical label does this utility function assign to the indifference curve that contains
your optimal bundle?
Answer: u(60,6) = (602 )(6) = 21,600.
(c) Set up the more general optimization problem where, instead of using the prices and income
given above, you simply use p 1 , p 2 and I . Then, derive your optimal consumption of x 1 and
x 2 as a function of p 1 , p 2 and I .
Answer: The more general optimization problem is
max u(x 1 , x 2 ) = x 12 x 2 subject to p 1 x 1 + p 2 x 2 = I , (6.21)

x 1 ,x 2
with corresponding Lagrange function
L (x 1 , x 2 ,λ) = x 12 x 2 + λ(I − p 1 x 1 − p 2 x 2 ). (6.22)
The first two first order conditions are then
2x 1 x 2 = λp 1
(6.23)
x 12 = λp 2 .
Dividing the first by the second equation, we get 2x 2 /x 1 = p 1 /p 2 which can be solved for
x 2 to get x 2 = (p 1 x 1 )/(2p 2 ). Substituting this into the budget constraint I = p 1 x 1 + p 2 x 2
(which is also the third first order condition), we get
p 1 x 1 2p 1 x 1 p 1 x 1 3p 1 x 1
I = p1 x1 + p2 = + = , (6.24)
2p 2 2 2 2
and this can be solved for x 1 as x 1 = 2I /(3p 1 ). Plugging this back into the expression
2x 2 /x 1 = p 1 /p 2 , we can then solve for x 2 as x 2 = I /(3p 2 ).
(d) Plug the values p 1 =2, p 2 =10 and I =180 into your answer to B(c) and verify that you get the
same result you originally calculated in B(a).
Answer: Our solution above was x 1 = 2I /(3p 1 ) and x 2 = I /(3p 2 ). Plugging in the specific
values for prices and income, we therefore get x 1 = 2(180)/(3(2)) = 360/6 = 60 and x 2 =
180/(3(10)) = 180/30 = 6 — 60 beers and 6 pizzas just as we concluded in B(a).
(e) Using your answer to part B(c), verify that your tastes are homothetic.
Answer: You can tell how consumption of each good changes with income by taking the
derivative of x 1 = 2I /(3p 1 ) and x 2 = I /(3p 2 ) with respect to I . This gives
∂x 1 2 ∂x 2 1
= and = . (6.25)
∂I 3p 1 ∂I 3p 2
Thus, as income increases, consumption of both goods increases linearly. Put differently,
as income doubles, consumption of both goods doubles. This is true only for homothetic
tastes where the MRS is the same along rays from the origin — which implies that optimal
bundles lie on rays from the origin as income changes.
(f) Which of the scenarios in A(b) through (d) could be generated by the utility function u(x 1 , x 2 ) =
x 12 x 2 ?
Answer: Only the last scenario in A(d) could be generated by this utility function since we
know it represents homothetic tastes. The scenario in A(b) has tastes that are quasilinear
in pizza, while the scenario in A(c) has beer consumption decreasing with an increase in
income (which is inconsistent with what we derived above).
6.7 Suppose Coke and Pepsi are perfect substitutes for me, and right and left shoes are perfect comple-
ments.
A: Suppose my income allocated to Coke/Pepsi consumption is $100 per month, and my income
allocated to Right/Left shoe consumption is similarly $100 per month.
(a) Suppose Coke currently costs 50 cents per can and Pepsi costs 75 cents per can. Then the price
of Coke goes up to $1 per can. Illustrate my original and my new optimal bundle with Coke
on the horizontal and Pepsi on the vertical axis.
Answer: This is illustrated in panel (a) of Graph 6.10. Budget lines are drawn solid while
indifference curves are drawn with dashed lines. Since Coke and Pepsi are perfect substi-
tutes that I am willing to trade one for one, the MRS is −1 everywhere. The original budget
has slope of −133/200 = −2/3, while the new budget constraint after the price increase has
slope −133/100 = −4/3. Thus, my original budget had slope shallower than my indifference
curves whereas my final budget has a slope that is steeper than my indifference curves.
The highest indifference curve that contains a point in the original choice set is then the
outer indifference curve containing A, whereas the highest indifference curve that contains
a point in the new choice set is the lower indifference curve containing B . Before the price
increase I spend my entire budget on Coke, but after the price increase I spend all of it on
Pepsi. This should make intuitive sense — when Coke is cheaper than Pepsi, I should spend
all my budget on Coke, but when Coke becomes more expensive than Pepsi, I should switch
to spending my entire budget on Pepsi.
Graph 6.10: Coke and Pepsi, Right Shoes and Left Shoes
(b) Suppose right and left shoes are sold separately. If right and left shoes are originally both
priced at $1, illustrate (on a graph with right shoes on the horizontal and left shoes on the
vertical) my original and my new optimal bundle when the price of left shoes increases to $2.
Answer: The change in budget constraints is illustrated in panel (b) of the graph, with an
initial budget that runs from 100 left shoes to 100 right shoes when both cost $1 each and
the final budget running from 50 left shoes to 100 right shoes when the price of left shoes
increases to $2. The optimal indifference curves are then illustrated on each budget con-
straint. Since right and left shoes are perfect complements, it must be that they are con-
sumed as pairs at any consumer optimum. This implies an initial bundle A of 50 pair of
shoes and a final bundle B of 33.33 pair of shoes.
(c) True or False: Perfect complements represent a unique special case of homothetic tastes in the
following sense: Whether income goes up or whether the price of one of the goods falls, the
optimal bundle will always lie on a the same ray emerging from the origin.
Answer: This is true. Since perfect complements are always consumed in pairs, the optimal
consumption level always lies on a ray from the origin. If the complementarity is such that
the goods are consumed in pairs of 1 each, then that ray is the 45-degree line (as in panel
(b)). Thus optimal bundles lie on the 45 degree line for the right shoe/left show case. (If
the complementarity were such that 2 of good 1 is always paired with 1 of good 2, then that
ray is the 30-degree line. In principle, the relevant ray can have any angle from the origin
depending on the rate at which the two goods are paired — but in our example here they
are paired 1 for 1.)
B: Continue with the assumptions about tastes from above.

(a) Write down two utility functions: one representing my tastes over Coke and Pepsi, another
representing my tastes over right and left shoes.
Answer: For Coke and Pepsi, the function u(x 1 , x 2 ) = x 1 + x 2 would work. For right and
left shoes, the function u(x 1 , x 2 ) = min{x 1 , x 2 } would work. These are the simplest possible
utility functions to describe the two sets of preferences. (Of course you could also choose
a variety of transformations of these, transformations like u(x 1 , x 2 ) = 2x 1 + 2x 2 for perfect
substitutes or u(x 1 , x 2 ) = 2min{x 1 , x 2 } for perfect complements.)
(b) Using the appropriate equation derived above, label the two indifference curves you drew in
A(a).
Answer: The higher indifference curve is such that x 1 + x 2 = 200 — thus, the utility function
u(x 1 , x 2 ) = x 1 + x 2 assigns it a label of 200 utils. The lower indifference curve, on the other
hand, is such that x 1 + x 2 = 133.33 — which means it has a label of 133.33 utils.
(c) Using the appropriate equation derived in B(a), label the two indifference curves you drew in
A(b).
Answer: The labels would be u A = 50 and u B = 33.33.
(d) Consider two different equations representing indifference curves for perfect complements:
u 1 (x 1 , x 2 ) = min{x 1 , x 2 } and u 2 (x 1 , x 2 ) = min{x 1 ,2x 2 }. By inspecting two of the indifference
curves for each of these utility functions, determine the equation for the ray along which all
optimal bundles will lie for individuals whose tastes can be represented by these equations.
Answer: In u 1 , the two goods are always used in pairs of 1 each. Thus, the optimal bundles
lie on the 45 degree line. In u 2 , on the other hand, you always use pairs of 2 of x 1 with 1 of
x 2 . The optimal bundles therefore lie on the 30 degree ray from the origin — i.e. a ray with
slope 1/2.
(e) Explain why the Lagrange method does not seem to work for calculating the optimal con-
sumption bundle when the goods are perfect substitutes.
Answer: This is because the optimal bundles will almost certainly be corner solutions (un-
less the ratio of prices happens to give the same slope of the budget line as the slope of all
the indifference curves). The Lagrange method finds points of tangency — but there are no
such points in the case of perfect substitutes.
(f) Explain why the Lagrange method cannot be applied to calculate the optimal bundle when
the goods are perfect complements.
Answer: The Lagrange method implicitly assumes differentiability. But the slope of the in-
difference curve at the kink points is undefined — so the Lagrange method cannot find tan-
gencies. Thus, the Lagrange method requires smoothness of the indifference curves.
6.8 I have two 5-year old girls — Ellie and Jenny — at home. Suppose I begin the day by giving each
girl 10 toy cars and 10 princess toys. I then ask them to plot their indifference curves that contain these
endowment bundles on a graph with cars on the horizontal and princess toys on the vertical axis.
A: Ellie’s indifference curve appears to have a marginal rate of substitution of −1 at her endowment
bundle, while Jenny’s appears to have a marginal rate of substitution of −2 at the same bundle.
(a) Can you propose a trade that would make both girls better off?
Answer: Any trade under which Jenny would give up x princess toys for 1 car and Ellie would
accept x princess toys in exchange for giving up 1 car would work so long as 1 < x < 2. This is
because Jenny would be willing to give up as many as 2 princess toys for 1 car — so the trade
will make her better off because she has to give up less; and Ellie would be willing to accept
as little as 1 princess toy to give up 1 car — so the trade will make her better off because she
gets more without giving up more.
(b) Suppose the girls cannot figure out a trade on their own. So I open a store where they can buy
and sell any toy for $1. Illustrate the budget constraint for each girl.
Answer: The budget constraints would be the same for the two girls — because they both
have the same endowment point (10,10) and both face the same prices (that result in a slope
of −1). These constraints are illustrated in panels (a) and (b) of Graph 6.11, with the endow-
ment point labeled E.
Graph 6.11: Toy Cars and Princess Toys
(c) Will either of the girls shop at my store? If so, what will they buy?
Answer: We can then add Ellie’s indifference curve through her endowment point in panel
(a) and Jenny’s indifference curve through her endowment point in panel (b). We know that
Ellie’s is tangent to her budget constraint because the budget constraint has a slope of −1
and the MRS described in A is also −1 at the endowment bundle E. So Ellie does not want to
buy or sell anything at my store at these prices. Jenny’s indifference curve at E, on the other
hand, has slope −2 — and thus we know her indifference curve cuts her budget constraint
at E from above. This implies that Jenny will have better points available in her choice set
— with all better points lying to the right of E. Jenny will therefore want to sell princess toys
and buy toy cars at my store.
(d) Suppose I do not actually have any toys in my store and simply want my store to help the girls
make trades among themselves. Suppose I fix the price at which princess toys are bought and
sold to $1. Without being specific about what the price of toy cars would have to be, illustrate,
using final indifference curves for both girls on the same graph, a situation where the prices
in my store result in an efficient allocation of toys.
Answer: It would have to be that the girls have the same tastes at the margin when they
leave my store. Thus, they would have to be at indifference curves that are tangent to the
same budget line (because their budget goes through the same endowment bundle and has
the same slope). Since Jenny likes cars more than Ellie does at their endowment points, this
implies that Jenny will end up selling princess toys and buying cars while Ellie will sell car
toys and buy princess toys. For the allocation of toys to be efficient, the price of cars will
have to be set so that the number of cars Ellie wants to sell is exactly equal to the number of
cars that Jenny wants to buy, and the number of princess toys Ellie wants to buy is exactly
equal to the number of princess toys Jenny wants to sell. Thus, the arrows on each axis in
panel (c) of the graph have to be the same size.
(e) What values might the price for toy cars take to achieve the efficient trades you described in
your answer to (d)?
Answer: We concluded in (a) that mutually beneficial trades had to have terms of trades
under which x princess toys are traded for 1 car, with x falling between 1 and 2. The price
of toy cars must therefore be between 1 and 2 times the price of princess toys, allowing
consumers to buy between 1 and 2 times as many princess toys as toy cars with any given
dollar amount. Since the price of princess toys is fixed at $1, this implies that the price of
cars must lie between $1 and $2. You can see from panel (b) that the price of cars can’t
possibly be lower than $1 because at a price of $1 Jenny wants to buy cars and sell princess
toys but Ellie is willing to do neither. Thus, the price of cars has to go up in order to induce
Ellie to be willing to sell cars and to induce Jenny to demand fewer cars. At the same time,
we could similarly show that the price can’t be higher than $2 — because at a price of $2,
Jenny would no longer want to trade but Ellie would definitely want to sell cars for princess
toys. Depending on exactly what the indifference maps look like, some price between $1
and $2 will therefore be just right.
B: Now suppose that my girls’ tastes could be described by the utility function u(x 1 , x 2 ) = x 1α x 2(1−α) ,
where x 1 represents toy cars, x 2 represents princess toys and 0 < α < 1.
(a) What must be the value of α for Ellie (given the information in part A)? What must the value
be for Jenny?
Answer: The MRS for this utility function is
∂u/∂x 1 αx 1α−1 x 21−α αx 2

MRS = − =− =− . (6.26)
∂u/∂x 2 (1 − α)x 1α x 2−α (1 − α)x 1
At the bundle (10,10), Ellie’s MRS is −1 — which implies that α = 0.5 for Ellie. Similarly, for
Jenny the MRS is −2 at the bundle (10,10) — which implies that α/(1 − α) = 2 or α = 2/3 for
Jenny.
(b) When I set all toy prices to $1, what exactly will Ellie do? What will Jenny do?
Answer: We can solve the general optimization problem in terms of α by writing the La-
grange function as
L (x 1 , x 2 ,λ) = x 1α x 2(1−α) + λ(20 − x 1 − x 2 ), (6.27)

where the 20 in the parentheses following λ is simply the value of the endowment of 10
car toys and 10 princess toys when the price of each is set to 1. The first two first order
conditions of this problem are
αx 1α−1 x 21−α = λ
(6.28)
(1 − α)x 1α x 2−α = λ.
Since the right hand side of each of these is equal to λ, we can just set the left hand sides
equal to each other and solve for x 2 to get
(1 − α)
x2 = x1 . (6.29)
α
Plugging this into the budget constraint 20 = x 1 + x 2 , we can solve for x 1 to get x 1 = 20α.
Plugging this back into equation (6.29), we can also get x 2 = 20(1 − α).
Since α = 0.5 for Ellie, this implies Ellie’s optimal bundle is (x 1 , x 2 ) = (10,10) — i.e. Ellie will
not trade. Since α = 2/3 for Jenny, it means Jenny’s optimal bundle is (x 1 , x 2 ) = (13.33,6.67).
Jenny will therefore want to trade 3.33 princess toys for 3.33 toy cars.
(c) Given that I am fixing the price of princess toys at $1, do I have to raise or lower the price of
car toys in order for me to operate a store in which I don’t keep inventory but simply facilitate
trades between the girls?
Answer: As we already concluded in part A(e), I will have to raise the price of cars to some-
where between $1 and $2.
(d) Suppose I raise the price of car toys to $1.40, and assume that it is possible to sell fractions of
toys. Have I found a set of prices that allow me to keep no inventory?
Answer: The Lagrange function written in terms of α is then
L (x 1 , x 2 ,λ) = x 1α x 2(1−α) + λ(24 − 1.4x 1 − x 2 ), (6.30)

where 24 is the value of the endowment (10,10). The first two first order conditions are
αx 1α−1 x 21−α = 1.4λ

(6.31)
(1 − α)x 1α x 2−α = λ.
Dividing the first by the second (and thus canceling λ), we can solve for x 2 in terms of x 1 to
get
1.4(1 − α)
x2 = x1 . (6.32)
α
Substituting this into the budget constraint and solving for x 1 , we get x 1 = (24/1.4)α =
17.143α. Plugging this back into equation (6.32) and solving for x 2 , we get x 2 = 24(1 − α).
For Ellie, α = 0.5 — which implies her optimal bundle will be (8.571,12). Thus, she wants to
give up 1.429 of x 1 in exchange for receiving 2 of x 2 . For Jenny, α = 2/3 — which implies her
optimal bundle will be (11.429,8). Jenny therefore wants to get 1.429 of x 1 in exchange for
giving up 2 of x 2 . The trades exactly offset each other — thus I have to keep no inventory at
these prices. I am simply facilitating efficient trade between Ellie and Jenny by setting the
price of cars equal to $1.40 (while setting the price of princess toys to $1.00.
6.9 Everyday Application: Price Fluctuations in the Housing Market: Suppose you have $400,000 to spend
on a house and “other goods” (denominated in dollars).
A: The price of 1 square foot of housing is $100 and you choose to purchase your optimally sized house
at 2000 square feet. Assume throughout that you spend money on housing solely for its consumption
value (and not as part of your investment strategy).
(a) On a graph with “square feet of housing” on the horizontal axis and “other goods” on the
vertical, illustrate your budget constraint and your optimal bundle A.
Answer: The budget constraint would have vertical intercept of $400,000 (since this is how
much other goods you can consume if you buy no housing) and horizontal intercept of 4,000
square feet of housing (since that is how much you can afford at $100 per square foot if you
spend all your money on housing.) The slope of this budget is −100. The budget is depicted
as the solid line in panel (a) of Graph 6.12.
Graph 6.12: Housing Price Fluctuations
(b) After you bought the house, the price of housing falls to $50 per square foot. Given that you
can sell your house from bundle A if you want to, are you better or worse off?
Answer: The (dashed) new budget line is also drawn in panel (a) of the graph. Note that it
has to go through A because A is your endowment point once you have bought the 2000
square foot house. Thus, you can always choose to consume that bundle regardless of what
happens to prices. But you can also sell your 2000 square foot house for $100,000 — which
would give you $300,000 in consumption, your new vertical intercept. Or you can take that
$300,000 and spend it on a new house and thereby buy as much as a 6,000 square foot house
since housing now only costs $50 per square foot. Since your indifference curve at A is
tangent to your original budget line, the new (shallower) budget line cuts that indifference
curve from below at bundle A. All the new bundles that are now affordable and that lie
above the original indifference curve u A therefore lie to the right of A. You are better off at
any of those bundles on the dashed line that lie above the indifference curve u A .
(c) Assuming you can easily buy and sell houses, will you now buy a different house? If so, is your
new house smaller or larger than your initial house?
Answer: You will buy a larger house — since all the better bundles on the dashed line in
panel (a) are to the right of A and therefore include a house larger than 2000 square feet.
(d) Does your answer to (c) differ depending on whether you assume tastes are quasilinear in
housing or homothetic?
Answer: No — in both cases you would end up better off consuming a larger house.
(e) How does your answer to (c) change if the price of housing went up to $200 per square foot
rather than down to $50.
Answer: Panel (b) of Graph 6.12 illustrates this change in prices. The original budget con-
straint (from $400,000 on the vertical to 4,000 square feet on the horizontal axis) with bundle
A is replicated from panel (a) and illustrates the budget when the price per square foot of
housing is $100. The steeper bold line going through A illustrates the new budget line when
A is the endowment point and the price of housing goes to $200 per square foot. If you sell
your 2000 square foot house at $200 per square foot, you would get $400,000 for it — which,
added to the $200,000 you have would give you as much as $600,000 in consumption if you
choose not to buy another house. If you do buy another house, the largest possible house at
the new prices is now a 3000 square foot house. But you can always choose to stay at A — so
A too is on the new budget line. The bundles on the new bold budget that also lie above the
indifference curve u A all lie to the left of A — indicating that the new house that you would
purchase would be smaller than your original 2000 square foot house.
(f) What form would tastes have to take in order for you to not sell your $2000 square foot house
when the price per square foot goes up or down?
Answer: The indifference curve through A would have to have a kink in it, as would be the
case if housing and other goods are perfect complements. This is illustrated in panel (c)
of Graph 6.12 where all three budget lines are drawn, as is an indifference curve u A that
treats the two goods as perfect complements. Technically, it could also be the case that the
indifference curve through A has a less severe kink at A — one where the slope to the left
of A is steeper than the bold budget line and the slope to the right of A is shallower than
the slope of the dashed budget line. What is important is that there is a sufficiently severe
kink — with no substitutability on the margin between the goods at the kink point. If there
is no kink at A — i.e. if there is any substitutability at the margin between housing and
other goods at A — then the bold and dashed indifference curves must necessarily cut the
indifference curve at A in the ways (though not necessarily with the magnitudes) illustrated
in (a) and (b).
(g) True or False: So long as housing and other consumption is at least somewhat substitutable,
any change in the price per square foot of housing makes homeowners better off (assuming it
is easy to buy and sell houses.)
Answer: This is true, as just argued in the answer above.
(h) True or False: Renters are always better off when the rental price of housing goes down and
worse off when it goes up.
Answer: This is true. Renters do not have endowment points in this model as homeowners
do. So changes in the rental price of housing rotate the budget line through the vertical
intercept — which implies that a drop in housing prices unambiguously expands the budget
set at every level of housing and an increase in housing prices unambiguously shrinks the
choice set at every level of housing.
B: Suppose your tastes for “square feet of housing” (x 1 ) and “other goods” (x 2 ) can be represented by
the utility function u(x 1 , x 2 ) = x 1 x 2 .
(a) Calculate your optimal housing consumption as a function of the price of housing (p 1 ) and
your exogenous income I (assuming of course that p 2 is by definition equal to 1.)
Answer: We want to solve the problem
max u(x 1 , x 2 ) = x 1 x 2 subject to p 1 x 1 + x 2 = I . (6.33)

x 1 ,x 2
L (x 1 , x 2 ,λ) = x 1 x 2 + λ(I − p 1 x 1 − x 2 ), (6.34)

which give us first order conditions
x 2 = λp 1
x1 = λ (6.35)
p1 x1 + x2 = I .
Substituting the second equation into the first, we get x 2 = x 1 p 1 , and substituting this into
the last equation, we get p 1 x 1 + p 1 x 1 = I or x 1 = I /(2p 1 ). Finally, plugging this back into
x 2 = x 1 p 1 , we get x 2 = I /2.
(b) Using your answer, verify that you will purchase a 2000 square foot house when your income
is $400,000 and the price per square foot is $100.
Answer: We just concluded that x 1 = I /(2p 1 ). When p 1 = 100 and I = 400,000, this implies
x 1 = 400,000/(2(100)) = 2000.
(c) Now suppose the price of housing falls to $50 per square foot and you choose to sell your 2000
square foot house. How big a house would you now buy?
Answer: By selling your 2000 square foot house at $50 per square foot, you would make
$100,000. Added to the $200,000 you had left over after you bought your original 2000 square
foot house, this gives you a total income of $300,000. Plugging I =300,000 and p 1 = 50 into
our equation for the optimal housing quantity x 1 = I /(2p 1 ), we get x 1 =300,000/(2(50))=3000.
Thus, you will buy a 3000 square foot house.
(d) Calculate your utility (as measured by your utility function) at your initial 2000 square foot
house and your new utility after you bought your new house? Did the price decline make you
better off?
Answer: Your initial consumption bundle was (2000, 200000). That gives utility
u(2000,200000) = 2000(200000) = 400,000,000. (6.36)

When price fell, you end up at the bundle (3000,150000) which gives utility
u(3000,150000) = 3000(150000) = 450,000,000. (6.37)

Since your utility after the price decline is higher than before, you are better off.
(e) How would your answers to B(c) and B(d) change if, instead of falling, the price of housing
had increased to $200 per square foot?
Answer: Again, we have already calculated that x 1 = I /(2p 1 ) and x 2 = I /2. When price in-
creases to $200 and you already own a 2000 square foot house, you can now sell your house
for $400,000 which, added to the $200,000 you had left over after buying your original house,
gives you up to $600,000 to spend. Treating this as your new I and plugging in the new hous-
ing price p 1 = 200, we then get that your new optimal bundle has x 1 = 600000/(2(200)) =
1500 and x 2 = 600000/2 = 300,000. Thus you will buy a 1500 square foot house and con-
sume $300,000 in other goods. This gives you utility
u(1500,300000) = 1500(300000) = 450,000,000, (6.38)

which is greater than the utility you had originally and equal to the utility you received from
the price decrease above. Thus, a price increase to $200 per square foot makes you better
off, exactly as much as a drop in price to $50 per square foot. You are therefore indifferent
between the price increase and the price decrease.
6.10 Suppose you have an income of $100 to spend on goods x 1 and x 2 .

A: Suppose that you have homothetic tastes that happen to have the special property that indiffer-
ence curves on one side of the 45 degree line are mirror images of indifference curves on the other side
of the 45 degree line.
(a) Illustrate your optimal consumption bundle graphically when p 1 = 1 = p 2 .
Answer: Panel (a) of Graph 6.13 illustrates the budget line in this case. Symmetry around
the 45-degree line implies that the slope of indifference curves on the 45 degree line must
be −1. Since the budget constraint in this case also has slope −1, the optimum must occur
on the 45 degree line. This is indicated as point A in the graph.
Graph 6.13: Homothetic Tastes and Optimization
(b) Now suppose the price of the first 75 units of x 1 you buy is 1/3 while the price for any addi-
tional units beyond that is 3. The price of x 2 remains at 1 throughout. Illustrate your new
budget and optimal bundle.
Answer: This implies that the first 75 units of x 1 cost $25, leaving you with $75 to spend on
x 2 . The kink point therefore happens at the bundle (75,75). Since the price of x 1 is 3 from
then on, you can buy at most 25 more units with the $75 you have left after buying the first
75 units of x 1 . The budget constraint therefore looks as it does in panel (b) of the graph. The
symmetry of the indifference curves then still implies that the optimum happens on the 45
degree line at the kink point B .
(c) Suppose instead that the price for the first 25 units of x 1 is 3 but then falls to 1/3 for all units
beyond 25 (with the price of x 2 still at 1). Illustrate this budget constraint and indicate what
would be optimal.
Answer: After buying 25 units of x 1 at $3 per unit, you have only $25 left. Thus, the new kink
point happens at (25,25). Since the resulting budget line (graphed in panel (c)) is symmetric
around the 45 degree line, the symmetry of the indifference curves implies that there will be
two optimal bundles (indicated by C and D). These may happen anywhere along the budget
line depending on how substitutable the two goods are for one another. If the indifference
curves themselves are kinked at the 45-degree line, it may even be the case that C = D so
long as the kink is more severe than the kink of the budget constraint (as would be the case
for perfect complements).
(d) If the homothetic tastes did not have the symmetry property, which of your answers might not
change?
Answer: Without the symmetry property, the optimal bundle in (a) would be to the left or
right of the 45 degree line, and there would not be two optimal bundles at symmetric dis-
tances from the 45 degree line in panel (c). (There might still be two optimal bundles, or
there might only be one.) But in panel (b), the optimum might well still occur at the kink
point because many different marginal rates of substitution can be “tangent” at that kink.
B: Suppose that your tastes can be summarized by the Cobb-Douglas utility function u(x 1 , x 2 ) =
x 11/2 x 21/2 .
(a) Does this utility function represent tastes that have the symmetry property described in A?
Answer: Yes. The MRS for this utility function is −x 2 /x 1 — which is equal to −1 when
x 1 = x 2 on the 45 degree line. We can furthermore see that the symmetry holds — if we
place x 1 on the vertical instead of the horizontal axis, the MRS simply switches to −x 1 /x 2
and thus retains the same shape as before.
(b) Calculate the optimal consumption bundle when p 1 = 1 = p 2 .
Answer: The optimum occurs where MRS = −p 1 /p 2 which is −x 2 /x 1 = −1. Solving for x 2
we get x 2 = x 1 , and plugging this into the budget constraint, we get x 1 +x 2 = x 1 +x 1 = 2x 1 =
100 or x 1 = 50 (which then also implies x 2 = 50).
(c) Derive the two equations that make up the budget constraint you drew in part A(b) and use
the method described in the appendix to this chapter to calculate the optimal bundle under
that budget constraint.
Answer: The first segment of the budget constraint is x 2 = 100 − (1/3)x 1 and the second
line segment is x 2 = 300 − 3x 1 . Optimal tangencies occur where MRS = −x 2 /x 1 = −p 1 /p 2 ,
which implies x 2 = (p 1 x 1 )/p 2 or x 2 = p 1 x 1 since p 2 = 1.
Along the first line segment, p 1 = 1/3. Substituting x 2 = p 1 x 1 = (1/3)x 1 into x 2 = 100 −
(1/3)x 1 , we get (1/3)x 1 = 100 − (1/3)x 1 or (2/3)x 1 = 100. Solving for x 1 , we get x 1 = 150
which lies on the portion of the budget line that is not truly part of the kinked budget. This
is illustrated as bundle A in panel (a) of Graph 6.14.
Along the second line segment, p 1 = 3. Substituting x 2 = p 1 x 1 = 3x 1 into x 2 = 300 − 3x 1 , we
get 3x 1 = 300−3x 1 or 6x 1 = 300. Solving for x 1 , we get x 1 = 50 which also lies on the portion
of the budget line that is not truly part of the kinked budget. This is illustrated as bundle B in
panel (a) of Graph 6.14. Note that, due to the symmetry of the indifference curves, bundles
A and B lie on the same indifference curve.
Graph 6.14: Homothetic Tastes and Optimization: Part 2
Since both optimization problems — i.e. the problems using both of the extended line seg-
ments as budgets — result in solutions outside the actual kinked budget, the actual opti-
mum lies at the kink point.
(d) Repeat for the budget constraint you drew in A(c).
Answer: The first segment of the budget constraint is now x 2 = 100−3x 1 and the second line
segment is x 2 = 33.33 − (1/3)x 1 . Optimal tangencies occur again where MRS = −x 2 /x 1 =
−p 1 /p 2 , which implies x 2 = (p 1 x 1 )/p 2 or x 2 = p 1 x 1 since p 2 = 1.
Along the first line segment, p 1 = 3. Substituting x 2 = p 1 x 1 = 3x 1 into x 2 = 100 − 3x 1 , we
get 3x 1 = 100 − 3x 1 or 6x 1 = 100. Solving for x 1 , we get x 1 = (100/6) = 16.67 which lies on
the portion of the budget line that is in fact part of the kinked budget. This is illustrated as
bundle C in panel (b) of Graph 6.14.
Along the second line segment, p 1 = (1/3). Substituting x 2 = p 1 x 1 = (1/3)x 1 into x 2 =
33.33 − (1/3)x 1 , we get (1/3)x 1 = 33.33 − (1/3)x 1 or (2/3)x 1 = 33.33. Solving for x 1 , we get
x 1 = 50 which also lies on the portion of the budget line that is in fact part of the kinked
budget. This is illustrated as bundle D in panel (b) of Graph 6.14. Note again that, due
to the symmetry of the indifference curves, bundles C and D lie on the same indifference
curve. Both of these bundles are therefore optimal.
(e) Repeat (b) through (d) assuming instead u(x 1 , x 2 ) = x 13/4 x 21/4 and illustrate your answers in
graphs.
Answer: The MRS for this function is MRS = −3x 2 /x 1 . Thus, optimal solutions occur at
MRS = −3x 2 /x 1 = −p 1 /p 2 or, equivalently, where x 2 = p 1 x 1 /3p 2 which can furthermore
be simplified to x 2 = p 1 x 1 /3 since p 2 = 1.
When p 1 = p 2 = 1 as in part (b), our optimality condition reduces to x 2 = x 1 /3. Putting this
into the budget constraint, we get x 1 +x 2 = x 1 +(x 1 /3) = 100 or (4/3)x 1 = 100. Solving for x 1
we then get x 1 = 75 which implies x 2 = 25. This is graphed as A in panel (a) of Graph 6.15.
In the scenario of part (c), the first segment of the budget constraint is x 2 = 100−(1/3)x 1 and
the second line segment is x 2 = 300−3x 1 . Substituting our optimality condition x 2 = p 1 x 1 /3
into the the first equation and letting p 1 = 1/3, we get x 2 = (1/3)(x 1 /3) = 100 − (1/3)x 1 or
(1/9)x 1 = 100 − (1/3)x 1 which solves to x 1 = 225 which is clearly outside the actual kinked
budget and is illustrated as A in panel (b) of Graph 6.15. Similarly, substituting our op-
timality condition x 2 = p 1 x 1 /3 into the the second equation and letting p 1 = 3, we get
x 2 = 3x 1 /3 = 300 − 3x 1 or x 1 = 300 − 3x 1 . Solving for x 1 , we get x 1 = 75. This is exactly
the kink point — and is therefore the optimal solution, illustrated as B in panel (b) of Graph
6.15.
In the scenario of part (d), the first segment of the budget constraint is x 2 = 100 − 3x 1 and
the second line segment is x 2 = 33.33 − (1/3)x 1 . Substituting our optimality condition x 2 =
p 1 x 1 /3 into the first equation and letting p 1 = 3, we get x 2 = 3(x 1 /3) = 100−3x 1 or x 1 = 100−
3x 1 which solves to x 1 = 25. This happens right at the kink point — which means it could
not possibly be an optimum since the indifference curve cuts the other part of the budget
constraint. This is illustrated in panel (c) of Graph 6.15 where the kink point is denoted C .
Substituting our optimality condition x 2 = p 1 x 1 /3 into the the second equation and letting
p 1 = 1/3, we get x 2 = (1/3)x 1 /3 = 33.33−(1/3)x 1 or (1/9)x 1 = 33.33−(1/3)x 1 . Solving for x 1 ,
we get x 1 = 75. This, illustrated as D in panel (c) of Graph 6.15, is in fact on the actual kinked
budget and is therefore the optimal bundle.
Graph 6.15: Homothetic Tastes and Optimization: Part 3

6.11 Policy Application: Gasoline Taxes and Tax Rebates: Given the concerns about environmental dam-
age from car pollution, many have proposed increasing the tax on gasoline. We will consider the social
benefits of such legislation later on in the text when we introduce externalities. For now, however, we can
look at the impact on a single consumer.
A: Suppose a consumer has annual income of $50,000 and suppose the price of a gallon of gasoline
is currently $2.50.
(a) Illustrate the consumer’s budget constraint with “gallons of gasoline” per year on the horizon-
tal axis and “dollars spent on other goods” on the vertical. Then illustrate how this changes if
the government imposes a tax on gasoline that raises the price per gallon to $5.00.
Answer: In panel (a) of Graph 6.16, the original budget constraint runs from $50,000 on the
vertical axis to 20,000 gallons of gasoline on the horizontal — with slope −2.5 which is the
pre-tax opportunity cost of gasoline. The tax increases that opportunity cost to 5 — thus
rotating the budget constraint in, with the consumer being able to now purchase at most
10,000 gallons of gasoline per year.
Graph 6.16: Gasoline Taxes and Rebates
(b) Pick some bundle A on the after tax budget constraint and assume that bundle is the optimal
bundle for our consumer. Illustrate in your graph how much in gasoline taxes this consumer
is paying and call this amount T .
Answer: This is also depicted in panel (a) of the graph. Once we have picked A, we simply
ask how much other consumption is left when we consume this much gasoline after the tax
— and compare it to how much other consumption would have been left had we consumed
the same amount of gasoline before the tax (at B ). The difference is T .
(c) One of the concerns about using gasoline taxes to combat pollution is that it will impose hard-
ship on consumers (and, perhaps more importantly, voters). Some have therefore suggested
that the government simply rebate all revenues from a gasoline tax to taxpayers. Suppose
that our consumer receives a rebate of exactly T . Illustrate how this alters the budget of our
consumer.
Answer: In panel (b) of Graph 6.16 we show the after tax (before rebate) budget with a
dashed line containing the optimal after tax (before rebate) bundle A and the tax payment
T . A rebate of T would shift up this budget without changing prices — which implies the
new budget that includes the tax and rebate goes through bundle B .
(d) Suppose our consumer’s tastes are quasilinear in gasoline. How much gasoline will she con-
sume after getting the rebate?
Answer: If tastes are quasilinear in gasoline, then the MRS along any vertical line is the
same. Thus, if point A is a tangency between an indifference curve and the after-tax (before-
rebate) budget, then point B must also lie at a tangency between an indifference curve and
the parallel after-tax, after-rebate budget. Thus, she will buy the same amount of gasoline
after the rebate as she did before (as long as she faces the same tax-distorted price in both
cases).
(e) Can you tell whether the tax/rebate policy is successful at getting our consumer to consume
less gasoline than she would were there neither the tax nor the rebate?
Answer: Yes. The indifference curve u B cuts the original (before-tax, before-rebate) budget
from above — causing bundles to the right of B and above the indifference curve u B to
become available. These are better than B — so the consumer would choose some bundle
between B and C in the graph. All of those bundles have more gasoline — so the tax/rebate
is effective at lowering gasoline consumption.
(f) True or False: Since the government is giving back in the form of a rebate exactly the same
amount as it collected in gasoline taxes from our consumer, the consumer is made no better
or worse off from the tax/rebate policy.
Answer: False. While it is true that the consumer gets back the dollars she sent to the gov-
ernment as tax payment, she nevertheless ends up on a lower indifference curve than the
pre-tax, pre-rebate indifference curve that is tangent to the original budget somewhere be-
tween B and C . Thus, the consumer is worse off as a result of the tax/rebate. (This ignores
any potential benefit to the consumer from lower pollution that results from everyone con-
suming less gasoline.)
B: Suppose our consumer’s tastes can be captured by the quasilinear utility function u(x 1 , x 2 ) =
200x 10.5 + x 2 , where x 1 denotes gallons of gasoline and x 2 denotes dollars of other goods.
(a) Calculate how much gasoline this consumer consumes as a function of the price of gasoline
(p 1 ) and income I . Since other consumption is denominated in dollars, you can simply set its
price (p 2 ) to 1.
Answer: We have to solve the problem
max u(x 1 , x 2 ) = 200x 10.5 + x 2 subject to p 1 x 1 + x 2 = I . (6.39)

x 1 ,x 2
The Lagrange function is then
L (x 1 , x 2 ,λ) = 200x 10.5 + x 2 + λ(I − p 1 x 1 − x 2 ). (6.40)

The first two first order conditions are
0.5(200)x 1−0.5 = λp 1
(6.41)
1 = λ,
which implies x 10.5 = 100/p 1 or x 1 = 10000/(p 12 ). Note that gasoline consumption is there-
fore not a function of income — which is a consequence of the fact that utility is quasilinear
in x 1 .
(b) After the tax raises the price of gasoline to $5, how much gasoline does our consumer purchase
this year?
Answer: x 1 = 10000/(p 12 ) = 10000/25 = 400.
(c) How much of a tax does she pay?
Answer: By purchasing 400 gallons at $5 per gallon, she is spending $2,000 on gasoline, half
of which is due to the tax. Thus, she is paying T = $1000.
(d) Can you verify that her gasoline consumption will not change when the government sends
her a rebate check equal to the tax payments she has made?
Answer: We determined that her gasoline consumption is x 1 = 10000/(p 12 ) and is not a func-
tion of income. Since the rebate does not change the price p 1 , it does not impact x 1 — and
therefore gasoline consumption remains the same after the rebate.
(e) How does annual gasoline consumption for our consumer differ under the tax/rebate pro-
gram from what it would be in the absence of either a tax or rebate?
Answer: In the absence of either program, the price of gasoline would be p 1 = 2.5. Thus
x 1 = 10000/(p 12 ) = 10000/(2.52 ) = 1600. The tax/rebate program has therefore reduced this
consumer’s gasoline consumption from 1600 gallons per year to 400 gallons per year.
(f) Illustrate that our consumer would prefer no tax/rebate program but, if there is to be a tax on
gasoline, she would prefer to have the rebate rather than no rebate.
Answer: Without the tax/rebate program, the consumer buys 1600 gallons of gasoline. This
costs 1600($2.50) = $4,000 which leaves $46,000 for other consumption. The before tax/rebate
utility is therefore
u(no tax, no rebate) = u(1600,46000) = 200(16000.5 ) + 46000 = 54000. (6.42)

With the tax and rebate, the consumer buys 400 gallons of gasoline at $2000 but also gets a
$1000 rebate check — leaving her with $49,000 in other consumption for utility of
u(tax and rebate) = u(400,49000) = 200(4000.5 ) + 49000 = 53000. (6.43)

Finally, if only a tax were imposed without a rebate program, the consumer would still buy
400 gallons of gasoline for $2000 — but now would only be left with $48,000 in other con-
sumption (because she does not get a rebate check). This leaves her with utility
u(tax and no rebate) = u(400,48000) = 200(4000.5 ) + 48000 = 52000. (6.44)

6.12 Business Application: Retail Industry Lobbying for Daylight Savings Time: In 2005, the U.S. Congress
passed a bill to extend daylight savings time earlier into the spring and later into the fall (beginning in
2007). The change was made as part of an Energy Bill, with some claiming that daylight savings time
reduces energy use by extending sunlight to later in the day (which requires fewer hours of artificial light).
Among the biggest advocates for daylight savings time, however, was the retail and restaurant industry
that believes consumers will spend more time shopping and eating in malls for reasons explored here.
A: Consider a consumer who returns home from work at 6PM and goes to sleep at 10PM. In the
month of March, the sun sets by 7PM in the absence of daylight savings time, but with daylight
savings time, the sun does not set until 8PM. When the consumer comes home from work, she can
either spend time (1) at home eating food from her refrigerator while e-mailing friends and surf-
ing/shopping on the internet or (2) at the local mall meeting friends for a bite to eat and strolling
through stores to shop. Suppose this consumer gets utility from (1) and (2) (as defined here) but she
also cares about x 3 which is defined as the fraction of daylight hours after work.
(a) On a graph with “weekly hours at the mall” on the horizontal axis and “weekly hours at home”
on the vertical, illustrate this consumer’s typical weekly after-work time constraint (with a
total of 20 hours per week available — 4 hours on each of the 5 workdays). (For purposes of
this problem, assume the consumer gets as much enjoyment from driving to the mall as she
does being at the mall).
Answer: This is illustrated in Graph 6.17. The consumer can spend either 20 hours at home
or 20 hours at the mall or some combination of 20 hours between the two places. Thus, the
opportunity cost of spending 1 hour at the mall is not being able to spend that hour at home
— leading to a slope of −1.
Graph 6.17: Daylight Savings Time
(b) Consider first the scenario of no daylight savings time in March. This implies only 1 hour of
daylight in the 4 hours after work and before going to sleep; i.e. the fraction x 3 of daylight
hours after work is 1/4. Pick a bundle A on the budget constraint from (a) as the optimum for
this consumer given this fraction of after-work of daylight hours.
Answer: This is also depicted in the graph, with the (solid) indifference curve going through
A labeled by x 3 = 1/4 and tangent to the budget constraint.
(c) Now suppose daylight savings time is moved into March, thus raising the number of after-
work daylight hours to 2 per day. Suppose this changes the MRS at every bundle. If the retail
and restaurant industry is right, which way does it change the MRS?
Answer: If the industry is right, then more sunlight leads consumers to, at every bundle, be
willing to give up more hours at home for an hour at the mall. Thus, the MRS becomes
larger in absolute value — leading to indifference curves with steeper slopes.
(d) Illustrate how, if the retail and restaurant industry is right, this results in more shopping and
eating at malls every week.
Answer: This is illustrated with the second (dashed) indifference curve in the graph — with
that indifference curve also passing through A but now labeled x 3 = 1/2. This indifference
curve has steeper slope as we concluded it must have if the retail and restaurant industry is
right. The shaded bundles between the new indifference curve and the budget line all make
the consumer better off than bundle A when x 3 = 1/2 — and each of these bundles involves
more time spent at the mall and restaurants.
(e) Explain the following statement: “While it appears in our 2-dimensional indifference maps
that tastes have changed as a result of a change in daylight savings time, tastes really haven’t
changed at all because we are simply graphing 2-dimensional slices of the same 3-dimensional
indifference surfaces.”
Answer: The consumer’s tastes have really not changed in any fundamental way — the con-
sumer always cared about sunlight but simply does not have control over how much sun-
light there is. Thus, for purposes of analyzing choices given the level of sunlight (i.e. given
x 3 ), we only have to focus on the slice of the 3-dimendsional indifference surfaces that illus-
trate combinations of mall hours, home hours and sunlight that the consumer is indifferent
between. When daylight savings time goes into effect, sunlight changes and the consumer
switches to a different portion of the 3-dimensional indifference surface — the portion that
is now relevant for the new level of sunlight. When these two slices of the 3-dimensional sur-
faces are depicted on a single graph, it looks like indifference curves cross and tastes must
have changed — but that is only because we are projecting two slices of the same tastes onto
a single 2-dimensional graph.
(f) Businesses can lobby Congress to change the circumstances under which we make decisions,
but Congress has no power to change our tastes. Explain how the change in daylight savings
time illustrates this in light of your answer to (e).
Answer: Congress did not need to change tastes in order to change behavior in line with
what retailers and restaurant owners lobbied for — all it needed to do was change the cir-
cumstances consumers face — which in this case includes the number of hours of daylight
after working hours. Often Congress changes individual circumstances through such poli-
cies as taxes or spending — but it also does so through regulations like when daylight savings
time begins. As circumstances change, behavior changes even if tastes remain the same.
(g) Some have argued that consumers must be irrational for shopping more just because daylight
savings is introduced. Do you agree?
Answer: Our model suggests there is nothing irrational at all about shopping more under
daylight savings time. By extending daylight hours at the end of the day, Congress has made
it more desirable to go shopping because people like to shop while it is still daylight out. As
a result, people shop more — they are merely responding to changed circumstances but are
optimizing given their circumstances both before and after daylight savings time goes into
effect.
(h) If we consider not just energy required to produce light but also energy required to power cars
that take people to shopping malls, is it still clear that the change in daylight savings time is
necessarily energy saving?
Answer: No, it is not clear since there are offsetting effects that result from the change in
people’s behavior. In fact, there are studies that claim to show that daylight savings time
actually costs more energy because of such adjustments in individual behavior to changed
circumstances.
B: Suppose a consumer’s tastes can be represented by the utility function u(x 1 , x 2 , x 3 ) = 12x 3 ln x 1 +
x 2 , where x 1 represents weekly hours spent at the mall, x 2 represents weekly after-work hours spent
at home (not sleeping), and x 3 represents the fraction of after-work (before-sleep) time that has day-
light.
(a) Calculate the MRS of x 2 for x 1 for this utility function and check to see whether it has the
property that retail and restaurant owners hypothesize.
Answer: The MRS is
∂u/∂x 1 12x 3 /x 1 12x 3

MRS = − =− =− . (6.45)
∂u/∂x 2 1 x1
We concluded in part A that retail and restaurant owners believe that, if there is more day-
light, people will be willing to give up more hours at home for every hour at the mall and
restaurants. This implies that the MRS should become larger in absolute value as x 3 —
the fraction of evening time with daylight — increases. That is indeed the case — as x 3
increases, 12x 3 /x 1 increases as well — causing the indifference curves at every bundle to
become steeper.
(b) Which of the three things the consumer cares about — x 1 , x 2 and x 3 — are choice variables
for the consumer?
Answer: The consumer only get to choose x 1 and x 2 — the amount of time spent outside
and inside the house. She does not get to decide how much daylight there is in the rest of
the day.
(c) Given the overall number of weekly after-work hours our consumer has (i.e. 20), calculate the
number of hours per week this consumer will spend in malls and restaurants as a function of
x3 .
Answer: The problem we have to solve is
max u(x 1 , x 2 , x 3 ) = 12x 3 ln x 1 + x 2 subject to x 1 + x 2 = 20. (6.46)

x 1 ,x 2
Note that, since x 3 is not a choice variable, it does not appear as part of the max notation in
the specification of the problem. The Lagrange function for this problem is then
L (x 1 , x 2 ,λ) = 12x 3 ln x 1 + x 2 + λ(20 − x 1 − x 2 ), (6.47)

where the Lagrange function is not a function of x 3 because x 3 enters the function only as
a parameter (exactly as the number “12” does), not as a variable. First order conditions are
then taken only with respect to x 1 and x 2 (and λ), with the first two of these giving us
12x 3
=λ
x1 (6.48)
1 = λ,
where the second equation can just be substituted into the first to get x 1 = 12x 3 . Notice that
x 1 is only a functions of x 3 and not of x 2 — that’s because tastes are quasilinear in x 1 . (We
can also derive the number of hours spent at home by simply putting x 1 = 12x 3 into the
budget constraint x 1 + x 2 = 20 to get 12x 3 + x 2 = 20 or x 2 = 20 − 12x 3 .)
(d) How much time per week will she spend in malls and restaurants in the absence of daily
savings time? How does this change when daylight savings time is introduced?
Answer: In the absence of daylight savings time, x 3 = 1/4 which implies x 1 = 12x 3 = 3. With
daylight savings time, x 3 = 1/2 which implies x 1 = 12x 3 = 6. Thus, daylight savings time
causes this consumer to go to the mall for 6 hours per week instead of 3 hours per week.
6.13 Policy Application: Cost of Living Adjustments of Social Security Benefits: Social Security payments
to the elderly are adjusted every year in the following way: The government has in the past determined
some average bundle of goods consumed by an average elderly person. Each year, the government then
takes a look at changes in the prices of all the goods in that bundle and raises social security payments by
the percentage required to allow the hypothetical elderly person to continue consuming that same bundle.
This is referred to as a “cost of living adjustment” or COLA.
A: Consider the impact on an average senior’s budget constraint as cost of living adjustments are put
in place. Analyze this in a 2-good model where the goods are simply x 1 and x 2 .
(a) Begin by drawing such a budget constraint in a graph where you indicate the “average bundle”
the government has identified as A and assume that initially this average bundle is indeed the
one our average senior would have chosen from his budget.
Answer: This is done in panel (a) of Graph 6.18 with the initial budget line going from I /p 2
on the vertical to I /p 1 on the horizontal and with u A tangent to that budget line at A.
Graph 6.18: Social Security COLAs
(b) Suppose the prices of both goods went up by exactly the same proportion. After the govern-
ment implements the COLA, has anything changed for the average senior? Is behavior likely
to change?
Answer: If both prices go up by exactly the same proportion, the slope of the budget line
−p 1 /p 2 does not change. Rather, in the absence of a COLA adjustment, the budget would
simply shift inward in a parallel way. But if the government will give enough additional
money to the senior to allow him to again consume A after the increase in prices, then the
government shifts the budget right back through A. Since the slope has not changed, the
new budget lies exactly on top of the old. Thus, the senior will not change his behavior — A
will still be optimal.
(c) Now suppose that the price of x 1 went up but the price of x 2 stayed the same. Illustrate how
the government will change the average senior’s budget constraint when it calculates and
passes along the COLA. Will the senior alter his behavior? Is he better off, worse off or not
affected?
Answer: This is also illustrated in panel (a) of the graph. The increase in p 1 causes the ro-
tation in the budget to the dashed budget line, and the COLA adjustment shifts that steeper
budget up to bundle A so that the person can still afford A. But in the process, the new bud-
get cuts the original indifference curve in a way that makes new bundles above u A available.
These bundles are more preferred by the senior — so the senior will optimize at a new bun-
dle like B which contains less of x 1 and more of x 2 . As a result, the senior moves to a higher
indifference curve and is therefore better off.
(d) How would your answers change if the price of x 2 increased and the price of x 1 stayed the
same?
Answer: This is illustrated in panel (b) of Graph 6.18. Now the increase in p 2 causes the
rotation of the budget to the dashed budget line, and the COLA adjustment then pushes this
line outward until it once again goes through A. In the process, new bundles that lie above
u A become available to the right of A, causing the person to optimize at a new bundle like
C . Thus, the senior will reduce consumption of x 2 and increase consumption of x 1 — and
will end up on a higher indifference curve at C . Thus, the senior is better off as a result of
the price increase and COLA adjustment.
(e) Suppose the government’s goal in paying COLAs to senior citizens is to insure that seniors
become neither better nor worse off from price changes. Is the current policy successful if all
price changes come in the form of general “inflation” — i.e. if all prices always change together
by the same proportion? What if inflation hits some categories of goods more than others?
Answer: The policy is successful when inflation is of a general kind and affects all prices
by the same proportion. But if prices change at different rates, the COLA adjustment is too
large to keep seniors just as happy as before.
(f) If you could “choose” your tastes under this system, would you choose tastes for which goods
are highly substitutable or would you choose tastes for which goods are highly complemen-
tary?
Answer: Seniors benefit from COLA adjustments to the extent to which prices change dif-
ferentially and the extent to which they are willing to substitute between goods. Consider,
for instance, the impact of a higher price p 1 (like the one graphed in panel (a)) in the case of
the two indifference curves u 1A and u 2A in panel (c) of the graph. The indifference curve u 2A
treats x 1 and x 2 as perfect complements — and as a result, the steeper new budget line with
the COLA adjustment does not cut the indifference curve because the indifference curve
has a sharp corner at A. Since the person with this indifference curve does not view x 1 and
x 2 as in any way substitutable, he continues to buy A on the new budget. He therefore does
not become any better off as a result of the COLA adjustment. Compare this to the individ-
ual with indifference curve u 1A . This indifference curve is one that treats x 1 and x 2 as quite
substitutable — and as a result, a large number of “better” bundles become available in the
new COLA budget. These are indicated in the graph as the shaded area between u 1A and
the new budget constraint. Thus, individuals who view goods as more substitutable ben-
efit more from the way the government adjusts social security checks in response to price
changes.
B: Suppose the average senior has tastes that can be captured by the utility function u(x 1 , x 2 ) =
³ ´
−ρ −ρ −1/ρ
x1 + x2 .
(a) Suppose the average senior has income from all sources equal to $40,000 per year and suppose
that prices are given by p 1 and p 2 . How much will our senior consume of x 1 and x 2 ? (Hint: It
may be easiest to simply use what you know about the MRS of CES utility functions to solve
this problem.)
³ ´
−ρ −ρ −1/ρ
Answer: For the general CES utility function v(x 1 , x 2 ) = αx 1 + βx 2 , the text derives
the MRS to be MRS = −(α/β)(x 2 /x 1 )(ρ+1) . In the utility function u of this problem, α and
β are implicitly set to 1. Thus, MRS = −(x 2 /x 1 )(ρ+1) . At an optimum, MRS = −p 1 /p 2 , or
µ ¶
x 2 ρ+1 p1
− =− . (6.49)
x1 p2
Solving for x 2 , we get
µ ¶
p 1 1/(ρ+1)
x2 = x1 . (6.50)
p2
Substituting this into the budget constraint p 1 x 1 +p 2 x 2 = 40000 and solving for x 1 , we then
get (after some tricky manipulation of exponents)
40000
x1 = ³ ´1/(ρ+1) . (6.51)
ρ
p1 + p2 p1
Substituting this back into equation (6.50), we can then also solve for x 2 (after some more
tricky exponents) as
40000
x2 = ³ ´1/(ρ+1) . (6.52)
ρ
p2 + p1 p2
(b) If p 1 = p 2 = 1 initially, how much of each good will the senior consume? Does your answer
depend on the elasticity of substitution?
Answer: Substituting p 1 = p 2 = 1 into equations (6.51) and (6.52), we get
40000 40000
x1 = = 20,000 and
=
1 + (1ρ 1)1/(1+ρ) 2
(6.53)
40000 40000
x2 = = = 20,000.
1 + (1ρ 1)1/(1+ρ) 2
Thus, the solution does not depend on ρ and therefore does not depend on the elasticity of
substitution.
(c) Now suppose that the price of x 1 increases to p 1 = 1.25. How much does the government
have to increase the senior’s social security payment in order for the senior to still be able to
purchase the same bundle as he purchased prior to the price change?
Answer: Before the price change, the senior purchases (20000,20000). To be able to afford
this bundle after the price change, he must have income of 1.25(20000) + 1(20000) = 45000,
or $5000 more than he had before. Thus, the COLA adjustment is $5000.
(d) Assuming the government adjusts the social security payment to allow the senior to continue
to purchase the same bundle as before the price increase, how much x 1 and x 2 will the senior
actually end up buying if ρ = 0?
Answer: The new income is now $45000. Thus, when ρ = 0 and income is raised to $45000,
equations (6.51) and (6.52) reduce to
45000 45000 45000 45000

x1 = = and x 2 = = . (6.54)
p 1 + (p 20 p 1 )1/(0+1) 2p 1 p 2 + (p 10 p 2 )1/(0+1) 2p 2
Thus, when p 1 = 1.25 and p 2 = 1, we get
40000 40000
x1 = = 18,000 and x 2 = = 22,500. (6.55)
2(1.25) 2(1)
(e) How does your answer change if ρ = −0.5 and if ρ = −0.95? What happens as ρ approaches
−1?
Answer: When ρ = −0.5 and income again is set to $45000, equations (6.51) and (6.52) give
x 1 = 16,000 and x 2 = 25,000, (6.56)
and when ρ = −0.95,
x 1 = 511 and x 2 = 44,361. (6.57)
Thus, the smaller ρ gets, the more the person will deviate from the original bundle. And as
ρ approaches −1, x 1 approaches 0 while x 2 approaches 45,000.
(f) How does your answer change when ρ = 1 and when ρ = 10? What happens as ρ approaches
infinity?
Answer: Again using equations (6.51) and (6.52), when ρ = 1,
x 1 = 19,003 and x 2 = 21,246. (6.58)
and when ρ = 10,

x 1 = 19,819 and x 2 = 20,225. (6.59)

Thus, the larger ρ gets, the less the person will deviate from his original bundle. And as ρ
approaches infinity, x 1 goes to 20,000, as does x 2 ; i.e. as ρ approaches infinity, the change
in behavior disappears.
(g) Can you come to a conclusion about the relationship between how much a senior benefits
from the way the government calculates COLAs and the elasticity of substitution that the se-
nior’s tastes exhibit? Can you explain intuitively how this makes sense, particularly in light
of your answer to A(f)?
Answer: Above we noticed that as ρ gets smaller, the person deviates more from his original
consumption bundle when prices change and COLAs are implemented. When p 1 increases
from 1 to 1.25, he does not change his consumption when ρ is very large but reduces his con-
sumption from 20,000 to 19,003 when ρ = 1, to 18,000 when ρ = 0, to 16,000 when ρ = −0.5,
to 511 when ρ = −0.95 and finally to 0 as ρ approaches zero. The elasticity of substitution is
σ = 1/(1 + ρ) — which implies that, as ρ gets smaller, the elasticity of substitution increases.
Thus, our results above say that, as the elasticity of substitution gets larger, the person devi-
ates more from his original consumption bundle. This is exactly what our intuition told us
in panel (c) of Graph 6.18 in our answer to A(f).
(h) Finally, show how COLAs affect consumption decisions by seniors under general inflation
that raises all prices simultaneously and in proportion to one another as, for instance, when
both p 1 and p 2 increase from 1 to 1.25 simultaneously.
Answer: When both p 1 and p 2 increase to 1.25, the COLA has to be sufficient for the senior
to once again be able to afford (20000,20000) at the new prices. This implies the senior
needs an income of 1.25(20000) + 1.25(20000) = 50000, which is 10000 more than the 40000
he has before the inflation. Thus, the COLA has to be $10,000. Replacing 40000 with 50000
in equations (6.51) and (6.52) and replacing p 1 with 1.25p 1 and p 2 with 1.25p 2 , we get
50000
x1 = ¡ ¢1/(ρ+1)
1.25p 1 + (1.25p 2 )ρ (1.25p 1 )
50000 40000 (6.60)
= µ ³ ´1/(ρ+1) ¶ = ³ ´1/(ρ+1) .
ρ ρ
1.25 p 1 + p 2 p 1 p1 + p2 p1
and
50000
x2 = ¡ ¢1/(ρ+1)
1.25p 2 + (1.25p 1 )ρ (1.25p 2 )
50000 40000 (6.61)
= µ ³ ´1/(ρ+1) ¶ = ³ ´1/(ρ+1) ,
ρ ρ
1.25 p 2 + p 1 p 2 p 2 + p 1 p2
both of which are identical to what we had before the inflation and COLA increase.
6.14 Business Application: Quantity Discounts and Optimal Choices: In end-of-chapter exercise 2.12,
you illustrated my department’s budget constraint between “pages copied in units of 100” and “dollars
spent on other goods” given the quantity discounts our local copy service gives the department. Assume
the same budget constraint as the one described in 2.12A.
A: In this exercise, assume that my department’s tastes do not change with time (or with who hap-
pens to be department chair). When we ask below whether someone is “respecting the department’s
tastes” we mean whether that person is using the department’s tastes to make optimal decisions for
the department given the circumstances faced by the department. Assume throughout that my de-
partment’s tastes are convex.
(a) True or False: If copies and other expenditures are very substitutable for my department, then
you should observe either very little or a great deal of photocopying by our department at the
local copy shop.
Answer: This is true. Panel (a) of Graph 6.19 illustrates one possibility of this with a single
indifference curve tangent at low and high numbers of photocopies (bundles A and B ). If
the indifference curves have more curvature, then the tangency would lie on the middle
portion of the budget constraint with a single optimal quantity that lies in between what
one might consider as high and low. It is of course also possible that indifference curves
with very little curvature are steeper that the steepest part of the budget — leading to an
extreme corner solution on one end of the budget; or that they are very shallow leading to
an extreme corner solution on the other end.
Graph 6.19: Discounts and Photocopies
(b) Suppose that I was department chair last year and had approximately 5,000 copies per month
made. This year, I am on leave and an interim chair has taken my place. He has chosen to
make 150,000 copies per month. Given that our department’s tastes are not changing over
time, can you say that either I or the current interim chair is not respecting the department’s
tastes?
Answer: No, we cannot say that with any certainty. In fact, the indifference curve in panel (a)
of Graph 6.19 illustrates the case where both chairs are respecting the department’s tastes
despite making very different decision. The reason for this is the non-convexity in the bud-
get set created by the discount policy of the photocopy store.
(c) Now the interim chair has decided to go on vacation for a month — and an interim interim
chair has been named for that month. He has decided to purchase 75,000 copies per month.
If I was respecting the department’s tastes, is this interim interim chair necessarily violating
them?
Answer: No, not necessarily. Panel (b) of the graph gives and example of an indifference
curve that would make both choices, A and C , optimal from the department’s perspective.
(d) If both I and the initial interim chair were respecting the department’s tastes, is the new in-
terim interim chair necessarily violating them?
Answer: Again, not necessarily. This is illustrated in panel (c) of Graph 6.19.
B: Consider the decisions made by the 3 chairs as described above.

(a) If I and the second interim chair (i.e. the interim interim chair) both respected the depart-
ment’s tastes, can you approximate the elasticity of substitution of the department’s tastes?
Answer: The elasticity of substitution σ is given by
¯ ¯ ¯Ã !Ã !¯
¯ %∆(x 2 /x 1 ) ¯ ¯¯ (x 2A /x 1A ) − (x C C
2 /x 1 ) MRS A ¯
¯
σ = ¯¯ ¯=¯ ¯, (6.62)
%∆MRS ¯ ¯ A
(x /x ) A MRS A − MRS C ¯
2 1
where bundle A is (50,4750) and C is (750,2275) as depicted in panel (c) of the graph. We
furthermore know that MRS A = −5 and MRS C = −3.5. Thus
¯µ ¶µ ¶¯
¯ (4750/50) − (2275/750) −5 ¯
σ = ¯¯ ¯ = 3.23. (6.63)
4750/50 −5 − (−3.5) ¯
(b) If the first and second interim chairs both respected the department’s tastes, can you approx-
imate the elasticity of substitution for the department?
Answer: Now the relevant bundles are C =(750,2275) and B =(1500,400) with MRS C = −3.5
and MRS B = −2, which implies
¯µ ¶µ ¶¯
¯ (2275/750) − (400/1500) −3.5 ¯
σ = ¯¯ ¯ = 2.13. (6.64)
2275/750 −3.5 − (−2) ¯
(c) Could the underlying tastes under which all three chairs respect the department’s tastes be
represented by a CES utility function?
Answer: Since we get different elasticity of substitution estimates from the different pairs of
choices, tastes that rationalize all three choices given the budget constraint cannot be rep-
resented by a constant elasticity of substitution utility function that has the same elasticity
of substitution everywhere.
6.15 Policy Application: AFDC and Work Disincentives: Consider the AFDC program for an individual as
described in end-of-chapter exercise 3.18.
A: Consider again an individual who can work up to 8 hours per day at a wage of $5 per hour.
(a) Replicate the budget constraint you were asked to illustrate in 3.18A.
Answer: This is done in panel (a) of Graph 6.20, with leisure hours on the horizontal and
consumption dollars on the vertical axis.
Graph 6.20: AFDC and Work Disincentives
(b) True or False: If this person’s tastes are homothetic, then he/she will work no more than 1 hour
per day.
Answer: This is false. Suppose, for instance, that leisure and consumption were perfect
complements in the sense that this person wants to consume 1 hour of leisure with every
$35 of consumption. Indifference curves would then be L-shaped, with corners happening
at bundles like (1,35) and (2,70). This would imply an optimal choice at (1,35) where the
worker takes exactly 1 hour of leisure per day and works 7 hours per day. Such tastes are ho-
mothetic, as are less extreme tastes that allow for some (but not too much) substitutability
between leisure and consumption. An example of an indifference curve u D from a some-
what less extreme indifference map is illustrated in panel (a) of the graph — with tangency
at D.
(c) For purposes of defining a 45-degree line for this part of the question, assume that you have
drawn hours on the horizontal axis 10 times as large as dollars on the vertical. This implies
that the 45-degree line contains bundles like (1,10), (2,20), etc. How much would this person
work if his tastes are homothetic and symmetric across this 45-degree line? (By “symmetric
across the 45-degree line” I mean that the portions of the indifference curves to one side of the
45 degree line are mirror images to the portions of the indifference curves to the other side of
the 45 degree line.)
Answer: Panel (b) of the graph depicts this “45 degree line” where $10 on the vertical axis
is the same distance as 1 hour on the horizontal. In order for indifference curves to be
symmetric around this line, it must be that the slope of the indifference curve for bundles
on the 45 degree line is −1. But since we are measuring $10 as geometrically equivalent to 1
hour, a slope of −1 is really a slope, or MRS of −10. If we were to draw a line from the point
(0,40) to (3,30), this line would have a slope of −10/3. But any indifference curve has a slope
of −10 on the 45 degree line — so we know that the indifference curve at (3,30) has a slope of
−10 at that point and gets steeper to the left. So all indifference curves going through (3,30)
or above on the 45 degree line pass above the budget constraint to the left of the 45 degree
line. Thus, such “symmetric” tastes will have an optimum to the right of the 45 degree line
— most likely at B but plausibly between B and A.
(d) Suppose you knew that the individual’s indifference curves were linear but you did not know
the MRS. Which bundles on the budget constraint could in principle be optimal and for what
ranges of the MRS?
Answer: Bundles on the budget between A and B could be optimal, as could bundle E. In
particular for MRS between 0 and −10/7, E would be optimal and the individual would
work all the time and take no leisure. This is because indifference curves would be straight
lines with sufficiently shallow slope to make the corner solution E optimal. For MRS be-
tween −10/7 and −5, B would be optimal. For MRS = −5, any bundle on the budget be-
tween B and A is optimal, with all these bundles lying on one indifference curve that is also
the highest possible indifference curve for such an individual. Finally, for MRS less than −5,
A becomes the optimal bundle.
(e) Suppose you knew that, for a particular person facing this budget constraint, there are two
optimal solutions. How much in AFDC payments does this person collect at each of these
optimal bundles (assuming the person’s tastes satisfy our usual assumptions)?
Answer: The only way there can be exactly two optimal solutions is if one of these is B and
the other lies anywhere from E to C . The person collects no AFDC between E and C but the
full $25 daily benefit at B .
B: Suppose this worker’s tastes can be summarized by the Cobb-Douglas utility function u(ℓ,c) =
ℓ1−α c α where ℓ stands for leisure and c for consumption.
(a) Forget for a moment the AFDC program and suppose that the budget constraint for our worker
could simply be written as c = I − 5ℓ. Calculate the optimal amount of consumption and
leisure as a function of α and I .
Answer: We need to solve the problem
max u(ℓ,c) = ℓ1−α c α subject to c = I − 5ℓ. (6.65)

ℓ,c
Setting up the Lagrangian, taking first order conditions and solving for ℓ and c, we get
(1 − α)I
ℓ= and c = αI . (6.66)
5
(b) On your graph of the AFDC budget constraint for this worker, there are two line segments with
slope −5 — one for 0-2 hours of leisure and another for 7-8 hours of leisure. Each of these lie
on a line defined by c = I −5ℓ except that I is different for the two equations that contain these
line segments. What are the relevant I ’s to identify the right equations on which these budget
constraint segments lie?
Answer: It’s easy to see from the graph that I is 40 for the lower line and 65 for the higher.
(c) Suppose α = 0.25. If this worker were to optimize using the two budget constraints you have
identified with the two different I ’s, how much leisure would he choose under each constraint?
Can you illustrate what you find in a graph and tell from this where on the real AFDC budget
constraint this worker will optimize?
Answer: When I = 40, he would optimize at ℓ = (1−0.25)40/5 = 6 and when I = 65, he would
optimize at ℓ = (1 − 0.25)65/5 = 9.75. This is illustrated in panel (a) of Graph 6.21 where F
with 6 hours of leisure occurs on the lower budget line and G with 9.75 hours of leisure oc-
curs on the higher. F cannot be optimal inside the (bold) AFDC budget because it lies inside
that budget. G, on the other hand, lies outside the (bold) AFDC budget and is therefore not
feasible. But we do see that the indifference curve uG is steeper than −5 on the ray connect-
ing the origin to the kink point A — which implies the highest possible indifference curve on
the bold AFDC budget goes through that kink point. Utility at A = (8,25), for instance, would
be u(8,25) = 80.75 250.25 = 10.63 while utility at B = (7,30) is u(7,30) = 70.75 300.25 = 10.07.
Thus, the real optimum when α = 0.25 is bundle A with no work and all leisure.
Graph 6.21: AFDC and Work Disincentives: Part 2
(d) As α increases, what happens to the MRS at each bundle?

Answer: The MRS for u(ℓ,c) = ℓ1−α c α is
∂u/∂ℓ −(1 − α)ℓ−α c α (1 − α)c

MRS = − =− =− . (6.67)
∂u/∂c αℓ1−α c α−1 αℓ
Thus, at any bundle (ℓ,c), the MRS becomes larger in absolute value as α decreases and
smaller in absolute value as α increases. Put differently, the slope of an indifference curve
at any bundle becomes steeper as α gets smaller and shallower as α gets larger.
(e) Repeat B(c) for α = 0.3846 and for α = 0.4615. What can you now say about this worker’s
choice for any 0 < α < 0.3846? What can you say about this worker’s leisure choice if 0.3846 <
α < 0.4615?
Answer: When α = 0.3846, ℓ = (1 − 0.3846)40/5 = 4.92 at the lower budget line and ℓ = (1 −
0.3846)65/5 = 8 on the higher budget line. The solution on the lower budget line lies inside
the AFDC budget and is therefore not optimal. The solution of 8 hours of leisure on the
higher budget, on the other hand, is within the AFDC budget — it is bundle A. Thus, when
α = 0.3846, the highest possible indifference curve on the AFDC budget is just tangent to
the extended budget line c = 65 − 5ℓ at A. Since lower α’s mean steeper indifference curves
at every point, we can conclude from that that A will be optimal for all α’s that lie between
0 and 0.3846. When α = 0.4615, ℓ = (1 − 0.4615)40/5 = 4.31 at the lower budget line and
ℓ = (1 − 0.4615)65/5 = 7 on the higher budget line. The solution on the lower budget is
again inside the AFDC budget — so it cannot be optimal. The solution of 7 leisure hours
on the higher budget, on the other hand, corresponds to B on the AFDC budget. Thus,
when α = 0.4615, the highest indifference curve on the AFDC budget is just tangent to the
extended budget line c = 65−5ℓ at B . Since the slope of indifference curves becomes steeper
as α falls, this implies that, for α between 0.3846 and 0.4615, the optimal leisure choice will
lie in between A and B on the AFDC budget at ℓ = (1 − α)65/5 = 13(1 − α).
(f) Repeat B(c) for α = 0.9214 and calculate the utility associated with the resulting choice. Com-
pare this to the utility of consuming at the kink point (7,30) and illustrate what you have
found on a graph. What can you conclude about this worker’s choice if 0.4615 < α < 0.9214?
Answer: When α = 0.9214, ℓ = (1 − 0.9214)40/5 = 0.629 giving consumption of w(8 − ℓ) =
5(8 − 0.629) = 36.856. (On the higher budget line, ℓ = (1 − 0.9214)40/5 = 1.02 which lies
outside the AFDC budget). The bundle on the lower c = 40 − 5ℓ line, (0.629,36.856), gives
utility u(0.629,36.856) = 0.629(1−0.9214) 36.8560.9214 = 26.76. At B , the consumer would get
utility u(7,30) = 7(1−0.9214) 300.9214 = 26.76. Thus, the optimal bundle H on the budget line
c = 40−5ℓ lies on the same indifference curve as B — as depicted in panel (b) of Graph 6.21.
For α < 0.9214, the indifference curve at H would be steeper and would therefore cut the
AFDC budget while passing below B — and thus B is optimal for α just below 0.9214. Thus
B is the optimal bundle for 0.4615 < α < 0.9214.
(g) How much leisure will the worker take if 0.9214 < α < 1?
Answer: Given that indifference curves become shallower at every bundle as α increases, we
know that the indifference curve at H will be shallower for α > 0.9214 than the one depicted
in panel (b) of Graph 6.21. This implies that the optimal bundle for α > 0.9214 lies to the left
of H at ℓ = (1 − α)40/5 = 8(1 − α).
(h) Describe in words what this tells you about what it would take for a worker to overcome the
work disincentives under the AFDC program.
Answer: The exponent α tells us how much weight a person places in his tastes on consump-
tion rather than leisure. When α is high, consumption is valued much more than leisure —
so even a small increase in consumption can justify giving up a lot of leisure. Thus, for very
high α, it is possible that someone with the AFDC budget constraint will in fact work close
to full time despite the work disincentives. But that person’s tastes would have to be pretty
extreme — he would have to place virtually no value on leisure time. For anyone that places
some non-trivial value on leisure time — which implies α isn’t close to 1 or, to be more pre-
cise, α < 0.9214 — the payoff from working close to full time is simply not high enough to
sacrifice that much leisure. Thus, for most values of α, the person will choose to work less
than 1 hour per day.
6.16 Policy Application: Food Stamps versus Food Subsidies: In exercise 2.17, you considered the food
stamp programs in the US. Under this program, poor households receive a certain quantity of “food
stamps” — stamps that contain a dollar value which is accepted like cash for food purchases at grocery
stores.
A: Consider a household with monthly income of $1,500 and suppose that this household qualifies
for food stamps in the amount of $500.
(a) Illustrate this household’s budget, both with and without the food stamp program, with “dol-
lars spent on food” (on the horizontal axis) and “dollars spent on other goods” on the vertical.
What has to be true for the household to be just as well off under this food stamp program
as it would be if the government simply gave $500 in cash to the household (instead of food
stamps)?
Answer: Panel (a) of Graph 6.22 illustrates these two budgets. The budget under food stamps
has a flat spot at the top because the first $500 in food consumption can be paid for through
the food stamps but non-food items cannot be paid for with those stamps. As long as the
household would have purchased at least $500 in food under a budget of $2,000 per month,
the food stamp program is exactly like a cash subsidy program for this household. Put dif-
ferently, so long as the indifference curve tangent to the extended outer budget in panel (a)
is tangent at food consumption levels greater than $500, there is no difference between the
two types of programs.
Graph 6.22: Food Stamps, Cash and Food Subsidies
(b) Consider the following alternate policy: Instead of food stamps, the government tells this
household that it will reimburse 50% of the household’s food bills. On a separate graph, illus-
trate the household’s budget (in the absence of food stamps) with and without this alternate
program.
Answer: Panel (b) of the graph illustrates the initial budget (going from $1500 on the vertical
axis to $1500 on the horizontal) and the new budget that has shallower slope because $1 of
food now only costs 50 cents.
(c) Choose an optimal bundle A on the alternate program budget line and determine how much
the government is paying to this household (as a vertical distance in your graph). Call this
amount S.
Answer: This is also illustrated in panel (b) of the graph. At bundle A, the household is
consuming x 1A in food. We can then read off the vertical axis how much in other consump-
tion the household was able to undertake at A and compare it to how much it would have
been able to consume of other goods had it consumed x 1A in food prior to the subsidy. The
difference between these two amounts is S.
(d) Now suppose the government decided to abolish the program and instead gives the same
amount S in food stamps. How does this change the household’s budget?
Answer: This change is illustrated in panel (c) of the graph. In both cases, the bundle A
will be available to the consumer because the government is giving S under both programs.
However, under the food stamp program, the subsidy amount remains the same regard-
less of how much food the household consumes, whereas under the price subsidy program
the amount of government transfer decreases if the household consumes less food and in-
creases if it consumes more food. Put differently, there is no change in opportunity costs
under the cash subsidy, with the price of food going back up to $1 for every $1 of food.
(e) Will this household be happy about the change from the first alternate program to the food
stamp program?
Answer: The household prefers the food stamps to the price subsidy. You can see this in
panel (c) where the indifference curve that makes A optimal under the price subsidy is tan-
gent to the shallower (price subsidy) budget. But this means that the new food stamp bud-
get cuts this indifference curve from above, making a set of new bundles that lie above the
indifference curve u A available to the household.
(f) If some politicians want to increase food consumption by the poor and others just want to
make the poor happier, will they differ on what policy is best?
Answer: Yes, they will differ. The food price subsidy causes the poor to consume more food
whereas the equally costly food stamp program is more preferred by poor households (i.e.
makes them happier).
(g) True or False: The less substitutable food is for other goods, the greater the difference in food
consumption between equally funded cash and food subsidy programs.
Answer: This is false. Imagine making u A in panel (c) of our graph the shape that presumes
food and other goods are perfect complements. In that case, the equally costly food stamp
program, which still contains A, will no longer cut the indifference curve u A — thus elim-
inating the “better” bundles on the food stamp budget that we identified in panel (c). The
household would therefore consume the same amount of food under either program. Then
imagine increasing the substitutability between food and other goods at point A — as you
do so, more and more “better” bundles become available.
(h) Consider a third possible alternative — giving cash instead of food stamps. True or False: As
the food stamp program becomes more generous, the household will at some point prefer a
pure cash transfer over an equally costly food stamp program.
Answer: This is true and relates to our answer to part (a). Since food stamps can only be
spent on food, they are equivalent to cash so long as the household would choose to spend
at least the value of food stamps on food even if the stamps were replaced by cash. But as
the food stamp program becomes more generous, it will at some point be the case that the
household would in fact use the food stamps to buy non-food items if it could — and it is
at that point that the household would strictly prefer the cash program over the food stamp
program.
B: Suppose this household’s tastes for spending on food (x 1 ) and spending on other goods (x 2 ) can
be characterized by the utility function u(x 1 , x 2 ) = α ln x 1 + ln x 2 .
(a) Calculate the level of food and other good purchases as a function of I and the price of food
p 1 (leaving the price of dollars on other goods as just 1).
Answer: We are asked to solve the problem
max u(x 1 , x 2 ) = α ln x 1 + ln x 2 subject to p 1 x 1 + x 2 = I . (6.68)

x 1 ,x 2
L (x 1 , x 2 ,λ) = α ln x 1 + ln x 2 + λ(I − p 1 x 1 − x 2 ), (6.69)

which gives rise to first order conditions, the first two of which are
α
= λp 1
x1
(6.70)
1
=λ
x2
Substituting the second equation into the first for λ, we get x 2 = p 1 x 1 /α. And substituting
this into the budget constraint (which is the third first order condition), we get p 1 x 1 + x 2 =
p 1 x 1 + p 1 x 1 /α = I which we can solve for x 1 to get
αI
x1 = , (6.71)
(α + 1)p 1
and substituting this back into x 2 = p 1 x 1 /α,
I
x2 = . (6.72)
(α + 1)
(b) For the household described in part A, what is the range of α that makes the $500 food stamp
program equivalent to a cash gift of $500?
Answer: The food stamps are equivalent to a cash gift so long as the household would have
spent at least the value of the food stamps on food were it to receive the cash gift instead.
Our household has income I = 1500 and the price of food is p 1 =$1 in the absence of a price
subsidy. To determine the value of α at which the household would buy exactly $500 of food
with a cash gift of $500, we need to substitute $2,000 for I and $1 for p 1 into our equation
for x 1 , set it to $500 and solve for α; i.e.
2000α 1
= 500 implies α = . (6.73)
α+1 3
Thus, for α > 1/3, the cash subsidy is equivalent to the food stamp program of $500.
(c) Suppose for the remainder of the problem that α = 0.5. How much food will this household
buy under the alternate policy described in A(b)?
Answer: Under this policy, p 1 drops to 1/2 while I remains at 1500. The household will
therefore buy
αI 0.5(1500)
x1 = = = 1000. (6.74)
(α + 1)p 1 1.5(0.5)
(d) How much does this alternate policy cost the government for this household? Call this amount
S.
Answer: If the household buys $1,000 of food and the government reimburses half, then
S = 500.
(e) How much food will the household buy if the government gives S as a cash payment and
abolishes the alternate food subsidy program?
Answer: In that case, I = 1500 + S = 1500 + 500 = 2000 and p 1 goes back to 1. Thus,
αI 0.5(2000)
x1 = = = 666.67. (6.75)
(α + 1)p 1 1.5(1)
(f) Determine which policy — the price subsidy that leads to an amount S being given to the
household, or the equally costly cash payment in part (e) — is preferred by the household.
Answer: Under the price subsidy policy, the household pays $500 to get $1000 of food, leav-
ing it with $1000 in other consumption. Thus, it consumes a bundle (1000,1000). This gives
utility
u(1000,1000) = 0.5ln(1000) + ln(1000) = 10.362. (6.76)

Under the cash subsidy policy, the household gets $500 in cash to raise its total income to
$2000 of which it spends $666.67 on food, leaving it with $1333.33 in other spending; i.e.
under cash subsidy, the household consumes bundle (667.67,1333.33). This gives utility
u(666.67,1333.33) = 0.5ln(666.67) + ln(1333.33) = 10.447. (6.77)

The household is happier under the cash subsidy policy.
(g) Now suppose the government considered subsidizing food more heavily. Calculate the utility
that the household will receive from three equally funded policies: a 75% food price subsidy
(i.e. a subsidy where the government pays 75% of food bills), a food stamp program and a
cash gift program.
Answer: First, consider the price subsidy program that lowers the price p 1 from 1 to 0.25
while keeping I at $1,500. This will result in food and other good consumption of
αI 0.5(1500) I (1500)
x1 = = = 2000 and x 2 = = = 1000. (6.78)
(α + 1)p 1 (1.5)(0.25) (α + 1) 1.5
The utility of this bundle is then
u(price subsidy) = u(2000,1000) = 0.5ln(2000) + ln(1000) = 10.708. (6.79)

Since food consumption under the price subsidy is 2000, this implies S = 0.75(2000) = 1500.
If S = 1500 is simply given as cash (where income then becomes $3000 and p 1 goes back up
to 1), this will result in food and other consumption of
αI 0.5(3000) I (3000)
x1 = = = 1000 and x 2 = = = 2000, (6.80)
(α + 1)p 1 (1.5)(1) (α + 1) 1.5
giving utility of
u(cash) = u(1000,2000) = 0.5ln(1000) + ln(2000) = 11.055. (6.81)

Finally, under the food stamp program of size S = 1500, the household would be forced to
consume $1500 of food rather than $1000 of food that it would have chosen had the money
been given in terms of unrestricted cash. Thus, under food stamps, the consumer would
buy the bundle (1500,1500) giving utility
u(food stamps) = u(1500,1500) = 0.5ln(1500) + ln(1500) = 10.970. (6.82)

Here the food stamp program has gotten so large that it is no longer equivalent to getting
cash — and so the consumer prefers the cash to the food stamps but still prefers the food
stamps to the food price subsidy.

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S O L U T I O N S

Solutions for Microeconomics: An Intuitive

They may not be made publicly available.

Reproduction and/or distribution of the solutions beyond classroom use is

In most colleges, it is a violation of the student honor code for a student to

• Each end-of-chapter exercise begins on a new page. This is to facilitate max-

• If you are assigning only the A-parts of exercises in Microeconomics: An In-

• Solutions to Within-Chapter Exercises are provided in the student Study Guide.

Graph 6.1: Grits and Cereal

L (x 1 , x 2 ,λ) = −x 1 x 2 + λ(I − p 1 x 1 − p 2 x 2 ), (6.1)

which gives as its first two first order conditions

Graph 6.2: Grits and Cereal: Part 2

L (x 1 , x 2 ,λ) = −x 12 − x 22 + λ(I − p 1 x 1 − p 2 x 2 ) (6.3)

−2x 1 = λp 1 and − 2x 2 = λp 2 . (6.4)

Graph 6.3: Coffee, Milk and Sugar

max α ln x 1 + βln x 2 + ln x 3 subject to p 1 x 1 + p 2 x 2 + p 3 x 3 = I . (6.6)

The Lagrange function for this problem is

L (x 1 , x 2 , x 3 ,λ) = α ln x 1 + βln x 2 + ln x 3 + λ(I − p 1 x 1 + p 2 x 2 + p 3 x 3 ), (6.7)

which gives us first order conditions of

Graph 6.4: Coffee, Coke and Pepsi

Graph 6.5: Love and Roses

L (x 1 , x 2 ,λ) = βx 1α + x 2 + λ(I − p 1 x 1 − x 2 ). (6.13)

Replacing λ with 1 in the first equation and solving for x 1 , we get

Graph 6.6: Love and Roses: Part 2

Graph 6.7: Different Interest Rates for Borrowing and Lending

Graph 6.8: Different Interest Rates for Borrowing and Lending

Graph 6.9: Beer and Pizza

max u(x 1 , x 2 ) = x 12 x 2 subject to p 1 x 1 + p 2 x 2 = I , (6.21)

with corresponding Lagrange function

L (x 1 , x 2 ,λ) = x 12 x 2 + λ(I − p 1 x 1 − p 2 x 2 ). (6.22)

The first two first order conditions are then

B: Continue with the assumptions about tastes from above.

Graph 6.11: Toy Cars and Princess Toys

∂u/∂x 1 αx 1α−1 x 21−α αx 2

L (x 1 , x 2 ,λ) = x 1α x 2(1−α) + λ(20 − x 1 − x 2 ), (6.27)

L (x 1 , x 2 ,λ) = x 1α x 2(1−α) + λ(24 − 1.4x 1 − x 2 ), (6.30)

αx 1α−1 x 21−α = 1.4λ

Graph 6.12: Housing Price Fluctuations

max u(x 1 , x 2 ) = x 1 x 2 subject to p 1 x 1 + x 2 = I . (6.33)

The Lagrange function for this problem is

L (x 1 , x 2 ,λ) = x 1 x 2 + λ(I − p 1 x 1 − x 2 ), (6.34)

u(2000,200000) = 2000(200000) = 400,000,000. (6.36)

u(3000,150000) = 3000(150000) = 450,000,000. (6.37)

u(1500,300000) = 1500(300000) = 450,000,000, (6.38)

6.10 Suppose you have an income of $100 to spend on goods x 1 and x 2 .

Graph 6.13: Homothetic Tastes and Optimization

Graph 6.14: Homothetic Tastes and Optimization: Part 2

Graph 6.15: Homothetic Tastes and Optimization: Part 3

Graph 6.16: Gasoline Taxes and Rebates

max u(x 1 , x 2 ) = 200x 10.5 + x 2 subject to p 1 x 1 + x 2 = I . (6.39)

The Lagrange function is then

L (x 1 , x 2 ,λ) = 200x 10.5 + x 2 + λ(I − p 1 x 1 − x 2 ). (6.40)

u(no tax, no rebate) = u(1600,46000) = 200(16000.5 ) + 46000 = 54000. (6.42)

u(tax and rebate) = u(400,49000) = 200(4000.5 ) + 49000 = 53000. (6.43)

u(tax and no rebate) = u(400,48000) = 200(4000.5 ) + 48000 = 52000. (6.44)

Graph 6.17: Daylight Savings Time

∂u/∂x 1 12x 3 /x 1 12x 3

max u(x 1 , x 2 , x 3 ) = 12x 3 ln x 1 + x 2 subject to x 1 + x 2 = 20. (6.46)

L (x 1 , x 2 ,λ) = 12x 3 ln x 1 + x 2 + λ(20 − x 1 − x 2 ), (6.47)

Graph 6.18: Social Security COLAs