Ch4_ans

1.4 a. David’s Lagrangian for utility maximization is

L = 10 q10.25 q20.75 + λ(Y – pq1 q1 – p2q2).

The first order conditions are

dL
= 2.5 q1–0.75 q20.75 – p 1λ = 0
dq1

dL
= 7.5 q10.25 q2–0.25 – p 2λ = 0
dq 2

dL
= Y – p q1 q1 – p 2 q2 = 0.
dl

Dividing the first condition by the second,

2.5q 2 p
= q1 .
7.5q1 pq 2

Rewriting,

æ pq1 ö
q2 = 3q1 ç ÷. (1)
ç pq 2 ÷
è ø

Substituting this into the third condition and solving for G, David’s optimal value
for gasoline is

æ pq1 ö
Y – pq1 q1 – pq2 3q1 ç ÷ =0
ç pq 2 ÷
è ø

Y – pq1 q1 – 3q1 pq1 = 0

Y = 4p q1 q1

Y
q1 = .
4 pq1

Substituting this into equation (1) above and solving for B, David’s optimal value of
bread is

æ Y ö æ pq1 ö
q2 = 3 ç ÷ç ÷
è 4 pq1 ø çè pq 2 ÷ø
 3Y
q2 = .
4 pq 2

b. The partial derivative of David’s optimal value of gasoline is

dq1 Y
=─ ,
dpq1 4( pq12 )

which is negative, indicating that David will demand less gasoline when the price of
gasoline increases.

c. The partial derivative of the effect of a change in the price of gasoline on David’s
optimal quantity of gasoline is

d 2 q1 1
=– ,
dpq1dY 4( pq12 )

which is negative, indicating that as income increases, David's response to a change

in the price of gasoline on his demand for gasoline becomes more negative.
1.7 The figure shows that the price-consumption curve is horizontal. The demand for CDs
depends only on income and the own price, q1 = 0.6Y/p1.
2.2 Guerdon consumes cereal with bananas at a price of pc + 0.5 pb. The quantity of cereal
will always equal twice the quantity of bananas.
Y
Qc =
1
pc + pb
2

If Guerdon consumes a bowl of cereal with half a banana, then his utility function is

U = min {qC, 2qB}.

Y
In this case, the demand for cereal is qC = , and the demand for bananas is
pC + 0.5 pB
0.5Y
qB = .
pC + 0.5 pB

2.4 The typical consumers demand for DVDs is given by q2 = 0.4Y/p2, where p2 = $20.
Consequently, her Engel curve is a straight line with a slope of dY/ dq2 = p2/ 0.4 = 50.

2.5 The income elasticity of demand (or income elasticity) is the percentage change in the
quantity demanded in response to a given percentage change in income, Y:

dq1 Y
x qq = .
dY q1

(a) First, consider the Cobb-Douglas utility function

U(q1, q2 ) = q1αq2(1-α).

The demand for q1 is

q1 =
(1 - a ) Y
p1
 The partial derivative of the demand for q1 with respect to Y is
dq1 (1 - a )
=
Y p1

Therefore, the income elasticity of demand is

æ1-a ö æ p1 ö
e q1 = ç ÷ * çç ÷÷ * Y
è p1 ø è (1 - a ) Y ø

or

e q1 = 1

(b) Second, consider the utility function

U(q1, q2) = αq1 + bq2, for a, b >0

for perfect substitutes. Assume the price of good q1 is less than the price of good q2.
If so, then the consumer will maximize utility at a corner solution, consuming only
good q1, and the demand for q1 is

Y
q1 = .
p1

The partial derivative of the demand for q1 with respect to Y is

dq1 1
= .
dY p1

Therefore, the income elasticity of demand is

1 Y
x q1 = .
p1 q1

(c) Last, consider the utility function

U(q1, q2) = min{aq1, bq2}, for a, b>0

for perfect complements. Individuals will consume perfect complements in

fixed proportions, a units of q1 to b units of q2. The demand for q1 is
 Y
q1 =
a
p1 + p2
b

The partial derivative of the demand for q1 with respect to Y is

dq1 1
= .
dY p + a p
1 2
b

Therefore, the income elasticity of demand is

dq1 1
e q1 = *Y *
dY q1

a
p1 + p2
1 b
= *Y *
a Y
p1 + p2
b

=1

As in the case of the Cobb Douglas utility function, the income elasticity of
demand in the case of perfect complements is 1.

3.1 The income effect reinforces the substitution effect for normal goods. It partially offsets
the substitution effect for inferior goods. When it more than offsets the substitution effect,
it is known as a Giffen good.

3.3 Eggs and toast are perfect complements. U = min (3Qt, 2Qe). If the price of eggs
increases, we compensate Pat to make him just as “happy” as he was before (which
means his utility is the same as before), his consumption of eggs will still be the same as
shown below. There is only income effect and no substitution effect because eggs and
toast are perfect complements; Pat will not substitute toast with eggs even though the
price of eggs increases.
3.7 Initially, when Bayer aspirin is cheaper (on budget line L1), only aspirin is consumed (at
e1 on indifference curve I1). Then, the price of aspirin increases, making Tylenol
relatively cheaper. The new utility maximizing consumption bundle on the new budget
constraint (L2) is e2 on indifference curve I2. The total effect of the price change is from
e1 to e2, when consumption of Bayer aspirin decreases from B1 to 0.

To find the substitution and income effects, draw a new line (L*) parallel to the new
budget constraint (L2) to reflect the new prices but touching the original indifference
curve (I1) to reflect compensated utility. Line L* touches indifference curve I1 at e*. The
substitution effect is from e1 to e* (consumption of Bayer aspirin decreases from B1 to 0)
and the income effect is the movement between parallel lines L* and L2, from e* to e2.
The income effect is zero because consumption of Bayer aspirin stays at 0 between e*
and e2.
3.12 The expenditure function (E) is the relationship showing the minimal expenditures
necessary to achieve a specific utility level for a given set of prices. The expenditure
function is the inverse of the indirect utility function. First, for Sylvan, q1 and q2 are
p2
<2
perfect substitutes, so he'll consume only good q2 if p1 . So, his uncompensated
p2
<2
demand functions if p1 are

Y
q1 = 0 and q2 = .
p2
p2
If > 2 , then
p1
Y
q1 = and q2 = 0 .
p1
p2 æ Y ö 2Y
His indirect utility function (V) if < 2 is V = 0 + 2 ç ÷ = .
p1 è p2 ø p2
p æY ö Y
His indirect utility function (V) if 2 > 2 is V = ç ÷ + 0 = .
p1 è p1 ø p1
The expenditure function and indirect utility function are inverses:
p2U p
E= if 2 < 2
2 p1
and
p2
E = p1U if > 2.
p1
Therefore, the compensated demand functions are
¶E ¶E U p
q1 = = 0 and q2 = = if 2 < 2
¶p1 ¶p2 2 p1
and
¶E ¶E p
q1 = = U and q2 = = 0 if 2 > 2 .
¶p1 ¶p2 p1
4.3 See figure below. Ann will buy more books and less ice cream this year, and her utility
will be better off this year on I2 than on I1. This is because the price of book rose by less
than the price of
ice cream. So Ann can gain higher utility by consuming more books and less ice cream.

4.4 The attractive feature of the Big Mac as an indicator of price index is its uniform
composition.
The component ingredients of the Big Mac are the same across a long period and among
most countries. Therefore, Big Mac is a standardized bundle of goods. For cross-country
comparisons, we should assume other factors such as tax, tariff, and service costs are the
same for all countries.