Problems with solutions, Intermediate microeconomics, part 1

Niklas Jakobsson, nja@nova.no

Problem 1. Demand
Bengt’s utility function is U(x, y) = x1 + ln x2
x1 - stamps
x2 - beer
Bengts budget p1 x1 + p2 x2 = m
p1 – price of stamps
p2 – price of beer
m – Bengt’s budget
a) What is Bengt’s demand for beer and stamps?
b) Is it true that Bengt would spend every krona in additional income on stamps?
c) What happens to demand when Bengt’s income changes (i.e. find the income elasticity)?
d) What happens to demand when p1 and p2 increase (i.e. find the price elasticities)?

Problem 2. Demand
Jan has fallen on hard times. His income per week is 400 kr, spending 200 kr on food and 200 kr
on all other goods. However, he is also receiving a social allowance in the form of 10 food stamps
per week. The coupons can be exchanged for 10 kr worth of food, and he only has to pay 5 kr for
such coupons. Show the budget line with and without the food stamps. If Jan has homothetic
preferences, how much more food will he buy when he receives the food stamps?

Problem 3. Demand
Find the demand functions for the individuals below, the budget constraint is p xx+pyy=m
Bill: U(x1,x2) = x12 x23
Buster: U(x, y)=x2/5y3/5
Ben: U(x, y) = (x+1)2 (y+2)3
Barbara: U(x1,x2) =3x1 +2x2
Beth: U(x, y)=min{x , y}

Problem 4. Demand
Birgitta spends 150 SEK per month on coffee and buns at the cafeteria. A cup of coffee costs 15 SEK
and a bun costs 10 SEK.
a) Write the equation for Birgitta’s cafeteria budget constraint and draw it in a diagram.
b) Assume that Birgitta never drinks coffee without eating one bun, and never eats buns without
drinking coffee. How much of each will she consume? Draw some of her indifference curves.
c) What do we call goods that are always consumed in the same proportion?

Problem 1. Consumer’s surplus

Mattias has quasilinear preferences and his demand function for books is B = 15 – 0.5p.
a) Write the inverse demand function
b) Mattias is currently consuming 10 books at a price of 10 kr. How much money would he be willing
to pay to have this amount, rather than no books at all? What is his level of consumer's surplus?

Problem 2. Consumer’s surplus

Suppose Birgitta has the utility function U = x10.1 x20.9. She has an income of 100 and P1= 1 and P2=
1. Calculate compensating and equivalent variation when the price of x1 increases to 2. Also,
what is the change in utility (the change in consumer surplus).

Problem 3. Consumer’s surplus

Explain the concept of “consumer surplus” in words and illustrate by a diagram.

Problem 4. Consumer’s surplus

The inverse demand curve (the demand curve but with p instead of q on the left hand side) is
given by p(q)=100-10q. The consumer consumes five units of the good (q).
a) How much money would you have to pay to compensate her for reducing her
consumption to zero? (The consumer is not paying anything for the goods.)
b) Suppose now that the consumer is buying the goods at a price of 50 per unit. If you now
require her to reduce her purchases to zero, how much does she need to get
compensated? Hint: The number you will find is the net consumer’s surplus.

Problem 5. Consumer’s surplus

New housing is planned in Karlstad but the location where it is to be built is used as a popular
recreation area for people in neighbouring parts of the city. In order to decide whether to build or
not, the city authorities want to make a survey to measure the decrease in welfare due the loss of
this recreation area. They are told by an economist that two measures are possible, compensating
variation (CV) and equivalent variation (EV).
a) How should they formulate the question if they want to measure the compensating
variation?
b) How should they phrase it if they want to measure the equivalent variation?

Problem 1. Market demand

Linus has a demand function q = 10 - 2p
a. What is the price elasticity of demand when the price is 3?
b. At what price is the elasticity of demand equal to -1?
c. Suppose that his demand function takes the general form q = a - bp. Write down an algebraic
expression for his elasticity of demand at an arbitrary price p.

Problem 2. Market demand

The demand function is q(p) = (p+1)-2
a. What is the price elasticity of demand?
b. At what price is the price elasticity of demand equal to minus one?
c. Write an expression for total revenue as a function of the price.
d. Answer a-c when the demand function takes the more general form q(p) = (p+a)b where a > 0 and
b < -1.

Problem 3. Market demand

Find the price elasticity of demand for the following demand functions.
a) D(p)=30-6p
b) D(p)=60-p
c) D(p)=a-bp
d) D(p)=40p-2
e) D(p)=Ap-b
f) D(p)=(p+3)-2

Problem 1. Equilibrium
Suppose we have the following demand and supply equations
D(p) = 200 - p
S(p) = 150 + p
a. What is the equilibrium price and quantity?
b. The government decides to restrict the industry to selling only 160 units by imposing a maximum
price and rationing the good. What maximum price should the government impose?
c. The government doesn't want the firms in the industry to receive more than the minimum price
that it would take to have them supply 160 units of the good. Therefore, they issue 160 ration
coupons. If the ration coupons were freely bought and sold on the open market, what would be the
equilibrium price of these coupons?
d. Calculate the dead-weight loss from restricting the supply of the goods. Will the dead-weight
loss increase or decrease if the government would not allow the coupons to be sold on the open
market?

Problem 2. Equilibrium
The demand curve is qD = 100 - 5p and the supply curve is q S = 5p.
a. A quantity tax of 2 kr per unit is placed on the good. Calculate the dead-weight loss of the tax.
b. A value (ad valorem) tax of 20 % is placed on the good. Calculate the dead-weight loss of the tax.

Problem 3. Equilibrium
Assume that both demand and supply for a good are linear functions of its price:

D(p) = a + bp, a > 0, b < 0

S(p) = c + dp, c < 0, d> 0

a) Draw curves that fit this description in a diagram.

b) Assume that a tax t per unit has to be paid by the consumer. Show the effects on demand, supply,
equilibrium price, quantity consumed and consumer and producer welfare in your diagram.

c) Assume instead that an equally large tax has to be paid by the producer. What are the effects now
on demand, supply, equilibrium price, quantity consumed and consumer and producer welfare. (Use
a diagram to illustrate.)

Problem 1. Intertemporal choice

Suppose that a consumer has an endowment of 200.000 kr each period (period 1 and 2). He can
borrow money at an interest rate of 200%, and he can lend money at a rate of 0%.
a. Illustrate his budget set.
b. The consumer is offered an investment that will change his endowment to m 1 = 300.000 and m2 =
150.000. Would the consumer be better or worse off, or can't you tell?
c. If he is offered m1 = 150.000 and m2 = 300.000, is he better or worse off?

Problem 2. Intertemporal choice

Mainy Landin has an income of 200.000 kr this year and she expects an income of 110.000 kr next
year. She can borrow and lend money at an interest rate of 10%. Consumption goods cost 1 kr and
there is no inflation.
a. What is the present value of Mainy's endowment?
b. What is the future value of Mainy's endowment?
c. Suppose that Mainy has the utility function U = C 1C2. Write down Mainy's marginal rate of
substitution.
d. Set this slope equal to the slope of the budget line and solve for the consumption in period 1 and
2. Will she borrow or save in the first period.
e. = d, but the interest rate is 20%. Will Mainy be better or worse off?

Problem 1. Uncertainty
Jonas Thern maximises expected utility:

U(π1, π2,c1,c2) = π1 c10,5 + π2 c20,5

Jonas's friend Stefan Schwarz has offered to bet him 10.000 kr on the outcome of the toss of a coin. If
the coin comes up head, Jonas must pay Stefan 10.000 kr, and if the coin comes up tails, Stefan must
pay Jonas 10.000 kr. If Jonas doesn't accept the bet, he will have 100.000 kr with certainty. Let Event 1
be "coin comes up heads".
a. What is Jonas’s utility if he accepts the bet and if he decides not to bet? Does Jonas take the bet?
b. Answer the question in a, if the bet is 100.000 kr.
c. Answer the question if Jonas must pay Stefan 100.000 kr if he coin comes up head, but if the coin
comes up tails Stefan must pay Jonas 500.000 kr.
d. Klas Ingesson would also like to gamble with Jonas. He is very intelligent and realises the nature of
Jonas' preferences. He offers him a bet that Jonas will take. Klas says: "If you loose you will give me
100.000 kr. If you win, I will give you ........?

Problem 2. Uncertainty
Gabriel likes to gamble and his preferences are represented by the expected utility function
U(π1, π2,c1,c2) = π1 c12 + π2 c22

Gabriel has not worked out very well, he only have 1.000 kr. Thomas shuffled a deck of cards and
offered to bet Gabriel 200 kr that he would not cut a spade from the deck.
a. Show that Gabriel refuses the bet.
b. Would Gabriel accept the bet if they would bet 1.000 kr instead of 200 kr?
c. Sketch one of Gabriel's indifference curves (let Event 2 be the event that a card drawn from a fair
deck of cards is a spade)
d. On the same graph, sketch the indifference curve when the gamble is that he would not cut a
black card from the deck.

Answers to the problems

Problem 1. Demand
a) Given prices, p1 and p2, find the quantities x1 and x2 which maximise Bengt’s utility!
Necessary condition:

MU 1 p1
MRS  
MU 2 p 2
MU1= 1 MU2=1/x2
MRS = x2

p1
Therefore the optimum occurs when x2 
p2
Money left to buy x1 for:
p1
m  p 2 x2  m  p 2  m  p1
p2
m  p1 m
x1   1
p1 p1
if m>p1
b) Yes, if m>p1 he won’t buy any more beer when m increases.
c)-d)
 dx1 p1 m p1 m p12
 p1   2  2 
dp1 x1 p1 m  p1 p1 m  p1
p1
m

m  p1
dx2 p2 p p
 p2    12 2  1
dp2 x2 p2 p1
p2
dx1 m 1 m p1m
 m1    
dm x1 p1 m  p1 p1 (m  p1 )
p1
m
 (m  p1 )
(m  p1 )
dx2 m m
 m2   0  0
dm x2 x2

Problem 2. Demand
y = 400
10 food stamps per week, price 5 kr. Can be exchanged for 10 kr worth of food.
Old budget line: max 400 other and 400 food.
New budget line: max 400 other and 450 food, kink at 100 food and 350 other.
Homothetic preferences: The income expansion path is a straight line through origin.
Since Jan spent half his income on food, he will continue doing so. His income increases by 50 kr, thus
he spends 25 kr more on food.

Problem 3. Demand
Bill:
u u
 2 xy 3  2x 2 y 2
x y

= (simplify)
= (solve for y)
y= (insert this into the budget restriction)
m = Py + Px x = + P x x = P x x (solve for x)

x= (insert this into the expression for y)

y= = =
We can also solve this by transforming the utility function to a Cobb-Douglas:
v(x2y3)1/5 = x2/5 y3/5
x= =
Ben:
u u
 2 x  1 y  2   2 x  1  y  2 
3 2 2

x y

= (simplify)
= (solve for y)
2y = 3(x+1) - 4
y= - (insert this into the budget restriction)
m = Px x + Py ( - ) (simplify)

m = Px x + Px - Py 2 = Px x + Px x + Px - 2 Py (solve for x)

Px x + Px x = m - Px + 2Py

Px x = m - Px + 2Py (divide both sides with Px)

x= - +2
x= - + (insert this into the expression for y)
y= -2
y= - + + 1-2 (simplify)
y= - + + -2
y= + -
y= + -

Problem 4. Demand
C denotes the number of cups of coffee and B the number of buns:
a) 15C+ 10B = 150. The budget line intersects the “coffee-axis” at C = 10 and the “bun-axis” at B = 15.
b) 6 of each. Her indifference curves are L-shaped with the corners on the 45-degree line.
c) Perfect complements.

Problem 1. Consumer’s surplus

a) P = 30 - 2B
b) Willingness to pay: 10*10 + = 200
Consumer’s surplus: = 100

Problem 2. Consumer’s surplus

U ( x, y )  x 0,1 y 0,9

m0 = 100, p0 = q0 = 1 where p is the price of x, q the price y

Caclulate CV and EV when p increases to 2
i) Initially U is a Cobb-Douglas function so we know that
am 0,1  100
x   10
p 1
bm 0,9  100
y   90
q 1
U  10 0,1  90 0,9
ii) If p = 2 then x = 0,1 *100*1/2 = 5
y is independent of p, and therefore unchanged.

U  50,1  90 0,9
iii) CV: Let m’ = 100 + CV and assume that p = 2
x = 0,05m’ y = 0,9m’
The definition of CV 
0,1m' 0,9m'
U( , )  U (10,90)  10 0,190 0,9
2 1
0,10,1
0,1
(m' ) 0,1  0,9 0,9 (m' ) 0,9  10 0,190 0,9
2
10 0,1  2 0,1  100 0,9  0,9 0,9
( m' ) 0,1 0,9 
0,10,1  0,9 0,9
0,1
 10 
m'     2 0,1  100 0,9  2 0,1  100 0,1 0,9  2 0,1  100  107,177
 0,1 
CV  7,18

iv) EV: Find the income m’= 100 –EV such that the maximal utility when p=2 and m=100 is the same
as when p=1 and m = m’
If p =2 and m = 100, U  50,190 0,9 according to ii)
If p = 1, m = m’ then x = 0,1m’ och y = 0,9m’
U  (0,1) 0,1  ( m' ) 0,1  (0,9) 0,9  ( m' ) 0,9  m'(0,1) 0,1  (0,9) 0,9  0,1  (9) 0,9 m'

should be equal to 50,190 0,9

After simplification, this implies that m’ = 100*2 -0,1 ≈93,30
EV ≈ 6,7

Problem 3. Consumer’s surplus

The consumer surplus is a (monetary) measure of the utility a consumer derives from her/his
consumption of the good and the price paid for it and it corresponds to the area under the demand
curve, but above the price (assuming that the income effect is so small that it can be disregarded).
p
p* and q* are the price and the quantity
CCS
p* demanded at this price.
 q*

If you see the demand curve as that of an individual, the reason for CS is that the reservation price is
decreasing in q and the person would have been willing to pay more if the seller could have charged
the highest possible price for each unit. If you see it as the market, aggregate demand different
individuals have different reservation prices and - since perfect price discrimination is usually not
possible – the market price for all buyers will be the reservation price of the marginal buyer. (Either
answer is OK.)

Problem 4. Consumer’s surplus

a) 5*50+(100-50)*5/2=375. (Hint: It is easier to see this if you plot the demand curve in a
figure.)
b) 375-(5*50)=125

Problem 5. Consumer’s surplus

a) To ask for the compensating variation: What compensation (for example, in the form of a tax
decrease) would make you agree to have the new housing construction?
b) To ask for the equivalent variation: How much would you be willing to give up (say, in the
form of a tax increase) if this could stop the construction plans?

Problem 1. Market demand

Demand function D(p) = q = 10 -2p
a) What is the price elasticity of demand when p = 3
dq
 2 q(3) = 10 – 2*3 = 4
dp

ε= -2 * ¾ = -3/2
b) At what price and quantity is ε = -1?
ε = -1 
dq p
  1
dp 10  2 p
p
2  1
10  2 p
2 p  10  2 p
10  2 p
p  5 p
2
p  2.5

c) If the demand function is D(p)=a-bp, what is the elasticity of demand?

dq p p
   b
dp q a  bp

Problem 2. Market demand

q(p) = (p+1)-2
a) The price elasticity of demand

dq p p 2p
   2( p  1)  3  2 p ( p  1)  3 ( p  1) 2  
dp q 2 p 1
( p  1)

 2p
b) If p≠-1 p  1  1  2 p   p  1  p  1

c) Total revenue R = pq = p(p+1)-2

d) Answers to a)-c) when q(p)=(p+a)b, a>o and b<-1
bp
 = -1 when p = -a/(b+1) R(p) = p(a+p)b
pa

Problem 3. Market demand

a) dD(p)/dp=-6 and p/q=p/(30-6p), so ϵ=-6p/(30-6p)
b) ϵ=-p/(60-p)
c) ϵ=-bp/(a-bp)
d) ϵ=-2
e) ϵ=-b
f) ϵ=-2p/(p+3)

Problem 1. Equilibrium
a. D(p) = S(p)
200 - p = 150 + p
p = 25
D(p) = 200 - 25 = 175
b. When is S = 160:
160 = 150 + p
p = 10
c. Willingness to pay at q = 160:
160 = 200 - p
p = 40
Maximum price - minimum price = 40 - 10 = 30 = price of the coupons.
d. Dead-weight loss of restricting the supply:
DW = = 225.

Problem 2. Equilibrium

qD = 100 - 5p qS = 5p

pS =
No tax:
100 - 5p = 5p
p = 10
q = 50
Tax:

pS = + 2 ==> q = 5p - 10
100 - 5p = 5p - 10
p = 11
q = 45
The revenue per unit is (according to the old supply curve):
p= =9
N.B. the price increase is not equal to the tax.

Problem 3. Equilibrium
a) With p on the vertical axis and q on the horizontal: The demand curve intersects the p-axis above
the q-axis and slopes downwards to the right, the supply curve slopes upwards to the right. It ends at
a point with p = 0 and q > 0 because p < 0 is not economically feasible. If the line had continued, it
would have intersected the p-axis at a value p<0.
b) See Varian, figure 16.3. The demand curves shifts downwards by the amount t, the supply curve is
unchanged. q is reduced, the consumer pays a higher price and the producer gets a lower price than
before. There is a loss of welfare, due to the deadweight loss (reduction in q). The amount of the tax
is a welfare loss to consumer and/or producer but not a social welfare loss since it is a transfer that
can be used for other welfare-increasing purposes. (Which may even compensate some deadweight
loss if it is used to rectify a market imperfection somewhere else in the economy or to make
distribution of wealth agree better with the social welfare function, which we will cover later on in
this course.)
c. See Varian figure 16.3. The results are exactly the same as in b. How much of the incidence of the
tax is born by consumers and producers, respectively, depends on the slopes of the demand and
supply curves, not on who formally pays the tax.
Problem 1. Intertemporal choice
a. C2 = m2 + (1+r)(m1 - C1)

Maximum consumption in period 1:

200.000 + = 200.000 + = 266.667
If she borrows 66.667 she will have to pay (1+r) 66.667 in period 2.
Maximum consumption in period 2:
200.000 + 200.000 = 400.000
b. New endowment: m1 = 300.000 and m2 = 150.000.

Maximum consumption in period 1:

300.000 + = 350.000
Maximum consumption in period 2:
300.000 + 150.000 = 450.000
The consumer will be better off. The consumption that she did choose before the change in the
endowment is still affordable.
c. m1 = 150.000 and m2 = 300.000

Maximum consumption in period 1:

150.000 + = 250.000
Maximum consumption in period 2:
150.000 + 300.000 = 450.000
b is better or at least as good as c.
If he is a saver then c is better than a. Better otherwise we cannot say if a or c is the better
alternative.

Problem 2. Intertemporal choice

a. PV = 300000
b. Future value = 330000
c. U = C1 C2

MRS = -
d. The budget constraint:
C2 = m2 + (1+r)(m1 - C1)

C2 = m2 + (1+r)m1 - (1+r)C1

Slope: = -(1+ r) = -(1 + 0,1)

Set this equal to the MRS:
- = -(1+0,1) (solve for C2)

C2 = 1,1 C1 (insert this into the budget constraint)

1,1C1 = 110.000 + (1+0,1)200.000 - (1+0,1)C 1 (solve for C1)

2,2C1 = 330.000

C1 = 150.000 (insert this into the expression for C2)

C2 = 1,1 * 150.000 = 165.000

She will save (200.000 - 150.000) 50.000 in the first period.

e. If r = 20% then C2 = 1,2C1 (insert this into the budget constraint)

1,2C1 = 110.000 + (1+0,2)200.000 - 1,2C 1 (solve for C1)

C1 =145.833

C2 = 1,2 * C1 = 175.000

Utility in d: U = 150.000 * 165.000 = 24.750.000

Utility in e: U = 145.833 * 175.000 = 25.520.775
She is better off if the interest rate is 20%.

Problem 1. Uncertainty
a. UNo game = = 316,2

UGame = 0,5 + 0,5 = 315,8

Jonas doesn't take the bet.

Declining marginal utility for money ==> risk aversion.
 Nytta
Konkav nyttofunktion
U(15)

U(10)

U(5) 0,5 U(5) + 0,5 U(15)

Förmögenhet

b. C1 = 0 C2 = 200.000

UGame = 0,5 = 223,6

Jonas doesn't take the bet, since UNo game > UGame

c. C1 = 0 C2 = 600.000

UGame = 0,5 = 387,3

Jonas take the bet, since UGame > UNo game

d. C1 = 0 C2 = X

UGame = 0,5 + 0,5

UNo game =

Set this two equal to find the value of X where Jonas is indifferent between taking the bet or not:
0,5 + 0,5 =
X = 400.000
That is: "If you win I will give you 300.000."

Problem 2. Uncertainty

a. UNo game = 1.0002 = 1.000.000

C1 = 800 C2 = 1.200 _1 = 0,75 _2 = 0,25

UGame = 0,75 * 8002 + 0,25 * 1.2002 = 840.000 < 1.000.000

b. UGame = 0,75 * 02 + 0,25 * 2.0002 = 1.000.000

He is indifferent between taking the bet or not.

c. UGame = UNo game

0,75 * C + 0,25 * C = 1.000.000

 C2 C1

0 1154,7
500 1118
1.000 1.000
1.500 763,8
2.000 0
d. UGame = UNo game

0,5 * C + 0,5 * C = 1.000.000

C1 =

C2 C1

0 1.414,2
500 1.323
1.000 1.000
1.414,2 0