ECON 317, Microeconomic Analysis

ECON 317, Microeconomic Analysis
Fall 2012, Dr. Walker
Name: _____________________________
CONSUMER THEORY
PROBLEM SET
Instructions: For some of these problems you will need a sheet of paper; others can be completed on the problem
set. Good luck.
1. Draw a figure showing a budget line for Meatwad, who spends his entire income (I=$50) on PeePantz CDs
(PCD=$5) and Cheez Whiz (PW = $4).
a. What is the slope of Meatwad’s budget line? Show your work.
b. What is the equation that describes Meatwad’s budget line? (Solve for the vertical axis intercept in general
terms. Then substitute in the values for the different variables. I want to see both.)
c. Show what happens to Meatwad’s budget line if Master Shake steals $15 from Meatwad AND the price of CDs
increases to $10 at the same time.
2. Suppose your cell phone service has a flat fee of $50, which includes up to 500 minutes. The next 100 minutes cost
a flat rate of $5. If you use more than these 600 minutes, you are charged 20¢ for each additional minute. Your
budget (I) to spend on cell phone minutes and the composite good is $100.
a. Draw the budget line for cell phone minutes (x axis) and the composite good (y axis).
b. Re-draw the budget line with cell phone on the y axis and the composite on the x axis.
c. Re-draw the budget line if each minute over 600 costs 45¢, but the other price information is the same.
3. Jeff Spicoli has I=$20 to spend on pot and tacos. The price of pot PP is $5 per bag, and the price of tacos PT is $2
each. Spicoli’s relative preferences for the goods are indicated in Figure 3a-b.
a. Draw the budget line on the figure. Then indicate Spicoli’s optimal bundle of goods (label the point “A”).
b. Next show what happens if PT rises to $3. (Be sure that you clearly indicate what happens to the budget line, and
what happens to the quantities of the goods consumed by Spicoli.)
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Figure 3a-b
Pot
10
2
1
0
1
2
10
Tacos
c. Suppose the government gives all high school students 2 units of pot, just to help them chill-out. How would this
affect Spicoli’s budget line and his consumption choices? Draw the new budget line and illustrate the optimal
consumption. Briefly explain the changes shown in the graph.
Figure 3c
Pot
10
2
1
0
1
2
10
2
Tacos
d. Katie’s preferences are that she strongly dislikes pot, but likes tacos. Draw her indifference curve on Figure 3c,
showing her optimal consumption point under the situation described in part c. Label this indifference curve K1.
Finally, draw another indifference curve for Katie if government not only gives students 2 units of pot, but it actually
forces them to smoke it too. Label this indifference curve K2. Under which situation is Katie better-off? Why?
4. What is a corner solution? Explain briefly. Then draw a graph and illustrate a corner solution for a consumer who
has a relatively strong preference for the good on the x-axis, but also likes the y-axis good.
5. Figure 5a-c (next page) shows Bubba’s budget and preferences for low-carb cigarettes and a composite (other
goods). Bubba’s income is I=$10.
a. What is the price of cigarettes?
b. Draw new budget lines (and label them) to represent the cases when (i) Bubba’s income is cut in half and (ii) when
his income is doubled (from the original budget). (You need to draw two additional budget lines, for three total.)
c. Draw two additional indifference curves and show the optimal consumption bundles for the budget lines drawn for
part b, assuming cigarettes are inferior goods for Bubba.
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Figure 5a-c
Other
goods
14
10
4
2
0
1
2
8
Low -carb
cigarettes
6. Carl lives near the southern Jersey shore, and wears sweatpants and tank-tops. His annual consumption behavior is
illustrated in Figure 6a-c.
a. The price of tank-tops PT is $3. What is the price of sweatpants, PS? Show your work.
b. What is Carl’s annual income? Show your work.
c. Draw the new budget line if PS rises by 50% and Carl’s income (I) rises by 50% (simultaneously). Draw a new IC
and illustrate Carl’s new consumption bundle.
4
Figure 6a-c
Sweatpants
10
2
1
0
1
2
10
Tanktops
d. Is Carl better off after the changes in part c, or was he happier in the initial situation? How do you know?
7. Suppose the demand for pizza is given by P = 8 – 0.5Qd, shown in the figure below. Calculate the price elasticity
of demand ( ) as required in each part below.
P
8
16
5
Q
a. Using the “(new-old)/old” formula for calculating percentage change (% ), calculate price elasticity of demand,
% Qd
, and suppose the price rises from $6 to $7. Recalculate it if price falls from $7 to $6.
% P
b. Use the “midpoint” formula to calculate . Recall that this method requires you to calculate the % as
“change/average”.
c. Explain which method, (a) or (b) is better for calculating the .
8. Suppose Carl has the budget line and indifference curve for pizza and beer as shown in the figure below.
a. Suppose the price of beer doubles. Draw the budget line that reflects the new price of beer. Then draw a possible
indifference curve and show the new consumption bundle for Carl.
b. Decompose the total effect of the price change into the substitution and income effects.
6
Qpizza
8
IC1
16
Qbeer
c. Explain what the “substitution” and “income” effects mean.
d. What does it mean that “the substitution effect is always negative, but the income effect can be positive or
negative”?
e. Does the case you’ve drawn above have a positive or negative income effect?
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9. On Tuesday, February 10, 2009, Treasury Secretary Timothy Geithner explained in very general terms part of his
proposal to restructure the financial industry. The federal government proposed to audit the biggest banks, and those
that weren’t “healthy” would get more federal money, with strings attached: the requirement that they use the money to
make loans.
The figures below illustrate the budget line and indifference curve for 1st Redneck Bank of Georgia (FRBG). The
bank uses its deposits and other money to pay CEO and executive bonuses, and to make loans. Suppose FRBG
qualified under Secretary Geithner’s plan as an “unhealthy” bank, and it receives $3 million from the federal
government. Follow the instructions below in order to complete figures (9a) and (9b) below.
(a) The bank has a relatively strong preference for increasing CEO bonuses; draw the initial indifference curve on the
budget line already shown on the graph. (Make the optimal consumption point that shown on the budget line at
[3,5].) Now draw the new budget line after the bank receives the bailout; make sure you draw the line so that it
represents an increase in the budget available for loans only. Next, suppose the bank interprets “the requirement that
they use the money to make loans” to mean that at least $3 million of the $11 million now available to the bank (postbailout) must be spent on making loans. Finally, draw the new indifference curve and clearly indicate the amount of
money the bank allocates to CEO bonuses and to loans.
Figure 9a
CEO bonuses
($ millions)
8
5
3
8
8
Loans
($ millions)
(b) Suppose the bank instead has moderate preferences for the goods on the x and y axes. Draw the initial indifference
curve on the budget line given in figure ii. (Make the optimal point that shown on the figure at [3,5].) Now draw the
new budget line after the bank receives the bailout. Next, suppose the bank interprets “the requirement that they use
the money to make loans” to mean that the entire $3 million must be used to make loans. This amount is in addition to
the amount that was being used for loans prior to the bailout.
Figure 9b
CEO bonuses
($ millions)
8
5
3
8
Loans
($ millions)
c. If the federal government allocates $50 billion to U.S. banks with the intent that $50 billion more in loans will be
given after the bailout is initiated, do you think that is the likely result? Explain.
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