Ch05solution Manual

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual
Chapter 5
The Theory of Demand
Solutions to Review Questions
1.
What is a price consumption curve for a good?
The price consumption curve plots the set of optimal bundles for two goods, say X and Y, by
changing the price of one good while holding the price of the other good and income constant.
2.
How does a price consumption curve differ from an income consumption curve?
The price consumption curve plots the set of optimal bundles for two goods as the price of one
good changes while the price of the other good and income remain constant. The income
consumption curve, on the other hand, plots the set of optimal bundles for two goods as the
consumers income changes while holding the prices of both goods constant.
3.
What can you say about the income elasticity of demand of a normal good? of an
inferior good?
With a normal good, when income increases, consumption of the good will increase. This
implies the income elasticity for a normal good will be positive. With an inferior good, when
income increases consumption of the good will decrease. This implies the income elasticity for
an inferior good will be negative.
4.
If indifference curves are bowed in toward the origin and the price of a good drops,
can the substitution effect ever lead to less consumption of the good?
If indifference curves are bowed in toward the origin and the price of, say, good X falls,
consumption of X will always increase; so the substitution effect will always be positive. A
decrease in the price of X implies that the slope of the budget line becomes flatter. When
indifference curves are bowed in, a direct consequence of this change in relative prices is that
any tangency will occur southeast of the original bundle along the initial indifference curve.
The only way for consumption to fall when price falls is for the income effect to be negative (an
inferior good) and for its magnitude to more than offset the substitution effect. In this rare
situation, the good is known as a Giffen good.
5.
Suppose a consumer purchases only three goods, food, clothing, and shelter. Could
all three goods be normal? Could all three goods be inferior? Explain.
If the consumer purchases only three goods and income increases, it is possible that consumption
of all three goods will increase. For example, the consumer might allocate one-third of the
increase to each of the three goods. Thus, it is possible for all three goods to be normal. If the
consumer purchases only three goods and income increases, it is not possible that consumption
of all three goods will decrease. Recall that if consumption falls when income increases the
Copyright 2014 John Wiley & Sons, Inc.
Chapter 5 - 1
good is inferior. If this were to occur, the consumer would be spending less income than he did
prior to the income increase. Thus, it is not possible for all three goods to be inferior.
6.
Does economic theory require that a demand curve always be downward sloping? If
not, under what circumstances might the demand curve have an upward slope over some
region of prices?
Generally speaking demand curves are downward sloping. Economic theory, however, suggests
a special case of an inferior good whose negative income effect is greater than its positive
substitution effect. In this event, consumption of the good falls when the price of the good falls.
This type of good is known as a Giffen good. While economic theory suggests that such a good
could exist, in practice no such good has been confirmed for humans (although the text suggests
an experiment on rats where a good was determined to be a Giffen good).
7.
What is consumer surplus?
Consumer surplus is the difference between the maximum amount a consumer is willing to pay
for a good and what he must actually pay when he purchases it in the marketplace. For example,
if Joe is willing to pay $20 for a cap but purchases it at the store for only $5, Joe will receive $15
in consumer surplus. This measure indicates how much better off the consumer is after
purchasing the good.
8. Two different ways of measuring the monetary value that a consumer would assign to the
change in price of the good are (1) the compensating variation and (2) the equivalent
variation. What is the difference between the two measures, and when would these
measures be equal?
Compensating variation answers the question, How much would the consumer be willing to
give up after a price reduction to achieve the same level of satisfaction as she had before the
price change? Equivalent variation, on the other hand, answers the question, How much
money would we have to give the consumer before a price reduction to leave her level of
satisfaction the same as it would be after the price reduction? In essence, both of these are
measures of the distance between the initial and final indifference curves after a price change.
Typically the compensating and equivalent variation measures will not be the same. In the case
of quasi-linear utility functions, however, the compensating and equivalent variation measures
will always be the same (they will be equal to the change in consumer surplus). In general, these
two measures will be identical when there is no income effect associated with a price change.
9. Consider the following four statements. Which might be an example of a positive
network externality? Which might be an example of a negative network externality?
(i) People eat hot dogs because they like the taste, and hot dogs are filling.
(ii) As soon as Zack discovered that everybody else was eating hot dogs, he stopped buying
them.
(iii) Sally wouldnt think of buying hot dogs until she realized that all her friends were
eating them.
(iv) When personal income grew by 10 percent, hot dog sales fell.
Chapter 5 - 2
(i) No network externality

(ii) Negative network externality
(iii) Positive network externality
(iv) Since sales fall when income increases, this might be a negative network externality if some
consumers stopped buying hot dogs not only because of a lower income, but also because other
consumers bought fewer hot dogs.
10. Why might an individual supply less labor (demand more leisure) as the wage rate
rises?
When the wage rate rises, the substitution effect will induce a worker to supply more hours of
labor. The income effect, on the other hand, may induce the worker to increase the amount of
leisure and decrease the amount of labor. If the income effect reduces the amount of labor
supplied more than the substitution effect increases it, the worker will ultimately supply less
hours of labor.
Solutions to Problems
5.1
Figure 5.2(a) shows a consumers optimal choices of food and clothing for three
values of weekly income: I1 = $40, I2 = $68, and I3 = $92. Figure 5.2(b) illustrates how the
consumers demand curve for food shifts as income changes. Draw three demand curves for
clothing (one for each level of income) to illustrate how changes in income affect the
consumers purchases of clothing.
Py
D2 (I=68)
D3 (I=92)
D1 (I=40)
y
5
11
5.2
Use the income consumption curve in Figure 5.2(a) to draw the Engel curve for
clothing, assuming the price of food is $2 and the price of clothing is $4.
Chapter 5 - 3
5.3
Show that the following statements are true:
a) An inferior good has a negative income elasticity of demand.
b) A good whose income elasticity of demand is negative will be an inferior good.
%Q Q / Q Q I

%I
I / I I Q
I and Q must be greater than zero. In addition, assume income increases, i.e., I 0 . If the
good is inferior, then Q 0 . Thus, the first term (Q / I ) 0 and the second term ( I / Q) 0 .
Multiplying these two terms together implies Q , I 0 . Inferior goods have a negative income
elasticity of demand.
a)
Q,I
b)
If income elasticity of demand is negative then

Q I
Q,I
0.
I Q
Since I and Q must be greater than zero, for Q , I to be negative, we must have
Q
0.
I
This can only happen if either a) Q 0 and I 0 or b) Q 0 and I 0 . In both
instances, the change in quantity demanded moves in the opposite direction as the change in
income implying the good is inferior.
5.4
If the demand for a product is perfectly price inelastic, what does the corresponding
price consumption curve look like? Draw a graph to show the price consumption curve.
Chapter 5 - 4
If demand for good X is perfectly price inelastic then the demand curve is a vertical line and
quantity remains constant as price changes. Graphing the price consumption curve for good X
on an optimal choice diagram would appear as
Y
Price consumption
curve
X
The price consumption curve is a straight line because the level of consumption of X is constant.
5.5
Ann consumes five goods. The prices of all goods are fixed. The price of good x is px.
She spends 25 percent of her income on good x, regardless of the size of her income.
a) Show that her income elasticity of demand of good x is the same for any level of income,
and determine its value.
b) Would the value of the income elasticity of demand for x be different if Ann always
spends 60 percent of her income on good x?
a) Since she spends 25% of her income on x, it must be true that pxx/I = 0.25. Thus x/I = 0.25/px.
This means that x/I is a constant. If I increases by 1%, x must also increase by 1%. Since the
percentage increase in x is the same as the percentage increase in I, the income elasticity must be
1.
b) The income elasticity of demand would still be 1. Now x/I = 0.6/px. This means that x/I is a
constant. If I increases by 1%, x must also increase by 1%.
5.6
Suzie purchases two goods, food and clothing. She has the utility function U(x, y) =
xy, where x denotes the amount of food consumed and y the amount of clothing. The
marginal utilities for this utility function are MUx = y and MUy = x.
a) Show that the equation for her demand curve for clothing is y = I/(2Py).
b) Is clothing a normal good? Draw her demand curve for clothing when the level of
income is I = 200. Label this demand curve D1. Draw the demand curve when I = 300 and
label this demand curve D2.
c) What can be said about the cross-price elasticity of demand of food with respect to the
price of clothing?
a)
At the consumers optimum we must have
Chapter 5 - 5
MU x MU y
Px
Py
y
x
Px Py
Substituting into the budget line, Px x Py y I , gives
P
Px y y Py y I
Px
2 Py y I
y
b)
I
2 Py
Yes, clothing is a normal good. Holding Py constant, if I increases y will also increase.
c)
The cross-price elasticity of demand of food with respect to the price of clothing must be
zero. Note in part a) that with this utility function the demand for y does not depend on the price
of x. Similarly, you can show that the demand for food is x = I / (2Px), which does not depend on
the price of y. In fact, the consumer divides her income equally between the two goods
regardless of the price of either. Since the demands do not depend on the prices of the other
goods, the cross-price elasticities must be zero.
5.7
Karls preferences over hamburgers (H) and beer (B) are described by the utility
function: U(H, B) = min(2H, 3B). His monthly income is I dollars, and he only buys these
two goods out of his income. Denote the price of hamburgers by PH and of beer by PB.
a) Derive Karls demand curve for beer as a function of the exogenous variables.
b) Which affects Karls consumption of beer more: a one dollar increase in PH or a one
dollar increase in PB?
Chapter 5 - 6
a)
Karls optimal bundle will always be such that 2H = 3B. If this were not true then he
could decrease the consumption of one of the two goods, staying at the same level of utility and
reducing expenditure. Also, at the optimal bundle, it must be true that PH H PB B I .
Substituting the first condition into the second we get B (1.5PH PB ) I which implies that the
demand curve for beer is given by, B
I
(1.5 PH PB )
b)
You can answer this just by looking at the demand curve. Because it has a larger
coefficient, the price of hamburgers affects the demand for beer more than the price of beer. A
one dollar increase in PH decreases demand for beer more than a one dollar increase in PB .
5.8
David has a quasi-linear utility function of the form U(x, y) = x + y, with associated
marginal utility functions MUx = 1/(2x) and MUy = 1.
a) Derive Davids demand curve for x as a function of the prices, Px and Py. Verify that the
demand for x is independent of the level of income at an interior optimum.
b) Derive Davids demand curve for y. Is y a normal good? What happens to the demand
for y as Px increases?
a)
Denoting the level of income by I, the budget constraint implies that
the tangency condition is
1
2 x
px x p y y I
and
px
py2
x
,
which
means
that
. The demand for x does not
py
4 px2
depend on the level of income.

b)
From the budget constraint, the demand curve for y is, y
py
I px x
I
.
py
p y 4 px
You can see that the demand for y increases with an increase in the level of income,
indicating that y is a normal good. Moreover, when the price of x goes up, the demand for y
increases as well.
5.9
Rick purchases two goods, food and clothing. He has a diminishing marginal rate of
substitution of food for clothing. Let x denote the amount of food consumed and y the
amount of clothing. Suppose the price of food increases from Px1 to Px2. On a clearly labeled
graph, illustrate the income and substitution effects of the price change on the consumption
of food. Do so for each of the following cases:
a) Case 1: Food is a normal good.
b) Case 2: The income elasticity of demand for food is zero.
c) Case 3: Food is an inferior good, but not a Giffen good.
d) Case 4: Food is a Giffen good.
a)
Chapter 5 - 7
B
C
X
Substitution Effect
Income Effect
b)
Y
B
A
C
X
Substitution Effect
Income Effect = 0
c)
Chapter 5 - 8
B
A
C
X
Substitution Effect
Income Effect
d)
Y
B
A
C
X
Substitution Effect
Income Effect
5.10 Reggie consumes only two goods: food and shelter. On a graph with shelter on the
horizontal axis and food on the vertical axis, his price consumption curve for shelter is a
vertical line. Draw a pair of budget lines and indifference curves that are consistent with
Chapter 5 - 9
this description of his preferences. What must always be true about Reggies income and
substitution effects as the result of a change in the price of shelter?
Food
Price
Consumption
Curve
Shelter
A pair of possible indifference curves and budget lines are shown above. For the Price
consumption curve to be a vertical line, it must be that Reggies demand for shelter does not
change even when the price of shelter changes and the budget line rotates.
The fact that his optimal bundle stays the same, despite a price change, means that
Reggies income and substitution effects as a result of a change in the price of shelter must
cancel each other out so as to leave a net zero effect. For example, if the price of shelter were to
decrease, the substitution effect would be positive and this would imply a negative income effect,
just large enough to cancel out the substitution effect. In other words, the two effects have the
same magnitude but opposite signs. This also implies that Reggie views shelter as an inferior
good.
5.11 Gingers utility function is U(x, y) = x2y, with associated marginal utility functions
MUx = 2xy and MUy = x2. She has income I = 240 and faces prices Px = $8 and Py = $2.
a) Determine Gingers optimal basket given these prices and her income.
b) If the price of y increases to $8 and Gingers income is unchanged, what must the price
of x fall to in order for her to be exactly as well off as before the change in Py?
Chapter 5 - 10
a)
The budget constraint is 8 x 2 y 240 and the tangency condition is
2y 8
4.
x
2
Solving, the optimal bundle is (x, y)=(20, 40) with a utility of 202(40)=16,000.
b)
Now py=8. We need to calculate px such that, with the new prices, Ginger reaches exactly
the same indifference curve as before. The new optimal bundle (x,y) must be such that:
2 y px
p x x 8 y 240, and x 2 y 16000 . The tangency condition now implies that

that is,
x
8
p x x 16 y. Substituting this into the budget constraint we find that y=10. Using the condition
x 2 y 16000 , we find that x = 40. Finally, substituting the values of x and y back into the budget
constraint, we can see that p x 40 8(10) 240 , or px=4. Therefore, if the price of y were to
increase to $8, Ginger would need the price of x to decrease to $4 in order to be exactly as well
off as before.
5.12 Anns utility function is U(x, y) = x + y, with associated marginal utility functions
MUx = 1 and MUy = 1. Ann has income I = 4.
a) Determine all optimal baskets given that she faces prices Px = 1 and Py = 1.
b) Determine all optimal baskets given that she faces prices Px = 1 and Py = 2.
c) What is demand for y when Px = 1 and Py = 1? What is demand for y when Px = 1 and Py
> 1? What is demand for y when Px = 1 and Py < 1? Plot Anns demand for y as a function of
Py.
d) Repeat the exercises in a), b) and c) for U(x, y) = 2x + y, with associated marginal utility
functions MUx = 2 and MUy = 1, and with the same level of income.
a)
Notice that MUx / MUy = 1 for all x and y. In this case indifference curves are straight
lines with slope 1. Therefore, when Px = 1 and Py = 1 all pairs of x and y such that x + y = 4 are
optimal baskets.
b)
Optimal consumption in this case is at a corner point. Since the price of x is smaller than
the price of y and marginal utility of each good is the same, consumer is better off purchasing
only x. (Another way to see this is to note that MU X/PX = 1/1 > MUY/PY = .) Hence, the
optimal basket consists of 4 units of x and zero units of y.
c)
When price of y is lower than 1 there are zero units of x in the optimal basket. Hence, for
Px = 1 and Py < 1 the demand for y equals to I / Py.
Chapter 5 - 11
Py
d)
By the same argument Ann purchases only x when Px = 1 and Py = 1. Marginal utility per
dollar from consumption of x is higher than marginal utility per dollar of y. When Px = 1 and Py =
2 marginal utilities per dollar are the same for both goods. Hence, all baskets such that 2x + y = 4
are optimal. Construction of the demand curve is similar as in part c).
5.13 Some texts define a luxury good as a good for which the income elasticity of
demand is greater than 1. Suppose that a consumer purchases only two goods. Can both
goods be luxury goods? Explain.
Consider any change in income I . For the budget constraint to hold, it must be true that
I Px x Py y .
(For example, if income increases then some of it may be spent on x and some on y, but the total
new expenditures must be equal to the change in income.) Since we are interested in income
elasticities, it helps to rewrite the previous equation as
1 Px
x
y
Py
I
I
Since x , I x I I / x and y , I y I I / y , we can write this as

1 Px
x
y
x , I Py y , I
I
I
Or
I Px x x , I Py y y , I
Chapter 5 - 12
But if both goods are luxury goods, then x , I 1 and y , I 1 so that the previous equation
implies
I Px x 1 Py y 1
Thus, if both x and y are luxury goods then I > I, which obviously is untrue! Therefore, both
goods cannot simultaneously be luxury goods.
5.14 Scott consumes only two goods, steak and ale. When the price of steak falls, he buys
more steak and more ale. On an optimal choice diagram (with budget lines and indifference
curves), illustrate this pattern of consumption.
When the price of steak falls, the budget line rotates from BL1 to BL2. The consumer now
maximizes utility on U2 at point B on BL2. The amounts of steak and ale consumed at point B
are greater than the initial amounts consumed at point A. This is shown in the following figure.
Ale
B
A
U2
U1
BL1
BL2
Steak
5.15 Dave consumes only two goods, coffee and doughnuts. When the price of coffee falls,
he buys the same amount of coffee and more doughnuts.
a) On an optimal choice diagram (with budget lines and indifference curves), illustrate this
pattern of consumption.
b) Is this purchasing behavior consistent with a quasi-linear utility function? Explain.
a)
Chapter 5 - 13
Doughnuts
B
BL1
A
BL2
Coffee
In the diagram above, the consumer purchases the same amount of coffee and more doughnuts
after the price of coffee falls.
b)
No, this behavior is not consistent with a quasi-linear utility function. While it is true that
there is no income effect with a quasi-linear utility function, the substitution effect would still
induce the consumer to purchase more coffee when the price of coffee falls.
5.16 (This problem shows that an optimal consumption choice need not be interior and
may be at a corner point.) Suppose that a consumers utility function is U(x, y) = xy + 10y.
The marginal utilities for this utility function are MUx = y and MUy = x + 10. The price of x
is Px and the price of y is Py, with both prices positive. The consumer has income I.
a) Assume first that we are at an interior optimum. Show that the demand schedule for x
can be written as x = I/(2Px) 5.
b) Suppose now that I = 100. Since x must never be negative, what is the maximum value of
Px for which this consumer would ever purchase any x?
c) Suppose Py = 20 and Px = 20. On a graph illustrating the optimal consumption bundle of
x and y, show that since Px exceeds the value you calculated in part (b), this corresponds to
a corner point at which the consumer purchases only y. (In fact, the consumer would
purchase y = I/Py = 5 units of y and no units of x.)
d) Compare the marginal rate of substitution of x for y with the ratio (Px/Py) at the
optimum in part (c). Does this verify that the consumer would reduce utility if she
purchased a positive amount of x?
e) Assuming income remains at 100, draw the demand schedule for x for all values of Px.
Does its location depend on the value of Py?
a)
If we are at an interior optimum the tangency condition must hold:

P
y
x
x 10 Py
Py y Px ( x 10)
Chapter 5 - 14
Substituting into the budget line, Px x Py y I , yields

Px x Px ( x 10) I
2 Px x 10 Px I
2 Px x I 10 Px
x
b)
I
5
2 Px
If I 100 , then
x
100
5
2 Px
50
5
Px
Since we must have x 0 , we must have

50
5 0
Px
50
5
Px
50 5 Px
Px 10
So the consumer would only purchase x for prices less than 10.
c)
Chapter 5 - 15
Given Px Py 20 , the slope of the budget line is 1. At the corner point optimum, the slope of
the indifference curve is
MU x
y
5
1

MU y
x 10
10
2
Because the indifference curve has a flatter slope than the budget line, the consumer would like
to substitute more y for x , but has no more x to give up at the corner point.
MU x
5 10 MU y
. If the consumer were to purchase any x , since the bang for

Px
20 20
Py
the buck for x is less than the bang for the buck for y , the consumer would reduce total
utility by increasing x above zero.
d)
e)
As shown in part a), the demand for x depends only on I and Px . Therefore, the location of the
demand curve does not depend on Py .
5.17 The figure below illustrates the change in consumer surplus, given by Area ABEC,
when the price decreases from P1 to P2. This area can be divided into the rectangle ABDC
and the triangle BDE. Briefly describe what each area represents, separately, keeping in
mind the fact that consumer surplus is a measure of how well off consumers are (therefore
the change in consumer surplus represents how much better off consumers are). (Hint: Note
that a price decrease also induces an increase in the quantity consumed.)
Chapter 5 - 16
P1
P2
As the figure shows, a decrease in the price from p1 to p2 induces an increase in quantity from q1
to q2. The resulting change in consumer surplus is due to two things:
First, the consumer is paying a lower price, per unit, on all the units of the good that he was
consuming before the price change. That is, for the q1 units he was earlier consuming, he now
pays a lower price and therefore enjoys a higher consumer surplus, denoted by the area of the
rectangle ABCD. Another way of putting this is that if he continued to consume q1 even after the
price change his consumer surplus would increase by only area ABCD.
Second, the lower price induces him to consume more of the good in question. In fact he
consumes (q2 q1) more units. The additional benefit he gets from this is the area of triangle
BDE.
5.18 The demand function for widgets is given by D(P) = 16 2P. Compute the change in
consumer surplus when price of a widget increases for $1 to $3. Illustrate your result
graphically.
For price of a widget equal to $1 consumer surplus is
CS$1 = (8 1) D(1) = 7 14 = 49.
When price is equal to $3 consumer surplus is
CS$3 = (8 3) D(3) = 5 10 = 25.
Chapter 5 - 17
$8
Area of ABE triangle

CS when P = $3 is 25
D(P) = 16 2P
$3
$1
Area of ACD triangle

CS when P = $1 is 49
D(P)
5.19 Jims preferences over cookies (x) and other goods (y) are given by U(x, y) = xy with
associated marginal utility functions MUx = y. and MUy = x. His income is $20.
a) Find Jims demand schedule for x when price of y is Py = $1.
b) Illustrate graphically the change in consumer surplus when the price of x increases from
$1 to $2.
a)
Jims optimal basket is a solution to equations MUx / MUy = Px / Py and Px x + Py y = I.
Hence, we have y / x = Px and Px x + y = 20 with solution x = 10 / Px and y = 10. Demand
schedule for x is D(Px) = 10 / Px.
b)
Px
$2
$1
B
C
D
5
10
The change in consumer surplus is area of region ABCD under the demand curve. The are of this
region can be computed by simple integration: [1,2] 10/p dp = 10 ln(2).
Chapter 5 - 18
5.20 Lous preferences over pizza (x) and other goods (y) are given by U(x, y) = xy, with
associated marginal utilities MUx = y and MUy = x. His income is $120.
a) Calculate his optimal basket when Px = 4 and Py = 1.
b) Calculate his income and substitution effects of a decrease in the price of food to $3.
c) Calculate the compensating variation of the price change.
d) Calculate the equivalent variation of the price change.
a)
Using the tangency condition,
y
4 , and the budget constraint, 4 x y 120 , Lous
x
initial optimum is the basket (x, y) = (15, 60) with a utility of 900.
b)
First we need the decomposition basket. This would satisfy the new tangency condition,
y
3 and would give him as much utility as before, i.e. xy 900 . This gives
x
or approximately (17.3,51.9). Now we need the final basket, which

satisfies the same tangency condition as the decomposition basket and also the new budget
constraint: 3 x y 120. Together, these conditions imply that (x, y) = (20, 60). The substitution
effect is therefore 17.3 15 = 2.3, and the income effect is 20 17.3 = 2.7.
( x, y ) (10 3 ,30 3 )
c)
The compensating variation is the amount of income Lou would be willing to give up
after the price change to maintain the level of utility he had before the price change. This equals
the difference between the consumers actual income, $120, and the income needed to buy the
decomposition basket at the new prices. This latter income equals: 3*17.3 + 1*51.9 = 103.8. The
compensating variation thus equals 120 103.8 = $16.2.
d)
The equivalent variation is the amount of income that Lou would need to be given before
the price change in order to leave him as well off as he would be after the price change. After the
price change his utility level is 20(60)=1200. Therefore the additional income should be such
that it allows Lou to purchase a bundle (x, y) satisfying the initial tangency condition,
y
4,
x
and also such that xy 1200. This implies that ( x, y ) (10 3 ,40 3 ) or approximately (17.3,
69.2). How much income would Lou need to purchase this bundle under the original prices? He
would need 4(17.3) + 69.2 = 138.4. That is he would need to increase his income by (138.4
120) dollars in order to be as well off as if the price of pizza were to decrease instead. Therefore
his equivalent variation is $18.4.
5.21 Carina buys two goods, food F and clothing C, with the utility function U = FC + F.
Her marginal utility of food is MUF = C + 1 and her marginal utility of clothing is MUC = F.
She has an income of 20. The price of clothing is 4.
a) Derive the equation representing Carinas demand for food, and draw this demand
curve for prices of food ranging between 1 and 6.
b) Calculate the income and substitution effects on Carinas consumption of food when the
price of food rises from 1 to 4, and draw a graph illustrating these effects. Your graph need
not be exactly to scale, but it should be consistent with the data.
Chapter 5 - 19
c) Determine the numerical size of the compensating variation (in monetary terms)
associated with the increase in the price of food from 1 to 4.
a)
MUF = C + 1
MUC = F
Tangency: MUF/MUC = PF / PC. (C + 1)/ F = PF/4 => 4C + 4 = PFF. (Eq 1)
Budget Line: PFF + PCC = I .
PFF + 4C = 20. (Eq 2)
Substituting (Eq 1) into (Eq 2): 4C + 4 + 4C = 20. Thus C = 2, independent of PF.
From the budget line, we see that PFF + 4(2) = 20, so the demand for F is F = 12/PF .
6
Demand for food
PF5
4
3
2
1
2
3 4
12
b)
Initial Basket: From the demand for food in (a), F = 12/1 = 12, and C = 2.
Also, the initial level of utility is U = FC + F = 12(2) + 12 = 36.
Final Basket: From the demand for food in (a), we know that F = 12/4 = 3, and C = 2. (Also, U
= 3(2) + 3 = 9.)
Decomposition Basket: Must be on initial indifference curve, with U = FC + F = 36 (Eq 5)
Tangency condition satisfied with final price: MUF/MUC = PF / PC. (C + 1)/ F = 4/4 => C +
1 = F. (Eq 3)
Eq 5 can be written as F(C + 1) = 36. Using Eq 3, (C + 1)2 = 36, and thus, C = 5. Also, by Eq 3,
F = 6.
So the decomposition basket is F = 6, C = 5.
Income effect on F: Ffinal basket Fdecomposition basket = 3 6 = -3.
Substitution effect on F: F decomposition basket Finitial basket = 6 12 = -6.
c)
PFF + PCC = 4(6) + 4(5) = 44. So she would need an additional income of 24 (plus
her actual income of 20).
The compensating variation associated with the increase in the price of food is
-24.
Chapter 5 - 20
Clothing 11
10
9
Initial U
8
7
Final U
Decomp Basket
5
4
Final BL
3
1
0
Initial Basket
Final
Basket
Decomp BL
Initial BL
10 11 12 13 14 15 16 17 18 19 20
Food
Inc
Effect
= -3
Subst Effect = -6
5.22 Suppose the market for rental cars has two segments, business travelers and
vacation travelers. The demand curve for rental cars by business travelers is Qb = 35
0.25P, where Qb is the quantity demanded by business travelers (in thousands of cars) when
the rental price is P dollars per day. No business customers will rent cars if the price
exceeds $140 per day. The demand curve for rental cars by vacation travelers is Qv = 120
1.5P, where Qv is the quantity demanded by vacation travelers (in thousands of cars) when
the rental price is P dollars per day. No vacation customers will rent cars if the price
exceeds $80 per day.
a) Fill in the table to find the quantities demanded in the market at each price.
b) Graph the demand curves for each segment, and draw the market demand curve for
rental cars.
c) Describe the market demand curve algebraically. In other words, show how the quantity
demanded in the market Qm depends on P. Make sure that your algebraic equation for the
market demand is consistent with your answers to parts (a) and (b).
Chapter 5 - 21
d) If the price of a rental car is $60, what is the consumer surplus in each market segment?
a)
Price ($/day)
100
90
80
70
60
50
Business (000
cars/Week)
10.0
12.5
15.0
17.5
20.0
22.5
Vacation (000
cars/Week)
15.0
30.0
45.0
Market Demand
(000 cars/Week)
10.0
12.5
15.0
32.5
50.0
67.5
Price
b)
160
140
120
100
80
60
40
20
0
Vacation
Business
Market
50.0
100.0
150.0
200.0
1000 Cars/Week
c)
For price greater than $80, vacation travelers demand will be zero. So above P 80 ,
market demand is Qb 35 0.25P .
For price between $0 and $80, market demand is the sum of the vacation and business demand,
Qm Qb Qv , or
Qm 35 0.25 P 120 1.5 P
Qm 155 1.75P
Above a price of $140, no purchases will be made so market demand is zero. In summary,
when P 140
0,
Qm 35 0.25 P, when 80 P 140

155 1.75P, when P 80
d)
Chapter 5 - 22
Business Demand
Price
150
CS=0.5(20)(80)
CS=800
100
50
0
-
10.0
20.0
30.0
40.0
1000 Cars/Week
Price
Vacation Demand
100
80
60
40
20
0
CS=0.5(30)(20)
CS=300
20.0
40.0
60.0
80.0
100.0
120.0
140.0
1000 Cars/Week
5.23 There are two types of customers in a market for sheet metal. Let P represent the
market price.
The total quantity demanded by Type I consumers is Q1 = 100 - 2P, for 0< P < 50.
The total quantity demanded by Type II consumers is Q2 = 40 - P, for 0< P < 40.
Draw the total market demand on a clearly labeled graph.
P
DII
50
40
MarketD
(heavyline)
DI
20 40
100
140
Chapter 5 - 23
5.24 There are two consumers on the market: Jim and Donna. Jims utility function is
U(x, y) = xy, with associated marginal utility functions MUx = y and MUy = x. Donnas
utility function is U(x,y) = x2y, with associated marginal utility functions MUx = 2xy and
MUy = x2. Income of Jim is IJ = 100 and income of Donna is ID = 150.
a) Find optimal baskets of Jim and Donna when price of y is Py = 1 and price of x is P.
b) On separate graphs plot Jims and Donnas demand schedule for x for all values of P.
c) Compute and plot aggregate demand when Jim and Donna are the only consumers.
d) Plot aggregate demand when there is one more consumer that has identical utility
function and income as Donna.
a)
Jims optimal basket is a solution to equations
MUx / MUy = P / Py and P x + Py y = IJ.
Hence, we have 2xy / x2 = P and P x + y = 100
with solution x = 200 / (3P) and y = 100 / 3.
Analogous system of equations for Donna is
y / x = P and P x + y = 150 with solution x = 75 / P and y = 75.
b)
Approximate shape of the demand curve for Jim and Donna is depicted below.
Px
c)
Aggregate demand is
Dx(P) = 200 / (3P) + 75 / P = 445 / (3P).
d)
When there is one more consumer that has preferences identical to Donnas then
her demand is also 75 / P and hence aggregate demand is
Dx(P) = 200 / (3P) + 75 / P + 75 / P = 650 / (3P).
Chapter 5 - 24
Shape of the demand curve in this case is the same as in part b).
5.25 One million consumers like to rent movie videos in Pulmonia. Each has an identical
demand curve for movies. The price of a rental is $P. At a given price, will the market
demand be more elastic or less elastic than the demand curve for any individual. (Assume
there are no network externalities.)
The market demand and individual demand will have the same price elasticity given any
particular price. Denote an individuals demand curve by Qi(P). With 1,000,000 identical
individuals the market demand curve will be Qm(P) = 1,000,000Qi(P). At a given price P, an
individuals demand curve will have elasticity Qi , P Qi P P / Qi . Since Qm(P) =
1,000,000Qi(P), it must also be true that
Qm
Qi
1,000,000
P
P
The elasticity for the market demand curve will be
Q
m ,P
Qm P
Qi
P
Qi P
1,000,000
Qi , P
P Qm
P 1,000,000Qi
P Qi
In other words, with identical consumers the elasticity of the market demand curve will equal the
elasticity of the individual demand curve at any price P.
5.26 Suppose that Bart and Homer are the only people in Springfield who drink 7-UP.
Moreover their inverse demand curves for 7-UP are, respectively, P = 10 4QB and P = 25
2QH, and, of course, neither one can consume a negative amount. Write down the market
demand curve for 7-UP in Springfield, as a function of all possible prices.
Bart will only consume when the price is less than 10. Therefore his demand curve for 7-UP is
10 P
, when P<10 and zero otherwise. Homer will only consume if the price is less than
4
25 P
, when P < 25 and zero otherwise.
25 so his demand curve is QH
2
QB
Therefore the market demand curve for 7-UP as a function of all possible values of price is:
Q M 0, if P 25
25 P
QM
, if 10 P 25
2
60 3P
QM
, if P 10
4
Chapter 5 - 25
5.27 Joes income consumption curve for tea is a vertical line on an optimal choice
diagram, with tea on the horizontal axis and other goods on the vertical axis.
a) Show that Joes demand curve for tea must be downward sloping.
b) When the price of tea drops from $9 to $8 per pound, the change in Joes consumer
surplus (i.e., the change in the area under the demand curve) is $30 per month. Would you
expect the compensating variation and the equivalent variation resulting from the price
decrease to be near $30? Explain.
a)
If the income consumption curve is vertical the utility function has no income effect.
This will occur, for example, with a quasi-linear utility function. This utility function will have
the same marginal rate of substitution for any particular value of tea regardless of the level of
total utility. If the price of tea falls, flattening the budget line, the consumer will reach a new
optimum where the marginal rate of substitution is equal to the slope of the new budget line.
Since the budget line has flattened, this cannot occur at the previous optimum amount of tea.
The substitution effect implies that this new optimum level of tea will be greater than the
previous level. Thus, when the price of tea falls, the quantity of tea demanded increases,
implying a downward sloping demand curve. This can be seen in the following figure.
Other
Income consumption
curve
Level of tea
consumption increases
Tea
Price of tea falls
b)
Yes, the values will be exactly $30. When the income consumption curve is vertical, the
consumers utility function has no income effect. As stated in the text, when there is no income
effect, compensating and equivalent variation will be identical and these will also equal the
change in consumer surplus measured as the change in the area under the demand curve.
5.28 Consider the optimal choice of labor and leisure discussed in the text. Suppose a
consumer works the first 8 hours of the day at a wage rate of $10 per hour, but receives an
overtime wage rate of $20 for additional time worked.
a) On an optimal choice diagram, draw the budget constraint. (Hint: It is not a straight
line.)
b) Draw a set of indifference curves that would make it optimal for him to work 4 hours of
overtime each day.
a)
Chapter 5 - 26
Slope = -20
400
Labor
300
Kink in budget line
200
Slope = -10
100
0
0
10
15
20
25
Leisure
Because the wage rate changes for any hours worked over eight (leisure less than sixteen) the
budget line has a kink at sixteen hours of leisure.
b)
400
Labor
300
200
160
100
0
0
10
12
15
20
25
Leisure
With this set of indifference curves, the consumer reaches an optimum at 12 hours of leisure and
12 hours of labor, or $160 of income.
5.29 Terrys utility function over leisure (L) and other goods (Y ) is U(L, Y ) = Y + LY. The
associated marginal utilities are MUY = 1 + L and MUL = Y. He purchases other goods at a
price of $1, out of the income he earns from working. Show that, no matter what Terrys
wage rate, the optimal number of hours of leisure that he consumes is always the same.
What is the number of hours he would like to have for leisure?
If Terrys wage rate is w, then the income he earns from working is (24 L)w. Since PY = 1, the
number of units of other goods he purchases is Y = (24 L)w.
Chapter 5 - 27
Now at an optimal bundle, Terrys MRS L,Y must equal the price ratio w/PY = w. Therefore, the
tangency condition tells us that
Y
w . The two conditions imply w(1 L ) ( 24 L) w .
1 L
This means that the optimal amount of leisure is L = 11.5. You can see that this does not depend
on the wage rate.
5.30 Consider Noahs preferences for leisure (L) and other goods (Y ), U(L, Y) = L + Y.
The associated marginal utilities are MUL = 1/(2L) and MUY = 1/(2Y). Suppose that PY =
$1. Is Noahs supply of labor backward bending?
If Noahs wage rate is w, then the income he earns from working is (24 L)w. Since PY = 1, the
number of units of other goods he purchases is Y = (24 L)w. Also, the tangency condition gives
us
24
Y
w . Combining the two conditions, w 2 L ( 24 L) w , or L
. Clearly, the
w 1
L
amount of leisure that Noah consumes decreases with an increase in the wage rate, and this is
true no matter what the wage rate is. Since the amount of labor that Noah supplies equals (24
L), we see that his supply of labor always increases with an increase in the wage rate. So, his
labor supply curve is always positively sloped that is, it is not backward bending.
5.31 Raymond consumes leisure (L hours per day) and other goods (Y units per day),
with preferences described by U (L,Y ) L 2 Y . The associated marginal utilities are
MUY 1 and MU L 1/ L . The price of other goods is 1 euro per unit. The wage rate is
w Euros per hour.

a) Show how the number of units of leisure Raymond chooses depends on the wage rate?
b) How does Raymonds daily income depend on the wage rate?
c) Does Raymond work more when the wage rate rises?
a) For this utility function, it turns out that the amount of leisure can be determined from the
MUL MUY
tangency condition alone. The tangency condition for an optimum is

, or
w
1
1/ L 1
. Thus w2 = 1/L, or L = 1/w2.
w
1
b) When Raymond consumes L units of leisure, he works (24 L) hours, and receives an income
of w(24 L) Euros per day. His expenditure on other goods is Y Euros per day. His budget
constraint will have income equal to expenditures, or w(24 L) = Y. In (a) we learned from the
tangency condition that L = 1/w2; substituting this into the budget equation reveals that w(24
[1/w2]) = Y, which can be rewritten as Y = 24w (1/w).
c) We can answer this in two ways. First, from part (a) we see that Raymond consumes less
leisure as the wage rate rises. Thus he works more as the wage rate rises. Alternatively, Raymond
works (24 L) hours per day, i.e., (24 [1/w2]) hours per day; this increases as w rises.
Chapter 5 - 28
5.32 Julie buys food and other goods. She has an income of 400 per month. The price of
food is initially $1.00 per unit. It then rises to $1.20 per unit. The prices of other goods do
not change. To help Julie out, her mother offers to send her a check each month to
supplement her income. Julie tells her mother, Thanks, Mom. If you would send me a
check for $50 per month, I would be exactly as happy paying $1.20 per unit as I would have
been paying $1.00 per unit and not receiving the $50 from you. Which of the following
statements is true? Explain.
The increased price of food has:
a) an income effect of + $50 per month.
b) an income effect of $50 per month.
c) a compensating variation of +$50 per month
d) a compensating variation of $50 per month
e) an equivalent variation of +$50 per month
f) an equivalent variation of $50 per month
The answer is (d). Lets call Julies initial basket A; this is the basket she chooses when she faces
a price of food of $1.00 per unit and has a monthly income of $400. Julies statement to her
mother indicates that she is indifferent between her initial basket A and a different basket (call it
basket B) which she would purchase if she had to pay $1.20 per unit of food, but received an
extra monthly income of $50. (Basket B would be the decomposition basket if we were analyzing
income and substitution effects associated with the increase in the price of food.) So her
compensating variation is - $50 per month.
5.33 Gina lives in Chicago and very much enjoys traveling by air to see her mother in
Italy. On the graph below, x denotes her number of round trips to Italy each year. The
composite good y measures her annual consumption of other goods; the price of the
composite good is py, which is constant in this problem. Several indifference curves from
her preference map are drawn below, with levels of utility U1 < U2 < U3 < U4 < U5. If she
spends all her income on the composite good, she can purchase y* units, as shown in the
graph below. When the initial price of air travel is 1000, she could purchase as many as 18
round trips if she spends all her income on air travel to Italy.
a) Make a copy of the graph below, and use it to determine the income and substitution
effects on the number of round trips Gina makes as the price of a round trip increases from
$1000 to $3000. Clearly label these effects on the graph.
b) Using the graph, estimate the numerical size of the compensating variation associated
with the price increase? You may refer to the graph to explain your answer.
c) Will the consumer surplus measured using Ginas demand for air travel to Italy provide
an exact measure of the monetary value she associates with the price increase? In a
sentence explain why or why not.
Chapter 5 - 29
y
y*
U5
U4
U3
10
U2
U1
12 14 16
18
Chapter 5 - 30
a)
B
C
y
y*
Final
BL
Decomposition
BL
Initial
BL
U5
U4
U3
Income Substitution.
Effect Effect
With the initial budget line

(labeled Initial on the
graph), Ginas income is
U1
x $18,000 (she could make a
maximum of 18 trips, each
6
18
2
4
8
10
12 14 16
costing $1000). She chooses
initial basket A, making 6 round trips. With the final budget line (labeled Final on the graph),
she could use her $18,000 to purchase only 6 trips (the horizontal intercept of the final budget
line). She chooses basket C, making 2 round trips.
The decomposition budget line (labeled Decomposition) is parallel to the final budget line, but
tangent to the initial indifference curve (U4) at basket B (with 4 trips).
The income effect is XC XB = (2 4) trips = - 2 trips.
The substitution effect is XB XA = (4 6) trips = -2 trips.
U2
b) The compensating variation is the additional amount of money we would have to give Gina so
that she can be as well off as she is initially (U4), but making purchases at the final price, in
which case she would choose basket B. The decomposition budget line has a horizontal intercept
of 9 trips, which represents an income of $27,000 at the final price of $3,000 per trip. Thus, we
would have to compensate Gina by giving her and extra $9,000 (above her initial income of
$18,000) to keep her as well off as she was initially. Because the price is rising, the
compensating variation is negative. So the compensating variation is -$9,000.
Chapter 5 - 31
c) No. From the graph we can see that the income effect is nonzero (for example, baskets B and
C are associated with different numbers of round trips). So consumer surplus will not provide an
exact measure of the monetary value of the price increase for Gina.
Chapter 5 - 32

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Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

What is a price consumption curve for a good?

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

What is consumer surplus?

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

(i) No network externality

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Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

If income elasticity of demand is negative then

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Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

At the consumers optimum we must have

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

Denoting the level of income by I, the budget constraint implies that

the tangency condition is

depend on the level of income.

From the budget constraint, the demand curve for y is, y

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

The budget constraint is 8 x 2 y 240 and the tangency condition is

p x x 8 y 240, and x 2 y 16000 . The tangency condition now implies that

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

Since x , I x I I / x and y , I y I I / y , we can write this as

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

If we are at an interior optimum the tangency condition must hold:

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

Substituting into the budget line, Px x Py y I , yields

Since we must have x 0 , we must have

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

. If the consumer were to purchase any x , since the bang for

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

Area of ABE triangle

Area of ACD triangle

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

Using the tangency condition,

or approximately (17.3,51.9). Now we need the final basket, which

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

Copyright 2014 John Wiley & Sons, Inc.

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

Besanko & Braeutigam Microeconomics, 5th editionSolutions Manual

Qm 35 0.25 P, when 80 P 140

Copyright 2014 John Wiley & Sons, Inc.