ME Problem Set II

(PGP 2016-18)

1. Dr. Strangetaste buys only french fries (F) and hot dogs (H) out of his income. He has
positive marginal utilities for both goods, but his MRSH,F is increasing. The price of hot dogs
is PH, and the price of french fries is PF.
a) Draw several of Dr. Strangetastes indifference curves, including one that is tangent to his
budget line.
b) Show that the point of tangency does not represent a basket at which utility is maximized,
given the budget constraint. Using the indifference curves you have drawn, indicate on your
graph where the optimal basket is located.

2. A consumer has the utility function U = xy, with the marginal utilities MUx = y and MUy =
x. The price of x is 2, the price of y is Py, and his income is 40. When he maximizes utility
subject to his budget constraint, he purchases 5 units of y. What must be the price of y and the
amount of x consumed?

3. Consider a consumer with the utility function U(x, y) = min(3x, 5y), that is, the two goods
are perfect complements in the ratio 3:5. The prices of the two goods are Px = Rs. 5 and Py =
Rs.10, and the consumers income is Rs. 220. Determine the optimum consumption basket.

4. Provide an intuitive explanation for why a buy one, get one free deal is not the same as a
half-price sale.

5. A recent study by Web Mystery Shoppers International indicates that holiday gift cards are
becoming increasingly popular at online retailers. Two years ago, online shoppers had to
really hunt at most e-retailers sites to purchase a gift certificate, but today it is easier to
purchase gift cards online than at traditional retail outlets. Do you think online gift cards are
merely a fad?

6. Robinson Crusoe lives alone on a deserted island. He can spend his time gathering
coconuts or bananas. He has 16 hours available each day and can gather 4 coconuts in an
hour or 8 bananas in an hour. Draw Robinson's budget constraint. Given that Robinson's
Marginal Utility of bananas is always 25 and his Marginal utility of coconuts is always 100,
what is his optimal consumption?
One day an individual from a neighbouring island arrives by boat and offers to exchange any
number of fruits at a rate of 1 coconut for 1 banana. Draw Robinson's budget constraint at

this exchange rate assuming he will now spend all his time gathering bananas. Is Robinson
better off? What does he consume?

7. Bobby is a college student who has $500 of income to spend each semester on books
and pizzas. The price of a pizza is $10 and the price of a book is $50. Draw Bobby's
budget constraint.
Now, suppose Bobby's parents buy her a $300 gift certificate each semester that can
only be used to buy books. (Bobby thinks her parents are crazy!!! They always make
sure that Bobby lives a miserable life with books only!!) But eventually Bobby could
find herself better-off with those gift certificates. Why?

8. Your preferences over pizza (x) and other goods (y) are given by U(x, y) = xy, with
associated marginal utilities MUx = y and MUy = x. Your income is $120.
a) Calculate your optimal basket when Px = 4 and Py = 1.
b) Calculate h income and substitution effects of a decrease in the price of food to $3.

9. If consumers do not buy less of a commodity when their incomes rise, they will
surely buy less when the price of the commodity rises. Why?