You are on page 1of 6

Q.1.

The utility approach to consumer demand theory is based on the assumption of cardinal utility, while
the indifference curve approach is based on ordinal utility. Which approach is better? Why?
Ans: A cardinal utility is a quantitative measure and ordinal utility is a qualitative measure. In cardinal utility, it is
assumed that consumers derive satisfaction through consumption of one good at a time. However, in ordinal utility it
is assumed that a consumer may derive satisfaction from the consumption of a combination of goods and
services, which will then be ranked according to preference. So, as ordinal utility is a qualitative measure, it is seemed
to be better.
Q. 2. If there are only two goods, is it possible to illustrate a consumers preferences over them with an
indifference map? Draw an indifference map with three indifference curves. What are a few standard
assumptions about what an indifference map can and cannot look like? What
are those assumptions and what reasoning lie behind them?
Ans: Yes, it is possible to draw an indifference map showing consumer preferences if there
are only two goods. A typical indifference map for goods is shown as follows.
Indifference curves are usually negatively sloped, cannot intersect, and are convex to the
origin.
1.

Indifference curves are negatively sloped because if one basket of goods X and Y
contains more of X, it will have to contain less of Y than another basket in order
for the two baskets to give the same level of satisfaction and be on the same
indifference curve. An indifference curve cannot be positively sloped. A positively
sloped curve would indicate that one basket containing more of both commodities gives the same utility or
satisfaction to the consumer as another basket containing less of both commodities.

2.

Indifference curves also cannot intersect. Intersecting curves are inconsistent with the definition of indifference
curves. For example, if curve 1 and curve 2 in the right panel of Figure 3.3 were
indifference curves, they would indicate that basket A* is equivalent to basket C*
since both A* and C* are on curve 1, and also that basket B* is equivalent to basket
C*
since both B* and C* are on curve 2. By transitivity, B* should then be equivalent
to
A*. However, this is impossible because basket B* contains more of both good X
and good Y than basket A*. Thus, indifference curves cannot intersect.

3.

Indifference curves are usually convex to the origin; that is, they lie above any
tangent to the curve. Convexity results from or is a reflection of a decreasing marginal rate of substitution

Q. 3. Table below gives Usmans marginal utility schedule for commodity X and commodity Y. Suppose
that X and Y are the only commodities available, the price of X and the price of Y are \$1, and Usmans
income is \$8 per time period and is all spent. (a) Indicate how Usman should spend his income in order to
maximize his total utility. (b) What is the total amount of utility received by Usman when he is at his
optimal point? (c) State mathematically the equilibrium condition for the consumer. [Hint: Equi-Marginal
Utility]

Ans: (a) With continuously decreasing MU, overall TU can be maximized by maximizing the utility received from
spending a dollar at the time. Thus, Usman should spend the first dollar of his income to purchase the first unit of Y.
From this he receives 19 utils. If he spent this first dollar to purchase the first unit of X, he would receive only 11 utils.
Usman should spend his second, third, fourth, and fifth dollars to purchase the second, third, fourth, and fifth units of Y.
From these he received 17, 15, 13, and 12 utils, respectively. Usman should spend his sixth dollar to purchase the first
unit of X (from which he receives 11 utils) rather than the sixth unit of Y (from which he would receive only 10 utils).
His seventh and eighth dollars should be spent on purchasing the sixth unit of Y and the second unit of X. Both give
him 10 utils of utility. Usman cannot go on purchasing more units of X or Y because her income is exhausted.
(b) When Usman spends his income to purchase 2 units of X and 6 units of Y, his total utility is 107 utils
(19+17+15+13+12+11+10+10). This represents the maximum utility Usman can receive from the expenditure. If
Usman spent his income in any other way, the total utility would be less.

(c)
Q. 4. If Ali is indifferent between Coke and Pepsi, what would Alis indifference curves look like?
Ans: As Ali is indifferent between Coke and Pepsi, any of them would give Ali the same utility in place of other or thus
they can be substituted for one another. Therefore, his indifference curve would be a straight line sloping downward as
Coke can be substituted for Pepsi and vice versa.

Q. 5. What is the relationship between two goods if the marginal rate of substitution between them is
zero? Explain.
Ans: The goods are perfect complement to each other if the marginal rate of substitution
between them is zero. The indifference curve is right-angled or L shaped, as shown in Figure.
The vertical portion of the I1 curve reveals that no amount of reduction in good Y will lead
even to a slight increase in good X. For example, points A, M and are all on the curve I 1 but
point involves the same amount of Y but more of X than point M. Thus MRS xy is zero. The two
goods X and Y are consumed in the desired ratio, as indicated by the slope of the ray OR at
point M. Such complementary goods are left and right shoes which are used in the 1:1 fixed
ratio.
Q. 6. If Alis budget line has intercepts 20 units of X and 30 units of Y and PY = \$10, what is Alis income?
What is PX? What is the slope of the budget line?
Ans:

As we know,
Y-Intercept = M/ Py
30 = M / 10
M = \$ 300
As we know,
X-Intercept = M / Px
Px = M / X-Intercept
Px = 300 / 20
Px = \$ 15
As we know,
Slope of Budget line = Px / Py
= 15 / 10
= 1.5

Q. 7. Sara spends her entire weekly food allowance of \$42 on Zinger and soft drinks. The price of a
Zinger is \$2, and the price of a soft drink is \$1. Sara purchases 12 Zingers and 18 soft drinks, and her
marginal rate of substitution between Zingers and soft drinks is 1. Is this the optimal consumption of
Sara? Explain.
Ans: We have
B = \$42, Pz = \$2, Psd = \$1. Qz = 12 Zingers, Qsd = 18 soft drinks, MRSz sd = 1
As MRSxy = MUx/MUy,

then MUz/MUsd = 1, so MUz = MUsd

The optimal consumption that maximizes utility is in the point, where MU x/Px = MUy/Py, but in our case as MUz = MUsd,
so MUz/\$2 is not equal to MUsd/\$1.
Thats why this is not the optimal consumption of Sara and she needs to decrease consumption of Zinger and increase
consumption of soft drinks, until MUz/Pz = MUsd/Psd.
Q. 8. Explain why points G, D, C, and F in Fig. given below are not the optimal points for Arsalan? (b)
Explain in terms of the slopes of the indifference curves and the slope of the budget line why a
movement from point C to point E increases Arsalans satisfaction and (c) do the same for a movement
from point F to point E.

Ans: (a) Given the price of X and the price of Y, Arsalans income is not sufficient to reach point G on indifference curve
III. At point D, Arsalan is on indifference curve I but is not spending all of his income. At points C and F, Arsalan would
be spending all personal income but is still on indifference
curve I and thus is not maximizing his satisfaction.
(b) At point C, the absolute slope of indifference curve I (which indicates what Arsalan is willing to do) exceeds the
absolute slope of the budget line (which indicates what Arsalan is able to do in the market). That is, starting at point C,
Arsalan is willing to give up more than 6 units of Y to obtain 1 more unit of X and still remain on indifference curve I.
However, Arsalan can get one additional unit of X in the market by giving up only 2 units of Y. Thus, by moving down
the budget line from point C toward point E, Arsalan increases his satisfaction.
(c) At point F, the absolute slope of the budget line is greater than the absolute slope of indifference curve I. This
means that Arsalan can obtain more of Y in the market than he is willing to accept in order to give up one unit of X.
Thus, by moving up the budget line from point F toward point E, Arsalan increases his satisfaction. At point E, the
MRSxy = Px/Py .
Q. 09. On the same set of axes, draw three indifference curves showing perfect substitutability between
X and Y.
Ans: The indifference curves are shown below:

For X and Y to be perfect substitutes, the MRSxy must be constant. That is, no matter what indifference curve we are on
and where we are on it, we must give up the same amount of Y to get one additional unit of X.

Q. 10. On the same set of axes, draw three indifference curves showing perfect complementarity
between X and Y.
Ans: The indifference curves are shown below:

For X and Y to be perfect complements, the MRS xy and the MRSyx must both be equal to zero. For example, points D, E,
and F are all on indifference curve I, yet point F involves the same amount of Y but more of X than point E. Thus, the
consumer is saturated with X and so the MRS xy= 0. Similarly, point D involves the same amount of X but more of Y
than point E. Thus, the consumer is saturated with Y and so the MRS yx = 0. Car and gasoline may be regarded as
perfect complements
Q. 11. On the same set of axes, draw three indifference curves showing increasing MRS as we move down
the indifference curves.
Ans: Ans: The indifference curves are shown below:

Q. 12. Consider a consumer chooses among branded clothes and second hand clothes. Initially with the
income level Rs 10,000, he optimizes his consumption by buying 10 units of second hand clothes and 6
units of branded clothes. Suppose his income rises to 20,000 and a result now he buys 6 units of second
hand clothes and 10 units of branded clothes. Taking second hand clothes on vertical axis and branded
clothes on horizontal axis, sketch this entire story in a graph and draw the income consumption curve.
Derive Engel curve for second hand clothes.
Ans:
Decision Time Frames
Q. 1. Which of the following news items involves a short-run decision and which involves a long-run
decision? Explain.
January 31, 2014: Starbucks will open 75 more stores abroad than originally predicted, for a total of 975.
Ans: This decision is a long-run decision. It increases the quantity of all of Starbucks factors of production, labor and
the size of Starbucks plant.
February 25, 2014: For three hours on Tuesday, Starbucks will shut down every single one of its 7,100
stores so that baristas can receive a refresher course.
Ans: This decision is a short-run decision. It involves increasing the quality of Starbucks labor and so only one factor of
productionlaborchanges and all the other factors remain fixed.
June 2, 2014: Starbucks replaces baristas with vending machines.

Ans: This decision is a short-run decision. It involves changing two of Starbucks factors of production, labor and one
type of capital. But other factors of production, such as Starbucks land and other capital inputs such as the store
itself, remain fixed.
July 18, 2014: Starbucks is closing 616 stores by the end of March.
Ans: This decision is a long-run decision. It decreases the quantity of all of Starbucks factors of production, labor and
the size of Starbucks plant.

Short-Run Technology Constraint

Use the following table to work Problems 2 to 5.
The table sets out Saifs Surfboards total product schedule.

Q. 2. Draw the total product curve.

Ans: To draw the total product curve measure labor on the x-axis and output on the y-axis. The total product curve is
upward sloping and is illustrated in Figure below.

Q. 3. Calculate the average product of labor and draw the average product curve.
Ans: The average product of labor is equal to total product divided by the quantity of labor employed. For example,
when 3 workers are employed, they produce 120 surfboards a week, so average product is 40 surfboards per worker.
As Figure shows, the average product curve is upward sloping when up to 3 workers are hired and then is downward
sloping when more than 4 workers are hired.

Q. 4. Calculate the marginal product of labor and draw the marginal product curve.
Ans: The marginal product of labor is equal to the increase in total product that results from a one-unit increase in the
quantity of labor employed. For example, when 3 workers are employed, total product is 120 surfboards a week. When

a fourth worker is employed, total product increases to 160 surfboards a week. The marginal product of increasing the
number of workers from 3 to 4 is 40 surfboards. We plot the marginal product at the halfway point, so at a quantity of
3.5 workers, the marginal product is 40 surfboards per worker per week. As Figure below shows, the marginal product
curve is upward sloping when up to 2.5 workers a week are employed and it is downward sloping when more than 2.5
workers a week are employed.

Q. 5. a. Over what output range does Saifs Surfboards enjoy the benefits of increased specialization and
division of labor?
Ans: The firm enjoys the benefits of increased specialization and division of labor over the range of output for which
the marginal cost decreases. This range of output is the same range over which the marginal product of labor rises. For
Saifs Surfboards, the benefits of increased specialization and division of labor occur until 2.5 workers are employed.
b. Over what output range does the firm experience diminishing marginal product of labor?
Ans: The marginal product of labor decreases after 2.5 workers are employed.
c. Over what output range does the firm experience an increasing average product of labor but a
diminishing marginal product of labor?
Ans: The marginal product of labor decreases and the average product of labor increases between 2.5 and 3.5 workers.
d. Indicate and explain the three stages of production using your diagram.
Ans: The three stages of production are as follows:
Stage 1 (Increasing Stage of Return): Stage 1 occurs when MPL > APL. The firm
enjoys the benefits of division of labor. This occurs until 2.5 workers are employed.
Stage 2 (Diminishing Return): Stage 2 occurs when MPL < APL. In this stage
increasing the labor results in decreasing return. This occurs after 2.5 labors have
been employed.
Stage 3 (Negative Return): Stage 3 occurs when MPL < 0. The firm does not
operate in this stage as MPL is still positive after 6.5 labors have been employed.
Note: The Assignment should be hand written on A4 paper.