EC 203.

01 PS: CH 10 FALL 2006

1. The intertemporal budget constraint for a consumer can be expressed by setting the present
value of her lifetime consumption equal to the future value of her endowment. FALSE

2. A newspaper article claims that more students are choosing 1-year M.B.A. programs instead of
2-year programs because the 2-year programs no longer guarantee a well-paid job. If the length of
your M.B.A. program doesnt matter to employers, and you take a job right after completing your
M.B.A., the present value of your lifetime earnings is the same whether you take a 1-year or 2-
year program. FALSE

3. Suppose that a person can borrow and lend at an interest rate of 10%. But there is a 5% rate of
inflation and the person has to pay an income tax of 30% on all interest income. If the person
borrows money, he can deduct interest as an expense. Where current consumption is on the
horizontal axis and future consumption is on the vertical axis, the budget line will
a. have a kink at the point of no saving or lending.
b. be a straight line with a slope of about 1.02.
c. be a straight line with a slope of about 1.05.
d. be a straight line with a slope of about 1.35.
e. None of the above. B

4. For every two boxes of strawberries that she consumes, Gaffur insists on having one pitcher of
cream. He does not, however, insist on consuming the same amount every week. His utility
functions is U = min{s1, 2c1} min{s2, 2c2}, where s1 and s2 are the number of boxes of
strawberries he consumes this week and next week and c1 and c2 are the number of pitchers of
cream he consumes this week and next. Strawberries cost $2 a box and cream costs $1 a pitcher.
He has a present value of $100 to spend on these goods in the next two weeks. The weekly
interest rate is 1%. How many boxes of strawberries will he consume this week?
a. 10 b. 20 c. 22 d. 14.1 e. 6.06 B

5. In an isolated peasant village, the only crop is corn. Good harvests alternate with bad harvests.
This year the harvest will be 1,000 bushels. Next year it will be 150 bushels. There is no trade
with the outside world. Corn can be stored, but rats will eat 25% of what is stored in a year. The
villagers have the Cobb-Douglas utility function U(c1, c2) = c1c2, where c1 is consumption this
year and c2 is consumption next year.
a. Draw a budget line for the village with this years consumption on the horizontal axis and next
years consumption on the vertical axis. On your graph show the quantities at which the budget
line intercepts the vertical and horizontal axes.
b. How much will the villagers consume this year?
c. How much will the rats eat?
d. How much will the villagers consume next year?
b. 600 bushels.
c. 100 bushels.
d. 450 bushels.

1
6. Burhan has the utility function U (c1 , c2 ) c1 2c2 where c1 is his consumption in period
1/ 2 1/ 2

1 and c1 is his consumption in period 2. He will earn 100 units of the consumption good in period
1 and 100 units of the consumption good in period 2. He can borrow or lend at an interest rate of
10%.
a. Write an equation that describes Burhans budget.
b. If Burhan neither borrows nor lends, what will be his marginal rate of substitution between
current and future consumption?
c. If Burhan does the optimal amount of borrowing or saving, what will be the ratio of his period
2 consumption to his period 1 consumption?

b. 2.
c. She will consume 4.84 times as much in period 2 as in period 1.