Managerial Economics Dr.

Heman Lohano

Handout 3 September 22, 2017

Q1:
A consumer receives utility from consuming good X and good Y as given by the utility
function:
U (X, Y) = X Y

The price of good X is Px = 1 rupee per unit. The price of good Y is Py = 1 rupee per unit.
The consumers total budget for these two goods is Rs. 100 per week.

(a) Find the optimal choice of good X and good Y that maximizes the consumers utility
function subject to the budget constraint?

(b) Suppose the price of good X decreases to Px = 0.5 rupee per unit (ceteris paribus: holding
all else constant). Now find the optimal choice of good X and good Y that maximizes the
utility function subject to the budget constraint.

(c) Draw the points of consumers demand curve for good X using the answers in parts (a)
and (b).

Solution:
For the consumers utility maximization, the first order necessary conditions will result in the
following two equations for solving this problem:

MU X PX
(1)
MU Y PY

PX X PY Y M (2)

Putting the given values, these equations can be written as:

Y 1
(3)
X 1

X Y 100 (4)

Solving these two equations for two unknowns yields:

X* = 50 & Y* = 50

(b) If the price of good X decreases to Px = 0.5 rupee per unit (ceteris paribus), then optimal
choice can be found, following the method used for part (a), as:

X* = 100 & Y* = 50
(c)
Note that the answers to parts (a) and (b) give the demand schedule for demand curve:

1
 Px X*
1 50
0.5 100

1.5

1
Px
0.5

0
0 25 50 75 100 125
X*

Q2:
A consumer receives utility from consuming food (F) and clothing (C) as given by the utility
function: U (F, C) = F C. The price of food is Rs. 20 per unit, the price of clothing is Rs. 100
per unit, and the consumers total budget for these two goods is Rs. 400 per week.

(a) Find the optimal choice of food (F*) and clothing (C*) that maximizes the consumers
utility function subject to the budget constraint?
(b) At the optimal levels of food and clothing F* and C* calculated in part (a), how much is
the marginal rate of substitution (MRS) between food and clothing? Interpret the value of
MRS.
(c) Suppose the price of food increases to Rs. 40 (ceteris paribus: holding all else constant).
Now find the optimal choice of food and clothing that maximizes the utility function
subject to the budget constraint.
(d) Draw the points of consumers demand curve for food using the answers in parts (a) and
(c).

Solution:
(a) Two equations for solving this problem are:
MU F PF
(1)
MU C PC

PF F PC C M (2)

Putting the given values, these equations can be written as:

C 20
(3)
F 100

20F 100C 400 (4)

Solving these two equations for two unknowns yields:

F* = 10 & C* = 2
C MU F
(b) MRS
F MU C

2
 MU F C
As , MRS at the optimal levels of food and clothing F* and C* is:
MU C F

C* 2
MRS 0.2 unit of clothing.
F * 10

MRS is the maximum amount of a good that a consumer is willing to give up in order to
obtain one additional unit of another good. The value of MRS calculated above, 0.2, is the
maximum amount of clothing the consumer is willing to give up in order to obtain one
additional unit of food.

(c) If the price of food increases to Rs. 40 (ceteris paribus), then optimal choice can be found,
following the method used for part (a), as:

F* = 5 & C* = 2

(d) Draw the points of demand curve (as done in Q1).