Solutions Serrano

Solutions to Exercises 1
A Short Course in Intermediate Microeconomics with Calculus

Solutions to Exercises1
2013
c
Roberto Serrano and Allan M. Feldman
All rights reserved
This file is intended to be used by instructors only.
1
We thank EeCheng Ong and Amy Serrano for their superb help in working out these solutions. We also thank
Rajiv Vohra for contributing some nice improvements to our previous version.
Chapter 2 Solutions
1.(a) Our consumer prefers a cup of coffee with one teaspoon (6 g) of sugar to a cup of coffee
with two teaspoons (12 g) of sugar, i.e., 6 12. However, she is indifferent between a cup
of coffee with n grams of sugar and a cup of coffee with n + 1 grams, i.e., n ∼ n + 1. By
transitivity, if n ∼ n + 1 and n + 1 ∼ n + 2, then n ∼ n + 2. With repeated applications of
transitivity, if 6 ∼ 7, 7 ∼ 8, ..., and 11 ∼ 12, then 6 ∼ 12. However, 6 ∼ 12 contradicts our
first statement, 6 12.
1.(b) Vote 1: x versus y.

Person 1 votes for x, Person 2 votes for y, and Person 3 votes for x. Therefore x y.
Vote 2: y versus z.
Person 1 votes for y, Person 2 votes for y, and Person 3 votes for z. Therefore y z.
Vote 3: x versus z.
Person 1 votes for x, Person 2 votes for z, and Person 3 votes for z. Therefore z x.
Now if x y and y z, then by transitivity we should have x z. But in Vote 3 we see

z x, which means majority voting violates transitivity.
2.(a) The indifference curve corresponding to u = 1 passes through the points (0.5, 2), (1, 1), and
(2, 0.5). The indifference curve corresponding to u = 2 passes through the points (0.5, 4),
(1, 2), (2, 1), and (4, 0.5).
2.(b) The M RS equals 1 along the ray from the origin x2 = x1 , and it equals 2 along the ray
from the origin x2 = 2x1 .
3.(a) The indifference curves are downward-sloping parallel lines with a slope of −1 and the
arrow pointing northeast.
3.(b) The indifference curves are upward-sloping with the arrow pointing northwest.
3.(c) The indifference curves are vertical with the arrow pointing to the right.
3.(d) The indifference curves are downward-sloping and convex with the arrow pointing north-
east.
4.(a) The indifference curves are horizontal; the consumer is neutral about x1 and likes x2 .
4.(b) The indifference curves are downward-sloping parallel lines with a slope of −1; the con-
sumer considers x1 and x2 to be perfect substitutes.
4.(c) The indifference curves are L-shaped, with kinks along the ray from the origin x2 = 12 x1 ;
the consumer considers x1 and x2 to be perfect complements.
4.(d) The indifference curves are upward-sloping and convex (shaped like the right side of a U);
the consumer likes x2 , but dislikes x1 , i.e., good 1 is a bad for the consumer.
∂u(x1 ,x2 ) ∂(3x21x42 )

5.(a) M U1 = ∂x1 = ∂x1 = 6x1 x42
∂u(x1 ,x2 ) ∂(3x21x42 )

5.(b) M U2 = ∂x2 = ∂x2 = 12x21 x32
M U1 6x1 x42 x2
5.(c) M RS = M U2 = 12x21x32
= 2x1
x2 4
5.(d) M RS = 2x1 = 2·2 =1
x2 2 1
5.(e) M RS = 2x1 = 2·8 = 8
His M RS has decreased. As he spends more and more time fishing, he is increasingly loath
to give up hammock time for an extra hour of fishing.
5.(f) Last week, u(x1 , x2 ) = 3x21 x42 = 3 · 22 · 44 = 3 · 22 · 28 = 3 · 210 .

This week, u(x1 , x2) = 3x21 x42 = 3 · 82 · 24 = 3 · 26 · 24 = 3 · 210 .
Thus, he is as happy this week as he was last week.
6.(a) The M RS is the amount of money I am willing to give up in exchange for working an
hour.
6.(b) Since work is a bad, I would need to receive a positive amount of money for every hour
I work. Therefore, my indifference curves are upward sloping, and the slope of an upward
sloping curve is positive. Given that M RS = − Indifference Curve Slope, the M RS should
be negative.
6.(c) If I’m working only an hour a day, a low hourly wage, say, $10, would be sufficient to
induce me to work another hour. If I’m already working 12 hours a day, I would need a
very high hourly wage, say, $100, to induce me to work another hour. Thus the slope of
the indifference curve is increasing as the hours of work increase. Given that M RS = −
Indifference Curve Slope, the M RS is decreasing as the hours of work increase.
Chapter 3 Solutions
1.(a) Let p1 = 2p1 and p2 = 12 p2 .

The new budget line equation is p1 x1 + p2 x2 = M or 2p1 x1 + 12 p2 x2 = M .
p −2p1 −4p1
The slope of the budget line has changed from − pp12 to − p1 = 1
p
= p2 .
2 2 2
1.(b) Let p1 = 2p1 and M = 3M .

The new budget line equation is p1 x1 + p2 x2 = M or 2p1 x1 + p2 x2 = 3M .
p −2p1
The slope of the budget line has changed from − pp12 to − p12 = p2 .
2.(a) Budget constraint: 3x1 + 2x2 = 900. Horizontal intercept at 300 and vertical intercept at
450.
p1 x22 3
2.(b) Tangency condition: M RS = p2 ⇔ 2x1 x2 = 2 ⇔ x2 = 3x1
Plugging x2 = 3x1 into the budget constraint gives us the optimal consumption bundle,
(x∗1 , x∗2 ) = (100, 300).
3.(a) George’s budget constraint is pa a + pb b = M . Given two affordable bundles, we have two
equations:
3 · 10 + pb · 30 = M
3 · 15 + pb · 15 = M
Solving the two equations simultaneously yields pb = 1 and M = 60.
3.(b) Since for George apples and bananas are perfect substitutes in a 1:1 ratio, he will spend
his entire allowance on the cheaper good. Thus he will consume 0 apples and 60 bananas.
4.(a) The x1 intercept is 27, the x2 intercept is 12, and the kink is at (20, 2).
4.(b) For Peter, pumpkins and cider are perfect substitutes. His indifference curves are linear,
with a slope of − 13 . His optimal consumption bundle is (0, 12).
4.(c) The x1 intercept is 11, the x2 intercept is 4, and the kink is at (4, 2).
4.(d) For Paul, pumpkins and cider are perfect complements. His indifference curves are L-
shaped, with kinks at (2, 3), (4, 6), etc. His optimal consumption bundle is (2, 3).
1.01
1+π
5.(a) Budget constraint: c1 + 1+i c2 = M ⇔ c1 + 1.01 c2 = 50 ⇔ c1 + c2 = 50
1+i 1.01
5.(b) Tangency condition: M RS = 1+π ⇔ c2
c1 = 1.01 ⇔ c2 = c1
Plugging c2 = c1 into the budget constraint gives us the optimal consumption bundle,
(c∗1 , c∗2) = (25, 25).
1.10
1+π
5.(c) Budget constraint: c1 + 1+i c2 = M ⇔ c1 + 1.00c2 = 50
1+i

Tangency condition: M RS = 1+π ⇔ cc21 = 1.00
1.10 ⇔ c2 = 1.00
1.10 c1
1.00
Plugging c2 = 1.10 c1 into the budget constraint gives us the optimal consumption bundle,
(c∗1 , c∗2) = (25, 22.73).
1.05
1+π 1 1
6.(a) Budget constraint: c1 + 1+i c2 = M1 + 1+i M2 ⇔ c1 + 1.10 c2 = 100+ 1.10 100 ⇔

c1 + 1.05
1.10 c2 = 190.91

1
The c1 -intercept is M1 + 1+i M2 = 190.91, which shows the amount of consumption if
Sylvester chooses to consume everything today and nothing tomorrow.

1
The c2 -intercept is 1+π [(1 + i )M1 + M2 ] = 200, which shows the amount of consumption
if Sylvester chooses to consume nothing today and everything tomorrow.
1+i
The slope is − 1+π = − 1.10
1.05 = −1.048, reflecting the relative price of current consumption.

M2
The zero savings point is M1 , 1+π = (100, 95.24), which is where Sylvester neither saves
nor borrows, i.e., he consumes exactly his income in each period.
1.05
6.(b) Budget constraint: c1 + 1.10 c2 = 190.91

Tangency condition: M RS = 1+π 1+i
⇔ 2cc12c2 = 2c
c1
2
= 1.10
1.05 ⇔ c 2 = 1 1.10
2 1.05 c1
1
Plugging c2 = 12 1.10
1.05 c1 into the budget constraint gives us the optimal consumption
bundle, (c∗1 , c∗2 ) = (127.27, 66.67). Therefore, Sylvester is a borrower.

Bundle S is below and to the right of the zero savings point. Sylvester’s indifference curve
going through bundle S is tangent to the budget line.
6.(c) The budget line pivots counterclockwise at the zero savings point, and now has a slope of
−1.
1.05 1

Budget constraint: c1 + 1.05 c2 = 100 + 1.05 100 ⇔ c1 + c2 = 195.24
1+i 2c2 1.05
Tangency condition: M RS = 1+π ⇔ c1 = 1.05 ⇔ c2 = 12 c1
1
Plugging c2 = 2 c1 into the budget constraint gives us the optimal consumption bundle,
(c∗1 , c∗2) = (130.16, 65.08).
6.(d) Bundle S is below and to the right of the zero savings point, and also below and to the
right of bundle S. Sylvester’s indifference curve going through bundle S is tangent to the
new budget line, which is less steep than the old budget line. His new indifference curve is
above his old indifference curve; he is better off than before.
Chapter 4 Solutions
1.(a) Budget constraint: p1 x1 + p2 x2 = M

Tangency condition: M RS = pp12 ⇔ xx21 = pp12 ⇔ x2 = ( pp21 )x1

Plugging x2 = pp12 x1 into the budget constraint yields the following:

p1
p1 x1 + p2 x1 = M
p2
2p1 x1 = M
M
x1 =
2p1
1.(b) Good 1 is normal (an increase in M results in an increase in x1 ) and ordinary (an increase
in p1 results in a decrease in x1 ). Goods 1 and 2 are neither substitutes nor complements
of one another (p2 does not appear in the demand function for good 1).
2.(a) First, find the original consumption bundle.

Budget constraint: x1 + x2 = 10
p1
Tangency condition: M RS = p2 ⇔ x2
x1 = 1 ⇔ x2 = x1
Thus the original consumption bundle is (x∗1 , x∗2 ) = (5, 5).
Next, find the new consumption bundle given p1 = 2.5.
5
Budget constraint: 2 x1 + x2 = 10
5
Tangency condition: M RS = p1
p2 ⇔ x2
x1 = 2 ⇔ x2 = 52 x1
5
Plugging x2 = 2 x1 into the budget constraint gives us the new consumption bundle,
(x∗∗ ∗∗
1 , x2 ) = (2, 5).
Hence the total effect on the demanded amount of good 1 is 2 − 5 = −3 units.
2.(b) To calculate the substitution effect, we allow M to increase such that utility is unchanged.
We must identify the point where M RS = or xx21 = 52 , and u(x1 , x2 ) = x1 x2 = 5 · 5 = 25.
p1
p2
√
Since x2 = 52 x1 = 25
x1 , we can solve for x1 ; x1 = 10.
√ √
Hence the substitution effect is 10 − 5 units and the income effect is 2 − 10 units.
3. With the Giffen good on the horizontal axis, the Hicks substitution effect bundle is to the
southeast of the original bundle, and the final bundle is to the northwest of the original
bundle. See Solutions-graphs file.
4.(a) His budget constraint is 0.20x + 0.05y = 2.

Given his preferences, he must consume equal quantities of x and y, i.e., x = y.
Therefore, his budget constraint can be rewritten as 0.20x + 0.05x = 0.25x = 2.
Thus x∗ = y ∗ = 8.
4.(b) His budget constraint is now 0.25x + 0.08x = 0.33x = 2.

200
Thus x∗∗ = y ∗∗ = 33 .
200 16
He will be paying 33 (0.05 + 0.03) = 33 in taxes.
M
4.(c) The demand functions are x = y = px +py .
The goods are normal (higher income results in higher consumption), ordinary (higher price
results in lower consumption), and complements of one another (higher price of one results
in lower consumption of the other).
5.(a) Sammy’s budget constraint is x + y = 2.

His tangency condition is M RS = px
py ⇔ y
x = 1 ⇔ y = x.
Thus his optimal consumption bundle is (x∗ , y ∗ ) = (1, 1).
5.(b) Sammy’s budget constraint is now 2x + y = 2.

px y
His tangency condition is M RS = py ⇔ x = 2 ⇔ y = 2x.
Plugging y = 2x into his budget constraint gives us his optimal consumption bundle,

(x∗∗ , y ∗∗) = 12 , 1 .
5.(c) In order for him to be as well off as he was originally, we must identify the point such that
M RS = px
or= 2, and u(x, y) = xy = 1 · 1 = 1. Since y = 2x = x1 , we can solve for
y
py x
√ √
x and y; x = √12 and y = 2. In order to afford consumption bundle (x, y) = √12 , 2 ,
√ √
Sammy requires an allowance of 2x + y = 2 · √12 + 2 = 2 2 ≈ $2.83. His parents would
have to increase his allowance by $0.83.
5.(d) All the answers are the same because v is an order-preserving transformation of u.
6.(a) The x-intercept is 8, and the y-intercept is 5. The budget line is horizontal between (0, 5)
and (3, 5), and is downward-sloping with a slope of −1 beyond (3, 5).
6.(b) His budget constraint is y = 5 for x ≤ 3 and x + y = 8 for x ≥ 3. We shall consider the
case for x ≥ 3.
px y+3
His tangency condition is M RS = py ⇔ x = 1 ⇔ y = x − 3.
Plugging y = x − 3 into his budget constraint gives us his optimal consumption bundle,
(x∗ , y ∗ ) = (5.5, 2.5).
Chapter 5 Solutions
1. Budget constraint: pC + wL = 24w

Tangency condition: M RS = w
p ⇔ C
L = w
1 ⇔ C = wL
Plugging p = 1 and C = wL into the budget constraint yields the following L = 12.
Thus l ∗ = T − L∗ = 24 − 12 = 12.

2. The budget line is downward-sloping between 0, wT p+M and T, M and vertical at T . The
p
optimal bundle is T, M p . See Solutions-Graphs file.
3.(a) The budget line has a kink at the zero-savings point. The slope is steeper to the right of
the zero savings point, and flatter to its left.
3.(b) The budget line has a kink at the zero-savings point. This time the slope is flatter to
the right of the zero-savings point, and steeper to its left. An indifference curve has two
tangency points with the budget line, each one at either side of the zero-savings point.
1.05 1
4.(a) Budget line equation: c1 + 1.05 c2 = 100 + 1.05 100 ⇔ c1 + c2 = 195.24
1
The c1 -intercept is 100 + 1.05 100 = 195.24, which shows the amount of consumption if they
chose to consume everything today and nothing tomorrow.
1
The c2 -intercept is 1.05 [(1.05)100 + 100] = 195.24, which shows the amount of consumption
if they chose to consume nothing today and everything tomorrow.
The slope is − 1.05
1.05 = −1, which reflects the relative price of current consumption.
100

The zero savings point is 100, 1.05 = (100, 95.24), which is where they neither save nor
borrow, i.e., they consume their income each period.
1+i 1.05
4.(b) Mr. A’s tangency condition: M RS = 1+π ⇔ c2
2c1 = 1.05 ⇔ c2 = 2c1
Plugging c2 = 2c1 into the budget constraint gives us Mr. A’s optimal consumption bundle,
(c∗1 , c∗2) = (65.08, 130.16). Thus Mr. A is a lender.
1+i 2c2 1.05

Mr. B’s tangency condition: M RS = 1+π ⇔ c1 = 1.05 ⇔ c2 = 12 c1
Plugging c2 = 12 c1 into the budget constraint gives us Mr. B’s optimal consumption bundle,
(c∗1 , c∗2) = (130.16, 65.08). Thus Mr. B is a borrower.
4.(c) Recall that the savings supply curve is s(i) = M1 − p1 c1 (i). Therefore, we need to derive
the demand for current consumption, c1 (i).
First, rewrite the budget constraint c1 + 1.05 1
1+i c2 = 100+ 1+i 100 as (1+i)c1 +1.05c2 = 100(2+i)
c2 1+i
For Mr. A, rewrite his tangency condition 2c1 = 1.05 as 1.05c2 = 2(1 + i)c1 .

100 2+i
Plug 1.05c2 = 2(1 + i)c1 into the budget constraint and solve for c1 ; c1 = 3 .1+i

Thus Mr. A’s savings supply curve is sA (i) = 100 − 100
3
2+i
1+i or sA (i) =
100 1+2i
3 1+i . This
is an increasing function of i; s = 33.33 for i = 0 and s = 50 for i = 1. Mr. A is always a

lender.
2c2 1+i
For Mr. B, rewrite his tangency condition = 1.05 as 1.05c2 = 12 (1 + i)c1 .
c1

Plug 1.05c2 = 12 (1 + i)c1 into the budget constraint and solve for c1 ; c1 = 200
3
2+i
.
1+i
Thus Mr. B’s savings supply curve is sB (i) = 100 − 2003
2+i
1+i or sB (i) = 3
100 −1+i
1+i . This
is an increasing function of i; s = −33.33 for i = 0 and s = 0 for i = 1. For the most

relevant values of i, i.e., any i < 1, Mr. B is a borrower.

i
The aggregate savings supply curve is sA (i) + sB (i) = 100 1+i , an upward-sloping curve
starting at the origin. Mr. A’s saving exceeds Mr. B’s borrowing; the economy saves
overall. See Solutions-Graphs file.
1.05 1
4.(d) Budget line equation: c1 + 1.10 c2 = 100 + 1.10 100
1.10
1.10
Mr. A’s tangency condition: 2cc2
1
= 1.05 ⇔ c 2 = 2 1.05 c1
1.10
Plugging c2 = 2 1.05 c1 into the budget constraint gives us Mr. A’s optimal consumption
bundle, (c∗1 , c∗2 ) = (63.64, 133.33).

Mr. B’s tangency condition: 2c c1
2
= 1.10
1.05 ⇔ c 2 = 1 1.10
2 1.05 c1

Plugging c2 = 12 1.10
1.05 c1 into the budget constraint gives us Mr. B’s optimal consumption
bundle, (c∗1 , c∗2 ) = (127.27, 66.67).

Mr. A’s initial utility was 29.71, and his current utility is 30.09; Mr. A is better off than
before. Mr. B’s initial utility was 29.71, and his current utility is 29.36; Mr. B is worse off
than before. Lenders benefit from a rise in i, while borrowers suffer.
5. One possible savings function in which the consumer switches from being a borrower to
a saver at a given interest rate. See Solutions-Graphs file. While there is a great deal of
arbitrariness in the shape of the savings curve, take into account the following observations.
Hint: Why must the savings supply curve be strictly increasing when the consumer is a
borrower, but not necessarily when he is a saver? Why can’t a saver ever become a borrower
in response to a rise in the interest rate?
6. The saver’s budget constraint is c1 + 1+π 1

1+i c2 = M1 + 1+i M2 . A decrease in π causes the budget
line to rotate clockwise on the x-intercept while an increase in i causes the budget line to
rotate clockwise on the zero savings point.
In both cases, the substitution effect causes c1 to fall and c2 to rise, while the income effect
causes both c1 and c2 to rise. In the first case, you can’t predict the direction of change in
savings either for a borrower or a saver. In the latter case, it is ambiguous for a saver, but
a borrower will definitely borrow less.
Chapter 6 Solutions
1.(a) Leah’s budget constraint is 4b + 2c = 200. Her optimal consumption bundle is (25, 50).
Her utility is 25 · 50 = 1, 250.
1.(b) The price of cream rises to $2.50 a pint. Her budget constraint is now 4b + 2.50c = 200.
Her new consumption bundle is (25, 40).
1.(c) Let the subsidy be s such that the new price of berries is pb − s. With the tax and the
subsidy, her budget constraint would be (4 − s)b + 2.50c = 200. If her utility in (a) is
1 200
maintained, then bc = 1, 250. With a Cobb-Douglas function, c∗ = 2 · 2.50 = 40. Thus
1,250
b = 40 = 31.25. Plugging the values for b and c into the budget constraint gives us
(4 − s)31.25 + 2.50 · 40 = 200 or s = 0.80. Thus the subsidy should be $0.80 a pint or 20
percent.
2.(a) Rachel’s budget constraint is m + 3c = 45. Her optimal consumption bundle is (15, 10).
Her utility is 15 · 102 + 100 = 1, 600.
2.(b) Rachel’s new budget constraint is m+4c = 45+R or m+4c = 45+c. With a Cobb-Douglas
1
function, m∗∗ = 3 · 45+c
1 and c
∗∗
= 2
3 · 45+c
4 . Solving the two equations simultaneously gives
us the new consumption bundle, (18, 9). Her utility is 18 · 92 + 100 = 1, 558 < 1, 600.
3. William views the two goods as perfect complements while Mary views them as perfect
substitutes. William is always made worse off by the tax, while Mary would be made worse
off by the tax only if the original price of good x were less than the price of good y.
4.(a) Louis’s budget constraint is 32c + s = 80. His optimal consumption bundle is (2, 16). His
utility is 10 · 24 · 16 = 2, 560.
4.(b) Louis’s new budget constraint is 16c + s = 80. His new consumption bundle is (4, 16). His
new utility is 10 · 44 · 16 = 40, 960.
4.(c) With Hicks, the hypothetical budget line has the same slope as the new budget line, but
is tangent to the original indifference curve. Therefore, the hypothetical bundle fulfills the
following:
4s 16
c = 1 ⇔ s = 4c
u(ch, sh ) = u(c∗ , s∗ ) ⇔ 10(ch)4 (sh ) = 2, 560
Solving the two equations simultaneously yields (ch , sh ) = (2.2974, 9.1896).
At the new prices (pc , ps) = (16, 1), the hypothetical bundle (ch, sh ) costs 16 · 2.2974 +
9.1896 = 45.948, and the new bundle costs 80. Thus the income effect is 34.052.
5.(a) The couple’s budget constraint is 100x + y = 33, 000. Their optimal consumption bundle
is (x∗ , y ∗ ) = (220, 11, 000) and their utility is u = 2202 · 11, 000 = 5.324 · 108 . The cost of
the program is $3,000.
5.(b) The couple’s budget constraint is 80x + y = 30, 000. Their optimal consumption bundle is
(x∗ , y ∗ ) = (250, 10, 000) and their utility is u = 2502 · 10, 000 = 6.25 · 108 . The cost of the
program is 250 · 20 = $5, 000.
Since the second program yields a higher utility than the first program, the couple will
choose the second program.
6. Pre-policy, the consumer in Group i solves the following problem:
max u(xi , yi ) subject to px xi + py yi = Mi
Group A solves: max u(xA , yA ) subject to 10xA + 10yA = 500

Group B solves: max u(xB , yB ) subject to 10xB + 10yB = 400
Group C solves: max u(xC , yC ) subject to 10xC + 10yC = 300
Clearly, x∗i = yi∗ ; x∗A = yA
∗
= 25, x∗B = yB
∗
= 20, and x∗C = yC
∗
= 15.
Post-policy, the consumer solves the following problem:
max u(xi, yi ) subject to (px − sx )xi + (py − sy )yi = Mi − Ti
Group A solves: max u(xA , yA ) subject to 9xA + 9yA = 500 − 68

Group B solves: max u(xB , yB ) subject to 9xB + 9yB = 400 − 40
Group C solves: max u(xC , yC ) subject to 9xC + 9yC = 300 − 12

Clearly, x∗∗ ∗∗ ∗∗ ∗∗ ∗∗ ∗∗ ∗∗ ∗∗
i = yi ; xA = yA = 24, xB = yB = 20, and xC = yC = 16.
Therefore, the welfare of the median consumer (Group B) is unchanged. Lower-income

consumers (Group C) are better off and higher-income consumers (Group A) are worse off.
Chapter 7 Solutions
1. Consider two points, (x1 , x2 ) and (x1 , x2 ), such that u(x1 , x2 ) = 10 and u(x1 , x2 ) = 5. The
vertical distance between the two points is x2 − x2 .
Rewrite u(x1 , x2 ) = v(x1 ) + x2 = 10 as x2 = −v(x1 ) + 10, and rewrite u(x1 , x2 ) = v(x1 ) +
x2 = 5 as x2 = −v(x1 )+5. Thus the vertical distance between the two points is x2 −x2 = 5.
2. Let the old bundle be x∗ = (x∗1 , x∗2 ), the new bundle be x∗∗ = (x∗∗ ∗∗
1 , x2 ), and the hypothetical
bundle be y = (y1 , y2 ). Since indifference curves are parallel under quasilinear preferences,
y is directly above x∗∗ , and the hypothetical bundle can be rewritten as y = (x∗∗
1 , y2 ).
The change in utility is u(x∗∗ ) − u(y) = [v(x∗∗ ∗∗ ∗∗ ∗∗

1 ) + x2 ] − [v(x1 ) + y2 ] = x2 − y2 .
The change in dollars is [p1 x∗∗ ∗∗ ∗∗ ∗∗ ∗∗

1 + p2 x2 ] − [p1 y1 + p2 y2 ] = [p1 x1 + p2 x2 ] − [p1 x1 + p2 y2 ] =
p2 (x∗∗ ∗∗
2 − y2 ) = x2 − y2 .
Thus the change in utility equals the change in dollars.
3. From Figure 7.5, Consumer 1’s surplus = 12 ab, and Consumer 2’s surplus = 12 cd. Thus the
sum of Consumer 1’s surplus and Consumer 2’s surplus = 12 ab + 12 cd.
Consumers’ surplus in the graph at the far right can be decomposed into two triangles with
areas 12 ab and 12 cd. Therefore Consumers’ surplus = 12 ab + 12 cd = Consumer 1’s surplus +
Consumer 2’s surplus.
4.(a) Case 1: p = 0
Consumers’ Surplus = 12 X(5 − p) = 1
2 · 1, 000, 000 · 5 = $2.5 million
Government Revenue minus Cost = pXp − 1, 000, 000 = 0 − 1, 000, 000 = −$1 million
Thus Net Social Benefit = $1.5 million.
√
5− 5
Case 2: p = 2
√ √
5− 5
X = 1, 000, 000 − 200, 000 2 = 100, 000 5 + 5
√ √ √ 2
1
Consumers’ Surplus = 2 · 100, 000(5 + 5) · 5 − 5−2 5 = 25, 000 5 + 5 =
$1.309 million
Government Profit = 0
4.(b) The government solves the following problem:

max Revenue = pXp = p(1, 000, 000 − 200, 000p)
By the First Order Condition, ∂R
∂p = 1, 000, 000 − 400, 000p = 0 and p = 2.5.
Case 3: p = 2.5
X = 1, 000, 000 − 200, 000 · 2.5 = 500, 000
1
Consumers’ Surplus = 2 · 500, 000(5 − 2.5) = $625, 000
Government Revenue minus Cost = 2.5 · 500, 000 − 1, 000, 000 = $250, 000
4.(c) Solve the following problem:
max Net Social Benefit = Consumers’ Surplus + Government Revenue minus Cost
1
= Xp (5 − p) + pXp − 1, 000, 000
2
1
= (1, 000, 000 − 200, 000p)(5 − p) + p(1, 000, 000 − 200, 000p) − 1, 000, 000.
2
Simplifying this expression, it is easy to see that this function is maximized at p = 0.
M 9 9
5. Given the demand function x1 = 2p1 and M = 18, x1 = p1 and p1 = x1 . At p1 = 1, x1 = 9.
At p1 = 2.25, x1 = 4. Thus when p1 rises from 1 to 2.25:

x1 =9
x1 =9
9
Loss in Consumer’s surplus = p1 (x1 ) dx1 = dx1
x1 =4 x1 =4 x1

9 9
= [9 ln(x1 )]4 = 9 ln = 7.2984.
4
6. Correction. There is an error in the textbook, where Carter’s utility function is shown as
u(x, y) = 10x + 13 x3 + y. The correct utility function is u(x, y) = 10x − 13 x3 + y. Also,
assume throughout this problem that py = 1, and that Carter’s income M is at least 12.
Here is the solution for the corrected problem:
2
6.(a) Carter’s tangency condition is M RS = 10−x
1 = ppxy = px . Therefore his demand function
√
for x is x = 10 − ppxy = 10 − px . When px = 1, he consumes x = 3. (He also consumes
M − x units of good y.)
6.(b) His inverse demand function for x is px = 10 − x2 . When px = 1 and Carter is consuming
3 units of x, his consumer’s surplus from his consumption of x is

x=3
Consumer’s surplus = px (x) dx − pxx
x=0

x=3 2
1 3 3
= 10 − x dx − 3 = 10x − x − 3 = 21 − 3 = 18.
x=0 3 0
√ √
6.(c) When px rises to 6 while py remains at 1, Carter will consume x = 10 − px = 4 = 2.
(This will cost px x = 12, which is why we assumed that M ≥ 12.) His consumer’s surplus
from his consumption of x is now

x=2
Consumer’s surplus = 10 − x2 dx − 6 · 2
x=0
2
1 8 8 16
= 10x − x3 − 12 = 20 − − 12 = 8 − = .
3 0 3 3 3
Chapter 8 Solutions
1.(a) dy
dx = 12 x−1/2
d2 y
dx2
= − 14 x−3/2 < 0 for x
= 0
1.(b) y = x1/2 ⇔ x = y2
C(y) = wx = 1 · y 2 = y 2
C(y) y2
AC(y) = y = y = y
M C(y) = dC(y)
dy = 2y
1.(c) The supply curve is the M C(y) curve, if p ≥ min AC(y), and M C(y) is rising.
First, determine min AC(y): min AC(y) = AC(0) = 0.
dM C(y)
Second, check whether M C(y) is rising: dy = 2 > 0.
Thus for p ≥ 0, the supply curve is given by p = M C(y) ⇔ p = 2y ⇔ y ∗ (p) = 12 p.
1 1 2 1 1 2
1.(d) π = p · y − w · x(y) = p 2 p − w 2 p = 10 2 · 10 − 1 2 · 10 = 25
3
2.(a) y = 5x1/3 − 30 ⇔x = 15 y + 6
3 3
C(y) = wx = 1 15 y + 6 = 15 y + 6
3
C(y) ( 1 y+6)
AC(y) = y = 5 y

3 1
2
M C(y) = dC(y)
dy = 5 5 y + 6
2.(b) The supply curve is the M C(y) curve, if p ≥ min AC(y), and M C(y) is rising.
dAC(y)
First, determine min AC(y): dy = 0 ⇔ y = 15. Therefore, min AC(y) = AC(15) =
48.6.
dM C(y) 6
1
Second, check whether M C(y) is rising: dy = 25 5y +6 > 0.
Thus for p < 48.6, the supply curve is y = 0.
3
1 2
And for p ≥ 48.6, the supply curve is given by p = M C(y) ⇔ p = 5 5y + 6 ⇔ y ∗ (p) =

5 5p
3 − 30.
3.(a) x = y 2
dx
dy = 2y
d2 x
dy2
=2 > 0
df (x) 1
3.(b) M P (x) = √
dx = 2 x
√
f (x)
AP (x) = x √1
x = x = x
1 √5
3.(c) V M P (x) = p · M P (x) = 10 · √
2 x
= x
10
V AP (x) = p · AP (x) = √
x
3.(d) The input demand curve is the V M P (x) curve, if max V AP (x) ≥ w, and V M P (x) is
falling.
First, determine max V AP (x): max V AP (x) = V AP (1) = 10.
dV M P (x)
Second, check whether V M P (x) is falling: dx = − 52 x−3/2 < 0 for x
= 0.
Thus for w > 10, the input demand curve is x = 0.
And for w ≤ 10, the input demand curve is given by w = V M P (x) ⇔ w = √5 ⇔
x
25
x∗ (w) = w2
.
25 1/2 25 25 1/2 25
3.(e) π = p · y(x) − w · x = p w2
−w w2
= 10 12
−1 12
= 25

df (x) 1 √2
4.(a) M P (x) = dx = 3 3x +1
f (x)
AP (x) = √1 1
x = 3x + 3

4.(b) V M P (x) = p · M P (x) = 6 · 13 √ 2
3x + 1 = 2 2
√
3x + 1

1 1 3
V AP (x) = p · AP (x) = 6 √ 3x + 3 = 2 √
3x + 1
4.(c) The input demand curve is the V M P (x) curve, if max V AP (x) ≥ w, and V M P (x) is
falling.
First, determine max V AP (x): max V AP (x) = V AP (1) = 8.
dV M P (x)
Second, check whether V M P (x) is falling: dx = − 43 x−4/3 < 0 for x
= 0.
Thus for w > 8, the input demand curve is x = 0.

2
And for w ≤ 8, the input demand curve is given by w = V M P (x) ⇔ w = 2 √ 3x +1 ⇔
3
4
x∗ (w) = w−2 for w > 2. If w ≤ 2, the firm would demand an infinite amount of input.
5. In a (y1 , y2 )- quadrant, a typical isofactor curve is concave to the origin (using the same
amount of input, the more additional units of output y1 the firm wants to produce requires
it to give up more units of output y2 ). The isorevenue curves are downward-sloping straight
lines of slope −p1 /p2 . The solution to the revenue maximization problem, conditional on a
level of input x, is found at the tangency of the highest possible isorevenue line with the fixed
isofactor curve. The solution to this revenue maximization problem yields the conditional
output supply functions y1 (p1 , p2 , x) and y2 (p1 , p2 , x). Finally, the profit maximization
problem is thus written:
max π = p1 · y1 (p1 , p2 , x) + p2 · y2 (p1 , p2 , x) − wx

x
Solving the maximization problem yields the input demand function, x(p1 , p2 , w).
6.(a) C(y1 , y2 ) = wx = y12 + y22 + y1 y2

∂C(y)
M C1 (y1 ) = ∂y1 = 2y1 + y2
∂C(y)
M C2 (y2 ) = ∂y2 = 2y2 + y1
6.(b) The supply curves are the M Ci (yi ) curves, subject to the non-negative profit condition.
The supply curves are given by p1 = 2y1 + y2 and p2 = 2y2 + y1 . Solving the two equations
simultaneously, the supply curves are y1∗ (p1 , p2) = 13 (2p1 − p2 ) and y2∗ (p1 , p2) = 13 (2p2 − p1 ).
6.(c) y1∗ (1, 1) = 13 (2 · 1 − 1) = 1

3
y2∗ (1, 1) = 13 (2 · 1 − 1) = 1
3
1 1

Thus π = p1 y1 + p2 y2 − wx = 3 + 3 − ( 13 )2 + ( 13 )2 + ( 13 )( 13 ) = 13 .
6.(d) y1∗ (1, 2) = 13 (2 · 1 − 2) = 0

y2∗ (1, 2) = 13 (2 · 2 − 1) = 1

Thus π = p1 y1 + p2 y2 − wx = 0 + 2 − 02 + 12 + 0 = 1.
Chapter 9 Solutions
1. Isoquants represent a firm’s production of output, and output is a cardinal measure. Indif-
ference curves represent a consumer’s utility level, and utility is an ordinal measure.
2. Profit-maximizing firms produce up to the point where Price = Marginal Cost. If the price
rises, then the marginal cost must rise to maintain the equality. Since the firm produces
where the marginal cost curve is rising, a rise in the marginal cost implies a rise in output.
1
3.(a) Tangency condition: T RS = w1
w2 ⇔ x2
x1 = 2 ⇔ x1 = 2x2
Plugging x1 = 2x2 into the production function gives us the conditional factor demands,
√ y2
x∗1 (y) = 2y 2 and x∗2 (y) = √2
.
√ y2
√
3.(b) C(y) = w1 x1 + w2 x2 = 1 · 2y 2 + 2 · √
2
= 2 2y 2
First, derive AC(y) and M C(y).
√
2 2y2
√
AC(y) = C(y)y = y = 2 2y
√
M C(y) = dC(y)
dy = 4 2y
Next, determine min AC(y): AC(0) = 0.

dM C(y) √
Then, check whether M C(y) is rising: dy = 4 2 > 0.
√
Thus for p ≥ 0, the long-run supply curve is given by p = M C(y) ⇔ p = 4 2y ⇔
y ∗ (p) = p
√
4 2
.
tLtK t2 LK tLK
4.(a) Since f (tL, tK) = 10 = 10 > 10 = tf (L, K) for t > 1, this technology shows
increasing returns to scale.
The isoquants are symmetric hyperbolas; the isoquants get closer and closer to each other
away from the origin.
10
4.(b) Tangency condition: T RS = wL
wK ⇔ K
L = 100 ⇔ L = 10K
Plugging L = 10K into the production function gives us the conditional factor demands,
√ √
L∗ (y) = 10 y and K ∗ (y) = y.
√ √ √
4.(c) C(y) = wL L + wK K = 10 · 10 y + 100 · y = 200 y
√ √ √
4.(d) If y = 1, then L∗ (1) = 10 1 = 10, K ∗ (1) = 1 = 1, and C(1) = 200 1 = 200.
√ √ √
If y = 2, then L∗ (2) = 10 2, K ∗ (2) = 2, and C(2) = 200 2.
√
C(y) 200 y 200
4.(e) AC(y) = = = √
y y y
dC(y) 100
√
M C(y) = dy = y
Both AC(y) and M C(y) are decreasing hyperbolas, and M C(y) < AC(y). There is no
long-run supply curve.
5.(a) Since the inputs are perfect substitutes, and input 2 is cheaper than input 1, the cost
minimizing technique is to use only input 2. Hence, the conditional factor demands are
x∗1 (y) = 0 and x∗2 (y) = y.
Thus C(y) = w1 x1 + w2 x2 = 2 · 0 + 1 · y = y.
5.(b) First, derive AC(y) and M C(y).

C(y) y
AC(y) = y = y =1
dC(y)
M C(y) = dy = 1
Therefore, the long-run supply curve is y = 0 for p < 1, and y ∈ [0, ∞) for p = 1.
5.(c) If w2 = 2, the firm’s conditional factor demands are x1 ∈ [0, y] and x2 ∈ [0, y] such that
x1 + x2 = y.
2y
Thus C(y) = 2x1 (y) + 2x2 (y) = 2[x1 (y) + x2 (y)] = 2y, AC(y) = y = 2, and M C(y) = 2.
Therefore, the long-run supply curve is y = 0 for p < 2, and y ∈ [0, ∞) for p = 2.
xj 1
6.(a) Tangency condition: T RSxi,xj = wi
wj ⇔ xi = 1 ⇔ xi = xj for i = 1, 2, 3, j = 1, 2, 3,
i
= j.
Plugging xi = xj into the production function gives us the conditional factor demands,
x∗1 (y) = x∗2 (y) = x∗3 (y) = y 5/3 .
6.(b) C(y) = w1 x1 + w2 x2 + w3 x3 = 1 · y 5/3 + 1 · y 5/3 + 1 · y 5/3 = 3y 5/3
3y5/3
3y 2/3
C(y)
AC(y) = y = y =
= dy = 5y 2/3
dC(y)
M C(y)
Next, determine min AC(y): AC(0) = 0.
dM C(y) 10
Then, check whether M C(y) is rising: dy = 3
√3y > 0 for y
= 0.
Thus for p ≥ 0, the long-run supply curve is given by p = M C(y) ⇔ p = 5y 2/3 ⇔ y ∗ (p) =
( p5 )3/2 .
Chapter 10 Solutions
f (x1,x2 ) [243+ 13 (x1 −9)3 ]x2 [243+ 31 (x1 −9)3 ]

1.(a) AP (x1 |1) = x1 = x1 = x1
∂f (x1,x2 ) 2 2
M P (x1 |1) = ∂x1 = (x1 − 9) x2 = (x1 − 9)
f (x1 ,x2 )
1.(b) AP (x2 |x01 ) = x2 = 243 + 13 (x01 − 9)3
∂f (x1,x2 )
M P (x2 |x01 ) = ∂x2 = 243 + 13 (x01 − 9)3
1.(c) In (a), AP (x1 |1) and M P (x1 |1) vary with x1 . In (b), AP (x2 |x01 ) = M P (x2 |x01 ), and both
average product and marginal product curves are constant for a given level of input 1.
2.(a) If w1 rises, x∗1 falls, and π falls.
2.(b) If w2 falls, x∗1 is unchanged, and π rises.
2.(c) If p rises, x∗1 rises, and π rises.
1/4 1/4 1/4

3.(a) Since y = x1 x2 = x1 · 11/4 , therefore x1 = y 4 .
Therefore C S (y) = w1 x1 + w2 x2 = 1 · y 4 + 2 · 1 = y 4 + 2.
3.(b) The supply curve is the M C S (y) curve, if p ≥ min AV C(y), and M C S (y) is rising.
First, derive AV C(y) and M C S (y).
4
AV C(y) = V C(y)
y = yy = y3
dC S (y)
M C S (y) = dy = 4y 3
Next, determine min AV C(y): AC(0) = 0.
dM C S (y)
Then, check whether M C S (y) is rising: dy = 12y 2 ≥ 0.
Thus for p ≥ 0, the short run supply curve is given by p = M C S (y) ⇔ p = 4y 3 ⇔
1/3
y ∗ (p) = p4 .
LK L·1
4.(a) Since y = 10 = 10 , therefore L = 10y.
Therefore C S (y) = w1 x1 + w2 x2 = 10 · 10y + 100 · 1 = 100y + 100.
C S (y)
4.(b) AT C(y) = y = 100 + 100
y
V C(y) 100y
AV C(y) = y = y = 100
S
dC (y)
M C S (y) = dy = 100
AT C(y) is a decreasing hyperbola that approaches 100. Both AV C(y) and M C S (y) are
constant at 100. Therefore the short-run supply curve is infinitely elastic at p = 100.
C S (y)
5.(a) AT C(y) = y = 100
y + 10 − 2y + y
2
2 +y3
= 10y−2y + y2
V C(y)
AV C(y) = y y = 10 − 2y
S
dC (y)
M C S (y) = dy = 10 − 4y + 3y 2
AT C(y) is a parabola starting at (0, ∞) with a minimum around y = 4. AV C(y) is a
parabola starting at (0, 10) with a minimum at (1, 9). M C S (y) is a parabola starting at
(0, 10) with a minimum at y = 23 . Notice that M C(y) intersects AV C(y) at min AV C(y)
and AT C(y) at min AT C(y).
5.(b) The supply curve is the M C S (y) curve, if p ≥ min AV C(y), and M C S (y) is rising.
Thus for p < 9, the short-run supply curve is y = 0.
And for p ≥ 9, the short-run supply curve is given by p = M C S (y) ⇔ p = 10−4y +3y 2 ⇔
√
2 3p−26
y ∗ (p) = 3 + 3 .
6. If the output price is below min AT C(y), then profit is negative. However, if the output
price is below min AT C(y) but above min AV C(y), the firm recoups some of the fixed cost
if it produces output. Therefore, in the short run, the firm produces output as long as the
output price is above min AV C(y).
1.(a) Assuming coffee is a normal good, an increase in consumers’ income shifts the demand
curve right. Hence, the equilibrium price and quantity both increase.
1.(b) An increase in factor prices increases marginal costs; the supply curve shifts left. Hence,
the equilibrium price increases and the quantity decreases.
1.(c) A technological improvement lowers marginal costs; the supply curve shifts right. Hence,
the equilibrium price decreases and the quantity increases.
4
2.(a) Tangency condition: T RS = w1
w2 ⇔ x2
x1 = 1 ⇔ x2 = 4x1
Plugging x2 = 4x1 into the production function gives us the conditional factor demands,
x∗1 (y) = 12 y and x∗2 (y) = 2y.
Therefore C(y) = w1 x1 + w2 x2 = 4 · 12 y + 1 · 2y = 4y.
Since AC(y) = M C(y) = 4, the long run supply curve is given by p = M C(y) ⇔ p = 4.
2.(b) Since p = 4, y = 1, 000, 000 − 1, 000 · 4 = 996, 000.
256
3.(a) Tangency condition: T RS = wK
wL ⇔ L
2K = 1 ⇔ L = 512K
Plugging L = 512K into the production function gives us the conditional factor demands,
1
K ∗ (h) = 64 h and L∗ (h) = 8h.
1
Therefore C(h) = wK K + wLL = 256 · 64 h + 1 · 8h = 12h.
Since AC(y) = M C(y) = 12, the long-run supply curve is given by p = M C(y) ⇔ p = 12.
The individual and market supply are infinitely elastic at p = 12, i.e., for p < 12, hS = 0,
and for p = 12, the supply is any non-negative amount.
3.(b) The competitive equilibrium is the intersection of the market demand and market supply.
Thus p = 12 and h∗ = 3, 000. Each firm earns zero profit because of constant returns to
scale. The individual amount produced by each firm is therefore indeterminate; all we know
is the aggregate amount produced by the industry, that is, 3,000 units.
3.(c) Under the new competitive equilibrium, p = 12 and h∗∗ = 2, 000. Again, each firm earns
zero profit and is indifferent between producing any non-negative amount.
Since profits are zero, firms are indifferent between staying in or out of the market. There-
fore, the number of producers is also indeterminate. The total amount of good h exchanged
in the market, however, is perfectly determined by demand.
4.(a) The representative firm’s supply curve is the M C(y) curve, if p ≥ min AC(y), and M C(y)
is rising.
C(y) 99 1 2
AC(y) = y = 2y − 2 y + y
= dC(y) 2
M C(y) dy = −y + 3y
dAC(y) 99 1
Next, determine min AC(y): dy = − 2y 2 − 2 + 2y = 0 ⇔ y = 3.
99 1
Therefore, min AC(y) = 2·3 − 2 · 3 + 32 = 24.
dM C(y)
Then, check whether M C(y) is rising: dy = −1 + 6y > 0 at y = 3.
Thus for p < 24, the representative firm’s supply curve is y = 0.
And for p ≥ 24, the representative firm’s supply curve is given by p = M C(y) ⇔ p =
√
−y + 3y 2 ⇔ y ∗ (p) = 16 1 + 1 + 12p .
4.(b) In the long run, the number of firms adjusts to drive the market to the zero-profit equi-
librium. The long-run market supply curve is horizontal at p = min AC(y) = 24. Each
√
firm produces yi = 16 1 + 1 + 12 · 24 = 3. At equilibrium, market supply equals market
demand: y = 1, 140 − 10 · 24 = 900. Therefore, there are 300 firms in the market.
1
5.(a) π(y) = R(y) − C(y) = 140y − 2y
2 + 40y + 2, 450 = 100y − 12 y 2 − 2, 450
5.(b) dπ(y)
dy = 100 − y = 0 ⇔ y ∗ = 100
1
5.(c) π(100) = 100 · 100 − 2 · 1002 − 2, 450 = 2, 550
5.(d) Since Dakota is earning positive profits, new firms will enter the industry in the long run.
Therefore, the number of firms in the rocking horse industry will rise.
6.(a) In the long run, Dakota will produce where p∗∗ = M C(y ∗∗ ) = AC(y ∗∗ ) = min AC(y).
C(y) 1 2,450
AC(y) = y = 2 y + 40 + y
dC(y)
M C(y) = dy = y + 40
Then, set M C(y) = AC(y) and solve for y ∗∗ .
M C(y) = AC(y)
1 2, 450
y + 40 = y + 40 +
2 y
y 2 = 2, 450 · 2

y= 4, 900
y ∗∗ = 70
Alternatively, find min AC(y) and solve for y ∗∗ .

1 2,450
min AC(y): dAC(y)
dy = 2 − y2
= 0 ⇔ y ∗∗ = 70
1 2,450
6.(b) In the long run, p∗∗ = AC(70) = 2 · 70 + 40 + 70 = 110.
Alternatively, p∗∗ = M C(70) = 70 + 40 = 110.
1
6.(c) π ∗∗ = π(70) = 110 · 70 − 2 · 702 + 40 · 70 + 2, 450 = 0
6.(d) The long-run market supply curve is infinitely elastic at p∗∗ = 30. Recall that the less
elastic side of the market bears the greater burden of the tax. Therefore, the tax burden
is borne entirely by the consumers. The firm’s profits are unaffected by the tax. Note that
Dakota may drop out of the market, but whether it stays in or out, its profit will be zero.
p
1. The markup is the fractional amount by which price exceeds cost, and equals MC −1 =
1 1
1−1/ − 1 = −1 . As elasticity decreases, the markup increases. Therefore, the markup (and
thus price) will be higher for the group with the lower elasticity of demand, which is Group
B.
2. Given R(h) = p · h = (50 − h

50 )h, M R(h) = 50 − h
25 . Given C(h) = 12h, M C(h) = 12.
Corleone will produce where:
M R(h) = M C(h)
h
50 − = 12
25
h = 950
950
Therefore, p = 50 − 50 = 31, and π = R(h) − C(h) = 31 · 950 − 12 · 950 = 18, 050.
3. Since R1 = p1 · y1 = (100 − y1 )y1 , M R1 = 100 − 2y1 , and since R2 = p2 · y2 = (75 − 12 y2 )y2 ,

M R2 = 75 − y2 . Since C(y1 , y2 ) = (y1 + y2 )2 , M C1 = M C2 = 2(y1 + y2 ). The monopolist
will produce where M R1 = M C1 and M R2 = M C2 , giving us two equations and two
unknowns:
M R1 = M C1
100 − 2y1 = 2(y1 + y2 )
50 = 2y1 + y2 (1)
M R2 = M C2
75 − y2 = 2(y1 + y2 )
75 = 2y1 + 3y2 (2)
Subtracting equation (1) from equation (2), we get 2y2 = 25 ⇔ y2 = 12.50. Plugging
y2 = 12.50 into equation (1) gives us 50 = 2y1 + 12.50 ⇔ y1 = 18.75. Finally, plugging y1
into p1 (y1 ) and y2 into p2 (y2 ), we find that p1 = 100−18.75 = 81.25 and p2 = 75− 12 (12.50) =
68.75.
4.(a) Given RB = pB · xB = (100 − xB )xB , M RB = 100 − 2xB , and given RF = pF · xF =

(30 − 2xF )xF , M RF = 30 − 4xF . Given C(xB , xF ) = xB + xF , M CB = M CF = 1. The
monopolist will produce where M RB = M CB and M RF = M CF :
M RB = M CB
100 − 2xB = 1
xB = 49.50
M RF = M CF
30 − 4xF = 1
xF = 7.25
Therefore, pB = 100 − 49.50 = 50.50 and pF = 30 − 2(7.25) = 15.50. Total profits are
π = RB + RF − C(xB , xF ) = 50.50(49.50) + 15.50(7.25) − (49.50 + 7.25) = 2, 555.37.
4.(b) The businesses’ surplus is the area of the triangle below the demand curve xB and above
the horizontal line at pB = 50.50. The families’ surplus is the area of the triangle below
the demand curve xF and above the horizontal line at pF = 15.50. The sum of the two
surpluses is the consumers’ surplus.
Consumers’ surplus = 12 (49.50)(100 − 50.50) + 12 (7.25)(30 − 15.50) = 1, 277.68.
The producer’s surplus is total profits.
Producer’s surplus = π = 2, 555.37.
4.(c) The market demand from aggregating the two groups is:
⎧
⎪
⎪
⎪
⎪ 0 if p ≥ 100
⎪
⎨
x = 100 − p if 100 ≥ p ≥ 30
⎪
⎪
⎪
⎪
⎪
⎩ 115 − 32 p if 30 ≥ p ≥ 0
The kink occurs at x = 70. The marginal revenue curves are obtained as follows:
For x < 70, R(x) = p · x = (100 − x)x, so M R(x) = 100 − 2x.

For x ≥ 70, R(x) = p · x = 230−2x
3 x, so M R(x) = 230−4x
3 .
Since M C(x) = 1, and the monopolist’s solution is given by M R(x) = M C(x), we have
230−4x 227
either 100−2x = 1 ⇔ x = 49.50 < 70, or 3 =1⇔x= 4 < 70 which contradicts x ≥
70. Hence, the solution is x = 49.50, p = 50.50, and π = 50.50(49.50) − 49.50 = 2, 450.25.
4.(d) Consumers’ surplus = 12 (49.50)(100 − 50.50) + 0 = 1, 225.12.

Producer’s surplus = π = 2, 450.25.
Society is worse off after this change is introduced; families cannot afford telephone services,
and Horizon Telephone earns lower profits.
5.(a) Given R(y) = p · y = (100 − 12 y)y, M R(y) = 100 − y. Given C(y) = y 2 + 10y, M C(y) =
2y + 10. Sue will produce where:
M R(y) = M C(y)
100 − y = 2y + 10
3y = 90
y ∗ = 30
1
5.(b) p∗ = 100 − 2 · 30 = 85.
5.(c) π ∗ = R(y ∗ ) − C(y ∗ ) = 85 · 30 − (302 + 10 · 30) = 1, 350.
5.(d) Consumers’ surplus = 12 (30)(100 − 85) = 225.
6.(a) If Sue is forced to price at marginal cost:
p(y) = M C(y)
1
100 − y = 2y + 10
2
5
y = 90
2
y ∗∗ = 36 > 30 = y ∗
1
6.(b) p∗∗ = 100 − 2 · 36 = 82 < 85 = p∗ .
6.(c) π ∗∗ = R(y ∗∗ ) − C(y ∗∗ ) = 82 · 36 − (362 + 10 · 36) = 1, 296 < 1, 350 = π ∗ .
6.(d) Consumers’ surplus = 12 (36)(100 − 82) = 324 > 225.
6.(e) Total welfare is 1, 296 + 324 = 1, 620 which is greater than total welfare in Question 5
(1, 350 + 225 = 1, 575).
1
1.(a) The inverse market demand curve is p(h) = 60 − 20 h. Their profit maximization problems
are:
max π1 = p(h1 , h2 )h1 − C1 (h1 )
h1

1 1
= 60 − h1 − h2 h1 − 10h1
20 20
max π2 = p(h1 , h2 )h2 − C2 (h2 )

h2

1 1
= 60 − h1 − h2 h2 − 20h2
20 20
To derive their reaction functions, h1 (h2 ) and h2 (h1 ), we solve the maximization problems.
∂π1 1 1
= 60 − h1 − h2 − 10 = 0
∂h1 10 20
1
h1 = 500 − h2
2
∂π2 1 1
= 60 − h1 − h2 − 20 = 0
∂h2 20 10
1
h2 = 400 − h1
2
1.(b) The Cournot equilibrium is the intersection of the reaction functions. Solving the reaction
functions simultaneously, we find that h∗1 = 400 and h∗2 = 200. The market price is
1
p∗ = 60 − 20 (400 + 200) = 30. Individual profits are π1∗ = 30 · 400 − 10 · 400 = 8, 000
and π2∗ = 30 · 200 − 20 · 200 = 2, 000.
2.(a) The cartel solution is obtained from the joint maximization problem:
max π = p(h1 , h2 )(h1 + h2 ) − C1 (h1 ) − C2 (h2 )

h1 ,h2

1 1
= 60 − h1 − h2 (h1 + h2 ) − 10h1 − 20h2
20 20
1 2 1 1
= 50h1 + 40h2 − h1 − h22 − h1 h2
20 20 10
The first order conditions obtained from differentiation are:
∂π 1 1
= 50 − h1 − h2 = 0
∂h1 10 10
h1 + h2 = 500
∂π 1 1
= 40 − h1 − h2 = 0
∂h2 10 10
h1 + h2 = 400
Clearly, the system does not have an interior solution. Hence, either h1 = 0 or h2 = 0.
Given the cost differential, it must be that h2 = 0. For completeness, we check both cases.
Case 1: h1 = 0:
1
max π = 60 − h2 h2 − 20h2
h2 20
∂π 1
= 60 − h2 − 20 = 0
∂h2 10
h2 = 400
1
The market price is p = 60 − 20 · 400 = 40. Profits are π = 40 · 400 − 20 · 400 = 8, 000.
Case 2: h2 = 0:
1
max π = 60 − h1 h1 − 10h1
h1 20
∂π 1
= 60 − h1 − 10 = 0
∂h2 10
h1 = 500
1
The market price is p = 60 − 20 · 500 = 35. Profits are π = 35 · 500 − 10 · 500 = 12, 500.
Therefore, profits are maximized when h∗1 = 500, h∗2 = 0, and p∗ = 35. Then, π ∗ = 12, 500,
3 2
and according to the agreement, π1∗ = 5 · 12, 500 = 7, 500 and π2∗ = 5 · 12, 500 = 5, 000.
2.(b) Case 1: Suppose Corleone breaks the agreement. If Chung sticks to the agreement, h2 = 0.
Corleone produces h1 = 500 and earns profits π1 = 12, 500, which exceeds π1∗ = 7, 500 under
the agreement. Thus, Corleone has an incentive to break the agreement. Furthermore, note
that Corleone is better off under the simultaneous quantity setting model in Question 1
than he is under the agreement. In this sense, Corleone has strong reasons to complain
about the split of cartel profits.
Case 2: Suppose Chung breaks the agreement. If Corleone sticks to the agreement, h1 =
500. Chung solves the following problem:

1 1
max π2 = 60 − · 500 − h2 h2 − 20h2
h2 20 20
∂π2 1
= 35 − h2 − 20 = 0
∂h2 10
h2 = 150
1 1
The market price is p = 60 − 20 · 500 − 20 · 150 = 27.50. Chung’s profits are π2 =
27.50 · 150 − 20 · 150 = 1, 125, which is lower than π2∗ = 5, 000 under the agreement. Thus,
Chung has no incentive to break the agreement, if we assume that, after breaking it, he
will stop receiving the check from the cartel. Otherwise, he would also have an incentive
to cheat, as the cartel agreement is not on his reaction function either.
3.(a) The inverse market demand curve is p(y) = 10−10−5 y. Their profit maximization problems
are:
max π1 = p(y1 , y2 )y1 − C1 (y1 )
y1

= 10 − 10−5 y1 − 10−5 y2 y1 − y12
max π2 = p(y1 , y2 )y2 − C2 (y2 )

y2

= 10 − 10−5 y1 − 10−5 y2 y2 − 5y2
Pear takes y1 as given and fixed, and chooses y2 to maximize profits.

∂π2
= 10 − 10−5 y1 − 2(10−5 )y2 − 5 = 0
∂y2
1
y2 = 250, 000 − y1
2
MBI substitutes y2 = 250, 000 − 12 y1 into its profit function, and chooses y1 accordingly.

−5 −5 1
max π1 = 10 − 10 y1 − 10 250, 000 − y1 y1 − y12
y1 2

15 1
= − · 10−5 y1 y1 − y12
2 2
∂π1 15
= − 10−5 y1 − 2y1 = 0
∂y1 2
200, 001 15
y1 =
100, 000 2
y1∗ ≈ 3.75
1
Plug y1∗ = 3.75 back into y2 (y1 ) to obtain y2∗ ; y2∗ = 250, 000 − 2 · 3.75 = 249, 998.12.
The market price is p∗ = 10 − 10−5 (3.75 + 249, 998.12) ≈ 7.50. Individual profits are
π1∗ = 7.50 · 3.75 − 3.752 = 14.06 and π2∗ = 7.50 · 249, 998.12 − 5 · 249, 998.12 = 624, 995.31.
3.(b) To calculate the Cournot equilibrium, we solve the profit maximization problems simulta-
neously. We need to derive MBI’s reaction function.
∂π1
= 10 − 2(10−5 )y1 − 10−5 y2 − 2y1 = 0
∂y1
1, 000, 000 1
y1 = − y2
200, 002 200, 002
1
≈5− y2
200, 000
From part (a), we know that y2 (y1 ) = 250, 000 − 12 y1 .
Solving the reaction functions simultaneously, we find that y1C ≈ 3.75 and y2C ≈ 249, 998.12.
Thus price and profits are equivalent to part (a). This problem shows that sometimes the
difference in costs plays a very important role in determining output and profits regardless
of the timing of entry into the market. MBI suffers from such a large cost disadvantage
compared to Pear that MBI benefits very little from its first-mover advantage.
4.(a) Their profit maximization problems are:
max π1 = p1 y1 (p1 , p2 ) − C1 (y1 (p1 , p2 ))

p1

1 1
= p1 80 − p1 + p2 − 80 80 − p1 + p2
2 2
max π2 = p2 y2 (p1 , p2 ) − C2 (y2 (p1 , p2 ))

p2

1 1
= p2 160 − p2 + p1 − 160 160 − p2 + p1
2 2
To derive their reaction functions, p1 (p2 ) and p2 (p1 ), we solve the maximization problems.
∂π1 1
= 80 − 2p1 + p2 + 80 = 0
∂p1 2
1
p1 = 80 + p2
4
∂π2 1
= 160 − 2p2 + p1 + 160 = 0
∂p2 2
1
p2 = 160 + p1
4
The Bertrand equilibrium is the intersection of the reaction functions. Solving the reaction
functions simultaneously, we find that p∗1 = 128 and p∗2 = 192. Output levels are y1∗ = 80 −
128+ 12 ·192 = 48 and y2∗ = 160−192+ 12 ·128 = 32. Profits are π1∗ = 128·48−80·48 = 2, 304
and π2∗ = 192 · 32 − 160 · 32 = 1, 024.
4.(b) Reuben and Simeon solve the following joint maximization problem.
max π = π1 + π2
p1 ,p2

1 1 1 1
= p1 80 − p1 + p2 −80 80 − p1 + p2 +p2 160 − p2 + p1 −160 160 − p2 + p1
2 2 2 2
∂π 1 1
= 80 − 2p1 + p2 + 80 + p2 − 80 = 0
∂p1 2 2
1
p1 = 40 + p2
2
∂π 1 1
= 160 − 2p2 + p1 + 160 + p1 − 40 = 0
∂p2 2 2
1
p2 = 140 + p1
2
440
Solving the reaction functions simultaneously, we find that p∗1 = 3 ≈ 146.67 and p∗2 =
640
3 ≈ 213.33. Output levels are y1∗ = 80−146.67+ 12 ·213.33 = 40 and y2∗ = 160−213.33+ 12 ·
146.67 = 20. Profits are π1∗ = 146.67·40−80·40 ≈ 2, 666.67 and π2∗ = 213.33·20−160·20 ≈
1, 066.67. Thus joint profits are π ∗ = 2, 666.67 + 1, 066.67 ≈ 3, 733.33.
5.(a) Their profit maximization problems are:
max π1 = p1 y1 (p1 , p2 ) − C1 (y1 (p1 , p2 ))

p1

1 1
= p1 34 − p1 + p2 − 24 34 − p1 + p2
3 3
max π2 = p2 y2 (p1 , p2 ) − C2 (y2 (p1 , p2 ))

p2

1 1
= p2 40 − p2 + p1 − 20 40 − p2 + p1
2 2
Jacob takes p1 as given and fixed, and chooses p2 to maximize profits.
∂π2 1
= 40 − 2p2 + p1 + 20 = 0
∂p2 2
1
p2 = 30 + p1
4
Laban substitutes p2 = 30 + 14 p1 into his profit function, and chooses p1 accordingly.

1 1 1 1
max π1 = p1 34 − p1 + 30 + p1 − 24 34 − p1 + 30 + p1
p1 3 4 3 4

11 11
= p1 44 − p1 − 24 44 + p1
12 12
∂π1 11
= 44 − p1 + 22 = 0
∂p1 6
p∗1 = 36
1
Plug p∗1 = 36 back into p2 (p1 ) to obtain p∗2 ; p∗2 = 30 + 4 · 36 = 39. Output levels are
y1∗ = 34−36+ 13 ·39 = 11 and y2∗ = 40−39+ 12 ·36 = 19. Profits are π1∗ = 36·11−24·11 = 132
and π2∗ = 39 · 19 − 20 · 20 = 361.
5.(b) Laban takes p2 as given and fixed, and chooses p1 to maximize profits.
∂π1 1
= 34 − 2p1 + p2 + 24 = 0
∂p1 3
1
p1 = 29 + p2
6
Jacob substitutes p1 = 29 + 16 p2 into his profit function, and chooses p2 accordingly.

1 1 1 1
max π2 = p2 40 − p2 + 29 + p2 − 20 40 − p2 + 29 + p2
p2 2 6 2 6

109 11 109 11
= p2 − p2 − 20 − p2
2 12 2 12
∂π2 109 11 55
= − p2 + =0
∂p2 2 6 3
437
p∗2 = ≈ 39.73
11
Plug p∗2 = 39.73 back into p1 (p2 ) to obtain p∗1 ; p∗1 = 29 + 16 ( 437
11 ) ≈ 35.62. Output levels are
1 1
y1∗ = 34 − 35.62 + 3 · 39.73 ≈ 11.62 and y2∗ = 40 − 39.73 + 2 · 35.62 ≈ 18.08. Profits are
π1∗ ≈ 135.02 and π2∗ ≈ 356.72.
6. For homogeneous goods markets, we rank the models in order of increasing output and
decreasing price: collusion (if successful), the Cournot and Stackelberg models, and the
Bertrand model. For differentiated goods, collusion, price leadership, and the Bertrand
model.
1.(a)
Player 2
Macho Chicken
Macho 0, 0 7, 2
Player 1
Chicken 2, 7 6, 6
1.(b) Neither player has a dominant strategy.
1.(c) The Nash equilibria are (Macho, Chicken) and (Chicken, Macho).
2.(a)
Jill
Build Don’t Build
Build 1, 1 -1, 2
Jack
Don’t Build 2, -1 0, 0
2.(b) Both of them have a dominant strategy, which is “Not Build.” The Nash equilibrium is
(Not Build, Not Build).
2.(c) This game resembles the Prisoner’s Dilemma. The Nash equilibrium (Not Build, Not
Build) is not socially optimal. Both of them would be better off at (Build, Build).
3.(a) This is a sequential game where Sam is the first mover.
3.(b) Sam will take Dan’s blanket if Dan doesn’t retaliate. Dan will not retaliate if his payoff
from not retaliating exceeds his payoff from retaliating, i.e., −10 > −10 + X ⇔ X < 0.
4.(a) This is a sequential game with payoffs occurring only when the game is terminated at
t = 1, ..., 99, and t = 100.
4.(b) At t = 100, player 2 will choose action B over action A. Anticipating this, at t = 99, player
1 will choose “Terminate” to guarantee himself a payoff of 99. Consequently, at t = 98,
player 2 will choose “Terminate” to guarantee himself a payoff of 98. Continuing with the
same logic, the backward induction solution is player 1 choosing “Terminate” at t = 1.
5.(a) By backward induction, at t = n, player X wins by taking the total to 100. At t = n − 1,

player Y must have taken the total to a range between 90 and 99. At t = n − 2, player
X should take the total to 89. Therefore, the winning strategy for player X is to take the
total to 100 − 11a at t = n − 2a.
5.(b) The first target total is 100 − 11 · 9 = 1 at t = n − 2 · 9 = n − 18, indicating that Player 1
chooses 1 in the first round. Clearly, there is a first-mover advantage in this game.
6. Firms will produce as long as they earn non-zero profits, i.e., πi = p · yi − 12 yi ≥ 0. Therefore,
p ≥ 12 . Suppose firm 1 sets p1 = x > 12 . Then firm 2 could capture the entire market by
setting a price p2 = x − > 12 , where is an arbitrarily small positive number. The firms
continue undercutting each other until p = 12 , where they split the market and earn zero

profits. The unique Nash equilibrium is p1 = 12 , p2 = 12 and y1 = y2 = 12 y.
1.(a) The Edgeworth box is a square, and each side is 6 units long, with Michael’s origin on the
lower left hand corner. The endowment point would be (xM , yM ) = (5, 1); (xA , yA ) = (1, 5)
1.(b) Their indifference curves are L-shaped, with kinks where xi = yi .
1.(c) Any allocation in the area bounded by the indifference curves through the initial endowment
is a Pareto improvement. For example, at W , each of them will consume three slices of
tiramisu and three cups of espresso at the new allocation.
2.(a) To find the contract curve, set M RS g = M RS f . Each M RS i = M Uxi /M Uyi . Setting the
M RS s equal gives:
αyg αyf
=
(1 − α)xg (1 − α)xf
yg yf
= (3)
xg xf
This is one equation with four unknowns. To get two more equations, write down the
market-clearing conditions:
xg + xf = 1
xf = 1 − xg (4)
yg + yf = 1
yf = 1 − yg (5)
Plugging (4) and (5) into (3), we get yg = xg . Therefore, the contract curve is the diagonal
of the Edgeworth box.
2.(b) The competitive equilibrium is on the contract curve. By part (a), yg = xg on the contract
curve. Therefore at the competitive equilibrium,
px αyg α
= M RS g = M RS f = = .
py (1 − α)xg (1 − α)
3.(a) Do the totals add up in Duncan’s suggested equilibrium?
xr + xt = x0r + x0t
4+1 = 2+3 = 5
yr + yt = yr0 + yt0
1+4 = 2+3 = 5
Duncan’s suggested allocation have the right totals.
3.(b) Rin’s original utility is u0r = 2 · 2 = 4, and his new utility is ur = 4 · 1 = 4. Tin’s original
utility is u0t = 3 · 32 = 27, and his new utility is ut = 1 · 42 = 16. Rin’s utility is unchanged,
and Tin’s utility falls. Therefore, Duncan’s suggested equilibrium allocation is not a Pareto
improvement over the endowment.
3.(c) With prices px = py = 1, Rin’s budget constraint is xr + yr = 4. With this budget, his
optimal consumption bundle is (xr , yr) = (2, 2).
3.(d) With prices px = py = 1, Tin’s budget constraint is xt + yt = 6. With this budget

constraint, his optimal consumption bundle is (xt , yt) = (2, 4).
3.(e) Duncan’s suggested equilibrium allocation and price vector is not a competitive equilibrium.
The totals add up, but consumers are not maximizing their utilities at this allocation with
these prices. When px = py = 1, there is excess supply of x and excess demand for y. This
suggests that in equilibrium, either px should drop below 1 or py should rise above 1.
4.(a) Rin’s budget constraint is xr + py yr = 2 + 2py . To find his desired consumption bundle,
we set M RS r = yr /xr = 1/py . This gives xr = py yr . Combining this with his budget
constraint leads to x∗r = 1 + py . It follows that yr∗ = (1 + py )/py .
4.(b) Tin’s budget constraint is xt + py yt = 3 + 3py . To find his desired consumption bundle,
we set M RS t = yt /2xt = 1/py . This gives 2xt = py yt . Combining this with his budget
constraint leads to x∗t = 1 + py . It follows that yt∗ = 2(1 + py )/py .
4.(c) In the market for x, total demand = total supply gives:
x∗r + x∗t = x0r + x0t ;
(1 + py ) + (1 + py ) = 2 + 3.
3
This gives py = .
2
4.(d) Competitive equilibrium:

5 5
(x∗r , yr∗ ) = ,
2 3

5 10
(x∗t , yt∗) = ,
2 3
3
py = .
2
5.(a) The original endowment is Pareto optimal. Shepard cannot be made better off without
making Milne worse off, i.e., there is no Pareto move from the original endowment.
5.(b) Milne’s new budget constraint is xm + py ym = 4 + 4py − 4 = 4py . Setting his marginal
rate of substitution equal to the price ratio gives M RS m = ym /3xm = 1/py . This gives
py ym = 3xm . It follows that his optimal consumption bundle is (x∗m , ym
∗ ) = (p , 3).
y
5.(c) Shepard’s new budget constraint is xs + py ys = 0 + 0py + 4 = 4. Setting his marginal rate
of substitution equal to the price ratio gives M RS s = ys /xs = 1/py . This gives py ys = xs .

It follows that his optimal consumption bundle is (x∗s , ys∗ ) = 2, p2y .
5.(d) We first use the market-clearing condition to solve for the equilibrium price. We want
total demand = total supply in the market for x. This gives:
x∗m + x∗s = x0m + x0s ;

py + 2 = 4 + 0.
This gives py = 2
Competitive equilibrium:
(x∗m , ym
∗
) = (2, 3)
(x∗s , ys∗ ) = (2, 1)
py = 2
5.(e) At the equilibrium allocation,
∗
M RS m = ym /3x∗m = 3/(3 · 2) = 1/2.
Similarly,
M RS s = ys∗ /x∗s = 1/2.
Since M RS m = M RS s, the new equilibrium allocation is Pareto optimal.
6. The first fundamental theorem says any competitive equilibrium allocation is Pareto optimal.
The second fundamental theorem says that lump-sum taxes and transfers can be used to
get an economy to any target Pareto optimal allocation. Per unit taxes and subsidies may
not accomplish the same thing. Consider Milne and Shepard in Question 5 above. Shepard
starts out with ωs = (0, 0). To induce him to go to (x∗s , ys∗ ) = (2, 1) with straightforward
per unit subsidies, you would have to sell him one or both goods at negative net prices.
Given his utility function, he would then want to consume infinite amounts of both goods.
1.(a) The Pareto efficient allocation is the tangency of the indifference curve and the production
function.
−M RSl,x = M Pl

1 1
− − = √
2 2 l
l=1
√
Therefore, x = 1 = 1.
1.(b) A utility-maximizing consumer’s tangency condition is −M RSl,x = w

1 ⇔ w = 12 .
A profit-maximizing firm solves the following problem:
√ l
max π = 1 · x − w · l = l−
l 2
Setting the derivative of π with respect to l equal to zero yields l = 1.

Therefore, x = 1, l = 1, w = 12 , and π = 12 .
function.
−M RSl,x = M Pl

1 2
− − = √
2 33l
64
l=
27
64 2/3 16
Therefore, x = 27 = 9 .
2.(b) As in Q1(b), w = 12 .
max π = 1 · x − w · l = l 2/3 − l/2

l
Setting the derivative of π with respect to l equal to zero yields l = 64/27.

16 64
Therefore, x = 9 , l= 27 , w = 12 , and π = 16
27 .
function.
−M RSl,x = M Pl
1
−(−4l) = √
2 l
1
l∗ =
4

1
Therefore, x = 4 + 1 = 32 .
3.(b) First, use the tangency condition to find the market wage rate.
w
−M RSl,x =
1
4l ∗ = w

1
w=4 =1
4
√
max π = 1 · x − w · l = l+1 −l
l
Setting the derivative of π with respect to l equal to zero yields l = 14 .

Therefore, x = 32 , l = 14 , w = 1, and π = 54 .
4.(a) By symmetry of her utility function, and since the production functions are identical,
Wendy should study an equal number of chapters of economics and mathematics. She
should spend two hours on each subject.
√ √
4.(b) Given lx = 2 and ly = 2, she studies 2 chapters of economics and 2 chapters of
mathematics.
√ √ √
4.(c) Her utility is u = 2 2 − 4 = 0.
4.(d) Wendy now studies eight hours a day, and spends four hours on each subject. Therefore,
√ √ √
x = 4 = 2 and y = 4 = 2. Her utility is now u = 2 · 2 − 8 ≈ 1.17.
5.(a) Since the wage is normalized to 1, Robinson’s firm’s profit is:
π = px x + py y − l
Substituting for l from the inverse production function,
π = px x + py y − (x2 + y 2 + 3xy)
The first order condition for x is

∂π
= px − 2x − 3y = 0
∂x
The first order condition for y is
∂π
= py − 2y − 3x = 0
∂y
These two equations together should yield the supply functions for x and y in terms of px
px −3y
and py . From the first equation, we get x = 2 . Substituting this into the second one,
we have
px − 3y
py − 2y − 3 =0
2
or,
2py − 4y − 3px + 9y = 0
which yields
1
y= (3px − 2py ) (6)
5
px −3y
as the supply function for y. Substituting this back into x = 2 , gives us the supply
function for x:
1
x= (3py − 2px ). (7)
5
5.(b) Robinson the price-taking consumer chooses x, y, l to maximize u(x, y, l), subject to his
budget constraint
px x + py y = l + π.
Robinson takes px , py and π as given. To solve this utility maximization problem, we use
the budget constraint to solve for l and then substitute back into the utility function. We
then maximize
3 1 3 1
u= xy + x + y − l = xy + x + y − (pxx + py y − π).
2 2 2 2
This results in the following first order conditions:
∂u 3 1
= y + 1 − px = 0
∂x 2 2
∂u 3 1
= x + 1 − py = 0.
∂y 2 2
From these we get:

px − 2
y= (8)
3
py − 2
x= (9)
3
as the demand functions for x and y. (The demands for x and y in this exercise are
independent of income because of quasi-linearity in l. Moreover, we have an interior solution
because the supply of labor is not assumed to have any bounds. In general, demand
functions will be more complicated functions of prices and profit than in this exercise.]
An alternative way to solve the consumer’s problem is to use a Lagrange function approach;
see the Appendix to Chapter 3.
5.(c) To find an equilibrium, we solve for px and py from (6), (7), (8), and (9). The solutions
are px = py = 5; this gives x = 1, y = 1 and, from the inverse production function, the
demand for labor input is l = 5. The profit for the firm is 5, and, for the consumer, the
right hand-side of the budget equation is 10. The supply of labor is found by using the
budget equation, which yields supply equal to 5 (also equal to the firm’s demand).
The competitive equilibrium in this one consumer economy can also be computed by first
finding the Pareto optimal allocation and then using the first welfare theorem. (This ap-
proach can provide a simpler way of computing the equilibrium but it generally works only
in a single consumer economy. Otherwise, there will be many Pareto optimal allocations).
Pareto optimality in this single consumer economy implies the maximization of u(x, y, l)
subject to the inverse production function. Substituting the latter into the utility function
results in:
3 1 1 1
xy + x + y − (x2 + y 2 + 3xy) = x + y − x2 − y 2 ,
2 2 2 2
and the first order conditions yield x = y = 1. This is the unique Pareto optimal allocation
of consumption goods in this economy. From the inverse production function l = 5. This
is the unique Pareto optimal allocation. By the first welfare theorem, a competitive equi-
librium must result in this allocation. From (8) and (9) we get px = py = 5. Check that
the profit and budget numbers are as before.
6. Robinson solves the following profit maximization problem:
max π = px x + py y + pz z − wl subject to l(x, y, z).

x,y,z
He solves the following utility maximization problem:
max u = u(x, y, z) subject to px x + py y + pz z ≤ wl + π.

x,y,z
1.(a) um (2) = 22 − 2 · 2 + 2 = 2
ul (2) = 22 = 4
uc (2) = −22 − 1 = −5
1.(b) um (3) = 32 − 2 · 3 + 2 = 5
ul (3) = 32 = 9
uc (3) = −32 − 1 = −10
1.(c) We want to maximize
u = um + ul + uc = x2 − 2x + 2 + x2 + (−x2 − 1) = x2 − 2x + 1
The first order condition for a maximum is
∂u
= 2x − 2 = 0,
∂x
but the second order condition for a maximum is not satisfied. In fact x∗ = 1 is a minimum;
the function x2 − 2x + 1 has no maximum; they should fill their house with puppies.
2.(a)
max us = 50p − p2 − 28h
p

1
= 50p − p2 − 28 p
2
= 36p − p2
∂us
= 36 − 2p = 0
∂p
pM = 18
1
Therefore, h = 2 · 18 = 9.
2.(b) uS = 36 · 18 − 182 = 324

1
uG = 4 · 182 + 3 · 18 = 135
2.(c)
max u = us + ug
p

2
1
= 36p − p + p2 + 3p
4
3
= 39p − p2
4
∂u 3
= 39 − p = 0
∂p 2
p∗ = 26
3.(a)
3
max ui = 8m − 2m2 − x
m 10
∂ui
= 8 − 4m = 0
∂m
mM = 2
Therefore, music is blasting 2 · 11 = 22 hours per day.
3
3.(b) ui = 8 · 2 − 2 · 22 − 10 (2 · 10) = 2
3.(c)
3
max u = 8m − 2m2 − (10m)
m 10
= 5m − 2m2
∂u
= 5 − 4m = 0
∂m
5
m∗ =
4
4.(a)

1 2
max πf = 50f − 5 f − b
f 3

∂πf 1
= 50 − 10 f − b = 0
∂f 3
1
f = b+5 (10)
3

1 2
max πb = 100b − 10 b − f
b 2

∂πb 1
= 100 − 20 b − f = 0
∂b 2
1
b= f +5 (11)
2
Solving equations (8) and (9) simultaneously, we find that f M = 8 and bM = 9.

2
πfM = 50 · 8 − 5 8 − 13 · 9 = 275
2
πbM = 100 · 9 − 10 9 − 12 · 8 = 650
4.(b)
max π = πf + πb
f,b

1 2 1 2
= 50f − 5 f − b + 100b − 10 b − f
3 2

∂π 1 1
= 50 − 10 f − b + 10 b − f = 0
∂f 3 2
10 8
f= + b (12)
3 9

∂π 10 1 1
= f − b + 100 − 20 b − f = 0
∂b 3 3 2
12 90
b= f+ (13)
19 19
Solving equations (10) and (11) simultaneously, we find that f ∗ = 17.2 and b∗ = 15.6.
2
πf∗ = 50 · 17.2 − 5 17.2 − 13 · 15.6 = 140
2
πb∗ = 100 · 15.6 − 10 15.6 − 12 · 17.2 = 1, 070
4.(c) Beatrice transfers between $135 and $420 to Flo.
5.(a)
pc = M Cc
700 = 10c + 100
cM = 60
pb = M Cb
10 = b − 140 + c
bM = 90
5.(b)
max π = πc + πb
c,b

2
1 2
= 700c − 5c + 100c + 10b − b − 140b + bc
2
∂π
= 700 − 10c − 100 − b = 0
∂c
b = 600 − 10c (14)
∂π
= 10 − b + 140 − c = 0
∂b
b = 150 − c (15)
Solving equations (12) and (13) simultaneously, we find that c∗ = 50 and b∗ = 100.
5.(c) Competitive market outcome: (cM , bM ) = (60, 90)
π M = πc + πb

1
= 700 · 60 − 5 · 602 + 100 · 60 + 10 · 90 − · 902 − 140 · 90 + 90 · 60
2
= 18, 000 + 4, 050
= 22, 050
Joint profit maximization outcome: (c∗ , b∗) = (50, 100)
π ∗ = πc + πb

2
1 2
= 700 · 50 − 5 · 50 + 100 · 50 + 10 · 100 − · 100 − 140 · 100 + 100 · 50
2
= 17, 500 + 5, 000
= 22, 500
Total profits from joint profit maximization, π ∗ , are greater than total profits from individ-
ual profit maximization, π M . If Bonnie transfers a minimum of $500 and a maximum of
$950 to Clyde, then πc∗ ≥ πcM and πb∗ ≥ πbM . Thus (c∗ , b∗) = (50, 100) is Pareto optimal.
5.(d) Since this is a negative externality, the creator of the externality, Clyde, pays the tax. The
negative externality imposed on Bonnie by Clyde is now internalized by Clyde.
5.(e) If Clyde and Bonnie are able to negotiate a mutually beneficial contract where Bonnie
pays Clyde to reduce his output from cM to c∗ , then they will end up at the Pareto optimal
outcome, (c∗ , b∗ ).
6. Please note two corrections of the problem in the text:

(1) After the second sentence, insert the following sentence: “The total pollution level had
been at 60.”
(2) In the next to last sentence, change “pollution produced” to “pollution abated.”
Because the government is issuing a total of 30 pollution permits, and because the total
pollution level had been 60, there must be 60 − 30 = 30 units of abatement. Therefore
x1 + x2 = 30.
Factory 1’s marginal cost of pollution abatement is M C1 = 120x1 . It could get rid of a
marginal unit of pollution by spending M C1 , or, alternatively, it could buy an additional
pollution permit, which would allow it to produce that marginal unit of pollution. Let p be
the market price of a pollution permit. In equilibrium we should have M C1 = p. Similarly,
in equilibrium we should have M C2 = p. It follows that M C1 = M C2 , or
120x1 = 3x22 .
Solving the two equations for x1 and x2 simultaneously, we find x1 = 10 and x2 = 20.
1.(a) Correction. The textbook should read: “What condition or conditions must hold for the
TV to be considered a public good?” The answer is: Nonexclusivity in use. Once the
television is bought, neither Fabio nor Paolo can be prevented from watching it.
1.(b) Each of them have a dominant strategy of not paying. The Nash equilibrium is (Don’t
Pay, Don’t Pay) with payoffs of (0, 0). Note that they would both have been better off
with (Pay, Pay) and payoffs of (50, 50). This game resembles the Prisoner’s Dilemma.
Paolo
Pay Don’t Pay
Pay 50, 50 -100, 200
Fabio
Don’t Pay 200, -100 0, 0
1.(c) The Nash equilibria are (Pay, Don’t Pay) with payoffs of (100, 400) and (Don’t Pay, Pay)
with payoffs of (400, 100). This is a game of Chicken.
Paolo
Pay Don’t Pay
Pay 250, 250 100, 400
Fabio
Don’t Pay 400, 100 0, 0
2. Correction There are two errors in the textbook. The original utility function is shown as
√ √
ui = xi yi . The correct utility function is ui = xi + yi . The new utility function where
√
movie streaming is a public good is shown as ui = xyi . The correct utility function is
√
ui = x + yi . Delete part (d). Here is the solution for the corrected problem:
1
√
2.(a) Since M RSx,y = 2 x
= 1 for both Fabio and Paolo, their optimal allocation are (xf , yf ) =
√
(0.25, 9.75) and (xp, yp) = (0.25, 19.75). Their utility levels are uf = 0.25 + 9.75 = 10.25
√
and up = 0.25 + 19.75 = 20.25.
√ √
2.(b) uf = 0.5 + 9.75 ≈ 10.46 > 10.25 and up = 0.5 + 19.75 ≈ 20.46 > 20.25.
2.(c) According to the Samuelson optimality condition, the sum of the marginal benefits from
the public good must equal the marginal cost of the public good:
1 1 1
M Bf (x) + M Bp (x) = √ + √ = √ = 1
2 x 2 x x
Therefore the Pareto optimal quantity of the public good is x = 1 > 12 . The allocation from
part (a) is not Pareto optimal.
3.(a) Each pig would be willing to contribute a maximum of hi towards buying a stone house
as long as the utility with a house is at least as great as the utility without a house. Each
pig faces a budget constraint of yi + hi = Mi . With a house, yi = Mi − hi , and without a
house, yi = Mi .
1
Pig 1: (3 + 1)y1 ≥ (3 + 0)y1 ⇔ 4(M1 − h1 ) ≥ 3M1 ⇔ h1 ≤ 4 M1
1
Pig 2: (2 + 1)y2 ≥ (2 + 0)y2 ⇔ 3(M2 − h2 ) ≥ 2M2 ⇔ h2 ≤ 3 M2
1
Pig 3: (1 + 1)y3 ≥ (1 + 0)y3 ⇔ 2(M3 − h3 ) ≥ 1M3 ⇔ h3 ≤ 2 M3
1
3.(b) The maximum amount each pig is willing to contribute is as follows: h1 = 4 · 2, 800 = 700,
1 1
h2 = 3 · 1, 800 = 600, and h3 = 2 · 1, 000 = 500. Since 700 + 600 + 500 = 1, 800, the pigs
buy the house.
1√
4.(a) M RSx,yi = 10 x
4.(b)

M Bi (x) = 1
i

1
1, 000 √ =1
10 x
x∗ = 10, 000
5. If agent 1 has to pay the full cost of all units of the public good, he maximizes u1 (x, y1) =
√
x + y1 subject to x + y1 = M1 . Equating marginal benefit with marginal cost yields
x = 1/4. Note that agent 1’s marginal benefit from another unit of the public good, net of
its full cost, is positive if x < 1/4, and negative if x > 1/4.
Similarly, if agent 2 has to pay the full cost of all units of the public good, he maximizes
√
u2 (x, y2 ) = 2 x + y2 subject to x + y2 = M2 , which leads to x = 1. Agent 2’s marginal
benefit from another unit of the public good, net of its full cost, is positive if x < 1, and
negative if x > 1.
Now suppose agent 2 were to contribute 0. Then, agent 1 would contribute 1/4, but then
agent 2 would not like to contribute 0. Therefore, agent 2 contributing 0 will never happen
in equilibrium. That is, if 1 chooses x = 1/4, there is 1/4 unit of the public good which
√
is available for agent 2’s consumption. Agent 2 wants to maximize u2 (x, y2 ) = 2 x + y2 ,
but the first 1/4 unit of the public good is already there at no cost to him. His constrained
utility maximum is still at x = 1, and so he buys 3/4 additional unit of the public good.
Therefore agent 2 does not free ride on agent 1’s prior purchase of the public good.

6.(a) Ti = C(x∗ ) − vj (x∗ )
j=i
T1 = 1, 000 − (200 + 300 + 400) = 100
T2 = 1, 000 − (100 + 300 + 400) = 200
T3 = 1, 000 − (100 + 200 + 400) = 300
T4 = 1, 000 − (100 + 200 + 300) = 400

6.(b) M Bi (1) = 100 + 200 + 300 + 500 = 1, 100 > 1, 000 = M C(1)
i
Since marginal benefit exceeds marginal cost, the park gets built. Family 4 pays a tax of
T4 = 1, 000 − (100 + 200 + 300) = 400. Since T4 is unchanged, family 4’s net benefit is also
unchanged.

6.(c) M Bi (1) = 100 + 200 + 300 + 300 = 900 < 1, 000 = M C(1)
i
Since marginal cost exceeds marginal benefit, the park does not get built. Family 4 does
not pay any taxes; T4 = 0. Family 4’s net benefit is zero, just as in part (a).
6.(d)
M B1 (1) + M B2 (1) + M B3 (1) + M B4 (1) = M C(1)
100 + 200 + 300 + 400 = 1, 000

1. Currently, the risk averse consumer i’s and the risk neutral consumer k’s utilities are as
follows:
√ √
ui (L) = 12 (10 50) + 12 (10 25) ≈ 60.36
uk (P ) = 0
If consumer i pays consumer k $13 to bear the risk, both of them would be better off. Their
utilities are now as follows:
√
ui (P ) = 10 37 ≈ 60.83
uk (L) = 13 + 12 (0) + 12 (−25) = 0.50
2.(a) E(L) = 13 (5) + 13 (50) + 13 (500) = 185

1
2.(b) ug (L) = 13 ug (5) + 13 ug (50) + 13 ug (500) = 1
3 2 · 52 + 1
2 · 502 + 1
2 · 5002 = 42, 087.5
2.(c) His certainty equivalent of the lottery is the dollar amount P such that he is indifferent
between accepting the certain payment P and playing the lottery L.
ug (P ) = ug (L)
1 2
P = 42, 087.5
2
P ≈ 290.13
2.(d) George is risk loving; his certainty equivalent of the lottery is greater than the expected
value of the lottery.
3.(a) E(L) = 14 (6) + 14 (2) + 14 (2) + 14 (0) = 2.5

3.(b) ua (L) = 14 ua (6) + 14 ua (2) + 14 ua (2) + 14 ua (0) = 1
4 62 + 22 + 22 + 02 = 11
ui (L) = 14 ui (6) + 14 ui (2) + 14 ui (2) + 14 ui (0) = 1
4 (2(6) + 2(2) + 2(2) + 2(0)) = 5
3.(c) An individual with a certainty equivalent less than 3 prefers to draw water at the foot of
the hill, while an individual with a certainty equivalent greater than 3 prefers to hike up
the hill.
Jack’s and Jill’s certainty equivalent are derived as follows:
ua(P ) = ua (L) ⇔ P 2 = 11 ⇔ Pa = 3.3
ui (P ) = ui (L) ⇔ 2P = 5 ⇔ Pi = 2.5
Therefore, Jack prefers to hike up the hill, and Jill prefers to draw water at the foot of the
hill.
3.(d) Jack is risk loving; Pa > E(L). Jill is risk neutral; Pi = E(L).
1 1
4.(a) E(L) = 2 ·8+ 2 ·0=4
√ √
4.(b) ua (L) = 12 ua (8) + 12 ua (0) = 1
2
3
8+ 3
0 =1
um (L) = 12 um (8) + 12 um (0) = 1
2 (8 + 0) = 4

us (L) = 12 us (8) + 12 us (0) = 1
2 83 + 03 = 256
4.(c) Compare their utility with protection to their utility without protection.

3 24 − 6
ua (P ) = ≈ 1.82 > 1 = ua (L)
3
24 − 6
um (P ) = = 6 > 4 = um (L)
3

24 − 6 3
us (P ) = = 216 < 256 = us (L)
3
Adam and Michael will buy protection. Stella will not buy protection.
4.(d) The neighborhood thug would have to set a price low enough such that Stella will buy
3
protection: us (P ) ≥ us (L) ⇔ 24−P
3 ≥ 256 ⇔ P ≤ 4.95
5. uk (L) = 16 uk (10) + 26 uk (−5) + 36 uk (−1) = 16 (10) + 26 (−5) + 36 (−1) = − 12

Since Ko’s utility from the lottery is negative, he does not accept it.
30 40 50
6. E(L) = 13 E(L1) + 13 E(L2 ) + 13 E(L3) = 1
3 100 · 20 + 13 100 · 15 + 1
3 100 · 10 = 17
3
Since Will paid $6 for the lottery ticket, the net expected value of his lottery ticket is − 13 .
1.(a) E(L) = 13 (3, 000) + 13 (2, 000) + 13 (1, 000) = 2, 000

Harry is willing to pay $2,000, and he ends up buying type B and type C cars.
1.(b) E(L) = 12 (2, 000) + 12 (1, 000) = 1, 500

Now Harry is willing to pay $1,500. However this results in his getting type C cars only.
(Eventually Harry fails as a businessman.)
2.(a) The market price for used cars would be $1,500.
2.(b) The market price for uninspected used cars would be $X/2.
2.(c) X − 300 = X
2 ⇔ X = 600
2.(d) Any car worth less than $600 will not get inspected, and there are 600/3 = 200 such cars.
Each uninspected car will be sold for 600/2 = $300.
3.(a) Ep (Loss) = 0.6(1, 000, 000) = 600, 000

Ej (Loss) = 0.2(1, 000, 000) = 200, 000
El (Loss) = 0.1(1, 000, 000) = 100, 000
3.(b) Placido is risk loving since W T Pp = 500, 000 < 600, 000 = Ep(Loss).
Jose is risk loving since W T Pj = 175, 000 < 200, 000 = Ej (Loss).
Luciano is risk averse since W T Pl = 125, 000 > 100, 000 = El (Loss).
1 6 1
2 1
1
3.(c) E(P ayout) = 3 10 + 3 10 + 3 10 1, 000, 000 = 300, 000
3.(d) If the price of insurance equals the expected payout, only Placido will buy insurance since
W T Pp = 500, 000 < 300, 000 = Price. The insurance company will make a loss, because
6
if Placido is the only buyer, E(P ayout) = 10 1, 000, 000 = 600, 000 > 300, 000 = Price.
4.(a) If Kevin does not buy insurance, his expected utility from locking the door 100 percent of
the time is H − 250, and his expected utility from locking the door 80 percent of the time
is H − 750 + 100 = H − 650. Therefore Kevin will lock his door 100 percent of the time.
4.(b) An insurance policy costs 0.02 · $5, 000 = $100.
4.(c) An insurance policy costs 0.06 · $5, 000 = $300.
4.(d) Insurance premiums range between $100 and $300. First, suppose an insurance policy
costs $100. Kevin’s net benefit from locking the door 100 percent of the time is H − 100.
His net benefit from locking the door 80 percent of the time is H −100+100 = H. Therefore
Kevin will lock his door 80 percent of the time. Clearly, if homeowners lock their doors 80
percent of the time when the premium is $100, insurance companies will eventually revise
premiums upward to $300. Kevin’s net benefit from locking the door 100 percent of the
time is now H − 300, while his net benefit from locking the door 80 percent of the time is
now H − 300 + 100 = H − 200. Therefore Kevin will still lock his door 80 percent of the
time.
In equilibrium, insurance policies cost $300. Kevin locks his door 80 percent of the time,
and his net benefit is H − 200.
4.(e) If homeowners lock their doors 100 percent of the time, policies cost $100, and each
homeowner’s net benefit is H − 100 > H − 200.
5.(a)
E(u, e = 1) = E(u, e = 0)
√ √
0.1 10c + 0.9 5c − 1 = 0
c ≈ 0.1844
E(π, e = 1) = 0.1(10 − 10c) + 0.9(5 − 5c) ≈ 4.49
5.(b)
E(u, e = 2) = E(u, e = 0)
√ √
0.9 10c + 0.1 5c − 2 = 0
c ≈ 0.4245
E(π, e = 1) = 0.9(10 − 10c) + 0.1(5 − 5c) ≈ 5.47
5.(c)
E(u, e = 2) > E(u, e = 1)
√ √ √ √
0.9 10c + 0.1 5c − 2 > 0.1 10c + 0.9 5c − 1
c > 1.82
The agent would have to be paid greater than 182 percent of the output in order to guarantee
that he works at high effort. Clearly, this is not a sustainable mechanism.
6.(a) Wage = 23 (900) + 13 (3, 000) = 1, 600.
6.(b) X < 600 and Y < 600.
6.(c) X > 400 and Y < 400.

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Solutions to Exercises 1

A Short Course in Intermediate Microeconomics with Calculus

This ﬁle is intended to be used by instructors only.

1.(b) Vote 1: x versus y.

Now if x y and y z, then by transitivity we should have x z. But in Vote 3 we see

∂u(x1 ,x2 ) ∂(3x21x42 )

∂u(x1 ,x2 ) ∂(3x21x42 )

5.(f) Last week, u(x1 , x2 ) = 3x21 x42 = 3 · 22 · 44 = 3 · 22 · 28 = 3 · 210 .

1.(a) Let p1 = 2p1 and p2 = 12 p2 .

1.(b) Let p1 = 2p1 and M = 3M .

Solving the two equations simultaneously yields pb = 1 and M = 60.

bundle, (c∗1 , c∗2 ) = (127.27, 66.67). Therefore, Sylvester is a borrower.

1.(a) Budget constraint: p1 x1 + p2 x2 = M

2.(a) First, ﬁnd the original consumption bundle.

Hence the total eﬀect on the demanded amount of good 1 is 2 − 5 = −3 units.

4.(a) His budget constraint is 0.20x + 0.05y = 2.

4.(b) His budget constraint is now 0.25x + 0.08x = 0.33x = 2.

5.(a) Sammy’s budget constraint is x + y = 2.

5.(b) Sammy’s budget constraint is now 2x + y = 2.

1. Budget constraint: pC + wL = 24w

optimal bundle is T, M p . See Solutions-Graphs ﬁle.

1+i 2c2 1.05

is an increasing function of i; s = 33.33 for i = 0 and s = 50 for i = 1. Mr. A is always a

is an increasing function of i; s = −33.33 for i = 0 and s = 0 for i = 1. For the most

bundle, (c∗1 , c∗2 ) = (127.27, 66.67).

than before. Lenders beneﬁt from a rise in i, while borrowers suﬀer.

6. The saver’s budget constraint is c1 + 1+π 1

6. Pre-policy, the consumer in Group i solves the following problem:

max u(xi , yi ) subject to px xi + py yi = Mi

Group A solves: max u(xA , yA ) subject to 10xA + 10yA = 500

Post-policy, the consumer solves the following problem:

max u(xi, yi ) subject to (px − sx )xi + (py − sy )yi = Mi − Ti

Group A solves: max u(xA , yA ) subject to 9xA + 9yA = 500 − 68

Group C solves: max u(xC , yC ) subject to 9xC + 9yC = 300 − 12

Therefore, the welfare of the median consumer (Group B) is unchanged. Lower-income

The change in utility is u(x∗∗ ) − u(y) = [v(x∗∗ ∗∗ ∗∗ ∗∗

The change in dollars is [p1 x∗∗ ∗∗ ∗∗ ∗∗ ∗∗

Thus the change in utility equals the change in dollars.

4.(b) The government solves the following problem:

4.(c) Solve the following problem:

Simplifying this expression, it is easy to see that this function is maximized at p = 0.

max π = p1 · y1 (p1 , p2 , x) + p2 · y2 (p1 , p2 , x) − wx

6.(a) C(y1 , y2 ) = wx = y12 + y22 + y1 y2

6.(c) y1∗ (1, 1) = 13 (2 · 1 − 1) = 1

6.(d) y1∗ (1, 2) = 13 (2 · 1 − 2) = 0

Next, determine min AC(y): AC(0) = 0.

5.(b) First, derive AC(y) and M C(y).

6.(b) C(y) = w1 x1 + w2 x2 + w3 x3 = 1 · y 5/3 + 1 · y 5/3 + 1 · y 5/3 = 3y 5/3

f (x1,x2 ) [243+ 13 (x1 −9)3 ]x2 [243+ 31 (x1 −9)3 ]

2.(a) If w1 rises, x∗1 falls, and π falls.

2.(b) If w2 falls, x∗1 is unchanged, and π rises.

2.(c) If p rises, x∗1 rises, and π rises.

1/4 1/4 1/4

2.(b) Since p = 4, y = 1, 000, 000 − 1, 000 · 4 = 996, 000.

Alternatively, ﬁnd min AC(y) and solve for y ∗∗ .

2. Given R(h) = p · h = (50 − h

3. Since R1 = p1 · y1 = (100 − y1 )y1 , M R1 = 100 − 2y1 , and since R2 = p2 · y2 = (75 − 12 y2 )y2 ,

100 − 2y1 = 2(y1 + y2 )

75 = 2y1 + 3y2 (2)

4.(a) Given RB = pB · xB = (100 − xB )xB , M RB = 100 − 2xB , and given RF = pF · xF =

4.(d) Consumers’ surplus = 12 (49.50)(100 − 50.50) + 0 = 1, 225.12.

5.(c) π ∗ = R(y ∗ ) − C(y ∗ ) = 85 · 30 − (302 + 10 · 30) = 1, 350.

5.(d) Consumers’ surplus = 12 (30)(100 − 85) = 225.

6.(a) If Sue is forced to price at marginal cost:

4.(d) Competitive equilibrium: