Economics 50

Stanford University

Summer 2007

Weekly Assignment 3
Due at the beginning of class, Tuesday, July 17, 2007.
(Total Points: 60)

Problem 1:

Paul consumes only two goods, pizza (P) and hamburgers (H), and considers them to be perfect
substitutes, as shown by his utility function: U(P,H)=P+4H. The price of pizza is $3 and the
price of hamburgers is $6, and Pauls monthly income is $300. Knowing that he likes pizza, Pauls
grandmother gives him a birthday gift certificate of $60 redeemable only at Pizza Hut. Though Paul
is happy to get the gift, his grandmother did not realize that she could have made him exactly as
happy by spending far less than she did. How much would she have needed to give him in cash to
make him just as well off as with the gift certificate? Show your work. (15 points)
Problem 2:
Lex spends his entire budget on espresso, gasoline, and downloadable music videos. You have the
following data on his choices: (15 points)

July
2005
August
2005
September
2005

Price of
each
gallon of
gasoline
$2.00

Price of
each shot
of espresso

Price of
each music
video

# of
espresso
shots
purchased
50

# of videos
purchased

$3.00

# of
gallons of
gasoline
purchased
100

$1.00

$2.40

$1.20

$2.40

100

50

30

$3.00

$1.20

$2.00

80

50

36

20

Using a revealed preference argument, are Lexs choices consistent with utility maximization?
Use an approach similar to the one outlined in class, and explain your steps.
Problem 3: Consider a consumer with the quasi-linear utility function U(x,y) = 2x
ordinary linear budget constraint. (30 points)

+ y, facing an

a) Derive this consumers demand functions X*(PX , PY , I) and Y*(PX , PY, I), noting that
both interior and corner solutions are possible. Show your work. Use your demand
functions to write down the relevant indirect utility function, U*(PX , PY, I). Also derive
H
her expenditure function, I*(PX , PY, U), and her Hicksian demand functions, X (PX , PY
H
, U) and Y (PX , PY, U) for the interior solution. (20 points)
b)

Calculate the income and substitution effects associated with an increase in the price of
X from pX =$1 to pX=$2, given that the price of Y remains at pY =$2 and income remains
at I=$12. (10 points