ECON 101: Assignment 2

1. Consider a consumer with Cobb-Douglas preferences over two goods, x and y. She spends
half of her income on each good. The prices of the two goods are initially both $1, and her
income is $100.

(i) If the price of good x increases to $2, what is the impact on her demand for good x?

(ii) Decompose this change into the substitution effect, and the income effect. How big is each?

(iii) Show that the substitution effect in isolation makes her better off than she is when prices
are both $1.

2. Two goods, x and y, are perfect complements, and are best consumed in a ratio of one-to-one.

(i) Using a diagram, show that if a tax is levied on consumption of good x, and the revenue is
returned to the consumer directly (as an income supplement) no loss of utility is imposed on the
consumer.

(ii) What about the case when x and y are perfect substitutes? Explain your reasoning, and
give some intuition.

3. Suppose an individual has an endowment of T units of time that she can devote to labor
supply (L) or leisure (R), so T = L + R. There is one consumption good in the economy,
denoted C, of which she has no endowment. Her endowment bundle is thus (ωR , ωC ) = (T, 0).
Let the price of the consumption good be one, and the wage w.

(i) Show that if the individual has Cobb-Douglas preferences over leisure and consumption bun-
dles, then her labor supply is independent of the wage (i.e., her choice of R and L does not depend
on w).

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(ii) Now suppose that her Cobb-Douglas preferences are described by the utility function

u(R, C) = R × C

and that her wage is initially w = 1. If the wage increases to w = 2, decompose the change in
her labor supply into the income effect and the substitution effect.

(iii) Use your calculations in (ii) to explain your answer to part (i).

4. Consider an individual who earns $10,000 this year, and is planning for her consumption needs
this year, and the next two years. She has two investment projects open to her. The first project
(project A) requires a $5000 investment, and yields returns of $4000 in each of the following two
years. The second project (project B) requires the full $10,000, and pays off nothing until the
third year, when a return of $14,000 is realized.

(i) Assuming first that the individual cannot borrow or lend, list her consumption bundles under
the three alternatives: don’t invest, invest in project A, and invest in project B. (Hint: A
consumption bundle is a vector with three components - (x1 , x2 , x3 ), where xt is her consumption
in period t).

(ii) Suppose the interest rate at which the consumer can borrow and lend is 5% per annum.
Which of the three options - don’t invest, invest in project A, or invest in project B - will she
prefer (explain your answer)?

(iii) If the interest rate is instead 20%, which option does she prefer?

(iv) What if the interest rate increases to 40%?

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5. An individual invests in a project. He is risk averse, with a utility index v(m) = m, where
m is the money he earns from the project. If the project succeeds, he will earn an income of
m = m0 > 0, but if it fails, he gets m = 0. Suppose the probability of the project succeeding is
p, which is between zero and one.

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(i) What is the individual’s expected income from the project? Denote this value by m.

(ii) Write down an expression for the individual’s expected utility from the project. (This ex-
pression should have p and m0 in it.)

(iii) If the individual got the expected income of the project, m, for sure, what would his expected
utility be? How does this compare with the expected utility of the project that you calculated
in part (ii)?

(iv) Suppose the individual could purchase insurance on the market. This insurance contract
guarantees the individual a fixed level of income, no matter what happens with the project. Let
m
b be the smallest fixed level of income that the individual would accept from the insurance
company. Show that the risk premium, m − m,
b is

m−m
b = p(1 − p)m0 .

6. Priya’s utility from vacations (V) and meals (M) is given by the function U (V, M ) = V 2 M .
Last year, the price of vacations was $200 and the price of meals was $50. This year, the price
of meals rose to $75, the price of vacations remained the same. Both years, Ed had an income of
$1500.

(i) Calculate the change in consumer surplus from meals resulting from the change in meal prices.

(ii) What is the compensating variation for the price change in meals?

(iii) Calculate the equivalent variation for the price change in meals.