Problem 1

ii.

𝑈 = 𝑥 𝑎 𝑦1−𝑎
I=px+qy=100 – income

p is price for x; q is price for y

MRS=a/(1-a) * y/x =p/q =1

x=aI/p

y=(1-a)I/q
𝑎 1 − 𝑎 1−𝑎
𝑈 = 𝐼( )𝑎 ( ) = 𝐼 ∗ 𝑎𝑎 (1 − 𝑎)1−𝑎
𝑝 𝑞
P increases

Substitution effect 1. The same utility; Also different MRS=2

𝐼(𝑎)𝑎 (1 − 𝑎)1−𝑎 = 𝑥𝑠𝑎 𝑦𝑠1−𝑎

𝑈𝑥 𝑎 𝑦 𝑝
𝑀𝑅𝑆 = = ∗ = =2
𝑈𝑦 1 − 𝑎 𝑥 𝑞

𝑎𝑦
𝑥=
2(1 − 𝑎)
𝑎𝑦𝑠
𝐼𝑎𝑎 (1 − 𝑎)1−𝑎 = 𝑥𝑠𝑎 𝑦𝑠1−𝑎 = ( )𝑎 𝑦1−𝑎
2(1 − 𝑎) 𝑠
𝐼 ∗ 𝑎𝑎 (1 − 𝑎)1−𝑎
𝑦𝑠 = 𝑎
( )𝑎
2(1 − 𝑎)
𝑦𝑠 = 2𝑎 𝐼(1 − 𝑎)

𝑥𝑠 (𝑠𝑢𝑏𝑠𝑡𝑖𝑡𝑢𝑡𝑖𝑜𝑛) = 2𝑎−1 𝑎𝐼

Substitution effect

𝒙𝒔 (𝒔𝒖𝒃𝒔𝒕𝒊𝒕𝒖𝒕𝒊𝒐𝒏) − 𝒙(𝒊𝒏𝒊𝒕𝒊𝒂𝒍) = 𝟐𝒂−𝟏 𝒂𝑰 − 𝒂𝑰 = 𝒂𝑰(𝟏 − 𝟐𝒂−𝟏 ) < 𝟎

New equilibrium x

x=aI/p=aI/2

Income effect on x
 𝒂𝑰 𝒂𝑰
𝒙(𝒇𝒊𝒏𝒂𝒍) − 𝒙(𝒔𝒖𝒃𝒔𝒕𝒊𝒕𝒖𝒕𝒊𝒐𝒏) = − 𝟐𝒂−𝟏 𝒂𝑰 = (𝟏 − 𝟐𝒂 ) < 𝟎
𝟐 𝟐

Problem 5 iv)

̂ ) = 𝑈(𝑓𝑎𝑖𝑙 𝑜𝑟 𝑠𝑢𝑐𝑐𝑒𝑠 𝑚0)

𝑢(𝑚

√𝑚
̂ = 𝑝√𝑚0

̂ = 𝑝2 𝑚0
𝑚

̂ = 𝒑𝒎𝟎 − 𝒑𝟐 𝒎𝟎 = 𝒎𝟎 ∗ 𝒑 ∗ (𝟏 − 𝒑)
̅ −𝒎
𝒎

Problem 6

i)

𝑈 = 𝑉 2𝑀
p=200 q1=50

New q2=75

I=1500
𝑈𝑣 2𝑉𝑀 2𝑀 𝑝
𝑀𝑅𝑆 = = 2 = =
𝑈𝑀 𝑉 𝑉 𝑞
2𝑀𝑞
𝑉=
𝑝
𝑝𝑉 + 𝑞𝑀 = 3𝑞 ∗ 𝑀 = 𝐼
500
𝑀= = 10
𝑞
1000
𝑉= =5
𝑝
∞ ∞ 75
500
∆𝐶𝑆 = ∫ 𝑀𝑑𝑞 − ∫ 𝑀𝑑𝑞 = − ∫ 𝑑𝑞
50 75 50 𝑞
𝟕𝟓
∆𝑪𝑺 = −𝟓𝟎𝟎 𝐥𝐧 ( ) = −𝟐𝟎𝟐. 𝟕
𝟓𝟎

ii)

Compensating variation (CV) is the difference in the consumer’s income and the income necessary to reach
the old indifference curve at the new prices.
 2𝑀𝑞 2 ∗ 75𝑀 3
𝑉= = = 𝑀
𝑝 200 4
Utility in the 1st year (before price increase)

𝑈 = 𝑉 2 𝑀 = 52 ∗ 10 = 250
We should have the same utility
3
( 𝑀)2 𝑀 = 250
4
𝑀 ≈ 7.63; 𝑉 ≈ 5.72
𝐼2 = 𝑝𝑉 + 𝑞𝑛𝑒𝑤 𝑀 = 200 ∗ 5.72 + 75 ∗ 7.6 ≅ 1717.25
𝑪𝑽 = 𝑰𝟐 − 𝑰 = 𝟏𝟕𝟏𝟕. 𝟐𝟓 − 𝟏𝟓𝟎𝟎 = 𝟐𝟏𝟕. 𝟐𝟓

iii)

EV or equivalent variation is the adjustment in income that changes the consumer’s utility equal to the level
that would occur IF the event had happened.

Again
2𝑀𝑞 3
𝑉= = 𝑀
𝑝 4
Utility in the 2nd year (after price increase)
500
𝑀= = 6.67
𝑞
1000
𝑉= =5
𝑝
𝐼2 = 𝑝𝑉 + 𝑞𝑜𝑙𝑑 𝑀 = 200 ∗ 5 + 50 ∗ 6.67 ≅ 1333.5
𝑬𝑽 = 𝑰 − 𝑰𝟐 = 𝟏𝟓𝟎𝟎 − 𝟏𝟑𝟑𝟑. 𝟓 = 𝟏𝟔𝟔. 𝟓