Answer Key for Assignment 1 Econ502

Q# Answer Difficulty Level Reference

1 A Easy 4
2 C Average 4
3 C Average 4
4 A Average 4-5
5 D Average 5
6 D Average 5
7 C Easy 5
8 B 1 1.1
9 D 1 1.1
10 D 1 1.1
11 D 1 1.2
12 A 2 1.2
13 B 1 1.2
14 B 1 1.3
15 B 1 1.3
16 C
17 B 1 2.1
18 C 1 2.1
19 C 1 2.1
20 D 2 2.1
21 C 2 2.1
22 D 1 2.2
23 D 1 2.2
24 B 2 2.2
25 A 2 2.2
26 B 2 2.3
27 C 3 2.3
28 D 1 2.3
29 A 2 2.3
30 C 2 2.3
31 B 2 2.3
32 A 2 2.3
33 C 1 2.4
34 C 1 2.4
35 D 2 2.4
36 D 1 2.4
37 A 1 2.4
38 B 1 2.4
39 C 1 2.4
40 B 1 2.5
41 A 2 2.5
42 C 1 3.1
43 D 1 3.1
44 B 1 3.1
45 D 1 3.1
46 D 1 3.1
47 D 1 3.1
48 D 2 3.1
49 A 1 3.1
50 A 3 3.1
51 C 2 3.1
52 D 2 3.1
53 D 1 3.2
54 D 2 3.2
55 B 1 3.5
56 B 2 3.5
57 A 3 3.5
58 A 1 3.6
59 C 1 3.6
60 C 1 3.6
Answer'Key'for'Assignment'1'Econ502'

Problem(Set(Part(

1. [8 points] Suppose we allocate $60 per week to the consumption of food and clothes. Food cost $2
per unit and clothes costs $3 per unit. Use a graph with food on the horizontal axis and clothes on the
vertical to answer the following questions.
Income'='$'60'
P'food'='$'2'per'unit'
P'clothes'='$'3'per'unit

(a) Write down the budget constraint (equation) and illustrate it on a graph.
P food F + P clothes C = Income
2F + 3 C = 60 ! Budget Constraint
If F = 0, C = 20
If C = 0, F = 30
Therefore,

(b) Identify the opportunity cost of 1 unit of food in terms of cloth and similarly, the opportunity cost
of 1 unit of cloth in terms of food.
Opportunity cost:
1 unit of food = 2/3 cloth
1 unit of cloth = 3/2 food
(c) How would your graph change in a sudden appearance of a flood that caused the price of food to
rise to $4 per unit, and how does this change the opportunity cost of food and cloth?
P food = $ 4 " 60/4 = 15
P clothes = $ 3 " 60/3 = 20
Opportunity Costs:
1 unit of Food = 4/3 cloth
1 unit of Cloth = 3/4 Food

(d) What happens in your graph if (instead of the change in (c)) income decreases from $60 to $30?
How does this change the opportunity cost of food and cloth?
Income decreases from $60 to $30, while P Food = $2 and P clothes = $3
Therefore: 2F + 3C = 30 ! New Budget Constraint
If F = 0, C = 10
If C = 0, F = 15

Therefore,
 Opportunity cost:
1 unit of food = 2/3 cloth
1 unit of cloth = 3/2 food

2. [8 points] Draw 2-3 indifference curves for each of the following pairs of goods and analyze
consumers’ marginal rate of substitution (Explain what is MRS for each case).

(a) Coffee and cookies- Alice always buys one coffee with two cookies and she never consumes the
two goods separately.
Perfect Complements

U1 > U2 > U3
MRS Complements, Cookie: Infinite on the vertical part of each indifference curve
MRS Complements, Cookie: 0 on the horizontal part of each indifference curve
 MRS Complements, Cookie: Not defined at the corner

(b) Coffee and bottled water- Barbara buys some combination of coffee and bottled water every day
to feel hydrated, and she enjoys variety.

MRS c, w > 0 " in absolute number

And it decreases as you consume more coffee (convexity)

(c) Coffee and coke- Craig only cares about coffee or coke for the caffeine they provide and he
knows that coffee supplies twice the caffeine as a coke.
Perfect Substitutes
A coffee gives twice the caffeine as coke

MRS c, coke = 2/1 => 2 [in absolute numbers]

MRS c, coke is always constant
 (d) Coffee and sugar- Don never uses sugar, but he likes coffee.
No preference on sugar (sugar is a neutral good)

MRS c, s = infinite in absolute value

3. [24 points] Azer earns 100 Manats (M) a month that he spends on burgers and pizza. A burger costs
him 2 M and similarly a slice of pizza costs him 4 M. His preferences are convexly defined by the
utility function, U(B,P)=BP, where MUB=P and MUP=B.

Income = 100 Manats

P burger = 2 M U (B,P) = BP
P pizza = 4 M MUB = P and MUP = B

(a) [3 points] Write down his budget constraint (BC) and draw the B.C on a graph. What is the
opportunity cost of a burger in terms of pizza? (Put burgers on the horizontal axis)
Budget Constraint " P burger * B + P pizza * P = Income
2B + 4P = 100
If B = 0, P = 25
If P = 0, B = 50

Opportunity Cost of 1Burger = -½ Pizza " PB/PP

(b) [5 points] Using the tangency condition, compute his optimal bundle of pizza and burger that he
should consume. Show this on your graph along with indifference curves. (Preferences are
convex and so, be careful with the shape of the indifference curves)

2 / 4 = Pb / Pb " 1 / 2 " MRSBP = MUB / MUP = P/B

P/B = 1/2 " B = 1/2 P
Substituting the value of B in Budget Constraint Equation:
2B + 4P = 100
2(1/2 P) + 4P = 100 (solve it to get the following values)
P = 20
B = 10

(c) [5 points] How would your answer to part (b) change if the price of pizza decreases to 2 M?
If PB = 2M
PP = 2M
I = 100M
New Budget Constraint will be: 2B + 2P = 100 " B + P = 50
From Tangency Criterion:
PB/PP = MUB/MUP
PB/PP = 2/2 Hence, P = B
Solve the equation by substitution method:
B + P = 50
B + B = 50 " B* = P* = 25
(d) [5 points] How would your answer to part (b) change if Azer gets an increase on his income for
20 M?
If PB = 2M
PP = 4M
I = 100 + 20 = 120M
New Budget Constraint:
2B + 4P = 120
When B = 0, P = 30
P = 0, B = 60
From Tangency Criterion
PB/PP = MUB / MUP
PB/PP = 2/4 " 1/2
B* = ½ P*
Solve the equation:
2B + 4P = 120
2(½ P*) + 4P = 120 " P*=24, B*=12
(e) [3 points] Using the prices (initially 4 M and then 2 M) and optimal quantities for pizza, draw
Azer’s demand curve for pizza. (put the price of pizza on the vertical axis and quantity on the
horizontal axis)
PP = 4M " Q1* = 20
PP’ = 2M " Q2* = 25

Note: The increase in the market price led to a decrease in the quantity demanded (movement along
the same demand curve).

(f) [3 points] What happens to his demand curve, when he receives an increase on his income? Show
this on the demand curve. Is pizza a normal or inferior good?
When(his(income(increases(to(120(M,(holding(market(price(constant(at(4M,(he(consumes(24(
units.((As(shown(in(the(graph(above)(

PP(=(4M("(P3*(=(24(
As(his(income(increases(while(holding(prices(constant,(we(observe(an(increase(in(his(demand(for(
pizza(as(his(demand(curve(shifts(right.(Since(he(consumers(more(pizza(as(his(income(goes(up,(
pizza(is(a(normal(good.(