Chapter D

Consumer theory

1 Live Session Preparation

1.1 Problem Set

1. For each of the following utility functions, write down the equation
for an indifference curve and then draw some indifference curves

• u( x, y) = xy. [2 marks]
• u( x, y) = x + y. [2 marks]
• u( x, y) = min{ x, y}. [2 marks]

2. Compute the MRS for the following utility functions

√
• u( x, y) = xy. [3 marks]
• u( x, y) = ln x + ln y. [3 marks]
• u( x, y) = 20 + 3( x + y)2 . [3 marks]

3. Consider the utility function u( x, y) = x2 + y2 .

(a) Does this satisfy the property of diminishing MRS? Show alge-
braically and also show by drawing indifference curves.[5 marks]
(b) Show that using the tangency condition (MRS equals price ratio)
would not lead to an optimum in this case. [5 marks]
(c) Show (in a diagram) the possible optimal bundles. [5 marks]

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EC2066 Microeconomics

4. Consider the quasilinear utility function u( x1 , x2 ) = ln x1 + x2 (this is

linear in x2 , but not in x1 , hence the name ‘quasilinear’). Let p1 and
p2 denote the prices of x1 and x2 respectively. Let m denote income.

(a) Calculate the demand functions. [5 marks]

(b) Draw the income-consumption curve. [5 marks]
(c) Calculate the price-elasticity of demand for each good.
[5 marks]
(d) Calculate the income-elasticity of demand for each good.
[5 marks]

5. Suppose that the government subsidizes housing expenditures of low-

income consumers by providing a dollar-for-dollar subsidy to a con-
sumer’s housing expenditure - i.e. if a consumer spends x of his own
on housing, the government gives him x, making total housing ex-
penditure 2x. Ariel qualifies for this subsidy and spends a total of
500 per month on housing: he spends 250 of his own and receives
a government subsidy of 250. Recently, a new policy has been pro-
posed that would provide each low income consumer with a lump
sum transfer of 250 which can be used for housing or other goods.
Using a graph, demonstrate whether Ariel would prefer the current
program, the proposed program, or would be indifferent between the
two. [8 marks]

6. A consumer has the following utility function:

u( x, y) = min{αx, βy},

where α, β > 0. The price of x is normalised to 1 and the price of y is

p. The consumer’s income is M. Derive the demand functions for x
and y. [8 marks]

7. Suppose u( x, y) = x1/2 y1/2 . Income is M = 72. The price of y is 1 and

the price of x changes from 9 to 4. Calculate the income effect (IE) and
the substitution effect (SE). [10 marks]

8. Consider an economy with two goods: food (F) and music (M). Har-
vey has an income of 800, and the relative price of M is 4. Suppose F
and M are good substitutes (but not perfect substitutes) for Harvey,
and his preferences are such that he optimally consumes 100 units of
M.

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 Chapter D. Consumer theory

(a) Suppose a new club opens which Harvey can join for a fee of
$300. The advantage is that once he joins the club, he can pur-
chase M at a relative price of 1. Would Harvey join the club?
[10 marks]
(b) Suppose Carol has the same income as Harvey, but her prefer-
ences are represented by the utility function

UC ( M, F ) = min(αM, F )

For what values of α would Carol prefer to join the club?

[10 marks]