Econ 102: Microeconomics I

First Semester, AY 2023-24

Assignment 5: Demand II

1. Suppose a consumer faced with prices p1 = 9, p2 = 12 consumes at some point x0

where x1 = 4., x2 = 7, U(x0) = 10. When p1 is lowered to p1 = 8, the consumer would move to
point x1, where x1 = 6, x2 = 6, U(x1) = 15. From these data, estimate the following values:
a) How much would the consumer be willing to pay to face the lower price of x1?
b) How much would a consumer initially at x1 have to be paid to accept the higher
price of x1 voluntarily?
c) Are your answers to (a) and (b) exact calculations of these values, or are they
approximations? If the latter, is the direction of bias predictable?
d) How much better off is the consumer at x1 than at x0?

2. Consider a household whose preferences are described by the utility function

u(x1, x2 ) = x1 x2 . Assume that in the initial situation, p1 = 1, p2 = 1 and y = 2. Suppose the
price of good 2 increases to 2.
(i) Calculate the equivalent variation and interpret what it represents.
(ii) Calculate the compensating variation and interpret what it represents.
(iii) Calculate the change in consumer surplus as a result of the price increase.
(iv) Is x2 a normal good? Explain.

3. Consider a representative consumer with utility function

𝑈 𝑞! , 𝑞! = 𝑙𝑛𝑞! + 𝑞! ,
where 𝑞! denotes liters of gas and 𝑞! is a numeraire representing all other goods. The price
of 𝑞! is therefore normalized to one, 𝑝! = 1, while the price of gas is 𝑝! 1 + 𝑡 , where
𝑡 ∈ 0, 1 represents ad valorem tax per gallon of gas. Denote the consumer’s income by
𝑦 > 0.

(i) Find the Marshallian demand for 𝑞! 𝑎𝑛𝑑 𝑞! , and distinguish the case in which 𝑚 > 1
and that when 𝑚 ≤ 1.
(ii) Derive the associated indirect utility function.

The government is considering implementing either of the following policies: (a) reduce the
tax on gas, from 𝑡 𝑡𝑜 𝑡 ! = 𝑡 − 𝛼; or (b) maintain the tax at t but give a subsidy s to the
consumer equal to the tax revenue collected by the tax on gas.

(iii) Using the indirect utility function, if 𝑦 > 1, which policy does the consumer prefer, tax
reduction or subsidy?
(iv) Using the indirect utility function, if 𝑦 ≤ 1, which policy does the consumer prefer, tax
reduction or subsidy?
Econ 102: Microeconomics I
First Semester, AY 2023-24

4. The preferences of a given consumer are represented by 𝑈 𝑞! , 𝑞! = 𝑚𝑖𝑛 𝑞! , 𝑞! .

We have been informed that only the price of good 2 has increased from 𝑝!! to 𝑝!! , but we
cannot observe how much this price changed. We know, however, that the amount of
income that has to be transferred to the consumer in order for him to recover his initial
!!! !
utility level is , where y is initial income, and 𝑝!! and 𝑝!! are the initial prices of goods 1
!!! !!!!
and 2, respectively. Can you provide some information about the size of the price increase,
i.e., the difference between 𝑝!! and 𝑝!! ?