Microeconomics I

Problem Set 5
Solution

Short Questions

1.When prices are (𝑝1′ , 𝑝2′ ) = (4,2) a consumer consumes (𝑥1′ , 𝑥2′ ) = (2,4), and when prices are
(𝑝1′′ , 𝑝2′′ ) = (2,4), he consumes (𝑥1′′ , 𝑥2′′ ) = (4,2). Is this behavior consistent with the model of
maximizing behavior? Explain. (10 points)

Bundle 1 Bundle 2
(2,4) (4,2)
Cost Cost
($4, $2) 1 $16 $20
($2, $4) 2 $20 $16

When price is (2,1), bundle 1 is chosen but bundle 2 is not affordable, and similarly when price is
(1,2), bundle 2 is chosen but bundle 1 is not affordable , so we cannot draw any inference from
these two observations regarding which bundle is preferred to the other by a revealed preference
argument. And therefore the behavior is consistent with the model of maximizing behavior (no
violation of weak axiom of revealed preference/strong axiom of revealed preference).

2. Mary obeys the weak axiom of revealed preferences. Her preferences don’t change over time.
One year she could afford bundle x but bought bundle y. If another year she buys bundle x, then
she can’t afford bundle y. True or false?

True.

3. It is possible for a consumer to satisfy the weak axiom of revealed preference but violate the
strong axiom of revealed preference. True or false?

True.

One example based on our discussion in lecture:

Total Cost of Bundles

Bundle 1 Bundle 2 Bundle 3

Prices 1 $20 $10* $22(∗)
2 $21 $20 $15*
3 $9 $15 $10

The actual chosen bundle in each price situation (data point) is highlighted in red.

From Observation1 (actual prices unspecified labelled as “1”):

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Bundle 1 is directly revealed preferred to Bundle 2.

From observation 2:
Bundle 2 is directly revealed preferred to Bundle 3; and so Bundle 1 is indirectly revealed
preferred to Bundle 3.

From observation 3:
Bundle 3 is directly revealed preferred to Bundle 1.
But from observation 2, Bundle 1 is indirectly revealed preferred to Bundle 3. This is a violation of
SARP. SARP requires that when a bundle is directly/indirectly revealed preferred to another
bundle. It cannot be the case that the latter bundle is directly/indirectly revealed preferred to the
former bundle (which means when the latter bundle is chosen, it has to be the case that the former
bundle is not affordable). However, in this example, WARP has not been violated because Bundle
1was never directly revealed preferred to Bundle 3.

4. Hillary has an initial endowment of $500 and is interested in two things: how many visits she
can make to the doctor and how much money will be left over to spend on other things. When a
trip to the doctor costs $40, Hillary sees the doctor 4 times. After health care reform, a visit to the
doctor will cost $10 but her taxes will rise by $160.

a. Explain what conditions are necessary for Hillary to be made better off by health care
reform.

Hillary must be able to afford a bundle she prefers to the one she is currently consuming after
health care reform.

b. Explain what conditions are necessary for Hillary to be made worse off by health care
reform.

If Hillary’s current consumption bundle and all other bundles she considers equally good have
been excluded from the new budget set, she has been made worse off.

c. Is it possible to tell whether Hillary has been made better/ worse off with the given
information?

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 No. Refer to the above diagram; we can see that the original bundle is no longer affordable
under the new reform. Not knowing Hillary’s indifference curves, it is impossible to tell
whether she has been made worse off or better off when her original bundle falls outside her
new budget set.

Multiple Choice Questions

1. According to Revealed Preferences, if a Consumer chooses a more expensive bundle of goods

over a cheaper bundle of goods, we can conclude

A) the consumer prefers the more expensive bundle of goods.

B) the consumer is behaving irrationally.
C) the consumer is unaware of the cheaper bundle of goods.
D) the consumer has convex preferences.

2. At prices ($4, $12), Harry chooses the bundle (9, 4). At the prices ($8, $4), Harry chooses the
bundle (2, 9). Is this behavior consistent with the weak axiom of revealed preference?

A) Yes.
B) No.
C) It depends on his income.
D) We would have to observe a third choice to be able to say.

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3. Let A stand for the bundle (7, 9), B stand for the bundle (10, 5), and C stand for the bundle (6, 6).
When prices are (2, 4), Betty chooses C. When prices are (12, 3) she chooses A.

A) A is directly revealed preferred to B.

B) A is indirectly revealed preferred to B.
C) C is directly revealed preferred to A.
D )None of the above.

4. Carlos has at one time or another lived in Argentina, Bolivia, and Colombia. He buys only two
goods, x and y. In Argentina the prices were ($9, $3) and he consumed the bundle (6, 7). In
Bolivia he consumed (9,2). In Colombia he consumed the bundle (6, 5) at the prices ($3, $3).

A) The Argentine bundle is directly revealed preferred to the Bolivian bundle.

B) The Argentine bundle is indirectly revealed preferred to the Bolivian bundle.
C)The Colombian bundle is directly revealed preferred to the Argentine bundle.
D) The Bolivian bundle is indirectly revealed preferred to the Argentine bundle.

5. When the prices were ($5, $1), Vanessa chose the bundle (x, y) = (6, 3). Now at the new prices,
(px, py), she chooses the bundle (x, y) = (5, 7). For Vanessa’s behavior to be consistent with the
weak axiom of revealed preference, it must be that

A) 4py < px.

B) px < 4py.
C) 5py < px.
D) py = 5px.