IDC Herzliya School of Computer Science Semester alef 2001

Introduction to microeconomics - Yossi Spiegel Solutions to selected problems Problem set 1 - problem 1 (a) The committees collective preferences are complete because we can tell who will get the majority (i.e., who the committee collectively prefers) in any given vote: when voting for Bob vs. Bill, Bob will be selected (Joe and John will vote for Bob). When voting for Bob vs. Bart, Bart will be selected (John and Jack will vote for Bart), and when voting for Bart vs. Bill, Bill will be selected (Joe and Jack will vote for Bill). But now, the committees collective preferences are not transitive since it prefers Bob over Bill, Bill over Bart, and Bart over Bob. This situation is called the Condorcet paradox of voting and was first identified by the 17th century French Mathematician and nobleman Marquis de Condorcet. Another way to describe the situation is to say that the preferences of the committee are such that "there is no Condorcet winner." Remark: The discussion that follows is for general interest only and in many ways it is "beyond the scope" of this course. If you wish you can skip it and move directly to part (b) of the question. Note that if the preferences of the committees members were for instance Joe 1 2 3 Bob Bart Bill John Bart Bob Bill Jack Bill Bart Bob

then Bart will beat Bob, Bob will beat Bill, Bart will beat Bill. Hence, Bart will be a Condorcet winner and the preferences of the committee will be transitive. This case is in many way more likely. To see why, note that each individual committee member has 6 possible rankings of the three candidates: (A) Bob, Bart, Bill, (B) Bob, Bill, Bart, (C) Bart, Bob, Bill, (D) Bart, Bill, Bob, (E) Bill, Bob, Bart, (F) Bill, Bart, Bob. There are now 56 distinct combinations of these rankings: 6+5+4+3+2+1 = 21 combinations that start with A: AAA (all 3 members have the ranking A), AAB (2 members have the ranking A and one the

2 ranking B), AAC, AAD, AAE, AAF; ABB, ABC, ABD, ABE, ABF; ACC, ACD, ACE, ACF; ADD, ADF, ADE; AEE, AEF; and AFF. 5+4+3+2+1 = 15 combinations that start with B: BBA, BBB, BBC, BBD, BBE, BBF; BCC, BCD, BCE, BCF; BDD, BDE, BDF; BEE, BEF; BFF. (all 6 combinations that start with BA are equivalent to those that start with AB); 4+3+2+1 = 10 combinations that start with C: CCC, CCD, CCE, CCF; CDD, CDE, CDF; CEE, CEF; and CFF. 3+2+1 = 6 combinations that start with D: DDD, DDE, DDF; DEE, DEF; and DFF. 2+1 = 3 combinations that start with E: EEE, EEF; and EFF. 1 combination that starts with F: FFF. For instance, the combination in the problem set is AEC (which is equivalent to ACE) and the combination in the table above is BCF. Of these 56 combinations, only 2 do not have a Condorcet winner: ADE, and BCF. (b) Joe likes Bob best. He knows that Bob can beat Bill but cannot beat Bart. Since he also knows that Bill beats Bart, he first lets the committee vote on Bill vs. Bart. Bill wins and then the committee votes on Bob vs. Bill so that Bob ends up being selected which exactly what Joe prefers. (c) Clearly controlling the agenda gives the chairman a power to manipulate the outcome and get what he wants.

Problem set 2 - problem 2 (a) Joes budget line is given by paxa + pbxb = M. Since Joe likes to consume 2 bananas with each apple, it must his optimal bundle will satisfy the equation xb = 2xa (that is, the number of bananas will be twice the number of apples). Substituting this equation in the budget line, we

3 get paxa + 2pbxa = M. Solving for xa yields xa = M/(pa + 2pb). Since xb = 2xa, it follows that xb = 2M/(pa + 2pb). (b) From Joes point of view, apples and bananas are normal since he wants to buy more when M is larger. From Joes point of view, apples and bananas are complements since he wants to buy less of each when the price of the other increases. Joes demand curve is a hyperbola. Joes demand curve for apples shifts inward when the price of bananas increases and it shifts outward when Joes income increases. Following the TV advertising campaign, Joe likes to consume one bananas with each apple, so his optimal bundle will satisfy the equation xb = xa. Substituting this equation in his budget line, we get paxa + pbxa = M. Solving for xa yields xa = M/(pa + pb). Since xb = xa, it follows that xb = M/(pa + pb). Hence, Joes demand curve for apples will shift outward.

(c)

(d) (e)

(f)

Problem set 3 - problem 1 (a) Since Jack always spends a fraction of his income on apples, paxa = M. Hence, Jacks demand for apples is xa = M/pa. Jacks demand curve for apples is a hyperbola. (b) Each low income consumer will have a demand function xa = ML/pa and each high income consumer will have a demand function, xa = MH/pa. The aggregate demand function is Xa = (nLML+nHMH)/pa. Again this is a hyperbola. (c) When nL increases and nH decreases, nLML+nHMH decreases so Xa shifts inward; when ML increases, Xa shifts outward; a change in pb does not affect Xa; and when increases, Xa shifts outward. (d) The price elasticity of the demand for apples is given by

All of the changes that were mentioned in (c) will have no effect on the elasticity pf demand for apples meaning that for each 1% increase in pa, the decrease in Xa will be 1%, no matter what nL, nH, ML, MH, pb, and are. (e) The income elasticity of the demand for apples is given by

Hence, a 1% increase in I, will lead to 1% increase in Xa. Problem set 4 - problem 3 Assuming that all employees spend the same amount at the espresso bar, option (i) implies a decrease of 25% in the espresso bars revenue from selling to employees of the high-tech company. (The decrease will be larger if the employees that loose their jobs spend more than those who stay and conversely if they spend less. However, without specific information on the behavior of different employees there is no reason to believe that that will be the case). Since the income elasticity of espresso is above 1, option 2 means that the demand for espresso and hence revenues will fall by more than 25%. Hence, option (ii) is more problematic for the espresso bar.