EC 203 - INTERMEDIATE MICROECONOMICS

Boğaziçi University - Department of Economics

Fall 2019
Problem Set 3 - Solutions

1. Leo consumes only nuts and berries. Fortunately, he likes both goods. The consumption bundle where
Leo consumes x1 units of nuts per week and x2 units of berries per week is written as (x1 , x2 ).

(a) The set of consumption bundles (x1 , x2 ) such that Leo is indifferent between (x1 , x2 ) and (16, 4) is
√
the set of bundles such that x1 ≥ 0, x2 ≥ 0, and x2 = 20 − 4 x1 . Plot several points that lie on the
indifference curve that passes through the point (16, 4) and sketch this curve.
√
Solution: We simply solve the equation x2 = 20−4 x1 to obtain, for example, the points (x1 , x2 ) =
(25, 0) , (16, 4) , (9, 8) , (4, 12) , (1, 16) , (0, 20) .
√
(b) In fact, Leo’s preferences can be represented by the utility function u(x1 , x2 ) = 4 x1 + x2 . The
price for nuts is $1 per unit and the price for berries is $2 per unit. Leo has $24 to spend on the
two goods. Write down Leo’s budget constraint and solve for his optimal consumption bundle.
Solution: Leo’s problem can be written as

√
max 4 x1 + x2 subject to x1 + 2x2 ≤ 24
x1 ,x2 ≥0

To solve this problem using the Lagrangian method, we write down the Lagrangian

√
L (x1 , x2 , λ) = 4 x1 + x2 + λ (24 − x1 − 2x2 ) .

The first order conditions are

 
∂L 1 −1/2
= 4 x1 − λ = 0,
∂x1 2
∂L
= 1 − 2λ = 0,
∂x2
∂L
= x1 + 2x2 − 24 = 0.
∂λ

The second equation gives us λ∗ = 1/2, which we can plug into the the first equation to give us
x∗1 = 16, which then plugged into the third equation yields x∗2 = 4.
Note that this utility function well-behaved: it is increasing in both x1 and x2 , MRS is diminishing
(check!), and it is continuous and differentiable. Thus, this problem can also be solved by setting
the slope of the indifference curve equal to the slope of the budget line. To do so, we set

p1 1
M RS = = .
p2 2

1
 Note that

M U1
M RS =
M U2
1

−1/2
∂u/∂x1 4 2 x1 2
= = =√ ,
∂u/∂x2 1 x1

and so we set
2 1
√ =
x1 2
to yield x∗1 = 16, which we substitute into the budget line equation x1 + 2x2 = 24 to yield x∗2 = 4.
(c) Now Leo has $10 more to spend on the two goods ($34 in total), and what is his optimal consumption
bundle now? Compare your solution with the previous one. Can you say anything interesting?
Solution: The new budget constraint is x1 + 2x2 ≤ 34. Leo now buys 16 units of nuts and 9 units of
berries. Notice the previous calculation shows that, as long as the prices for nuts and berries remain
1 and 2 respectively, Leo always purchases 16 units of nuts. (This is an example of a quasilinear
utility function. A consumer who has a quasilinear utility function consumes a fixed amount of one
good, if he can afford it.) Thus we only need to substitute x1 = 16 in the new budget line to get
x2 = 9.
(d) Now Leo has only $9 in total to spend. Is he still able to consume the same amount of nuts as in
part b? Explain.
Solution: The new budget constraint is x1 + 2x2 ≤ 9, and so Leo can no longer afford 16 units of
nuts. The (absolute value of the) slope of the indifference curve at (9, 0) is

1

−1/2
∂u/∂x1 |x1 =9 4 2 x1 |x1 =9 2
= = ,
∂u/∂x2 |x2 =0 1 |x2 =0 3

which is steeper than the slope of the budget line, which is (in absolute value) p1 /p2 = 1/2. Therefore,
Leo cannot afford anything that gives him higher utility.

2. Leo’s birthday is coming up and all he has in his possession is one bottle of soda. His friends get together
and decide to buy him a gift. They agree on getting him some bottles of soda (s) and some fancy colorful
soda making powder/shaker contraptions (f ). Leo’s utility function is given by U (s, f ) = s + f s − f 2 .
The soda costs ps = 1 and the powder shaker contraptions cost pf = 2. His friends decide to buy him
two bottles of soda (in addition to the one he already has) and one powder shaker thing, spending a
total of $4. (Throughout this question, you can assume that both soda and the fancy powder things can
be consumed in any fractional amount. When drawing diagrams, put soda on the horizontal axis and
the powder shaker things on the vertical axis. Also, you should only be concerned about the negatively
sloped portions of the indifference curves. Do not worry about portions which are positively sloped.)

(a) At Leo’s initial position prior to receiving the gifts, is he optimized?

Solution: Leo’s initial position of having one bottle of soda and no fancy shakers yields him a

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 utility level of U0 = U (1, 0) = 1 + (0 × 1) − 02 = 1. The optimization problem can be written as

max s + f s − f 2 subject to s + 2f = 1
s,f

since his income in essence is 1 when he has the one bottle of soda in his possession. Solving the
budget constraint for s yields
s + 2f = 1 ⇒ s = 1 − 2f.

Substituting this back into the utility function yields the utility function in one good (f ) given by

b (f ) = 1 − 2f + f (1 − 2f ) − f 2
U
= 1 − f − 3f 2 .

Notice that this function is decreasing in f for all positive values of f, meaning that Leo is actually
less happy if he has more of the fancy shaker contraptions. Because it is not possible for him to
have negative amounts of the shakers, he is best off having zero, which is in fact what he has, and
therefore Leo is indeed optimized.
(b) What is Leo’s utility level before (U0 ) and after (U1 ) the gifts?
Solution: We already determined in part a that U0 = 1. Now that Leo has a total of three bottles
of soda and one fancy shaker thing, his new utility is given by U1 = U (3, 1) = 3 + (1 × 3) − 12 = 5.
(c) Could Leo’s friends have spent their money more wisely in terms of making Leo happier? Explain.
If so, what would have been a better way to spend the $4?
Solution: The optimization problem is given by

max s + f s − f 2 subject to s + 2f = 5 and s ≥ 1

s,f

The first constraint is the budget constraint taking into account the $4 to be spent by Leo’s friends
and the $1 worth of soda that Leo already had. The second constraint, s ≥ 1, simply indicates that
Leo’s friends cannot take away any of the one bottle of soda that Leo already has. We will not
worry about this while solving the problem unless it turns out the optimal amount of soda is less
than s = 1, in which case we will revisit the problem taking into account this constraint. As we did
in part a, we solve the budget constraint for s to get

s + 2f = 5 ⇒ s = 5 − 2f.

Substituting this back into the utility function yields the utility function in one good (f ) given by

b (f ) = 5 − 2f + f (5 − 2f ) − f 2 = 5 + 3f − 3f 2 .
U

Taking the first order condition yields

b 0 (f ) = 3 − 6f
0=U ⇒ f = 1/2.

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 b 00 (f ) = −6 < 0, so the second order condition is satisfied and
(Note that the second derivative is U
we have in fact found a maximum.) Substituting f = 1/2 back into the budget constraint yields

s = 5 − 2(1/2) = 4.

Because s ≥ 1, we need not change anything to satisfy the constraint that Leo’s friends cannot take
away the one bottle Leo already had. So we have found that Leo’s friends could have made Leo
even happier by spending the $4 on 1/2 shaker contraptions and an additional 3 bottles of soda,
rather than the 1 shaker and 2 bottles. This would have yielded Leo the maximum possible utility
of U1max = U (4, 1/2) = 4 + (1/2 × 4) − (1/2)2 = 5.75 > 5 = U1 .

3. Leo consumes only goods 1 and 2. Their prices are p1 and p2 , respectively, and we let p = (p1 , p2 ). Leo’s
√
income is m. His utility function is u(x) = x1 + x2 .

(a) Suppose p1 = 1. Find the general form of his demand functions xL L

1 (1, p2 , m) and x2 (1, p2 , m), which
solve the problem
max u(x1 , x2 ) subject to 1 · x1 + p2 · x2 = m
x1 ,x2 ≥0

Solution: The Lagrangian is

√
L(x1 , x2 , λ) = x1 + x2 + λ(m − x1 − p2 x2 ).

The FOCs are

∂L 1 −1
= x1 2 − λ = 0, (1)
∂x1 2
∂L
= 1 − p2 λ = 0, (2)
∂x2
∂L
= m − x1 − p2 x2 = 0. (3)
∂λ
1
Solving (2) yields λ = p2 , which plugged into (1) yields

1 − 21 1 p22
x1 − =0 =⇒ x1 = ,
2 p2 4

which then plugged into (3) yields

m p2
x2 = − .
p2 4
Note that x1 ≥ 0 is guaranteed, but we must be more careful about the constraint x2 ≥ 0 (as we
m p2
saw in part (b)). If, in fact, p2 − 4 ≥ 0 does not hold, we must again adopt the corner solution
(x1 , x2 ) = (m, 0). Therefore the solution for p = (1, p2 ) is
 2  m p2 m p2
p2 m p2
if ≥  p2 − 4 if ≥

 

 4 p2 4
 p2 4
xL
1 (1, p2 , m) = , xL
2 (1, p2 , m) =

 

0 otherwise.

 m 
otherwise

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 (b) Now find the demand functions for a general price vector (p1 , p2 ). (Hint: Use the homogeneity
property of the demand: for any α > 0 and prices and income, (p1 , p2 , m), we have xL (p1 , p2 , m) =
xL (αp1 , αp2 , αm), that is, when all prices and income change proportionately the demand does
not change. This is because the budget set does not change when all prices and income change
proportionately, as we have discussed in class.)
Solution: Setting α = 1/p1 ,
p2 m
xL (p1 , p2 , m) = xL (1, , ).
p1 p1
Therefore,
 2
p2 m p2  m p2 m p2
if ≥
 p2 − 4p1 ≥


 4p21
  if
 p2 4p1  p2 4p1
xL
1 (p, m) = , xL
2 (p, m) =
m

 

otherwise. 0 otherwise.

 

p1

(c) Find the marginal utility of income in terms of prices and income.
Solution: We know that the Lagrangian multiplier attached to the the budget constraint is the
marginal utility of income (shadow price of income, as it’s often called). From our solution above we
1
already know that λ = p2 , when the solution is interior, which is the case when the income is high
enough: m/p2 ≥ p2 /4p1 . In this case the utility function r calculated at the optimal bundle is given
p22 p2
by v(x1 (p1 , p2 , m), x2 (p1 , p2 , m)) = v(p1 , p2 , m) = 4p2 + ( pm2 − 4p 1
). You can see that the partial
1

derivative of v(p1 , p2 , m) with respect to m is 1/p2 .

m p2
However when the income is not large enough then we have a corner solution: if p2 < 4p1 then the
optimal bundle is x1 = m/p q1 and x2 = q
0. Thus, the utility function
q calculated at the optimal bundle
m m m 1
is given by v(p1 , p2 , m) = p1 + 0 = p1 . The partial of p1 with respect to m is 2√mp 1
. Thus
we have the marginal utility of income given as

1 m p2


 if ≥


 p2 p2 4p1
M Um (p, m) = λ(p, m) =

 1
√ otherwise.


2 mp1


4. For each of the following utility functions below, for good 1, derive and draw the Engel curve, x1 (m),
and the demand curve, x1 (p1 ).
1/3 2/3
(a) u(x1 , x2 ) = x1 x2
Solution: We know from the previous problem set and from lecture notes, that x∗1 = 1m
3 p1 . Thus,
1m
the demand function is x1 (p1 ) = 3 p1 (where m is given) and it is depicted below. The Engel curve
1m
is x1 (m) = 3 p1 (where p1 is given) and it is depicted below.

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 p1 m

Demand curve Engel curve

slope : 3p1

x1 x1

(b) u(x1 , x2 ) = x21 + x22

M Ux 2x x
Solution: The MRS is equal to M Uy = 2y = y, which is increasing in x. Thus, MRS is not
diminishing. The solution will be a corner solution. If p1 > p2 , spend all income on x2 , that is,
x∗1 = 0. If p1 = p2 , any x amount between x∗1 = 0 and x∗1 = m
p1 will be optimal. If p1 < p2 , spend all
income on x, that is, x∗1 = m
p1 .

p1 m m
Engel curve Engel curve
p1 > p2 p1 < p2
Demand curve

p2

slope : p1
m/x1 = p1
m = p 1 x1

m/p2 x1 x1 x1

(c) u(x1 , x2 ) = 2x1 + 3x2

Solution: Note that this is a perfect substitute case. MRS is constant and equal to 2/3. Thus
p1
If p2 < 32 , then x∗1 = m
p1 .
p1
If p2 = 32 , x∗1 ∈ [0, pm1 ].
p1
If p2 > 32 , x∗1 = 0.

p1 m m
Engel curve Engel curve
3p1 > 2p2 3p1 < 2p2
Demand curve

2p2 /3

m/x1 = p1 slope : p1
m = p 1 x1

3m/2p2 x1 x1 x1

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 1/2
(d) u(x1 , x2 ) = x1 + 2x2
−1/2
M Ux 1/2(x1 ) 1
Solution: MRS is given by M Uy = 2 = 1/2 . This is diminishing as x1 goes up. Then,
4x1
1 p1 p2 2
tangency implies 1/2 = p2 , which gives x1 = ( 4p1
) . If m is large enough, the demand will be
4x1
p2 2
x1 = ( 4p 1
) , otherwise it will be x1 = m/p1 . Thus we have
p22 p2 2
If m ≥ 16p1 , x∗1 = ( 4p1
) .
p2
If m < 16p2 1 , x∗1 = m
p1 .

p1 p1 m

Demand Demand
if m ≥ p2 2
16p1
if m < p2 2
16p1
Engel

p22
16p1

p2 2 m
x1 = ( 4p 1
) x1 = p1

x1 x1 p2 2
( 4p ) x1
1

5. Determine in the following scenarios whether the good in question is a normal good for sure, an inferior
good for sure, or whether one cannot tell from the information given.

(a) When Alex was a graduate student with very low income at Boston U, he always ate burritos from a
food truck for lunch. Now Alex has graduated and has a well-paying job in Toronto, where burritos
from food trucks are cheaper than they were in Boston. Alex eats far fewer burritos now even though
he has just as much time for lunch, his preferences haven’t changed, the burritos are just as good
and the lunch alternatives are more or less the same. For Alex, what kind of good are food truck
burritos?
Solution: Burritos have gotten cheaper relative to other lunch alternatives, and so the substitution
effect alone must be positive. However the total effect is observed to be negative (since Alex now eats
fewer burritos), meaning the income effect must be negative. Since Alex now has a higher income
(in two senses!–Alex has a higher income in nominal terms and also has a higher real income due to
the decrease in the price of burritos), the income effect being negative means that the burritos must
be an inferior good.
(b) In his grad student days, Alex hardly ever bought himself a lemonade, let alone buying lemonade for
others. Now, when he comes back to visit Boston, it’s quite possible to see him buy entire rounds
of lemonades, even for strangers. The price of lemonade in Boston has not changed, nor have Alex’s
preferences. For Alex, what kind of good is lemonade?
Solution: Essentially nothing has changed here except for Alex’s income. Since an increase in
income has led to an increase in his consumption of lemonade, lemonade must be a normal good.
(c) Since Alex got his job in Toronto, the Canadian dollar (the currency in which Alex is paid his salary)
has been becoming increasingly more valuable relative to the U.S. dollar. Because Alex visits the

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U.S. quite often, it is as easy for him to shop for clothes in either country. Lately, he has been doing
more and more of his clothes shopping in the U.S. The price tags have not changed in either country,
and the clothes Alex buys are the same kind in both countries. For Alex, what kind of good are
clothes?
Solution: The question is asking about clothes in general, not clothes in one particular country.
Therefore, all we are really observing is that Alex is choosing to buy clothes from the cheaper place
(the U.S.) rather than the more expensive one (Canada). This tells us nothing whatsoever about
income effect. Rather, it tells us Alex is good at understanding the exchange rate and wants to buy
identical things for less rather than more. While this leads us to believe that Alex is normal, we
cannot say anything about whether clothes are normal or not.