Economics 203: Intermediate Microeconomics I Instructor: Dr.

Donna Feir

University of Victoria Fall 2013

Problem Set #3 Solutions

Coverage: Chapter 5 Applications of Rational Choice and Demand Theories, and Chapter 16.1 General Equilibrium. All page and question references refer to the Frank and Parker text. Recommended Completion Date: October 15, 2013.

Question 1: Page 159 in Old Text and Page 172 in New Text, Problem 2.

Let price of other goods equal 2 and your original income equal 2M. Your original budget constraint was ( )); after the gas price increase, it was b ( a (given by ( )); and now, after the money from your uncle, it is c. The interpret with the horizontal axis is M+1000 because your budget constraint would equal if no other goods were consumed. You can still afford the original bundle you bought. But your indifference curve at the original optimum is below your new budget constraint. By decreasing your gas consumption and increasing other goods consumption, you can reach a higher indifference curve which means you are better off . (see dotted indifference curve). Note that the numbers for the price of other goods and income are chosen in an ad hoc fashion. You did not have to give the same numbers as long as they gave the same answer and the same general graph. You could have also chosen the price of other goods to equal 1 for example and income to be M.

Question 2: No. with the entire tax money returned, her income is identical to the original situation.
However, the relative price of gasoline has increased, which means that it is in the consumers best interest to substitute away from the initial amount of gasoline.

Economics 203: Intermediate Microeconomics I Instructor: Dr. Donna Feir

University of Victoria Fall 2013

Question 3: Consumer Surplus =area underneath the demand curve and above the price (area of a triangle) = (150*$300)/2 50 =$2250050=$22450. Note that since the price per item is zero. If we were to calculate consumer surplus with the price of each unit being equal to 100 dollars the calculation would be: ((100)*($300-$100))/2 50.

Question 4: Page 528529 in Old Text and Page 582 in New Text, Problem 1, 2, and 3 (they go together)..

Equilibrium price ratio =1 (any other price ration would result in a corner solution for Bert) This time the initial allocation lies on the contract curve, so there are no other allocations Pareto superior to it. The equilibrium price ratio must again be 1.

Economics 203: Intermediate Microeconomics I Instructor: Dr. Donna Feir

University of Victoria Fall 2013

Question 5: Page 528529 in Old Text and Page 582 in New Text, Problem 6 Identify the entire contract curve as well as the Core.

Core

Contract curve

Question 6: Sketch a typical consumption contract curve in an Edgeworth box for Ada (A) and Bob (B). The two products are apples and tents. Identify two consumption baskets where A and B are off the contract curve. Label the first point (a), where A values apples much more than B does; and label the second point (b), where A values apples much less than B does.

Sample points a and b are shown. At a, Adas indifference curve is steeper than Bobs, and at b the reverse is true. An allocation of resources is Pareto optimal if A) it is impossible to make one person better off without making at least one other person worse off.

Economics 203: Intermediate Microeconomics I Instructor: Dr. Donna Feir B) no further mutually beneficial exchange is possible. C) it is on the contract curve. D) all answers. The answer is D

University of Victoria Fall 2013

Question 8: In the standard case, if one is on the contract curve in an Edgeworth exchange box: A) the allocation is Pareto optimal. B) the indifference curves of both consumers are tangent. C) no further voluntary trade will occur. D) all answers. The answer is D Question 9: Annie and Bernie are the only residents of Lost Island. The Table below describes the quantities of Honey (X) and Cumquats (Y) they each have, as well as their preferences: Honey (X) 27 4 Cumquats (Y) 3 8 Preferences ( ( ) )

Annie Bernie i)

Draw the Edgeworth box of this economy

ii) Show that the following allocation is Pareto efficient Honey (X) 82/9 197/9 Cumquats (Y) 738/85 197/85

Annie Bernie

In a pareto efficient allocation, 1) the MRS for the two consumers are equal and 2) all goods in the economy are consumed. MRSA = YA/3XA; MRSB=3YB/XB For the proposed allocation:

Economics 203: Intermediate Microeconomics I Instructor: Dr. Donna Feir

University of Victoria Fall 2013

( ( ( ) ) ( ( ) )

iii) What is the price ratio (terms of trade) required for the economy to move from the initial endowment to the allocation above? Is this the equilibrium of the economy? Explain. Moving from the initial endowment and the allocation, Annie gains 738/85 3 = 483/85 units of Y and gives up 2782/9=161/9 units of X. The price ratio (the number of units of Y in exchange for a unit of X) is therefore ((483/85)/(161/9))=(27/ 85). Since the price ratio equals the MRS of both consumers, this is an equilibrium. iv) Complete the Edgeworth box, indicating the final allocation, indifference curves and price line associated with the solution. Indicate the core of the economy.

iv)