KENYA METHODIST UNIVERSITY MOMBASA CAMPUS

ECON 301 INTERMEDIATE MICROECONOMICS

ASSIGNMENT SOLUTIONS

Q1
Explain briefly using a well-labelled diagram how maximum price restriction by the
government leads to market disequilibrium. (4 marks)
A maximum price also known as a ceiling price is when the price is set below the market
clearing price level. This is a mechanism imposed by government primarily in order to increase
availability perhaps hereby increasing equality in society by permitting more people to afford the
good. Notable examples have been war-time centralised prices, extreme measures in times of high
inflation and when prices are set centrally in planned economies. In all cases there are two major
side-effects. The first effect is an excess of demand which in turn will create queues and secondhand selling, i.e. black (parallel) markets.
A price ceiling occurs when the government puts a legal limit on how high the price of a product
can be. In order for a price ceiling to be effective, it must be set below the natural market
equilibrium.
Rent control is an example of a price ceiling, a maximum allowable price. With a price ceiling, the
government forbids a price above the maximum. A price ceiling that is set below the equilibrium
price creates a shortage that will persist.

For the price that the ceiling is set at, there is more demand (Q2) than there is at the equilibrium
price. There is also less supply (Q1) than there is at the equilibrium price, thus there is more
quantity demanded than quantity supplied i.e. shortage.

Disequilibrium means supply does not equal demand.

Price Control or Ceiling (PC): Governments intervention (e.g., by setting maximum price of bread
above) prevents market price from moving up to clear the market and achieve equilibrium. Thus PC
< Pe ; where PC is the ceiling price. That is, price ceiling is below equilibrium price.
Q2
Using a well-labelled diagram show the income and substitution effect for a normal good and
a price fall. (6 marks)
Income Effect is caused by an increase or decrease in real income represented by a subsequent
increase or decrease in utility, or movement to a higher or lower indifference curve. A price
decrease brings about an increase in real income; purchasing power.
The Substitution Effect involves the substitution of good x1 for good x2 or vice-versa due to a
change in relative prices of the two goods.
Normal goods are any goods for which demand increases when income increases, and falls when
income decreases but price remains constant, i.e. with a positive income elasticity of demand.
In this case, the income effect adds to (reinforces) the substitution effect.
The following chart illustrates the substitution, income, and total effects of price increases and
decreases for normal and inferior goods.
Substitution Effect
Income Effect
Total Effect
Price Increase
Normal Good
{-}
{-}
{-}
Inferior Good
{-}
{+}
Either
Price Decrease
Normal Good
{+}
{+}
{+}
Inferior Good
{+}
{-}
Either

Consider a decrease in the price of consumption good X. When the price of X decreases, the budget
constraint pivots outward along the axis measuring the quantity of consumption good X. The
consumer moves from utility maximizing consumption bundle a to utility maximizing consumption
bundle b. This movement is the total effect of the price decrease. It is what we actually observe.

To identify the substitution and income effects, draw a new dotted line (shown above) that is just
tangent to the original budget constraint (at point c) but with the same slope as the new budget
constraint (BC2). This dotted line will represent enough income to get back to the original

indifference curve (the original level of utility) but with the slope of the new budget constraint to
reflect the new relative prices. In other words, income is adjusted to keep utility the same from
points A to C at the new relative prices.
The substitution effect is from a to c and it is positive. To see this, recall that the slope of the budget
constraint represents the ratio of relative prices (pX/pY). When the slope of the budget constraint
gets flatter, this indicates that pX/pY decreases and that consumption good X has gotten relatively
less expensive. According to the substitution effect, consumers will substitute toward the
consumption good that has gotten cheaper. Thus, the substitution effect prompts the individual to
consume more of good X, which is the positive effect from a to c.
We argue that the movement from consumption bundle a to consumption bundle c contains no
income effect because both consumption bundles are on the same indifference curve. If there had
been a change in real income, then the same level of utility would not have been achieved.
The income effect is from c to b and it is positive. Between c and b, the dotted line moves in a
parallel fashion to the new budget constraint. This represents the increase in real income or
purchasing power experienced when prices decrease. An increase in real income prompts
consumers to purchase more of all normal goods, which is the positive income effect.
We argue that the movement from c to b contains no substitution effect because the dotted line and
the new budget constraint have the same slope. This indicates that there has been no relative price
change between these two lines only a change in real income. If there had been a change in
relative prices, then the two lines would have had different slopes.
Note that in this example, consumption good X and consumption good Y are substitutes: when the
price of consumption good X decreases, the individual consumes less of consumption good Y.
We can also show that in this example, as the price of consumption good X decreases, total
expenditures on consumption good X increase. This is because income equals the price of
consumption good X multiplied by the quantity of X consumed price plus the price of consumption
good Y multiplied by the quantity of Y consumed. That is, I = pXX + pYY. In this instance, nominal
income and the price of consumption good Y have not change. Since the individual consumes less
of consumption good Y when the price of X decreases, less is spent on Y. Since nominal income is
unchanged, more must have been spent on consumption good X.
We can also determine that the demand curve for consumption good X is inelastic. When a price
increase results in an increase in total expenditures (or, total revenue from the firms perspective),
demand is inelastic.

Q3
Computers have elastic demand while pharmaceutical drugs have inelastic demand. Suppose
that technological advances doubles the supply of both products, that is, the quantity supplied
at unit price is double what it was before: ...(6 marks)
(a) What happens to the equilibrium price and quantity in each market?
In both markets, the increase in supply reduces the equilibrium price and increases the equilibrium

quantity.
(b) Which product experiences a larger change in price?
Pharmaceutical drugs. In the market for pharmaceutical drugs, with inelastic demand, the increase
in supply leads to a relatively large decline in the price and not much of an increase in quantity.
(c) Which product experiences a larger change in quantity?
Computers. In the market for computers, with elastic demand, the increase in supply leads to a
relatively large increase in quantity and not much of a decline in price.
Additionally, in the market for pharmaceutical drugs, since demand is inelastic, the percentage
increase in quantity will be less than the percentage decrease in price, so total consumer spending
will decline. In contrast, since demand is elastic in the market for computers, the percentage
increase in quantity will be greater than the percentage decrease in price, so total consumer
spending will increase.
Q4
Briefly explain own price elasticity of demand. (4 marks)
This is a measure of the percentage change in the quantity demanded caused by a percentage
change in price.
Price Elasticity of Demand = % change in Quantity demanded / % change in Price
Because the demand function is an inverse relationship between price and quantity the coefficient of
price elasticity will always be negative.
Q5
Each day, Paul, who is a first year student, eats breakfast at school. He likes only cookies (x)
and ice-cream (y), and these provide him with a utility of U(xy) = x0.5y0.5
(a) If cookies cost $0.10 and ice-cream costs him $0.25 per cup, how should Paul use the $1 his
mother gives him to maximise his utility? (6 marks)
To maximize utility, given a fixed amount of income to spend, an individual will buy those
quantities of goods that exhaust his or her total income and for which the psychic rate of trade-off
between any two goods (the MRS) is equal to the rate at which the goods can be traded one for the
other in the marketplace.
The utility function is U(x,y)=x0.5y0.5
Paul's budget constraint is Px*X+Py*Y=I
We will use the MRS (Marginal Rate of Substitution) method. MRS is the maximum amount of
good y that a consumer is willing to give up to get one more good x.

Thus, MRS = dY/dX = Slope of Indifference Curve

Or MRS = MUx/MUy (where MUx = dU/dX; MUy = dU/dY)
Let us Find MRS
MRS = MUx/MUy
= (dU/dX)/( dU/dY)
= (0.5 X-0. 5 Y0. 5)/ (0.5 X0. 5 Y-0. 5)
= Y/X
Set MRS = Px/Py
Y/X = 1/1
Therefore, Y = X
Step Three: Plug Y= into Budget Constraint and solve for X
I = Px X + Py Y
I = 0.1X + 0.25Y
* Since Y=X & I = $1, therefore:
1 = 0.35X
X = 2.86 (2 dp)
Therefore, Y = 2.86
Thus, Paul will maximize his utility when he buys 2.86 of good X and 2.86 of good Y.
He will therefore budget his allowance in the following way:
On good Y...
2.86 * $ 0.25 = $ 0.715
On good X...
$ 1 $ 0.715 = $ 0.285
(b) If the school tries to discourage cookie consumption by raising the price to $0.40, by how
much will Paul's mother have to increase his lunch allowance to provide him with the same
level of utility he received in part (a)? (4 marks)
We need to get new income allowance.
New price of good X = $0.40
Plug this into budget constraint....
(0.40*2.86) + (0.25*2.86)=I
1.144+0.715=I
I = $ 1.859
Income (breakfast allowance) will increase by $ 1.859 - $ 1 = $ 0.859