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University of Toronto | Department of Economics | ECO 204 | Summer 2012 | Ajaz Hussain
TEST 2 SOLUTIONS

TIME: 1 HOUR AND 50 MINUTES
YOU CANNOT LEAVE THE EXAM ROOM DURING THE LAST 10 MINUTES OF THE TEST.
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Question Maximum Possible Points Score
1 15
2 35
3 25
4 25
Total Points = 100

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Question 1 [15 Points]
Whenever you dine out at restaurants, you like have food and alcohol as perfect complements in a 1:1 ratio. As for
alcohol, you perceive 2 glasses of wine to be a perfect substitute for a glass of gin. Assume food and alcohol can be
consumed in any non-negative amount, that you are a price taker, and that all pecuniary terms are strictly positive.
(a) [10 Points] Let food =

, wine =

and gin =

. Solve your UMP for

and

. Show all calculations below.


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(b) [5 Points] Please answer this question according to the last digit of your ID #:
If your ID # ends in 0, 2, 4, 6, or 8 When will you only drink wine at dinner? How many glasses of wine will you order
per plate of food? Show all calculations.
If your ID # ends in 1, 3, 5, 7, or 9 When will you only drink gin at dinner? How many glasses of gin will you order
per plate of food? Show all calculations.

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Question 2 [35 Points]
Whenever you dine out at restaurants, you like have food and alcohol as complements in a 1:2 ratio (i.e. 1 unit of food
combined with 2 units of alcohol). As for alcohol, you prefer to have wine and gin as perfect complements i.e. 1:1
ratio. Assume food and alcohol can be consumed in any non-negative amount, that you are a price taker, and that all
pecuniary terms are strictly positive.
(a) [10 Points] Let food =

, wine =

and gin =

. Solve your UMP for

and



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(b) [5 Points] Suppose

. How much food, wine and gin will you order? What is
the impact of a $1 income tax on your optimal utility and optimal consumption of food and alcohol (please give answers
for the total changes in consumption and utility). Show all calculations.
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(c) [10 Points] Suppose

. Calculate the excise tax rate on food which will


generate the same amount of tax revenue as the income tax in part (b) and calculate its impact on your utility and the
optimal consumption of food and alcohol (please give answers for the total changes in consumption and utility). Show all
calculations.
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(d) [10 Points] Decompose the price effect of the excise tax on food in part (c) into the substitution and income effects.
Show all calculations.

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Question 3 [25 Points]
Using data from Apples 2011 and 2012 10-K reports, an analyst has estimated the following linear demand curve for
Apple iPads:

Here $ price/iPad and # of iPads.
(a) [5 Points] In 2012-Q2 the average price of an iPad was $558.57. According to the demand curve, how many iPads will
be sold in 2012-Q2? What will be the price elasticity of an iPad in 2012-Q2? Show all calculations.


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(b) [5 Points] Calculate the representative Apple iPad consumers utility level from consuming Apple iPads (not the
utility level from consuming iPads and all other goods). You dont need to prove any equations used for this calculation.
Show all calculations and state all assumptions.

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(c) [5 Points] What is the impact of a 1% excise tax on the representative Apple iPad consumers utility level from
consuming Apple iPads and all other goods? You dont need to prove any equations used for this calculation. Show all
calculations and state all assumptions.
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(d) [10 Points] Confirm your answer in part (c) by deriving and using the representative Apple iPad consumers utility
function of consuming Apple iPads and all other goods. Show all calculations and state all assumptions.
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Thus:
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Question 4 [25 Points]
Consider a 3 period economy ( ) where at the beginning of each consumer receives (individual-
specific) real incomes

(in units of corn) respectively. In the first two periods, consumers can borrow or
save corn at the prevailing real interest rate.
Suppose a consumer has the following utility function over consumption at and :



Assume and that the nominal interest rate and inflation rate are .
(a) [15 Points] Assume a uniform rate of inflation and nominal interest rate between periods and .
Solve the consumers inter-temporal UMP for

. Show all calculations.


Hints: For we must have


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(b) [10 Points] Please answer this question according to the last digit of your ID #:
If your ID # ends in 0, 2, 4, 6, or 8 Under what conditions will the consumer save corn at ? What will happen to
savings at if the real interest increases? Show all calculations.
If your ID # ends in 1, 3, 5, 7, or 9 Under what conditions will the consumer borrow corn at ? What will happen
to borrowings at if the real interest increases? Show all calculations.
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