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Problem set 2

Due Monday 2nd March 12 noon


Adeola Oyenubi [60 marks]
Question 1 [20 marks]
1.1 Consider a Cobb-Douglas Utility given by (, ) = 1/4 3/4, a customer has a
budget constraint given by 2 + 3 = 10. Suppose (, ) = (, ) is another utility
function. Write down an expression for (, ) and argue whether or not (, )
preserve the preference ranking under(, )? Justify your answer [4 marks].

(, ) = + [2marks]
(, ) (, ).[2marks]
1.2 Solve the maximization problem
max (, ) . . 2 + 3 = 10 . [10 marks]
,

(, , ) =

+ ( + )[]

= [2 marks]

= [2 marks]

= + [ ]

= , = [1marks each]
1.3 Suppose you are to maximize
max (, ) . . 2 + 3 = 10
,

Instead what will the answer be? Justify your answer. (Hint: You dont need to work this
out) [2 marks]

= , = [1 mark each].

Since both (, ) (, ) represent the same preferences the solution to both


maximization problems under the same budget constraint should be equal.
[4marks]

Question 2 [20marks]
2.1Katty likes to consume a bottle of coke () with half a loaf of bread (). If she had 2
bottles of coke and 3 loaves of bread the remaining two loaves will go to waste. For this

reason her utility function is given by (, ) = min(2 , ). A loaf of bread sells for
while a bottle of coke sells for . Assume that katty has only Rm (m rands). Write an
equation that represents kattys budget line? [4 marks]
= + [4marks]
2.2 Find kattys optimal consumption bundle. [12 marks]
The optimality condition is given by

= []

Solving this simultaneously with the budget constraint yields

=
[]
+

=
[]
+
2.3 If katty has R20 and = 10 while = 5 how many units of coke and bread will be
in kattys optimal consumption bundle.
This requires simple substitution to yield = , = [ ]
Question 3[20marks]
Phiwe a utility maximizing consumer has the following utility function for Ferrari
California (denoted ) and audi A8 (denoted ): (, ) = 4 + . Ferrari goes for R2m
per unit while Audi goes for R1m per unit.
3.1 Calculate the marginal utility of [4 marks]

= []

=
= []

3.2 Assume Phiwe has R6m to spend on cars, given the prices calculate the marginal
rate of transformation of Ferrari for Audi. (Hint: You should think about what Thabo can
afford) [4 Marks]
Markets MRT is the relative price. The budget constraint is + =
[2marks]


= []

Or using the budget constraint = then calculate which gives similar


result.
=

3.3 By setting MRT equals MRS and the condition that Phiwes optimal choice must lie
on the budget line is it possible to predict how many units of Phiwe will
purchase (yes or No)? Explain your answer [5 marks]
No[2marks]
MRT and MRS are constant so that equating MRS and MRT yields no meaningful
result. This is so since the goods are perfect substitutes [3marks].
3.3 Now find the optimal bundle by calculating

and

[5 marks].


= = []


= = []

Since

<

Phiwe will rather spend all her money of Ferrari. [3marks]

3.4 Determine the optimal consumption bundle for Phiwe [2 marks]


+ =
+ =
= []