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# 1. Consider two, goods ice cream and beer.

## At low levels of consumption both

are goods (more is better) but after a threshold level each of them becomes a
bad (more is worse). Draw an indifference curve for the case described and
clearly identify the better than set.

2. Consider two goods x1 and x2, with M= \$100, p1=1, and p2=2. Place x2 on
the vertical axis and x1 on the horizontal axis. Label the budget lines as
noted in parentheses.

## a. Draw the budget line as noted above (1)

b. Draw a new budget line with M= \$100, and p2=2
c. Draw a new budget line with prices as in part a., M = \$200, and a coupon
allowing consumption of 20 units of good 1. The coupon can be purchased
for \$5

## 3. Consider the utility functions U(x1,x2)=x1 a + x2 b, V(x1,x2)=alnx1 +

blnx2
a. Do U and V represent the same preferences? Prove your point
mathematically.

4. Walt consumes strawberries and cream but only in the fixed ratio of three
boxes of strawberries to two cartons of cream. At any other ratio, the excess
goods are totally useless to him. That is, his utility function is given by U(S,
C)=min (3S,2C). The cost of a box of strawberries is \$10 and the cost of a
carton of cream is \$10. Walts income is \$200. What is Walts demand for
strawberries and cream?

5. a. Generate the cost function for the production function y=x1 1/4 x2 1/2
when W1=1 and w2=10. You can use the Lagrangean approach or make a
solid argument about the optimality conditions. If you do the latter use a

b. Using the first order conditions for profit maximization derive the supply
function for all prices greater than zero.

c. What are firm profits if p=1? Does the firm choose to operate?

## 6. (i) Consider the production function y= f(K,L) = K a Lb, where K and L

represent capital and labor respectively. Show either analytically (using
symbols only) r numerically that increasing returns to scale is associated with
the condition a+b>1 and decreasing returns to scale with a+b<1.
(ii) What are the implications for cost and optimal output if the production
function has increasing returns to scale. Use a diagram of your choice to
demonstrate the implications of increasing returns to scale.

7. Consider the utility fuction U(x1, x2) = x1 a x b and the budget constraint
m = p1x1 + p2x2. You can assume that a and b are between 0 and 1 and that
a+b=1

a. Explain in plain English and with a graph why the utility maximizing choice
occurs where the slope of the budget line and the slope of the indifference
curve are equal.

b. Derive the optimality conditions associated with part a. for the utility function
using the Lagrangean approach.

c. Solve the ordinary demands x1* and X2* using the budget constraint to pin
down a specific level of demand. (Remember you should solve so that each
good is expressed in terms of prices, income, and preference parameters, not
the other x). Are your demands downward sloping?

d. Rearrange the expression you derived for x1* so that the preference
parameters a, and b, are isolated on one side of the equality. Interpret the
meaning of the expression defined by the preference parameters in terms of
the other variables (x, p, and M).

8. Suppose that the optimality conditions in a consumer choice problem are not
satisfied and the MRS is greater that the ratio of the good prices. Assume also
that the consumer is consuming some of each good and has well behaved
convex preferences. Would the consumer want to adjust their consumption by
increasing x1 or x2? Why? Draw a diagram and show the direction

## 9. Why is using the Lagrangian approach to solve the utility maximization

problem inappropriate when goods are perfect substitutes? Use math, a
graph and in plain English explain your reasoning.

10.Consider the case of concave preferences in which the worse than set is
convex and the better than set is not. Draw an example of an indifference
curve that is smooth that meets the requirements for concave preferences.
Explain why the optimality conditions are relating the marginal rate of
substitution to the price ratio are not helpful for determining optimal choice.
(Hint: draw more than one indifference curve and a budget line).

11.A thirsty fox is walking down a path and sees a bundle of grabs hanging from
a branch of grape tree. The fox tries repeatedly to reach the grapes but is
unable to do so. As he walks away he thinks, those grapes were probably
sour anyway. Explain how his reasoning is inconsistent with the rational
choice diagram.