6.1 Finding demand-function from price elasticity.

“The Travel-King” is a small travel agency operating out of Copenhagen

selling weekend skiing trips to Sweden. It is charging DKK 4.000 for a trip.
It rents the busses including the driver in the period January to March.
Besides the winter season there is no activity in the firm. It estimates the
price elasticity to be (minus) 2.

It had the following Profit & Losses (P&L) for 2017:

Revenue: 4.000.000
Salaries: 2.000.000
Bus rental: 1.000.000
Hotels etc.: 1.000.000
Profit: 0

a) What is the inverse demand function?

To find the inverse demand function we need to use the point price elasticity
formula so we can solve for the direct demand’s slope

∂Q ∂Q
∗P ∗4000
∂P ∂P
ε P= −2=
Q Q

To get Q we look at the revenue and divide it by how much they charge each
person, to know how many people payed

4000000
Q= =1000
4000
Now
∂Q
∗4000 ∂Q
∂P −2= ∗4
−2= ∂P
1000

So now we solve for the slope of the direct demand

−2 ∂Q −1 ∂Q
= =
4 ∂P 2 ∂P
And to get the inverse demand we just flip it
−2 ∂ P
=
1 ∂Q
M= -2
Q= 1000
P= 4000
P−4000=−2 ( Q−1000 ) P=−2Q+6000

b) Which component(s) from the P&L are variable?

Bus and hotel.
We can assume that the salaries are not dependent on Q, which makes them
fixed. The bus and hotel would depend on Q, and therefore would be
variable.

c) If the current price is optimal, what is then MC?

If the current price is optimal and the price elasticity is minus 2, then:

MC MC
P¿ = 4000=
1 1 4000∗0.5=MC MC=2000
[ ( )]
1+
εP [ ( )]
1+
−2

And since at the optimal point MR=MC, MR is the also 2000

6.2 Utility Maximization, Income and Substitution effects.

A consumer has a utility function: 𝑈(𝑋, 𝑌) = 𝑋 ∗ 𝑌 and a budget

(B,Px,Py)=(8,1,1).

U ( X , Y )=X a∗Y b
Find the combination (X,Y) that maximize utility given the budget
constraint

8=X +Y U =X∗Y

Equal slopes, or just find the point where they intersect

a b
∗B 1 ∗B 1
a+b x= ∗8 x=4 a+b y= ∗8 y=4
x= 2 y= 2
Px Py

So (4,4) A will have utility:

U ( 4 , 4 )=16

Draw the indifference curve and the budget line in Excel

 16
16=X∗Y Y =
X

8=X +Y Y =8− X

UTILITY MAXIMIZATION
18

16

14

12

10
GOOD Y

B8
8 UTILITY 16

0
0 1 2 3 4 5 6 7 8 9
GOOD X

The price of X increases to 𝑃𝑋 = 4

c) How much should the Budget (B) increase to make the consumer
equally good off?
(Hint: what are the general solutions X* and Y* to a maximization problem
when we have a Cobb-Douglas Utility function)

8=4 X +Y Y =8−4 X
1
∗8
2 x=1(1,4)
x=
4

We want to find were the budget line and the indifference curve intercept:

−M U X −M U Y
= M U X = yM U Y =x
PX PY

− y −x
= → y=4 x <- this means that the budget line and the
4 1
utility function will meet whenever y=4x

We have (1,4)
 This combination is the new equilibrium when the price of x
increases to 4 (this combination is on a new utility curve)

4
U =4 Y =
X

Now, we have to draw the parallel line with the same slope of the
new budget line that intersects with the original utility function
(to make the consumer equally good).

The utility function that we want to reach is x∗y =U 1 → 4∗4=16

x∗y =16

The parallel line has the equation y=4 x

Now, we can substitute these two functions and solve for x and
y.

x∗4 x=164 x2 =16x 2=4 x=2 → y =8

The new hypothetical budget is:

y− y1 =m ( x−x 1 ) y−8=−4 ( x−2 ) y=−4 x +8+8 y=−4 x +16 16= y +4 x

The new budget is 16

U =2∗8=16

d. Show the new equilibrium on Excel

 CHANGE IN BUDGET AND SAME UTILITY FOR MORE EXPENSIVE GOOD

14

12

10
B8
8 UTILITY 16
GOOD Y

UTILITY 4
6 NEW BUDGET
H BUDGET
4

0
0 1 2 3 4 5 6 7 8 9

GOOD X

The price of X decreases to 𝑃𝑋 = 0,25

e) Calculate the new combination (X,Y) that maximize utility

given the budget constraint

8= y +0.25 xY =8−0.25 X

1
∗8
2 x=16
x=
0.25

(16,4)

64
U =6464=X∗Y Y =
X

f) Calculate the total effect of the price change on the quantity of

X consumed
 UTILITY MAX. FOR CHEAPER GOOD X

14

12

10

Original B
8
GOOD Y

UTILITY 16
NEW BUDGET
6 UTILITY 64
B
4 A

0
0 5 10 15 20 25 30 35

GOOD X

When price decreases from 1 to 0,25 then the total effect is 12 (16-
4). This is the difference between point B and point A.

g) Calculate the substitution and income effects on the quantity

of X consumed
Is X a normal or inferior good?

We want to find were the budget line and the indifference curve
intercept:

−M U X −M U Y Y X
= = y=0.25 x
PX PY 0.25 1

In order to find the substitution and income effect, we need to draw a

line that is parallel with the budget line of the decreased price but
intersects with the utility 16 function.

We know from the previous question that the decreased price budget
line will intersect with a utility function when y=0.25x

We substitute this Y in the utility function

16=x∗y16=x∗0.25 x16=0.25 x264=x 2 x=8 y=2
And since it has to have the same slope:
y−2=−0.25 ( x−8 ) y=−0.25 x + 4

SUBSTITUTION AND INCOME EFFECTS

14

12

10
Original B
8 UTILITY 16
GOOD Y

NEW BUDGET
UTILITY 64
6
H. BL
A B
4

0
0 5 10 15 20 25 30 35

GOOD X

Substitution effect: 8-4=4 (from point C to A) – comparing different

combinations in the same utility

Income effect: 16-8=8 (from point B to C) – comparing consumption with

different budgets

e) Is X a normal or inferior good?

X is a normal good because when price falls the consumer buys more of x.

Either by substituting some y for more x, or just buying more x and

achieving a higher utility.

The consumer increases the consumption of x with an increase in income,

which means that it is a normal good.