Problem Set 2 P2.1.

Caesar is offered a choice between 12 loaves of bread and 5 circuses, or 9 loaves of bread and 20 circuses a. Suppose that all you know about Caesar is that his preferences are complete, transitive, and satisfy the assumption of local non-satiation. On the basis of this information alone, can you predict which bundle he will prefer? b. A utility function is a rule that indicates the amount of satisfaction (utility) associated with any bundle of commodities. For example, if an individuals utility function, U, for bread (B) and circuses (C) is U = BC2, then his utility when he consumes 5 loaves of bread and 2 circuses is 20. Suppose that BC2 is in fact Caesars utility function. With this information, can you predict which bundle in part a) he will prefer? c. Find 3 bundles that yield the same amount of utility as the bundle that Caesar prefers. Use this information to sketch one of Caesars indifference curves. P2.2 . Calpurnia is indifferent among the following market baskets: a. b. c. d. e. 15 pounds of cheese and 1 bottle of wine 8 pounds of cheese and 2 bottles of wine 5 pounds of cheese and 3 bottles of wine 2 pounds of cheese and 6 bottles of wine 1 pound of cheese and 10 bottles of wine

i. Graph these points on a diagram with pounds of cheese on the horizontal axis and bottles of wine on the vertical axis, and draw an indifference curve through them. ii. Suppose wine costs $5 per bottle and cheese costs $3 per pound, and Calpurnia has $30 to spend on wine and cheese during this time period. Show graphically which bundle she will choose. iii. At this bundle, what is her marginal rate of substitution? iv. Suppose the price of wine falls to $3 per bottle and the price of cheese rises to $6 per pound. How much wine and how much cheese does she buy? Now what is her marginal rate of substitution? P2.3. A production possibilities curve is simply societys budget constraint. Explain the logic of this statement. We generally draw an individuals budget constraint as a straight line while the production possibilities curve is drawn bowed outward from the origin. What accounts for the difference? Under what conditions is an individuals budget constraint similarly bowed outward from the origin? P2.4. Figure 2.4 shows several of Cascas indifference curves for meat and all other goods. His budget is $120. The price of all other goods is $1. The price per pound of meat is $4. Sketch Cascas budget constraint, and predict how much meat he will purchase. Now repeat the exercise when the price per pound of meat is $6, and when it is $12. Use the information to sketch Cascas demand curve for meat in the bottom panel. [Note: Two copies of Figure 2.4 are included in the packet. Rip out one of them and hand it in with your work on it.]

P2.5. In some communities water is priced according to a two-tiered declining block method. According to this scheme, an individual pays an initial minimum charge, which entitles her to a specified quantity of water. After she exceeds this specified quantity of water, she is subject to declining block pricingas more water is purchased, the price per gallon drops. a. In a diagram with gallons of water on the horizontal axis and all of other goods on the vertical, sketch the budget constraint associated with this scheme. (You do not have enough information to know the exact slope and intercepts. Just sketch a constraint that is generally consistent with this scheme.) b. Given that an individual has paid the initial minimum charge, do you expect her to consume less than the amount to which the minimum charge entitles her? To answer this question properly, you need to superimpose some indifference curves on the same diagram as the budget constraint. According to your diagram, can an amount less than that to which the minimum charge entitles the individual ever be part of a utilitymaximizing bundle? P2.6. For Livia, coffee and tea are perfect substitutes: One cup of coffee is equivalent to one cup of tea. Suppose Livia has $90 per month to spend on these beverages, and coffee costs $0.90 per cup while tea costs $1.20 per cup. Find Livias best affordable bundle of tea and coffee. How does the equilibrium condition differ from the condition we derived in lecture for the typical case? How much could the price of a cup of coffee rise without harming her standard of living? P2.7.This question is multiple choice. Explain your answer briefly.
I like olives. Artichokes, on the other hand, dont do much for me one way or another (i.e., they neither increase nor decrease my utility). My indifference curves between olives (0) and artichokes (A) look like:

A. B. C. D. E.

(i) (ii) (iii) (iv) (v)

P2.8. After the terrorist attack of 9/11, the United States dramatically increased its spending on homeland security. Assuming the political process followed the wishes of the people, what in our model of individual choice can explain the publics wish for more spending on security? Put security spending on the horizontal axis of the graph and all other goods on the vertical axis and describe what happened to move the optimal market basket toward further security goods consumption. Distinguish between possible changes in the budget constraint and possible changes in the indifference map.

. P2.9 Read the entry Free Lunch Thinking at Harvard from Greg Mankiws blog that is reproduced below. Implicitly, Mankiw is suggesting that Harvards administration doesnt really care about teaching quality. That is, for a given amount of research quality, utility is not increased by additional units of teaching quality. Consider a diagram with teaching quality on the horizontal axis and research quality on the vertical axis. Assuming that Mankiw is correct, sketch the indifference map of Harvards administrators.

Free Lunch Thinking at Harvard "There is no such thing as a free lunch" is as good a slogan as any I know. Whenever I hear someone propose a reform and suggest that it does not involve any costs, my first reaction is to think that they aren't being honest. Life is full of hard tradeoffs. If you think otherwise, you probably haven't thought enough. I see some students being lulled into free lunch thinking when discussing raising wages of lowincome workers at Harvard. Even putting aside any possible adverse side effects of aboveequilibrium wages, advocates of higher wages need to confront the real question of limited resources. If Harvard is to raise wages above the going market levels, the money to pay those wages has to come from somewhere, such as higher tuition, less financial aid, or fewer faculty. Saying "Harvard has a large endowment" is not an answer--the endowment represents future spending on items the university values. Harvard administrators are lulled into free lunch thinking when discussing teaching quality. An article in yesterday's NY Times offers this insight into the issue: The aim of the report is not to de-emphasize research in any way, but to bring about a greater institutional focus on teaching, Professor Ulrich said. This is not a report that says were going to hire teachers who are not also scholars, she said. We want both. But better teaching is not a free lunch. If the university puts more weight on teaching in its hiring and promotion decisions, it must put less weight on research. Sure, there are some scholars who are great at both activities, but those are not the marginal hires. You will know the university is serious about increasing teaching quality when it says it is willing to hire scholars with less distinguished research records in order to get better teachers, or when it says it will spend more money to compete more vigorously with Princeton and Yale for the best professors (and tells you where that money will come from). But unless the university says it is willing to confront the hard tradeoffs, it is just posing.