Solutions to Midterm Exam for Econ 200, Sec.

07
Instructor: Bradley J. Setzler
November 3, 2014
Instructions:
You have from 12:00pm until 1:20pm (80 minutes) to solve the three problems below.
This examination is graded on a 100-point scale, and it is worth 30% of the total course
grade.
Each problem has multiple parts. Any part can be solved without solving the part
before it, so do not give up on a problem if you cannot solve a part of it.
Each part of each problem was solved and explained in class lectures.
All answers should be written neatly on the exam, with very clear labels about which
part of which problem is being solved. If your work cannot be read, it will not receive
points. Write your name on the exam.
You will be monitored closely for cheating, and any cheating results in a grade of 0
points and referral to the Dean of the College for displinary procedures.
Try to spend less than 30 minutes per problem. Budget your time carefully, and good
luck!

1. [30 points total] Consider a consumer with monotonic (increasing) preferences over
x, y, who faces prices px , py and income m.
(a) [5 points] Rewrite the budget in units of x (apples) instead of m (dollars). What
are the units of the new price attached to y (where y is in units of oranges)?
i. [1 point] The budget constraint is m = px x + py y,
ii. [2 points] Since m is in $, x is in apples, px is in $/apple, y is in oranges, py
is in $/orange, then pmx is in apples, x is in apples, and ppyxy is in apples. Thus,
m
= x + ppxy y is in apples.
px
iii. [2 points] The units of

py
px

is ($/orange)/($/apple), or apples per orange.

(b) [5 points] Prove that 1 = sx x + sy y , where x is the elasticity of demand for x

with respect to income, y is the elasticity of demand for y with respect to income,
sx is the fraction of income spent on x, and sy is the fraction of income spent on
y.
i. [2 points] Take the derivative of the budget constraint with respect to m:
dy
dx
dm
= 1 = px dm
+ py dm
.
dm
ii. [3 points] Write 1 =

px x m dx
m x dm

py y m dy
m y dm

= sx x + sy y .

(c) [10 point] If x is a necessity, can we determine whether y is a necessity or luxury?

If so, which is it and why? If not, why not?
i. [2 points] x is a necessity means 0 < x < 1.
x x
ii. [2 points] Since 1 = sx + sy , it follows that y = 1s
.
1sx
iii. [6 points] Since 1 sx x > 1 sx by x (0, 1), it follows that y > 1, so y
is a luxury.
(d) [10 points] Let m = 100. Suppose a consumer chooses x = 10, y = 20 when
px = 2, py = 4. Now, suppose px increases to px = 4, maintaining py = 4. Now,
the consumer chooses x = 4, y = 21, so that the consumer has less x and more y.
Is the consumer better off or worse off when px increases? Why?
i. [10 points] Notice that he could have afforded x = 4, y = 21 before the price
increase, but chose a different bundle, which is no longer affordable after the
price increase. By revealed preferences, the price increase forced him to take
a bundle that he did not prefer to the initial bundle. Thus, he is worse off
(unless he is exactly as well off).

2. [30 points total] Consider a consumer who likes two goods, x, y, facing constant prices
px , py , and income m. Also, suppose preferences satisfy rationality, continuity, monotonicity, and convexity.
(a) [5 points] Write Marshalls problem.
i. [5 points] maxx,y U (x, y) : m = px x + py y
(b) [5 points] Prove that the solution to Marshalls problem satisfies MRS=PR, where
MRS means marginal rate of substitution and PR means price ratio. Hint: Use
the Lagrange method.
i. [1 point] L U (x, y) + (m px x py y).
ii. [2 points ]FOCs: Ux = px and Uy = py .
x
= ppxy .
iii. [2 points] Ratio: UUxy = p
py
(c) [10 points] Show Marshalls problem graphically, demonstrating which line the
consumer moves around to find the optimal bundle, and which line remains
fixed. Remember to label the axes and lines.
i. [2 points] Label x on x-axis and y on y-axis.
ii. [2 points] Label pmx and pmy as x-axis and y-axis intercepts of budget line.
iii. [2 points] Draw a few indifference curves with labels U (x, y) = c for various
c.
iv. [2 points] Label the point at which MRS=PR as Marshallian demand.
v. [2 point] Denote xM and y M at this point.
(d) [10 points] If at the current bundle of consumption (x, y), the marginal rate of
substitution is greater than the price ratio, what would the consumer in Marshalls
problem do and why? Hint: you may explain in terms of selling one good and
using the money to buy the other, but make sure you get the amounts right that
the consumer receives from selling and how much the consumer can buy with it.
(Next page is blank in case you need more space.)
i. [2 points] Suppose you sell a unit of y. This gives you py dollars.
ii. [2 points] With py dollars, you can buy ppxy additional units of x.
iii. [2 points] The locally-approximated marginal gain in utility from
units of x is ppxy Ux .

py
px

additional

iv. [2 points] The locally-approximated marginal cost in utility from 1 lost unit
of y is Uy .
v. [2 points] Since ppxy Ux > Uy by MRS>PR, the marginal gain in utility is greater
than the marginal cost, so he is better off.
vi. [Alternate solution, worth up to 8 points] Since Upxx is utils/$ from buying x
and Upyy is utils/$ from buying y, he can get utils cheaper at the margin by
buying less y and more x.

3. [40 points total] Consider a consumer who likes two goods, x, y, facing prices px , py ,
and income m. Also, suppose preferences satisfy rationality, continuity, monotonicity,
and convexity.
(a) [5 points] State the two duality relationships between the Marshallian and Hicksian demands for x.
i. [3 points, worth more since the next question is about the other] xM (px , py , m) =
xH (px , py , c = V (px , py , m))
ii. [2 points] xM (px , py , m = E (px , py , c)) = xH (px , py , c)
(b) [10 points] Using one of the duality relationships, prove that the cross-price SlutH
M
M
= x
y x
, is true.
sky equation, x
py
py
m
i. [5 points] Take the derivative with the chain rule:

xM (px , py , m) py E (px , py , c)
m

xH
py

(px , py , c) =

xM
py

(px , py , m)

ii. [3 points] By envelope theorem, py E (px , py , c) = py px xH + py y H = y H ,
and y H = y M = y by duality.
M
H
M
iii. [2 points] Rearranging and simplifying: x
= x
+ y x
.
px
px
m
(c) [10 points] Prove that x and y are Marshallian (gross) substitutes if x is an
inferior good. Hint: you may wish to draw a simple graph to justify a claim
H
. Hint: put (+) and (-) signs under the appropriate terms
about the sign of x
py
on the right side of the equation
side will be positive or negative.

xM
py

i. [2 points per sign, 6 points total]

ii. [2 points] Argument for why

xH
py

xH
py

xM
py

y x
in order to see when the left
m

xH
py
(+)

xM
m
(+) ()

gets a (+) sign.

iii. [2 points] Combine results: the right-hand side is positive, so the left-hand
M
side must also be positive, x
> 0.
py
(d) [15 points] In a graph, show the cross-price Slutsky decomposition by indicating
which movement of x is the substitution effect and which movement is the income
effect, assuming x is an inferior good as above. Remember to label the axes and
lines. Label the original bundle A, intermediate bundle B, and final bundle C.
(Next page is blank in case you need more space.)
i. [4 points] Correctly indicate the change in the budget constraint when price
of y increases.
ii. [4 points] Correctly indicate the compensated budget line after price effect,
tangent to original indifference curves.
iii. [4 points] Correctly indicate total effect, from the initial budget line to the
final budget line, with indifference curves tangent to each. Final x should be
to the right of compensated x by inferiority.
iv. [3 points] Correctly label the income and substitution effects and the axes.