ECON 50 Proposed Midterm Questions

Fanqi Shi
October 19, 2015

Question 1 (Consumer Problem, Market Demand and Sales Tax)

There are two types of consumers (A and B) and two goods (x and y) in
a perfectly competitive economy. For a typical consumer A, his/her utility
function is given by U A (x, y) = x3 y 2 . For a typical consumer B, his/her utility
function is given by U B (x, y) = x2 y 3 . Both types of consumers have an income
of 1 and the price of good y is fixed at Py . For the following analysis, we focus
on good x.
(a) Write down a typical consumer A and Bs individual demand xA (Px ) and
xB (Px ), respectively (no need to show the derivation).
Suppose there are exactly 121 consumers of each type (A or B) and the
market supply curve is given by X s = Px .
(b) Derive the market demand curve X d (Px ) (from individual demand).
(c) Calculate the market equilibrium price Px and quantity X .
Now suppose as in the real-world, the government charges sales tax on
consumers. The tax rate is fixed at 21% (i.e. If the market-clearing
price for good x is 1, a consumer pays 0.21 to the government for each unit
purchased).
(d) Derive the new market demand curve (X d )0 (Px ) and calculate the new equi-
librium price (before tax) (Px )0 and quantity (X )0 .

(e) Calculate the deadweight loss from sales tax. (Hint: If you do not know
how to evaluate the area, approximate the area by treating the curved line
segment as straight.)

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Question 2 (Kinked Budget Line and Revealed Preference)
Assume Fanqi is a rational consumer (complete, transitive and continuous
preference) with a strictly monotonic preference. His daily income is $100, which
he allocates between two goods x and y. Initially, the prices of x and y are the
same, at $1 each.

(a) Write down Fanqis budget set and show it in a graph. (Be sure not to forget
the non-negativity constraints.)
Suppose for once, we observe Fanqi chooses the bundle (x, y) = (35, 65)
under the initial prices. Now, the suppliers of good x think its price is
too low, but in order not to disrupt the market too much, they adopt the
following pricing strategy: For the first 50 units a consumer purchases, the
unit price of x stays at $1. Beyond that, the price goes up to $2. The price
of good y stays unchanged.
(b) Write down Fanqis new budget set and show it in a graph. (Be sure not to
forget the non-negativity constraints.)

(c) Give an optimal bundle of Fanqi under the new prices. Explain.
(d) Is the bundle you find in part (c) necessarily the unique optimal choice of
Fanqi under the new prices? If yes, explain. If no, provide a counter-example
(of Fanqis preference).

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Suggested Solutions
Question 1
3
(a) Both consumers have the Cobb-Douglas utility, so xA (Px ) = 5Px and
xB (Px ) = 5P2 x .
(b) Notice the demand for both type of consumers are strictly positive for any
Px > 0, so we can apply the horizontal sum without any difficulty. X d (Px ) =
121(xA (Px ) + xB (Px )) = 121
Px .

(c) Setting X d (Px ) = X s (Px ), we get Px = 11 and X = Px = 11.

(d) The effective price (including the sales tax) faced by consumers is (1 + )Px ,
so the new market demand curve (X d )0 (Px ) = (1+ 121 100
)Px = Px . Equating the
new market demand with market supply, we get (Px ) = 10 and (X )0 = 10.
0

(e) (Graph Omitted) The market supply curve represents social marginal costs
and the original market demand curve gives social marginal benefits. De-
spite the sales tax, the true social marginal benefits stay the same, so the
source of deadweight loss is under-production. With this intuition, the dead-
weight loss is given by the region lying between the original market demand
and supply curve where under-production occurs. To evaluate the area, we
need the original inverse demand and supply curve: Pxd = 121 s
X and Px = X.
R X 11
And DWL= (X )0 (Pxd Pxs )dX = 10 ( 121
R
X X)dX = 121 ln(1.1) 10.5
1.03. Alternatively, if we approximate the original demand curve with a
straight line segment for X ((X )0 , X ), we have Pxd ((X )0 ) = 12.1 and
DWL 21 (Pxd ((X )0 ) (Px )0 ) (X (X )0 ) = 21 2.1 1 = 1.05.

Question 2
(a) (Graph Omitted) The budget set is {(x, y) R2+ : x + y 100}.
(b) (Graph Omitted) The new budget set is {(x, y) R2+ : x+y 100, 2x+y
150}.

(c) Notice the new budget set is a subset of the original budget set, but the
original bundle (x, y) = (35, 65) is still affordable. By revealed preference,
it must still be an optimal choice.
(d) No. A counter-example is where x and y are perfect substitutes for Fanqi,
with U (x, y) = x+y. (Notice, if we knew the original bundle (x, y) = (35, 65)
were the unique optimal choice of Fanqi under the old prices, we could
conclude it would still be the unique optimal choice under the new prices.
Nevertheless, revealed preference only sheds light on weak preference.)