ECON306 Intermediate Microeconomics

Fall 2016 (FTU)

Instructor: Dr. Anita Alves Pena
Problem Set 1 Solutions

Working in study groups is highly encouraged. However, problem sets must be written up (on separate
paper from this assignment sheet) and submitted individually. Your final write-up should not look
exactly like that of another student but may share some similarities. Start early. All pages of your
problem set should be stapled, clipped, or otherwise attached together. Please underline, circle, or
highlight any relevant numbers or final solutions to numerical questions. Please submit your answers in
correct numerical order and clearly write your name on the front page of your submission. You will lose
points for not following these directions. The problem set will be graded out of 10 points based on
accuracy and completeness of answers. Half points are possible. Round to two decimal places whenever
relevant.

1. [2 points] (Math Review Topics)

a. What is the critical value for the function f(X)=8X2-32X?
Note that the critical value comes from the first order condition for a maximum or a minimum. The first
order condition is written by setting the first derivative of the function equal to zero. The critical values can
then be solved for by solving the first order condition equation. Here, the first derivative, df/dX, equals
16X-32. (Recall, we can use the power rule and the addition/subtraction rule to get this.) Setting this equal
to zero creates one equation with one unknown, so we can rearrange and solve for the critical value. Here,
16X-32=0 so X=2. (Note that some students extended this to the value of the function at this point. That is
ok for credit here.)
b. For what values of X, is the function in part a increasing?
Recall that to determine whether a function is increasing, decreasing, or constant, we calculate the first
derivative (slope) of the function and compare that to zero for the range that we are interested in. If the
derivative is greater than zero, then our function is increasing. If the derivative is less than zero, then our
function is decreasing. If it is equal to zero, then our function is constant. Since the first derivative, df/dX,
equals 16X-32, to find the Xs for which this is increasing, we set 16X-32>0 which implies that the function
is increasing for all Xs that satisfy X>2. Note that this cutoff is the same as our critical number.
c. What is the partial derivative of f(X,Y)=X2Y-3X+20Y-100 with respect to X?
Using the rules from the calculus handout from class, ∂f/∂X=2X2-1Y-3+0-0=2XY-3
d. What is the partial derivative of f(X,Y)=X2Y-3X+20Y-100 with respect to Y?
∂f/∂Y=X2(1)Y1-1-0+20-0=X2(1)Y0+20=X2+20.

2. [2 points] Suppose that the price of a textbook was $150 in 2000 and is now $220 in 2016. Suppose
further that the CPI in 2000 was 100 and the CPI today in 2016 is 110.
a. What is the real price of the 2016 textbook in 2000 dollars? Show your work.
The real price of the 2016 textbook in 2000 dollars is (100/110)*220=200.
b. Has the real price of this textbook increased or decreased between 2000 and 2016? Clearly specify
your conclusion and indicate which specific numbers that you are comparing for full credit.
This indicates that the real price of the textbook has increased substantially over time. We can see this by
comparing $200 (the value of the 2016 textbook in 2000 terms) to $150 (the value of the 2000 textbook in
2000 terms).
c. Now suppose that textbooks cost $180 in 2016 anywhere that you purchase them in the U.S. Suppose
that the 2016 CPI is 125 in New York City but only 105 in Fort Collins. What is the real price of a
textbook purchased in New York City in 2016 expressed in Fort Collins terms? Show your work.
The real price of a New York City textbook expressed in Fort Collins based dollars is
(105/125)*180=151.20.
d. Is the real price of this textbook higher or lower in Fort Collins? Clearly specify your conclusion and
indicate which specific numbers that you are comparing for full credit.
Note that we would expect a lower number in Fort Collins given the lower cost of living here, but the
problem assumes that the same price is charged anywhere. As a result, the real price of the New York City
book in this problem is lower than the Fort Collins one.

3. [3 points] Suppose that you own a company and that the aggregate demand for your product can be
written as: QD = 8,000 – P + 10P1 – 50P2 + 0.02I where P is the price of your product, P1 and P2 are prices
of related goods (which we will refer to as related goods 1 and 2), and I is income. Further suppose that

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the price of your product (P) is $100, the prices of related goods (P1 and P2) are $20 and $30 respectively,
and income is $100,000.
a. What is the cross-price elasticity for related good 2? Show your work and round your calculation to
two decimal places if necessary.
At these prices and income, quantity is 8,000 – 100 + 10(20) – 50(30) + 0.02(100,000)=8,600.
The cross price elasticity for related good 2 is: (P2/QD)(ΔQD/ΔP2)=(30/8,600)(-50)≈ –0.17.
b. Describe what the magnitude of your answer to part a means verbally. (i.e. What positive (as opposed
to normative) economic relationship is the value that you calculated telling you? Be precise.)
This means that you would expect a one percent increase in the price of related good 2 to be associated with
a 0.17 percent decrease in the quantity demanded of your product.
c. Indicate whether the relationship in part a is inelastic, elastic, or unit elastic. Explain why.
This relationship is inelastic since a 1 percent change in price of one good is associated with a less than 1
percent change in quantity demanded of another.
d. Are your product and related good 2 substitutes or complements? Explain your answer using an
argument based on microeconomic theory.
Your product and related good 2 are complements given this demand function. We know this because as
the price of related good 1 increases, the quantity of your product demanded decreases. An equivalent
answer for credit could be based on the negative cross-price elasticity in part a. Again, note that the
complements relationship (like substitutes) is one between the price of one good and the quantity of another
and therefore answers based on two prices or two quantities are not acceptable here. Also note that answers
without explanation are not acceptable here.
e. What is the equation for the inverse demand curve at the current prices of goods 1 and 2 and current
income?
Sub in for prices of the related goods and for income, Q=8,000 – P + 10(20) – 50(30) +
0.02(100,000)=8,700-P.
Rearranging, P=8,700-Q
f. What is the “choke” price for this demand curve?
When Q=0, price from demand is: P=8,700

4. [3 points] An agent’s utility function is written as U(X,Y) = 2X + 20Y. The price of good X is 2, the price of
good Y is 10, and income is 500.
a. Which special case of the utility function applies here? Provide the name of this case or describe the
shape of the indifference curves.
This is an example of a perfect substitutes indifference curve/utility function. Note that this additive form
of the utility function corresponds to straight line indifference curves in (X,Y) space.
b. What is the marginal utility of X? What is the marginal utility of Y? What is the marginal rate of
substitution of X for Y? Give indication as to how you are finding your answers.
Using partial derivatives,
U
MU X  2
X
U
MU Y   20
Y
MU X 2
MRS XY    0 .1
MU Y 20
c. What are the optimal amounts of X and Y? (In other words, what are the quantities of X and Y that
maximize utility?) How do you know?
The budget constraint can be written 2X+10Y=500. The slope of the budget constraint is negative the price
ratio of good X over good Y. Here, this is -2/10 or -0.2. Another way to see this is to rewrite the budget
constraint in point-slope form, Y=50-0.2X. The slope is the coefficient on X, which is -0.2. In absolute value
form, this is 0.2. (Note that you could also graph the budget equation line and use the rise over run slope
formula to calculate slope.) Since the convention in economics to flip the MRS to a positive expression, we
likewise do the same for the slope of the budget constraint when solving for an interior optimum. The
question therefore asks for this slope in absolute value form which is positive.
There are three optimum possibilities for the perfect substitutes case. Possible solutions are the two corners or
the entire budget set (for the case that the slope of the indifference curve and the slope of the budget constraint
are exactly equal). Here the slope of the indifference curve written as a positive number is 0.1 (MRS), and this
does not equal the slope of the budget constraint in absolute value (price ratio, also written as a positive
number) of 0.2. Since the indifference curve set is shallower in slope than the budget constraint, the solution is

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 a corner solution where the consumer consumes all good Y and no good X. To determine the number of units
of good Y (required for full credit here), we can use the budget constraint to see what’s affordable. Since
2X+10Y=500 and at the relevant corner X=0, Y=50.
d. Suppose instead that the agent’s utility function is written as U(X,Y) = X0.75Y0.25. Which case of the
utility function applies here? Provide the name of this case or describe the shape of the indifference
curves.
This is an example of a Cobb-Douglas indifference curve/utility function. Note that this multiplicative form
of the utility function corresponds to convex (curved) indifference curves in (X,Y) space.
e. [this subpart is worth 1 point, others are 0.5] What are the optimal amounts of X and Y if the agent’s
utility function is as given in part d above? (Assume that prices and income are as given in the setup of
the problem.) Show your work.
The Lagrangian equation is Φ=X0.75Y0.25-λ(2X+10Y-500)
To find the optimal consumption of each good, maximize the Lagrangian equation with respect to X,
Y and λ, which is the same as maximizing utility subject to the budget constraint. The necessary
conditions for a maximum are
(1)∂Φ/∂X=(0.75)X-0.25Y0.25-2λ=0
(2)∂Φ/∂Y=(0.25)X0.75Y-0.75-10λ=0
(3) ∂Φ/∂λ=-2X-10Y+500=0
Combining conditions (1) and (2) results in
λ=(0.75)X-0.25Y0.25/2=(0.25)X0.75Y-0.75/10, or 3Y/2=X/10 or 15Y=X (4)
Now substitute (4) into (3) and solve for Y.
2X+10Y=500
2(15Y)+10Y=500
40Y=500
Y=12.5, X=15(12.5)=187.5.
Notice that we can also solve this the short-cut way.
MUX=∂U/∂X=(0.75)X-0.25Y0.25 and MUY=∂U/∂Y=(0.25)X0.75Y-0.75.
Then, MRSXY=MUX/MUY=(0.75)X-0.25Y0.25 /(0.25)X0.75Y-0.75=3Y/X.
At an interior optimum, we know that MRSXY=PX/PY
Subbing in for both sides: 3Y/X=2/10.
Cross-multiply: 30Y=2X or 15Y=X.
We can sub this for X into the budget line (the other equation with two unknowns) to solve.
The budget line is: 2X+10Y=500
So again,
2(15Y)+10Y=500
40Y=500
Y=12.5, X=15(12.5)=187.5.
Thus, we get the same answer without using the full Lagrangian method.