Answer Keys (ME-2018 Problem Set-I)

1.
(a)

(b)

(c)

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2.

Individual A has relatively flat indifference curves, since A requires relatively large numbers
of coconuts to compensate for the loss of pineapples that she values highly.

Individual B has relatively steep indifference curves, since B requires relatively few coconuts
to compensate for the loss of pineapples that he does not value highly.

C's indifference curves are vertical; the level of satisfaction is affected only by coconuts.

D's indifference curves are horizontal; the level of satisfaction is affected only by pineapples.

E's indifference curves are L-shaped.

MRS measures (at the margin) the maximum number of pineapples that the consumer will be
willing to give up in order to get one more unit of coconuts.

A's MRS is low. A is willing to relinquish few pineapples relative to coconuts since
pineapples are dear to A.

B's MRS is high, for the opposite reason.

C's MRS is infinite. Since C's utility is not affected by pineapples, she is willing to relinquish
all pineapples (an infinite number) to obtain additional coconuts.

D's MRS is zero. D is not willing to give up any pineapples to obtain additional coconuts.

E's MRS is infinite when Qp > Qc, zero when Qc > Qp, and undefined when Qc = Qp.

3. These preferences do not exhibit a diminishing marginal rate of substitution since

consumers are always willing to substitute the same amount of store-brand sugar for an
additional pound of producer-brand sugar.

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4. The two graphs are shown below. It can be seen from both graphs that this function does
not satisfy the law of diminishing marginal utility. The first figure shows that utility increases
with x, and moreover, that it increases at an increasing rate. For example, an increase in x
from 2 to 3, increases utility from 12 to 27 (an increase of 15), while an increase in x from 3
to 4 induces an increase in utility from 27 to 48 (an increase of 21).
This fact is easier to see in the second figure. The marginal utility is an increasing function of
x. Higher values of x imply a greater marginal utility. Therefore this function exhibits
increasing marginal utility.

U(x) = 3x2

MUx = 6x

5. When the consumer maximizes utility, his optimal consumption basket will be on the
budget constraint and satisfy the tangency condition.
Any basket on the budget line will satisfy Pxx + Pyy = I, or 2x + 5py = 40.
The tangency condition requires that MUx / Px = MUy / Py, or that 5 / 2 = x / Py. This implies
that 5Py = 2x.
Putting these two equations together reveals that 5Py + 5Py = 40; thus Py = 4.

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6. This question cannot be solved using the usual tangency condition. However, you can see
from the graph below that the optimum basket will necessarily lie on the “elbow” of some
indifference curve, such as (5, 3), (10, 6) etc. If the consumer were at some other point, he
could always move to such a point, keeping utility constant and decreasing his expenditure.
The equation of all these “elbow” points is 3x = 5y, or y = 0.6x. Therefore the optimum point
must be such that 3x = 5y.
The usual budget constraint must hold of course. That is, 5 x  10 y  220 . Combining these
two conditions, we get (x, y) = (20, 12).

(20,12)

(10,6)
(5,3)

x
7. Robinson’s initial budget constraint is BC1 on the diagram below. Since His
indifference curves are always flatter than her budget constraint, he will consume all
coconuts. Thus, he gathers and consumes 64 coconuts. When his neighbor arrives
and offers the exchange, his budget constraint becomes BC2. It is now optimal for
him to gather all bananas and exchange them 1 for 1 with his neighbor for coconuts.
This gives him 128 coconuts to consume. This brings him to the higher indifference
curve I2. Robinson is better off.

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8. Gift cards are not merely a fad. Retailers experience significant benefits from gift
cards since they minimize product returns; independent of whether the good is normal
or inferior. Gift cards can also benefit consumers. A gift card does not impact the
amount purchased for one good (say the good on the Y axis), but shifts out the budget
constraint for the other good (the good on the X axis) by the face value of the gift
card. The expanded budget constraint permits the consumer to reach a higher
indifference curve; resulting in greater utility.