UNIVERSITY OF TORONTO SCARBOROUGH

DEPARTMENT OF MANAGEMENT
ECMB02: Price Theory: A Mathematical Approach
Fall 2010

Instructor: A. Mazaheri
Test-1 (Solutions)
Instructions: This is a closed book test.

You have 2 Hours.

Good Luck!
Last
Name:
First
Name:

ID

FOR MARKERS ONLY:

Q1

Q2

Q3

Q4

Q5

Total

38

13

15

24

10

100

Marks
Earned
Maximum
Marks
Possible

Page 1 of 1

Answer all following 5 questions:

Question-1 [38 Points] Answer the following Short Questions:
a) [4 points] The price of laptop computers has dropped dramatically in the last two decades
while the quantity sold has risen substantially. Use a demand and supply framework to show
why? Briefly comment.

Answer: Demand has shifted out (increased) rather dramatically but due to lower cost of
production, the supply has shifted out (increased) even more dramatically.
b) [4 points] Using the following graph, what can you conclude about the relation between X and
Y?
Answer: X & Y are complement since a change in the price of X leads to an increase in
demand for Y.
Y

Price-consumption Curve

Page 2 of 2

c) [8 Points] Graph the indifference curves for the following two cases:
i) (4 Points) Mary does not care whether she has two cups of tea or one cup of coffee or any
combination thereof. Graph two representative indifference curves for Mary.
Perfect Substitute:
Coffee
2

Tea
2

ii) (4 Points) Ali does not want more than three cups of tea a day. If he is given more than that he
will pour it down the drain. Graph his indifference curves.
Everything else

Tea

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d) [9 Points] Kumar likes Hamburger and he likes it with 2 cans of Coke only. Hamburger costs
$2 and Coke costs $1 a can and Kumar has $20 to spend on Hamburger & Coke. On the graph
below, draw Kumars budget line and at least two of his indifference curves. Label the lines
appropriately and identify the values of the intercepts.
Hamburger

10
(10,5)

20

Coke

Find Kumars optimal consumption choice? That is, how many hamburgers and cup of coffees
maximize his utility? Identify his optimal consumption on the graph above.
If price of Coke increases to 2, what would be the income effect?

Solution:

U = min{Y, 0.5X} or U = min{2Y, X}

Y = 0 .5 X
20 = X + 2 Y
=> 20 = X + 2(0.5X)
=> X = 10, Y = 5
If the price X rises to 2 the demand of the X declines to:

20 = 2 X + 2(0.5X)
=> X = 20 / 3
There will be no SE, the TE = 10-20/3 is equal to IE as well.

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e) [6 Points] Alexandria is a vivid coffee drinker. Her daily income is $10, the price of coffee
(X) is $1 and the price of everything else (Y) is $2. Star$ where Alexandria buys her coffee
from has offered her a special deal. If she buys two cups at a regular price the third cup will be
free and any additional cup after that will be at 50% discount. (i.e. she pays $1 for the first two
cups, nothing for the third cup and 50 cents for anything more)
Illustrate her budget line in the following diagram. Make sure you label all the points.

Everything Else

Coffee
2

19

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f) [7 Points] Assume a utility function that is given by U(x,y) = xy. Further assume a budget of
$40. When the prices where Px=2 and Py=1, you consumed x= 10 and y = 20, while when the
prices changed to Px=1 and Py=1, you consumed x = 20 and y = 20.
Numerically find and then use the following diagram to graph the substitution effect and the
income effect of this price change on the purchase of x.

1 : U = 10 20 = 200 = xy
y 1
= => y = x
x 1
(1), (2) => 200 = x x => x = 14.14
2 : MRS =

SE = 14.14 10 = 4.14
IE = 20 14.14 = 5.86
Graphically:
y
40

20

SE

IE

x
10

14.14

20

40

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Question-2 [13 Points] Suppose that the short-run world demand and supply elasticities for
Gasoline are -0.076 and 0.088, respectively. The current price per liter is 30 cents (you wish) and
the short-run equilibrium quantity is 23.84 Billion litters per year.
a) (8 Points) Derive the linear demand and supply equations.
b) (5 Points) Suppose as a result of a government policy the demand for gasoline declines by 1%.
What would be the new equilibrium price?
Solution: If the demand curve is linear, it is in the form of
Qd = a + bP Also, we know that E = b P/Q b = E QP = -0.076 (23.84 / 30) = -0.060.
Rearranging the linear expression for demand allows us to solve for a as follows:
a = Qd - bP a = 23.84 + 0.060(30) = 25.640.
We may now write the linear expression for demand as Qd = 25.640 - 0.060P.
If the supply curve is linear, it is in the form of
Qs = c + dP. Also, we know that E = d PQ d = E QP = 0.088 (23.84/30) = 0.070.
Rearranging the linear expression for demand allows us to solve for c as follows:
c = Qs - dP c = 23.84 - 0.070(30) = 21.740.
We may now write the linear expression for supply as Qs = 21.740 + 0.070P.

b)
New demand = (0.9)Qd = (25.640 - 0.060P)(.99)
Qd = 25.384 0.0594P
Equate Qd to Qs to get new equilibrium price.
25.384 0.0594P = 21.740 + 0.070P
P* = 28.158 Per litre

Page 7 of 7

Question-3 [15 Points] Jane consumes two goods, X and Y. She has a utility function given by
the expression:
U = 2X0.5 + Y0.5
The current prices of X and Y are 40 and 20, respectively.
Jane currently has an income of 900 per time period.
a) (4 Points) Calculate the optimal quantities of X and Y that she should choose, given her budget
constraint.
b) (6 Points) Suppose that the government rations purchases of good X such that Jane is limited
to 12 units of X per time period at a price of 30. Assuming that she chooses to spend her entire
income, how much Y will she consume? Is she better off with or without rationing?
c) (5 Points) Illustrate your solution on a clearly labeled graph.
Solution:
a)

MRS =

X 0.5
2Y 0.5 PX 40
=
=
=
0.5Y 0.5
X 0.5
PY 20

1)Y = X
2)900 = 40 X + 20Y = 40 X + 20( X ) = 60 X
=> X = 15, Y = 15
b)

2Y 0.5 30
=
= 1 .5
X 0.5 20
1)Y = 0.752 X
MRS =

2)900 = 30 X + 20(0.752 X ) = 41.25 X

=> X = 21.82, Y = 12.27
But the constraint is binding therefore she will consume 12 units of X:
900 = 30*12+20Y=> Y = 27
Her initial utility is:
U initial = 2X 0.5 + Y 0.5 = 2 150.5 + 150.5 = 11.62
Her utility with rationing is:
U ration = 2 12 0.5 + 27 0.5 = 12.12
better off with rationing.

Page 8 of 8

c) Graph

45

Post ration U=12.12

>
27

Initial U=11.62

15

12

15

22.5

30

Page 9 of 9

Question-4 [24 Points] Kumar has the following utility function: U ( x , y ) = 8 x 1 / 2 + 2 y . Let px
and py be the corresponding prices and I his income.
a) [6 Points] Setup the Lagrangian function and find the first order conditions (FOCs). Use these
FOCs to find the expression for the marginal rate of substitution (MRS). Do you see anything
specific about this MRS.
Solution:

L = 8 x1 / 2 + 2 y ( p x X + p yY I )
L
= 4 x 1/ 2 p x = 0
x
L
= 2 p y = 0
y
L
= ( p x X + p y Y I ) = 0

p
2 x 1 / 2
2
= 1/ 2 = x = MRS
x
py
1
MRS does not depend on y. Which means y can be any number including zero and negative
=>The indifference curve can cross the horizontal axis.

Page 10 of 10

b) [8 Points] Find the demand functions for x and y. Find the optimal bundle if px=1and py=1and
I =1. Graph your solution.
Solution:

2 py
2 x 1 / 2 p x
=
=> x =
1
py
px

Demand for x = 4
2 py
I p x
I px x
px
Demand for y =
=
py
py

= I 4 py
py
px

But with current prices and income => y < 0.

More specifically if x = 4 then y = -3 which is not possible
Therefore this a corner solution
=> y = 0, x = 1. (3 Points for the graph)
Note: The graph is not up to the scale

-3

Page 11 of 11

c) [5 Points] Graph the Income-consumption and the Engle curve for x. Briefly explain your
findings.
y

I-C Curve

x
4

Engle Curve
I

x
4

He consumes all his money if he has less than $4 (corner solution). Thereafter, he only
consumes 4 units.

Page 12 of 12

d) [5 Points] Suppose instead Kumars income is $20 and not $1 as we had earlier. If the price of
x rises from $1 to $2, what would be the substitution and the income effects on x?
Solution:

2 py
x =
px

2
=> x = = 1
2

His consumption of x drops from 4 to 1. There is no income effect therefore all the change would
be due to the substitution effect.

Page 13 of 13

Question-5 [10 Points] Individual Female and Male demand for breakfast at the popular restaurant
Cora is

d
d
Q Female
= 18 3P , and Q Male
= 24 6 P respectively. Suppose there are 1000 individuals

equally distributed between females and males. Derive the total market demand curve for breakfast
and illustrate the market demand on the following graph. Make sure to clearly label your graph.

Solution:
At prices below $4 the market demand is:
d
d
Q M = 500Q Female
+ 500Q Male
= 500{(18 3P ) + ( 24 6 P )} = 21000 4500 P .

But demand seizes to exist when the price is 6 for females and 4 or more for males. Therefore,
when the price is less than 4 both are in the market and the demand will be what we wrote while
when the price exceeds 4 only females will be in the market therefore:

Q M = 500(18 3P ) = 9000 1500( P > 4)

Q M = 21,000 4500 P ( P 4)

3000

21000

Page 14 of 14