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Universidade Nova de Lisboa

Faculdade de Economia
Microeconomics
Mid term
Maria Do Carmo Seabra Date: 5/11/2010
Clara Costa Duarte Duration: 1h30
Doruk Iris
Joo Miguel Silva
Nuno Sobreira
Important announcements
1. Calculators are not allowed, nor any other electronic device .
2. There will be no individual clarifying questions during the exam
3. Any interpretation doubt should be clearly identied on the exam
sheet
Honour Commitment
I declare on my honour that I will not use nor contribute, directly or indi-
rectly, to the use of any fraudulent method on the realization of this test
Signature: _____________________________________________
I (5)
Show that:
1. Indierence curves cannot intersect.
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2. A production function can exhibit increasing returns to scale together
with decreasing marginal productivity in every input.
II (5)
Read the following sentences. State whether they are right, wrong or uncer-
tain and explain carefully your answer.
1."If a demand curve is completely rigid, the substitution and income eects
associated with a price increase are necessarily zero."
2
2. "When marginal productivity is decreasing, it can be higher or lower than
average productivity."
3
III (10)
1. Bernardo (B) and Joana (J) are brothers and sisters who like to consume
bonbons (b) and chocolates (c), but they have dierent preferences on
these goods, which can be represented by the following utility functions,
respectively for Bernardo and Joana:
U
B
(b; c) = (2b +c)
2
and U
J
(b; c) =
2
p
bc
Their father gave them some pocket money (M) for them to go to super-
market to buy the goods as they like, but he warned them to share the money
equally between them,
M
2
= M
B
= M
J
.
a) What type of preferences do these mathematical expressions represent?
Explain.
b) What are the individual demands of each children?
4
c) Given the prices P
b
= 1, P
c
= 1, and M = 48 Euros, how much of goods
b and c will they buy at optimum?
d) Now the price of bonbons has increased to P
0
b
= 4 Euros. What will their
new optimal choices be?
5
e) Their father learned about this price change and does not want the chil-
dren to consume less than what they were initially consuming, so he wants to
compensate them via increasing the pocket money such that they will be able to
buy what they were initially buying. How much should this extra amount be?
What is this compensation called? (After compensation, M
0
B
may be dierent
from M
0
J
)
6
f) After the increase in the pocket money, Bernardo and Joanas mom tells
the father that they may be over-compensating the children. What do you
think? Do you suggest any other way of compensating? Justify (you may
answer intuitively with no additional calculations).
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Solutions:
2)
a) Bernardos demand for bonbons and chocolate: (His preferences are per-
fect substitutes)
b

B
(P
b
) =
_

_
0; if P
b
> 2P
c
_
0;
M
2
P
b
_
; P
b
= 2P
c
M
2
P
b
; P
b
< 2P
c
c

B
(P
c
) =
_

_
0; if P
b
< 2P
c
_
0;
M
2
Pc
_
; P
b
= 2P
c
M
2
Pc
; P
b
> 2P
c
Joanas demand for bonbons and chocolate: (Her preferences are Cobb-Douglas)
b

J
(P
b
) =
1
2
M
2
P
b
and c

J
(P
c
) =
1
2
M
2
P
c
b) Initial Optimal Choices: (Substituting the values into demand functions)
_
b
I
B
; c
I
B
_
= (24; 0)
_
b
I
J
; c
I
J
_
= (12; 12)
c) Final Optimal Choices:
_
b
F
B
; c
F
B
_
= (0; 24)
_
b
F
J
; c
F
J
_
= (3; 12)
d) CV
SLUTSKY
: Lets call the children pocket money separately, M
B
=
M
J
=
M
2
For Bernardo: M
0
B
= 24 4 + 0 1 = 96
CV
SLUTSKY
B
= 96 24 = 72
For Joana: M
0
J
= 12 4 + 12 1 = 60
CV
SLUTSKY
J
= 60 24 = 36
CV
SLUTSKY
TOTAL
= 72 + 36 = 108
e) After the compensation, the optimal choices of the children are changed
while the initial optimal bundles were available. M
0
B
= 96 and M
0
J
= 60
_
b
SLUTSKY
B
; c
SLUTSKY
B
_
= (0; 96)
_
b
SLUTSKY
J
; c
SLUTSKY
J
_
=
_
15
2
; 30
_
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Thus, they are better-o.
CV
HICKS
B
: At new prices, Bernardo consumes only the chocolate.
U
INT
B
= U
I
B
,
2b
INT
B
+c
INT
B
= 2 24 + 0 ,
c
INT
B
= 48 ,
M
0
B
P
c
= M
0
B
= 48 ,
CV
HICKS
B
= 48 24 = 24
CV
HICKS
J
:
U
INT
J
= U
I
J
,
b
INT
J
c
INT
J
= 12 12 ,
_
1
2
M
0
J
P
0
b
__
1
2
M
0
J
P
c
_
= 12
2
,
(M
0
J
)
2
= 4 2
2
12
2
,
M
0
J
= 48
CV
HICKS
J
= 48 24 = 24
CV
HICKS
TOTAL
= 24 + 24 = 48
f) Optimal Choice after CV
HICKS
: Both children doubled their pocket
money. Thus:
_
b
HICKS
B
; c
HICKS
B
_
= (0; 48)
_
b
HICKS
J
; c
HICKS
J
_
= (6; 24)
Substitution Eect (SE):
SE
B
= b
HICKS
B
b
I
B
= 0 24 = 24
SE
J
= b
HICKS
J
b
I
J
= 6 12 = 12
Income Eect (IE):
IE
B
= b
F
B
b
HICKS
B
= 0 0 = 0
IE
J
= b
F
J
b
HICKS
J
= 3 6 = 3
Total Eect (TE):
TE
B
= SE
B
+IE
B
= 24 + 0 = 24
TE
J
= SE
J
+IE
J
= 12 3 = 15
TE = TE
B
+TE
J
= 39
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