ME Problem Set I

PGP 2015-17
(Solutions)

1. 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.

2. Robinsons 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.

P.S.This might be a reason why Robinson Crusoe stayed so many days in that island alone J
He could find himself better off and had no incentive to move out of that island !!

3.

Without the gift certificate, Bobby's budget constraint is indicated by the line segment from
10 books and 0 pizza to 0 books and 50 pizzas (labelled BC1 ). With the gift certificate that
can only be used for book purchases, Bobby still cannot afford anymore than 50 pizzas.
However, she is guaranteed 6 books even if she spends all her money on pizza. Since the
price of books and pizza hasn't changed, the slope of her new budget constraint is the same as
the slope of the old budget constraint. The new budget constraint is drawn above as BC2 .
Note that with the gift certificate, Bobby has an expanded opportunity set and is guaranteed
more of both goods no matter what her original consumption choice on BC1 was. This
implies that Bobby is strictly better-off with the gift certificate.

y
= 4 , and the budget constraint, 4 x + y = 120 ,
x
your initial optimum is the basket (x, y) = (15, 60) with an utility of 900.

4. a)

Using the tangency condition,

b) First we need the decomposition basket. This would satisfy the new tangency
y
condition, = 3 and would give you as much utility as before, i.e. xy = 900 . This gives
x
( x, y ) = (10 3 ,30 3 ) or approximately (17.3,51.9). Now we need the final basket, which
satisfies the same tangency condition as the decomposition basket and also the new budget
constraint: 3 x + y = 120. Together, these conditions imply that (x, y) = (20, 60). The
substitution effect is therefore 17.3 15 = 2.3, and the income effect is 20 17.3 = 2.7.

5. Self-expnanatory !!! It is a normal good !