1.

a) The consumers budget constraint is

The consumers problem is stated as
Max U(

)=

S.T
We formulate a langrage of the form

Obtaining first order conditions

.(1)

..........(2)

..(3)
b)
From 1 and 2
From 1

(4)
From 2

(5)
Equating 4 and 5

This function can be rewritten as

Simplifying the LHS function

Making

the subject

Making

the subject

Next, we substitute these values of

Substituting

and

into equation 3, one at a time.

Multiplying through by 2
2
3

(demand function for

Substituting

(demand function for

c) If p1 = p2 = 10 and I = 600, then the optimal levels of

At the optimum level, utility is given by

and

will be

U(

)=

U(

)=

U(

)=

The utility function therefore becomes

On the other hand, the budget constraint becomes

graphing the budget constraint with X2 on the vertical axis and X1 on the
horizontal axis, we can generate at least two points as follows.
0
60

40
20

60
0

d) If p2 = 20 (still p1 = 10 and I = 600), the optimal values become

The budget constraint changes to

The new coordinates are

0
30

40
10

60
0

The utility function becomes

U(

)=

U(

)=

U(

)=

The following graph shows the effect of the change

When the price of X2 doubles, consumers consume less of this commodity

and more of X1. This is shown through the substitution effect. The higher price of
X2, lowers the purchasing power of the consumer thus causing an inward shift in
their budget constraint.
e) If income increases to 1,200, then the optimal solution becomes

The budget constraint changes to

0
120

80
40

The utility function becomes

U(

)=

U(

)=

U(

)=

120
0

Doubling the income of the consumer means that he/she consumes twice as much
for each product at a particular price level. This causes the budget line to shift
outwards thus interacting with a higher indifference curve.
2.
a) The consumers budget constraint is
The consumers problem is stated as
Max U(x1, x2) = ln x1 + x2
S.T
We formulate a langrage of the form

Obtaining first order conditions

.(1)

..........(2)

..(3)

b) From 2,

Replacing in 1

( optimal value/demand function of

Replacing

into equation 3

(( optimal value/demand function of

c) If p1 = 10, p2 = 50 and I = 100

The Budget line has the equation

0
2

5
1

10
0

The optimum level of utility is

= 2.6094
2.6094=

d) If price of good 2 increases, becoming p2 = 120 (still p1 = 10 and I =

100), the solution to optimal choice becomes:

(approximately zero, since one cannot demand a negative

value.

0
0.833

10
0

Since the value of X2 is zero, it is not possible to plot an indifference

curve. Therefore, the optimal solution is a corner solution where the
consumer consumes 10 units of X1 and 0 units of X2. He/she cannot
consume 12 because it is not affordable. Due to the negative value of X2,
the ratio of MRS fails to be equal to that of prices;