ME Problem Set-1

PGP 2019 - 21

1. Draw a set of indifference curves for the following pairs of goods:

a. Hamburgers and carrots for a vegetarian who neither likes nor dislikes meat. (Vegetarians
do not eat meat.)
b. Peanut butter and jelly for an individual that will not eat peanut butter sandwiches or jelly
sandwiches, but loves peanut butter and jelly sandwiches made with two parts peanut butter
and one part jelly.
c. Tickets for Knott's Berry Farm (KBF) and Universal Studios (US) for a tourist that
believes that KBF and US are perfect substitutes.
d. Ice cream and pie if these are goods that you like, but if you consume enough of either,
you get sick of them. If you are sick of a good, consuming more of it lowers your utility.

2. In the field of financial management it has been observed that there is a trade-off between
the rate of return that one earns on investments and the amount of risk that one must bear to
earn that return.

a. Draw a set of indifference curves between risk and return for a person that is risk averse
(a person that does not like risk).
b. Draw a set of indifference curves for a person that is risk neutral (a person that does not
care about risk one way or the other).
c. Draw a set of indifference curves for a person that likes risk.

3. An island economy produces only two goods, coconuts and pineapples. There are five
people (A, B, C, D, and E) living on the island with these preferences:

A has a strong preference for pineapples.

B has a strong preference for coconuts.
C doesn't care for pineapples (assigns no value to them).
D doesn't care for coconuts (assigns no value to them)
E will only consume pineapples and coconuts in the fixed proportion of
one pineapple to one coconut.

For each of these five individuals, construct a representative indifference curve with
pineapples on the vertical axis and coconuts on the horizontal axis. Discuss the shape of the
indifference curves and relate them to the MRS.

4. It is common for supermarkets to carry both generic (store-label) and brand-name

(producer-label) varieties of sugar and other products. Many consumers view these products
as perfect substitutes, meaning that consumers are always willing to substitute a constant
proportion of the store brand for the producer brand. Consider a consumer who is always
willing to substitute 4 pounds of a generic store-brand sugar for 2 pounds of brand-name
sugar. Do these preferences exhibit a diminishing marginal rate of substitution between store-
brand and producer-brand sugar?

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5. Consider the single-good utility function U(x) = 3x2, with a marginal utility given by MUx
= 6x. Plot the utility and marginal utility functions on two separate graphs. Does this utility
function satisfy the principle of diminishing marginal utility? Explain.

6. Robinson Crusoe lives alone on a deserted island. He can spend his time gathering coconuts
or bananas. He has 16 hours available each day and can gather 4 coconuts in an hour or 8
bananas in an hour. Draw Robinson's budget constraint. Given that Robinson's Marginal
Utility of bananas is always 25 and his Marginal utility of coconuts is always 100, what is his
optimal consumption?
One day an individual from a neighbouring island arrives by boat and offers to exchange any
number of fruits at a rate of 1 coconut for 1 banana. Draw Robinson's budget constraint at this
exchange rate assuming he will now spend all his time gathering bananas. Is Robinson better
off? What does he consume?

7. Bobby is a college student who has $500 of income to spend each semester on books
and pizzas. The price of a pizza is $10 and the price of a book is $50. Draw Bobby's
budget constraint.
Now, suppose Bobby's parents buy her a $300 gift certificate each semester that can
only be used to buy books. But eventually Bobby could find herself better-off with
those gift certificates. Why?

8. Your preferences over pizza (x) and other goods (y) are given by U(x, y) = xy, with
associated marginal utilities MUx = y and MUy = x. Your income is $120.
a) Calculate your optimal basket when Px = 4 and Py = 1.
b) Calculate h income and substitution effects of a decrease in the price of food to $3.

9. “If consumers do not buy less of a commodity when their incomes rise, they will
surely buy less when the price of the commodity rises.” Why?