ECN 301: Microeconomics

Summer, 2007

Assignment #1

1) Assume that the market demand and supply of 1-quart organic milk are given by:
QD  15  2 P
QS  5  3P

a) What is the equilibrium price and quantity?

b) Calculate the price elasticity of demand at equilibrium price and quantity.
Is the demand elastic or inelastic at this price and quantity?
c) Calculate the price elasticity of supply at equilibrium price and quantity.
d) Suppose the government sets a ceiling of $3 for quart organic milk. Will
there be a shortage or surplus of organic milk? Explain.

2) Suppose the cable TV industry is currently unregulated. Due to complaints from consumers
that the price of cable TV is too high, the government imposes a price ceiling below the
current equilibrium price.
a) Explain graphically, using the supply and demand analysis, the effects of
the price ceiling.
b) Suppose a new technological innovation reduces the cost of providing
cable TV to customers. Given the existing price ceiling, what would be the
effect of this innovation on price and quantity?

3) Andy derives utility from two goods, potato chips (QP) and Cola (QC). His marginal utility
(MU) from the two goods is given as follows:

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QP MUP
0 0
1 12
2 10
3 8
4 6
5 4
6 2
7 -2
8 -4
QC MUC
0 0
1 24
2 22
3 20
4 18
5 16
6 14
7 12
8 10

a) What is the total utility Andy will receive if he consumes 5 units of potato
chips and no cola?
b) If the price of potato chips is $0.50 and the price of Cola is $4 and he has
unlimited income, how many units of potato chips will he consume?
c) Suppose instead the price of potato chips is $1 and the price of Cola is $4
and Andy’s income is $8. What is Andy’s utility maximizing consumption
bundle?

4) Draw indifference curves depicting the following preferences and indicate the direction in
which utility would increase:
a) Asha neither likes nor dislikes hamburgers but she likes carrots.
b) Nick always consumes peanut butter and jelly together. He always puts
two parts peanut butter and one part jelly in his sandwiches.
c) Jane dislikes broccoli but loves beans.

5) (From Exercises #3.14) Connie has a monthly income of $200 that she allocates among two
goods: meat and potatoes.

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a) Suppose meat costs $4 per pound and potatoes $2 per pound. Draw her
budget constraint.
b) Suppose also that her utility function is given by the equation
u(M, P) = 2M + P. What combination of meat and potatoes should she
buy to maximize her utility? (Hint: Meat and potatoes are perfect
substitutes.)
c) Connie’s supermarket has a special promotion. If she buys 20 pounds of
potatoes (at $2 per pound), she gets the next 10 pounds for free. This
offer applies only to the first 20 pounds she buys. All potatoes in excess
of the first 20 pounds (excluding bonus potatoes) are still $2 per pound.
Draw her budget constraint.
d) An outbreak of potato rot raises the price of potatoes to $4 per pound.
The supermarket ends its promotion. What does her budget constraint
look like now? What combination of meat and potatoes maximizes her
utility?

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 ECN 301: Microeconomics

Summer, 2007

Assignment #1 (Key)

1.)
a) To solve for the equilibrium price P* we need to set demand equal to supply in
the market. In other words, set QD = QS to get 15 – 2P = 5 + 3P. Therefore, P* = 2
and Q* = 15 – 2(2) or 5 + 3(2) = 11.
b) Price elasticity of demand  P  (QD / P)( P / QD )  2( P / QD ) . At the

equilibrium price and quantity P* and Q* this is (-2)(2/11) = -4/11. Since the
absolute value of EP is less than 1, demand is inelastic.
c) Similarly, at P* and Q* the elasticity of supply is given by
(QS / P)( P / QS )  (3)(2 /11)  6 /11 .

d) In this case, since the equilibrium market price is $2, the price ceiling is not
binding. There will be no shortage or surplus of organic milk.

2.)
a) Since the price ceiling is below the equilibrium price, it will be binding. As seen
from the graph, there will be a shortage of cable TVs.

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 b) In this case, the supply curve shifts to the right. If the curve shifts enough (to S1)
the new equilibrium price might be below (or at) the price ceiling. As an example
see price P1 in the graph. This means the price ceiling does not bind. In this case
the shortage will be eliminated. If the shift in the supply curve is small (to S2), the
new equilibrium price (P2), though lower than before, will still be above the price
ceiling. In the case, the price ceiling will be binding and there will be a shortage
of cable TVs in the economy. The shortage at the new equilibrium price will not
be as severe as the one before the innovation.

3.)
a) The total utility received will be 40, which is the sum of the MUs for units 1
through 5 of potato chips consumed.
b) Since income is unlimited, Andy will keep consuming potato chips and cola until
MU for each of the goods is positive. In the case of potato chips, he will consume
6 units of potato chips because beyond 6 units, the extra or marginal utility
obtained from the seventh unit is negative. This means that by consuming the
seventh unit, Andy is total utility from potato chips will decrease and Andy does
not want that.
c) At the utility maximizing consumption bundle, we require MUP/MUC to be equal
to the price ratio PP/PC which is ¼. Also Andy’s expenditure cannot exceed

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 income 8. From the table, the only possible way this can be happen is when Andy
consumes 4 units of potato chips and 1 unit of Cola. Total expenditure is 4(1) +
+1(4) = 8

4.)
a)

b)

c)

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5.)
a) Let M = meat and P = potatoes. Connie’s budget constraint is 200 = 4M + 2P or
M = 50 - 0.5P.

b) When the two goods are perfect substitutes, the indifference curves are linear.
To find the slope of the indifference curve, choose a level of utility. Suppose u =
50, then M = 25 – 0.5P. Thus, Connie’s budget line and her difference curves
have the same slope. Any combination of meat and potatoes along this line will
provide her with maximum utility.
c) Assume that potatoes are on the horizontal axis. Connie’s budget constraint has
a slope of -1/2 until Connie has purchased 20 pounds of potatoes, is then flat
from 20 to 30 pounds of potatoes, since the ten next pounds of potatoes are
free, and then has a slope of -1/2 until it intercepts the potato axis at 110.
d) With the price of potatoes at $4, Connie may buy either 50 pounds of meat or 50
pounds of potatoes, or some combination in between. She maximizes utility at U
=100 at point A when she consumes 50 pounds of meat and no potatoes. This is
a corner solution.

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