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ECON7030 MICROECONOMIC ANALYSIS
MOCK PROBLEM SET 2
Instruction:
This is an open-book problem set. You are NOT ALLOWED to discuss the problem
set and/ or the answers with anyone else. You can do your own research to find the
answers. If your answers are based on a reference, you MUST properly CITE the source
of such reference. The use of AI to develop responses is prohibited and may constitute
student misconduct under the Student Code of Conduct.
You have 24 hours to complete AND submit your answers by the due time. Hand-
written as well as typed answers are welcome. Make sure that you upload a single PDF
file containing multiple pages. Submit on time, ideally at least 1 hour in advance of the
deadline. It shows competence and professionalism, and it will ensure that you avoid late
penalties.
Answer all questions. Justify all your answers. Every graph (figure or diagram) in
your answers has to be well-labelled. For functions that intersect the axis, the points
where they intersect them must be identified (providing the corresponding numbers).
All quantities of goods can be treated as continuous variables unless explicitly stated
otherwise. Show your work.
Question 1 True, False, or Uncertain? Justify your answers.
(a) (5 marks) Inflation and the rising cost of living are currently a big problem. Suppose
that the prices of all the goods in your consumption bundle increase at the same rate
of 5%. The Union negotiated a nominal salary increase of the same rate, 5%. You
are equally well off.
Solution: True.
When the prices of all the goods in your consumption bundle increase at the same
rate (no substitution effect), an increasing in income by the same rate will move you
back to the original bundle that yield the same level of utility.
(b) (5 marks) Tom consumes only two goods, X and Y . He spends 40% of his income
in X. Tom’s income elasticity of demand for X is β, where β > 0. Tom’s (Marshal-
lian) demand for X has a price elasticity equal to −0.4β. X and Y are perfect
complements for Tom. [Hint: Slutsky equation.]
1
Solution:True.
Based on the Slutsky Equation:
mxx =
h
xx − sxηx
We know that sx = 0.4, ηx = β. Hence −sxηx = −0.4β. If mxx = −0.4β = −sxηx,
then hxx = 0 or the substitution effect is nil. As a result, good X and Y can only be
perfect complements.
(c) (5 marks) John has monotonic preferences for two goods, X and Y . The price of
Y is one dollar per unit. The following diagram illustrates one of his indifference
curves, labelled U0. It also shows two budget lines corresponding to income levels
M and M ′, respectively, while the prices of X and Y remain constant. A = (xA, yA)
is the optimal bundle when the income is M . When the income changes to M ′,
ceteris paribus, John’s new optimal bundle(s) must be located along the
blue section.
x
y
U0
M
M ′
xA
yA A
B
C
D
Solution: False or Uncertain
• If both x and y are normal goods and income increases from M to M ′, then he
will consume more of both x and y. Hence, the new optimal bundle would be
along the blue section such as C.
• If x is normal but y is inferior and income increases from M to M ′, then he will
consume more x but less y. Hence, the new optimal bundle would be along the
green section such as D.
• If x is inferior but y is normal and income increases from M to M ′, then he will
consume less x but more y. Hence, the new optimal bundle would be along the
red section such as B.
(d) (5 marks) Bob consumes only two goods, X and Y . Consider the price combinations
A, B and C, in the following table. Bob’s chosen bundle in each situation is also
shown in the table. Bob’s preference satisfies both WARP and SARP.
2
Situation Px Py X Y
A $2 $4 6 2
B $5 $5 3 5
C $8 $2 5 4
Solution: False.
Bob’s preference satisfies WARP but violates SARP. Let’s compute the costs of each
bundle given different situation
Cost of bundle A Cost of bundle B Cost of bundle C Revealed Pref.
A 2(6)+4(2)=20 2(3)+4(5)=26 2(5)+4(4)=26 A R B, A R C
B 5(6)+5(2)=40 5(3)+5(5)=40 5(5)+5(4)=45 B R A, B R C
C 8(6)+2(2)=52 8(3)+2(5)=34 8(5)+2(4)=48 C R B, C R A
WARP:
(i) We have B R A and A R B.
(ii) We have C R B and B R C.
Hence, WARP is satisfied.
SARP: There is only one indirect revealed preference relation which can be identified
as the following:
C R B and B R A ⇒ C IR A
(i) We have B R A and A R B.
(ii) We have C R B and B R C.
(iii) We have C IR A and A R C
(iv) We have C IR A and C R A. This case does not satisfy SARP.
Hence, SARP is violated.
(e) (5 marks) Let
p: per-unit price of insurance,
pi: probability of accident,
L: loss wealth from the accident
X: amount of purchased insurance.
An insurance purchaser is an expected utility maximiser. The insurance is unfair
in favour of the insurance company; that is, the per-unit premium is higher than
the probability of insurance payout, p > pi. The insurance model suggests that
risk-averse consumers choose to be fully insured, i.e, X = L.
3
Solution: False. The risk-averse consumer will be under-insured.
Let c1 be a consumption with accident and c2 be a consumption without accident.
p > pi ⇒ p
1− p >
pi
1− pi
The slope of the BL is steeper than the slope of th IC at the certainty line. The
risk-averse utility maximiser will choose the bundle (c1, c2) such that
MRSc1,c2 =
piu′(c1)
(1− pi)u′(c2) =
p
1− p
For the above equation to hold and this consumer is risk-averse meaning u′(·) > 0
and u′′(·) < 0, thus
u′(c1)
u′(c2)
> 1
u′(c1) > u′(c2)
c1 < c2
Given that c1 = w − L + (1− p)X and c2 = w − pX where L is the loss if accident
occurs and X is the amount of insurance purchased.
The consumption without accident is greater than the consumption with accident,
c1 > c2 implies that this consumer is under-insured, i.e., X < L. In particular,
c1 < c2
w − L+ (1− p)X < w − pX
w − pX + (X − L) < w − pX
∴ X − L < 0
X < L
Question 2 The 2022 Australia Federal election is just around the corner. The compe-
tition between the two candidates, Scoot Morris and Antone Alba, is fierce.
As a consumer (and Australian voter), you only care about public transportation and
child care. Let public transportation be good X and child care be good Y . Each trip in
the public transportation costs $10 and each day of child care service costs $100. Your
after-tax income is $500 per week. Assume that you always consume a positive amount
of both X and Y (also known as interior bundles). Your utility function is given by:
U(x, y) = αxβ + 2y + 1,
4
xy
U1
U2
Figure 1. Vertically Parallel ICs
where α > 0 and 0 < β < 1.
(a) (5 marks) Write down the MRS in terms of α, β, x, and y.
Solution:
MRSxy =
MUx
MUy
=
αβxβ−1
2
=
αβ
2x1−β
MRSxy does not depend on y. This utility function is quasi-linear and it is strictly
concave in x. In particular,
U ′x = αβx
β−1 > 0
U ′′x = αβ(β − 1)xβ−2 < 0
(b) (5 marks) Draw two indifference curves. Do the indifference curves have the same
slope along any vertical line (when x is held constant)? Illustrate and explain.
Solution:Yes, the ICs have the same slope along any vertical line when x is held
constant. This is because the slope of the ICS, or MRSxy, does not depend on y.
Any bundles with the same amount of x, regardless of the amount of y, would have
the same MRSxy.
(c) (2 marks) Is it possible to establish whether Y is a normal or inferior good? Explain.
Solution: Yes, it is possible. Since there is no income effect on X, i.e, the income
elasticity of X is zero, X is neither normal nor inferior. Therefore, Y must be a
normal good. Recall that when analysing the 2-good situation, at least one good
must be a normal good.
5
(d) (5 marks) Based on your answer in part (c), is the price elasticity of Hicksian demand
for Y greater, smaller, or equal to that of Marshallian demand? Explain. DO NOT
derive the Hicksian and Marshallian demand functions for Y .
Solution: Recall that the price elasticity of demand for y is determined by:
y =
%∆y
%∆Py
When Py decreases by 10%, the substitution effect causes y
H to increases. Since y
is a normal good, the income effect reinforces the substitution effect and causes y to
increase even further. yM , consisting of both income and substitution effects, will
therefore increase more than yH . In particular, %∆yH < %∆yM .As a result,
Hy =
%∆yH
%∆Py
<
%∆yM
%∆Py
= My
We would expect the price elasticity of Hicksian demand for Y to be smaller than
than of Marshallian demand.
(e) Scoot Morris promises an income tax reduction that increases you after-tax weekly
income by 10%, from $500 to $550.
(i) (2 mark) Without solving the utility maximisation problem, establish how your
consumption of X and Y will change. Justify.
Solution: Since the ICs are parallel when x is constant, the increased income
will not affect the optimal x but will increase the optimal y.
(ii) (4 marks) Find the optimal consumption bundles with and without this tax
reduction.
Solution: Assume interior solution.
Tangency Condition:
MRSxy =
Px
Py
αβ
2x1−β
=
Px
Py
x1−β =
αβPy
2Px
x∗ =
(
αβPy
2Px
) 1
1−β
(1)
6
Budget Equation:
Pxx+ Pyy = M
Px
(
αβPy
2Px
) 1
1−β
+ Pyy = M
y∗ =
M − Px
(
αβPy
2Px
) 1
1−β
Py
(2)
Plug in M = 500, Py = 100, and Px = 10 into eq. (1) and (2), we get
x∗0 =
(
αβ × 100
20
) 1
1−β
= (5αβ)
1
1−β
y∗0 =
500− 10 (5αβ) 11−β
100
= 5− 0.1 (5αβ) 11−β
Next, Scoot’s campaign would increase M by 10% or M1 = 550. Therefore,
x∗1 =
(
αβ × 100
20
) 1
1−β
= (5αβ)
1
1−β
= x∗0
y∗1 =
550− 10 (5αβ) 11−β
100
= 5.5− 0.1 (5αβ) 11−β
> y∗0
In conclusion, Scoot’s campaign will not affect the amount of optimal X you consume
but you would increase Y consumption by 0.5 unit. Since your preference is strongly
monotone (you can easily verify this!), you would strictly prefer the new bundle with
more Y and the same amount X.
(f) Now consider Antone Alba’s campaign instead. He promises to reduce the child care
cost by 10%.
(i) (2 mark) Without solving the utility maximisation problem, establish how your
consumption of X and Y will change. Justify.
Solution: The totol (price) effect of the decrease in py includes both substitution
and income effect.
The effect of the decrease in py on X:
- Substitution effect: X decreases.
- Income effect: X remains unchanged*.
7
*There is no income effect on X due to the nature of the quasi-linear utility
function. The effect of the decrease in py on Y :
- Substitution effect: Y increases.
- Income effect: Y increases**.
**Since X is not a normal good, then Y must be a normal good.
Therefore, we could expect that the X consumption will decrease and the Y
consumption will increase.
(ii) (2 marks) Find the optimal consumption bundle with the reduced cost of child
care.
Solution:Antone’s campaign affects Py whereas Px and M remain the same. In
particular, P ′y = 90. Hence,
x∗2 =
(
αβ × 90
20
) 1
1−β
= (4.5αβ)
1
1−β
< x∗0 = x
∗
1
y∗2 =
500− 10 (4.5αβ) 11−β
90
=
50− (4.5αβ) 11−β
9
(iii) (5 marks) With a well-labeled diagram, illustrate the Hicksian decomposition of
the price effect of Antone’s campaign into the substitution effect and the income
effect. Do not forget to explain and label the diagram.
Solution:
8
y child
care)
A-→B : 5.E .
B→c : I. E. Co☒= 0)
5900-0=5.5-6
5
YE - - - - - -
--B&i•
'
,
!A
✗ ( Bus trip )
✗ 50
(g) (5 marks) Now assume that α = 1 and β = 0.2, who should win your vote, Scoot
Morris or Antone Alba? If you are indifferent between the two, choose a “silent”
vote. Show and explain only within the context of your previous answers and the
given information available. Please do not assert your personal political views here.
9
Solution: Let α = 1 and β = 0.2, then
x∗1 = (5αβ)
1
1−β
= (5× 1× 0.2) 10.8
= 1
y∗1 = 5.5− 0.1 (5αβ)
1
1−β
= 5.5− 0.1(5× 1× 0.2) 10.8
= 5.4
x∗2 = (4.5αβ)
1
1−β
= (4.5× 1× 0.2) 10.8
= 0.919
y∗2 =
50− (4.5αβ) 11−β
9
=
50− (4.5× 1× 0.2) 10.8
9
= 5.453
U(x, y) = αxβ + 2y + 1
= x0.2 + 2y + 1
U(x∗1, y
∗
1) = 1
0.2 + 2(5.4) + 1
= 12.800
U(x∗2, y
∗
2) = 0.919
0.2 + 2(5.453) + 1
= 12.889
Since U(x∗1, y
∗
1) < U(x
∗
2, y
∗
2), you should vote for Antone.
(h) Your sister, Josephine, is also an eligible voter who faces the same dilemma. She
earns the same as you. However, we do not know her utility function.
(i) (5 marks) During the family gathering on ANZAC day, Josephine indicated
that, if Scoot Morris wins, she will choose the bundle S = (3, 5.2). Assume
that Josephine’s preferences satisfy WARP. Draw the set of possible bundles
that Josephine may choose from if Antone wins. Call this set W . REDRAW
the diagram only with the budget lines under Scoot’s and Antone’s campaigns.
Illustrate the set W in this new diagram.