MICROECONOMICS – ECON 204-A,B

MIDTERM EXAM ANSWERS

The. Answers are given after the question set.

p1 x2

u2 = 8

Z
u1 = 5

x1
x1
Figure A Figure B

1. (7 points) Consider Figure A showing the demand curve of good 1, one unit of which is
perfect substitute for one unit of good 2. Why does it have the horizontal segment (in red
color) at p1 = z? Explain briefly what you would do to obtain the value of z if you were
given the utility function (no numerical examples-just explanation).

2. (7 points) Figure B displays two indifference curves. Based on what you see, can you tell if
these preferences violate (i) Transitivity? Why? (ii) Convexity? Why? (iii) Monotonicity?
Why? (Grading will depend on explanation, not “yes” or “no” answers)

3. (15 points) Suppose that all indifference curves of a consumer have the form displayed in
Figure B above.
(i) Using indifference curves in Figure B and also budget lines, explain how the consumer’s
choice will vary as p1 is varied from low levels to high levels, holding p2 and m constant.
(ii) Draw the demand curve for good 1 on the basis of your analysis. Explain what you do.

4. (7 points) Draw a linear demand curve that is very inelastic. Write down the verbal definition
of elasticity (no formulas). Then tell us what makes the demand curve you have drawn
“very inelastic.”

5. (15 points) You want to maximize revenues by selling a product for which the demand curve
is P = a − bQ where a and b are positive numbers. However, there is a price ceiling PC.
(i) (7 points) Maximize the expression of revenues under this demand curve, assuming that the
price ceiling is not effective. What price will you choose? Demonstrate. (No numerical
examples)
(ii) (8 points) Suppose there is also a quota QX besides the price ceiling. Given the answer in
part (i), under what condition about QX and PC will the quota be effective but not the price
ceiling? Also, illustrate this situation, QX and PC, in a figure.
6. (7 points) We take 10 TL from Ali’s income and give it to Veli. We then observe that the
market demand for sugar falls. Suppose we know that sugar is an inferior good for Ali. Can
we say that sugar is normal or inferior for Veli, or can we not? Why? Explain.

7. (7 points) The price of tomatoes is 5TL/kg. Later, the government gives 1 TL/kg subsidy to
the producers, but we observe that the equilibrium market price that consumers pay stays
at 5 TL/kg. Illustrate this possibility on a figure and explain it.
Identify also the government’s total subsidy payments on the figure.

8. (15 points) There are two goods. The price of water p1 (good 1) increases. The government
will compensate (transfer income to) the consumer. It has two options:
A. The compensation is such that the consumer can just afford the amount of water
he was consuming before the price increase.
B. The compensation is such that the consumer is just able to reach her (initial)
utility level before the price increase.

Suppose the consumer has strictly convex and monotonic preferences. Which compensation, A
or B, is smaller? Answer this question by clearly illustrating the two options on one same
figure you draw in the (x1, x 2) plane. Explain.

9. (15 points) A consumer has quasilinear preferences, with utility function and corresponding
demand functions given by
p2 2 m p
U = 10 x1 + x2, x1 = 25( ), x2 = − 25 2
p1 p2 p1
(i) (7 points) If the consumer’s income is below a critical level mC, these demand functions
will have a different form. What Is the expression for mC and what are the demand
functions if m < mC?
(ii) (8 points) The consumer’s income is m = 100 and the prices are p1 = 1, p2 = 1.
The price of good 1 increases to p1 = 2. (a) How much income Δm is needed to
compensate the consumer? (b) What is the total effect of the price change on the demand
for good 1? (c) How much of the total change in this demand for good 1 is due to the
substitution effect, how much is due to the income effect? Demonstrate.

10. (7 points) When the price of a good falls from p0 to p1, there are two reasons why the
consumer’s surplus might increase. What are they? Explain briefly using a demand curve.

ANSWERS
1. Under perfect substitutes, the consumer’s MRS = 1. If p1 > p2 the consumer chooses
x1 = 0, and if p1 < p2 she chooses (only) x1 = m /p1. If in the market the prices are
equal, p1 = p2, then the budget line and the indifference curves are parallel and any
choice of x1 between zero and x1 = m /p1 is optimal. This corresponds to the horizontal
segment on the demand curve for good 1. Thus, z = p2.
2. (i) There is no indication of violation of transitivity, because the indifference curves do not
intersect each other. (ii) Convexity is violated because lines connecting two points on
the indifference curve correspond to lower, not higher, levels of utility. The consumer is
worse off by “balancing” any two bundles. (iii) monotonicity is violated because the
indifference curves have increasing segments (at the left parts). Starting from x1 = 0
on an indifference curve, by raising x1 the consumer falls below the Indifference curve.
3.

(i). The slopes of the colored budget lines are the price ratios p1 /p2. Denote slope of the black
budget line by ( p1 /p2 )C. For p1 /p2 < ( p1 /p2 )C as shown by the red budget line, the
consumer’s optimal choice is along the x-axis and given by x1 = m /p1. At
p1 /p2 = ( p1 /p2)C (black budget line) he is indifferent between spending all his income on
good 1 and good 2, so x1 = m /p1 and x1 = 0 are both optimal.
If p1 /p2 > ( p1 /p2 )C, (green budget line) the consumer will consume good 2 only, so
x1 = 0.
(ii) The demand function for good 1 can be drawn on the basis of the analysis in (i), as follows:

p1

P1c

X1

The green part of the demand corresponds to budget lines as the green budget line. There is a
jump in x1 at the price P1c, which corresponds to the black budget line. Below that price
demand curve equation becomes (in red) x1 = m /p1.

4.
This demand curve is very inelastic. Elasticity
P shows by what percentage demand will fall if
price increases one percent. Its value at any
point on the demand curve depends on the
price/quantity ratio and the slope of the demand
curve. The slope of this linear inverse demand
curve is very high, therefore the slope of the
demand curve itself is very small. Therefore
elasticity is small.
Q
 5. (i) Since the price ceiling is not effective, we can maximize the revenues without any
constraint, R = (a − bQ)Q. Taking the derivative and setting it equal to zero to find the
maximum yields a − 2bQ = 0, hence, Q = a /2b. The revenue-maximizing price is
p = a /2.
(ii) If the quota is effective, it must be that Qx < a /2b. Since the price ceiling is not effective,
pC > a /2. For example, as in the figure below:

P
a

Pc

a/2

Qx. Q

6. Since sugar is an inferior good for Ali, with 10TL less income Ali’s demand should increase.
We know that the market demand for sugar falls, so, Veli’s demand (with 10 TL more
income) must have fallen. Therefore sugar must be inferior for Veli.

7.
P S

Ps

5 D

Q Qs Q

If demand is infinitely elastic (horizontal, consumers can purchase any quantity at the price 5 TL
but will. not, if price is above 5), the market equilibrium with subsidy will be as illustrated above. We
have pS = 5 + s. The equilibrium quantity will increase from Qo to Qs.

There is an alternative scenario below, with inelastic supply (vertical, producers supply a fixed
quantity that does not change with price)
 P D S

Ps

Po = 5

Qs. Q

8. Under compensation option A, the last budget-after line is shifted back until it passes through
the initial consumption bundle. Under compensation option B, the last budget-after line is shifted
back until it becomes tangent to the initial indifference curve (utility level).

X2

Compensation B
Compensation A

Initial choice

budget after

Initial indiff. curve

X1

Compensation A (the shift of the budget-after until the budget line in red) is larger than B (the shift
of the budget-after until the budget line in green).

9. (i) This is quasilinear utility. We know that for low income levels the consumer’s optimal choice
is a corner solution. The solution given in the question is the demand function corresponding to an
m p2 ( p2)2
interior solution, where x 2 = 0 i f − 25 ≤ 0, or if m ≤ 25 ≡ mC.
p2 p1 p1
If m ≤ mC the demand functions are x1 = m /p1 and x 2 = 0.
 Δm = Δp1 . x*
(ii) (a)
1
= (2 − 1).25 = 25 TL. (b) Initial demand for good 1 is 25 units. The final
2
demand is 25(1/2) = 25/4. Thus, demand for good 1 falls by 75/4 units.
C) To find the income and substitution effects, we must compensate the consumer (extra 25 TL
found above) so that he can consume the initial consumption bundle. With compensated income
125. TL, his demand for good 1 is still the same as the final demand, 25/4. Therefore the income
effect is zero and all the effect consists of the substitution effect.

10. Let Qo be the quantity purchased at the initial price P0. When price falls to P1 and the
consumer increases his demand to Q1, his surplus increases because he pays a lower price for
the Qo units, and also earns a surplus from the extra quantities Q1-Qo he now starts to buy. These
are the two reasons why consumer’s surplus increases.