UNIVERSITY OF TORONTO SCARBOROUGH

DEPARTMENT OF MANAGEMENT

MGEB02: Price Theory: A Mathematical Approach

Instructor: A. Mazaheri
Sample Test-1.2 (Solutions)

Instructions: This is a closed book test.

You have 2 Hours.

Good Luck!
Last
Name:

First
Name:

ID

FOR MARKERS ONLY:

Q1 Q2 Q3 Q4 Q5 Total
Marks
Earned
Maximum
Marks 33 12 18 20 12 95
Possible

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Answer all following 5 questions:

Question-1 [33 Points] Answer the following Short Questions:

a) [4 points] Use a demand and supply framework to show the following:

Between 1970 and 2007 the annual cost of education increased by more than two folds while total
students enrolments increased by more than two folds.

b) [4 Points] The following figure depicts a consumer who initially (higher relative prices of X -
the first two budget lines) considers X and Y as independent then complement. Graph her price
consumption curve. (The answer is the left graph, the right graph is when the price increases
i.e. you move from right to left.)

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 c) [7 Points] Graph the indifference maps for the following two cases:

i) (3 Points) I always have my coffee with two sugars.

Coffee

Sugar
2

ii) (4 Points) Kumar cannot live without two cups of coffee a day. In fact, with less than 2 cups a
day, he doesn’t care about food at all. Suppose once he has two cups of coffee, he only cares
about food.

Coffee

Food

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d) [5 Points] Mary’s utility for Cola (x) and Water (y) is given by U(x,y) = x + 2y. The price of
Cola is $1 and the price of Water is $1. Mary’s income is $20. With the help of the following
(incomplete) diagram show her optimal combination of Water and Cola.

Solution: She will only consume Water because:

MU x 1 MU y 2
= =1< = = 2,
Px 1 Py 1
PX
MRS = 0.5 < =1
PY

Water

20

Cola

20

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d) [5 Points] Adam likes Coffee & Donut. Coffee costs $1 per cup and Donut cost $1 each. Adam
received a coupon through the mail that will last all of next week. By using the coupon, he will
get one-cup of coffee for free for the first five cups of coffee purchased and he will also get a
50% reduction on the price of coffee after the purchase of the first 5 cups. He has $10 to spend.

Illustrate his budget line with and without the coupon in the following diagram. Make sure you
label all the points.

Donut

10

Cups of Coffee

5 6 10 16

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 e) [8 Points] A consumer has $100 to spend on x, which costs $10 or y, which costs $5. His
utility function is U = x 0.25 y 0.25 . Given this utility function, he initially purchases 5 units of x
and 10 units of y. If the price of x increases to $20, he will purchase 2.5 units of x and 10 units of
y.

Numerically find and then use the following diagram to graph the substitution effect and the
income effect of this price change on the purchase of x.

1 : U = 100.25 × 50.25 = 2.659 = x 0.25 y 0.25

y 20
2 : MRS = = => y = 4 x
x 5
(1), ( 2) => 2.659 = x 0.25 ( 4 x ) 0.25 => x = 3.536
SE = 3.536 − 5 = −1.464
IE = 2.5 − 3.536 = −1.036

Graphically:

20

10

IE SE

x
2.5 3.536 5
10 20

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Question-2 [12 Points] Bicycle co makes 100 bicycles per day, each sells for $200. Suppose the
own price elasticity of demand for bicycles is -0.6 and the price elasticity of supply is 2. Assume
that both demand and supply are linear.

a) [7 Points] Compute the slope and intercept coefficients for the linear supply and demand
equations.

Solution:

Demand: Qd = a0 + a1P Supply: Qs = b0 + b1P

Use: E = (P/Q) × (ΔQ/ΔP) to compute a1 and b1.

-0.6 = (200/100)a1 2 = (200/100) b1

a1 = -0.3 b1 = 1

Solve for a0 and b0

Qd = a0 + a1P Qs = b0 + b1P
100 = a0 + -0.3(200) 100 = b0 + (200)

a0 = 160 b0 = -100
Qd = 160 - 0.3P Qs = -100 + P

b) [5 Points] In order to promote bicycle riding, the local government has started paying $20
subsidy per unit purchased. What would be the new equilibrium price of bicycle and the
equilibrium number of bicycles sold?

Solution:

Pd = Ps – 20
QS = Qd = Q

Qs = -100 + PS
or PS = Qs + 100

Qd = 160 –0.3 Pd
or Pd = 160/.3 – Qd/.3

then:

Pd = Ps – 20 => 160/.3 – Q/.3 = Q + 100 – 20

Q = 104.62 => Pd = 184.62

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Question-3 [18 Points] John is a utility function U(X,Y), where X denotes his consumption of
gallons of gasoline per week, and Y stands for consumption of all other goods (composite good)
in the economy.

U(X,Y) = 0.05 ln(X) + 0.95 ln(Y)

John’s income is $1000 per week. The price of gasoline is $1 per gallon. The price of the
composite good is $1 as well.

Note: MUX = 0.05(1/X), MUY = 0.95(1/Y)

a) (8 Points) Due to shortages, the government has introduced a rationing system such that John
can only buy 20 gallons of gasoline at $1 a gallon. What would be John’s optimal consumption
bundle? Find his satisfaction with and without the rationing.
b) (5 Points) Illustrate your solution in a clearly labeled graph. Make sure to illustrate the budget
lines clearly as well as his utility levels.
c) (5 Points) [A bit Challenging] Next suppose a black market in gasoline opens up, where he
can buy additional quantities for $1.40 per gallon (while continuing to buy the ration of 20
gallons at the “legal” price of $1). How much gasoline will she buy on the black market?

Solution

a)

1
0.05
MRS = X = Y =1
1 19 X
0.95
Y
=> Y = 19 X
=> X + 19 X = 1000
=> X = 50
=> Y = 950
But cannot consume more than 20, therefore corner solution:

X + Y = 1000
X = 20, Y = 980
U Withration = 0.05 ln( 20) + 0.95 ln(980) = 6.693
U Withoutration = 0.05 ln(50) + 0.95 ln(950) = 6.709

b)

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 1000
6.693
6.709

20 50 1000

c)
1
0.05
MRS = X = Y = 1.4
1 19 X 1
0.95
Y
=> Y = 26.6 X = 26.6( 20 + X BlackMarket )
=> 1.4 X BlackMarket + 26.6( 20 + X BlackMarket ) = 980
=> 28 X BlackMarket = 980 − 532 = 448
=> X BlackMarket = 16

Will purchase 20 at the regular price of 1 (costs $20) and 16 at the black market price.

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Question-4 [20 Points] Jen has the following utility function: U ( x, y ) = 3 y + 6 x 1 / 2 . Let px and
py be the corresponding prices and I his income.
a) [6 Points] Setup the Lagrangian function and find the first order conditions (FOCs). Use these
FOCs to find the expression for the marginal rate of substitution (MRS). The MRS suggests that
this utility function may lead to corner solutions, why?

L = 3 y + 6 x1 / 2 − λ ( p x X + p yY − I )
∂L
= 3 x −1 / 2 − p x λ = 0
∂x
∂L
= 3 − pyλ = 0
∂y
∂L
= − ( p x X + p yY − I ) = 0
∂λ
x −1 / 2 p
= MRS = x
1 py
Since MRS does not depend on y, y can be any number including zero and even negative. This
means that the tangency might not be feasible (if leads to y<0) area. This will result in corner
solution.

b) [8 Points] Find the demand functions for x and y. Find the optimal bundle if px=1and py=1and
I = 0.5. Graph your solution.

x −1/ 2 p x
=
1 py
2
p 
=> x =  y  if p x x* < I
*

 px 
I
=> x = if p x x* ≥ I
px
2
p 
I − p x  y 
I − px x  p x  = I − p y if p x* < I
y= = x
py py p y px
y = 0if p x x* > I

if px=1and py=1and I = 0.5 if x=1, y=-0.5 which is not possible

Therefore, y=0, x=0.5. (3 Points for the graph)
0.5

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0.5 1
c) [6 Points] Graph the Income-consumption and the Engle curve for x. Briefly explain your
findings.

I-C Curve y

x
1
Engle Curve
I

He consumes all his money if he own less than $1 (corner solution). Thereafter he only
consumes 1 unit.

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 Question-5 [12 Points] The demand for scientific calculators can be segmented into two
components. The first component is the demand by math students. The individual demand for this
market is given by qA = 270 – 2P. The second component is the demand by all others. The
individual demand for this component is given by qB = 350 - 10P. Suppose there are 100
consumers in each of these two markets.

a) (7 Points) Derive the total market demand curve and illustrate the market demand on the
following graph. Make sure to clearly label your graph.

Solution:

100q A = 100[270 − 2 P ] = 27,000 − 200 P

100Q B = 100[350 − 10 P ] = 35,000 − 1,000 P
Q M = 62,000 − 1,200 P

But demand seizes to exist in A when the P >135 while in (B) the demand is zero when P>35
therefore the demand will be kinked at P = 35 or:

QM = 62,000 − 1,200 P( P < 35)

QM = 27,000 − 200 P( P > 35)

135

35

20,000 62000

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b) (5 Points) Suppose the equilibrium price is 40, find the consumer surplus.

Solution:

At the equilibrium price only A is in the market, therefore the consumer surplus will be:

Q M = 27,000 − 200 P ( P > 35)

P = 40, Q M = 19,000
CS = (135 − 40)19,000 / 2 = 902,500

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