Econ 1150.PS#5.Answers.23.docx

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Econ 1150 Problem Set #5 Utility Theory and Indifference Curves (In class) 1. For each of the following pairs of goods, draw the indifference curves in a properly labelled graph. a. Cookies and Pepsi b. Root Beer and Pepsi c. Old Dutch barbeque potato chips and Lays barbeque potato chips 2. Consider the following indifference curves for Sandra a. Sandra has $12 of income to spend, and popcorn costs $3 and Cola cost $3. What is her budget line equation and show it on the graph? b. How much cola and popcorn does she buy? What is her Marginal Rate of Substitution at that point? c. The price of cola falls to $1.50. What combination of Cola and popcorn does she now purchase? d. Show the two points on her demand curve for Cola. e. Show the income and substitution effect of the price change for Cola on your indifference curve graph.

Econ 1150 Problem Set #5 (ANSWERS) Utility Theory and Indifference Curves (In class) 1. For each of the following pairs of goods, draw the indifference curves in a properly labelled graph. a. Cookies and Pepsi b. Root Beer and Pepsi c. Old Dutch barbeque potato chips and Lays barbeque potato chips a..For cookies and Pepsi, the indifference curves are typically curved indicating that more of doesn’t equally replace less of the other. b..Since Root Beer is a near substitute for a can of Pepsi, the tradoff between Root Beer and Pepsi is roughly one-for- one but not perfectly straight. c..Since the two types of chips are identical in flavour and taste, and only differ by the brand, they are nearly perfect substitutes. The tradoff between one and the other is perfectly one-for-one (perfectly straight indifference curves).

3. Consider the following indifference curves for Sandra a. Sandra has $12 of income to spend, and popcorn costs $3 and Cola cost $3. What is her budget line equation and show it on the graph? Her original budget is $12 = $3Y + $3X b. How much cola and popcorn does she buy? What is her Marginal Rate of Substitution at that point? She consumes 2 cola and 2 popcorn, and her marginal rate of substitution is MRS = 1 or she values one popcorn for one Cola at that point. c. The price of cola falls to $1.50. What combination of Cola and popcorn does she now purchase? She will now move to the new budget line $12 = $3Y + $1.50X and a higher indifference curve I3, and consume 1 on popcorn and 6 or Cola. d. Show the two points on her demand curve for Cola. price $3 $1.50 demand $0 0 1 2 3 4 5 6 e. Show the income and substitution effect of the price change for Cola on your indifference curve graph. Note the line parallel to the new budget line but touching the original indifference curve. The substitution effect is from the original 2 units of X Cola to the 3 units of cola and the income effect is from the 3 units of cola to the 6 units of cola.

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0 1 2 3 4 5 6 7 8 X Cola (cans) 0 1 2 3 4 5 6 7 8 Y popcorn (bags) I 0 I 2 I 3 I 4 Original budget $12 = $3Y + $3X New budget $12 = $3Y + $1.50X

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