X= ( B, D ) Y= ( B, D)

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1 1) (30 points) Suppose Homer consumes only two goods: Beer (B) and Donut (D). Homer s income from working at a nuclear plant is $120. A pack of beer costs $10, a pack of donuts costs $6. a) Assume Beer and Donuts are perfect substitutes for Homer with a constant MRS of 2. (at each bundle, Homer is willing to sacrifice up-to 2 packs of donuts for one pack of beer) Draw Homer s budget line (label it BUD 1 ) and find his optimal consumption bundle, label it X and write it below. Draw Homer s indifference curve that passes through the optimal bundle. X= ( B, D ) b) Now suppose Marge imposes a new rule where Homer is not allowed to buy more than 6 packs of beer. Draw Homer s budget line (label it BUD 2 ) and find his optimal consumption bundle, label it Y and write it below. Draw Homer s indifference curve that passes through the optimal bundle. Y= ( B, D)

2 c) Alternatively, suppose Marge is not able to limit Homer s beer intake directly. Instead she convinces Tim Horton to establish a quantity discount program. If you buy more than 10 packs of donut, each additional pack is only $3. Draw Homer s budget line (label it BUD 3 ) and find his optimal consumption bundle, label it Z and write it below. Draw Homer s indifference curve that passes through the optimal bundle. Z= ( B, D ) d) Does Homer prefer the method in part (b) or the method in part (c). Explain in one sentence.

3 2) (25 points) Suppose Goran s initial wealth (his assets + his money) is $20,000. Goran likes to ride his dirt-bike on the weekends. His riding skills are such that he is facing three possibilities: with 10% probability he would cause an accident which would result him loosing his dirt-bike completely, worth $5,000, with 20% probability he would cause an accident which would cause minor damages to his dirt-bike that would cost $400 to fix and with 70% probability no accident would occur. His utility function is given by: U = M where M is his total wealth. a) Calculate his expected utility if he does not buy insurance. b) [Full Coverage Insurance: No deductible] An insurance agent offers him an insurance with a cost of $1,000, which would cover all his losses in the case of an accident. Would he accept this insurance offer? c) [Partial Coverage Insurance: $500 deductible] An insurance agent offers him an insurance with a cost of $800, but he would be responsible to pay the first $500 of any damages on his dirt-bike. Would he accept the insurance offer?

4 3) (25 points) Suppose Scott has an income of $40,000 this year and $60,000 of income next year. Scott can borrow at an interest rate of 50% and lend at interest rate of %25. Scott s indifference curves representing his preferences for consumption over the two periods are given below. a) Draw Scott s budget constraint in the below graph and find his optimal consumption bundle and label it A. A= (, ) Is Scott borrowing or lending? How much is he borrowing or lending? Answer one of the following depending on whichever is relevant to your answer from above: If Scott is borrowing how much will he have to pay next year? If Scott is lending, how much will he retrieve next year?

5 b) Assume there is a maximum borrowing limit of $10,000. Draw Scott s budget constraint in the below graph and find his optimal consumption bundle and label it B. B= (, ) Is Scott borrowing or lending? How much is he borrowing or lending?

6 4) (20 points) Kyle spends his monthly allowance of $48 on Songs (S) from itunes and paperback books (B) from Amazon. The price of each song is P S =$2 and the price of a book is P B =$6. Kyle s indifference curves are given below: Books Songs a) Draw Kyle s budget set and find his consumption bundle and label it as A A= ( S, B) b) Now assume itunes raises the price of songs to P S =$8. i) How much should his parents raise Kyle s allowance so that he can afford his previous consumption bundle A, at the new prices? ii) Alternatively, how much should his parents raise Kyle s allowance so that he will be as happy as before the price change

7 5) (10 points) Consider a two consumer and two good general equilibrium model studied in class. Assume Leonard and Sheldon are the only residents who live in this economy. In this economy there is no production and the total quantity of the two goods available are fixed. In the following Edgeworth box the horizontal axis corresponds to the total quantity of Green Lantern comics (14 total) and the vertical axis corresponds to the total quantity of Superman Comics (10 total) available in this economy. The two consumer s origins, L for Leonard and S for Sheldon are marked in the Edgeworth box. The initial endowments of these consumers are given as: Leonard Green Lantern: 4 Green Lantern: 10 Sheldon Superman: 8 Superman: 2 Assume Price of Green Lantern comics is $4 and Price of Superman comics is $3. The two consumers are free to sell their initial endowments at the market prices given above and choose to purchase any bundle that they wish. Their preferences are represented by the indifference curves given below. a) Is the consumer s initial endowment efficient or not? (Yes or No) b) Draw the consumer s budget line on the graph below and mark their optimal bundle. c) Is the optimal bundle efficient or not? (Yes or No) S L