Intermediate Microeconomics Assignment 3

ECON2210 Fall 2023

Suggested answers

1. (a) We first find out the marginal rate of substitution

x2 +1
M U1 = x2 + 1; M U2 = x1 − 1 M RS12 (x1 , x2 ) = x1 −1
x2
Notice that M RS12 (x1 , x2 ) cannot be expressed in term of the ratio x1 . Conse-
quently, for t ̸= 1,

tx2 + 1 x2 + 1
M RS12 (tx1 , tx2 ) = ̸= = M RS12 (x1 , x2 )
tx1 − 1 x1 − 1

The bundles (tx1 , tx2 ) and (x1 , x2 ) lies on the same ray from the origin and have
generally different point slope of the indifference curves.
A numerical example is to consider the bundles (2, 1) and (4, 2)

M RS12 (4, 2) = 1 ̸= 2 = M RS12 (2, 1)

So the preference is not homothetic.

(b) We first verify that the consumption bundle is always on the budget line

m + p1 + p2 m − p1 − p2
p1 x
e1 + p2 x
e2 =p1 + p2
2p1 2p2
m + p1 + p2 + m − p1 − p2
= =m
2

Notice that in the region m > p1 + p2 , the quantities for both goods are always
positive,

m + p1 + p2 m − p1 − p2
x
e1 = > 0; x
e2 = >0
2p1 2p2

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 The consumption bundle is an interior solution. It suffices to verify the tangency
condition
m−p1 −p2
x
e2 + 1 2p2 +1
M RS12 (e
x1 , x
e2 ) = = m+p1 +p2
e1 − 1
x 2p1 −1
m−p1 +p2
2p2 p1
= m−p1 +p2 =
2p1
p2

2. Substitute p1 = 2 and p2 = 1 into the demand function, it becomes

 
m 1
X
e= − ,1 , if m ≥ 1;
2 2
X
e = (0, m) , if m < 1.

One can graph the mathematical function to find out the income offer curve and
Engel curve. In the subsequent discussion, let us provide some economic elaboration.

(a) For m < 1, the household buys only good 2. When the income level increases,
the household simply buys more good 2. In this region, the income offer curve
coincide with the vertical axis.
For m ≥ 1, the quantity demanded for good 2 is constant while the quantity
demanded for good 1 keeps increasing with the income level. The reason is that
√
M RS12 (x1 , x2 ) = 2 x2 . Consequently, all bundles on the horizontal line have
the same marginal rate of substitution, which is equal to the relative price. So
the optimal bundle contains the same quantity of good 2 when the income level
increases. The increase in income is entirely spent on good 1. In this region,
the income offer curve is a horizontal line.

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 (b) From the demand function,

x1 + 1, if m ≥ 1;
m = 2e
x
e1 = 0, if m < 1.

For m < 1, the household does not consume good 1 at all. Hence the Engel
curve coincides with the vertical axis. For m > 1, the household keeps buying
the same quantity of good 2 and spends the increase in income level on good 1.
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The quantity of good 1 thus increases at the rate of p1 .

3. (a) The vertical axis of the cross-sectional Engel curve indicates the calories intake
through sugar sweetened beverage. Let us assume that the government taxes

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 on the quantity of the soda and all soda has the same sugar content. The cross-
sectional Engel curve then indicates that the high-income households consume
less soda than the low-income group. Assuming no systematic difference in the
preference across income groups, we call the soda an inferior good. As the high-
income group will pay less soda tax than the low-income group, the introduction
of soda tax makes the tax regime more regressive.

The conclusion remains the same if the government directly taxes on the quantity
of sugar in the beverage instead of the quantity of the soda. In this case, we
can relax the assumption that all soda has the same sugar content.
(b) In general, the expenditure shares of different goods differ across the income
groups. To make the consumption tax regime progressive, the government must
set higher tax rates on the goods of which the expenditure share is higher for
the high-income households than the low-income group. Cosmetics and new cars
are often subject to higher tax rates. In contrast, utilities, grocery and rental
expense are usually exempted from consumption tax.

Assuming no systematic difference in the preference across income groups, we

may tie the discussion to the terminologies we covered. The government should
set a higher tax rate on the luxury, which expenditure share increases with the
income level. The tax rate on necessity or inferior goods should be lower or even
negative (subsidy).

4. (a) We separate the bundles using the straight line x1 + x2 = 1. For the bundles
above the line, they satisfy x1 + 1 < 2x1 + x2 . The utility level is given by

U (x1 , x2 ) = x1 + 1

In this region, the household prefers bundles with more good 1 and is indifferent
about an increase in x2 . The indifference curves are thus vertical lines. For the
bundles below the line x1 + x2 = 1, they satisfy x1 + 1 > 2x1 + x2 . The utility
level is given by

U (x1 , x2 ) = 2x1 + x2

In this region, the indifference curves are parallel straight lines with M RS12 = 2.

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 Note that the indifference curves are kinked and continuous along the line x1 +
x2 = 1.

x1 + 1 = 2x1 + x2 ⇔ x1 + x2 = 1

(b) i. Consider the income range m < 1. Recall that the horizontal and vertical
m m m m
intercepts of the budget line are respectively p1 and p2 . Since p1 < p2 < 1,
the household cannot afford one unit of good 1 or good 2. The entire budget
line is below the straight line x1 + x2 = 1. In this case, for every bundle on
the budget line
p1
M RS12 = 2 < 4 = p2
The optimal bundle is a corner solution with x
e1 = 0. The household con-
sumes only good 2.

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 m m
Consider the income range m ∈ [1, 4]. Since p2 ≥1≥ p1 , the budget line
intersects with the straight line x1 + x2 = 1.

The intersection point, which is the kink point of the IC, is indeed the
optimal bundle. Consider the bundles on the budget line. For the bundles
above the straight line x1 + x2 = 1, the indifference curve is steeper than
the budget line, and the household will gain by reallocating expenditure to
good 1. For the bundles below the straight line x1 + x2 = 1, the opposite
happens. Graphically, the bundle at the kink-point lies on the highest IC
among all bundles on the budget line.
m
Consider the income range m > 4. Since 1 < p1 , the household can afford
more than one unit of good 1. The entire budget line is above the straight

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line x1 + x2 = 1. The household will spend the entire budget on good 1.
The optimal bundle is a corner solution with x
e2 = 0.

Putting together, we depict the income offer curve in the colored graph
below

When the income level is low, the household cannot meet her basic calories
need. She buys the cheaper canned food only. When the income level keeps
increasing, the household can afford her basic calories need at some point.
She then starts replacing canned food with the more expensive fresh food in
one-to-one ratio. When the income level is sufficiently high, the household
replaces all canned food with fresh food and only consumes the later.

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ii. For the income range m ∈ (1, 4), the optimal bundle moves along the line
x1 + x2 = 1 when income level increases. The household consumes more
good 1 and fewer good 2. Thus good 2 is inferior and good 1 is normal.