Econ 100A Ans to PS1

# Econ 100A Ans to PS1 - Department of Economics University...

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Econ 100A-Spring 2010 Page 1 Problem Set 1 Answers Department of Economics Spring 2010 University of California, Berkeley Prof. Woroch Economics 100A PROBLEM SET 1 ANSWER SHEET I. TRUE or FALSE and EXPLAIN : For each statement below, decide whether it is true or false, and explain the reasoning behind your answer in a few sentences . When appropriate, provide a diagram. 1) Theresa likes coffee from Starbucks and bagels from Noah's, but only together in specific proportions, and so her marginal rate of substitution between coffee and bagels is constant. False. Theresa’s indifference curves are L-shaped with the corner located where the two goods—coffee and bagels—are in the desired proportions. Accordingly, her “MRS of coffee for bagels” is zero or infinite depending on whether there are too many or too few bagels relative to cups of coffee given her desired proportions. At the corner, the MRS is undefined because the slope of the indifference curve is not defined. In any case, her MRS is not constant; that is indicative of perfect substitutes , not complements 2) Since Jennifer’s income elasticity of demand for potatoes is negative, she violates the assumption of “more is better.” False. Negative income elasticity means potatoes are an inferior good but that does not mean she prefers less to more. It does say that when her income increases, she will consume less potatoes, but her consumption of goods other than potatoes will increase. 3) Joaquin buys life insurance but also is known to play the lottery regularly, and so he cannot be an expected utility maximizer. False. This question is open ended, if only because it does not give details on whether the lottery and the life insurance constitute a fair bet, a sub-fair bet or a super-fair bet. Invariably, gambling favors “the house” so we could assume the lottery is a sub-fair bet, which Joaquin would play only if he is risk loving. The life insurance policy could go either way. If Joaquin is in much better health and takes all the precautions (no ski diving or base jumping), then the average policy may be super-fair for him—if he somehow places a dollar-value on losing his life. We could imagine that Joaquin’s utility function exhibited both risk loving behavior (i.e., increasing MU of income, convex) over some final income levels and risk aversion (i.e., decreasing MU of income, concave) over others. For example this occurs with the cubic utility that we discussed in lecture: u(I) = (100 + I) 3 ). It is possible that expected utility for a utility function like this could result in a higher level of expected utility if Joaquin both played the lottery and purchased insurance compared to doing one, or the other, or neither. Notice that, if in addition to the assumption of expected utility maximization, we assume Joaquim is everywhere risk loving or risk averse, then simultaneous gambling and insuring could not occur. (Behavioral economics has other explanations for such behavior that does not impose expected utility

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## This note was uploaded on 07/15/2010 for the course ECON 100A taught by Professor Woroch during the Spring '08 term at University of California, Berkeley.

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Econ 100A Ans to PS1 - Department of Economics University...

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