Intermediate Microeconomics NYUAD, Spring 2023

Midterm Exam Solution

Problem 1: Utility maximization with coupons

Bob goes to the supermarket to buy milk and cereal. He has $20 to spend.
A consumption bundle consists of a quantity of milk, x (in liters), and a
quantity of cereal, y (in kilograms). For all of the following questions you
can assume that the consumption set is R2+ . This means that milk and
cereal can be consumed in any non-negative quantity. Bob has continu-
ous, strictly monotone, and strictly convex preferences over consumption
bundles, which can be represented by the following utility function

√
u(x, y) = αx + 2 y,
where α > 0 is a preference parameter.

The price of milk at the supermarket is p = 4$/liter. The price of cereal is

q = 2$/kilogram.

(a) Formulate and solve Bob’s utility maximization problem to find how
Bob’s demand for milk and cereal depends on the preference parameter
α.

Bob notices that the supermarket has a special coupon. A coupon states:
“Buy 1 liter of milk and get 1 box of cereal for free”. A box of cereal
contains 2 kilograms of cereal. Each shopper is limited to one coupon.

(b) Solve Bob’s utility maximization problem to find how Bob’s demand
for milk and cereal depends on the preference parameter α, given the
special coupon available at the supermarket.

Now suppose that Bob is smart and his friends are lazy. Bob’s friends know

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the prices at the supermarket but they do not know about the coupons.
Bob offers to buy their cereal for them, and his friends agree to pay him
exactly what they would have to pay for cereal at the supermarket, i.e.,
they will pay him 2$/kilogram of cereal. Suppose that Bob’s friends are
willing to buy an unlimited amount of cereal at this price. Bob’s budget
set now consists of all consumption bundles he can afford given his wealth
of $20, the prices at which he can buy milk and cereal at the supermarket,
the special coupon, and the price at which he can sell cereal to his friends.

(c) Solve Bob’s utility maximization problem to find how Bob’s demand
for milk and cereal depends on the preference parameter α, given the
special coupon available at the supermarket and Bob’s option to sell
cereal to his friends. For what values of α is it optimal for Bob to sell
a strictly positive quantity of cereal to his friends?

Finally, suppose that, due to popular demand, the supermarket extends

its special offer. Each customer is now allowed to use n coupons, where n
is an integer. Bob is still able to sell cereal to his friends, as in part (c).

(d) Solve Bob’s utility maximization problem to find how Bob’s demand
for milk and cereal depends on the preference parameter α and the
number of coupons n available at the supermarket.

Solution:
√
First, note that M RS(x, y) = −α y, which means that limy→0 M RS(x, y) = 0 (indifference curves
become flat as they approach the horizontal axis in a consumption space diagram with quantities of
cereal on the vertical axis and quantities of milk on the horizontal).
√
(a) The UMP is max(x,y)≥0 αx + 2 y s.t. 4x + 2y ≤ 20. Equivalently, the constraint is 2x + y ≤ 10.
The only parameter is the preference parameter α > 0.
√ 4 2
At an interior solution, α y = 2 =⇒ y = α2 =⇒ x = 5 − α2 , which is strictly positive if and only if
p
α > 2/5.

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Intermediate Microeconomics NYUAD, Spring 2023

There is no corner solution with y = 0 since the indifference curves become flat as they approach the
horizontal axis.

At a corner solution on the vertical axis, x = 0 and y = 10. This is only a solution if M RS(0, 10) =
√ p
α 10 ≤ 2, which means α ≤ 2/5.

Therefore,  
5 − 2
p 4
p
α2 if α > 2/5 
α2 if α > 2/5
x(α) = p y(α) = p
0 if α≤ 2/5 10 if α≤ 2/5

(b) Since preferences are monotone, it is never optimal to buy strictly less than 1 liter of milk or less
than 2 kilograms of cereal. Hence, there are now three potential types of solutions: (i) a solution where
Bob buys 1 liter of milk, gets a coupon, and uses the coupon and all remaining wealth to purchase 10
kilograms of cereal; (ii) a solution where Bob buys 5 liters of milk, gets a coupon, and uses it to obtain
2 kilograms of cereal; (iii) a solution where Bob buys x liters of milk and y kilograms of cereal, where
x ∈ (1, 5) and y = 10 − 2x + 2 = 12 − 2x (the +2 coming from the coupon); or, equivalently, y ∈ (2, 10)
and x = 6 − 21 y

At a type (i) solution, (x, y) = (1, 10). This is a solution only if the indifference curve at the point (1, 10)
√ p
is flatter than the budget line (see figure 1(a)). Therefore, when α 10 ≤ 2, which means α ≤ 2/5.

At a type (ii) solution, (x, y) = (5, 2). This is a solution only if the indifference curve at the point (5, 2)
√ √
is steeper than the budget line (see figure 1(b)). Therefore, when α 2 ≥ 2, which means α ≥ 2.

At a type (iii) solution, there is a tangency between one of Bob’s indifference curves and the budget line
√
(see figure 1(c)). Hence, α y = 2 =⇒ y = α42 =⇒ x = 6 − α22 . However, this is only a type (iii)
p √
solution if 1 < 6 − α22 < 5 , which means 5/2 < α < 2.

Therefore,

 p  p
1

 if α≤ 2/5 10

 if α≤ 2/5
√ √
x(α) = 5 if α≥ 2 y(α) = 2 if α≥ 2

 2
p √ 
 4
p √
6− if 5/2 < α < 2 if 5/2 < α < 2
 
α2 α2

𝑦 𝑦 𝑦

10 10 10

5 𝑥 5 𝑥 5 𝑥

(c) The difference now, relative to part (b), is that Bob can obtain more than 5 liters of milk by selling
the cereal from his coupon and using the money to buy up to one more liter of milk. Since the indifference

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Intermediate Microeconomics NYUAD, Spring 2023

curves become flat as they approach the horizontal axis, there is no corner solution where Bob only ends
up with milk. So there are two types of solution: (i) the solution where (x, y) = (1, 10), but only if
√ √
α 10 ≤ 2, or (ii) a solution where α y = 2, x = 6 − 12 y, and x ∈ (1, 6). Therefore,

 p  p
6 − 2 4
α2 if α > 2/5 
α2 if α > 2/5
x(α) = p y(α) = p
1 if α≤ 2/5 10 if α≤ 2/5

(d) Given n coupons, it is always optimal to buy at least n liters of milk. There are two types of
√ √
solution: (i) the solution where (x, y) = (n, 10), but only if α 10 ≤ 2, or (ii) a solution where α y = 2,
x = 5 + n − 21 y, and x ∈ (n, 5 + n). Therefore,

 p  p
5 + n − 2 4
α2 if α> 2/5 
α2 if α > 2/5
x(α) = p y(α) = p
n if α≤ 2/5 10 if α ≤ 2/5

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Intermediate Microeconomics NYUAD, Spring 2023

Problem 2: Expenditure minimization with a weight constraint

There are two goods, X and Y , available in arbitrary non-negative quan-

tities (so the consumption set is R2+ ).

Flora has preferences over consumption bundles that can be represented

by a Cobb-Douglas utility function u : R2+ → R+ , given by

u(x, y) = xy

where x is the quantity of good X (in kilograms) and y is the quantity of

good Y (in kilograms).

Flora has a busy schedule and is unable to go to the store to purchase

the goods herself. Her neighbor kindly offers to go to the store for Flora.
However, her neighbor is able to carry at most 5 kilograms of weight. The
price of a unit of good X at the store is p Dirhams/kilogram, and the price
of a unit of good Y is 1 Dirham/kilogram. How much money would Flora
need to give her neighbor so that her neighbor can purchase a consumption
bundle that the neighbor is able to carry, and so that Flora can attain a
utility of at least 4 utiles?

(a) Formulate this problem as an expenditure minimization problem.

(b) Illustrate the constraint set of the expenditure minimization problem

in an appropriate diagram.

(c) Solve the expenditure minimization problem to find the amount of

money that Flora would need to give to her neighbor as a function of
the price p, and illustrate this function in an appropriate diagram.

Solution:

(a) The EMP is min(x,y)≥0 px + y s.t. xy ≥ 4 and x + y ≤ 5.

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Intermediate Microeconomics NYUAD, Spring 2023

(b) The constraint set is {(x, y) ≥ 0 : xy ≥ 4, x + y ≤ 5}. To illustrate the set, it is useful to first find
the consumption bundles where the weight-budget line intersects with the indifference curve for utility
4. This is a system of two equations. From the utility constraint, y = x4 . Plugging this into the weight-
budget line, x + x4 = 5 , which means x2 − 5x + 4 = 0. Factoring, x2 − 5x + 4 = (x − 1)(x − 4), so there
are two solutions where (x, y) = (1, 4) or (x, y) = (4, 1). The shaded region in Figure 1 then illustrates
the constraint set for the optimization problem.

𝑥𝑦 = 4

1 4 5 𝑥

(c) The slope of an isoexpenditure line is −p and the M RS(x, y) = − xy

There are three types of solution: (i) a solution where (x, y) = (1, 4) and the isoexpenditure line is steeper
than the indifference curve at the point (1, 4) (see figure 2(a)); (ii) a solution where (x, y) = (4, 1) and
the isoexpenditure line is flatter than the indifference curve at the point (4, 1) (see figure 2(b)); or (iii) a
solution at a tangency between the indifference curve and an isoexpenditure line (see figure 2(c)).

𝑦 𝑦 𝑦

5 5 5

𝑥𝑦 = 4 𝑥𝑦 = 4 𝑥𝑦 = 4

1 4 5 𝑥 4 5 𝑥 4 5 𝑥
1 1

At a type (i) solution, (x, y) = (1, 4) but this is only a solution if p ≥ 4. In that case, the value of the
problem is p + 4.

At a type (ii) solution, (x, y) = (4, 1) but this in only a solution if p ≤ 14 . In that case, the value of the
problem is 4p + 1.

At a type (iii) solution, xy = p and yx = 4. From the first equation, y = px, and so from the second
√
equation px2 = 4 =⇒ x = √2p =⇒ y = 2 p. However, this is only a type (iii) solution if 1 < √2p < 4,
√ √
which means 14 < p < 4. In that case, the value of the problem is p √2p + 2 p = 4 p.

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Intermediate Microeconomics NYUAD, Spring 2023

Therefore, the optimal expenditures (i.e., the amount of money Flora will need to give her neighbor) are

p + 4

 if p≥4
e(p) = 1
4p + 1 if p≤ 4
 √

 1
4 p if 4 <p<4

√ p √
Note that 4 4 = 8 = 4+4 and 4 1/4 = 2 = 4 14 +1; hence, e is continuous. Also, the derivative of 4 p is
3
√2 > 0; the second derivative is −p− 2 < 0; and so this function is strictly increasing and strictly concave.
p
Moreover, since √24 = 1 and √2 = 4, the function e(p) is smooth (the derivative as you approach from
1/4
the left is equal to the derivative as you approach from the right). Figure 3 then illustrates the function
e(p).

𝑒(𝑝)
8

1 4 𝑝
4