Budget Constraints

1. What is the prisoners’ dilemma? What do we mean when we say that every market transaction is a solution to the prisoners’ dilemma? How does this relate to the enforcement problem? Explain carefully, using examples liberally to support your explanations.
2. Suppose you have a budget constraint of $400 dollars for the week and you must decide how to divide the $400 between exactly two goods. (You must spend it all on the two goods.) The first good costs $20 per unit and the second good costs $10 per unit. You have a standard utility function for the items (more is better, but with an eventual diminishing return on each product). Answer the following questions:
   1. Which point do you think has a higher utility, 10 of good one and 20 of good two or 12 of good one and 16 of good two? Show that it is possible for a reasonable person to prefer either of these bundles. (Hint: Try different sets of indifference curves.) Do these points satisfy your budget constraint?
   2. Using indifference curves, show how you would find the optimal bundle of goods. (You need not use numbers. Just show graphically what a solution would look like.

3. BONUS QUESTION What does it mean to say that decisions should be made at the margins? Explain carefully and thoroughly, using examples to illustrate.

4. ANOTHER BONUS QUESTION Suppose a product sells 500,000 units at a price of $12 but only 490,000 units at a price of $16. Answer the following questions:

1. What is the price elasticity of demand for this product, based on these two points? Use the midterm formula to calculate.
2. Is the product elastic or inelastic? Explain.
3. Speculate as to what product this might actually be. Why do you think so? (There is no one right answer, but there are a lot of wrong ones. Choose wisely.)