Chapter 4: Appendix

CHAPTER 4 APPENDIX DEMAND THEORY A MATHEMATICAL TREATMENT

EXERCISES
1. Which of the following utility functions are consistent with convex indifference curves and which are not? a. U(X, Y) = 2X + 5Y b. U(X, Y) = (XY)0.5 c. U(X, Y) = Min(X, Y), where Min is the minimum of the two values of X and Y. Indifference maps for the three utility functions are presented in Figures 4A.1(a), 4A.1(b), and 4A.1(c). The first is a series of straight lines, the second is a series of hyperbolas and the third is a series of L-shaped curves. Only the second utility function has strictly convex indifference curves. To graph the indifference curves which represent the preferences given by U(X,Y) = 2X + 5Y, set utility equal to some level, U0, and solve for Y to get

Y=

U0 2 X. 5 5

Since this is the equation for a straight line, the indifference curves are linear with intercept

different values of U, where U0 < U1 < U2.

U0 2 and slope . The graph shows three indifference curves for three 5 5

U2 5 U1 5 U0 5

U0
U0 2

U1
U1 2
Figure 4A.1(a)

U2
U2 2

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Chapter 4: Appendix To graph the indifference curves that represent the preferences given by U( X , Y) = ( XY )0.5 , set utility equal a given level U0 and solve for Y to get

Y=

2 U0 . X

By plugging in a few values for X and solving for Y, you will be able to graph the indifference curve for utility value U0, which is illustrated in Figure 4A.1(b), along with the indifference curve for a larger utility value, U1.

U1 U0

X
Figure 4A.1(b) To graph the indifference curves which represent the preferences given by U ( X , Y ) = Min ( X , Y ) , first note that utility functions of this form result in indifference curves that are L-shaped and represent a complementary relationship between X and Y. In this case, for any given level of utility U0, the minimum value of X and Y will also be equal to U0. If X increases but Y does not, utility will not change. If both X and Y change, then utility will change, and we will move to a different indifference curve. See the following table which illustrates how the utility value depends on the amounts of X and Y in the consumption bundle. X 10 10 12 12 8 8 Y 10 12 12 11 11 9 U 10 10 12 11 8 8

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Chapter 4: Appendix

U1 U0

U1 Uo

U0

U1
Figure 4A.1(c)

2. Show that the two utility functions given below generate the identical demand functions for goods X and Y: a. U(X, Y) = log(X) + log(Y) b. U(X, Y) = (XY)0.5 If two utility functions are equivalent, then the demand functions derived from them are identical. Two utility functions are equivalent if you can transform one of them and get the other one. The transformation must be performed by a function that transforms one set of numbers into another set without changing their order. So, for example, the square function could be used, because it does not change the order of numbers that are squared. If w is larger than z, then w2 is larger than z2. The logarithm function can also be used as a transformation function, and that is what we use here. Taking the logarithm of U(X, Y) = (XY)0.5 we obtain logU(X, Y) = 0.5 log(XY) = 0.5 (log(X) + log(Y)). Now multiply both sides by 2, which yields the utility function in a. 2[logU(X,Y)] = log(X) + log(Y). Therefore, the two utility functions are equivalent and will yield identical demand functions. We can also demonstrate this directly by solving for the demand functions in both cases and showing that they are the same. a. To find the demand functions for X and Y, corresponding to U(X, Y) = log(X) + log(Y), we must maximize U(X, Y) subject to the budget constraint. To do this, first write out the Lagrangian function, where is the Lagrange multiplier: = log(X) + log(Y) (PXX + PYY I ).

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Chapter 4: Appendix Differentiating with respect to X, Y and , and setting the derivatives equal to zero:

1 = PX = 0 X X 1 = PY = 0 Y Y

= I PX X PY Y = 0.
The first two conditions imply that PX X = The third condition implies that I
1 1
1

and PY Y =
2 . I

= 0 , or =

Substituting this expression into PX X =

I X = 2P X

and PY Y =

gives the demand functions:

.

I and Y = 2P Y

Notice that the demand for each good depends only on the price of that good and on income, not on the price of the other good. Also, the consumer spends exactly half her income on each good, regardless of the prices of the goods. b. To find the demand functions for X and Y, corresponding to U(X,Y) = (XY)0.5 = (X0.5)(Y0.5), first write out the Lagrangian function: = (X)0.5(Y)0.5 (PXX + PYY I ) Differentiating with respect to X, Y, and setting the derivatives equal to zero:

= 0.5 X 0.5Y 0.5 PX = 0 X = 0.5 X 0.5Y 0.5 PY = 0 Y = I PX X PY Y = 0 Y

Take the first two conditions, move the terms involving to the right hand sides, and P Y then divide the first condition by the second. After some algebra, youll find = X , X PY or PY Y = PX X . Substitute for PYY in the third condition, which yields I = 2PXX.
, which are the same demand functions we found I I Therefore, X = 2P and Y = 2P X Y for the other utility function.

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Chapter 4: Appendix 3. Assume that a utility function is given by Min(X, Y), as in Exercise 1(c). What is the Slutsky equation that decomposes the change in the demand for X in response to a change in its price? What is the income effect? What is the substitution effect? The full Slutsky equation is dX dPX = X PX |U =U * X (X / I ) , where the first term on the right represents the substitution effect and the second term represents the income effect. Because there is no substitution effect as price changes with this type of fixed proportions utility function, the substitution effect is zero. Therefore, the Slutsky equation for the fixed proportions utility function is dX dPX = X (X / I ) . A numerical example will help explain how this works. Suppose the consumer originally purchases 10 units of X, and we know that he would buy 1 more unit if his income increased by $5 (so that X / I = 1 $5 = 0.2 ). Using the Slutsky equation, dX dPX = 10(0.2) = 2 . Therefore, if the price of X increased by $1, the consumer would buy 2 fewer units of X, which would be due solely to the income effect. Conversely, if the price of X decreased by $1, the consumer would buy 2 more units. Figure 4A.3 below shows that when the price of X falls, the consumers budget line pivots out from L1 to L2. A parallel shift of the new budget line back to the original indifference curve, U1, gives us the hypothetical budget line L3 from which we determine the substitution effect. Because the consumer would purchase the same bundle of X and Y as he did along the original budget line, the substitution effect is zero. The income effect is determined by the shift from budget line L3 to L2, which results in an increase in utility from U1 to U2 and an increase in consumption of X.

L2 L1
U2

L3

U1

New Budget, New Utilility New Budget, Old Utility

X

Old Budget, Old Utility

Figure 4A.3

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Chapter 4: Appendix 4. Sharon has the following utility function:

U( X , Y) =

X+ Y

where X is her consumption of candy bars, with price PX = $1, and Y is her consumption of espressos, with PY = $3. a. Derive Sharons demand for candy bars and espressos.

Using the Lagrangian method, the Lagrangian equation is

X + Y ( PX X + PY Y I ) .

To find the demand functions, we need to maximize the Lagrangian equation with respect to X, Y, and , which is the same as maximizing utility subject to the budget constraint. The necessary conditions for a maximum are (1) (2) (3)
= 0.5 X 0.5 PX = 0 X

= 0.5Y 0.5 PY = 0 Y = I PX X PY Y = 0 .

Combining conditions (1) and (2) results in

=
(4)

1 1 = , so that PX X 0.5 = PY Y 0.5 , and therefore 0.5 2 PX X 2 PY Y 0.5

PY2 X = P 2 Y . X

Now substitute (4) into (3) and solve for Y. Once you have solved for Y, you can substitute Y back into (4) and solve for X. Note that algebraically there are several ways to solve this type of problem; it does not have to be done exactly as shown here. The demand functions are:

Y=

PX I I or Y = P + PY PX 12 3I PI X= 2 Y or X = . PX + PY PX 4
2 Y

b. Assume that her income I = $100. How many candy bars and how many espressos will Sharon consume?

Substitute the values for the two prices and income into the demand functions to find that she consumes X = 75 candy bars and Y = 8.33 espressos.
c. What is the marginal utility of income?

As shown in the appendix, the marginal utility of income equals 8. From part a, 1 1 = = . Substitute into either part of the equation to get = 0.058. 0.5 2 PX X 2 PY Y 0.5 This is how much Sharons utility would increase if she had one more dollar to spend.

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Chapter 4: Appendix 5. Maurice has the following utility function: U ( X ,Y ) = 20 X + 80Y X 2Y , where X is his consumption of CDs, with a price of $1, and Y is his consumption of movie videos, with a rental price of $2. He plans to spend $41 on both forms of entertainment. Determine the number of CDs and video rentals that will maximize Maurices utility.
2 2

Using X as the number of CDs and Y as the number of video rentals, the Lagrangian equation is

= 20X + 80Y X 2Y ( X + 2Y 41).

To find the optimal consumption of each good, maximize the Lagrangian equation with respect to X, Y and , which is the same as maximizing utility subject to the budget constraint. The necessary conditions for a maximum are

(1) (2) (3)

= 20 2 X = 0 X = 80 4Y 2 = 0 Y = X + 2Y 41 = 0.

Note that in condition (3), both sides have been multiplied by 1. Combining conditions (1) and (2) results in

= 20 2X = 40 2Y
(4) 2Y = 20 + 2 X .
Now substitute (4) into (3) and solve for X. Once you have solved for X, you can substitute this value back into (4) and solve for Y. Note that algebraically there are several ways to solve this type of problem, and that it does not have to be done exactly as here. The optimal bundle is X = 7 and Y = 17.

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