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Problem Set 2
Due: September 22, 2014 at 13.00
Legibly write your name (and the names of any collaborators) on your independently written-up solutions.
Submit your solutions to the assignment drop box. Do not bring solutions to lecture.
Show your work. Include brief and precise explanations of intuition and derivations as appropriate.
Help us out.
u(x1 , x2 ) = (x1 + x2 )
(1)
The utility function u(x1 , x2 ) is an example of preferences with a constant elasticity of substitution (CES).
Preferences in this class are the work-horse preferences of many models in macroeconomics or in the study
of international trade. Therefore, understanding their properties is critical. In such applications, they often
1/
R
1/
P
1
L
when there is
x
d
for
the
L-good
case
and
x
appear in their more generalized forms:
=1
0
a continuum of goods. For this question, we will stick with the simple two-good version in (1).
a) Sketch the consumers indifference curves for different values of (, 1]. (You may wish to use a
computer to simplify this step.) Are these preferences convex? Are these preferences homothetic (see
Problem Set 1)?
b) Sketch the consumers indifference curves when = 2. Are these preferences convex?
c) Suppose henceforth that (, 1). Derive the consumers Walrasian demand function for goods 1 and
2.
d) The elasticity of substitution between goods 1 and 2 is defined by
h
h i
i
p1
xx12 (p,w)
(p,w)
p2
i.
h i h
12 (p, w) =
x1 (p,w)
pp12
x2 (p,w)
Show that for the CES utility function, 12 (p, w) =
1
1 .
P
2
j=1 xj
1
3. Maximizing a Maximum
Maximilian consumes two goods. His utility function is
u(x1 , x2 ) = max{x1 + x2 , x2 + x1 }
where , > 0. Let p1 and p2 be the prices of goods 1 and 2, respectively. Let w > 0 be Maximilians
wealth. What are Maximilians Walrasian and Hicksian demand correspondences?
4. Homothetic Preferences and Price Indices
The consumer price index (CPI) measures the change in the price of a fixed basket of goods and services.
Sometimes, media report that the CPI measures the change in the cost of living. This latter statement
is not entirely true. CPI measures neglect the substitution among goods and services that consumers often
make in response to price changes.
Let pt = (pt1 , . . . , ptL ) be the prices of goods 1, . . . , L in period t. Let xt = (xt1 , . . . , xtL ) be the bundle of
goods purchased by a utility-maximizing consumer in period t when pt are the prevailing prices. There are
several ways we can define a price index based on the bundle of goods which serves as a reference point. We
define a Laspeyres Price Index as
PL
p2 x1
p2 x1
CP IL = P=1
= 1 1.
L
1 1
p x
=1 p x
A Paasche Price Index is
PL
CP IP = P=1
L
=1
CP IF =
p2 x2
p1 x2
p2 x2
.
p1 x2
p
CP IL CP IP .
In contrast with the above measures a cost of living adjustment (COLA) would measure the change in
expenditure necessary for a consumer to maintain/achieve a given level of utility as prices change. We can
define
e(p2 , u2 )
e(p2 , u1 )
and
COLA
=
.
COLA1 =
2
e(p1 , u1 )
e(p1 , u2 )
e(pt , us ) is the minimum expenditure needed to attain utility level us when the prevailing prices are pt . If xt
P
t t
t
t
t
t
is a utility-maximizing bundle, then under our usual assumptions L
=1 p x = e(p , u ) where u = u(x ).
a) While COLAt is an appealing measure, identify at least one practical problem with its use.
b) A natural question to ask is how well the CPI measures approximate the cost of living adjustments.
Show that CP IL overestimates COLA1 and CP IP underestimates COLA2 . What implications for public
policy, if any, do these biases imply? (The syllabus offers some background readings on the CPI.)
Suppose that a consumer has wealth w = 8 in each of two periods and faces prices (p11 , p12 ) = (1, 1) in
period 1 and prices (p21 , p22 ) = (1, 4) in period 2 for goods 1 and 2. The consumer has identical CobbDouglas preferences u(x1 , x2 ) = x1 x2 for consumption in each period and chooses bundles for each period
independently to maximize utility in that period.
c) What are the consumers optimal bundles in periods 1 and 2?
d) Compute the CPI for these bundles and prices based on the Laspeyres index, the Paasche index, and the
Fisher ideal index.
e) Now find the exact change in wealth necessary to achieve period 1s utility in period 2. Do any of the
price indices accurately reflect this change in the cost of living?
1
.
x1
Janices income is w > 0 and she faces prices p1 and p2 for the two goods. (Throughout this problem, be
mindful of corner solutions.)
a) Derive Janices Walrasian demand function, x (p, w), for all possible values of p1 , p2 , and w.
b) Derive Janices Hicksian demand function, h (p, u
), for all possible values of p1 , p2 , and u
.
c) Derive Janices expenditure function, e(p, u
). Does the Hicksian demand function equal the derivative of
the expenditure function? (MWG Proposition 3.G.1.)
Parts (c) and (d) are optional, but you should complete them before the midterm exam.
d) Suppose prices on Monday are p01 = 10, p02 = 10 and Janices income is w = 40. On Tuesday, the store
selling good 1 raises its price for good 1 to p11 = 16 dollars. The price of good 2 is unchanged. Use
compensating variation, equivalent variation, and consumer surplus to quantify the change in Janices
well-being. Are these values the same or are they different? Explain.
e) Suppose prices on Monday are p01 = 10, p02 = 10 and Janices income is w = 40. On Tuesday, the
store selling good 2 has a sale and lowers its price for good 2 to p12 = 5 dollars. The price of good 1
is unchanged. Use compensating variation, equivalent variation, and consumer surplus to quantify the
change in Janices well-being. Are these values the same or are they different? Explain.