API 111 / Econ 2020a / HBS 4010

Maciej H. Kotowski / Harvard University

Problem Set 3
Due: September 29, 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.

Enclose final answers with a box.

Notation: In some questions in this problem set you may see the notation = (p1 z1 , p2 z2 , . . .).
This stands for a lottery that offers a prize of z1 with probability p1 , a prize z2 with probability
p2 , and so on.
1. Amandas Quasilinear Preferences

Amanda has quasilinear preferences for goods 1 and 2. Her utility function is u(x1 , x2 ) = 4 x1 + x2 .
Amandas 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 Amandas Walrasian demand function, x (p, w), for all possible values of p1 , p2 , and w.
b) Derive Amandas Hicksian demand function, h (p, u
), for all possible values of p1 , p2 , and u
.
c) Derive Amandas expenditure function, e(p, u
). Does the Hicksian demand function equal the derivative
of the expenditure function? (MWG Proposition 3.G.1.)
d) Suppose prices on Monday are p01 = 10, p02 = 10 and Amandas 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 Amandas
well-being. Are these values the same or are they different? Explain.
e) Suppose prices on Monday are p01 = 10, p02 = 10 and Amandas 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 Amandas well-being. Are these values the same or are they different? Explain.

2. Perfect Complements and Welfare Analysis

Consider a consumer with utility function u(x1 , x2 ) = min{2x1 , x2 }. Suppose the consumers wealth is
w = 80 and that the prices for goods 1 and 2 are p1 = 4 and p2 = 2, respectively. Suppose that the
government imposes a tax of $1 per unit on good 2 so that the net price per unit increases from 2 to 3
dollars.
a) How much tax revenue does the government collect from this consumer?
b) Sketch the consumers Walrasian demand for good 2. Also sketch the consumers Hicksian demands for
good 2 associated with his utility levels before and after the tax. (Assume p1 = 4 is fixed and w = 80.)
c) Calculate the compensating and equivalent variation measures of welfare change associated with price
change. How does it compare with the tax raised? Explain.

3. Polluting a River
The Pristine River is a popular destination for recreation. The river has an abundant fish supply and it has
abundant wildlifedeerliving in its vicinity. On a typical day it attracts 100 sportsmen to fish and hunt.
The utility function of a typical sportsman is given by
u(x1 , x2 ) =

x1 x2 .

x1 is the number of deer hunted and x2 is the number of fish caught. A sportsman spends 10 hours in the
wilderness, either hunting or fishing (or a little of both). It takes 1 hour to catch one fish and 5 hours to
hunt one deer.
a) Set-up the utility maximization problem for a typical sportsman. How many deer do they hunt and how
many fish do they catch given the 10 hours of available time? (To simplify computation, assume that
deer and fish are perfectly divisible goods.)
Smokestack Industries, a giant industrial conglomerate, has a production plant near the Pristine River. One
day the plant had an accident and it spilled some chemicals into the river. While the fish left in the river
were still safe to consume, they were much more difficult to catch. Following the spill, it took 2 hours to
catch one fish. The population of deer in the area was not affected.
b) Consider again the problem of the typical sportsman; how many deer do they hunt now and how many
fish do they catch on a typical day?
c) The chemical spill harmed the sportsmen. Suppose the law says that Smokestack Industries must pay
compensation to the sportsmen. What level of compensation per sportsman would you propose? Assume
that a typical sportsman was planning on hunting/fishing for 20 more days during the current year.
Assume that the fish population rebounds to its pre-spill level after the end of the year. When they are
not hunting or fishing, sportsmen have mundane office jobs which pay $25 per hour.
If you feel like you need to make additional assumptions to answer this question, go ahead, but state
them clearly. There is no need to overcomplicate this exercise, but a few assumptions were left implicit
in the story above.
(This example is somewhat light-hearted, but often economic damages need to be computed in practice.
Economists often serve as consultants on such matters because courts need to quantify the damages in a
legal case, for example. As you might imagine, the soundness and validity of different assumptions can
have a big impact on the cases final outcome.)

4. Buy 3 and Get 1 Free Pricing and Discrete Goods

Gertrude likes sending birthday cards to her friends and family. Her monthly birthday card budget is w = 24.
Gertrude buys her cards at the Papyrus store located in Harvard Square. Suppose Papyrus sells two kinds of
birthday cards: glittered (good 1) and letterpress (good 2). Glittered cards sell at a price of p1 = 3 per card
and letterpress cards are p2 = 6 per card. Gertrudes utility function is given by u(x1 , x2 ) = x1 x2 . Hence,
she has Cobb-Douglas preferences.
Unlike nearly every other problem set question you will ever encounter, throughout this question
assume that cards come only
in integer units. That is, Gertrude can buy the bundle (x1 , x2 ) =
(4, 2) but (x1 , x2 ) = (4.51, 2) is not possible.
a) Given the prices at the store and Gertrudes budget, sketch her budget set noting the integer constraint
on consumption. (This should look like a collection of dots on the x1 -x2 plane.)
b) Identify Gertrudes optimal consumption bundle given the prevailing prices and her budget.

Recently the Papyrus store introduced the following Buy 3 and Get 1 Free pricing policy. For every 4
greeting cards you bring to the register, you get the cheapest one in the lot for free. Hence, you buy three
and get one free.1
c) Sketch Gertrudes budget set given the stores Buy 3 and Get 1 Free pricing policy.
d) Identify Gertrudes optimal consumption bundle given the promotional policy.
e) Gertrude is clearly (weakly) better off with the Buy 3 and Get 1 Free pricing policy than without it.
Use compensating variation and equivalent variation to quantify the benefits she derived from the offer.
(As before, cards can only be consumed in integer quantities.)
f) In 23 sentences, explain why a store might adopt such a pricing policy?

5. Mixtures and the Independence Axiom

Consider the lotteries 1 = (1/3 z1 , 2/3 z2 ) and 2 = (3/4 z2 , 1/4 z3 ).
a) Construct a third lotterydenoted 3 such that you can write lotteries 1 and 2 as mixtures of the
form 1 = 3 + (1 )1 and 2 = 3 + (1 )2 , for some value [0, 1].
b) Suppose a decision maker has vNM expected utility preferences. Show that 1 2 if and only if 1 2 .
c) Suppose that she is indifferent between 1 and 2 , i.e. 1 2 . What is the set of all lotteries such that
1 ? Draw this set in the Marschak-Machina probability triangle.2
6. Georges Unknown Risk Preferences
George is risk averse and makes decisions according to the principles of von Neumann-Morgenstern expected
utility theory. Let u : R R denoted his Bernoulli utility function over monetary lotteries. Very little is
known about the function u(). However, we know its value at three points:
u(0) = 0
u(4) = 8
u(12) = 12
a) Suppose George is offered a choice between lotteries A and B:
Lottery A: $12 with probability 0.5 and $0 with probability 0.5.
Lottery B: $4 with probability 1.
Given what we know about George, what option will he select? Prove your assertion.
If there is not enough information to determine his preferred choice, explain briefly.
b) Suppose George is offered a choice between lottery C and D:
Lottery C: $10 with probability 0.5 and $3 with probability 0.5.
Lottery D: $4 with probability 1.
Given what we know about George, what option will he select? Prove your assertion.
If there is not enough information to determine his preferred choice, explain briefly.
1 This question was inspired by Maciejs experience buying cards at Papyrus in September 2013, where such a pricing policy
was used (its still in place as of September 9, 2014). Such pricing schemes make a consumers problem somewhat non-trivial.
(Despite his efforts, Maciej could not solve this problem while still in the store. Hence, its now a problem set question.)
2 Examples of such triangles are found in MWG 6.B. An intermediate-level exposition to the concept is found in the book
Richard Watt, The Microeconomics of Risk and Information. Palgrave Macmillan, 2011. Specifically, see Chapter 3.

Additional Practice Problems (Do Not Hand In)

7. Philips Fruit Diet
Philip only eats mangoes and nectarines. His utility from consuming x1 kilograms of mangoes and x2

kilograms of nectarines in a day is u(x1 , x2 ) = x1 + x2 . Suppose Philip has w dollars to spend on fruit
each day and that the market price of mangoes is p1 dollars per kilogram. The market price of nectarines is
p2 dollars per kilogram.
a) Derive Philips Walrasian demand for mangoes and nectarines.
b) What is Philips price elasticity of demand for mangoes? Are mangoes price elastic or inelastic goods?
What is the income elasticity of demand for mangoes?
Suppose scientists suddenly discover that consuming (strictly) more than 1 kg of nectaries per day elevates
the risk of contracting an extremely rare disease by 0.00000001%. Philip is not especially concerned about
this discovery and his preferences for mangoes and nectarines are left unchanged.
However, Philips mother is terrified! She forbids him from consuming more than 1 kg of nectarines per
day.
c) What is the new consumption possibility set for Philip given that he must listen to his mother? Sketching
a picture is helpful.
d) Suppose that before and after the scientific discovery, w = 4, p1 = p2 = 1. What is Philips new level of
consumption of mangoes and nectarines.
e) Describe how Philips welfare has changed using compensating and equivalent variation.

8. Back-of-the-Envelope (Linear) Estimates of Demand Curves with Elasticity Data

Consider the market for gasoline, which we will call good 1. We will will assume the price of all other goods
is fixed and consumers income is fixed. Hence, we will write the per-day Walrasian demand of a typical
consumer for gasoline in liters as x1 (p1 ), suppressing the prices of other goods and income. Assume that the
following (very) stylized facts about the gasoline market are true:
The per-liter price of gasoline today is p01 = 1.
The average consumption of gasoline is 4.5 liters per day. Hence, x1 (1) = 4.5.
The demand elasticity of gasoline is 1 = 0.25.
The income elasticity of demand for gasoline is 1 = 0.4.
The average person spends 3.5% of their income on gasoline.
a) Using the above data, derive a (linear) approximation of the Walrasian demand curve. Call this estimated
curve x
1 (p1 ). It should have the property that at the price p01 = 1, x
1 (1) = x1 (1) = 4.5.
b) Using the Slutsky equation, show that you can write the elasticity of the Hicksian demand curve, h1 =
dh
1 p1
, at points where x1 = h1 , as h1 = 1 + 1 B1 . B1 is the share of income spent on gasoline, 1 is the
dp1 h
1
demand elasticity of gasoline, and 1 is the income elasticity of demand.
c) Using the above data, derive a (linear) approximation of the Hicksian demand curve at price p01 = 1.
1 (p1 ). Your estimate should have the property that at the price p0 = 1,
Call this estimated curve h
1
1 (1) = h (1) = x (1) = 4.5.
h
1
1

d) Suppose there is a proposal to tax gasoline such that the (tax-inclusive) price becomes p11 = 1.5. Use your
estimated demand curves to provide two different estimates of the welfare impacts of this proposal: The
change in consumer surplus and a measure based on the Hicksian demand curve. (Is the latter estimate
approximating to compensating or equivalent variation?)

9. Consuming Lottery Winnings

Jane consumes goods 1 and 2. On the open market, these goods sell at prices p1 = p2 = 1. Janes utility
1/3 2/3
function is u(x1 , x2 ) = x1 x2 .
a) Suppose Jane is offered a choice between a lottery that pays $100 with probability 1/2 and $200 with
probability 1/2 or a certain payment of $160. She wishes to maximize her expected utility. Will Jane
prefer the gamble or the certain payment given that she will use whatever winnings to purchase goods 1
and 2 at the market prices. (Assume she has not other money available.)
b) More generally, is Jane risk averse, risk neutral, or risk loving?
c) Do your conclusions change if Janes consumption preferences are summarized by the utility function
u(x1 , x2 ) = log(x1 ) + 2 log(x2 ) instead. Explain.

10. Certainty Equivalents

Consider a decision maker who makes decisions according to vNM expected utility, with a strictly increasing
Bernoulli utility function u(z). Consider the following Bernoulli utility functions: u1 (z) = z 1/2 , u2 (z) = z 1/4 ,
u3 (z) = z 3/2 .
a) For each Bernoulli utility function, calculate the certainty equivalent and risk premium associated with
the lottery 1 = (0.5 0, 0.5 16).
b) For each Bernoulli utility function, calculate the certainty equivalent and risk premium associated with
the lottery 2 = (0.5 0, 0.5 256).
c) Discuss your results from parts (a) and (b).

11. Calibrating Risk Preferences

Felix has vNM expected utility preferences with a Bernoulli utility function u(x) = ex . Suppose Felix
tells you that for all wealth levels w he would reject a 5050 gamble to win $110 or lose $100. At first sight,
this seems reasonableperhaps you would also reject such a gamble. Formally,


1
1
(1 w)
(w + 110), (w 100)
2
2
for all values of w. w is Felixs wealth level.
a) Prove that Felixs coefficient of absolute risk aversion must be larger than 0.0009.
b) Prove that Felix would also reject the following gamble: With probability 1/2 he would lose $1000 and
with probability 1/2 he would win a gazillion dollars. (Gazillion is a number as large as you would like!)
For similar examples and for the general argument, read Matthew Rabin, Risk Aversion and ExpectedUtility Theory: A Calibration Theorem, Econometrica 68(5):12811292, 2000. (This question is adapted
from a problem set in a course that was taught by Matthew Rabin.)