Problem Set 1 - SOLUTIONS

ECH-32306 Advanced Microeconomics, Part 1, Fall 2016

Instructor: Dusan Drabik, De Leeuwenborch 2106

1. A consumer has a preference relation on R1 which can be represented by the utility function
u(x) = x2 + 4x + 4. Is this function quasi-concave? Briefly explain. Is there a concave utility
function representing the consumer's preferences? If so, display one; if not, why not?

Solution
Without loss of generality, consider any two points x1 , x2  R1 , such that x1  x2 . Because
du dx  0 for x1  R1 , we have u  x1   u  x2  , from which u  x1   min u  x1  , u  x2  . Now,
form xt  tx1  1  t  x2 for t   0,1 . Because xt  x1 and du dx  0 , it must be the case that
u  xt   u  x1   min u  x1  , u  x2  , hence u(x) is a quasi-concave function.

Alternatively, the set  x  0 : u  x   k   x  0 : x 2  4 x  4  k    


  k  2,  for k  4 
 is
  0,   for k  4 
a convex set for all k  R .

1
Yes, there is such a concave utility function, for example: v  x   x , or v  x   x . 2

2. A consumer has Lexicographic preferences on R 2 if the relationship satisfies x1 x2

whenever x11  x12 , or x11  x12 and x12  x22 . Show that lexicographic preferences on R 2 are
rational, i.e., complete and transitive.

1
3. A consumer with convex, monotonic preferences consumes non-negative amounts of x1 and
x2.
1

a.) If u  x1 , x2   x1 x
 2
2 represents those preferences, what restrictions must there be on the
value of parameter  ? Explain.
b.) Given those restrictions, calculate the Marshallian demand functions.

Solution
a.) Monotonicity requires
1 
1 1
   1
u x1   x1 1 x22 0    0 and u x2      x1 x2 2  0    . Because the
2  2
utility function is homogeneous of degree ½, it is strictly concave, hence also quasi-
concave and quasi-concave functions have convex superior sets (i.e., preferences are
convex). So no further restrictions on  are required.

b.) x1 
2 y
, x2 
1  2  y .
p1 p2

4. There are two goods, x   x1 , x2   R 2 . A consumer has the utility function

U  x   u1  x1   u2  x2  where each ui is twice continuously differentiable with ui '  xi   0
and ui ''  xi   0 for all xi  R1 . Each ui also satisfies the condition: lim xi  0 ui '  xi    .
Assume that prices of both goods are strictly positive, each pi > 0, and wealth is strictly
positive, w > 0. [The conditions in this problem are sufficient to guarantee that the optimal
bundle of goods x* is interior, i.e. x* >> 0. So you can ignore inquality constraints of the
form x  0 .]

a.) Write the consumer's problem as a constrained optimization problem and display the first
order conditions for this optimization problem.
b.) Show that if wealth increases then the demand for good 1 increases.
c.) What is the sign of the effect of a change in the price of good 1 on the consumer’s
demand for good 1? Show your work.

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5. In a two-good case, show that if one good is inferior, the other must be normal.

3
 Solution
p1 x1  p2 x2  y
x1 x
p1  p2 2  1
y y
x1 y p1 x1 x2 y p2 x2
 1
y x1 y y x2 y
1s1  2 s2  1
where
x y px 2
i  i , si  i i ;  si  1; i  1,2
y xi y i 1
Without loss of generality, assume x1 is the inferior good. Then, we must have 1  0 , which
means that 2  0 because 1>0. Thus, x2 must be a normal good.

6. How would you determine whether the function

X  px , p y , I  
2 px I
px 2  p y 2
could be a demand function for commodity x of a utility maximizing consumer with
preferences defined over the various combinations of x and y? Is it a demand function?

Solution
One has to check all the properties of the Marshallian demand function, as well as the
negative semi-definiteness of the Slutsky matrix. The function above is not a Marshallian
 
demand function because the s11 px , p y ,I entry of the Slutsky matrix

2 I  p x  p y   2 p x 2 
2

s11  px , p y ,I      0 . This entry is negative for a well-behaved

p  py 2 
2 2
x

Marshallian demand function.

7. An economy consists of I consumers indexed by i = 1, 2,..., I. Consumers incomes are

 yi i 1 . There are N goods, x   x1 ,..., xN  . All consumers have the same utility function U(x)
I

which is strictly increasing, strictly concave, twice continuously differentiable, and

homogenous of degree one.

a.) Show that the form of individual i’s indirect utility function is V(p, yi) = V(p,1)yi, where
p = (p1,...,pN) is the price vector.
b.) Does there exist a positive representative consumer for this economy? Prove your
answer.

Solution
a.)

4
 Vi  p, yi   max U  x   U x*  

Vi  p, yi   U x*  p, yi  
Because U . is HoD 1, we have
  
U tx*  p, yi   tU x*  p, yi  
1
Now, take t 
yi
1  1

U  x*  p, yi    U x*  p, yi  
 yi  yi
1
Define z  x*  p, yi 
yi


U z *  p,1  1
yi

U x*  p, yi  
1
Vi  p,1  Vi  p, yi 
yi
Vi  p, yi   yiVi  p,1

b.) All individual utility functions can generally be written as:

Vi  p, yi   ai  p   b  p  yi  GORMAN FORM .
In our case:
ai  p   0
, so yes, there exists a positive representative consumer.
b  p   V  p,1

8. There are two consumption goods x  0 and y  0 . An individual has homothetic preferences
with typical indifference curve I as illustrated below.

2
I
1

1 2 x
These goods can be purchased at prices p = (px, py).

a.) Provide a utility function, in which I is assigned utility level 1, that represents this
individual’s preferences.

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 b.) Find the expenditure function for utility 1, that is, e(p,1).
c.) Find the Hicksian demand for good x at utility 1, that is, hx(p,1).
d.) Is there a dual relationship between e(p,1) and hx(p,1) for this individual? Explain.

Solution

 x  y
a.) u  x, y   min  x, y, 
 3 
 2 px  p y for px  p y

b.) e  p,1   3 px for px  p y
 p  2 p for p  p
 x y x y

 2 for px  p y

c.) hx  p,1  1, 2  for px  p y
 1 for p  p
 x y

d.) No, because hx  p,1 is a correspondence.