Week 4 Problem Set Suggested Solutions

T1 Suppose that a consumer has the following utility function: u(x1 , x2 ) = x21 x2
(a) Derive the consumer’s Marshallian demand functions, x1 (p, y) and x2 (p, y).
Sol: The optimality conditions are given by
2x1 x2 2x2 p1
M RS12 = 2 = = and p1 x1 + p2 x2 = y.
x1 x1 p2
Solving the equations,
2y y
x1 (p1 , p2 , y) = and x2 (p1 , p2 , y) = .
3p1 3p2
(b) Compute the consumer’s own-price elasticity for good 1, ε1 .
Sol:
dx1 (p1 , p2 , y) p1 2y p1
ε1 = =− 2 = −1.
dp1 x1 (p1 , p2 , y) 3p1 2y/(3p1 )
(c) Compute the consumer’s cross-price elasticity between good 1 and good 2, ε12 . Sol:
ε12 = 0, because x1 (p1 , p2 , y) is independent of p2 .
(d) Compute the consumer’s income elasticity for good 1, η1 .
Sol:
dx1 (p1 , p2 , y) y 2 y
η1 = = = 1.
dy x1 (p1 , p2 , y) 3p1 2y/(3p1 )
(e) Suppose that p2 = 2 and y = 24. If p1 increases from 1 to 2, what happens to the
consumer’s consumption of good 1?
Sol: From xA C
1 = x1 (1, 2, 24) = 16 to x1 = x1 (2, 2, 24) = 8.
(f) In (e), how much change is due to the substitution effect?
Sol: In order to identify the substitution effect (and for later use as well), we derive the
consumer’s Hicksian demand functions. The optimality conditions are given by
2x2 p1
M RS12 = = and u = x21 x2 .
x1 p2
Solving the two equations,

2p2 1/3 1/3 p1 2/3 1/3

   
h h
x1 (p1 , p2 , u) = u and x2 (p1 , p2 , u) = u .
p1 2p2
In addition, x2 (1, 2, 24) = 4, and thus u = u(16, 4) = 162 4 = 210 . It then follows that
h 0
xB h 10
1 = x1 (p1 , p2 , u) = x1 (2, 2, 2 ) = 2
11/3
= 8 · 22/3 .

Therefore, the substitution effect is from 16 to 8 · 22/3 .

(g) Calculate the equivalent variation of the price change in (e).
Sol: From the Hicksian demand functions in (f),

2p2 1/3 1/3 p1 2/3 1/3

   
3 2/3 1/3
e(p1 , p2 , u) = p1 u + p2 u = 2/3 p1 p2 u1/3 .
p1 2p2 2
In addition, x2 (2, 2, 24) = 4, and thus u0 = u(8, 4) = 82 · 4 = 28 . It then follows that

EV = e(p1 , p2 , u0 ) − y = e(1, 2, 28 ) − 24 = 12 · 21/3 − 24 = 12(21/3 − 2) ≈ −8.8809.

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 (h) Calculate the compensating variation of the price change in (e).
Sol: Based on the previous calculations,
CV = y − e(p01 , p2 , u) = y − e(2, 2, 210 ) = 24 − 24 · 22/3 = 24(1 − 22/3 ) ≈ −14.0976.

(i) How much does the consumer’s consumer surplus decrease in (e)?
Sol: The change in consumer surplus is equal to
Z 2
2y
CV = − dt = −16 ln(2) ≈ −11.0904
1 3t
√
T2 Redo all the exercises in T1 with the following utility function: u(x1 , x2 ) = 4 x1 + x2 .
Assume that y > 4p22 /p1 .
(a) Derive the consumer’s Marshallian demand functions, x1 (p, y) and x2 (p, y).
Sol: The optimality conditions are given by
√
2/ x1 p1
M RS12 = = and p1 x1 + p2 x2 = y.
1 p2
Solving the equations,
4p22 y 4p2
x1 (p1 , p2 , y) = 2 and x2 (p1 , p2 , y) = − .
p1 p2 p1
(b) Compute the consumer’s own-price elasticity for good 1, ε1 .
Sol:
dx1 (p1 , p2 , y) p1 8p2 p1
ε1 = = − 32 2 2 = −2.
dp1 x1 (p1 , p2 , y) p1 4p2 /p1
(c) Compute the consumer’s cross-price elasticity between good 1 and good 2, ε12 . Sol:
dx1 (p1 , p2 , y) p2 8p2 p2
ε12 = = 2 = 2.
dp2 x1 (p1 , p2 , y) p1 4p22 /p21
(d) Compute the consumer’s income elasticity for good 1, η1 .
Sol: η = 0, because x1 (p1 , p2 , y) is independent of y.
(e) Suppose that p2 = 2 and y = 24. If p1 increases from 1 to 2, what happens to the
consumer’s consumption of good 1?
Sol: From xA C
1 = x1 (1, 2, 24) = 16 to x1 = x1 (2, 2, 24) = 4.
(f) In (e), how much change is due to the substitution effect?
Sol: The whole change is due to the substitution effect, because this is a quasilinear
utility function. To see this more clearly, we derive the consumer’s Hicksian demand
functions. The optimality conditions are given by
√
2/ x1 p1 √
M RS12 = = and u = 4 x1 + x2 ,
1 p2
which lead to
4p22 8p2
xh1 (p1 , p2 , u) = and xh2 (p1 , p2 , u) = u − .
p21 p1
Since xh1 (p1 , p2 , u) is independent of u,
h 0
xB h 10
1 = x1 (p1 , p2 , u) = x1 (2, 2, 2 ) = 4.

Therefore, the substitution effect is from 16 to 4.

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 (g) Calculate the equivalent variation of the price change in (e).
Sol: From the Hicksian demand functions in (f),

4p22 4p2
 
8p2
e(p1 , p2 , u) = p1 2 + p2 u − = p2 u − 2 .
p1 p1 p1

In addition, x2 (2, 2, 24) = 8, and thus u0 = u(4, 8) = 16. It then follows that
equivalent value
price changes EV = e(p1 , p2 , u0 ) − y = e(1, 2, 16) − 24 = 16 − 24 = −8.

(h) Calculate the compensating variation of the price change in (e).

Sol: x2 (1, 2, 24) = 4, and thus u = u(16, 4) = 20. Therefore,
university wants take away
CV = y − e(p01 , p2 , u) = y − e(2, 2, 20) = 24 − 32 = −8.
stipend; prices change but still
want same spending power
(i) How much does the consumer’s consumer surplus decrease in (e)?
Sol: The change in consumer surplus is equal to
Z 2 Z 2  2
16 16
CV = − x1 (t, p2 , y)dt = − 2
dt = = −8.
1 1 t t 1

2/3 2/3
T3 Redo all the exercises in T1 with the following utility function: u(x1 , x2 ) = (x1 + x2 )3/2 .

(a) Derive the consumer’s Marshallian demand functions, x1 (p, y) and x2 (p, y).
Sol: The optimality conditions are given by
 1/3
x2 p1
M RS12 = = and p1 x1 + p2 x2 = y.
x1 p2
Solving the equations,

p22 y p21 y
x1 (p1 , p2 , y) = and x 2 (p 1 , p2 , y) = .
p1 (p21 + p22 ) p2 (p21 + p22 )

(b) Compute the consumer’s own-price elasticity for good 1, ε1 .

Sol:
dx1 (p1 , p2 , y) p1 p2 y(3p2 + p2 ) p2 (p2 + p2 ) 3p2 + p22
ε1 = = − 22 2 1 2 22 1 12 2 = − 21 .
dp1 x1 (p1 , p2 , y) p1 (p1 + p2 ) p2 y p1 + p22

(c) Compute the consumer’s cross-price elasticity between good 1 and good 2, ε12 . Sol:

dx1 (p1 , p2 , y) p2 2p21 p2 y p1 p2 (p21 + p22 ) 2p21

ε12 = = = .
dp2 x1 (p1 , p2 , y) p1 (p21 + p22 )2 p22 y p21 + p22

(d) Compute the consumer’s income elasticity for good 1, η1 .

Sol:
dx1 (p1 , p2 , y) y p22 p1 (p21 + p22 )y
η1 = = = 1.
dy x1 (p1 , p2 , y) p1 (p21 + p22 ) p22 y
(e) Suppose that p2 = 2 and y = 24. If p1 increases from 1 to 2, what happens to the
consumer’s consumption of good 1?
Sol: From xA C
1 = x1 (1, 2, 24) = 96/5 to x1 = x1 (2, 2, 24) = 6.

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 (f) In (e), how much change is due to the substitution effect?
Sol: In order to identify the substitution effect (and for later use as well), we derive the
consumer’s Hicksian demand functions. The optimality conditions are given by
 1/3
x2 p1 2/3 2/3
M RS12 = = and u = (x1 + x2 )3/2 .
x1 p2
Solving the two equations,
p32 u p31 u
xh1 (p1 , p2 , u) = and x h
2 (p1 , p2 , u) = .
(p21 + p22 )3/2 (p21 + p22 )3/2
√
In addition, x2 (1, 2, 24) = 12/5, and thus u = u(96/5, 12/5) = 12 5. It then follows
that √ √
h 0
xB h
1 = x1 (p1 , p2 , u) = x1 (2, 2, 12 5) = 3 10.
√
Therefore, the substitution effect is from 96/5 to 3 10.
(g) Calculate the equivalent variation of the price change in (e).
Sol: From the Hicksian demand functions in (f),

p32 u p31 u p1 p2 u
e(p1 , p2 , u) = p1 2 2
+ p 2 2 2
= 2 .
(p1 + p2 ) 3/2 (p1 + p2 ) 3/2 (p1 + p22 )1/2
√
In addition, x2 (2, 2, 24) = 6, and thus u0 = u(6, 6) = 12 2. It then follows that
√
0
√ 24 10
EV = e(p1 , p2 , u ) − y = e(1, 2, 12 2) − 24 = − 24 ≈ −8.8211.
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(h) Calculate the compensating variation of the price change in (e).
Sol: Based on the previous calculations,
√ √
CV = y − e(p01 , p2 , u) = y − e(2, 2, 12 5) = 24 − 12 10 ≈ −13.9473

(i) How much does the consumer’s consumer surplus decrease in (e)?
sheppard’s Sol: The change in consumer surplus is equal to
lemme Z 2 Z 2
p22 y
CV = − x1 (t, p2 , y)dt = − 2 2 dt
1 1 p1 (p1 + p2 )
 2  
1 2 2 8
= −y ln(t) − ln(t + p2 ) = −24 ln(2) + 12 ln = 12 ln(0.4) ≈ −10.9955
2 1 5

1.52 The n-good Cobb-Douglas utility function is

n
Y
u(x) = A xαk k ,
k=1
Pn
where A > 0 and k=1 αk = 1.

(a) Derive the Marshallian demand functions.

Sol: For each j 6= i, it must be that
Qn αk

A k=1 xk αi x−1
i xj pi αj
M RSij = Qn αk
−1 = x = p ⇒ pj xj = α pi xi .
A k=1 xk αj xj i j i

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 Plugging this into the budget equation and arranging the terms, we get
P 
n n
X X αk αk p i x i pi xi αi y
p k xk = p i xi = = = y ⇒ xi (p, y) = .
αi αi αi pi
k=1 k=1

(b) Derive the indirect utility function.

Sol: Using the solution in (a), we get
n  n 
!
αk y αk αk αk
Y  Y 
v(p, y) = A =A y.
pk pk
k=1 k=1

(c) Compute the expenditure function.

Sol: By the duality theorem,
n  n 
!
αk αk p k αk u
Y  Y 
v(p, e(p, u)) = A e(p, u) = u ⇒ e(p, u) = .
pk αk A
k=1 k=1

(d) Compute the Hicksian demands.

Sol: By Shephard’s lemma,
n 
α i Y p k αk u

∂e(p, u)
xhi (p, u) = = .
∂pi pi αk A
k=1

1.61 Show that the Slutsky relation can be expressed in elasticity form as

εij = εhij − sj ηi ,
where εhij is the elasticity of the Hicksian demand for xi with respect to price pj , and all other
terms are as defined in Definition 1.6.
Sol: Recall that
∂xi (p, y) ∂xhi (p, u∗ ) ∂xi (p, y)
= − xj (p, y) ,
∂pj ∂pj ∂y
where u∗ = v(p, y). Multiplying both sides by pj /xi (p, y),

∂xi (p, y) pj ∂xhi (p, u∗ ) pj ∂xi (p, y) pj

εij = = − xj (p, y) .
∂pj xi (p, y) ∂pj xi (p, y) ∂y xi (p, y)

By the duality theorem, xi (p, y) = xhi (p, v(p, y)) = xhi (p, u∗ ). Therefore, the first term in the
right-hand side is equal to εhij . The second term can be rewritten as follows:

∂xi (p, y) pj pj xj (p, y) ∂xi (p, y) y

xj (p, y) = = s j ηi ,
∂y xi (p, y) y ∂y xi (p, y)

where the last equality is simply due to the definitions of sj and ηi .

where ev and cv are over hicks ian the consumer surplus is easier with
marshall ian demand because know prices and the income w data.

cs always between EV and Cv; if utility function is quasi linear that they are the same and so can use
either without loss of generality 5