Utility Maximization and Choice Exercises (Ch. 7-8 Varian

Utility Maximization Choice
Exercises of Microeconomics
Utility Maximization - Choice (Ch. 7-8 Varian)
Fabio Tramontana (University of Pavia)
slides available at: http://tramontana.altervista.org/teaching.html
PhD in Economics at L.A.S.E.R.
Tramontana
Exercises Micro
Utility Maximization Choice
Outline
Utility Maximization Exercise 7.1 Exercise 7.2 Exercise 7.3 Exercise 7.4 Exercise 7.5
Choice Exercise 8.5 Exercise 8.6 Exercise 8.7 Exercise
Tramontana
Exercises Micro
Exercise 7.1 Utility Maximization Choice Exercise 7.2 Exercise 7.3 Exercise 7.4 Exercise 7.5
Outline
Tramontana
Exercises Micro
Exercise 7.1
Consider preferences dened over the nonnegative orthant by
(x1 , x2 )
(y1 , y2 )
if x1 + x2
< y1 + y2 .
Do these preferences exhibit
local nonsatiation? If these are the only two consumption goods and the consumer faces positive prices, will the consumer spend all of his income? Explain.
What does local nonsatiation mean? Local Nonsatiation
given any x in X and any with |x
> 0, then there y | < such that
is some bundle y in X
x.
Tramontana
Exercises Micro
Solution
bundle.
In other words,
there must always exist a better
Maybe it cannot be reached (it costs too much),
but it exists.
In our case the bundle exists. So our consumer does not spend any amount of income. It is not a real good what we are talking about.
(0, 0)
is the best one and no better bundle
Tramontana
Exercises Micro
Outline
Tramontana
Exercises Micro
Exercise 7.2
A consumer has a utility function u (x1 , x2 )
= max {x1 , x2 }.
What is
the consumer's demand function for good 1? What is his indirect utility function? What is his expenditure function?
The meaning of this kind of utility function is obvious. Only a good is important, the one whose amount is the highest. So, if prices dier, the better choice for the consumer is to spend all the income for the lowest priced good. Otherwise, with the same prices, the better choice is the spend all the income for only one good, randomly chosen.
Tramontana
Exercises Micro
Solution
So, the demand functions are
xi
m/pi
0 or m /pi 0
if if if
pi pi pi
< pj = pj > pj
We can also build the indirect utility function:
v (p1 , p2 , m) = max {m/p1 , m/p2 }

The expenditure function relates income with utility and prices:
e (p , u ). In our case: e (p1 , p2 , u ) = u min {p1 , p2 } .

Tramontana Exercises Micro
Outline
Tramontana
Exercises Micro
Exercise 7.3
A consumer has an indirect utility function of the form
v (p1 , p2 , m) =
m
min {p1 , p2 }
What is the form of the expediture function for this consumer? What is the form of a (quasiconcave) utility function for this consumer? What is the form of the demand function for good 1?
Let us start by writing down the indirect utility function in a dierent way:
v (p1 , p2 , m) =
m/p1 m/p m/p2
if if if
p1
< p2 = p2 p1 > p2
p1
Tramontana
Exercises Micro
Solution
The best thing consists in starting from the demand function. In fact, it is clear that the consumer will use all his income for the good with the lowest price:
x1
m/p1
any x1 and x2 such that p1 x1 + p2 x2 0
if
=m
if if
< p2 = p2 p1 > p2
p1
p1
and similarly for the demand function of the good 2. This means that we have a corner solution, that is typical of a linear utility function (or any monotonic transformation):
u (x1 , x2 ) = x1 + x2
Solution
Finally, we must obtain the expenditure function, so a measure of how much the consumer should spend in order to reach a certain level of utility, given the goods' prices. Our consumer spends:
xi pi
where i denotes the good with the lowest price. But the quantity of the good i is equal to m /pi that is also the amount of utility reached. In other words:
e (p1 , p2 , u ) = u min {p1 , p2 } .
Tramontana
Exercises Micro
Outline
Tramontana
Exercises Micro
Exercise 7.4
Consider the indirect utility function given by
v (p1 , p2 , m) =
m p1 + p2
(a) What are the demand functions? (b) What is the expenditure function? (c) What is the direct utility function?
The standard way to obtain the (Marshallian) demand functions given the indirect utility function is by using the Roy's identity: Roy's identity
xi (p , m) =
v (p ,m) pi v (p ,m) m
Tramontana
Exercises Micro
Solution
So we need to calculate the partial derivatives of the indirect utility function with respect to prices and income:
v p1 v m
v = p = (p 1 = p +p
2 1 2
m
1
+p2 )2
and by using the Roy's identity we obtain:
x1 (m, p ) = x2 (m, p ) =
so the goods are equally consumed.
m p1 + p2
Tramontana
Exercises Micro
Solution
The expenditure function e (p , u ) gives the information about how much it costs to obtain a certain level of utility given the market prices. Costs substained by the consumer are generally of the following form:
= x1 p1 + x2 p2
We can use the demand functions to obtain:
m p1 + p2
p1 +
m p1 + p2
p2
Tramontana
Exercises Micro
Solution
We know that the level of utility rechaed is exactly u we have:
m p1
+p2 , so
e (p1 , p2 , u ) = (p1 + p2 )u
The direct utility function relates the level of utility with the amount of goods consumed: u (x1 , x2 ). We know that the consumer buys the same amount of the two goods:
x1
= x2 =
m p1 + p2
that also corresponds to the level of utility reached, given the indirect utility function.
Tramontana
Exercises Micro
Solution
In other words we can write down:
u (x1 , x2 ) = min {x1 , x2 } .
Tramontana
Exercises Micro
Outline
Tramontana
Exercises Micro
Exercise 7.5
A consumer has a direct utility function of the form
U (x1 , x2 ) = u (x1 ) + x2 .
Good 1 is a discrete good; the only possible levels of consumption of good 1 are x1
=0
and x1
For convenience, assume
= 1. that u (0) = 0
and p2
= 1.
(a) What kind of preferences does this consumer have?
These preferences are called quasi-linear, because they are additive and linear in at least one good.
Tramontana
Exercises Micro
Exercise 7.5(b)
(b) The consumer will denitely choose x1 than what?
=1
if p1 is strictly less
In order to answer to this question, let us consider the maximum utility that can be reached with x1
=0
and with x1
= 1.
If the consumer only consumes the good 2, given that its price is equal to 1 and given that (from the utility function) there is 1-1 correspondence between level of utility and amount of good 2, we have:
u |x =0 1
=m
Tramontana
Exercises Micro
Solution
On the other hand, one unit of good 1 gives to the consumer an utility of u (1). The consumer now can only buy an amount equal to m p1 of the, that is also the value of the utility brought by good 2. So we have:
u |x =1 1
= u (1) + m p1
Now, in order to make the consumer preferer the situation with one unity of good 1, this condition must be realized:
u |x =0 1
< u |x
=1
Tramontana
Exercises Micro
Solution
That is:
p1
< u (1).
Tramontana
Exercises Micro
Exercise 7.5(c)
(c) What is the algebraic form of the indirect utility function associated with this direct utility function?
It is a consequence of the previous point that the utility reached will be the higher between the two considered, that is:
v (p1 , p2 , m) = max {m p1 + u (1), m} .
Tramontana
Exercises Micro
Exercise 8.5 Utility Maximization Choice Exercise 8.6 Exercise 8.7 Exercise
Outline
Tramontana
Exercises Micro
Exercise 8.5
Find the demand bundle for a consumer whose utility function is

3 2 u (x1 , x2 ) = x1 x2 and her budget constraint is 3x1 + 4x2
= 100.
The Lagrangian function for this optimization problem is the following:
L (x , ) = x1 x2 (3x1 + 4x2 100)

2
But it is more useful to see the utility function in logaritmic form 3 2
L (x , ) =
ln x1 + ln x2 (3x1 + 4x2 100)
Tramontana
Exercises Micro
Solution
The rst order conditions are obtained by dierentiating the Lagrangian function with respect to x1 , x2 and
These derivatives
are equal to zero for the optimum bundle values:
3 = 0 4 = 0 x 3x1 + 4x2 100 = 0

2x1 1
2
The rst two equation can be seen as:
= =
from which we obtain:
1 2x1 1 4x2
x1
Tramontana
= 2x2
Exercises Micro
Solution
By substituting x1
= 2x2
in the third f.o.c. we get: 6x2 + 4x2
= 100 x2 = 10
and then:
x1
= 20;
x2
= 10; =
1 40
Tramontana
Exercises Micro
Outline
Tramontana
Exercises Micro
Exercise 8.6
1 1 3
Use the utility function u (x1 , x2 )
= p1 x1 + p2 x2
to calculate
= x1 x2 and the budget constraint x (p , m), v (p , m), h(p , u ) and e (p , u ).

2
The Lagrangian function is the following:
L (x , ) = x1 x2 (p1 x1 + p2 x2 m)
2 3
while the f.o.c. are:

1 2 1 3
x1
1 2 1
1 3 x2
= p1 = p2 =m
2 x1 x2
2 3
p1 x1 + p1 x2
Tramontana
Exercises Micro
Solution
by following a procedure similar to the one followed in the previous exercise we obtain the Marshallian demand functions:
x1 (p , m) = x2 (p , m) =
3 m 5 p1 2 m 5 p2
The indirect utility function can be obtained if we put the Marshallian demand functions into the utility function:
1 2 1 3 5 6 1 1
v (p , m ) =
3 m 5 p1
2 m 5 p2
m
5
p1
p2
Tramontana
Exercises Micro
Solution
It is now simple to obtain the expenditure function. It is sucient to take the indirect utility function and replace v (p , m ) with u and m with e (p , u ):
e (p , u )
5
5 6
p1
p2
and solve it for e (p , u ):
e (p , u ) = 5
p1
3
3 5
p2
2
2 5
u5
Tramontana
Exercises Micro
Solution
One of the properties of the expenditure function is the following: Property of e (p , u ) If h (p , u ) is the expenditure-minimizing bundle necessary to achieve utility level u at prices p (Hicksian demand), then
hi (p , u ) =
e (p , u ) pi
for i
= 1, ..., k
so we need to calculate the partial derivatives of the expenditure function, obtaining:
h1 (p , u ) = h2 (p , u ) =
e (p ,u ) p1 e (p ,u ) p2
= =
p1 3 p1 3
2 5
3 5
p2 2 p2 2
2 5
u5 u5
6
3 5
Tramontana
Exercises Micro
Outline
Tramontana
Exercises Micro
Exercise 8.7
Extend the previous exercise to the case where
u (x1 , x2 ) = (x1 1 )1 (x2 2 )2 and check the symmetry of the

matrix of substitution terms
hj (p ,u ) . pi
An alternative way to solve this problem consists in considering the expenditure minimization problem, whose Lagrangian is:
L (x , ) = p1 x1 + p2 x2 (x1 1 ) (x2 2 ) u
1 2
from which we can derive the f.o.c.:
= 1 (x1 1 ) 1 (x2 2 ) p2 = 2 (x1 1 ) (x2 2 ) 1 (x1 1 ) (x2 2 ) = u

p1
1 2 1 2 1 2 Tramontana Exercises Micro
Solution
If we divide the rst equation by the second we obtain:
p1 2 p2 1
x2 2 x1 1
The term x2 2 can be obtained from the third equation:

1
x2 2
= (x1 1 )
We can substitute it in the ratio between the rst two equations and solve it for x1 , obtaining the Hicksian demand:
2 1 +2
h1 (p , u ) = 1 +
p2 1 p1 2
u 2
Tramontana
Exercises Micro
Solution
The other demand is:
h2 (p , u ) = 2 +
p1 2 p2 1
u 1
1 1 +2
The symmetry of the substitution matrix is proved by showing that:
h1 (p , u ) h2 (p , u ) u = = p2 p1 1 + 2
1
p1
2
p2
1 +2
Tramontana
Exercises Micro
Solution
The expenditure function is obtained by using the Hicksian demands in p1 x1 + p2 x2 :
e (p , u ) = p1 1 +
p2 1 p1 2
u 2
2 1 +2
+ p2 2 +
p1 2 p2 1
u 1
1 1 +2
The following step consists in substituting e (p , u ) with m and u with v (p , m ) in the expenditure function and solve it for
v (p , m) to obtain the indirect utility function:
1 v (p , m ) = 1 + 2
m 2 p2 p1
2 1 + 2
m 1 p1 p2
Tramontana
Exercises Micro
Solution
Finally, we can use Roy's law to get the Marshallian demands:

1
x1 (p , m) = + 1 2 x2 (p , m) = + 1 2
1
1 2 + 2 m p 2 1 + 1 m p
1 p1
2 2 p2
Tramontana
Exercises Micro
Outline
Tramontana
Exercises Micro
Exercise (not from Varian)

Let there be two commodities, x1 and a composite commodity called money M . assume a utility function
= log(x1 ) + M
and income level Y . The price of x1 is p1 and the price of M is 1. (a) Derive the Marshallian demand function for x1 .
We can write down the constrained maximization problem: maxU

x1 M
= log(x1 ) + M = M + p1 x1
Exercises Micro
s .t . Y
Tramontana
Solution
The Lagrangian is the following:
L (x1 , M , ) = log(x1 ) + M (M + p1 x1 Y )
The f.o.c. are:
L x1 L M L
= x p1 = 0 = = 0 = Y M p1 x1 = 0
1
from the rse f.o.c. we have that:
x1
p1
Exercises Micro
Tramontana
Solution
from the second we have that
= , =
so:
x1
. p1
Note that the demand for the good 1 is independent of income (has zero income elasticity).
Tramontana
Exercises Micro
Exercise (b)
(b) Derive the Hicksian demand curve for x1 .
To answer to this question it is better to write down the constrained minimization problem: min M
x1 M
+ p1 x1
s .t . u
= log(x1 ) + M
The Lagrangian is the following:
L (x1 , M , ) = M + p1 x1 + [ log(x1 ) + M u ]
Tramontana
Exercises Micro
Solution
The f.o.c. are:
L x1 L M L
= p1 x = 0 = 1 = 0 = u log(x1 ) M = 0
1
from the rst f.o.c. we have that:
x1
p1
given that, from the second f.o.c., we know that
= 1/ :
x1
p1
that is the demand for good 1 is indipendent of the level of utility reachable.
Exercise (c)
(c) What is the relationship between the Marshallian and the Hicksian demands? Is this a general relationship which holds for all utility functions and, if not, why does it hold in this case?
Marshallian and Hicksian demands are the same; In the Marshallian demand function, the quantity of good demand depends upon its price and the income of the consumer, while in the Hicksian demand function it depends upon its price and the utility that the consumer wants to reach;
Tramontana
Exercises Micro
Solution
In our case the demand for the good 1 has zero elasticity (that is, it's independent) both with respect to income and to respect to utility. It only depends on the parameters and on the price of the good. This is why the two demands are equal; Obviously, this cannot be considered a general result, but only what happens in this peculiar case.
Tramontana
Exercises Micro

Utility Maximization and Choice Exercises (Ch. 7-8 Varian

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Utility Maximization and Choice Exercises (Ch. 7-8 Varian

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Utility Maximization Choice

Fabio Tramontana (University of Pavia)

slides available at: http://tramontana.altervista.org/teaching.html

PhD in Economics at L.A.S.E.R.

Utility Maximization Choice

Choice Exercise 8.5 Exercise 8.6 Exercise 8.7 Exercise

Choice Exercise 8.5 Exercise 8.6 Exercise 8.7 Exercise

Do these preferences exhibit

What does local nonsatiation mean? Local Nonsatiation

given any x in X and any with |x

> 0, then there y | < such that

there must always exist a better

Maybe it cannot be reached (it costs too much),

is the best one and no better bundle

Choice Exercise 8.5 Exercise 8.6 Exercise 8.7 Exercise

A consumer has a utility function u (x1 , x2 )

We can also build the indirect utility function:

v (p1 , p2 , m) = max {m/p1 , m/p2 }

e (p , u ). In our case: e (p1 , p2 , u ) = u min {p1 , p2 } .

Choice Exercise 8.5 Exercise 8.6 Exercise 8.7 Exercise

m/p1 m/p m/p2

e (p1 , p2 , u ) = u min {p1 , p2 } .

Choice Exercise 8.5 Exercise 8.6 Exercise 8.7 Exercise

and by using the Roy's identity we obtain:

We can use the demand functions to obtain:

In other words we can write down:

u (x1 , x2 ) = min {x1 , x2 } .

Choice Exercise 8.5 Exercise 8.6 Exercise 8.7 Exercise

A consumer has a direct utility function of the form

For convenience, assume

(a) What kind of preferences does this consumer have?

(b) The consumer will denitely choose x1 than what?

v (p1 , p2 , m) = max {m p1 + u (1), m} .

Choice Exercise 8.5 Exercise 8.6 Exercise 8.7 Exercise

Find the demand bundle for a consumer whose utility function is

The Lagrangian function for this optimization problem is the following:

L (x , ) = x1 x2 (3x1 + 4x2 100)

But it is more useful to see the utility function in logaritmic form 3 2

ln x1 + ln x2 (3x1 + 4x2 100)

are equal to zero for the optimum bundle values:

3 = 0 4 = 0 x 3x1 + 4x2 100 = 0

The rst two equation can be seen as:

in the third f.o.c. we get: 6x2 + 4x2

Choice Exercise 8.5 Exercise 8.6 Exercise 8.7 Exercise

Use the utility function u (x1 , x2 )

= x1 x2 and the budget constraint x (p , m), v (p , m), h(p , u ) and e (p , u ).

The Lagrangian function is the following:

while the f.o.c. are:

and solve it for e (p , u ):

so we need to calculate the partial derivatives of the expenditure function, obtaining:

Choice Exercise 8.5 Exercise 8.6 Exercise 8.7 Exercise

u (x1 , x2 ) = (x1 1 )1 (x2 2 )2 and check the symmetry of the

from which we can derive the f.o.c.:

= 1 (x1 1 ) 1 (x2 2 ) p2 = 2 (x1 1 ) (x2 2 ) 1 (x1 1 ) (x2 2 ) = u

The term x2 2 can be obtained from the third equation:

The other demand is:

The symmetry of the substitution matrix is proved by showing that:

v (p , m) to obtain the indirect utility function:

Finally, we can use Roy's law to get the Marshallian demands:

Choice Exercise 8.5 Exercise 8.6 Exercise 8.7 Exercise

Exercise (not from Varian)

We can write down the constrained maximization problem: maxU

from the rse f.o.c. we have that:

What does local nonsatiation mean? Local Nonsatiation

(b) The consumer will denitely choose x1 than what?

The rst two equation can be seen as:

from the rse f.o.c. we have that:

from the rst f.o.c. we have that: