Answers to some selected exercises to Consumer

Theory
R Finger
Advanced Microeconomics ECH-32306
September 2012
Please report mistakes in typesetting. The current version is based on inputs
from Thomas Herzfeld.
1.6 Cite a credible example were the preferences of an ordinary consumer
would be unlikely to satisfy the axiom of convexity.
Answer: Indierence curves representing satiated preferences dont
satisfy the axiom of convexity. That is, reducing consumption would
result in a higher utility level. Negative utility from consumption of
bads (too much alcohol, drugs, unhealthy food etc.) would rather
result in concave preferences.
Adapted from J and R Sketch a few level sets for the following utility
functions: y = x
1
+ x
2
and y = min[x
1
, x
2
]. Discuss the properties
of the presented preferences. Derive Marshallian demand functions,
indirect utility functions and expenditure functions.
Answer
6
-
x
1
x
2
@
@
@
@
@
@
@
@
@
@
(a) y = x
1
+ x
2
6
-
x
1
x
2
(b) y = min(x
1
, x
2
)
Figure 1: Sets to Exercise
See lecture notes and handout on utility functions for other solutions.
Adapted from J and R Suppose f(x
1
, x
2
) = (x
1
x
2
)
2
and g(x
1
, x
2
) =
(x
2
1
x
2
)
3
to be utility functions.
1
(a) f(x
1
, x
2
) is homogeneous. What is its degree?
f(tx
1
, tx
2
) = t
4
(x
1
x
2
)
2
k = 4
(b) g(x
1
, x
2
) is homogeneous. What is its degree?
g(tx
1
, tx
2
) = t
9
(x
2
1
x
2
)
3
k = 9
(c) h(x
1
, x
2
) = f(x
1
, x
2
)g(x
1
, x
2
) is homogeneous. What is its degree?
h(x
1
, x
2
) = x
8
1
x
5
2
h(tx
1
, tx
2
) = t
13
(x
8
1
x
5
2
k = 13 Obviously, when-
ever two functions are homogeneous of degree m and n, their product
must be homogeneous of degree m + n.
(d) k(x
1
, x
2
) = g (f(x
1
, x
2
), f(x
1
, x
2
)) is homogeneous. What is its degree?
k(tx
1
, tx
2
) = t
36
(x
1
x
2
)
18
k = 36
(e) Prove that whenever f(x
1
, x
2
) is homogeneous of degree m and g(x
1
, x
2
)
is homogeneous of degree n, then k(x
1
, x
2
) = g (f(x
1
, x
2
), f(x
1
, x
2
)) is
homogeneous of degree mn.
k(tx
1
, tx
2
) = [t
m
(f(x
1
, x
2
), f(x
1
, x
2
))]
n
k = mn
1.12 Suppose u(x
1
, x
2
) and v(x
1
, x
2
) are utility functions.
(a) Prove that if u(x
1
, x
2
) and v(x
1
, x
2
) are both homogeneous of
degree r, then s(x
1
, x
2
) u(x
1
, x
2
) +v(x
1
, x
2
) is homogeneous of
degree r.
Answer: Whenever it holds that t
r
u(x
1
, x
2
) = u(tx
1
, tx
2
) and
t
r
v(x
1
, x
2
) = v(tx
1
, tx
2
) for all r > 0, it must also hold that
t
r
s(x
1
, x
2
) u(tx
1
, tx
2
) + v(tx
1
, tx
2
) = t
r
u(x
1
, x
2
) + t
r
v(x
1
, x
2
).
(b) Prove that if u(x
1
, x
2
) and v(x
1
, x
2
) are quasiconcave, then m(x
1
, x
2
)
min{u(x
1
, x
2
), v(x
1
, x
2
)} is also quasiconcave.
Answer: Forming a convex combination of the two functions u
and v and comparing with m(x
t
) satises the denition of quasi-
concavity:
When u(x
t
) min

u(x
1
), u(x
2
)

and
v(x
t
) min

v(x
1
), v(x
2
)

so
m(x
t
) min

u(x
t
), v(x
t
)

.
1.20 Suppose preferences are represented by the Cobb-Douglas utility func-
tion, u(x
1
, x
2
) = Ax

1
x
1
2
, 0 < < 1, and A > 0. Assuming an
interior solution, solve for the Marshallian demand functions.
2
Answer: Use either the Lagrangian or the equality of Marginal Rate
of Substitution and price ratio. The Lagrangian is
L = Ax

1
x
1
2
+(y p
1
x
1
p
2
x
2
). The rst-order conditions (FOC)
are
L
x
1
= Ax
1
1
x
1
2
p
1
= 0
L
x
2
= (1 )Ax

1
x

2
p
2
= 0
L

= y p
1
x
1
p
2
x
2
= 0
By dividing rst and second FOC and some rearrangement, we get
either x
1
=
x
2
p
2
(1)p
1
or x
2
=
(1)p
1
x
1
p
2
. Substituting one of these ex-
pressions into the budget constraint, results in the Marshallian demand
functions: x
1
=
y
p
1
and x
2
=
(1)y
p
2
.
1.21 Weve noted that u(x) is invariant to positive monotonic transforms.
One common transformation is the logarithmic transform, ln(u(x)).
Take the logarithmic transform of the utility function in 1.20; then,
using that as the utility function, derive the Marshallian demand func-
tions and verify that they are identical to those derived in the preceding
exercise (1.20).
Answer: Either the Lagrangian is used or the equality of Marginal
Rate of Substitution with the price ratio. The Lagrangian is
L = ln(A) + ln(x
1
) + (1 ) ln(x
2
) + (y p
1
x
1
p
2
x
2
). The FOC
are
L
x
1
=

x
1
p
1
= 0
L
x
2
=
(1 )
x
2
p
2
= 0
L

= y p
1
x
1
p
2
x
2
= 0
The Marshallian demand functions are: x
1
=
y
p
1
and x
2
=
(1)y
p
2
.
They are exactly identical to the demand functions derived in the
preceding exercise.
1.22 We can generalise further the result of the preceding exercise. Suppose
that preferences are represented by the utility function u(x). Assum-
ing an interior solution, the consumers demand functions, x(p, y), are
determined implicitly by the conditions in (1.10). Now consider the
utility function f(u(x)), where f > 0, and show that the rstorder
conditions characterising the solution to the consumers problem in
both cases can be reduced to the same set of equations. Conclude
3
from this that the consumers demand behavior is invariant to posi-
tive monotonic transforms of the utility function.
Answer: The set of rstorder conditions for a utility function, as-
suming a linear budget constraint, are as follows:
L
x
i
=
u
x
i
p
i
L
x
j
=
u
x
j
p
j
u/x
i
u/x
j
=
p
i
p
j
The set of rstorder conditions for a positive monotone transform of
a utility function, assuming a linear budget constraint, are as follows:
L
x
i
=
f(u)
u
u(x)
x
i
p
i
L
x
j
=
f(u)
u
u(x)
x
j
p
j
f(u)/u
f(u)/u
u/x
i
u/x
j
=
p
i
p
j
After forming the Marginal Rate of Substitution, the outer derivative
cancels out. Therefore, the demand function should be unaected by
the positive monotonic transformation of the utility function.
1.24 Let u(x) represent some consumers monotonic preferences over
x R
n
+
. For each of the functions F(x) that follow, state whether
or not f also represents the preferences of this consumer. In each
case, be sure to justify your answer with either an argument or a
counterexample.
Answer:
(a) f(x) = u(x) + (u(x))
3
Yes, all arguments of the function u are trans-
formed equally by the third power. Checking the rst- and second-
order partial derivatives reveals that, although the second-order partial
is not zero, the sign of the derivatives is always invariant and positive.

2
f
x
2
i
=

2
u
x
2
i
+ 6(u(x))
u
x
i
+ 3(u(x)
2

2
u
x
2
i
Thus, f represents a monotonic transformation of u.
4
(b) f(x) = u(x) (u(x))
2
No, function f is decreasing with increasing
consumption for any u(x) < (u(x))
2
. Therefore, it can not represent
the preferences of the consumer. It could do so if the minus sign is
replaced by a plus sign.
(c) f(x) = u(x) +

n
i=1
x
i
Yes, the transformation is a linear one, as the
rst partial is a positive constant, here one, and the second partial
of the transforming function is zero. Checking the partial derivatives
proves this statement:
f
x
i
=
u
x
i
+ 1 and

2
f
x
2
i
=

2
u
x
2
i
.
1.38 Complete the proof of Theorem 1.9 by showing that
x
h
(p, u) = x(p, e(p, u)).
Answer: We know that at the solution of the utility maximisation or
expenditure minimisation problem e(p, u) = y and u = v(p, y). Sub-
stitute the indirect utility function v into the Hicksian demand func-
tion gives x
h
(p, v(p, y)). As the new function is a function of prices
and income only, it is identical to the Marshallian demand function.
Furthermore, by replacing income by the expenditure function we get
the expression x(p, e(p, u)). Carefully check the proof on page 45 and
try to follow the argumentation also in this case.
1.40 Prove that Hicksian demands are homogeneous of degree zero in
prices.
Answer: We know that the expenditure function must be homoge-
neous of degree one in prices. Because any Hicksian demand function
equals, due to Shephards lemma, the rst partial derivative of the
expenditure function and, additionally, we know that the derivatives
degree of homogeneity is k1 (Theorem A2.6). The Hicksian demand
functions must be homogeneous of degree 1 1 = 0 in prices.
1.42 For expositional purposes, we derived Theorems 1.14 and 1.15 sep-
arately, but really the second one implies the rst. Show that when the
substitution matrix (p, u) is negative semidenite, all ownsubstitution
terms will be nonpositive.
Answer: Theorem 1.15 implies Theorem 1.14 because all elements of
the substitution matrix represent secondorder partial derivatives of
the expenditure function. The diagonal elements of this matrix must
be negative because the expenditure function is required to be con-
cave in prices. Subsequently, any compensated demand function is
required to be nonincreasing in its own price. With the substitution
matrix being negative semidenite, all principal minors (not only the
leading ones) will be non-positive. Removing all but one columns and
rows (with the same number) will leave us diagonal elements, i.e. all
own-substitution terms.
5
Gien behavior Read the article of Jensen and Miller. Gien Behavior
and Subsistence Consumption. Am Econ Rev. 2008 September 1;
98(4), pp. 1553 to 1577. Recall and discuss the role of substitution
and income eects.
1.43 In a two-good case, show that if one good is inferior, the other good
must be normal.
Answer: The Engel-aggregation in a two-good case is the product of
the income elasticity and the repsective expenditure share s
1

1
+s
2

2
=
1. An inferior good is characterised by a negative income elasticity,
thus, one of the two summands will be less than zero. Therefore, to
secure this aggregation, the other summand must be positive (even
larger one) and the other commodity must be a normal good (even a
luxury item).
1.60 Show that the Slutsky relation can be expressed in elasticity form
as
ij
=
h
ij
s
j

i
, where
h
ij
is the elasticity of the Hicksian demand
for x
i
with respect to price p
j
, and all other terms are as dened in
Denition 1.6.
Answer: The Slutsky relation is given by
x
i
p
j
=
x
h
i
p
j
x
j
x
i
y
.
Multiplying the total expression with y/y and p
j
gives
x
i
p
j
p
j
=
x
h
i
p
j
p
j

p
j
x
j
y
x
i
y
y.
By assuming that x
h
i
= x
i
before the price change occurs, we can
divide all three terms by x
i
. The result of this operation is
x
i
p
j
p
j
x
i
=
x
h
i
p
j
p
j
x
i
s
j
x
i
y
y
x
i
This is equivalent to:
ij
=
h
ij
s
j

i
4.19 A consumer has preferences over the single good x and all other goods
m represented by the utility function, u(x, m) = ln(x) + m. Let the
price of x be p, the price of m be unity, and let income be y.
(a) Derive the Marshallian demands for x and m.
Answer The equality of marginal rate of substitution and price
ratio gives 1/x = p. Thus, the Marshallian demand for x is
6
x = 1/p. The uncompensated demand for m separates into two
cases depending on the amount of income available:
m =

0 when y 1
y 1 when y > 1.
(b) Derive the indirect utility function, v(p, y).
Answer Again, depending on the amount of income available
there will be two indirect utility functions:
v(p, y) =

ln

1
p

when y 1
y 1 + ln

1
p

when y > 1.
Note that +ln(1/p) can be written as ln(1)-ln(p), i.e. -ln(p)
(c) Use the Slutsky equation to decompose the eect of an own-price
change on the demand for x into an income and substitution ef-
fect. Interpret your result briey.
Answer A well-known property of any demand function derived
from a quasi-linear utility function is the absence of the income
eect. Which can be easily seen in the application of the Slutsky
equation:
x
p
=
x
h
p
+ x
x
y
We see (using our Marshallian demand derived above) that the
income eect is zero. Thus:
x
p
=
x
h
p
Therefore, the eect of an own-price change on the demand for
x consists of the substitution eect only, the partial derivative of
the compensated demand function with respect to price.
(d) Suppose that the price of x rises from p
0
to p
1
> p
0
. Show that
the consumer surplus area between p
0
and p
1
gives an exact mea-
sure of the eect of the price change on consumer welfare.
Answer The consumer surplus area can be calculated by integrat-
ing over the inverse uncompensated demand function of x (we see
from our above derived demand function that this is p = 1/x):
CS =

p
0
p
1
1
x
dx = ln p
0
ln p
1
.
Calculating the change in utility induced by a price change gives:
v = v
1
(p
1
, y
0
)v
0
(p
0
, y
0
) = y1ln p
1
(y1ln p
0
) = ln p
1
+ln p
0
.
7
We here assumed y > 1. However, analyzing the case for y <
1 will lead to the same result. (Alternatively, we could have
used the (direct) utility function to come to this result). As the
two expressions ( CS and v) are equal, the consumer surplus
area gives an exact measure of the eect of the price change on
consumer welfare in the case of quasi-linear preferences (this also
means that CS will equal EV and CV for this type of utility
function).
(e) Carefully illustrate your ndings with a set of two diagrams: one
giving the indierence curves and budget constraints on top, and
the other giving the Marshallian and Hicksian demands below.
Be certain that your diagrams reect all qualitative information
on preferences and demands that youve uncovered. Be sure to
consider the two prices p
0
and p
1
, and identify the Hicksian and
Marshallian demands.
Answer Drawing the gure, note that Hicksian and Marshallian
demands are identical here.
8