Scribd
Upload
21 views5 pages

PS1 Umax Sols

This document provides solutions to 4 problems involving consumer utility maximization and choice. 1) It plots indifference curves and finds preference between bundles for a consumer with utility u(x1, x2) = x1x2. 2) It sets up and solves the Lagrangian for a consumer choosing jeans and hoodies with Cobb-Douglas utility and budget constraint. 3) It describes the consumer's optimal choice when indifference curves are straight lines with slope -b, comparing this to the price ratio. 4) It finds that for utility u(x1, x2) = x1x24, the consumer will spend 4/5 of income on good 2.

Uploaded by

ebbamork
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
21 views5 pages

PS1 Umax Sols

This document provides solutions to 4 problems involving consumer utility maximization and choice. 1) It plots indifference curves and finds preference between bundles for a consumer with utility u(x1, x2) = x1x2. 2) It sets up and solves the Lagrangian for a consumer choosing jeans and hoodies with Cobb-Douglas utility and budget constraint. 3) It describes the consumer's optimal choice when indifference curves are straight lines with slope -b, comparing this to the price ratio. 4) It finds that for utility u(x1, x2) = x1x24, the consumer will spend 4/5 of income on good 2.

Uploaded by

ebbamork
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 5

Problem Set 1

Suggested Solutions

Utility Functions

1. Consider a consumer with utility u( x1 , x2 ) = x1 x2 .

(a) Plot the indifference curve that passes through (3,4).

First, fix an arbritary utility level k such that k = x1 x2 . Then, solve


for x2 to obtain

k
x2 = .
x1
To plot the equation we first solve for k. We know that k = 3 × 4 =
12. So we plot
12
x2 = .
x1

(b) Consider two bundles : A=(3,4) and B=(5,3). Which one does the
consumer prefer?

Let us compute the utilities. First, for u A = 3 × 4 = 12 and for


bundle B we have u B = 5 × 3 = 15. Hence, the consumer derives
more utility from bundle B.

1
(c) Compute the marginal utilities for both goods.

The marginal utilities are obtain by taking partial derivative with


respect to the variable.

MU1 = x2

MU2 = x1

(d) Compute the marginal rate of substitution at the point (3,4).

The marginal rate of substitution (MRS) is simple the ratio of marginal


utilities
x2 4
MRS = = .
x1 3
Notice that the MRS is decreasing in x1 , that is when you increase
x1 the MRS falls. This is another way to represent the convexity of
the utility function. At the point (3, 4) we obtain

4
MRS = .
3

Choice

2. Let x1 and x2 denote Jeans and Hoodies. Consider the problem of a


consumer choosing a bundle ( x1 , x2 ) in a shop, given prices p1 = 20 Euros
and p2 = 10 Euros, and given that total income available is 200 Euros.
Suppose further that tastes can be represented by a Cobb Dougla s utility
x11/2 x21/2 .

2
This problem can be written mathematically as

max x11/2 x21/2


x1 ,x2

st:

20x1 + 10x2 = 200

(a) Setup the Lagrangian for this problem.

L = x11/2 x21/2 − λ(20x1 + 10x2 − 200)

(b) Derive the first order condition for x1 , x2 and m. The FOCs are

1/2
− λp1 = 0
x1
1/2
− λp2 = 0
x2
20x1 + 10x2 − 200 = 0

(c) Derive the demand for x1 and x2 .

We follow the steps given in the lecture. First, from the first two
FOCs we get

1/2 = λ20x1

1/2 = λ10x2

Rearranging terms we have plug x1 and x2 into the budget con-


straint
1 10
20 + = 200
40λ 20λ

3
This gives a value of λ of
1
λ=
200
Finally, plug this value into the FOCs

x1 = 5

x2 = 10

3. Suppose that indifference curves are described by straight lines with


slope −b. Given prices and money p1 , p2 and m, what will the consumer’s
choice will look like?
The solution of this exercise is similar to the one covered in lecture
where we used a slope of -1 for the indifference curve (see fig 5.5 in the
book). Now we need to compare the price ratio p2 /p1 with −b.

• If p1 /p2 < −b, then x1∗ = m/p1 and x2∗ = 0.

• If p1 /p2 > −b, then x1∗ = 0 and x2∗ = m/p2 .

• If p1 /p2 = −b, then any bundle that satisfies the budget constraint
is optimal.

4. If a consumer has utility function u( x1 , x2 ) = x1 x24 , what fraction of her


income will she spend on good 2?
You can solve this problem by recalling a property of Cobb Douglas
utility function. For this utility the fraction of the income that is allocation
to a good is equal to the exponent in the utility.
For this particular utility you can raise to the power of 1/(1+4) to get

ut ( x1 , x2 ) = x11/5 x24/5

4
Since a power is a monotone transformation we now that the two utilities
are equivalent. For this utility the fraction spent in good 2 is

p2 x2
= 4/5
m

Similarly, you spend 1/5 of your income on good 1.

You might also like