Microeconomics

Home Assignment 1

SOLUTIONS

Due Date: September 25, 2024, before lecture

Problem 1.(MWG 1.D.3) (5 points)

Let X={x,y,z}, and consider the choice structure (Β, C(·)) with Β={{x,y},{y,z},{x,z},{x,y,z}} and
C({x,y})={x}, C({y,z})={y}, C({x,z})={z}. Show that (Β, C(·)) must violate the WARP.
Solution:
Consider possible choices C({x,y,z}). The possibilities include {x}, {y}, {z}, {x,y}, {x,z}, {y,z}, {x,y,z}.
Note that each one of them would violate WARP. Consider C({x,y,z})={x}. This violates WARP since
C({x,z})={z}. Similarly, we can show that all other possible choices violate WARP.

Problem 2. (10 points) Suppose Professor N likes students who ask questions in class, are punctual, and get
high grades on written assignments. If student A outperforms student B on at least two out of these three
characteristics, then Professor N prefers student A to student B. He is indifferent between them otherwise.
Consider three students:
Student X: asks questions all the time, late to class all the time, gets 80 (out of a 100) points on written
assignments.
Student Y: sometimes asks questions, never late to class, gets 70 points on written assignments.
Student Z: never asks questions, sometimes late to class, gets 90 points on written assignments.

Can Professor N’s preferences be represented by a utility function? Explain.

Solution:
No utility function. We can see that X is preferred to Y, Y is preferred to Z, but Z is preferred to X.
Thus, the preferences are not transitive. They are not rational preferences and only rational
preference can have a utility function representation. [Note. There is literature on working with non-
transitive preferences: deriving demands with such preferences, representing them in some way. But
they cannot be represented with utility functions as these functions are defined in classical theory.]

Problem 3 (15 points total)

Alla’s preference ordering over bundles in  2 is represented by the following utility function:
min{x, y} if x and y are int egers
u  x, y   
 0, otherwise.
A. (4 points) Are Alla’s preferences locally nonsatiated? Prove or give a counterexample.

Solution
The preferences are not LNS. For example, the ball of radius 0.1 around the bundle (0.2, 0.2)
contains no integer pairs. Thus, every bundle in this ball gives utility of 0, so no nearby point is
strictly preferred to bundle (0.2, 0.2).

B. (4 points) Are Alla’s preferences convex? Prove or give a counterexample.

Solution
The preferences are not convex. For example, bundles (2,2) and (3,3) are both preferred to bundle
(1,1). However, their convex combination (2.5,2.5) (for example), which gives utility of 0, is not.

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 C. (7 points) Derive Alla’s Walrasian demand correspondence in terms of prices p x and p y and
wealth w.

Solution
We can have two cases:
1) p x  p y  w , so Alla cannot afford any positive integer amounts of both goods. In that case, any
bundle she can afford gives her utility of 0, so her demand is her entire budget set:
x( px , py )  ( x, y) 2 : px x  p y y  w .
2) p x  p y  w . Alla will buy the as many pairs of the goods as she can afford. If she has money
left, she may or may not also buy more units of one good (doing so will not affect her utility). Thus,
x( px , p y )  {( x, y)  Z 2 : px x  p y y  w, min{x, y}  max{z  Z : ( px  p y ) z  w}} .

Problem 4 (35 points total)

Jim’s preferences over bundles in  2 can be represented by the following CES utility function:
u( x1 , x2 )  [1 x1  2 x2 ]1/  , with  1   2  1 . He faces strictly positive prices of two goods p1 and p2 and
has wealth w>0.

A. (20 points) Properly set up and solve Jim’s utility maximization problem by checking both first and
second order conditions. Find both the Walrasian demand and the indirect utility function.

Solution
max[ x1  x2 ]1/  ,
x1 , x2

such that x1  0,
x 2  0,
p1 x1  p 2 x 2  w,

1. Write down the Lagrangian and take the first order necessary conditions:
L  x1 , x2 , 1 , 2 ,    [ x1  x2 ]1/   1 x1  2 x2    w  p1 x1  p2 x2 

F.O.N.C.s:
L
1)  x1 1[ x1  x2 ]1   /   1   p1  0 ;
x1
L
2)  x2 1[ x1  x2 ]1   /   2   p2  0 ;
x2
L
3)  x1  0, 1  0, 1 x1  0 ;
1
L
4)  x 2  0,  2  0,  2 x 2  0 ;
 2

L
5)  w  p1 x1  p2 x2  0,   0,  ( w  p1 x1  p2 x2 )  0 .


2. Solve the system of F.O.N.C.s:

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a) Since the utility function is strictly increasing in both of its arguments and w  0 , Jim would
never chose bundle (0,0). For the same reason, his budget constraint binds, that is, he would
spend all of his income at the optimum.

b) Consider the following candidate for the solution: x1  0, x 2  0. Then,

w
x1  ,
p1
x2  0 ,
1
 ,
p1
1  0 ,
p
2  2 .
p1
w
The indirect utility at this bundle v( p1 , p2 , w)  .
p1
This solution would not work if   1 (from FONC 2)).

c) Similarly, x1  0, x2  0 :
x1  0 ,
w
x2  ,
p2
1
 ,
p2
p1
1  ,
p2
2  0 ,
v p1 , p 2 , w 
w
.
p2
Again, this solution would not work if   1 (from FONC 1)).

d) Finally, x1  0, x2  0 :
From 1) and 2)
 1
 x1  p
   1
 x2  p2
Using the budget constraint, if   1,
p11 /   1 w
x1   /   1 ,
p1  p 2 /   1
p12 /   1 w
x 2   /   1 ,
p1  p 2 /   1

  [ p1 /   1  p2 /   1 ]1  /  ,

1  0 ,
2  0 ,
v  p1 , p2 , w   w[ p1 /   1  p2 /   1 ]1   /  .
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 p1
If   1, when  1, Jim can choose any bundle that is on his budget constraint. That is, if
p2
p  p1  p 2 ,
1 w
  , 1  0 ,  2  0 and v( p1 , p2 , w)  .
p p
Also, this is the only candidate solution if   1 .

3. Now, let’s check the second order conditions.

If   1, the utility function is not quasi-concave. In this case we would have corner solutions:
𝒘
, 𝒊𝒇 𝒑𝟏 ≤ 𝒑𝟐
𝒙𝟏 (𝒑𝟏 , 𝒑𝟐 , 𝒘) = {𝒑𝟏
𝟎, 𝒐𝒕𝒉𝒆𝒓𝒘𝒊𝒔𝒆
𝒘
, 𝒊𝒇 𝒑𝟐 ≤ 𝒑𝟏
𝒙𝟐 (𝒑𝟏 , 𝒑𝟐 , 𝒘) = {𝒑𝟐
𝟎, 𝒐𝒕𝒉𝒆𝒓𝒘𝒊𝒔𝒆
𝒘
, 𝒊𝒇 𝒑𝟏 ≤ 𝒑𝟐
𝒑𝟏
𝒗(𝒑𝟏 , 𝒑𝟐 , 𝒘) = { 𝒘
, 𝒐𝒕𝒉𝒆𝒓𝒘𝒊𝒔𝒆
𝒑𝟐

If   1 , the utility function is quasi-concave. The solution is in part d).

If   1, this is the perfect substitutes utility function.
𝒘
, 𝒊𝒇 𝒑𝟏 < 𝒑𝟐
𝒑𝟏
𝒙𝟏 (𝒑𝟏 , 𝒑𝟐 , 𝒘) = 𝟎, 𝒊𝒇 𝒑𝟏 > 𝒑𝟐
𝒘
[𝟎, ] , 𝒊𝒇 𝒑𝟏 = 𝒑𝟐 = 𝒑
{ 𝒑
𝟎, 𝒊𝒇 𝒑𝟏 < 𝒑𝟐
𝒘
, 𝒊𝒇 𝒑𝟏 > 𝒑𝟐
𝒙𝟐 (𝒑𝟏 , 𝒑𝟐 , 𝒘) = 𝒑𝟐
𝒘
− 𝒙𝟏 , 𝒊𝒇 𝒑𝟏 = 𝒑𝟐 = 𝒑
{𝒑

𝒘
, 𝒊𝒇 𝒑𝟏 < 𝒑𝟐
𝒑𝟏
𝒘
𝒗(𝒑𝟏 , 𝒑𝟐 , 𝒘) = , 𝒊𝒇 𝒑𝟏 > 𝒑𝟐
𝒑𝟐
𝒘
, 𝒊𝒇 𝒑𝟏 = 𝒑𝟐 = 𝒑
{𝒑

Marking scheme: 5 points setup, 5 points FOCs, 5 points solutions of FOCs, and 5 points answers with
SOCs checks.

For the rest of the problem, assume that   1 .

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B. (10 points) Set up and solve Jim’s expenditure minimization problem. Find the Hicksian demand and the
expenditure function.

Solution

min{ p1 x1  p2 x2 }
x1 , x2

such that x1  0,
x 2  0,
[ x1  x2 ]1/   u ,
We assume also that u  u(0,0) .

1. Write down the Lagrangian and take the first order necessary conditions:
L( x1 , x2 , 1 , 2 ,  )  ( p1 x1  p2 x2 )  1 x1  2 x2  [( x1  x2 )1/   u ] .
F.O.N.C.s:
L
1)   p1  1   x1 1 ( x1  x2 )(1  )/   0 ,
x1
L
2)   p2  2   x2 1 ( x1  x2 )(1  )/   0 ,
x2
L
3)  x1  0, 1  0, 1 x1  0 ,
1
L
4)  x 2  0,  2  0,  2 x 2  0 ,
 2
L
5)  ( x1  x2 )1/   u  0,   0, [( x1  x2 )1/   u ]  0


2. Solve the system of F.O.N.C.s:

𝝏𝒖(𝒙)
When   1 , 𝐥𝐢𝐦 = ∞. Thus, Jim would never choose a bundle with either good in
𝒙𝒊 →𝟎 𝝏𝒙𝒊
zero quantity. We can also see this from FONCs 1) and 2).
Thus, the only candidate solution is x1  0 , x2  0 .
up11/   1
x1  ,
( p1 /   1  p2 /   1 )1/ 
up  
1/  1
x2   /   1 2  /   1 1/  ,
( p1  p2 )
  [ p1 /   1  p2 /   1 ](  1)/  ,
1  0 ,
2  0 ,
 /   1  /   1 (  1)/ 
e( p1 , p2 , u )  u [ p1  p2 ] .

3. If   1 , the objective function is convex, so the S.O.C. holds. Thus,

up1  
1/  1
h1 ( p1 , p2 , u )  ,
( p1 /   1  p2 /   1 )1/ 

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 up2  
1/  1
h2 ( p1 , p2 , u )  ,
( p1 /   1  p2 /  1 )1/ 
 /   1  /   1 (  1)/ 
e( p1 , p2 , u )  u [ p1  p2 ] .

C. (5 points) Are the conditions of the equivalence theorem satisfied? If so, check that the equivalence of
the functions you have found in parts A and B.

Solution

The utility function is continuous, it is strictly increasing, and u  u(0,0) . Thus, the conditions of
the theorem are satisfied.
Here we check the theorem only for good 1. For good 2 the solution would be analogous.

i)
 /   1
 p2   )(1  )/  ] p1 
 /  1 1/  1
[ w( p1
h1 ( p1 , p2 , v( p1 , p2 , w))  
( p1    p2   )1/ 
 /  1  /  1

wp1  
1/  1
  x1 ( p1 , p2 , w).
p1    p2  
 /  1  /  1

ii)
 /   1  /   1 (  1)/ 
p1 
1/  1
u [ p1  p2 ]
x1 ( p1 , p2 , e( p1 , p2 , u ))   /   1  /   1

p1  p2
up1  
1/  1
  /   1  h1 ( p1 , p2 , u ).
 p2   )1/ 
 /  1
( p1

iii)
e( p1 , p2 , v( p1 , p2 , w))  [w( p1    p2   )(1  )/  ]( p1    p2   )(  1)/   w.
 /  1  /  1  /  1  /  1

iv)
v( p1 , p2 , e( p1 , p2 , u ))  [u ( p1    p2   )(  1)/  ]( p1    p2   )(1  )/   u .
 /  1  /  1  /  1  /  1

Problem 5 (35 points total)

Wilma the Witch and her sister Wendy consume only toads and snakes. They make stew out of these
ingredients using strict proportions, but each sister has her preferred recipe. Specifically, Wilma’s
preferences for toads (t) and snakes (s) can be described by utility function (𝑡, 𝑠) = min{𝑡, 𝑠} , while
Wendy’s preferences have the following utility function representation: 𝑣(𝑡, 𝑠) = min{2𝑡, 𝑠}. Suppose also
that they can purchase toads and snakes at respective prices 𝑝𝑡 > 0 and 𝑝𝑠 > 0, and joint wealth w>0 to
spend on both goods.
A. (5 points) Set up Wilma’s utility maximization problem and derive her Walrasian demand
correspondence, assuming she gets to spend all of their joint wealth.
Solution:
𝐦𝐚𝐱{ 𝐦𝐢𝐧{𝒕, 𝒔}}
𝒕,𝒔
s.t. 𝒑𝒕 𝒕 + 𝒑𝒔 𝒔 ≤ 𝒘,
𝒕 ≥ 𝟎, 𝒔 ≥ 𝟎.
Only graphical solution is possible.
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 𝒘
𝒕(𝒑𝒕 , 𝒑𝒔 , 𝒘) = 𝒑 + 𝒑 ,
𝒕 𝒔
𝒘
𝒔(𝒑𝒕 , 𝒑𝒔 , 𝒘) = 𝒑 + 𝒑 .
𝒕 𝒔

B. (5 points) Set up Wendy’s utility maximization problem and derive her Walrasian demand
correspondence.
Solution:
𝐦𝐚𝐱{ 𝐦𝐢𝐧{𝟐𝒕, 𝒔}}
𝒕,𝒔
s.t. 𝒑𝒕 𝒕 + 𝒑𝒔 𝒔 ≤ 𝒘,
𝒕 ≥ 𝟎, 𝒔 ≥ 𝟎.
Only graphical solution is possible.
𝒘
𝒕(𝒑𝒕 , 𝒑𝒔 , 𝒘) = 𝒑 + 𝟐𝒑 ,
𝒕 𝒔
𝟐𝒘
𝒔(𝒑𝒕 , 𝒑𝒔 , 𝒘) = 𝒑 + 𝟐𝒑 .
𝒕 𝒔

C. (10 points) Suppose that over time the sisters realize that they’ve developed a joint taste for a
different recipe. That is, they now always maximize the following joint utility function:
1 1
𝑈(𝑡, 𝑠) = 2 min{𝑡, 𝑠} + 2 min{2𝑡, 𝑠}.
Set up the utility maximization problem of this household and derive the Walrasian demand
correspondence [Hint: it will help if you draw the indifference curves.]
Solution:
𝟏 𝟏
𝐦𝐚𝐱{ 𝐦𝐢𝐧{𝒕, 𝒔} + 𝐦𝐢𝐧{𝟐𝒕, 𝒔}}
𝒕,𝒔 𝟐 𝟐
s.t. 𝒑𝒕 𝒕 + 𝒑𝒔 𝒔 ≤ 𝒘,
𝒕 ≥ 𝟎, 𝒔 ≥ 𝟎.
Only graphical solution is possible. See graph below for a sample indifference curve:

𝒕∗ ∈ 𝒕(𝒑𝒕 , 𝒑𝒔 , 𝒘) and 𝒔∗ ∈ 𝒔(𝒑𝒕 , 𝒑𝒔 , 𝒘), where

𝒘 𝟐𝒘
If 𝒑𝒔 < 𝒑𝒕, then 𝒕∗ = 𝒑 + 𝟐𝒑 , 𝒔∗ = 𝒑 + 𝟐𝒑 .
𝒕 𝒔 𝒕 𝒔
𝒘 𝒘
If 𝒑𝒔 > 𝒑𝒕, then 𝒕∗ = 𝒑 + 𝒑 , 𝒔∗ = 𝒑 + 𝒑 .
𝒕 𝒔 𝒕 𝒔
𝒘 𝒘 𝒘
If 𝒑𝒔 = 𝒑𝒕 = 𝒑, then 𝒕∗ ∈ [𝟑𝒑 , 𝟐𝒑], 𝒔∗ = 𝒑 − 𝒕∗ .

Forget the condition in C, no joint taste anymore.

Suppose the sisters decide, that when 𝑝𝑡 > 𝑝𝑠 , Wilma makes shopping and cooking decisions according
to her preferences. That is, the preferences of their household coincide with her preferences. When 𝑝𝑡 ≤ 𝑝𝑠 ,

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Wendy is the one with the decision power – only her preferences affect the sisters’ demand for toads and
snakes.
D. (6 points) Find the demand of their household when 𝑝𝑡 = 2, 𝑝𝑠 = 1 and 𝑤 = 9. Find the demand of
their household when 𝑝𝑡 ′=1, 𝑝𝑠 ′ = 1 and 𝑤 ′ = 6.
Solution:
1) 𝒑𝒕 = 𝟐, 𝒑𝒔 = 𝟏 and 𝒘 = 𝟗. Use Wilma’s demand functions since she is the one making
𝟗
decisions. Thus, 𝒕 = 𝒕(𝟐, 𝟏, 𝟗) = 𝟐+ 𝟏 = 𝟑, 𝒔 = 𝒔(𝟐, 𝟏, 𝟗) = 𝟑.
2) 𝒑𝒕 ′ = 𝟏, 𝒑𝒔 ′ = 𝟏 and 𝒘′ = 𝟔. Use Wendy’s demand functions since she is the one making
𝟔
decisions when prices are the same. Thus, 𝒕′ = 𝒕(𝟏, 𝟏, 𝟔) = 𝟏+ 𝟐∗𝟏 = 𝟐, 𝒔′ = 𝒔(𝟏, 𝟏, 𝟔) = 𝟒.

Marking scheme: 3 pts each.

E. (9 points) Formulate WARP specifically for the Wilma’s and Wendy’s choices and budget sets (i.e.,
using the relevant notation for goods and their prices). Do the actual choices in part A comply with
or violate WARP? Explain.
Solution:
WARP: Given (𝒑𝒕 , 𝒑𝒔 , 𝒘) and (𝒑𝒕 ′, 𝒑𝒔 ′, 𝒘′) if 𝒑𝒕 𝒕′ + 𝒑𝒔 𝒔′ ≤ 𝒘 and (𝒕, 𝒔) ≠ (𝒕′ , 𝒔′ ), then 𝒑′𝒕 𝒕 + 𝒑′𝒔 𝒔 >
𝒘′.
Check for the particular budgets and choices from part C:
𝒑𝒕 𝒕′ + 𝒑𝒔 𝒔′ = 𝟐 ∗ 𝟐 + 𝟏 ∗ 𝟒 = 𝟖 < 𝟗 = 𝒘 and (3,3) ≠(2,4). However,
𝒑′𝒕 𝒕 + 𝒑′𝒔 𝒔 = 𝟏 ∗ 𝟑 + 𝟏 ∗ 𝟑 = 𝟔 = 𝒘′. Thus, WARP is violated. Each bundle is affordable with the
other budget, yet they do not choose the same bundle under both budgets.
Each sister is a rational utility maximizer. Demands of each sister would satisfy WARP.
However, their joint demand violates WARP, since prices and wealth affect their joint demand
in a more complex way: prices influence the allocation of decision power between the two
sisters. To an observer, the resulting demands of this household may look like inconsistent
preference reversals.

Marking scheme: WARP formulation 4 pts (-1 pt if formulated in general, not specific to the
problem). Violation with demonstration is worth 5 pts. No explanation of why it happens
required.