Microeconomic Theory I

Assignment #2 - Answer Key

1. [Checking WARP]. For each of the following demand functions, check whether they
satisfy the weak axiom of revealed preference (WARP).

(a) “Random demand”: For any pair of prices p1 and p2 and wealth w, the consumer
randomizes uniformly over all points in the budget frontier.
Let us prove it by a counterexample.
x2

Bp,w

x(p’,w’)

x(p,w)

Bp’,w’

x1

Random demand

WARP states that

if p x (p0 ; w0 ) w and x (p0 ; w0 ) 6= x (p; w) then p0 x (p; w) > w0
That is, if the new consumption bundle (chosen under the new prices and
wealth) would not have been a¤ordable under the old prices and wealth, then
it must be the case that the old consumption bundle is not a¤ordable under
the new prices and wealth. In this case, we …nd that
p x (p0 ; w0 ) w and x (p0 ; w0 ) 6= x (p; w) but p0 x (p; w) < w0
That is, the old consumption bundle is still a¤ordable under the new prices
and wealth. Hence, there exists a probability greater than zero that random
demand assigns bundles as the ones chosen in the …gure. As a consequence
we can conclude that random demand does not satisfy WARP.
(b) “Average demand”: The expected “random demand”given p1 , p2 and w.
First, note that if the consumer randomizes uniformly over all points in her
budget line, then the expected random demand is allocated at the midpoint
of the budget line.
x2
w/p2
Bp,w

x(p,w)

0.5w/p2

0.5w/p1 w/p1 x1

Average demand

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 Let us now prove that WARP is satis…ed for average demand. Let us work
by contradiction, by assuming that average demand violates WARP. There
are two possibilities in which this violation might take place, as the following
two …gures illustrate.
x2 x2
w/p2 w/p2
Bp,w Bp,w
x(p’,w’) x(p’,w’)
x(p,w)

x(p,w)

Bp’,w’ Bp’,w’

w/p1 w’/p1' x1 x1 ' x1 w/p1 w’/p1' x1

Let us compute point x1 and x01 . Recall that these points have to be allocated
at the midpoint of the budget line. Hence,

1w 1 w0
x1 = and x01 =
2 p1 2 p01
0
therefore 2x1 = pw1 and 2x01 = wp0 . Moreover, we can see in both …gures that
1
x01 < x1 . Therefore, 2x01 < 2x1 , which implies

w0 w
0
<
p1 p1
0
But in both …gures we in fact see that wp0 > pw1 . Hence, we have reached a
1
contradiction, and average demand cannot violate WARP.
(c) “Conspicuous demand”: For any p1 , p2 and w,
8 n o
> w
< pi if pwi = min pw1 ; pw2 and w
6= w
p1 p2
xi (p1 ; p2 ; w) = w
if pw1 = pw2 and i = 1
>
: pi
0 otherwise
w w
Let us divide it into two cases: Case 1, in which p1 p2
, and Case 2, in which
w
p1
> pw2 .
w w
Case 1 p1 p2
: The demand function to the following expression
8 w
if pw1 6= pw2
< p1
w
xi (p1 ; p2 ; w) = if pw1 = pw2
p1
:
0 otherwise

2
 x2

Bp,w

x(p,w)

w/p1 x1

w w
Case 2 p1
> p2
: The demand function to the following expression

w
p2
if pw1 6= pw2
xi (p1 ; p2 ; w) =
0 otherwise

x2

x(p’,w’)

w’/p2'

Bp’,w’

x1

Finally, in this …gure we represent both cases simultaneously.

x2

Bp,w
x(p’,w’)

w’/p2'

x(p,w)
Bp’,w’

w/p1 x1

Let us now check if conscopious demand satis…es WARP. As mentioned in

part (a), WARP states that

if p x (p0 ; w0 ) w and x (p0 ; w0 ) 6= x (p; w) then p0 x (p; w) > w0

But as we can see in the …gure that deals with both cases, we have that
p0 x (p; w) < w0 . Hence, conscopious demand violates WARP.

2. [Stone-Geary utility function]. Exercise 4.12 from Nicholson and Snyder.

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 See answer key at the end of the handout.

3. [UMP, EMP, and Duality]. A consumer has a Cobb-Douglas utility function

u (x1 ; x2 ) = x1 x21 ,
where > 0 and x1 ; x2 2 R+ . Assume that the price vector satisifes p (p1 ; p2 ) >> 0,
and wealth w > 0.

(a) Write the consumer’s utility maximization problem. Find Walrasian demands,
and the indirect utility function function v(p1 ; p2 ; w):
The consumer’s UMP is
max x1 x12 s.t. p1 x1 + p2 x2 w:
x1 ;x2

And the Lagrangian is

L = x1 x21 + (w p1 x1 + p2 x2 )
Taking …rst-order conditions, we obtain
1 1
1 1 x1 x2
x1 x2 p1 = 0 () =
p1
and
(1 ) x1 x2
(1 ) x1 x2 p2 = 0 () =
p2
The above two conditions imply that
1 1
x1 x2 (1 ) x1 x2
=
p1 p2
or rearranging,
p2 x2
p1 x1 =
1
From the budget constraint, p1 x1 + p2 x2 = w, or p2 x2 = w p1 x1 , which we
can insert in the right-hand side of the above expression to obtain

p1 x1 = (w p1 x1 ) :
1
Solving for x1 , we …nd the Walrasian demand for good 1,
w
x1 (p; w) = ;
p1
Using the budget constraint again, p2 x2 = w p1 x1 or x2 = w pp21 x1 we can
insert the Walrasian demand for good 1 in order to obtain that of good 2,
w p1 pw1
x2 (p; w) =
p2
(1 )w
= :
p2

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 Then inserting Walrasian demands into the utility function x1 x12 , we …nd
the indirect utility function
1
w (1 )w
v(p1 ; p2 ; w) =
p1 p2
1
1
= w:
p1 p2

(b) Write the consumer’s expenditure minimization problem. Find Hicksian demands,
and the expenditure function e(p1 ; p2 ; u).
The EMP is

min p1 x1 + p2 x2 s.t. u (x1 ; x2 ) x1 x21 u:

x1 ;x2

The Lagrangian in this case is

L = p1 x1 + p2 x2 x1 x12 u

Taking the …rst-order conditions, we have

1 1
x1 x2 1
p1 x1 1 x21 = 0 () =
p1
and
(1 )x1 x2 1
p2 (1 ) x1 x2 = 0 () =
p2
The above two conditions imply that
1 1
x1 x2 (1 )x1 x2
=
p1 p2
or rearranging,
p2
x1 = x2
1 p1
Substituting it into the constraint x1 x12 = u, we obtain

p2
x2 x21 =u
1 p1

which simpli…es to
p2 +(1 )
x2 =u
1 p1
which solving for x2 , yields the Hicksian demand for good 2,

(1 ) p1
h2 (p; u) = u:
p2

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 p2
Therefore, we can use x1 = 1
x
p1 2
to …nd the Hicksian demand for good 1,
as follows
p2 (1 ) p1
h1 (p; u) = u
1 p1 p2
1
p2
= u
(1 ) p1
Finally, inserting Hicksian demands into the EMP, we get the expenditure
function
1
p2 (1 ) p1
e(p1 ; p2 ; u) = p1 u + p2 u
(1 ) p1 p2
1
= (1 ) p1 p21 u:
(c) Evaluate the Walrasian demands x(p1 ; p2 ; w) at w = e(p1 ; p2 ; u), and show that
Walrasian and Hicksian demands coincide, that is,
x(p1 ; p2 ; e(p1 ; p2 ; u)) = h(p1 ; p2 ; u):
The Walrasian demands x(p1 ; p2 ; w) is the best bundle that maximize the con-
sumer’s utility when his/her wealth equals the minimum expenditure. Sub-
stituting w = e (p1 ; p2 ; u) into the Walrasian demand functions, we obtain
1
x1 (p1 ; p2 ; e (p1 ; p2 ; u)) = (1 ) p1 p12 u
p1
1
p2
= u = h1 (p1 ; p2 ; u)
(1 ) p1
and
1 1
x2 (p1 ; p2 ; e (p1 ; p2 ; u)) = (1 ) p1 p21 u
p2
(1 ) p1
= u = h2 (p1 ; p2 ; u) :
p2
Therefore, Walrasian and Hicksian demands coincide when income equals the
minimum expenditure.
(d) Evaluate the Hicksian demands h(p1 ; p2 ; u) at u = v(p1 ; p2 ; w), and show that
Hicksian and Walrasian demands coincide, that is,
h(p1 ; p2 ; v(p1 ; p2 ; w)) = x(p1 ; p2 ; u):
The Hicksian demands is the commodity bundle which make the consumer
spend the least to reach utility level u. Substituting u = v (p1 ; p2 ; w) into the
Hicksian demand functions, we obtain
1 1
p2 1
h1 (p1 ; p2 ; v (p1 ; p2 ; w)) = w
(1 ) p1 p1 p2
w
= = x1 (p1 ; p2 ; ; u)
p1

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 and
1
(1 ) p1 1
h2 (p1 ; p2 ; v (p1 ; p2 ; w)) = w
p2 p1 p2
(1 )w
= = x2 (p1 ; p2 ; ; u) :
pw
This implies that Hicksian and Walrasian demands coincide at u = v (p1 ; p2 ; w).
(e) Evaluate the indirect utility function v(p1 ; p2 ; w) at w = e(p1 ; p2 ; u), and show
that
v(p1 ; p2 ; e(p1 ; p2 ; u)) = u:
The indirect utility function v(p1 ; p2 ; e (p1 ; p2 ; u)) is the highest utility level the
consumer can get when his/her wealth is the minimal expenditure e (p1 ; p2 ; u).
Inserting w = e (p1 ; p2 ; u) into the indirect utility function, we obtain
1
1 1
v(p1 ; p2 ; e (p1 ; p2 ; u)) = (1 ) p1 p12 u
p1 p2
= u:
(f) Evaluate the expenditure function e(p1 ; p2 ; u) at u = v(p1 ; p2 ; w), and show that
e(p1 ; p2 ; v(p1 ; p2 ; w)) = w:
The expenditure function e(p1 ; p2 ; v(p1 ; p2 ; w)) is the minimum wealth that
the consumer has to spend in order to reach the utility level u = v(p1 ; p2 ; w).
Substituting u = v(p1 ; p2 ; w) into the expenditure function, we …nd
1
1 1
e(p1 ; p2 ; v(p1 ; p2 ; w)) = (1 ) p1 p12 w
p1 p2
= w:

4. [Choosing between two types of labor.] Consider an individual who is endowed

with one unit of time which can be allocated to leisure (l) or to either of two types of
labor. Generally, the person uses its labor income to purchase consumption goods c at
the price p. The …rst type of labor, L1 , pays a lower wage (w1 ) but is easier to perform,
whereas the second type, L2 , pays a higher wage (w2 > w1 ) but is more di¢ cult. The
person’s preferences are given by the strictly concave utility function
u(c; l; L1 ; L2 )

where the partial derivatives are uc > 0, ul > 0, and uLi < 0 for both types of labor
i = f1; 2g. In terms of these partial derivatives, one way to formalize the notion that
“L1 is easier than L2 ”by wrting that, when the individual works the same amount of
time in both types of labor, L1 = L2 , he has uL1 > uL2 implying that, since uLi < 0,
the marginal disutility from L2 is larger (i.e., more negative) than that from L1 .

(a) Assume the person can do L1 or L2 but not both, and that it is only possible to
choose Li 2 0; 13 ; that is, labor can only be supplied in the discrete amounts 0
or 1/3. Explain how the individual would choose which job, if either, to perform.

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 There are three possibilities:
– L1 = L2 = 0, which implies that all his time is allocated to leisure, l = 1,
and that he does not obtain any wage to buy consumption goods, i.e.,
c = 0;
– L1 = 31 and L2 = 0, thus implying that the remaining time for leisure is
only l = 32 , and that he obtains a salary w1 13 which allows him to a¤ord
w1
3p
units of the consumption good c; or
– L1 = 0 and L2 = 13 which also implies a reamining leisure of l = 32 , and
that he obtains a salary w2 31 which allows him to a¤ord w3p2 units of the
consumption good c. (Note that the option L1 = 13 , L2 = 13 and l = 31 is
not allowed in this context, since the individual can only supply one type
of labor, but not both.)
Finally, the individual chooses option 1, 2 or 3, depending on which one
yields the highest utility level, i.e., he compares u(0; 1; 0; 0), u( w3p1 ; 23 ; 13 ; 0) and
u( w3p2 ; 23 ; 0; 31 ).
(b) Now assume that labor can be supplied continuously but that again it is not
possible to do both jobs. In this case, explain how the individual would choose
which job to accept.
In this case, we …rst need to solve the value of L1 that maximizes this indi-
vidual’s utility function, that is,

w1 L1
v1 = max u ;1 L1 ; L1 ; 0 (1)
L1 p

where L1 > 0, L2 = 0, and the remaining leisure time is thus l = 1 L1 .

Similarly, if the individual only works in the second job, he chooses L2 to
maximize
w2 L2
v2 = max u ; 1 L2 ; 0; L2 (2)
L2 p
Once we have the value functions v1 and v2 , the individual compares v1 and
v2 : if v1 > v2 , then he chooses the argmax of problem (1); while if v1 < v2 he
chooses the argmax of problem (2).
(c) Next, assume it is possible to supply both types of labor. Formulate the individ-
ual’s decision problem and characterize the solution in terms of the appropriate
…rst order conditions.
The individual now chooses the values of L1 and L2 that solve

w1 L1 + w2 L2
max u ;1 L1 L2 ; L1 ; L2
L1 ;L2 p

where w1 L1 + w2 L2 describes the total salary from both types of labor, and
l = 1 L1 L2 denotes the remaining leisure (out of a total time of 1 unit)
that this individual can enjoy after working L1 hours on the …rst type of job
and L2 hours on the second type of job.

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 Taking …rst order conditions with respect to L1 we obtain
w1
uc ul + uL1 0
p
and similarly with respect to L2 ,
w2
uc ul + uL2 0
p
(d) Prove that in order for the agent to supply positive quantities of both types of
labor, it is necessary that L2 should be more di¢ cult than L1 according to the
de…nition of “L1 is easier than L2 ”we described at the beginning of the exercise.
For an interior solution in which the individual supplies positive amounts of
both types of labor, we need that both of the above …rst order conditions
hold with equality, that is
w1 w2
uc ul + uL1 = 0 and uc ul + uL2 = 0
p p
Hence, solving for the common term ul on both expressions, we obtain
w1 w2
uc + uL1 = uc + uL2
p p
and rearranging,
w1 w2
uc = uL2 uL1
p
Therefore, if w2 > w1 , we need that uL1 > uL2 for this expression to hold
with equality.
(e) Finally, suppose that while L1 is easier than L2 (i.e., entails less e¤ort) it is also
more boring. As presently formulated, is the above model su¢ cient to allow these
two factors (e¤ort and boring) to be taken into consideration? If so, explain.
Otherwise, discuss how the model might be extended to incorporate them.
According to the present formulation, all that matters is the combined e¤ect of
the two factors (e¤ort and boring), as captured by uL2 . While both factors can
play a role, only their combined e¤ect is re‡ected in the values of the variables
of the model. The separate e¤ects cannot be distinguished. Intuitively, on
the basis of e¤ort, uL1 > uL2 since “L2 is more di¢ cult than L1 ,”but on the
basis of boredom, uL1 < uL2 since “L1 is more tedious than L2 ”The current
formulation combines the two e¤ects.
In order to represent the e¤ects separately, it would be necessary to distin-
guish the two factors in the utility function, such as

u(c; l; f (e1 ; b1 ); f (e2 ; b2 )),

| {z } | {z }
L1 L2

where ei denotes the e¤ort in labor type i = f1; 2g, while bi represents how
boring labor i is.

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 Answer key – Homework #2

Nicholson and Snyder 4.12, Stone-Geary Utility

a. For x < x0 utility is negative, so he will spend px x0 first. With I- pxx0 extra
income, this is a standard Cobb-Douglas problem:

p x ( x − x0 ) = α ( I − p x x0 ), β ( I − p x x0 )
py y =

b. Calculating budget shares from part (a) yields

p xx (1 − α ) px x0 py y β px x0
=α + and = β−
I I I I

and the limiting points of these two ratios (budget shares) when income
approaches infinity are
px py y
lim( I → ∞) x =α and lim( I → ∞) =β
I I