Microeconomic Theory - Fall 2011

Collegio Carlo Alberto

Prof. Ignacio Monzon

M IDTERM E XAM - 27 O CT 2011

A NSWER K EY

Instructions
1. Do not read the rest of the pages until I ask you to do so.
2. You have 120 minutes to solve this exam.
3. Write your name in all pages. Number all pages. In the first page, specify the total
number of pages you hand in.
4. You can use a dictionary. You can use a calculator.
5. You cannot use books, notes or classmates.
6. Provide justification for all your answers.
7. The answer should be clear from what is written. In other words, what is written
should suffice.
8. Do not hand in draft answers.
9. Spend the first 15 minutes reading the whole exam, so you can ask all necessary
questions during those first 15 minutes.
10. The questions are ordered in my subjective order of difficulty. Attempt the easy ones
first.

1. Jane has locally non-satiated, strictly convex, rational preferences. She consumes
only apples (A) and bananas (B). In period 1, prices were ( PA , PB ) = (2, 1), while in
period 2 prices were ( PA , PB ) = (1, k). Her chosen bundles were:
Apples
Bananas

t=1
10
20

t=2
5
25

Which values can k take?

Answer: Figure 1 shows Janes budget line in period 1, as well as her choice in
that period and also in the following period. From the figure, it is easy to check
that p1 x2 w1 , where p1 = (2, 1) are prices on the first period, x2 = (5, 25) are
quantities on the second period and w1 = p1 x1 = (2, 1)(10, 20) = 40 is wealth in the
first period. We know that the demand satisfies Walras Law since preferences are
non-satiated. We know that the demand is unique because of strict convexity. So we
wonder what can we tell from rationality. We know that in such a case, it has to be
the case that p2 x1 > w2 , that is, the bundle chosen in period 1 should be unavailable
in period 2. Thus,
p2 x 1 > w2
(1, k)(10, 20) > (1, k)(5, 25)
10 + 20k > 5 + 25k
5 > 5k
1>k

B
40

(5, 25)
(10, 20)

20

Figure 1: Apples and Bananas

L . Preferences < are monotone if

2. Let X = R+

xyxy.
Show that if preferences < are monotone, a straight line from the origin crosses each
indifference curve at most once.
L and x 0 R L be any two distinct points in the same straight
Answer: Let x R+
+
line. Then, x 0 = x for some 0 and 6= 1. If > 1, then x 0  x and so by
monotonicity, x 0  x. If < 1, then x  x 0 and so by monotonicity, x  x 0 . In either
case, x 6 x 0 .

3. Alexs preferences over two goods are represented by

u( x, y) = max { x, y} +

1
min { x, y} .
2

(a) Draw the indifference curves for u = 3 and u = 6.

(b) Find Alexs demand function.
Bob has preferences that can be represented by u( x, y) = x + y.
(c) Say you see choices, but dont know who made them. Could you tell if choices
were made by Alex or by Bob? Why?
Answer:
(a) Indifference curves for utility levels u = 3 and u = 6 are shown in Figure 2. To
build them, note there are two possible cases, depending on the relative values
of x and y:
(
y + 21 x if y x
u( x, y) =
x + 21 y if y < x
y
y=x
6
4
3

u=3
u=6

Figure 2: Indifference curves for u( x, y) = max { x, y} + 21 min { x, y}

(b) Given the shape of the indifference curves, the budget line will touch the highest possible indifference curve at a corner. This occurs because the budget
line is actually a straight line, whereas indifference curves are convex. Consequently, the decision of the agent will depend on the ratio of prices. Alexs
demand is given by,


w

if p x < py
px , 0






w
w
x A ( p x , p y , w ), y A ( p x , p y , w ) =
if p x = py
p x , 0 or 0, py

0, w
if p x > py
py
4

3
u=3
u=6
3

Figure 3: Indifference curves for u( x, y) = x + y

(c) Bobs indifference curves can be seen in Figure 3
Given the shape of the indifference curves, the budget line will touch the highest possible indifference curve also at a corner. This occurs because the budget
line is actually a straight line, and indifference curves are also straight lines.
The only situation in which the decision of the agent may be interior is when
prices are exactly equal. Bobs demand is given by,


w

,0
if p x < py
px


B
B
w
x ( p x , py , w), y ( p x , py , w) = anything such that x + y = px if p x = py



0, w
if p > p
py

So in most cases it will be impossible to tell from choices whether choices were
made by Alex or Bob.

4. Preferences are separable in the first J goods if they can be represented by a utility
function of the following form:
!
J


u ( x ) = v l ( x l ) + V x J +1 , . . . , x L
l =1

(a) Show first that if L = 2 and u( x ) = v1 ( x1 ) + v2 ( x2 ), then for all x1 , x10 , x2 , x20 ,






( x1 , x2 )  x10 , x2 x1 , x20  x10 , x20 .
(b) Now, generalize the result for L goods. Let a J and a0J be vectors of the first J
0 be vectors of the remaining L J goods. Show
goods. Similarly, let b J and b
J
0 ,
that for all a J , a0J , b J , b
J
 




0 0
0

a
,
b
.
( a J , b J )  a0J , b J a J , b
J
J J
(c) Show that if preferences are not separable, the previous result may not hold.
Answer:
(a) Let L = 2 and u( x ) = v1 ( x1 ) + v2 ( x2 ). By the definition of the utility function,




( x1 , x2 )  x10 , x2 u ( x1 , x2 ) u x10 , x2


v1 ( x1 ) + v2 ( x2 ) v1 x10 + v2 ( x2 )


v1 ( x1 ) v1 x10






v1 ( x1 ) + v2 x20 v1 x10 + v2 x20




u x1 , x20 u x10 , x20




x1 , x20  x10 , x20
And thats what we wanted to show.
(b) Now, in general,




0
0
( a J , b J )  a J , b J u ( a J , b J ) u a J , b J
!
!
J
J






+ V b J +1 , . . . , b L
vl ( al ) + V b J +1 , . . . , bL vl a0l
l =1
J

vl ( al )

l =1
J

vl ( al )

l =1

vl

+V

a0l

l =1

b0J +1 , . . . , b0L

l =1

vl

l =1





0
0 0

u
a
,
b
u a J , b
J
J J

 

0
0 0
a J , b
J  a J , b J
And again, thats what we wanted to show.
6

!


0

al

+V

b0J +1 , . . . , b0L

(c) Let u ( x1 , x2 ) = min { x1 , x2 }. Then, preferences are not separable. Let x1 = 2,

x2 = 2, x10 = 3 and x20 = 3. Then,






but
x1 , x20 6< x10 , x20
( x1 , x2 ) < x10 , x2
In this case,

(2, 2) < (3, 2)

but

(2, 3) 6< (3, 3)

To see this, note that

(2, 2) < (3, 2) u (2, 2) u (3, 2)

min {2, 2} min {3, 2}
2 2
and

(2, 3) 6< (3, 3)

u (2, 3) 6 u (3, 3)
u (2, 3) < u (3, 3)
min {2, 3} < min {3, 3}
2<3

5. Let X be a finite set of alternatives. The function V : X R assigns a value to each

element of X. Let us propose two choice rules over sets B B.
C ( B) = { x B : V ( x ) V (z) for at least half of the elements z X }
If no element fulfills the previous condition, then C ( B) = B
D ( B) = { x B : V ( x ) V (z) for at least half of the elements z B}
The rule C () selects the elements of B with values greater or equal than (at least)
half the elements of the whole set of alternatives X. The rule D () selects the elements
of B with values greater or equal than (at least) half the elements of B itself.
(a) Does C () satisfy the weak axiom of revealed preference?
Answer: C () satisfies the weak axiom of revealed preference. We need to
show that for all x, y X,




x, y B, x, y B0 , x C ( B), y C B0 x C B0
We know that y C ( B0 ). It may be for one of two reasons.
First, it may be that there is no element w B0 such that V (w) V (z) for at
least half of the elements z X. In such a case, C ( B0 ) = B0 , and then of course
x C ( B0 ) and we are done.
Second, it may be that there are elements w B0 such that V (w) V (z) for at
least half of the elements z X. In such a case, V (y) V (z) for at least half
of the elements z X (since y C ( B0 )). Then, there are elements w B such
that V (w) V (z) for at least half of the elements z X. We know that since
y is one of them. As a result, if x C ( B) it is because V ( x ) V (z) for at least
half of the elements z X. This in turn implies that x C ( B0 ).
(b) Does D () satisfy the weak axiom of revealed preference?
Answer: D () does not satisfy the weak axiom of revealed preference. We provide a (kind of long) counterexample (there may be a shorter one: any ideas?).
Let X = { a, b, c, d, e} with V ( a) = 1, V (b) = 2, V (c) = 3, V (d) = 4, V (e) = 5.
Then, C ({c, d, e}) = {d, e} and C ({ a, b, c, d, e}) = {c, d, e}. Note c, d {c, d, e}
and c, d { a, b, c, d, e}. Moreover, d C ({c, d, e}) and c C ({ a, b, c, d, e}).
The weak axiom does not hold because c 6 C ({c, d, e}).