FALL 2009

Solutions to Practice Problems for Lectures 5 to 7

5.1 Cobb-Douglas and Duality
(a) Start by writing the Lagrangian:for the cost-minimization problem (minimum cost for
achieving utility level u)
1-
L(x, y, u) = px + qy (u - x y )
Taking partial derivatives gives the first-order conditions
-1 1-
-1
=
p (x/y)
L / x = p x y

q (1-) (x/y)
L / y = q (1-) x y =
1-
L / = u - x y

=
=
=

0;
0;
0.

(1)
(2)
(3)

As usual, the derivative with respect to makes the constraint (holding with equality) one
of the first-order conditions while the first-order conditions based on the other two partial
derivatives equalize the marginal utilities of expenditures on goods x and y.
Solving (1) and (2) for yields

=
=

(p/) (y / x) /

(q/(1-)) (y / x) ;

Setting these equal,

-1
(p/) (x / y) / p
OR
p (1-)
OR
y

=
=
=

[q/(1-)] (y / x) ;
q (y / x);
(1-) px / q.

-1

(4)

Note that this is the same equation as the solution to the consumer problem in 3.1 based
on the same Cobb-Douglas utility function. This is the point of duality that the
relationship between x and y takes the same form for the expenditure minimization
problem as for the consumer problem. Further, the solution to one problem is always the
solution to the other problem under some conditions.
The difference in the specific bundles that are optimal for (CP) and (EMP) is a function
of the constraints that govern each problem. Hicksian demand functions are simply the
result of using (3) to solve (4).

1-

x y

1-
x [ (1-) px / q]
1-
x [ (1-) p / q]
x
and similarly
y

=
=
=
=

u
u
u
1-
u [q / (1-) p]

(1-) px / q

y
y

=
=

(1-) pu [q / (1-) p]

u [(1-) p / q]

1-

/ q

These solutions represent Hicksian demand functions:

1-
=
u [q / (1-) p]
hx(p, u)

hy(p, u)
=
u [(1-) p / q]
(b) e(p, u)

= p hx(p, u) + q hy(p, u)

1-
1-

= u p [q / (1-)] + uq [(1-) p / ]
1-
1-
1-

= u p q [( / (1-)) + ((1-) / ) ]

(c) From problem 3.1, the optimal bundles in the consumer problem are
x* = W / p; y* = (1- ) W / q.
So v(p, W)

= u(x*(p, W), y*(p, W))

1-
= (W / p) [(1- ) W / q]

1-
= W ( / p) [(1- ) / q]

(d) hx(p, v(p, W)) = x*(p, W)

Star with the equation from (a):

hx(p, u) = u [q / (1-) p]

Substituting u = v(p, W) = W ( / p) [(1- ) / q]

1-

1-

gives

1-

1-

hx(p, v(p, W)) = (W ( / p) [(1- ) / q] ) [q / (1-) p]

hx(p, v(p, W)) = W [( / p)] = x*(p, W).
(d) e(p,v(p,W)) = W
e(p, v(p, W)) = p hx(p, v(p, W)) + q hy(p, v(p, W))
= p x*(p, W) + q y*(p, W)
= W.
5.2 The Linear Expenditure System

Assume that w p1b1 p2b2 p3b3 , and let w ' w p1b1 p2b2 p3b3 .
(a) If a1 a2 a3 1 , we can make a transform such that

[u ( x1 , x2 , x3 )]1/( a1 a2 a3 ) ( x1 b1 ) a1 /( a1 a2 a3 ) ( x2 b2 ) a2 /( a1 a2 a3 ) ( x3 b3 ) a3 /( a1 a2 a3 )
Then, the exponents on the right hand side sum up to 1.
(b) Take a log-transform, and set, we have

U ( x1 , x2 , x3 ) log u ( x1 , x2 , x3 ) a1 log( x1 b1 ) a2 log( x2 b2 ) a3 log( x3 b3 ) .

Set up a Lagrangian:
L a1 log( x1 b1 ) a2 log( x2 b2 ) a3 log( x3 b3 ) ( p1 x1 p2 x2 p3 x3 w)
Note that in the optimum, we must have xi bi , or the log-utility will be undefined. So,
the solution must be interior, and the first order conditions give
a3
a1
a2

(1)
p1 ( x1 b1 ) p2 ( x2 b2 ) p3 ( x3 b3 )
p1 x1 p2 x2 p3 x3 w (2)
Equation (2) is equivalent to
p1 ( x1 b1 ) p2 ( x2 b2 ) p3 ( x3 b3 ) w p1b1 p2b2 p3b3 w ' (3)
ai w '
bi
Solving the system (1) and (3), we get xi ( p, w)
(a1 a2 a3 ) pi
a3 w '
a1w '
a2 w '
V ( p, w) a1 log
a2 log
a3 log
(a1 a2 a3 ) p1
(a1 a2 a3 ) p2
(a1 a2 a3 ) p3
a
a
a
w'
) a1 a2 a3 ,
v( p, w) ( 1 ) a1 ( 2 ) a2 ( 3 ) a3 (
p1
p2
p3
a1 a2 a3
where w ' w p1b1 p2b2 p3b3 .
(c) Compared with the Walrisian demand function for a Cobb-Douglas utility function,
ai w '
bi , there is a constant on the right, and the
we find that here, xi ( p, w)
(a1 a2 a3 ) pi
wealth on the numerator becomes w ' w p1b1 p2b2 p3b3 .
That is, if we define xi ' xi bi , then the utility function can written in terms of
( x1 ', x2 ', x3 ') as u ( x1 ', x2 ', x3 ') x1 'a1 x2 'a2 x3 'a3 , which is a standard Cobb-Douglas utility
function. That is, preferences among all bundles with xi ' 0 are homothetic
in ( x1 ', x2 ', x3 ') . However, it is not the case that preferences are homothetic in ( x1 , x2 , x3 ) .
(d) The consumer will start at (b1 , b2 , b3 ) if w p1b1 p2b2 p3b3 , and growth rate with
ai
increasing income is consistent with
for each good i.
(a1 a2 a3 ) pi
5.3 The Envelope Theorem (Problem 3 on Problem Set 3)
Solution will be included with Problem Set 3 Solutions

6.1

CV, EV, and Wage Negotiations

There are many ways to calculate the correct EV and CV . Here, we will go the most
direct route via indirect utility functions.
From question 1 on problem set 2, we know that the general solution for a Cobb-Douglas
utility function, u x1 , x2 x1a1 x2 a2 , is given by

w ai
.
pi a1 a2
In our case, this simplifies to
w 12
w
xi p, w

.
1
1
pi 2 2 2 pi
xi p, w

Plugging the result into u x1 , x2 , we obtain indirect utility given by

1

w 2 w
v p, w

2 p1 2 p2

w
2

p1 p2

We want to adjust w by either A or B to keep indirect utility constant before and after
the price change:

v p 0 , w A v p1 , w

w A
2

1
p10 p2 0

w
2

p11 p21

500 A 1 500 1

2
2 2
1
A 146.4

v p 0 , w v p1 , w B

w
2

1
p10 p2 0

w B
2

1
p11 p21

500 1 500 B 1

2 1
2
2
B 207.1

A and B are calculated from the bosss perspective. A is the answer to the question of
how much she can decrease the consumers wage to make him as well off without the
move as with. B is the answer to the question of how much the boss would have to pay
the consumer after moving to make him as well of as before. A corresponds to
Equivalent Variation, B corresponds to Compensating Variation. Note, however, that
EV and CV are defined from the perspective of the consumer. Therefore,
EV A 146.4 and CV B 207.1 .
. Note that CV being calculated at
The reason these values are different is that
higher prices only means that the absolute value of CV will be higher if were dealing
with a normal good (and if

then CV = EV).

6.2 Quasilinear Utility and Welfare Measures

Solution will be included with Problem Set 3 Solutions
6.3 Perfect Complements and Welfare Analysis (Problem 1 on Problem Set 4)
Solution will be included with Problem Set 4 Solutions
7.1 Taxation and Deadweight Loss (on Problem Set 4)
Solution will be included with Problem Set 4 Solutions
7.2

Comparing Two Taxes

(a) x1 x 0 p1 p 0
8

(b) EV =

dx
11 (10 8)(0.5) 10
dp

h( p,u )dp
1

10

We do not have an exact functional form for h( p,u1 ) . So our first step is to estimate
it using the first order Taylor approximation (a fancy term for a linear
approximation). In particular, we are interested in h( p 0,u1 ) . [We already know
h( p1,u1 ) , which is equal to x1 .] We will use the Slutsky equation to replace
x x

h( p1 , u1 )
with
x( p1 , w) .
p
p w

h( p1 , u1 ) 0
p p1

x x
x( p1 , w) p 0 p1
x( p1 , w)

p w

h( p 0 , u1 ) h( p1 , u1 )

= 10 + (0.5 + (0.01)(10)) (8 10) = 10.8

Lets graph our known points, h( p 0, u1 ) = 10.8, h( p1, u1 ) = x1 = 10, and x 0 = 11:

h( p,u )dp

EV =

10

10

h( p,u1 )dp = Area of (a + b) = (10 8)(10 0) 12 (10

8

8) (10.8 10) = (2)(10) 12 (2)(0.8) = 20.8

(c) Now we need to estimate h( p1, u 0 ) :
h( p 0 ,u 0 ) 1
1
0
0
0
h( p ,u ) h( p ,u )
p p0

x x
x( p 0 ,w)
x( p 0 ,w)p1 p 0
p w

= 11 + (0.5 + (0.01)(11)) (10 8) = 10.22

CV =

10

h( p,u 0 )dp h( p,u 0 )dp = Area of (c + d) = (10 8)(10.22 0) 12 (10

10

8) (11 10.22) = (2)(10.22) 12 (2)(0.78) = 21.22

(d) CS =

10

10

x( p,w)dp x( p,w)dp = Area of (e + f) = (10 8)(10 0) 12 (10

8

8) (11 10) = (2)(10) 12 (2)(1) = 21

(e) CV answers the question about how much the government needs to compensate
individuals to be as well off after the tax increase as before. Since we may want to
know how much it would cost to keep everybody as well off as before, and we are
only evaluating the welfare impact of one particular policy, CV is the most
appropriate measure.
dx
dx
0 . This is not the case here. However, dw
is
(f) CS is equivalent to EV and CV iff dw
indeed very close to zero. Hence, CS would be a good estimate of CV in this case.
(And you will note that the values you find in parts c and d are very close to one
another.)

(g) Tax revenue (TR) = (2)(10) = 20

Deadweight loss associated with EV (DWLEV) = (Area b) = 12 (2)(10.8 10) = 0.8
DWLCV = (Area d) = 12 (2)(11 10.22) = 0.78
DWLCS = (Area f) = 12 (2)(11 10) = 1
Note that DWLEV and DWLCS lend themselves to the interpretation of DWL as the
difference between tax revenue and the change in welfare: DWLCS = CS TR and
DWLEV = |EV| TR. Calculating DWLCV in this way, |CV| - TR, would result in a
number much larger than DWLCV = 0.78 calculated above. (It would be equal to
21.22 20 = 1.22!)
Even though CS is a good estimate of CV in this case, DWLCS is not a good
approximation of DWLCV, since the DWL values are relatively small. In this case,
DWLCS overestimates DWLCV by over a quarter.

7.3 Comparative Statics and Welfare Measures (Problem 3 on Problem Set 4)

7.4 Welfare Analysis of a Price Change: Does the Path Matter?

a) First, note that Walrasian demands for goods 1 and 2 do not depend on wealth. Pick
two levels of utility, u and u. By definition, hl ( p, u ) xl ( p, e( p, u )) and
hl ( p, u ') xl ( p, e( p, u ')) . Given that xl ( p, e( p, u )) xl ( p, e( p, u ')) for any u and u
(because there are no wealth effects), hl ( p, u ) hl ( p, u ') . The Walrasian and Hicksian
demand functions are, therefore, merely functions of the prices of goods 1 and 2.
Using this plus the fact that hl ( p, u ) xl ( p, e( p, u )) , we can conclude that the
Hicksian demand functions are exactly the same as the Walrasian demand functions.
i) Using the equation on p. 84 of the NMN for EV when multiple prices change:
p20

p10

p2

p1

EV ((1,1), (2, 2), w) EV ( p 0 , p1 , w) 1 h2 ( p10 , s, p30 , u1 )ds 1 h1 ( s, p12 , p30 , u1 )ds

The EV of a change from prices (1,1) to (1,2) will equal the first integral and the EV
of a change in prices from (1,2) to (2,2) will equal the second integral. You can
calculate these integrals by calculating the area of the appropriate trapezoids (i.e. the
area under the demand curves over the range of the appropriate price changes). Note
that when the price of good one changes, we do not add any integral related to h2 as a
function of p1!
Plugging in the numbers given in the problem,
EV ( p 0 , p1 , w) EV ((1,1), (2, 2), w) EV ((1,1), (1, 2), w) EV ((1, 2), (2, 2), w)
EV ((1,1), (1, 2), w) (11 (3 / 2)a )
EV ((1, 2), (2, 2), w) 9
EV ((1,1), (2, 2), w) 20 (3 / 2)a

ii)
EV ( p 0 , p1 , w) EV ((1,1), (2, 2), w) EV ((1,1), (2,1), w) EV ((2,1), (2, 2), w)
EV ((1,1), (2,1), w) 8
EV ((2,1), (2, 2), w) (12 (3 / 2)a)
EV ((1,1), (2, 2), w) 20 (3 / 2)a

b) The solutions to (ai) and (aii) will always be the same. The most intuitive way to
think about this is that the solutions to UMP and EMP are the same regardless of the
path of price changes. No matter how we get to the final prices, our demand will be
the same, and our utility and expenditure will be the same. So any good measure of a
welfare change must be independent of the path prices take to get from original prices
to final prices. This is of course not a proof that EV and CV are good measures of a
welfare change, but you can take for granted that they are. Note that whenever there

are wealth effects, CS is not path independent, which is the main reason we dont
like it.
The reason for this is a little tricky: it comes from the fact that

(one of the

properties of EMP is that

, so
). Note that the solutions
to (ai) and (aii) being equal does NOT depend on there being no wealth effects in the
demand for goods 1 and 2.
The way to think about this intuitively is that when you change p1, you are shifting
the Hicksian demand curve for good two by the same proportional amount that a
change in p2 would shift the Hicksian demand curve for good one. In the case of this
problem, in part (i) the change in the price of good 2 increased the area under the
Hicksian demand curve for good 1 by one unit (from 8 to 9; between p1 = 1 and p1 =
2). In part (ii), the change in the price of good 1 increased the area under the Hicksian
demand curve for good 2 by one unit (from 11-(3/2)a to 12-(3/2)a). Because
, these changes in the area under the Hicksian demand curves will always
be the same, even when the prices of the goods change by different amounts.
Note: this is a very tricky point, and I wouldnt worry much if you have trouble
following this argument.
c) When a =2, EV1 = -8, EV2 = -8, and EVT = -17 (just use the formulae from part a).
Clearly, |EV1| + |EV2| < |EVT|.
Why? An increase in just one price allows the consumer to substitute away from the
more expensive good, which mitigates some of the loss of utility. Meanwhile, an
increase in the prices of both goods 1 & 2 makes it harder for the consumer to
substitute away from the price increase (although he/she can still substitute towards
good 3, the numeraire). So, the sum of the welfare loss from either price change on
its own is not as severe as the welfare loss from both simultaneously.
Think about the difference between Hicksian and Slutsky compensation for a price
change Hicksian compensation is less than the Slutsky compensation, because the
consumer can still maintain the same utility with less wealth by substituting away
from the more expensive good.
d) DWL = -EV - Tax revenue

Note that DWL is typically reported as a positive number thats why we use the
negative EV. DWL is the loss in welfare to society a decrease in the EV that is not
matched by an increase in tax revenue.
Tax revenue is simply number of units purchased * per unit tax. Plugging back into
the demand, x1(2, 1) = 7, and x2(1, 2) = 7. And the per unit tax in both cases = 1. So
the tax of either individual change raises revenue = 7. For the double tax, x1(2, 2) =
x2(2, 2) = 8, so revenue = 16.

So,

DW1 = 8 - 7 = 1
DWT DW1 + DW2

DW2 = 8 - 7 = 1

DWT = 17 - 16 = 1

Why? DWL comes from distorted behavior where consumers buy less of
something that they value (which the producer can make at an affordable price),
because the tax creates a wedge between the consumers price and the producers
price. The greater the distortion, the greater the DWL.
The tax on both goods at once produces less distortion than the tax on either good
individually for the same reason discussed in part c: When you tax both goods
simultaneously, there is less room for the consumer to adjust. So the overall DWL of
the tax on both goods is relatively smaller (although the consumer is hit harder by it,
evident in a larger EV).
Note that the tax on both goods is not a lump sum tax on consumption, because the
numeraire good is still not being taxed at all.