Advanced Microeconomics WS 09 Prof.

Aleksander Berentsen
Solutions to Exercise Set 1 Assistant Daniel Muller

Solutions to exercise set 1: Decisions under certainty

Exercise 1
a) To be demonstrated: x  y and y  z x  z
According to the definition of a strict preference relation, it follows from x  y that x % y
and y  x; and from y  z, that y % z and z  y. Owing to the transitivity of %, it follows
that x % z. It now remains to be demonstrated that z  x. Let us assume that z % x holds.
However, because x % y holds (see above), z % y must also hold owing to the transitivity
of %. This is a contradiction (see above) and therefore z  x must hold. From x % z and
z  x it follows that x  z and we have thus demonstrated that  is transitive.

b) To be demonstrated: x y and y z x z
According to the definition of the indifference relation it follows from x y that x % y
and y % x; and from y z that y % z and z % y. Due to the transitivity of % it follows
from x % y and y % z that x % z; and from z % y and y % x, that z % x. From x % z and
z % x it finally follows that x z. We have thus shown that is transitive.

c) To be demonstrated: x  y % z x  z
According to the definition of a strict preference relation and the transitivity of %, x  y %
z implies that x % y as well as y  x and thus x % z hold. It remains to be demonstrated
that z  x. Let us assume that z % x holds. From the formulation we know that y % z.
Owing to the transitivity of %, y % x must hold. This is a contradiction to what was stated
above and therefore z  x must hold. It follows that x  z.

d) To be demonstrated: x y % z x % z
Since x y implies that x % y and y % x, x % z follows directly from the transitivity of
%.

Exercise 2
Convexity: y % x and z % x py + (1 p) z % x, for all p [0, 1].
Strict convexity: y % x and z % x py + (1 p) z  x, for all p (0, 1).

a) The function is represented by linear indifference curves:

Convexity is satisfied; strict convexity is not satisfied.

b) The function is represented by right-angled indifference curves

Convexity is satisfied; strict convexity is not satisfied.

c) Convexity as well as strict convexity are not satisfied.

d) Convexity as well as strict convexity are satisfied.

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Advanced Microeconomics WS 09 Prof. Aleksander Berentsen
Solutions to Exercise Set 1 Assistant Daniel Muller

e) The logarithmized utility function is apparently a (positive, monotonic) transformation

of the Cobb-Douglas function from d). The respective indifference curves look alike;
i.e., convexity and also strict convexity are satisfied.

Exercise 3
a) Leontief preferences represent the case of perfect complementarities. The indifference
curves are right-angled in this case and can be illustrated as follows:

x2

U4

U3

U2

U1

45
x1
0

Figure 1: Leontief preferences

b) u(x1 , x2 ) = min(x1 , x2 ) and, naturally, all positive monotonic transformations of this.

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Advanced Microeconomics WS 09 Prof. Aleksander Berentsen
Solutions to Exercise Set 1 Assistant Daniel Muller

Exercise 4
a) In order to calculate Marshallian demand functions, we have to maximize the utility
function as an auxiliary function subject to the budget constraint.

maxAx1 x21 s.t. p1 x1 + p2 x2 y

x1 ,x2

Lagrange:
L = Ax1 x21 + (y p1 x1 p2 x2 )
First-order condition:
L
= Ax11 x21 p1 = 0
x1
L
= A (1 ) x1 x2 p2 = 0
x2
L
= y p1 x1 p2 x2 = 0

Solve the first two conditions for , equate and solve for x1 . This gives:

Ax11 x21 A (1 ) x1 x2
=
p1 p2
p2
x2 = x1
(1 ) p1
Now, we substitute this result for x1 in the 3rd first-order condition and can thus calculate
x2 :
p2
0 = y p1 x2 p2 x2
(1 ) p1
 
0 = y + 1 p2 x2
|1 {z }
1
1

(1 ) y
x2 =
p2
Inserted in the result for x1 we get:
p2 (1 ) y y
x1 = =
(1 ) p1 p2 p1

In summary, the Marshallian demand for both goods is thus:

y (1 ) y
x1 (p1 , p2 , y) = and x2 (p1 , p2 , y) =
p1 p2

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Advanced Microeconomics WS 09 Prof. Aleksander Berentsen
Solutions to Exercise Set 1 Assistant Daniel Muller

b) The indirect utility function v is defined as follows:

v (p, y) = u (x (p, y))

Similarly, we can construct the indirect utility function by inserting the Marshallian de-
mand functions calculated in a) into the given utility function:
! !1
y (1 ) y
v (p1 , p2 , y) = A
p1 p2

(1 )1
= Ay
p1 p1
2

c) The following relationship exists between the indirect utility function and the expendi-
ture function:
v (p, e (p, u)) = u
This means that we simply determine the expenditure function by setting v (p1 , p2 , y) = u
and solving for y (= e (p1 , p2 , u)):

(1 )1
A e (p1 , p2 , u) = u
p1 p1
2
u p1 p1
e (p1 , p2 , u) = 2
A (1 )1

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Advanced Microeconomics WS 09 Prof. Aleksander Berentsen
Solutions to Exercise Set 1 Assistant Daniel Muller

Exercise 5
In order to calculate optimal consumption in each period, we have to maximize the utility
function given the auxiliary condition
P
t=0 xt 1, as the consumer only possesses 1 unit of the
good and distributes this over her whole life. Technically, the optimization problem is:

X
X
max ln(xt )
t
s.t. xt 1
x0 ,x1 ,x2,...
t=0 t=0

The Lagrange function has the following form:

X X
L = ln (xt ) + 1
t

xt
t=0 t=0

Deriving the Lagrange function for any chosen period xt and the subsequent period xt+1 gives:

L t
= =0
xt xt

L t+1
= =0
xt+1 xt+1
Solving for and equating gives:

t t+1
=
xt xt+1
xt+1 = xt

In each period the agent thus consumes times what she has consumed in the previous period.
As (0, 1), she consumes all the less, the further forward she is in the future. This holds for
all periods. Thus

x1 = x0
x2 = x1 = 2 x0 etc.

In general:
xt = t x0
xt = 1 must hold. We insert the above result in this condi-
P
Where consumption is optimal t=0
tion and get:

X
xt = 1
t=0
X
x0 t = 1
t=0
1
x0 = 1
1

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Advanced Microeconomics WS 09 Prof. Aleksander Berentsen
Solutions to Exercise Set 1 Assistant Daniel Muller

(In the last step we use the summation formula for infinite geometric series.) With this we get
the optimal consumption in period 0
x0 = 1
For optimal consumption in period t it holds that:

xt = t (1 )

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