Problem Set 1 [Suggested Solutions] API 111 / ECON 2020A / HBS 4010 (Fall 2017)

Maciej H. Kotowski / Harvard University

For the benefit of your classmates and this course’s future students, please let us know if you believe there is a serious error or
typo in the solution key.

1. College Admissions and the Stability of Marriage [Solution]

a) α − C, β − D, γ − A, δ − B.
b) α − C, β − D, γ − A, δ − B.
There is only one stable matching in this economy.

2. Constructing Unusual Utility Functions [Solution]

There are many possible answers to this question. However, in general, the simpler the model the better,
even if it seems “too simple.” (In practice, its way easier to make a simple more more complicated than
go the other way.) Feel welcome to speak with the instructor or a TF if you want more feedback on your
particular answers.1
a) In this case, the decision maker has preferences over his own wealth (say, w) and the neighborhood’s
average wealth, not including his own (say, n).2 Thus, its natural to identify his choice set with R2+ and
he’s choosing bundles (w, n) ∈ R2+ .
A good trick to use when constructing a utility function is to ask, “if we exogenously increase increase
one variable, how must the other change to keep the decision maker indifferent?” From the description
it is clear that the decision maker will dislike an increase in n unless it is accompanied by a rise in w. In
other words, n decreases utility (when w is held fixed) and w increases utility (when n is held fixed).
Perhaps the simplest function capturing this relationship is u(w, n) = w − n. With this utility function,
a person would prefer to have an income of $2 in a neighborhood with an average income $1 over an
income of $2 million in a neighborhood with an average income of $2 million + 1 cent. (These numbers
are purposefully extreme.) More generally if the tradeoffs between own- and neighborhood wealth are
more subtle, we might say that u(w, n) = f (w) − g(n), where f (·) and g(·) are increasing functions.
b) This decision maker “prefers mangoes to apples” but “refuses to take the last mango from a basket of
fruit.”
Arguably, this description gives us very little information about the decision maker. (In fact, we don’t
even know for sure that he likes apples!) For the moment, assume that the decision only likes mangoes
and does not care for apples (we’ll add them back in later).
Lets identify this decision maker’s choice as between bundles of the form (m, b) ∈ Z+ × Z+ where m is
the number of mangoes consumed and b is the number of mangoes left in the basket. (We’re assuming
that mangoes come in discrete units.)
Since mangoes are delicious, we can assume that if m > m′ , then (m, b) ≻ (m′ , b) for any b ≥ 1. That is,
the decision maker will like more mangoes provided at least one mangoes is left in the basket. However,
(0, 1) ≻ (m, 0) for all m, since leaving no mangoes for others is unacceptable.
A utility function capturing this relationship is
u(m, b) = (m + 1)1(b ≥ 1)
1 Ifyou have a particularly interesting answer, let us know. We’re happy to add more solutions to future versions of this
problem set.
2 By focusing on this case, we are assuming that the decision maker is “small” in the economic sense of the term. His presence

does not materially alter the neighborhood’s average wealth level.

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 where 1(b ≥ 1) is the indicator function. (It equals 1 when b ≥ 1 and zero otherwise.)3 If we want to add
apples back into the mix, assuming they are liked by the decision maker, we could say that
 
1
u(m, b, a) = (m + 1)1(b ≥ 1) + 1 − .
a+1

This decision maker considers one mango to be better than an infinite number of apples.

3. Preference Relations [Solution]

a) Lexicographic preferences satisfy all the properties except continuity. Consider the following two se-
quences of bundles: The constant sequence xn = (1, 1) and y n = (1 − n1 , 2). For all n, xn ≻ y n . However,
y n → (1, 2) and (1, 2) ≻ (1, 1).
The indifference curve passing through the bundle (2, 2) is just the point (2, 2).
b) The preferences are continuous. To verify this fact, we let xn → x∗ and let y n → y ∗ be two sequences
such that xn % y n for all n. Then,

xn % y n ⇐⇒ xn1 + xn2 − y1n − y2n ≥ −1

for all n. xn → x∗ and y n → y ∗ means that

xn1 → x∗1
xn2 → x∗2
y1n → y1∗
y2n → y2∗

Hence, x∗1 + x∗2 − y1∗ − y2∗ ≥ −1, which means x∗ % y ∗ .

The preferences do not satisfy transitivity since (4, 5) ∼ (4, 4.5) and (4, 4.5) ∼ (4, 4) but (4, 5) ≻ (4, 4).
Likewise, they are not monotone and not locally-non-satiated.

4. Convex Preferences and Quasi-Concave Utility Functions [Solution]

a) Read section 3.2 of the Miller notes if you have not done so already.
You can find them online: <https://business.illinois.edu/nmiller/notes.html>
b) Without loss of generality, suppose x % y. Thus, u(x) ≥ u(y). Fix α ∈ [0, 1] and let z = αx + (1 − α)y
be the “in-between” bundle. By the definition of convexity, z % y. Thus, u(z) ≥ u(y). Hence, u(z) ≥
u(y) ≥ min{u(x), u(y)}. The above argument applies for all α ∈ [0, 1]. Thus, u(·) is quasi-concave.
c) Let α ∈ [0, 1]. Since % is a rational preference relation, without loss of generality, suppose x % y.
Thus, u(x) ≥ u(y). Since u(·) is quasi-concave, u(αx + (1 − α)y) ≥ min{u(x), u(y)} = u(y). Thus,
αx + (1 − α)y % y. Thus, % is a convex preference relation.
3 Alternatively, we could write (
m+1 if b ≥ 1
u(m, b) = .
0 if b = 0

2
 x2

2 b

x1
2 3 5

Figure 1: The indifference curve (or indifference set) passing though the bundle (2, 2).

d) Suppose u(x) ≥ u(y). Since u(·) is concave,

u(αx + (1 − α)y) ≥ αu(x) + (1 − α)u(y)
≥ αu(y) + (1 − α)u(y)
= u(y)
= min{u(x), u(y)}
Thus, u(·) is quasi-concave.
e) The function u(x) = x21 is strictly convex (since u′′ (x) > 0). To see that it is quasi-concave (when x1 ≥ 0),
assume without loss of generality that 0 ≤ x1 ≤ y1 . Then, u(αx + (1 − α)y) = (αx1 + (1 − α)y1 )2 ≥
(αx1 + (1 − α)x1 )2 = x21 = min{x21 , y12 } = min{u(x), u(y)}.
f) Consider x = (1, 1) and y = (2, 1). Then, for all α ∈ (0, 1), u(αx+(1−α)y) = (α+2(1−α))2 . On the other
hand, αu(x)+(1−α)u(y) = α+(1−α)4. You can verify that for all α ∈ (0, 1), α+(1−α)4 > (α+2(1−α))2 .
Consider the utility function ũ(x1 , x2 ) = 2 log(x1 ) + 2 log(x2 ). ũ and u represent the same preferences
since ũ(x1 , x2 ) = log(u(x1 , x2 )) and log(·) is a strictly increasing function. log(·) is also a concave function,
which is convenient.
We first show that ũ is quasi-concave:
ũ(αx1 + (1 − α)y1 , αx2 + (1 − α)y2 ) = 2 log(αx1 + (1 − α)y1 ) + 2 log(αx2 + (1 − α)y2 )
   
≥ α 2 log(x1 ) + 2 log(x2 ) + (1 − α) 2 log(y1 ) + 2 log(y2 )
= αũ(x1 , x2 ) + (1 − α)ũ(y1 , y2 )
≥ min{ũ(x1 , x2 ), ũ(y1 , y2 )}
Thus, log(u(αx1 +(1−α)y1 , αx2 +(1−α)y2 )) ≥ min{log(u(x1 , x2 )), log(u(y1 , y2 ))}, which implies u(αx1 +
(1 − α)y1 , αx2 + (1 − α)y2 ) ≥ min{u(x1 , x2 ), u(y1 , y2 )}.
g) The utility function u(x1 , x2 ) = x21 + x22 represents preferences that are not convex. (Try plotting them on
your computer.) Non-convex preferences are reasonable in cases where extremes are better than averages.
I like ice cream and I like bacon; bacon ice cream makes me less happy than either food alone.

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5. Canonical Utility Functions and Walrasian Demand [Solution]
α w β w
a) x∗1 (p, w) = α+β ∗
p1 , x2 (p, w) = α+β p2 . Note: A person with Cobb-Douglas preferences spends fraction
α/(α + β) of his wealth on good 1 and fraction β/(α + β) of his wealth on good 2.
b) If w − αp2 > 0, the x∗1 (p, w) = α pp12 and x∗2 (p, w) = w−αp2
p2 . If w − αp2 ≤ 0, x∗1 (p, w) = w
p1 . x∗2 (p, w) = 0.
This is an example of a corner solution. Consumption of good 2 can be zero if its price is high enough
relative to income.
α p1 p1
c) If β < then x∗1 (p, w) = 0 and x∗2 (p, w) = pw2 . If α
p2 ,
∗ w ∗
β > p2 , then x1 (p, w) = p1 and x2 (p, w) = 0. If
α p1
β = p2 , then
(x∗1 (p, w), x∗2 (p, w)) = {(x1 , x2 ) ∈ R2+ : p1 x1 + p2 x2 = w}.
Depending on the price ratio, the person typically spends all of his money on good 1 or 2. In the special
p1
case where α β = p2 , many different bundles maximize utility. In this case, the budget line is exactly
parallel to the consumer’s indifference curves.
d) x∗1 (p, w) = βp1βw ∗
+αp2 , x2 (p, w) =
αw
βp1 +αp2 . A person with Leontief preferences consumes at the “kink-point”
of his indifference curves.

6. Utility Maximization with a Quantity Discount [Solution]

Due to the quantity discount, Betty’s budget line is not linear. When x1 < x̃1 , the discount does not apply
and the budget line takes its regular form. When x1 > x̃1 , the discount applies. In this case, the consumer
spends p1 x̃1 on the first x̃1 kilograms, p̃1 (x1 − x̃1 ) on the remaining purchase of rice, and p2 x2 on vegetables.
The budget line is thus (
w−p1 x1
p2 x1 ≤ x̃1
x2 = w−p 1 x̃1 −p̃1 (x1 −x̃1 )
.
p2 x1 > x̃1
When p1 = p2 = 4, p̃1 = 1, and w = 32, this becomes
(
8 − x1 x1 ≤ x̃1
x2 = 32−3x̃1 −x1 .
4 x1 > x̃1

To solve the consumer’s problem, we consider two sub-problems and compare solutions at the end.

1. Suppose the consumer solves maxx1 ,x2 u(x1 , x2 ) such that x2 = 8 − x1 . This sub-problem assumes the
consumer maximizes her utility ignoring the quantity discount. The Lagrangian for this problem is
L = x1 x2 − λ(x1 + x2 − 8). The problem’s first order conditions are
∂L
= x2 − λ = 0
∂x1
∂L
= x1 − λ = 0
∂x2
∂L
= −(x1 + x2 − 8) = 0
∂λ
Solving this problem is standard. We arrive at a solution xA A
1 = x2 = 4. The utility value of consuming
this bundle is 16 and it is labeled as A in the diagrams of Figure 2. As long as x̃1 > 4 (as it is in our
problem), this bundle of goods is on the frontier of the consumer’s budget set.
2. The second sub-problem assumes the consumer buys more than x̃1 units and thus consumes on the
budget line x2 = 32−3x̃41 −x1 . We will find the optimal bundle on this budget line and compare the
resulting utility to the utility of bundle A. Specifically, we solve maxx1 ,x2 u(x1 , x2 ) such that x2 =

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 32−3x̃1 −x
4 .
The Lagrangian for this problem is L = x1 x2 − λ(x1 + 4x2 − (32 − 3x̃1 )). The problem’s
first order conditions are
∂L
= x2 − λ = 0
∂x1
∂L
= x1 − λ4 = 0
∂x2
∂L
= −(x1 + 4x2 − (32 − 3x̃1 )) = 0
∂λ
Solving this problem is standard. We arrive at the solution xB B
1 = (32 − 3x̃1 )/2 and x2 = (32 − 3x̃1 )/8.
In the diagrams of Figure 2, this bundle is labeled as B.

a) If x̃1 = 6, then xB Ba
1 = 7 and x2 = 1.75. The associated utility value is 12.25. Thus, the consumer will
a

demand bundle A, (4, 4).

b) If x̃1 = 5, then xB Bb
1 = 8.5 and x2 = 2.125. The associated utility value is 18.0625. Thus, the consumer
b

will demand bundle Bb , (8.5, 2.125).

c) If x̃1 = 16/3, then xB
1
c
= 8 and xB 2
c
= 2. The associated utility value is 16. Thus, the consumer is
indifferent between bundle A, (4, 4), and bundle Bc , (8, 2)—both are optimal!
d) In a world without a discount, the consumer purchases an equal amount of rice and vegetables. The
quantity discount provides incentives for the consumer to consume more rice than vegetables. (Perhaps
you have experienced this at the grocery store yourself where such discounts are common.) The impor-
tance of this discount depends on the value of x̃1 . If x̃1 is very large, then the consumer needs to buy
much more of x1 and much less of x2 just to get to a point where the discount applies. The resulting gain
in utility from purchases of good x1 under the discount is not enough to outweigh the cost of purchasing
the first x̃1 units. When x̃1 is sufficiently small, the consumer takes advantage of it and buys more than
x̃1 units of the good. x̃1 = 16/3 is a critical value where this switch in behavior kicks in.

7. Pedantically Proving Transitivity (Jehle & Reny 1.4) [Solution]

a) Let x, y, z ∈ X be such that x ≻ y and y ≻ z. We need to establish that x ≻ z. Note that x ≻ y =⇒ x % y
and y ≻ z =⇒ y % z. By transitivity, x % z. Suppose z % x. Since % is transitive, we have that
y % z % x. But this implies x % y, which is a contradiction since x ≻ y =⇒ y 6% x. Therefore, z 6% x.
But then x % z and z 6% x together imply that x ≻ z, as per the definition.
The relation ≻ is not complete since x ⊁ x.
b) Let x, y, z ∈ X be such that x ∼ y and y ∼ z. We need to establish that x ∼ z. Note that x ∼ y =⇒ x % y
and y ∼ z =⇒ y % z. Likewise, x ∼ y =⇒ y % x and y ∼ z =⇒ z % y. Hence, z % x by transitivity.
However, x % z and z % x together imply that x ∼ z, as per the definition.
In general, ∼ is not complete since it is possible that x 6∼ y and y 6∼ x.

8. A Confused Decision Maker [Solution]

Consider a preference relation % defined on a choice set X, which is finite and has at least three-million
distinct elements. We say that x % y if and only if x ∼ y or x ≻ y. Next, we define the “∼” and ”≻”
relations:
• If x, y ∈ X, x ∼ y ⇐⇒ x = y.
• If x, y ∈ X, x ≻ y if and only if x 6= y and there exists z ∈ X such that x ≻ z and z ≻ y.

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x2 x2

8 8

b
A b

b
Bb

Ba
x1 x1
x̃1 x̃1
(a) x̃1 = 6 (b) x̃1 = 5

x2

b
A

b
Bc

x1
x̃1
(c) x̃1 = 16/3

Figure 2: Utility Maximization with a Quantity Discount

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a) No, % cannot be complete. The choice set is finite has at least three million distinct elements. Thus,
if x ≻ y, then there must exist x′ ∈ X such that x ≻ x′ and x′ ≻ y. But this implies there is an x′′
such that x ≻ x′′ and x′′ ≻ x′ . And so on. Since the choice set is finite, we will eventually arrive at a
contradiction.
b) Yes, % is transitive. Suppose x % y and y % z. If x = y or y = z, the conclusion is immediate. Thus,
suppose x ≻ y and y ≻ z. But this immediately implies that x ≻ z by the definition of ≻.

9. “Separable” Utility Functions [Rubinstein 2012, Problem 4.6] [Solution]

P
a) Cobb-Douglas preferences can be represented by the utility function u(x) = j αj log(xj ); hence, they
are separable.
b)
X X X X
(aJ , c−J ) % (bJ , c−J ) ⇐⇒ vk (ak ) + vk (ck ) ≥ vk (bk ) + vk (ck )
k∈J k∈J
/ k∈J k∈J
/
X X X X
⇐⇒ vk (ak ) + vk (dk ) ≥ vk (bk ) + vk (dk )
k∈J k∈J
/ k∈J k∈J
/
⇐⇒ (aJ , d−J ) % (bJ , d−J )

c) We know
(a, b) % (c, d) =⇒ v1 (a) + v2 (b) ≥ v1 (c) + v2 (d), and
(c, e) % (f, b) =⇒ v1 (c) + v2 (e) ≥ v1 (f ) + v2 (b)
Adding the inequalities together gives v1 (a) + v2 (e) ≥ v1 (f ) + v2 (d), which implies (a, e) % (f, d).
d) It is sufficient to consider two goods and to find preferences which violate the Hexagon condition. Figure
3 sketches an example. All of the indifference curves shown in the figure of straight lines; however, they
are slightly twisted which leads to a violation of separability. Any preferences with such indifference
curves are not separable.

10. Fred’s Savings Account (or Fred’s Credit Card) [Solution]

a) See Figure 4. When no saving or borrowing is allowed, Fred can consumer at most his income each period.
His budget set is A. When he can save, he can consume along the solid blue line: w̄2 = w2 + (1 + r)w1 .
Thus, his budget set is A + B. When he can borrow, he can consume along the dashed blue line:
w2
w̄1 = w1 + 1+ρ . Therefore, if he can save and borrow, his budget set is A + B + C.
b) Fred must maximize utility subject to the constraint that x1 + x2 /(1 + r) ≤ w1 + w2 /(1 + r). We can
solve this problem as usual with the Lagrangian:
 
x2 w2
L(x1 , x2 , λ) = log(x1 ) + δ log(x2 ) − λ x1 + − w1 − .
1+r 1+r
The first order conditions are
∂L 1
= −λ=0
∂x1 x1
∂L δ 1
= −λ =0
∂x2 x2 1+r
∂L x2 w2
= −x1 − + w1 + =0
∂λ 1+r 1+r

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 (a, e) b b
(c, e)

(a, b) b b
(f, b)

b b

(c, d) (f, d)

Figure 3: Non-Separable Preferences. A violation of the “Hexagon Condition.” Note the orange hexagon—
which rationalizes the condition’s name.

Solving this system gives

w2
w1 + 1+r
x∗1 (r, w1 , w2 ) =
1+δ
(1 + r)w1 + w2
x∗2 (r, w1 , w2 ) =
1 + δ1

The comparative statics are quite intuitive. As the interest rate increases (r ↑), Fred saves more/borrows
less (x∗1 ↓). His consumption in period 1 declines. As Fred values the future more (δ ↑) he saves
more/borrows less (x∗1 ↓). If Fred’s period 1 income declines (w1 ↓), his period 1 consumption also falls
(x∗1 ↓); however, it falls less than his fall in income. Specifically, if Fred’s income falls by 1 dollar, his
1 dx∗ 1
consumption only decreases by 1+δ < 1 dollars. To see this, consider dw11 = 1+δ . This is an example
of Fred “smoothing” his consumption between periods. He prefers to reduce his period 2 consumption a
little bit and borrow (save less) in period 1 to make up for the drop in period 1 income.

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 x2

w̄2

B
w2 b

A C
x1
w1 w̄1

Figure 4: Fred’s possible budget sets.