Problem Set 2: Microeconomic Theory - II (ECO-631, Spring 2019) 1

Instructor: Dr. Adnan Haider

Problem Set 2
Classical Demand Theory
Due: At the time of Mid Term Exam

• Note: You may work on the problem sets with at most two other students in which case you
still have to hand in your own problem set with the names of the group members listed on it.
Do not copy others answers. You are strongly encouraged to work on the problems on your
own before meeting your study group (problem sets constitute the best studying material for
the exams). You must not use the solutions manuals, or other extraneous sources. Show your
work, give reasons; no credit will be given for correct answers if the derivation is missing or
if there is more than one answer.

1. Moiz has a utility function U (x1 , x2 ) = (x1 + 2)(x2 + 6), where x1 is the number of cookies
and x2 is the number of glasses of milk that he consumes.

(a) What is the equation for Moizs indifference curve? (Write it in the mathematical form
as: x2 =...) Draw Moizs indifference curve that passes through points (4, 6), (?, 0), (7,
?), and (2, ?).
(b) What is the slope of Moizs indifference curve at the point where he is consuming the
bundle (4, 6)?
(c) Moiz currently has the bundle (4, 6). Asim offers to give Moiz 9 glasses of milk if
Moiz will give Asim 3 cookies. If Moiz makes this trade, what is the bundle he would
have? But, if Moiz refuses to trade. Was this a wise decision?
(d) Asim says to Moiz, Moiz, your marginal rate of substitution is 2. That means that an
extra cookie is worth only twice as much to you as an extra glass of milk. I offered to
give you 3 glasses of milk for every cookie you give me. If I offer to give you more
than your marginal rate of substitution, then you should want to trade with me. Why
did Moiz refuse to trade?
(e) Would Moiz be willing to give up 1 cookie for 3 glasses of milk? Would Moiz be
willing to give up 2 cookies for 6 glasses of milk?
Problem Set 2: Microeconomic Theory - II (ECO-631, Spring 2019) 2

(f) On your graph, draw a line with slope -3 through the point (4, 6). This line shows all
of the bundles that Moiz can achieve by trading cookies for milk (or milk for cookies)
at the rate of 1 cookie for every 3 glasses of milk. Highlight the segment of this line
that represents trades that make Moiz better off than he was without trade.

2. Sarah has preferences represented by the utility function u(x, y) = min{4x + y, x + 6y}.

(a) Draw Sarah indifference curve such that she enjoys a utility of 46 (with x on the hor-
izontal axis and y on the vertical axis). Locate 3 distinct consumption bundles on this
indifference curve.
(b) What is the slope of her indifference curve at the point (9, 4)?

3. (Homothetic Preferences) Show that any (rational) preference relation that is homothetic,
continuous and monotone can be represented by a utility function that is homogenous of
degree one.

4. An individual has the following preferences on X = R2+ :

x % y ⇐⇒ x ≥ y.

(a) Derive the induced strict preference relation  and the induced indifference relation ∼.
Consider any bundle xo in X. Can you find y 6= xo , such that y ∼ xo .
(b) Are these preferences, % complete, transitive, continous and convex? Do they satisfy
Local Nonsatiation?
(c) Can these preferences be represented by a utility function?

5. (From Rubinstein Lecture notes) Consider that the set of alternatives is the set of real num-
bers, that is X = R. There is an individual whose attitude is ”the more the better”; however,
he finds it impossible to determine whether a is greater than b unless the difference is at least
1. He will say, x  y if x ≥ y + 1, and he will say, x ∼ y if |x − y| < 1. Check whether,
and ∼ are transitive?

6. Consider a consumer in a world with two commodities having the following preferences:

x % y if x1 + x2 > y1 + y2 or x1 + x2 = y1 + y2 and x1 ≥ y1

Show that this preference relation is strictly convex but not continues. Is it possible to derive
Walrasian demand function induced by it?
Problem Set 2: Microeconomic Theory - II (ECO-631, Spring 2019) 3

7. A consumer has Lexicographic preferences over X ∈ R2+ , if the relation % satisfies (x1 , x2 ) %
(y1 , y2 ) whenever, x1 > y1 , or x1 = y1 and x2 ≥ y2 .

(a) Sketch an indifference map for these preferences.

(b) Can these preferences be represented by a continues utility function? Why or why not?
(c) In general, Can a continuous preference relation be represented by a discontinuous
function? (If yes, provide example, if no, provide counter example)

8. We showed in class that if X is finite, then there is a utility function u(.) that represents
%p . In this question, we will see what happens when X is uncountable or infinite. Suppose,
X ∈ R2+ , if the relation %p satisfies (x1 , x2 ) % (y1 , y2 ) whenever, x1 > y1 , or x1 = y1 and
x2 ≥ y2 (Lexicographic preference relation).

(a) Show that %p defines a complete, reflexive and transitive preference relation on X.
(b) Show that there is no utility function, u : X −→ R that represents %p . What does this
mean for the theorem that we proved in class (that if X is finite and %p is complete,
reflexive and transitive, then there is a utility function that represents %p ?
(c) Theorem 1.1 in Jehle-Reny book shows that if X = Rn and %p is complete, reflexive
and transitive satisfying two additional axioms (continuity and strict monotonicity),
then %p can be represented by a utility function. Which of these properties are violated
in the case of Lexicographic preferences?

9. Let u : R2 −→ R and let p1 , p2 and M ∈ R++ . Consider the constrained optimization

problem with the equality constraint: maxx1 ,x2 u(x1 , x2 ) subject to: p1 x1 + p2 x2 = M .

(a) Write the first order necessary conditions for this problem.
(b) Write the second order necessary conditions for this problem.
∂x1
(c) Under what conditions can we derive the expression for ∂p1
.
(d) Supposed that the required condition the second last part of this question hold. Derive
expression for ∂x
∂p1
1
.

10. Prove the theorem: Suppose that u(x) is continues and quasi-concave on Rn+ , and that
(p, y) >> 0. If u is differentiable at x∗ , and (x∗ , λ∗ ) >> 0 solves FOC’s, then x∗ solves the
consumer maximization problem at prices p and income y.
Problem Set 2: Microeconomic Theory - II (ECO-631, Spring 2019) 4

11. Prove the following relations:

∂v(p0 ,w0 )
∂v(p0 ,w0 )
(a) xM 0 0
i (p , w ) =− ∂pi
∂v(p0 ,w0 )
provided that: ∂w
6= 0.
∂w

∂e(p0 ,u0 )
(b) xH 0 0
i (p , u ) = ∂pi

(c) e(p, v(p, w)) = w ∀(p, w) >> 0

(d) v(p, e(p, u)) = u ∀(p, u) ∈ Rn++ ∗ R
(e) xM H
i (p, w) = xi (p, v(p, w))

(f) xH M
i (p, u) = xi (p, e(p, u))
∂xM
i (p,w) ∂xH
i (p,u) ∂xM
i (p,w)
(g) ∂pj
= ∂pj
− xj (p, w) ∂w

12. Show that if x(p, w) is homogenous of degree one with respect to w, i.e., x(p, αw) =
αx(p, w), for all α ∈ (0, 1) and satisfies Walras-Law, then lw = 1 (elasticity) for every
l. Can you say something about Dx x(p, w) and the form of the Engel functions and curves
in this case?

13. Suppose L = 3, and consider the demand function x(p, w) defined by:
p2 w
x1 (p, w) = .
p1 + p2 + p3 p1
p3 w
x2 (p, w) = .
p1 + p2 + p3 p2
βp1 w
x3 (p, w) = .
p1 + p2 + p3 p3
Does this demand function, x(p, w) satisfy homogenous of degree zero and Walras Law,
when β = 1? What about, when β ∈ (0, 1)?

14. Suppose L = 3, and consider the demand function x(p, w) defined by:
p2 w
x1 (p, w) = .
p1 + p2 + p3 p1
p3 w
x2 (p, w) = .
p1 + p2 + p3 p2
p1 w
x3 (p, w) = .
p1 + p2 + p3 p3
Problem Set 2: Microeconomic Theory - II (ECO-631, Spring 2019) 5

(a) Compute the substitution matrix. Show that at p = (1, 1, 1), it is semi-definite but not
symmetric.
(b) Show that this demand function does not satisfy the Weak-axiom. [Hint: Consider
p = (1, 1, ) and show that the matrix is not negative semi-definite for  > 0, where 
is very small]

15. Calculate the substitution matrix for the Cobb-Douglas demand system with two goods.
Verify that the diagonal terms are negative and the cross price effects are symmetric.

16. The substitution matrix for a utility maximizing consumer’s demand system at prices (8, p)
is:  
a b
2 −1/2
Find a, b and p.

17. Show that the Slutsky relation can be expressed in elasticity form as:

M H
ij = ij − sj η i

Where, Hij denote the elasticity of the Hicksian demand for xi with respect to price pj . sj
denotes expenditure share of jth commodity and η is income elasticity.

18. A Consumer has a utility function u(x1 , x2 ) = max{x1 , x2 }. What is the consumer’s de-
mand function for good 1? What is his indirect utility function? What is his expenditure
function?

19. A consumer has an indirect utility function of the form:

w
v(p1 , p2 , w) =
min{p1 , p2 }
(a) What is the form of the expenditure function for this consumer?
(b) What is the form of a (quasi-concave) utility function for this consumer?
(c) What is the form of the demand function for good 1?

20. Consider the indirect utility function given by:

w
v(p1 , p2 , w) =
p1 + p 2
Problem Set 2: Microeconomic Theory - II (ECO-631, Spring 2019) 6

(a) What are the demand functions?

(b) What is the expenditure function?
(c) What is the direct utility function?

21. In an L-commodity world, a consumer’s Walrasian demand function is:

w
xk (p, w) = L
X
pl
l=1

(a) Is this demand function homogenous of degree zero in (p, w)?

(b) Does it satisfy Walras-Law?
(c) Does it satisfy Weak-Axiom?
(d) Compute the Slutsky-substitution matrix for this demand function. Is it negative semi-
definite? Negative definite? Symmetric?

22. Consider the utility function:

1/2 1/2
u = 2x1 + 4x2

(a) Find the demand functions, x1 (p, w) and x2 (p, w).

(b) Find also the compensated demand functions, h1 (p, w) and h2 (p, w).
(c) Find the expenditure function e(p, u) and verify that: h(p, w) = ∇p e(p, w). item Find
the indirect utility function and verify Roy’s identity.

23. Let (q, w) be prices and income, and let p = q/w. Use Roy’s identity to derive the formula:
∂v(p)
∂pi
xi (p) = k
X ∂v(p)
pj
j=1
∂pj