Haramaya University

School of Agricultural Economics and Agribusiness

Department of Agricultural Economics

MSc. CEP Program

Assignment on Microeconomics (AgEc511)

Name: Beriso Kedir

ID No: C/pg/65/12

Assignment
1. The utility function U(X, Y) satisfies all but one of the axioms of preference discussed in class.
Which one is not satisfied and explains why?

2. Can you explain why taking a monotonic transformation of the utility function doesn’t change
the marginal rate of substitution?

Monotonic transformation is a way of transforming a set of numbers into another set that
preserves the order of the original set, it is a function mapping real numbers into real numbers,
which satisfies the property, that if x>y, then f(x)>f(y), simply it is a strictly increasing function.

Applying a monotonic transformation to a utility function representing a preference relation

simply creates another utility function representing the same preference utility of utility,
basically what this means is that when monotonic transformation of utility is applied the
marginal rate of substitution does not change here is why.

Marginal rate of substitution does not change when a transformation of utility function is
undertaking by any positive monotonic transformation, this will be presented through a concept,
by an example

U (X, Y) =X0.4 Y0.6

Computing marginal rate of substitution

For U (X) and U (Y), marginal rate of substitution is the

Ration of marginal utility.

MRS=UxUy

Computing for marginal derivative

=0.4( ) 0.6

0.6( ) 0.4

V (X, Y) =2 LOGx +3 LOGv

MRS=

Computing for marginal utilities

MRS= =

Simplification

 So basically the expression of the marginal rate of substitution is equal to the second
function, different utility functions can give you the exact same preference, the two
functions can be related to express one as the function of the other;

V (x,y) = LOGx2 +LOGv3

=LOG (x2 y3) = LOG ((x25 y3|5)) =

LOG ((v (x, y5))

V (X, Y) = 5 LOG (U(X, Y))

These two utility functions are directly related to one another and not only are they directly
related but if the derivative of (5 log (v(x,y)), is being applied to the utility function of

U (x, y) =x0.4 y0.6, a positive derivative will be obtained, this is why generally it is the case
consider a general argument for why , the marginal rate of substitution *************** $$$$$
$$$$, where the same for the utility function of V(X,Y) U(X,Y)

V (x, y)=g(u(x,y)), suppose there is a utility function of U(x,y), it is then transformed by

applying an increasing function G,G has a positive derivative no matter what value it is applied
in this =g(U(x,y)), and the result is this new utility function of V (x,y), given this setup the
marginal rate of substitution for this V(x,y) =

MRS=VxVy

here the marginal utility can be computed simply by taking the derivative of the outside
function(g(u(x,y))) and multiply it by the derivative of the inside function

MRS=VxVy=g1(u(x,y)) .Ux g1(u(x,y)) .Ux

This is an expression of the marginal rate of substitution using the utility function V(X,Y)

MRS=VxVy=g1(u (x,y)) .Ux g1(u(x,y)) .Ux(This derivative can be cancelled out as long as they
are positive)

Which means it can be divided through by g1 which will be

MRS=VxVy=g1(u (x,y)) .Ux g1(u(x,y)) .Ux= UxUy

The marginal rate of substitution are the same for the utility function U(x,y) and any increasing
transformation of u(X,Y), so if the utilities are to be transformed to some other utility function
using some increasing function , the marginal rate of substitution will not be changed because the
marginal rate of substitution will not be changed at any point , the preferences that where
describing using transformed utility function are no different , so when we have this
transformation of cobb Douglass utility function

=V (x, y)= 5 log (u(x,y)

Transforming it by log and multiplying it by 5that did not change what was computed for the
marginal rate of substitution.

Subtracting or adding a number of “units” from a utility function does not change the ordering of
the preferences. It makes the utility level shift up or down by some constant number of units.
Multiplying a utility function by any positive number is also simple. This change multiplies the
number of units of utility by that positive number without changing their order. The same goes
for exponents as long as the application of the same positive exponent is done to the whole utility
function, we just increase or decrease the number of units by that exponent with- out changing
the order.

“the preference and indifference curve order remains the same with a positive monotonic
transformation of utility function this is true for any monotonic transformation including
multiplying a utility function by a positive constant or raising the function to the power of some
positive constant”

All this is basically a demonstration of why a monotonic transformation of a utility function

does not affect or change the marginal rate of substitution.

3. If the consumer has a utility U(x1, x2) = x1x24, what fraction of her income will she spend
on good 2?

 This is a Cobb-Douglas utility function, so she will spend 4/ (1 + 4) = 4/5 of her income spends
on good.

4. Suppose that the original budget constraint is p1x1+p2x2=m

 a. What is the budget constraint if we tax the consumption of good 1 at a rate of t quantity
tax?

From the viewpoint of the consumer if the price of good 1 has increased by an amount .the
new budget constraint is

(P+t) x1+ p2x2= m So that a quantity tax on a good increases the price
perceived by the consumer.

b. What would be the form of this budget constraint if we consider an income tax that
raises the same amount of revenue?

The revenue raised by this tax is R*= tx 1* ………by considering an income tax that raises
at the same amount of revenue, the forms of budget constraint looks like

P1x1+ p2x2= m-R* then substituting R*=tx1

P1x1+ p2x2= m- tx1
5. What distinguishes the income and substitution effects of normal, inferior and
Giffen goods?
 As the price of product decreases (declines) , the lower the opportunity will induce to buy
more of it since it become less expensive even if they have to give the product . This is
called Substitution effect.
 When fixed amount of money income, a reduction in price of product will increase
consumer real income .The amount of good and service consumer are able to purchased,
typical consumer will respond by purchasing more of the cheaper product as well as other
product. This is called Income effect
 The effect of fall in price

Substitution effect Income effect over all

Normal Increase in quantity Increase in quantity Increase in quantity
good demand Demand demanded, downward
sloping demand curve

Inferior Increase in quantity demand Decrease in quantity Increase in quantity

good demand demanded, downward
sloping demand curve

Giffen Increase in quantity demand Decrease in quantity Increase in quantity

demand demanded, upward sloping
demand curve

6. Consider that the utility function (U) of Mr. Chala from good X and good Y is given by:
U = 3X1/4 Y3/4
a. Derive the Marshallian demand functions for both goods X and Y.
Marshallian demand functions for both goods X and Y.
Budget equation = PXX+PYY=I
L=3X1/4 Y3/4+ (I- PxX1 – PyY)
3PxX=PyY then substitute in budget constraint Mr. Chala.
3PxX +PxX=I equal to 4PxX=I and X*=I/4Px this is Marshallian Demand for X.
This implies this individual will allocate 25% of his/her income to good X.
And the Marshallian Demand for Y*= 3I/4Py. This implies that individual will
allocate 75% of his/her income to good Y.
In the same way when we substitute this equation x = in to budget equation to solve
Marshallian Demand function for Y* =

b. Derive the equation for income consumption curve.

The consumer utility maximization problem is
 U= 3X1/4 Y3/4

At equilibrium =
-3/4 3/4
MUx == 3/4X Y

-1/4 1/4
MUy = = 9/4Y X

then =

4 X1X23 /9/4Y-1/4X1/
3/

c. Derive the indirect utility and expenditure functions

We can derive indirect utility functions from Marshallian demand curve. We have
Marshallian demand for X and Y derived at question 6(a).

Then substitute in utility function, U= 3X1/4 Y3/4

U (3( )1/4 (3/U1= = U1= (I=E) then multiply both side by denominator we get U 1=7E, then
dived by 7 we get the derived expenditure function E=

d. Given that price of X is 5, price of Y is 4, and income is equal to 150, find the utility
maximizing bundles of goods X and Y
Utility maximizing bundle for X= 7.5, implies 25% individual income is allocated
for X.
Utility maximizing bundle for Y= 28.125, implies 75% individual income is
allocated for X.

6. Consider the following production function: x=4K 0.5L0.5 where x denotes the level of output,
K is capital input, L is labor input, w is unit price of labor and r is unit price of capital.
 a. Is the function increasing, decreasing, or constant return to scale? Explain why.
 The function is Constant return to scale means per unit is constant. That means
proportional increase in all input increase output by the same percentage as cost.

b. Find the function for the firm’s expansion path.

The objective function TC = rk+wL
Subject to
X= 4k0.5L0.5
Then L= rk+wL+λ(X- 4k0.5L0.5)
(L0.5) =0

When we solve for k we get k= so the the firm expansion path = k=

c. Determine the cost constrained conditional demand function for K and L.

To solve the demand function for k and L
to substitute k= in to cost function TC= rk+wL and we can solve for L then
TC= r () + wL TC= 2Wl, L= the demand function for L= L*=
To solve demand function for K= Tc = rk+w (k* = the demand function K

d. With w = Br. 1 and r = Br. 4, find the output maximizing input combination if cost
is limited to Br. 120.
Given price of L= 1, price of k= 4 and cost = 120
the output for L= 60 the output for k= 15
e. What is the corresponding output level?
The corresponding output level is X= 4(15)0.5(60)0.5 = 12

7. How would you illustrate the indifference curve for one good and one bad?
8. Suppose that a consumer always consumes 2 spoons of sugar with each cup of coffee. If the
price of sugar is P1 per spoonful and the price of coffee is P2 per cup and the consumer has M
dollars to spend on coffee and sugar, how much will he or she want to purchase?
 Let z be the number of cups of coffee of the consumer buys. Then we know that 2z is
the number of tea spoons of sugar he/she buys .we must satisfy the budget constraint
2p1z + p2z= m…………………Solving for z we have
z = m/2p1+p2
9. Profit Maximization. Consider a pizza shop with a demand curve
Q = 60-2P

Suppose that the TC function for pizza is TC = 100 + Q2/4

a. Identify profit maximizing number of pizzas, as well as the profit-maximizing price and
maximum profits.

Q= 60-2P then by re arranging P= 30-Q/2

TR=PQ (30- Q/2)Q,

TR=30Q-Q2/2, & MR= 30-Q and

MC=Q/2 now we calculate Q.

At equilibrium MR=MC which is 30-Q= Q/2

3Q=60 then Q=20 units.

 The maximum number of pizza that maximizes profit is 30 unit of Q*.

To calculate profit maximizing price

Substitute 30 units Q* in demand equation and calculate price P (Q) =30- Q/2

P (20) =30- 20/2=20 dollar or Birr. Price that maximizes profit is 20 Birr or 20 Dollar.

Total Profit= TR-TC= 30Q-Q2/2-100 - Q2/4

Maximum profit at MR=MC is (P=20, Q=20, TC=100+ (20)2/4=200

 Profit (π) = TR-TC= 20*20-200=400-200= 200, Maximum profit of pizza shop is
200.

b. Identify analytically the MC curve and the SATC and SAVC curves
MC Curve==MC=Q/2 =Q/2,
Short run Average Total Cost (SATC) or Short Run Unit per Cost=100/Q+ Q2/4Q dividing
TC by per unit output SATC=100/Q+ Q/4, SATC Curve
Short Run Average Variable Cost = TAVC/Q=Q 2/4Q this is equal to TAVC/Q=Q/4, this is
SAVC Curve
c. The shutdown point for the firm, P*=20$,
AVC=Q2/4Q = 202/4*20 =400/80=$5 Dollar then the shut down point for the
firm is a point at price is less than five (P<5$)
The breakeven point for the firm is at the point P=ATC means not at minimum point
of ATC.
ATC= 100/20+202/4*20=5$ +5$=$10.

d. Use your P, MR, MC, SATC and SAVC functions to illustrate the profit maximizing
output.
e. At the profit maximizing price, the price elasticity of demand is calculated
P=30-Q/2, then Q=60-2P and p*=20$, Q*=20$
=.20/20 =-2 (inelastic) implies P=2MC =2*10$=20$
f. How do producer surplus and profits differ here?
Profit maximizing price (P*=20$ for monopoly and P*=15$ for competitive), Qm= 20 unit, Qc =
30 unit profit maximizing Quantity (Q*=20 Unit) at this point then producer Surplus (PS) = ($10)
(20 units) + (15-10) $(20unit) =200$+100$
= 300$, this implies profits are immersed in Profit.
10. Monopoly
a. Show that if the market inverse demands function is P (Q), the profit maximizing monopoly

−1
1
will charge a price equal to MC (1+ ) , where MC is the firm’s marginal cost of
eQ ,P
production and e Q , P is the price elasticity of market demand.
If monopolist choosing its output (Q) and price simultaneously, recognizing, the constrained
imposed by demand:-
It wants to sell more out put it has to lower its price, the unit selling (Q).
It has the entire market, when lower price, it has to take into account the effect of the price
reduction on all the units it sells.
= P + Q then divide both side by we get MR= P + Q/
MR = P (1 + Q/P) = MC, this implies that, Q/P = 1/and divide both side by
+ 1/e qp)
P= MC/ (1 + 1/) that means P
b. Calculate the deadweight loss to monopoly when the demand function is given by Q=100-P
and C (Q) =4Q.
Q=100-P and C (Q) =4Q.

Use this quantity and the demand curve to find the monopolist’s profit maximizing Price:

P = 100 – 2Q or P = $52 per unit and AC=4.

Profit is equal to TR – TC Or (P-AC)Q: Then Profit=($52 per Unit) (48 units)- [( (4) (48) ]
=$2304

CS = (1/2) ($100 per unit - $52 per unit) (48 units) = $1152

PS = (1/2) ($52 per unit - $4 per unit) (48 units) = $1152

DWL = (1/2) ($52 per unit - $4 per unit) (96units – 48 units) = $1152
A monotonic transformation of a utility function will either multiply the whole function by
some value or will add or subtract some constant.

Let’s say you start with a utility function of U = [x^a][y^(1-a)] where x and y are two normal
goods (e.g. x = pizza and y = cola) and this is a Cobb-Douglas function (the powers add to
1).
An example of a monotonic transformation would be to multiply both sides of the equation
by 2, so that 2U = 2[x^a][y^(1-a)]. Visually, on a diagram with x on one axis and y on the
other, the indifference curve 2U will represent exactly twice as much pizza, twice as much
cola and the consumer derives twice as much utility.

Now suppose we go a step further and we have a budget constraint of M = p1x + p2y
where M is income, p1 is the price of x and p2 is the price of y.

In order to find the optimal combination of goods which gives the consumer the highest
level of utility given their budget constraint, we set up a Lagrangean function as so:

L = [x^a][y^(1-a)] - G[p1X + p2Y]

where G is the Lagrangean Multiplier

It’s solved by differentiating the function with respect to x, and then by y, solving in both
cases for G, then equating the values for G to get rid of the multiplier. I won’t write out the
whole of the algebra but we get values for G of:

G = [ax^(a-1)y(1-a)]/p1

G = [(1-a)(x^a)(y^-a)]/p2

Equating the values for G gives:

[ax^(a-1)y(1-a)]/p1 = [(1-a)(x^a)(y^-a)]/p2

This solves to give a value for y of:

y = [(1-a)xp1]/ap2

If you plug that back into the budget constraint, you can solve to find the utility-maximising
values for x and y, which are:

x = (m/p1)a

y = (m/p2)(1-a)

Now, coming back to the original question. If you make a monotonic transformation
of the utility function, e.g. multiply by 2, when you get to the stage where you equate
the values of the Lagrangean multiplier, you get:

2[ax^(a-1)y(1-a)]/p1 = 2[(1-a)(x^a)(y^-a)]/p2

and obviously the 2’s on each side just cancel out and you arrive at the same answer.
If the monotonic transformation is done by adding a constant to the utility equation,
this disappears because constants disappear in the differentiation process. Again, you
arrive at the same answer. However, I don’t think it makes intuitive sense to add a
constant to the utility function as this suggests that utility is derived before any pizza
or cola is even bought (maybe if you subtract a constant, this could represent the
disutility derived from hunger/thirst before the pizza/cola is bought??).

The more intuitive answer however may just be that indifference curves represent the
utility derived from the relative amount of each good the consumer has, rather than
absolute amounts. So, say at a particular consumption bundle, the consumer is willing
to give up two bottles of cola in exchange for one pizza. If you double everything,
they are now willing to give up four bottles of cola in exchange for two pizzas, so the
marginal rate of substitution remains the same.