Hawassa University

Wondogenet collage of forestry and natural resources

Advanced Microeconomics (NrEp 521)
Solution to Assignment Problems
BY:
1. Teshome Sorato
2.Aster Abera(MSc/NRE/043/11)
3. Daniel W/Meskel
4. Meselu Tegenie (MSc/NRE/046/11)
Submitted to: Alemayehu Siyum (PHD)
December ,
2011
Wondogenet,
Ethiopia
1
1. Assume the commodity X has demand function
Q=150-5P
x
and supply function
SS=8+10P
x
a) Calculate the equilibrium quantity and price
b) Support your finding with graphical representation
Solution:
The market equilibrium quantity is reached when SS=Q=Q*
150-5P
x
=8+10P
x
142 15
x
P
15
142
*
x
P

The equilibrium price is
15
142
*
x
P
Then the equilibrium quantity is :
Q*=8+10(
15
142
)

The equilibrium quantity is
67 . 102 * Q
4. The n-goods Cobb-Douglass utility function is :
U(X)=Ax
1
1
x
2
2
x
3
3
x
n
n
Where A>0 and

n
i
i
1
1
2
67 . 102 * Q
P P
*
*
*
*
*
*
*
SS
DD
Q
Q

SS
P
P

*
*
*
*
*
*
*
a) Derive the Marshallian utility function
b) Derive the indirect utility function
c) Derive the expenditure function
d) Derive the Hicksian demand function
Solution:
a) Suppose the price of good x
i
be p
i
and the consumer income be M
Then the primal problem we consider here is:
Maximize U(X)=Ax
1
1
x
2
2
x
3
3
x
n
n
Where A>0 and

n
i
i
1
1
s.t

n
i
i i
M p x
1

Now setting the Lagrangian
) ( ....
1
2 1
2 1

+
n
i
i i n
p x M x x Ax L
n

Finding first order partial derivatives and setting up first order conditions we have
0
0 ....
......... .......... .......... .......... .......... ..........
0 ....
0 ....
0 ....
1
1
3 2
3
1
3 2 3
3
2 3
1
2 2
2
1 3 2
1
1
1
3 2 1
3 2 1
3 2 1
3 2 1

n
i
i i
n n n
n
n
n
n
p x M
L
p x x x x
x
L
p x x x x
x
L
p x x x x
x
L
p x x x x
x
L
n
n
n
n

Now
3
n
n n n n
p
x x x A
p
x x x A
p
x x x A
n n n
1
2 1
2
1
2 1 2
1
2
1
1 1
...
....
... ...
2 1 2 1 2 1

Equating the partial derivatives of the Lagrangian with respect to the x

1
and x
i
i=2, 3, 4,
., n we get the following
n i
p
x p
x
x p x p
x p
x x
x p
x x
p
x x
p
x x
n i
p
x x x x A
p
x x x x A
i
i
i
i i
i
i i
i i i
i
i i i
i
n i i n i
i i
i i
n i n i
,....., 4 , 3 , 2 ,
,.... 4 , 3 , 2 ,
. .. .. ..
1
1 1
1 1
1
1
1 1
1 1
1
1
1
1
1 1
1
2 1
1
2
1
1 1
1 1
1 1
2 1 2 1

Substituting these values of x
i
,i=2,3,4,.,n in to the equation
0
1

n
i
i i
p x M
we get
1
1
1
1 1
1 1
2 1
1 1
2 1
1 1
1 1
2 1
1 1
1 1
) (
)
1
1 (
0
0
p
M
x
M
p x
M p x
x p
p x M
p
x p p
p x M
n
i
i
n
i
i
n
i
i
n
i i
i i

+
+
+

Substituting this value of x

1
in
n i
p
x p
x
i
i
i
,...., 3 , 2 ,
1
1 1

We get the Marshallian demand functions

4
n i
p
M
x
n i
p
M
p
p
x
i
i
i
i
i
i
,.... 3 , 2 . 1 ,
,...., 3 , 2 ,
1
1
1
1

1
]
1

The Marshallian demand function for each good x

i
is given by:
n i
p
M
x
i
i
i
,.... 3 , 2 . 1 ,

b) The indirect utility function is found by substituting the Marshallian demand
expressions of each good X
i
in to the direct utility function

1
]
1

n
i
i
i
i
A M p V
p
M
i
1
) , (


c) The expenditure function e is the dual of the utility function and is given by:

n
i
i i i i
p x p x e
1
) ( ) , (
and the total expenditure for the maximized utility is

n
i i
i
i i
M
p
M
p p M e
1
)) ( ( ) , (


d) Derive the Hicksian demand function
Hicksian demand function is the solution of the dual problem to the direct utility
maximization problem set as shown below
Minimize

n
i
i i i i
p x p x e
1
) ( ) , (
Subject to:
U x x Ax
n
n


....
2 1
2 1
where U is the fixed utility to be achieved
Now setting the Lagrangian and the first order necessary conditions we have
5
0 ....
0 ....
...... .......... .......... .......... .......... ..........
0 ....
0 ....
) .... (
2 1
2 1
2 1
2 1
2 1
2 1
1
2 1
1
2 1 2 2
2
2
1
1 1 1
1
2 1
1

n
n
n
n
n
n
n
n n n
n
n
n
n
n
i
i i
x x Ax U
x
L
x x x A p
x
L
x x x A p
x
L
x x x A p
x
L
x x Ax U p x L

Solving for we get the following

1
1
1
1
2 1 2
1
1 1
1
1
2 1
1
2 1 2
2
2
1
1 1
1
,....... 4 , 3 , 2 ,
... ... ... ...
...
....
... ...
2 1 2 1
2 1 2 1 2 1
x
p
p
x
n i
x x x x A
p
x x x x A
p
x x x A
p
x x x A
p
x x x A
p
i
i
i
n i i
i
n i
n n
n
n n
n i n i
n n n

Substituting this values of x
i
in 0 ....
2 1
2 1

n
n
x x Ax U

We get
A
U p p p
p
x
p p p
p
A
U
x
p
p
p
p
p
p
A
U
x
U x
p
p
p
p
x
p
p
Ax
n
n
n
n
n
n
n
n
n
n
n
n

) ....( ) ( ) (
) ....( ) ( ) (
) ....( ) ( ) (
) ....( ) ( ) (
3 2
1
3 2
1
3 2
3 2 1
3
3
2
2
1
1
1
1
3
3
2
2
1
1
1
1
1
1
3 1
1 3
2 1
1 2
1
1
1
1
3 1
1 3
1
2 1
1 2
1

,
_

,
_

Then substituting this value of x

1
we get the

Hicksian demand function of each
good
6
n i
A
U p p p
p p
p
P U x
n
n
n
i
i
i
,... 3 , 2 , 1 , ) ....( ) ( ) ( ) , (
3 2
1
3
3
2
2
1
1
1
1
1

,
_

7. Duopolists produce substitute goods Q

1
and Q
2
they face inverse demand function
P
1
= 20 +
2
1
P
2
-Q
1
P
2
= 20+
2
1
P
1
-Q
2
Each firm has constant marginal cost MC= 20 and no fixed costs and each firm is a
Cournot competitor in price not in quantity. Compute the Cournot equilibriums in this
market giving the equilibrium price and output of each good?
Support your answer with graph
Solution
Given
P
1
= 20 +
2
1
P
2
-Q
1

P
2
= 20+
2
1
P
1
-Q
2
and MC=20 the direct demand functions are
Q
1
= 20 +
2
1
P
2
-p
1
(demand function for firm 1)
Q
2
= 20 +
2
1
P
1
-p
2
(demand function for firm 2)
1 2
1
2
2
1 1 2 1
1 2 1 2 1 1 1 1
2
2
1
40
10 400
2
1
40
)
2
1
20 ( 20 )
2
1
20 ( 20
p p
p
p p p p p
p p p p p Q p Q
+

+
+ +

Setting this partial derivative to zero

7
We get
2 1
4
1
20 p p +
. (1) (the reaction function of firm 1 to firm 2)
Similarly the reaction function of firm 2 to firm 1 is
1 2
4
1
20 p p +
(2)
Substituting (2) in (1) we get the Cournot equilibrium prices
3
80
) 1
4
1
20 (
4
1
20
1
1

+ +
p
p p
And
3
80
)
3
80
(
4
1
20
2
+ p
The Cournot equilibrium quantities
Can be calculated by substituting Cournot prices in to the demand functions
Q
1
= 20 +
2
1
p
2
-p
1

3
20
3
20
3
80
3
80
*
2
1
20
2
1
20
1
1 2
1

+ +
c
c
Q
p p Q
Q
2
= 20+
2
1
p
1
-p
2
3
20
3
20
3
80
3
80
*
2
1
20
2
1
20
2
2 1
2

+ +
c
c
Q
p p Q
8
10. Explain Pareto efficient allocation in consumption and production.
Answer
An economic situation is Pareto efficient if there is no way to make some group of people better
off without making some other group of people worse off.
So an economic situation is Pareto efficient in consumption when each group or individual in
the economy system is maximizing its consumption without undermining the consumption of
other groups in the system. Similarly an economic system is Pareto efficient in production if each
firm or individual is maximizing its output without making the production of other firms in the
economic system worse off.
13. A consumer has A utility function U(x, y)=xy and the budget line M = P
x
x + P
y
y
A) Formulate the Lagrange for and drive the first order condition
y p x p M
L
p x
y
L
p y
x
L
y p x p M xy L
y x
y
x
y x
+

+ +

)) ( (
9
The first order conditions are
0 0
0 0
0 0
+

y p x p M
L
p x
y
L
p y
x
L
y x
y
x

B) From the first order condition find expression from the demand of commodity x and y
(good x and y)
Solving the first order conditions simultaneously we get
Expressions for the demands of good x and y as follows
y y
x
x
x
y
x
y x
y
x
x y
p
M
p
p
p
M
y
p
M
x
p
xp
p x p M
p
xp
y
p
y
p
x
2
*
2
,
2
0

C) Find out the dual form of the U(x, y)=xy function
The dual form of
Maximize U(x, y)=xy
s.t
M = P
x
x + P
y
y
Is
Minimize e(x,y)= P
x
x + P
y
y
s.t.
xy=U where U is fixed level of utility and e(x,y) is expenditure for goods x and y
10
D) Calculate the expression (X and Y) from the dual function
Solution
x
y
y
x
y
x
x
y
y
x
y
x
y
x
y
x
y x
p
p U
p
p
p
xp
y
p
p U
x
p
xp
x U
p
xp
y
x
p
y
p
xy U
L
x p
y
L
y p
x
L
xy U y p x p L

+ +
,
0
0
0
0
) (

11
13. Suppose Duopolists have the following demand curve; P = 30 - Q; MC
1
= 0 and MC
2
= 0
and total quantity: Q = Q
1
+ Q
2
.
Find the reaction curve of both firms
Assume the firm collude, find the new price p and profit at Cournot equilibrium.
Solution
Given P=30-Q, Q=Q
1
+Q
2
and MC
1
=MC
2
=0
TR
1
=PQ
1
=(30-Q
1
-Q
2
)Q
1
TR
2
=PQ
2
=(30-Q
1
-Q
2
)Q
2
2 1 2 1
2
2
1 2 2 1
1
1
2 30 0 2 30
2 30 0 2 30
Q Q Q Q
Q
TR
Q Q Q Q
Q
TR

If the firms collude they maximize their profit at MC=MR

15
15 30
15
0 2 30
Q
TR
Q)Q - 30 (
2 1

+
p
P
Q
Q
PQ TR TR TR
12
P1
P
2
P
1
F
12
=reaction
curve of firm1
to 2
F
21
=reaction curve
of firm 2to 1
Collusion point
Q
2
Q
1
F
12
=reaction
curve of firm1
to 2
F
21
=reaction curve
of firm 2to 1
Collusion point