Econ 5533 Homework 3 - Answer Outline

Fall 16; Professor Horowitz;

1. For the utility functions below derive the indirect utility function, Marshallian demand functions,
expenditure functions and the Hicksian demand functions. You can utilize the results you derived in
Homework 2 and/or use the duality mappings.

Answer outline: Since I suggested you use the results from Homework 2, the answers below
utilize the transformed utility functions as the primal problem. For example, we use the
value function without the constant (-100 on problem 1a). In other cases I left the constant
in (for example, 1d on the answer key to Homework 2) so it is utilized in the value function
below. The Hicksian demand could be found either by solving the expenditure minimization
problem or, more efficiently, using the duality mappings. Regarding the graphs below of the
income and substitution effects, these are Hicks Decomposition as on page 122 of the text.

a &b. For either form of the Cobb-Douglas (i.e., U(x) = ln x1 + ln x2 or U x1 x2 we found
M M
Marshallian demand functions: x1* x2*
P1 ( ) P2 ( )

M M
v u ( x , x )
* *
v Now, solve for M to get e(p,u)
P1 ( ) P2 ( )
1 2

1
P P2 P P
U ( ) 1 M M U ( ) 1 2 e( p , u )


P2
1 1
P P
h1 x1 ( p, e( p, u )) U ( ) 1 2 U

P1 ( )
1P

P
1 1
P P
h2 x 2 ( p, e( p, u )) U ( ) 1 2 U 1
P2 ( ) P2

c. U x1 x2 Using the same solution methods as in the previous homework for the
.5

interior solution we find:

Case 1 Interior solution:
 M p P12
x1 1 x2
P1 16 p2 16 P22
2M P P
v ( p, m ) 1 1 U*
P1 8P2 4 P2
The above is the maximum utility with income M . Now solve for M tofind
the minimum expenditur e to obtain utility U* .
UP1 P2 e( p, u )
e( p , u ) 1 ; hi
2 16 P2 pi
Case 2 - The Now consider the corner solution.
x1 0
x 2 M P2
1
M 2
U 0 v ( p, m)
P2

e( p, u )
M P2 u 2 e( p, u ); hi
pi

d) This is the case of perfect substitutes with linear indifference curves and b-line. We
consider the relationship between the ratios of prices and preference weights to determine
which corner solution is relevant. Let the graph guide you for these problems.
Once you have the expenditure functions just take the partials with respect to

p1
Case 1 :
p2
x1 0
x 2 M P2
U x1 x 2 100
M
v ( p, m) U*
P2
M UP2 100 P2
U 100 M e( p , u )
P2
 p1
case 2 :
p2
M
x1
P1
x2 0
M
v ( p, m ) x1 100 100 U
P1
U 100
M e( p , u ) P
1
e( p, u ) u 100
h1
p1
e( p, u )
h2 0
p1

e). These are perfect compliments. The arguments of the min function will be equated to
maximize utility. Therefore utility is equal to either of arguments. We x1 below in the
expression for the indirect utility function.

U min(x1 , x 2 ) U x1 x2
M
U v ( p, m )
P1 P2
( P1 P2 )U
M e( p, u );

e( p, u )
h1
p1
e( p, u )
h2
p1
Again, I will leave the algebra to you.

2. Write and the four duality mappings presented in class and explain graphically why they are true.

Answer outline: See Varian page 106 (3rd Edition). For the second part of the question you
can just repeat the demonstration I made in class. To outline the class demonstration, I first
showed the primal problem graphically with indifference curves representing the objective
function and the budget line the constraint. I then drew the dual problem with the maximum
indifference curve in the primal problem (u*) as the constraint and iso-expenditure lines
representing the objective function. Given the same prices (p*), the M* of the primal problem
must be equal to the minimum expenditure achieved in the dual minimization problem and x* =
h*. I expect you to be able to reproduce the graphs and arguments I presented in class.
Hopefully you took good notes, or can find a colleague who did
3. Use the duality mappings to derive the Slutsky equation.
Answer: see Varian.

4. Suppose the price of good 1 decreases from $2 to $1 per unit. Approximate the substitution and
income effects (for good 1) for the demand systems associated with the utility functions below.
You may assume P2 = 1 and M =1. You may use the demand functions you
derived in Problem Set 2 in answering parts a and b.
(a). U(x1, x2) = x1 x 2
(b). U(x1, x2) = x1 + x12 / 2 (interior solution only).
(c). U(x1, x2) = x2x1 + x1

Answer Outline:
a. In previous homework we found the Marshallian and Hicksian demands. Below I
use the normalization used on the prior answer keys so that this homework
is linked easily to the prior answers.
1 1
1 *1
M 1 1
x1* x1 ( p, m ) 2 x1 ( p1 , m) 2
P1 2 4 1 2
1
1
M 1
x 2* x 2 ( p, m ) 2
P2 1 2

1 1 1 3
1 2 1 2 1 1 2 1 2

U x1 x 2
4 2 2 2 2
3 1 3
P2 1 2 1 2 1 2
1

h1 ( p1 , u ) U
.35
P1 2 1 2
1
Substituti on effect h1 ( p1 , u ) x1 ( p1 , m) .35 .1
4
Income effect x1 ( p1 , m) h1( p1 , u ) .5 .35 .15

U1 U2
X2

x1(p1,M) h1 (p1,u) x1(p1,M) X1

(b). U(x1, x2) = x1 + x12 / 2 .
From your solutions Problem Set 2 you have the interior solution:
m p 1 2 3 1 1
x1* 21 ; x1' 0
p1 4 p2 2 4( 1 ) 2 1 1
4

So these prices and income lead to the corner solution of all income spent on good 2
since a negative value of x1 is a contradiction to the interior solution case we have
assumed. Therefore we know the correct case immediately in a 2 good world. And the
income and substitution effect are then pretty simple that is, both are zero! Therefore,
in this case we do not even need to recall the Hicksian equations.

(c). This is a new utility function so we have to solve for the Marshallian and Hicksian before
computing the effects.
U x1 x2 x1 s.t. px M
max L x1 x2 x1 ( M P1 x1 P2 x2 )
Lx1 x2 1 P1 0 (1)
Lx 2 x1 P2 0 (2)
L M P1 x1 P2 x2 0 (3)
case 1 x1 , x2 0
x1P1
(1) (2) x2 1 substituti ng for x2 from (3)
P2
P1 M xP
x1 1 1 1
P2 P2 P2
2 x1P1 M M P2 M P2
1 x1*
P2 P2 P2 2 P1
M P2 P1
x2* 1 from (1) and (2)
2 P1 P2
M P2
x2*
2 P2
Note: there in no contradiction in this case as long as M > P2 otherwise x2* 0
which is a contradiction for the interior solution. Now derive the Hicksians:
 M P2 M P2 M P1
v( p.m)
2 P1 2 P2 2 P1
M P2 M P2 M P2 M P2
1
2 P1 2 P2 2 P1 2 P2
( M P2 ) 2
v U solve for M to find e( p, u )
4 P1 P2
( M P2 ) 2
M U 4 P1 P2 2 P2 e( p, u )
1
U
4 P1 P2
1
e( p, u ) P2 2
h1 U after simplifica tion
P1 P1
1
e( p, u ) P1 2
h2 U 1
P2 P2
We are finally ready to compute the income and substitution effects:

4c.( continued )
M P2 M P2
x1* x2*
2 P1 2 P2
11 1 11
x1 x2 0
2*2 2 2 *1
11
x1 1
2 *1
1 1 1
U x1 x2 x1 *0
2 2 2
1 1
P 2 1 12 1
h U 2
P1 2 1 2
2 1
Substituti on effect h1 x1
2
1
Income effect x1 h1 1
2