24 October

4 hours
Full points: 30
Fall 2017
ECN 201E Midterm Examination Solutions
Answer all 3 questions below. If you are stuck on a question, I recommend moving on to the
next question and returning to the problem after you have finished answering all the other
questions.
Make sure to show all your working and calculations for significant partial credit. You must
show all the steps that you did to get to your answer. If you just give me the answer, you
will get 0 even if it is correct. I will also give you 0 if all you give me is a formula without
any working.
Good luck!
Please write your name and ITU ID number on your answer sheet.
Question 1
A consumer has Cobb-Douglas preferences over two goods: good 1 and good 2. The
consumer’s preference can be represented by the utility function 𝑢(𝑥1 , 𝑥2 ) = 𝑥1 𝑥22 where 𝑥1
is the amount of good 1 and 𝑥2 is the amount of good 2 that the consumer consumes
respectively. The price of good 1 is 𝑝1 and the price of good 2 is 𝑝2 . The consumer has a
money income of 𝑚 that she intends on spending on both goods.
a) State the consumer’s constrained maximization problem. [2 points]

b) Find the demand functions for good 1 and good 2. [6 points]

c) Draw the Engel curve for good 1. What is the slope of the Engel curve for good 1? [2
points]
Question 2
A consumer always consumes good 1 and good 2 in fixed proportions. With every 1 unit of
good 1, the consumer consumes 1.5 units of good 2. The price of good 1 is 𝑝1 and the price of
good 2 is 𝑝2 . The consumer has a money income of 𝑚 that she intends on spending on both
goods.
a) Draw indifference curves of the consumer for goods 1 and 2. Write down a utility
function that represents the consumer’s preference over goods 1 and 2. [5 points]

b) Find the demand functions for good 1 and good 2. [5 points]

Question 3
ai) What is a Giffen good? [1 point]
aii) What is an inferior good? [1 point]
aiii) The below identity is the Slutsky equation:
̅)
𝜕𝑥1 (𝑝1 ,𝑝2 ,𝑚 𝜕𝑥1𝑠 (𝑝1 ,𝑝2 ,𝑥
̅̅̅1̅,𝑥
̅̅̅2̅) ̅)
𝜕𝑥1 (𝑝1 ,𝑝2 ,𝑚
= − 𝑥1
̅̅̅.
𝜕𝑝1 𝜕𝑝1 𝜕𝑚

In the above equation, 𝑝𝑖 is the price of good i, , 𝑚 ̅ is money income, 𝑥̅𝑖 is the quantity
demanded of good i, 𝑥1 (𝑝1 , 𝑝2 , 𝑚 ̅ ) is the ordinary demand function of good 1 and
𝑠
𝑥1 (𝑝1 , 𝑝2 , ̅̅̅,
𝑥1 𝑥 ̅̅̅)
2 is the Slutsky demand function of good 1.

With reference to the above equation, explain why it is a necessary condition that to be a
Giffen good a good has to be an inferior good but it is not a sufficient condition. [5 points]
100
b) The market demand function for a good is 𝑥(𝑝) = . Calculate the change in
𝑝
consumers’ surplus when price increases from $𝑒 to $𝑒 3 . Make sure you show your
2

working to derive the change in consumers’ surplus. [3 points]

Answer 1
1a) The consumer’s constrained maximization problem is:
𝑀𝑎𝑥𝑥1 ,𝑥2 𝑥1 𝑥22
𝑠. 𝑡. 𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝑚

1b) There are two methods to derive the demand functions for goods 1 and 2. One method is
solving by substitution and the other is by forming a Lagrangian. I will just show the
Lagrangian method here but I will accept both methods.
We can monotonically transform 𝑢(𝑥1 , 𝑥2 ) by taking its natural logarithm: 𝑣(𝑥1 , 𝑥2 ) =
ln 𝑥1 + 2 ln 𝑥2 .
Because we know that a monotonic transformation of 𝑢(𝑥1 , 𝑥2 ) represents the same
underlying preferences as 𝑢(𝑥1 , 𝑥2 ), we can rewrite the consumer’s constrained maximization
problem as:
𝑀𝑎𝑥𝑥1 ,𝑥2 ln 𝑥1 + 2 ln 𝑥2
𝑠. 𝑡. 𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝑚
We can then form a Lagrangian:
𝐿 = ln 𝑥1 + 2 ln 𝑥2 − 𝜆(𝑝1 𝑥1 + 𝑝2 𝑥2 − 𝑚) , (1)
where 𝜆 is the Lagrange multiplier.
The 3 first-order conditions are:
𝜕𝐿 1
= − 𝜆𝑝1 =0, (2a)
𝜕𝑥1 𝑥1

𝜕𝐿 2
= 𝑥 − 𝜆𝑝2 =0, (2b)
𝜕𝑥2 2
𝜕𝐿
= 𝑝1 𝑥1 + 𝑝2 𝑥2 − 𝑚 = 0. (2c)
𝜕𝜆

From first-order conditions (2a) and (2b), we get respectively:

1 = 𝜆𝑝1 𝑥1 , (3a)
2 = 𝜆𝑝2 𝑥2 . (3b)
Adding equations (3a) and (3b):
1 + 2 = 𝜆(𝑝1 𝑥1 + 𝑝2 𝑥2 ),
⇒ 3 = 𝜆𝑚
3
∴ 𝜆 = 𝑚. (4)

Substituting the value of 𝜆 from equation (4) into equation (3a) to get the demand function
for good 1:
1 = 𝜆𝑝1 𝑥1 ,
3
⇒ 1 = 𝑚 𝑝1 𝑥1
𝑚
∴ 𝑥1 = 3𝑝 . (5)
1

Similarly, we can substitute the value of 𝜆 from equation (4) into equation (3b) to get the
demand function for good 2:
2 = 𝜆𝑝2 𝑥2 ,
3
⇒ 2 = 𝑚 𝑝2 𝑥2
2𝑚
∴ 𝑥2 = 3𝑝 . (6)
2

Equations (5) and (6) show the demand functions for goods 1 and 2 respectively i.e.:
𝒎
𝒙𝟏 (𝒑𝟏 , 𝒎) = 𝟑𝒑 , (5)
𝟏

𝟐𝒎
𝒙𝟐 (𝒑𝟐 , 𝒎) = 𝟑𝒑 . (6)
𝟐

1c) We can draw the Engel curve for good 1 by holding prices fixed and plotting how the
optimal consumption of good 1, 𝑥1 , varies with the consumer’s money income 𝑚. We plot 𝑚
on the vertical axis and 𝑥1 on the horizontal axis.

The optimal consumption of good 1 is given by good 1’s demand function:

𝑚
𝑥1 = 3𝑝 . We see from the demand function that the optimal consumption of good 1 is a
1
linear function of money income 𝑚. Specifically, if we re-arrange good 1’s demand function
we get 𝑚 = 3𝑝1 𝑥1 . This means the Engel curve for good 1 is a straight line through the
origin with a slope of 𝟑𝒑𝟏 .
Answer 2
3a) Goods 1 and 2 are perfect complements. Their indifference curves will look like below:
The consumer’s preferences can be represented by either of the two utility functions (I have
given full credit if you could give me any single utility function that represents the
consumer’s preferences over goods 1 and 2 accurately):
𝟐
𝒖(𝒙𝟏 , 𝒙𝟐 ) = 𝐦𝐢𝐧{𝒙𝟏 , 𝒙𝟐 } or 𝒖(𝒙𝟏 , 𝒙𝟐 ) = 𝐦𝐢𝐧{𝟑𝒙𝟏 , 𝟐𝒙𝟐 }.
𝟑

3b) As can be seen in part (3a) the indifference curves of the consumer are “kinked” i.e. they
are not continuous. Hence, the standard maximization methods (such as the Lagrangian and
substitution) cannot be used to solve the consumer’s maximization problem and derive the
demand functions. Below is the method to derive the demand functions for two goods that are
perfect complements.
We know that the consumer purchases goods 1 and 2 in the ratio 2:3. Hence, we have:
𝑥2 = 1.5𝑥1 . (13)
Substituting the value of 𝑥2 from equation (13) into the budget constraint:
𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝑚,
⇒ 𝑝1 𝑥1 + 1.5𝑝2 𝑥1 = 𝑚,
𝑚
∴ 𝑥1 = 𝑝 . (14)
1 +1.5𝑝2

Equation (14) is the demand function for good 1. Because we know that the consumer will
always purchase goods 1 and 2 in the ratio 1:3, the demand function for good 2 is:
𝑥2 = 1.5𝑥1 ,
1.5𝑚
∴ 𝑥2 = 𝑝 .
1 +1.5𝑝2
(15)
The demand functions for goods 1 and 2 are given by equations (14) and (15) respectively:
𝒎
𝒙𝟏 (𝒑𝟏 , 𝒑𝟐 , 𝒎) = 𝒑 , (14)
𝟏 +𝟏.𝟓𝒑𝟐

𝟏.𝟓𝒎
𝒙𝟐 (𝒑𝟏 , 𝒑𝟐 , 𝒎) = . (15)
𝒑𝟏 +𝟏.𝟓𝒑𝟐

Answer 3
ai) A Giffen good is a good whose quantity demanded increase with an increase in its price:
𝜕𝑥
> 0.
𝜕𝑝

aii) An inferior good is a good whose quantity demanded decreases with an increase in one’s
𝜕𝑥
income: 𝜕𝑚 < 0.

aiii) For a good to be a Giffen good it must be that the left-hand side of the Slutsky equation
̅)
𝜕𝑥1 (𝑝1 ,𝑝2 ,𝑚
must be positive: > 0. Now we know that the substitution effect is always
𝜕𝑝1
 𝜕𝑥1𝑠 (𝑝1 ,𝑝2 ,𝑥
̅̅̅1̅,𝑥
̅̅̅2̅)
negative: < 0. Therefore because ̅̅̅
𝑥1 is always positive on the right-hand side
𝜕𝑝1
̅)
𝜕𝑥1 (𝑝1 ,𝑝2 ,𝑚 ̅)
𝜕𝑥1 (𝑝1 ,𝑝2 ,𝑚 ̅)
𝜕𝑥1 (𝑝1 ,𝑝2 ,𝑚
of the Slutsky equation, must be negative for > 0. But <0
𝜕𝑚 𝜕𝑝1 𝜕𝑚
implies that good 1 being an inferior good must be a necessary condition for it to also be a
Giffen good. However, this is not a sufficient condition because the absolute value of
̅)
𝜕𝑥1 (𝑝1 ,𝑝2 ,𝑚 𝜕𝑥1𝑠 (𝑝1 ,𝑝2 ,𝑥
̅̅̅1̅,𝑥
̅̅̅2̅) ̅)
𝜕𝑥1 (𝑝1 ,𝑝2 ,𝑚
𝑥1 must be greater than the absolute value of
̅̅̅ for > 0.
𝜕𝑚 𝜕𝑝1 𝜕𝑝1
Hence, being an inferior good is a necessary condition for being a Giffen good but not
sufficient.

b) The change in consumer’s surplus ∆𝐶𝑆 can be calculated as below:

𝑒 3 100
∆𝐶𝑆 = ∫𝑒 2 𝑑𝑡 = 100[3 ln 𝑒 − 2 ln 𝑒]
𝑡

= $100(3 − 2)
= $100.

Because it is a loss you have to be a negative sign so the correct answer is -$100 (or
equivalently you can state there is a $100 loss in consumer surplus with the price increase).