EC411 Microeconomics

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London School of Economics Dr Francesco Nava
Department of Economics Office LIF 3.20
EC411 2013/2014


Answers to Problem Set 1


1. (a) The consumer chooses (x,y) to maximise x+y s.t.
y y
M M y p x 2 + s + and
M x 2 s .
(b) If 2 p
y
< , x=0, and
y
y
p
M M
y
+
= . If 2 p
y
> ,
2
M
x = , and
y
y
p
M
y = .




2.
(i) Initial price ratio p
1
1
: p
2
1
= 1 : 1; new price ratio p
1
2
: p
2
2
= 3 : 2.

(ii) Bundle bought in week 2 was available in week 1. Thus, week 1
consumption is revealed to be superior to week 2 consumption.

(iii) Set prices at p
2
and increase income from m = p
2
x
2
to m + Am = p
2
x
1
(the
dashed line). By revealed preference the optimal choice must lie along
EC411 Microeconomics

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dashed line to northwest of x
1
. This follows by LNS and quasiconcavity,
since the indifference curve of the consumer is tangent to the flatter BC at
(5.3). Hence when income rises consumption of x
1
falls. Thus x
1
must be
an inferior good.

(iv) The price of good 1 has gone up. Consumption of good 1 has also gone up.
This observation is not sufficient to show Giffen because income has
changed.
Remember
m
x
x
m
x
x
p
h
p
x
1
1
1
1
1
1
1
1
+ = where
1
x = 4 is the weekly
endowment of good x
1
, and
1
1
p
x
means the effect of a change in p
1
holding
everything else constant.
In terms of good 2 however, p
1
has gone up from 1 to 1 and income has
gone up from 14 + 14 = 8 to 14

+ 14 = 10. We also know from (iii)
that good 1 is inferior. Therefore, this rise in income must make demand
for good 1 fall holding all else constant. Therefore, if income had not
increased the demand for good 1 would have increased even more than it
did. Therefore this good must be Giffen.



3. (a) Note that the indifference curve is a circle with centre at the origin (as in
problem set 1, question 1(ii)). Hence, only boundary solutions exist. If
2 1
p p > ,
2
2 1
p
m
x , 0 x = = . If
2 1
p p < ,
1
1 2
p
m
x , 0 x = = . If
2 1
p p = , either
2
2 1
p
m
x , 0 x = = or
1
1 2
p
m
x , 0 x = = .


EC411 Microeconomics

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(b) True


Old budget set = OAB
New budget set = OACD
For the family to be indifferent, butter consumption must have fallen
(x
0
x
1
).

In order to afford x
1
, the family must be receiving a net subsidy of AM > 0.


(c) False. Consider the following example. Let clothing be the numeraire.
The rationpoint system that the consumer faces an additional (linear)
EC411 Microeconomics

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constant RS : e.g.

Before the increase in income, the allowed consumption set is ORAC. The
consumers choice is
0
x (point A).

After the increase (AM) in income, the allowed consumption set is ORBD. The
consumers choice is
1
x (point B).

Consumption of clothing has decreased.

Yet: Without the rationpoint constraint RS, consumption would change from
x
0
to x
1
: an increase in clothing. That is, clothing is a normal good.



(d) Let m be income and
i
p the price of good i. If (m/(
1
p ))3, the optimal choice is
1
x =(m/(
1
p )) and 0 x
2
= . If (m/(
1
p ))>3, utility maximisation implies that
2 1
x 3 x + = . Hence, ) p p /( ) p 3 m ( x
2 1 2 1
+ + = and ) p p /( ) p 3 m ( x
2 1 1 2
+ = .



4. (i) Marshall: 1 = p
1
, |
1
(q
2
) = p
2
|
1
(q
2
) = p
2
/ p
1


Hicks: p
1
= , p
2
= |
1
(q
2
) |
1
(q
2
) = p
2
/ p
1


Observe that the absence of an income effect for good 2 is a consequence
of this form of the utility function.

Significance: area under Marshallian (market) demand function is
precisely the CV and the EV.

EC411 Microeconomics

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(ii)
( )
( )
2 2p
dp p dp
p
1
CV
/p p q
q
1
) (q
1
4
2
1
2
2
2
1
1
4
2 2
1
4
2
1
2
2
1
2 1 2
2
2
1
=
(

=
=
|
|
.
|

\
|
=
= =

} }




5. The indirect utility function, v(p,m), is nondecreasing in m. The claim then
follows noting that ) u , p ( h
p
e
i
i
=
c
c
and )) m , p ( v , p ( h ) m , p ( x
i i
= (by hypothesis,
) u , p ( h
i
is increasing in u).