Econ 629

Problem Set 1

Dr. Gronberg
Fall 2005

1.

MWG; Problems 1.B.1, 1.B.2, 3.B.1, 3.B.3

2.

Consider preferences defined over the nonnegative orthant by (x1,x2) { (y1,y2) if x1 + x2 <
y1 + y2. Do these preferences exhibit local nonsatiation? If these are the only two
consumption goods and the consumer faces positive prices, will the consumer spend all of
his income? Explain.

3.

Consider a parameter of an economic model. The null hypothesis (H0) is a statement

about the parameters true value. A decision rule to accept or reject the null hypothesis is
called a statistical test.
Type I Error:
Type II Error:

Rejecting H0 when it is true

Accepting H0 when it is false

Consider an econometricians preferences over Type I and Type II error. Denote the
probabilities of Type I and Type II error [P(I),P(II)]. Suppose that [P(I),P(II)] is weakly
preferred to [P(I)1,P(II)1] if either P(II) < P(II)1 or {P(II) = P(II) and P(I) < P(I)1}.
Determine if this econometricians preference relation is complete, transitive, strongly
monotone, and strictly convex. Define a utility function that represents the preference
ordering.

4.

Suppose a utility function in terms of x1 and x2 is specified as

(1)

u = x1x2

Let there also be the following utility functions:

a)

(2)

u = x12 x 22

(3)

u = 4x1x2

(4)

u = 4x1x2 + 17

(5)

u = ln(x1x2)

If utility is assumed to be cardinally measurable, then the only allowable

transformations of u are positive affine transformations.

Which transformations can replace (1) from a cardinal point of view? From an
ordinal point of view?
b)

5.

Fill in the utility values in the following table, in which each column corresponds
to one of the five utility functions specified above.
x2

1
1
2
2
3

1
2
1
2
2

(1)

(2)

(3)

(4)

(5)

Let u(x) be a utility function satisfying our axioms. Let v = (u), with 1 > 0 designate
the whole class of utility functions representing the same preference ordering. Consider
the first and second order partial derivatives of u:
u
x i

a)

, xu2i , xi ux j .
2

Derive the corresponding first and second order partial derivatives of v, i.e.

v
x i

6.

x1

, xv2i , xi vx j .
2

b)

Is the absolute value of the first order partial derivatives of u invariant to the
allowable transformations?

c)

Is the sign of the first order partial derivatives invariant within the class of utility
functions considered?

d)

Is the absolute value of the second order partial derivatives invariant? Is the sign
invariant?

e)

If u is cardinal, how are your answers to (b)-(d) affected?

Use the transformations from problem (5) to illustrate your conclusions in question (6) as
to the invariance of absolute value and the sign of the first and second order (direct and
cross) partial derivatives. Which utility function obeys the law of decreasing marginal
utilities?

7.

8.

9.

Consider a consumption set with three elements {A, B, C}. There are three individuals
with the preference orderings given below:
Person 1

A { B, C { A, B { C

Person 2

A { B, A { C, B { C

Person 3

B { A, C { B, A { C

a)

Are the preference orderings of these individuals rational?

b)

Suppose these three individuals form a group, and the binary relation for the
group is defined by receives more votes in a pairwise decision than. Will the
group preference ordering be rational?

Treat charitable contributions, C, as a good entering the utility function. Treat personal
consumption as a composite good, X, with PX = 1. Assume that contributions can be
deducted from income, w, in arriving at taxable income. Assume a proportional income
tax rate equal to t.
a.

Graph the budget set.

b.

If the government changed tax laws (i.e., scrapped the old charitable deduction
rule) so that taxes were reduced by a flat amount T if charitable contributions
were at least C0, illustrate the new choice set.

Consider a simple two-good choice problem involving commodity X1, leisure, and
commodity X2, consumption (assume P2 = 1). The consumer is endowed with a fixed
allocation of time, T, which is allocated between leisure and labor. There are two jobs
available: the primary job offers wage, w1 per unit labor, but only for a fixed number of
hours t1 = T/3; the secondary job offers a lower wage, w2 per unit labor, for any number
of hours the worker chooses.
a)

Graph the budget set.

b)

Consider the case of a worker who chooses to moonlight, i.e. takes the second
job (for some number of hours) in addition to working the first job. Use
indifference curves to illustrate the case where an increase in the wage rate offered
on the primary job will reduce the number of hours the worker moonlights.

10.

An individual maximizes the utility function

L

U( x1 ,..., x " ) = b " log( x " a " )

"=1

where a , b  0 for all 5 and

5

b
"=1

"

= 1.

Prices are given by p (5 = 1,...,L) and income by

5

W > p "a "

" =1

Obtain the Walrasian demand functions and explain how the parameters (a ,b ) may be
interpreted.
5

11.

A consumer has a two-period utility function

U(X1,X2) = ln X1 +

ln X2,

0<

<1

and initial wealth w1 which is spent on consumption in the first period X1 and the
remainder invested in an asset paying a rate of interest r. Assume P2 = P1(1+ ) and w2=0.
a)

Write down the two-period budget constraint in linear form. Interpret the slope
expression dx2/dx1.

b)

Show that the utility-maximizing (you may assume an interior solution) allocation
of consumption over the two periods is

c)

X1 =

w1
(1+) P1

X2 =

w1
(1+)

(1+r )

(1+) P1

How does consumption vary with respect to changes in ? How would one
interpret the parameter ?