PROBLEM SET: MODULE 1

By: AGNIJ SUR (EE), SAYAN MAITY (AE), SAYANTAN ROY (FE), SAMRAT CHAUDHURI (FE), KUMARAN (FE), AVISHEK RAKSHIT(EE)

1. U (t,s) = t 0.5 s0.5 , t= Twinkies and s= soda

a. If Twinkies cost $0.1 each and soda costs $0.25 per cup, how should Paul allocate $1 to
maximize his utility?

b. If the price of Twinkies increases to $0.4, by how much will Pauls mother have to increase
his allowance to provide him with the same level of utility as before?

Solution:

Pauls utility function is defined as (, ) = 0.5 0.5

Pauls budget constraint is g=0.1 + 0.25 = 1

[Pt =$0.1 is the price of Twinkies and Ps = $0.25 is the price of soda.]

So we are faced with the problem of

, = . . . + . =

The Lagrangian function of this optimization model is

= 0.5 0.5 + [1 0.1 0.25]

As the first order condition, we have the following set of simultaneous equations:

= 0.5 0.5 0.5 0.1 = 0 1.1

= 0.5 0.5 0.5 0.25 = 0 1.2

= 1 0.1 0.25 = 0 1.3

Equations 1.1 and 1.2 are equivalent to

= =

0.5 0.5 0.5 0.1 2

Therefore, = . Solving this equation we get = 5 .
0.5 0.5 0.5 0.25

Putting the value of s in equation 1.3, we get

 s*= 2 and t*=5

Now to see whether the bundle (5,2) is the utility maximizing bundle we need to check the
second order conditions.

= 0.25 1.5 0.5 1.4

= 0.25 0.5 1.5 1.5

= 0 1.6

= 0.25 0.5 0.5 = 1.7

= 0.1 1.8

= 0.25 1.9

Therefore the Bordered Hessian is

0 0.1 0.25
|H|= | 0.1 0.25 1.5 0.5 0.25 0.5 0.5 |
0.25 0.25 0.5 0.5 0.25 0.5 1.5
Solving for t=5 and s=2 (as we are checking if the bundle (5,2) is the utility maximizing choice )
we get,

|H| = 0.4349 > 0

Therefore d2Z is negative semi-definite for the bundle (5,2) subject to dg=0; at (5,2) we get a
maximum for Z.

Thus the bundle (5,2) is the maximizing choice.

The maximised utility is U*=50.5x20.5=3.1623

Now the price of the twinkies increases to $0.4. Let M, be the new allowance to keep Paul in
same utility as before. Therefore, the new demand function will be
0.5 0.5
= = 1.25 and = = 2
0.4 0.25

Now, to be at the same utility as before,

(1.25)0.5 (2)0.5 = 3.1623

Or, 2

Therefore, Paul will need $2 extra to compensate the setback faced after price rise of twinkies.
2. A young connoisseur has $600 to build a wine cellar. She enjoys two vintages, French, W f
priced at $40 and Californian Wc. priced at $8. Utility U = Wf 2/3 Wc 1/3 .

a. How much of each wine she should buy?

b. If the price of French wine has fallen to 20, how much of each should she purchase in the
altered condition?

c. Explain if the wine fancier is better off in (a) or (b)? How would you put a monetary value
on this utility increase?

Solution:
2 1
a. The utility function of the young connoisseur is given by = 3 3

Let Pf and Pc be the price of French and Californian vintage respectively.

Pf =$40 and Pc = $8 and her income is $600.

The budget constraint is 40 + 8 = 600 => 5 + = 75 2.1

The connoisseur is now faced with the problem

/ /
, = + =

At equilibrium,

= 2.2

2 1/3 1/3 1 2/3 2/3

= and = .
3 3

Solving, we get: 2 = 5 2.3

By substituting 2.3 in 2.1 and solving for WC and Wf we get

= 25 and = 10

Now to see whether the bundle (10,25) is the utility maximizing choices then we need to
check the second order conditions.

2 4/3 1/3
= = 2.4
9

2 5
2
= = 3 3
2.5
9
 2 1/3 2/3
= = = 2.6
9

Now for = 10, = 25, we have < 0 and < 0.

The bordered Hessian at = 10, = 25 is

0 40 8
|H|= |40 0.0301 0.0121 | = 17.3504 > 0
8 0.0121 0.0048
Since |H|>0, d2Z subject to dg=0 is negative semi-definite. Therefore, the utility function
subject to the equality constraints under consideration reaches a maximum at (10,25).
The bundle is the utility maximizing choice of the connoisseur, as the necessary and
sufficient conditions are satisfied.

b. When Pf falls to 20, then at equilibrium

20
= => 4 = 5 2.7
8

The new budget constraint is 20 + 8 = 600

Substituting equation 2.7 in the new budget constraint we get,

= 20, = 25

The necessary Second order conditions are satisfied.

c. At = 10, = 25,
2/3 1/3
= = 13.57

At = 20, = 25,
2/3 1/3
= = 21.54

2 1 2 1 2 1
2 3 1 3 23 13 23 13
=( . ) ( . ) = . . 2 1 = . . 2 1
3 3 3 3
1 2 3 3
1 3 2 3 403 .83

2 1
23 13
Or, 21.54 = . . 2 1
3 3
403 .83

Or, = 952.24

Therefore, to achieve the new utility at the old price set, the wine fancier needed an extra
$(952.24-600) = $352.24. Thus, after price fall and with the previous budget the wine
fancier is better off than before.
3. For the Utility function U (g, v) = Min (g/2, v), calculate the demand functions for g and v.
a. What is the indirect utility function?
b. What is the expenditure function? For each level of utility, show spending as a function of
prices.

Solution:
The Utility function is a minimum function which is not differentiable. But at the equilibrium it
must be so, that

= or, = 2. (3.1)
2

Let P1 and P2 be the price of the good and respectively. Let M be the total money income. So
the budget constraint is 1 + 2 = (3.2)

From 3.1 and 3.2 we get - 1 . 2 + 2 = i.e. = .
+

= = .
+

The respective values of v* and g* are the demand functions for v and g.
So, the Indirect Utility Function is

(, ) = ( 2 , 2 )= .
1+ 2 1+ 2 21+ 2
Suppose U be the utility level that the consumer wants to achieve at prices (P1, P2). So the
expenditure function can be written as
(, ) = (21 + 2 ).

4. For the C.E.S. utility function given by U (x, y) =( x + y )1/ ,

a. Calculate the indirect utility function
b. Show that the function derived above is homogenous of degree zero in prices and income.
c. Show that this function is strictly increasing in income and decreasing in any price.
d. Calculate the expenditure function and show that it is homogenous of degree one in prices.
e. Show that the expenditure function I increasing in prices and that it is concave in each
price.
 f. Find the compensated demand functions using Sheppards lemma.

Solution:
The utility function is - = ( + )1/ .
Let, P1 and P2 be the prices of the goods x and y respectively. Let M be the money income.
The budget constraint is
1 + 2 = 4.1
We know at equilibrium
MRS= price ratio
1
Or, = 1 [1 = , 2 = ]
2 2

1
Or, = 1
1 2
1

Or, = (1 )1 4.2
2

By substituting 4.2 in 4.1 we get,

1
1
[(1 ) . 1 + 2 ] =
2

1/(1)
.2
Or, =
(1 1 )+(2 1 )
1/(1)
.1
Therefore, =
(1 1 )+(2 1 )
The Marshalian demand functions are given by .
The Indirect Utility Function is
1
1 1
.1 1 .2 1
= {( ) +( ) }
(1 1 )+(2 1 ) (1 1 )+(2 1 )

(1)


Or, = . {1 1 + 2 1 }
Now to check homogeneity of the indirect utility function V (P1, P2, M) , we increase all prices
and income by times.
Now,
 (1)

(1 , 2 , ) = . {(1 ) 1 + (2 ) 1 }
(1)


Or, (1 , 2 , ) = . { 1 (1 1 + 2 1 )}
(1)

1
Or, (1 , 2 , ) = . . . {(1 1 + 2 1 )}

(1)


Or, (1 , 2 , ) = . {(1 1 + 2 1 )} = (1 , 2 , )

So, I.U.F is Homogeneous of degree 0 w.r.t. 1 , 2 , .

Now,
(1)

(1 , 2 , ) = . {1 1 + 2 1 } .
(1)


= {1 1 + 2 1 } > 0 , 1 , 2 > 0

So the function is strictly increasing in M.

(1)

1
(1)

1
= .

. {1 1 + 2 1 } . 1 . 1 1
1

(12)
1
=. {1 1 + 2 1 } . 1 1 < 0 > 0, 1 , 2 > 0

Similarly, < 0, > 0, 1 , 2 > 0
2

The function is strictly decreasing in prices.

d. The consumer wants to achieve the utility level U at price (1 , 2 ).
So, the expenditure function is
(1)

) = {1
(, 1 + 2 1 }
.
 (1)

) = {1
Now, (, 1 + 2 1 }
.
(1)

) = {
Or, (, 1 [1 1 + 2 1 ]}
.
(1)

) = [1
Or, (, 1 + 2 1 ] = . (,
. )

So, Expenditure function is homogeneous of degree 1 in prices.

(1)

e. ) = {1
(, 1 + 2 1 }
.

(1)
1
)
(, (1) 1
= {1 1 + 2 1 } . . 1

.
1 1 1
1
1
)
(,
Or, = {1 1 + 2 1 } > 0 1 , 2 > 0
. 1 (1) .
1
)
(,
Similarly, > 0 1 , 2 >0
2
1

2 (,
) 1


1 1+

2 =[ {1 1 + 2 1 } . 1 1 {1 2
1 { 1 + 2 1 } . 1
2
}] . < 0
1 1

[0 < < 1]
Similarly,
1
)
2 (, 1 1 1+
2
2 = [ {1 1 + 2 1 } . 2 1 {2 {1 1 + 2 1 } . 2 2 }] < 0
2 1

[0 < < 1]
(1)

f. ) = {1
(, 1 + 2 1 }
.
Let us denote the Hicksian(Compensated) demand functions of x and y as xh and yh
respectively.
Therefore,
 1
1
)
(,
= = {1 1 + 2 1 } and,
. 1 1 .
1
1
1

= {1 1 + 2 1 }
. 2 1 .

5. For the Quasi Linear utility function U(x,y) =x+ ln y ,

a. Find the optimal demand bundles.
b. Calculate the income effect for each good. Also calculate the income elasticity
of demand for each good.
c. Show that Slutsky equation applies to this function.

Solution:
(, ) = +
Let P1 and P2 be the prices of x and y respectively and M be the money income.
Therefore the budget constraint is 1 + 2 =
At equilibrium,
1 1 1 1
= or, 1 = or, = 5.1
2 2 2

From the budget constraint and equation 5.1, we get,

1 + 1 = , or, = 1
1

So the demand functions are:

1
= 1, = > 1
1 2

and, = 0, = 1 .
2

b. [Case 1: when M > P1]

1
= 1, =
1 2

Differentiating with respect to M, we get,

1
= =0
1

Income Elasticity of the demand functions are:

 1 1
= . = . . =
1 1 1

= 0
[Case 2: when M P1]

= 0, =
2

Differentiating with respect to M, we get,

1
= 0 =
2

Income Elasticity of the demand functions are:

= . =0

1 2
= . . =1
2

c. [Case 1: when M > P1]

1
= 1, =
1 2

Indirect Utility Function is given by

(, ) = 1 + ln( 1)
1 2

The Expenditure function can be written as

) = 1 [
(, + 1 ln ( 1)] taking =

2

)
(,
= ln ( 1)
=
1 2

1
| =
1
1

=
1 1 2
1
=
1

1 1
| . = ( 1) = =
1
1 1 1 1 2 1

Therefore, the Slutsky equation holds for good 1.

)
(, 1
= =
2 2
 1
| =
2
2 2

1
=
2 2 2

=0

1 1
| . = 2 +0 = =
2
2 2 2 2

The Slutsky equation holds for good 2.

[Case 2: when M P1]

= 0, =
2

The indirect utility function is

(, ) = ln ( )
2

Expenditure Function is given by

) = . 2
(,
Therefore,
)
(,
= =
2

| =0
2


=
2 2 2
1
=
2

1
| . = . = =
2
2 2 2 2 2

The Slutsky equation holds for good y as well as good x.

6. Ellsworth's utility function is U(x, y) = min(x, y). Ellsworth has $150 and the
price of x and the price of y are both 1. Ellsworth's boss is thinking of sending
him to another town where the price of x is 1 and the price of y is 2. The boss
offers no raise in pay. Ellsworth, who understands compensating and equivalent
variation perfectly, complains bitterly. He says that although he doesn't mind
moving for its own sake and the new town is just as pleasant as the old, having to
 move is as bad as a cut in pay of $A. He also says he wouldn't mind moving if
when he moved he got a raise of $B. What are A and B equal to?

Solution:
(, ) = min(, )
Let P1 and P2 be the prices of good x and y respectively. Let M be the money income.
Initially P1 = 1 = P2 and M=150. The budget constraint is + = 150.
This is a case of complementary goods. So at equilibrium x=y.
Therefore, x*=y*=75.

The demand functions are - x*=y*=
1 +2

The indirect utility function is (1 , 2 , ) = min [ , ]=
1 +2 1 +2 1 +2

Now, when price of y changes to $2 from $1, the budget constraint becomes
+ 2 = 150.
The new budget constraint and the equilibrium condition of x=y gives us
= = 50
Before the price change Ellsworth has a utility of 75 and after the price change his utility
decreased to 50.
Ellsworth says he wouldnt mind moving if he got a raise of $B which will compensate the
setback he faces of $A. $B is nothing but compensated variation.

) = (1 + 2 )
Ellsworth expenditure function is: (,
Compensated demand function for y is
)
(,
=
=
2
2
$B = C.V. = 1 0 2 = 75
Ellsworth thinks that moving to the new town is as bad as cut in pay by $A which is nothing but
E.V.
2
Thus, E.V. = $A = 1 1 2 = 50.

7. Over a three-year period, an individual exhibits the following consumption

behaviour:

Px Py X Y
 Year 1 3 3 7 4
Year 2 4 2 6 6
Year 3 5 1 7 3

Is this behaviour consistent with the strong axiom of revealed preference?

Solution:

Year Prices\Bundle 1 2 3
1 33 36 30
2 36 36 34
3 39 36 38

The diagonal terms in the table means how much the consumer is spending at each bundle. The
other elements of the box means, how much the consumer wouldve spent if she purchased a different
bundle.
We put highlight the entry in row S and column T if the number in that entry is less than the entry
in row S and column S.
A violation of SARP consists of two observations T and S such that row T and column S contains
one highlighted entry. For this would mean that the bundle purchased at S is revealed preferred to the
bundle purchased at T and vice-versa.
There is a violation of SARP because row 2 and column 3 contains one highlighted entry and row
3 column 2 contains another.
So the behaviour is not consistent with SARP.