University of Warwick

MRes in Economics, 2016

EC9A1: Advanced Microeconomic Theory

Suggested solutions to problem set 3

1. At the end of the file.

4. (See appendix A at the end of chapter 3 in Mas-Colell) Assume x() is not continuous. Take a sequence (pn , wn )
converging to (p, w) >> 0., and a sequence (xn ) with xn = x(pn , wn ) for all n, with limit x 6= x(p, w).
By definition of xn we have that pn xn wn for all n. Then taking limits as n goes to infinity: px w. Therefore
x is feasible under (p, w), but not optimal. Hence there exist x, feasible, such that u(x) > u(x).
By continuity of u() there exist a y sufficiently close to x such that py < w and u(y) > u(x). Since (pn , wn )
(p, w), then for n large enough we have: pn y < wn .
We see that y is affordable under (p, w), but u(xn ) u(y) (by definition of xn ). Using the continuity of u() and
taking the limit as n goes to infinity we have that: u(x) u(y) a contradiction.

5.
(a) First we need to show that x() and v() are homogeneous of degree 1 in w. Let x = x(p, w), then u(x) u(y)
for all y affordable under (p, w). If px w, then x is affordable under (p, w) for 0. Consider y such that
py w, then p1 y w. Therefore 1 y is affordable under (p, w) and so u(1 y) u(x). Using the fact that
u() is homogeneous of degree one we have: 1 u(y) u(x) or u(y) u(x). But this means that x = x(p, w).
Then, v(p, w) = u(x(p, w)) = u(x(p, w)) = u(x(p, w)) = v(p, w).
Differentiating the equation x(p, w) = x(p, w) with respect to and evaluating it at = 1 we get w x(p,w)
w =
x(p, w). This implies the wealth elasticity of demand is one.
We also have that x(p,w)
w = w1 x(p, w) = x(p, 1). This implies that x(p,w)
w is a function of p only. Therefore the
wealth expansion path is a straight line passing trough the origin.
(b) We want to use Roys Identity (see Proposition 3.G.4). Then, we need to argue that v is differentiable and
preferences are LNS. First notice that since both u() and x(p, w) are differentiable, then v(p, w) is differentiable.
Now we argue that preferences are LNS. In order to get a contradiction, assume preferences do not satisfy LNS.
Then there is an  > 0 and a bundle y such that for all x in a ball of radius  around y we have y % x. But then
the strict quasiconcavity of u implies that y must be a global satiation point (why?). Thus, v(p, w) is bounded
above by u(y) which contradicts v(p, w) = wv(p).
Since u satisfies LNS and v() is homogeneous of degree one in w, we now use Roys identity to show that x(p, w)
is homogeneous of degree one in w. Since v() is homogeneous of degree one in w, Dp v(p, w) = Dp v(p, w) and
Dw v(p, w) = Dw v(p, w) (to get this differentiate v(p, w) = v(p, w) with respect to w). Using Roys identity:
x(p, w) = Dp v(p, w)/Dw v(p, w) = Dp v(p, w)/Dw v(p, w) = x(p, w).
Now we show that u is homogeneous of degree 1. Let x X. Then by the strict quasi-concavity of u() and LNS
there exists (by the supporting hyperplane theorem) a vector p such that x solves the UMP at prices p and wealth
w = p x. That is, x = x(p, w) and, hence, v(p, w) = u(x(p, w)). By assumption: v(p, w) = v(p, w). Therefore:

v(p, w) = u(x(p, w)) = u(x(p, w)) = u(x) (1)

But we also have that:

v(p, w) = v(p, w) = u(x(p, w)) = u(x) (2)
Using (1) and (2) we have that u is homogeneous of degree one.

7. Assume both prices in cities a and b are positive. Then the indirect utility function of the consumer in cities
2 2
a and b are given by: v a = 4pwa pa and v b = 4pwb pb . By assumption we know that pa1 pa2 = pb1 pb2 . Therefore the
1 2 1 2
consumer is indifferent between cities a and b. Similarly, the indirect utility function of the consumer in city c
2
is: v c = 4pwc pc . The utility function is continuous and represents preferences that satisfy LNS, therefore we know
1 2
that the indirect utility function is quasiconvex. By fixing wealth in the three cities then we know by definition
of quasiconvex functions that: max{v(pa , w), v(pb , w)} v(pc , w), because pc is a linear combination of pa and pb .

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As v(pa , w) = v(pb , w) quasiconvexity implies: v(pa , w) v(pc , w). In this case it is possible to show that v() is
strictly quasiconvex (actually it is convex in p), and therefore v(pa , w) > v(pc , w).

8. We do not need to worry about non-negativity of consumption because the log function is defined for the
positive reals only. The utility function is strictly concave (the Hessian matrix is a diagonal matrix with all of its
elements strictly negative) and strictly increasing, and the constraint is linear in consumption. We know that the
constraint will be satisfied with equality at any solution. If R = 0 the problem is ill-defined. If R < 0 there is
no solution to the problem. Assume R > 0, then we can use the Lagrangian method to solve this problem (the
constraint qualification holds), and furthermore using theorem M.K.4 we know that the FOC are necessary and
sufficient. To characterize the solution we can write the Lagrangian and solve the system of FOC. From lecture
slides on the classical demand theory we know that FOC are given by:
1
t1 = t1 t.
ct R
We can rearrange the equation above as:
ct
t1 = t.
Rt1
Adding the equation above for all t: !
X X ct
t1
= .
t t
Rt1
P ct
Using the budget constraint ( t Rt1 = w) we can solve for :
P t1

= t .
w
Finally we can write the solution for ct as using the FOC and the expression for :
t1
w (R)
ct = P t1 .
t

10. Assume for now that h() is homogeneous of degree one in u. Then by definition of e(p, u):

e(p, u) = ph(p, u) = ph(p, u) = ph(p, u) = e(p, u).

Above we see that if h() is homogeneous of degree one in u, so is e(). Now we show that the assumption of
u() being homogeneous of degree one implies that h() is homogeneous of degree one in u. Let c = h(p, u), then
u(c) u. By assumption we have: u(c) = u(c) u. We see that c is feasible in the expenditure minimization
problem
with utility level u. Take b
c such that u(bc) u. Then u(1 b c) = 1 u(b
c) 1 u = u. Therefore
1
p b c pc, or pbc px. This implies that c = h(p, u), or h(p, u) = h(p, u).

12.
(a) If LNS holds, then Walras law holds, and we can derive x3 from the budget constraint: x3 = (wp1 x1 p2 x2 )/p3 .
(b) xj (p, w) should be homogeneous of degree zero in (p, w). It is not difficult to show that indeed this is the case,
by directly using the definition of homogeneity.
(c) Here we can use proposition 3.G.2 in Mas-Colell. We know that Dp h() is symmetric and n.s.d; and using the
Slutsky equation to link Walrasian and Hicksian demands, this implies that:
x1 x1 x2 x2
+ x2 = + x1
p2 w p1 w
or

+ x2 = + x1 .
p3 p3 p3 p3
This implies that x1 = x2 or that = 100and = = 5.
Using hl /pl 0 for all l. If we compute this derivatives, it is not difficult to see that the only way to ensure
that they are non-positive is if = 0.
(d) From (c) we know that x1 = x2 for all prices. This implies that the indifference curves are L-shaped in the
(x1 , x2 )-plane, with a kink in the diagonal.

2
(e) We know that = 0, this implies x x2
w = w = 0. We have no wealth effects for goods x1 and x2 . Remember
1

from question 1 that the price level determined the consumption of x1 and the rest of the income (if any) was
consumed in the other good. Therefore we have that the utility function is quasilinear: u() = min{x1 , x2 } + x3
(or a monotone transformation of u()).

14. Let px = (1, 3, 10), py = (4, 3, 6), and pz = (1, 1, 5).

(a) Under px : x and z were affordable, and the consumer chose x, and when z was chosen x was not affordable.
So x is directly revealed preferred (d.r.p.) to z.
Under py : x and y were affordable, and y was chosen, and when x was chosen, y was not affordable. Therefore y
is d.r.p. to x.
A similar analysis shows that z is d.r.p. to y.
Hence, there is no violation of the WARP.
(b) From (a) we have: x is d.r.p to z, which is d.r.p. to y, which is d.r.p. to x. Therefore the SARP is violated.

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Exercise 1

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