Econ 11 Midterm 1 Review Question

Dr. Petre
December 7, 2017

The Mad Hatter only consumes two goods: bowler hats (B) and top hats (T ). Although
he his mad, his preferences satisfy the axioms of preferences and can be represented with
the following utility function:
 2
U (B, T ) = B /2 + 3T
1 1/2

His income is I, the price of bowler hats is pb , and the price of top hats is pt .
a) Write the Mad Hatter’s utility maximization problem. (2 points)
SOLUTION:
 2
max B /2 + 3T
1 1/2
s.t. I = pb B + pt T

b) Write the Mad Hatter’s expenditure minimization problem. (2 points)

SOLUTION:
 2
min pb B + pt T s.t. U = B /2 + 3T
1 1/2

c) Obtain his Marshallian demand functions for bowler hats and top hats. (4 points)
SOLUTION:
 2
L = B /2 + 3T
1 1/2
+ λ(I − pb B − pt T )

Taking FOC:
∂L 2 −1
= B /2 (B /2 + 3T /2 ) − λpb = 0
1 1

∂B 2

∂L 2 −1
= 3 T /2 (B /2 + 3T /2 ) − λpt = 0
1 1

∂T 2

∂L
= I − pb B − pt T = 0
∂λ
Setting λ = λ gives:

(B 1/2 + 3T 1/2 ) 3(B 1/2 + 3T 1/2 )

=
B 1/2 pb T 1/2 pt

1
 !2
1/2 1/2 pt
⇒T pt = 3B pb ⇒ B = T
3pb

9pb I pt I
⇒ T∗ = , B∗ =
p2t + 9pb pt pb pt + 9p2b

d) Show whether Marshallian demand for top hats is increasing, decreasing, or does not
change with respect to the price of bowler hats and with respect to income. (4 points)
SOLUTION:
∂T ∗ 9p2 I
= 2 t 2 > 0
∂pb (pt + 9pb pt )

∂T ∗ 9pb
= 2 >0
∂I pt + 9pb pt
Demand for top hats is increasing in the price of bowler hats and income.
e) Obtain his Hicksian demand functions for bowler hats and top hats. (4 points)
SOLUTION:
  2 
1/2 1/2
L = pb B + pt T + µ U − B + 3T

Taking FOC:
∂L 1 −1
= pb − µ(2) B /2 (B /2 + 3T /2 ) = 0
1 1

∂B 2

∂L 1 −1
= pt − µ(2) (3)T /2 (B /2 + 3T /2 ) = 0
1 1

∂T 2

∂L  2
= U − B /2 + 3T /2 = 0
1 1

∂µ
Setting µ = µ implies:
!2
B 1/2 + 3T 1/2 3(B 1/2 + 3T 1/2 ) 3pb
= ⇒T = B
pb B 1/2 pt T 1/2 pt

Therefore: !
U 3pb U
Bc∗ = ∗
2 ; Tc =
pt 9pb 2
 
9pb
1+ pt
1+ pt

f) Find the cross price elasticity of uncompensated and compensated demand for bowler
hats. (4 points)

2
 SOLUTION:
∂B ∗ pt 9pb
B,pt = ∗
=
∂pt B pt + 9pb

∂T ∗ pb pt
T,pb = =
∂pb T ∗ pt + 9pb

∂Bc∗ pt 18
cB,pt = ∗
=
∂pt Bc 9pb + pt

∂Tc∗ pb 1 18pb
cT,pb = ∗
= −
∂pb Tc pb 9pb + pt

g) Are bowler hats and top hats net substitutes? Net complements? Gross substitutes?
Gross complements? Explain. (2 points)
SOLUTION:
Since B,pt > 0, T,pb > 0, bowler hats and top hats are gross substitutes.
Since cB,pt > 0, cT,pb > 0, bowler hats and top hats are net subsititutes.
h) Find the income elasticity of demand for bowler hats and top hats. (4 points)

∂T ∗ I 3pb I
T,I = ∗
= 2 =1
∂I T 3pb + pt pb T ∗

∂B ∗ I pt I
B,I = = 2
=1
∂I B ∗ 3pb + pt pb B ∗