Advanced Microeconomics - Assignment 1

(deadline: Tuesday, October 23, 2018, 09:45am)

Prof. Dr. Andreas Irmen & Ka-Kit Iong

University of Luxembourg
Fall 2018

Question 1.

The preference relation % on X = Rn+

is continuous if it is preserved under
n n ∞ n n
limits. That is, for any sequence of pairs {(x , y )}n=1 with x % y for all
n, x = limn→∞ xn , and y = limn→∞ y n , we have x % y .

A lexicographic preference relation on X is dened as follows:

x%y if either  x1 > y1  or  x1 = y1 and x2 ≥ y2 

a) Interpret in your own words the meaning of lexicographic preferences

and give an example.

b) Show that the lexicographic preference relation is not continuous. [Hint:

To get started you may want to consider an arbitrary reference bun-
dlex1 = (x1 , y1 ) and draw the weakly preferred to set dened as
% (x1 ) ≡ {x | x ∈ X, x % x1 }.]

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Question 2.

Consider the following denitions:

Denition 1 A monotone preference relation % on X = RL+ is homothetic

if all indierence sets are related by proportional expansion along rays; that
is, if x ∼ y then αx ∼ αy for any α ≥ 0.
Denition 2 The preference relation % on X = (−∞, ∞) × RL−1
+ is quasi-
linear with respect to the good 1 if
1.) All the indierence sets are parallel displacements of each other along
the axis of good 1. That is, if x ∼ y, then (x + αe1 ) (y + αe2 ) for
e1 = (1, 0, · · · , 0) and any α ∈ R.

2.) Good 1 is desirable; that is, x + αe1  x for all x and α > 0.
Now, prove the following statements:

a) A preference % can be represented by a utility function only if it is

complete and transitive.

b) A continuous % is homothetic if and only if it admits a utility function

u(x) that is homogeneous of degree one, i.e., u(αx) = αu(x) for all
α > 0.

c) A continuous % on (−∞, ∞) × RL−1

+ is quasilinear with respect to the
rst good if and only if it admits a utility function u(x) of the form
u(x) = x1 + φ(x2 , ..., xL ). [Hint: For the "only if" part, you can assume
n−1
for every x̂ ∈ R+ there exist a unique α ∈ R such that αe1 ∼ (0, x̂).]

Question 3.

Consider a consumer with preferences represented by U (x1 , x2 ) = min{x1 , x2 }.

a) Verify that the preferences are convex.

b) Derive the consumer's demand functions xi (p, y), i = 1, 2, and the

indirect utility function V (p, y). Verify Roy's identity.

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Question 4.

Consider an economy with A ∈ N+ dierentiated consumption goods. Let

u(xj ) = xαj , 0 < α < 1,

denote the utility derived from the consumption of good j = 1, ..., A. The
consumer's overall utility depends on the consumed quantity of each con-
sumption good. More precisely, let

" A
# α1
X
U = A(σ−1)(1−α) u(xj ) , σ > 0,
j=1

be the overall utility from the consumed quantity of each dierentiated con-
sumption good.

a) Let y>0 denote the consumer's income. Consider a symmetric con-

guration with pj = p > 0 and xj = x > 0 for all j = 1, ..., A.
a1) Show for this conguration that
 
(σ−1)(1−α)+1 y
U =A α .
Ap
Interpret.

a2) Show that this conguration implies ∂U/∂A > 0. Interpret.

b) Let the price vector of consumption goods be positive, p = (p1 , · · · , pA ) 

0. Set up the consumer's expenditure minimization problem for a given
level of utility, ū. Interpret the objective function and the constraint(s).

c) Derive the associated Hisksian demand function, xhj (p, ū).

d) Derive the associated expenditure function, e(p, ū). Verify Shephard's
lemma.

e) Dene the ideal price index as P ≡ e(p, 1). Verify

" A
#− 1−α
α
X − α
P = A(σ−1) pj 1−α .
j=1

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Q uestion 5.

Denote c≥0 an individual's consumption, l≥0 h ≥ 0 her

her leisure, and
hours worked. We normalize the individual's time budget such that l = 1−h,
i. e., l≥0 is the fraction of this time budget spent as leisure time whereas
h is the fraction supplied to the labor market. In what follows, we refer to
h as the individual labor supply. The individual evaluates consumption and
leisure/labor supply according to the following utility function

 ν

U (c, h) = ln c + κ ln 1 − φhc 1−ν , κ > 0, φ > 0, ν < 1;

The price of each unit of the consumption good is p > 0 Euro. For each unit
of h supplied to the labor market the individual earns a wage equal to w > 0
Euro.

a) Interpret the utility function U (c, h). Is the marginal product of con-
sumption always positive? Are consumption and leisure complements?

b) The individual wants to know her consumption demand, her demand

for leisure, and her supply of labor. Set up the consumer's utility
maximization problem. Be careful to specify all constraints.

c) Consider an interior solution of the consumer's maximization problem.

Moreover, suppose that all parameters imply ∂U (c, h)/∂c > 0 and the
second order conditions for an interior maximum. Show that the in-
dividual's demand function for consumption and her labor supply are,
respectively, given by (Hint: Determine the demand for consumption
and the labor supply. When doing the computations go for the labor
supply rst.)

 1−ν  1−ν
1 1−ν
w
c(p, w) = ×
φ 1−ν+κ
p
 1−ν  −ν
1 1−ν w
h(p, w) = ×
φ 1−ν+κ p

d) Interpret c(p, w) and h(p, w). In particular discuss the role of ν for the
eect of an increasing real wage. What is the role of κ?