Econ 2020a/ API 111 / HBS 4010

Fall 2008
Solutions: Problem Set 2

1. Cobb-Douglas Utility
1a) The utility function is homogenous of degree (a1+a2) in (x1,x2). To see this, multiply both
x1 and x2 by :
u (x1 , x 2 ) (x1 ) a1 (x 2 ) a 2 a1 a 2 x1a1 x 2a 2 a1 a 2 u ( x1 , x 2 )

Does (a1+a2) need to be an integer? Not necessarily. The MWG appendix (p. 928), gives a
definition of homogeneity of degree K where K is an integer. However, this definition is more
restrictive that the more general definition which allows K to take on non-integer values as well
(see, e.g., Chiang p. 410).
1b) Start by writing the Lagrangian:
Max L x1a1 x2a 2 ( w p1 x1 p 2 x2 )
x1, x 2

Taking the first-order-conditions (FOCs):

dL
a1 x1a11 x2a 2 p1 0
dx1
dL
a2 x1a1 x2a 21 p2 0
dx2
dL
w p1 x1 p2 x2 0
d
Rearrange and solve for x1 and x2 however you like. For example, you could start by solving
the first two equations for , and then setting them equal to each other:
a x a2
a x a1
1 12a1 2 11a 2
p1 x1
p2 x2
Then you can write x2 as a function of the other variables:

a p
x2 2 1 x1
p 2 a1
And then substitute into the last equation from the FOCs (the constraint):

a p
w p1 x1 p 2 2 1 x1
p 2 a1
Solving for x1, and then plugging the solution into the equation for x2, yields the Walrasian
demand functions:

a1 w

x1 ( p, w)
a

a
2 p1
1
a1 w

x 2 ( p, w)
a1 a 2 p 2
NOTE: Whenever you think you have found the demand functions, you should double-check to
make sure that each there are no xs remaining in your x(p,w) functions. For example, if your
function for x1(p,w) includes any x1s or x2s in it, you are not done yet!
IF YOU TRANSFORMED THE UTILITY FUNCTION using the natural logarithm (a
positive monotonic transformation, preserving the utility functions ordinal properties) you
would have:
Max L a1 ln x1 a2 ln x2 ( w p1 x1 p2 x2 )
x1, x 2

With FOCs:
dL a1
p1 0
dx1 x1
dL a 2

p 2 0
dx2 x 2
dL
w p1 x1 p 2 x 2 0
d

Again, you could solve the first two equations for , set them equal to each other, solve for either
x1 or x2, and substitute into the constraint. The Walrasian demand functions will be identical to
the ones above, whether or not you took the natural log approach.
FEATURES OF COBB-DOUGLAS UTILITY: All Cobb-Douglas utility functions generate
Walrasian demand functions with the following special properties:
- the budget shares (expenditures on each good as a fraction of wealth) are constant for all (p,w)
for all goods. Furthermore, the budget share (bi=pixi/w) for good i equals the exponent on xi
divided by the sum of all the exponents. In this case, b1=a1/(a1+a2) and b2=a2/(a1+a2).
- xi(p,w) is homogenous of degree 1 in w. Equivalently, iw=1 for all i. Equivalently, income
expansion paths (for all prices) are rays from the origin.

- cross-price elasticities are 0. Equivalently, ij=0 for all i j. You can see this from the demand
functions, because p2 does not appear in the function x1(p,w), and p1 does not appear in the
function for x2(p,w).
1c) Use the same FOCs as above to solve for the Lagrange multiplier:
a
( p, w) 1
p1

p2

a2

a1 a 2

a2

w a 2

p1 a1 a 2

a11

And then simplify as much as possible:

a
( p, w) 1
p1

a1

a2

p2

a2

a1 a 2

a1 a 2 1

IF YOU TRANSFORMED THE UTILITY FUNCTION using the natural log function, notice
that you will get a different value for the Lagrange multiplier. Why? The Lagrange multiplier
tells you how much extra utility you get by relaxing the constraint a little bit. If you change the
units in which you are measuring utility, you will change the value of the Lagrange multiplier.
Using the alternative FOCs from above, you would have:

a1
x1 p1

and

x1 ( p, w)

w
p1

a1

a1 a 2

Substituting x1(p,w) into the formula for gives you:

a1 a 2

( p, w)

2. Another Comparative Statics Exercise

a) Note that the problem does not say anything about the consumers wealth level; the solutions
below assume the budget constraint is non-binding. If you assumed a budget constraint, you will
get the same answers as below, assuming wealth is high enough to consume the optimal quantity
of bananas (the utility function is not locally non-satiated, so Walras Law will not hold). If
wealth is not high enough to consume the optimum quantity of bananas, the consumer will spend
all her wealth on bananas.
FOC: Use the Kuhn-Tucker Conditions (for one variable, no budget constraint, we have two
FOCs):

U
0
b
1
p 0
*
b 1
1 p
b*
p

1)

2)b

U
0
b

We know that b* cannot be negative. Thus, putting the two FOC conditions together, along with
the non-negativity constraint, we get:

b*

1 p
p

b 0
*

if

1 p
0
p

if

1 p
0
p

And this can be rewritten as:

b*

1 p
p

b* 0
b)

if p 1
if p 1

We can check the second derivative of the utility function to see if it is concave.

U
1

p
b b 1
2U
1
2

(b

1)

b 2
(b 1) 2

This second derivative is negative for all values of b, so the utility function is strictly
concave. So, this means that there cannot be multiple maxima the one we found in part a must
be the only one. We can be confident that we found a global maximum.
More specifically, if p > 1, we have a corner solution at b* = 0, and the utility is strictly
decreasing for all values of b greater than 0. If p 1, we have a single optimum at b* = (1-p)/p,
with utility strictly decreasing as we move away in either direction from b*.
Graphically, convince yourself that this is true with the following two cases. These are
two graphs of U(b), first plugging in p=2 and then p=.5. U(b) is on the y-axis, and b is on the xaxis. Pay attention only to the right side of the graphs (since b cannot be negative):

CORNER SOLUTION: where p > 1 (in this case, p = 2), so b* = 0.

INTERIOR SOLUTION: where p 1 (in this case, p = .5), so b* = (1-p)/p.

c)

Simply take the derivative of b* with respect to p:

b*

1 p
p

b* 0
Then:

if p 1
if p 1

b *
1
(1 p)( p 2 ) (1)p 1 2
p
p
b *
0
p

if p 1

if p 1

If the consumer is currently buying any bananas (i.e. p 1), then an increase in price
causes a decrease in the number of bananas purchased; and this decrease is inversely
proportional to price squared. If the consumer is not buying any bananas (i.e. p > 1), then an
increase in price causes no change in banana consumption.
d)

Derive the indirect utility function:

1 p 1 p
1
V(p) U(b * (p)) ln
1 p
ln p 1
p
p
p

V(p) ln p p 1

if p 1

V(p) ln(0 1) p 0 0

if p 1

if p 1

Now, consider the effect of a change in p:

V
1
1
p
p

if p 1

V
0
p

if p 1

The first expression is always negative (since p < 1), while the second expression is
always 0. So, a price increase leads to decreased utility as long as the consumer is buying a
positive amount of bananas; if the consumer isnt buying any bananas, the change in price (of
course!) has no effect on utility.

3. Perfect Complements
3a) Indifference curves are L-shaped, with the vertex of the L along the line ax1=x2. See MWG
p. 49. If you have trouble visualizing the indifference curves, you can always plug in some
different values of x1 and x2 to see what happens to U(x). For example, say that a=2, x1=1, and
x2=1. Then min((2*1),1)=1. You can keep increasing x1 forever, and still stay on the same
indifference curve, e.g. min((2*50000),1)=1. You can decrease x1 all the way to and still stay
on the same indifference curve because min((2*1/2),1)=1. Now, holding x1=1/2, you can keep
increasing x2 and still stay on the same indifference curve. And so on.
3b) Because the curves are L-shaped, you can't solve this problem by taking a derivative.
Instead, look at the graph you've drawn and use your intuition. Hopefully you see that the
optimal point will be at a "kink" in one of the indifference curves, and that all of the "kinks" lie
along the line ax1=x2. Using this equation along with the budget constraint (p1x1 + p2x2 = w, by
Walras Law) implies demand functions of:
x1 ( p, w)

w
p1 ap2

and

x 2 ( p, w)

aw
p1 ap2

3c) At the prices and wealth given, this consumption bundle could conceivably be optimal under
either U(x) or V(x) you cannot distinguish between the two with this single data point. The
consumption bundle (x1,x2)=(1,1) could be optimal under U(x) if a=1. It could also be optimal
under V(x) if =1/2. Note, the utility function V(x) is again a form of Cobb-Douglas utility. As
described in (1b), the solution to the UMP with Cobb-Douglas utility says that you will spend a
constant fraction of your budget on each good, i.e. x1(p,w)=(w)/p1 and x2=((1- )w)/p2.
3d) No, this new data point does not help distinguish between the two utility functions.
Hopefully you notice that at the new point, all of the prices and wealth are exactly doubled.
Since demand is homogenous of degree 0, doubling prices and wealth gives us no new
information. If you didn't realize this right away, you could use the same logic as in (3c) to
figure out that the new data point is also consistent with U(x) if a=1 or V(x) if =1/2.
3e) With this new data point, in addition to the observation from either (3c) or (3d), you can rule
out the utility function V(x). From (3c) or (3d), V(x) could only be the true utility function if
=1/2. But if =1/2, then at the new prices and wealth, the consumer would have to adjust the
consumption bundle so that he/she is still spending of wealth on each good. Since the new
bundle is the same as the old bundle, this rules out V(x). On the other hand, the new observation
is consistent with U(x) if a=1. If a=1, then the consumption bundle (1,1) is still the best
affordable bundle under the new prices and wealth.
3f) In general, you need at least two observations to distinguish between U(x) and V(x). The
first observation established "candidate" values of a and (a=1 and =1/2, in this example).
The second observation "tests" these values (in this example, the candidate value for a survived
the test, but the candidate value for did not). However, as illustrated with the data point in
(3e), not every two observations will work. In particular, since both U(x) and V(x) are

homothetic (see, e.g., MWG p. 45), the two data points must feature different relative prices (that
is, p1/p2 cannot be the same for both observations).
OPTIONAL PROBLEMS
4.

MWG 2.D.4:

You should be able to identify the non-convexity of this budget set immediately: if you were to
draw a line connecting the points (24,0) and (a, M), the points on this line would lie outside the
budget set. What this means in practical terms is that the individual can choose to have 24 hours
of leisure (no work) and no consumption, or a hours of leisure and M consumption, but if the
individual were to choose an amount of leisure exactly of the way between a and 24, they
would get less than M in consumption. [The same is true if you pick any other fraction.] This
makes it unlikely that individuals will choose (leisure, consumption) bundles that place them on
the non-convex portion of a budget set. Try drawing some indifference curves and you will see
that depending on how steep or flat these curves are, people will tend to locate either at (24,0) or
(a,M). Moreover, two people with very similar indifference curves might end up choosing very
different bundles because of this non-convexity.
To demonstrate this non-convexity mathematically, the strategy is to find the slope of the line
connecting (24,0) and (a,M), and then show that at the point on this line where leisure=16 (or
alternatively, work=8 hours), you get a consumption level above the point on the budget set
(16,b). Thus, the first helpful step is to find the values for a and b.
The point (16,b) is attained with 8 hours of labor at a wage rate of s per hour, so b=8s. The value
of a indicates how much leisure you will have left, if you work enough hours to consume M.
You can consume M by working 8 hours at wage rate s and (16-a) hours at wage rate s:
M 8s (16 a ) s '
M 8s
16 a
s'
M 8s
a 16
s'
If we work 8 hours (leisure=16), where would this put us on the line between (24,0) and (a,M)?
If we calculate the slope of the line with respect to work hours instead of with respect to leisure
hours, we get rise/run = (M-0)/(24-a). Working 8 hours would thus give consumption of:
8M
M 8s
8
s'
And then we need only show that this quantity is larger than 8s. There are many ways to do this;
the most elegant is to notice that if we changed s to s in the above expression:
8M
8M

8s
M 8s
M
8
s
s
(continued)

Since we know from the problem that s>s,

8M
8M
8M

8s
M 8s
M 8s
M
8
8
s'
s
s
This demonstrates that the line is outside the budget set.
NOTE: A full mathematical proof was ideal, but not necessary. Instead, a descriptive answer
showing a clear understanding of the mathematical meaning of convexity as well as its practical
interpretation in this problem, along with an appropriate graphical illustration, would be
sufficient.

MWG 2.E.1, pg. 23

Walras Law:

p x p1 x1 p 2 x 2 p3 x3 w

px

p3
p p 2 p3
p2
p1
w
w
w 1
w
p1 p 2 p3
p1 p 2 p3
p1 p 2 p3
p1 p 2 p3

When =1, Walras Law holds. When 1, Walras law does not hold.
Homogeneity of Degree Zero:

p 2
p2
w
w

x1
p1 p 2 p3 p1 p1 p 2 p3 p1
p3
p3
w
w
x 2 (p1 , p 2 , p3 , w)

x2
p1 p 2 p3 p 2 p1 p 2 p3 p 2
p1
p 2
w
w
x3 (p1 , p 2 , p3 , w)

x3
p1 p 2 p3 p3 p1 p 2 p3 p3
x1 (p1 , p 2 , p3 , w)

So x1, x2, and x3 are all homogenous of degree zero. Note that x3 is homogenous of
degree zero regardless of the value of .

MWG 2.E.2, pg. 28

L

a)

p
l 1

xl
x k ( p, w) 0
p k

For a given term p l

x l
x
x x
x 1
, rewrite p l l p l l l p l xl l
p k
p k
p k xl
p k xl

Then multiply the whole equation by pk/w. This yields:

L
p l xl xl p k p k

x k ( p, w) 0

w p k xl
w
l 1
Which can be rewritten as:
L

b
l 1

b)

p
l 1

lk bk 0

xl
1
w

For a given term rewrite pl

xl
x x w p x x w
pl l l l l l
w
w xl w
w w xl

So then the entire sum can be written as:

L

b
l 1

lw 1

MWG 2.F.3 (parts a-d)

a) The weak axiom of revealed preference states that the bundle chosen by the consumer is
preferred to all other bundles the consumer could have chosen. For a mathematical definition,
see MWG p. 29.
The consumers year 1 choices reveal that he prefers (x1, x2) = (100, 100) to all other bundles
having 100x1 + 100x2 20,000; or x1 + x2 200. The consumer would be exhibiting
inconsistent behavior if he could have consumed either bundle in both years. That is, year
two consumption is such that (a) x1 + x2 200 (where x1 denotes consumption of good 1 in
year 2) and (b) the bundle (100, 100) would be affordable with new prices and wealth.
For (a) to be true, we need that x2 80.
For (b) to be true, we need that x1p1 + x2p2 100 p1 + 100 p2. Plugging in values, we get
120100 + x280 100100 + 10080, or x2 75.
Therefore, if the consumer chose a year two bundle having x2 between 75 and 80, this would
indicate inconsistent behavior.
b) This is the case if (a) the bundle from year 2 would have been affordable in year 1, but (b)
the bundle in year 1 would not have been affordable in year 2. This is the case if x2 < 75:
(a) requires x2 80.
(b) requires x2 < 75.
c) This is the case if (a) the bundle from year 1 would have been affordable in year 2, but (b)
the bundle in year 2 would not have been affordable in year 1. This is the case if x2 > 80:
(a) requires x2 75.
(b) requires x2 > 80.
d) The ranges of values given in the answers to parts a-c cover all real numbers, so we can
always make one of the three conclusions.

5. Continuity and Indifference Curves

)+
For the continuity axiom to hold, we need that for any sequence of pairs *(
with
, and
, we have
(MWG p.46). Note here
that
is a consumption bundle, and
is another consumption bundle.
a) We can define a sequence of pairs of bundles with
(
) (
) ( )
);(
We know that any point on having
pairs have
. Since

on

Since both

) pairs have
and

simply being point A:

is preferred to A (2,2). Therefore, all (

)
by continuity,
.

We go through the exact type of argument to show that

(
) (
) ( )
);(
All (

and

. Since

by continuity,

, we have shown that A ~ D.

b) If
, then by definition
and
. Since
( ), we know that
either
or
. Taking the first case of
, we know that there is a sequence of
bundles
such that
and such that
. This violates continuity,
since by continuity we should have
. A similar argument shows that we also cant have
.