Problem 4 Suggested Solution

Fanqi Shi

November 29, 2016

Using similar transformations to those in the problem, we can write

the Hicksian demand, expenditure function and indirect utility function as
h1 (p1 , u), e(p1 , u) and v(p1 , y). Hence, we can write equivalent variation as:
EV = e(p1 , v(p01 , y)) e(p01 , v(p01 , y)) (definition)
e(p, v(p01 , y))
Z p1
= dp
p01 p
Z p1
= h1 (p, v(p01 , y))dp (Shephards lemma)
p0
Z 1p1
= d1 (p, e(p, v(p01 , y)))dp (Marshallian-Hicksian identity)
p01

Similary, we can write compensating variation as:

CV = e(p1 , v(p1 , y)) e(p01 , v(p1 , y)) (definition)
Z p1
e(p, v(p1 , y))
= dp
0
p1 p
Z p1
= h1 (p, v(p1 , y))dp (Shephards lemma)
p0
Z 1p1
= d1 (p, e(p, v(p1 , y)))dp (Marshallian-Hicksian identity)
p01

Moreover, the change of consumer surplus is given by:

Z p1
CS = d1 (p, y)dp
p01

Now, we have:
Z p1 Z p1
EV CS = d1 (p, e(p, v(p01 , y)))dp d1 (p, y)dp
p0 p01
Z 1p1
= [d1 (p, e(p, v(p01 , y))) d1 (p, y)]dp
p01

1
Notice p1 > p > p01 , so v(p01 , y) > v(p, y) and e(p, v(p01 , y)) > e(p, v(p, y)) = y
and we can apply the bound in the problem:
Z p1

EV CS [e(p, v(p01 , y)) y]dp
p01 p

Now, notice the consumer can still achieve utility v(p01 , y) with the bundle
D(p01 , p1 , y) at price (p, p1 ), so:

e(p, v(p01 , y))y (p, p1 )D(p01 , p1 , y)(p01 , p1 )D(p01 , p1 , y) = (pp01 )d1 (p01 , y)

It follows that:
Z p1
p1
EV CS (p p01 )d1 (p01 , y)dp = (p1 p01 p01 ln )d1 (p01 , y)
p01 p p01

On the other hand:

Z p1 Z p1
CS CV = d1 (p, y)dp d1 (p, e(p, v(p1 , y)))dp
p0 p01
Z 1p1
= [d1 (p, y) d1 (p, e(p, v(p1 , y)))]dp
p01

Again notice p1 > p > p01 , so v(p1 , y) < v(p, y) and e(p, v(p1 , y)) < e(p, v(p, y)) =
y and we can apply the bound in the problem:
Z p1

CS CV [y e(p, v(p1 , y))]dp
p01 p

Consider the term y e(p, v(p1 , y)). Using similar simplification as be-
fore, we can write it as:

y e(p, v(p1 , y)) = e(p1 , v(p1 , y)) e(p, v(p1 , y)) (definition of expenditure function)
Z p1
e(q, v(p1 , y))
= dq
p q
Z p1
= h1 (q, v(p1 , y))dq (Shephards lemma)
p
Z p1
= d1 (q, e(q, v(p1 , y)))dq (Marshallian-Hicksian identity)
p

So we have:
Z p1
p1
Z
CS CV [ d1 (q, e(q, v(p1 , y)))dq]dp
p01 p p

2
By continuous differentiability, we can apply the Fubinis Theorem (change
the order of integral):
Z p1 Z q
1
CS CV d1 (q, e(q, v(p1 , y)))[ dp]dq
p0 p01 p
Z 1p1
q
= ln d1 (q, e(q, v(p1 , y)))dq
p01 p01

Rewriting q as p and noticing v(p1 , y) < v(p, y), we have:

Z p1
p
CS CV ln
d1 (p, e(p, v(p1 , y)))dp
p01 p01
Z p1
p
ln 0 d1 (p, e(p, v(p, y)))dp
p0 p 1
Z 1p1
p
= ln 0 d1 (p, y)dp
p01 p1

As good 1 is normal and p1 > p > p01 , using integration by parts, we

have:
Z p1
p p1
CS CV ln 0 d1 (p01 , y)dp = (p1 ln 0 + p01 p1 )d1 (p01 , y)
p01 p1 p1

To sum up, we have:

p1
0 EV CS (p1 p01 p01 ln )d1 (p01 , y)
p01

and
p1
0 CS CV (p1 ln + p01 p1 )d1 (p01 , y)
p01