Assignment 4: Solutions

Intermediate Microeconomics, Fall 2010

Question 1
U (h, x) = .3 ln(T − h) + .7 ln x. px = 1 T = 16. w is wage, h is hours worked and must satisfy
0 ≤ h ≤ T . Non-labor income is I = 80. Total labor income is wh. Total income wh + I is all
spent on x so given h, x(h) = wh + I. Plug these in: U (h, x(h)) = .3 ln(T − h) + .7 ln(wh + I). The
FOC is

dU (h, x(h)) −.3 .7w .3I

= + = 0; .3(wh+I) = .7(T −h); .3wh+.7wh = .7wT −.3I; h∗ = .7T −
dh T − h wh + I w

This is the optimal choices as long as the solution h∗ > 0. However, at smaller wages, this produces
a negative answer and the individual chooses the corner solution h∗ = 0. (The corner solution
h = T gives utility −∞)
(a) The reservation wage w∗ is the smallest wage that does not give the h∗ = 0 corner solution.
It solves h∗ = .7T − .3I/w∗ = 0. The solution is w∗ = .3I/.7T = 3I/7T . For I = 80 and T = 16,
w∗ = 2.14.
(b) If w = 8, h∗ = .7T − .3I/w = .7 ∗ 16 − .3 ∗ 80/8 = 8.2.
(c) If 20 percent of the earnings are taken by the government, then individual takes home wage
w0 = (1 − .2)w = .8 ∗ 8 = 6.4 per hour. h∗ = .7T − .3I/w0 = .7 ∗ 16 − .3 ∗ 80/6.4 = 7.45
(d) If non-labor income is also taxed at 20 percent, then the individual takes home non-labor
income I 0 = (1 − .2)I = .8 ∗ 80 = 64 and h∗ = .7T − .3I 0 /w0 = .7 ∗ 16 − .3 ∗ 64/6.4 = 8.2.

Question 2
50 individuals of type 1 have U1 (a, b) = a + b, I=10. They demand a∗1 = 0, b∗1 = I/pb if pa /pb >
1/1 = 1 and a∗1 = I/pa , b∗1 = 0 if pa /pb < 1. 50 individuals of type 2 have U2 (a, b) = a + b, I=10.
They demand a∗2 = 0, b∗2 = I/pb if pa /pb > 2/1 = 2 and a∗2 = I/pa , b∗2 = 0 if pa /pb < 2.
(a) pa = .5, pb = 1. pa /pb = .5 so type 1 individuals demand a∗1 = I/pa = 10/.5 = 20, b∗1 = 0
and type 2 individuals demand a∗2 = I/pa = 10/.5 = 20, b∗2 = 0. Total market demand is a∗ =
50a∗1 + 50a∗2 = 50 ∗ 20 + 50 ∗ 20 = 2000, b∗ = 50b∗1 + 50b∗2 = 50 ∗ 0 + 50 ∗ 0 = 0.

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 (b) pa = .3, pb = .2. pa /pb = 1.5 so type 1 individuals demand a∗1 = 0, b∗1 = I/pb = 10/.2 = 50
and type 2 individuals demand a∗2 = I/pa = 10/.3 = 33.33, b∗2 = 0. Total market demand is
a∗ = 50a∗1 + 50a∗2 = 50 ∗ 0 + 50 ∗ 33.33 = 1667, b∗ = 50b∗1 + 50b∗2 = 50 ∗ 50 + 50 ∗ 0 = 2500.
(c) pa = 10, pb = 4. pa /pb = 2.5 so type 1 individuals demand a∗1 = 0, b∗1 = I/pb = 10/4 = 2.5
and type 2 individuals demand a∗2 = 0, b∗2 = I/pb = 10/4 = 2.5. Total market demand is a∗ =
50a∗1 + 50a∗2 = 50 ∗ 0 + 50 ∗ 0 = 0, b∗ = 50b∗1 + 50b∗2 = 50 ∗ 2.5 + 50 ∗ 2.5 = 250.

Question 3
50 individuals of type 1 have U1 (a, b) = .3 ln a + .7 ln b and income I1 . They demand a∗1 =
.3I1 /pa , b∗1 = .7I1 /pb . 50 individuals of type 2 have U1 (a, b) = .7 ln a + .3 ln b and income I2 .
They demand a∗2 = .7I2 /pa , b∗2 = .3I2 /pb .
(a) I1 = 30, I2 = 10. Total market demand is a∗ = 50a∗1 + 50a∗2 = 50 ∗ .3 ∗ I1 /pa + 50 ∗ .7 ∗ I2 /pa =
50 ∗ .3 ∗ 30/pa + 50 ∗ .7 ∗ 10/pa = 800/pa , b∗ = 50b∗1 + 50b∗2 = 50 ∗ .7 ∗ I1 /pb + 50 ∗ .3 ∗ I2 /pb =
50 ∗ .7 ∗ 30/pb + 50 ∗ .3 ∗ 10/pb = 1200/pb .
(b) I1 = 20, I2 = 20. Total market demand is a∗ = 50a∗1 + 50a∗2 = 50 ∗ .3 ∗ I1 /pa + 50 ∗ .7 ∗ I2 /pa =
50 ∗ .3 ∗ 20/pa + 50 ∗ .7 ∗ 20/pa = 1000/pa , b∗ = 50b∗1 + 50b∗2 = 50 ∗ .7 ∗ I1 /pb + 50 ∗ .3 ∗ I2 /pb =
50 ∗ .7 ∗ 20/pb + 50 ∗ .4 ∗ 20/pb = 1000/pb . Giving more income to the individuals who prefer good
a increases the total consumption of a.
(c) Now everyone has the same Cobb-Douglass utility U1 (a, b) = U2 (a, b) = U (a, b) = α ln a +
(1 − α) ln b (I don’t know if α is supposed to be .3 or .7 but it doesn’t matter.) but potentially
different incomes. The 50 individuals of type 1 demand a∗1 = αI1 /pa , b∗1 = (1 − α)I1 /pb . The
50 individuals of type 2 have demand a∗2 = αI2 /pa , b∗2 = (1 − α)I2 /pb . Total market demand is
a∗ = 50a∗1 + 50a∗2 = 50αI1 /pa + 50αI2 /pa = α · 50(I1 + I2 )/pa , b∗ = 50b∗1 + 50b∗2 = 50(1 − α)I1 /pb +
50(1 − α)I2 /pb = (1 − α) · 50(I1 + I2 )/pb . So the answer is “No.” Total market demand depends
only on the total income 50(I1 + I2 ), not how it’s distributed between the two types. (Note that
this result holds for the Cobb-Douglass utility function but not for all utility functions.)