Microeconomics I

Assignment 1
Due on: September 03, 2014 (before 04:00 PM)
To be submitted to Mr. Manhar (TA)

1. Consider a representative individual whose utility function is u = q1 q2 . Suppose that

he is a government employee. His salary consists of two parts: basic salary (I) and
dearness allowance (DA), which is adjusted with an increase in the price level to
neutralize the effects of inflation.
Assume that the government supplies q2 at a fixed price p2 (with the provision that
consumers can by as much as they want), but q1 is to be bought from the free market.
Therefore, D adjusts to change in p1 .
First consider the base case, where D = 0. Typically, immediately after a Pay
Commission review, salary consists only of the basic salary (I). Then over time as
prices change (in this case p1 ), the DA comes into the picture. Let the base prices
be denoted as p01 , p02 .
(a) Derive the consumers optimal consumption of q1 and q2 .
(b) Now consider the following years case, when p1 increases to p1 . What should
be the appropriate DA amount to neutralize the effect of price change? Specify
how you define the neutralization of the inflation effects.
(c) Now suppose that the economic advisor of the government proposes to revise the
DA amount and to recover half of the revised DA amount from the consumer
by increasing the price of good 2 from p02 to (p02 + t). What will be the revised
DA amount and what will be the value of t in order to neutralize the effects of

IGIDR

2014

Microeconomics I, Assignment 1

change in income and change in prices? Should you suggest the government to
accept the economic advisors proposal? Explain your answer adequately.
3+6+6=15

hours to allocate between work, L, and leisure, l. He buys a con2. A worker has L
sumption goods c which is priced at p. However, he cannot devote his entire income
to his own consumption as he has to remit a fixed amount Rs. k to support his family living in a distant village. Therefore, the worker has to make two labour supply
decisions: one for his own consumption, L1 , and another for his family, L2 , so that
L1 + L2 = L.
While he can freely choose L1 , his choice of L2 is solely dictated by the family needs.
That means, L2 must satisfy k = wL2 . The hourly wage rate w is fixed. The workers
utility function u(c, l) is quasi-concave in c and l.
(a) Write the utility maximization problem of the worker, and graphically illustrate
his choice.
(b) Derive the precise relationship between l and w (i.e.,

l
).
w

In particular, discuss

how the two labour supply curves - L1 , L2 - and aggregate labour supply depend
on w when leisure is an inferior good.
(c) Next, if k increases, how do the workers choices of c, L1 and L change? What
happens, if c is inferior?
(d) Now assume that k is sensitive to p such as k = k(p), k 0 (p) > 0. Derive

c
.
p

5+5+5+5=20

Page 2 of 4

IGIDR

2014

Microeconomics I, Assignment 1

3. Suppose that there are four commodities and that utility can be written in the
form, u(x1 , x2 , x3 , x4 ) = U (f (x1 , x2 ), x3 , x4 ), where the functions U (.) and f (.) are
differentiable.
(a) Show that the marginal rate of substitution between goods 1 and 2 is independent of the amount of good 3.
(b) Construct an example of a utility function of this form such that the marginal
rate of substitution between goods 3 and 4 depends on the amounts of goods 1
and 2.
5+5=10

4. Suppose that a consumers utility function is given by u(x1 , x2 ) = ax1 + ax2

x21 +2x1 x2 +x22
,
2

where a > 0 and (0, 1). Let p1 , p2 and m denote price of good

1, price of good 2 and the consumers money income, respectively. The marginal
utility of money of consumer is one.
(a) Write the consumers utility maximization problem and derive her direct demand functions.
(b) If only the price of good 1 changes, what are the income and substitution effects
of the price change for the consumer?
(c) What is the consumers surplus, if prices are p01 and p02
(d) Can you tell us whether the consumers preferences satisfy the Gorman Form?
(e) Can you derive the expenditure function of the consumer? What are the compensated demand functions of the consumer?
(f) Now suppose that there are n consumers. The utility function of consumer i is
ui (x1 , x2 ) = ai x1 +ai x2

x21 +2x1 x2 +x22

,
2

where a > 0 and (0, 1); i = 1, 2, .....n.

Income of consumer i is mi . Marginal utility of money of each consumer is one.

Is it possible to represent their preferences through a representative consumers
Page 3 of 4

IGIDR

2014

Microeconomics I, Assignment 1

utility function? If no, why? If yes, what will be the (direct) utility function of
the representative consumer? What are the aggregate (direct) demand functions
of good 1 and good 2? Can you calculate the aggregate consumer surplus, if
prices are p01 and p02 ?
3+2+3+4+3+(5+2+3)=25

Page 4 of 4