UN 3211

Intermediate Microeconomics Section II

—
Problem Set 3- Due Wednesday October 2nd @
6pm (on Gradescope)

Instructor
Wouter V ERGOTE
]
Teaching Assistants
Yu Kyung Koh, Matt Mazewski, Alexander Unver-Papalexopoulos and Zhouyao Xie

Fall 2019
Question 1 Intertemporal choice (4 points)
Adrian makes his consumption and saving decisions for the next two years. His income this
month is $1100, and he knows that he will get a raise next year and receive $1200. The price level
is constant and equal to 1 in both years. The current interest rate (at which he is free to borrow
or lend) is 20%. Denoting this year’s consumption by x and next years’s by y, Adrian’s utility
function is U (x, y) = xy 2 .

1. How much will Adrian consume this year? and next year? Does he save or borrow this year?
(2 points)

2. How would your answer change if Adrian does not receive any interest (interest of 0%) on
any money he lends while he needs to pay 20% on money he borrows? (2 points)

Question 2. Revealed preferences(2 points)

Adriana has an income of $600 per week and buys two goods, x and y. Initially she faces prices
(px , py ) = ($4, $2) and chooses basket (x, y) = (120, 60). Later prices change to (p0x , p0y ) = ($3, $3)
and she chooses (x0 , y 0 ) = (80, 120). Illustrate these choices together with the associated budget
line. Can we tell from the data whether Adriana is a utility maximizer? Explain carefully.

Question 3. Theory of Demand (4 points)

Kim chooses between two goods, x and y, with prices px and py , respectively. She has an income
I and her preferences are represented by the utility function U (x, y) = 4xy.

1. Assuming that an interior solution exists to the constrained utility maximization problem,
derive Kim ’s Marshallian demand function for each of the two goods. Are both goods normal?
Explain

2. Find the indirect utility function, V (px , py , I).

3. Derive Kim’s Hicksian demand function for each of the two goods and the expenditure func-
tion. Compare the Marshallian demand for good x and the Hicksian demand for good x. Are
these different functions? If so, why? If not, why not?

4. Suppose that I = 16, px = 1 and py = 1. How much of good x and good y will Kim optimally
choose?

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Question 1: Intertemporal choice (4 points):
1.1) max U(x,y) = xy2
𝑦 1,200 𝑦
s.t.: 𝑥 + 1.20 = 1,100 + 1.20
==> 𝑥 + 1.20 − 2,100 = 0
𝑦
Maximize Langrangian: max L(x,y,λ) = 𝑥𝑦 2 − 𝜆 ∗ (𝑥 + 1.20 − 2,100)

FOC assuming constraint is binding

𝑑𝐿
(1)
𝑑𝑥
= 𝑦2 − 𝜆 = 0 ➔ 𝑦2 = 𝜆
𝑑𝐿 𝜆 𝜆
(2)𝑑𝑦 = 2𝑥𝑦 − 1.20 = 0 ➔ 𝑥𝑦 = 2.40

𝑑𝐿 𝑦 𝑦
(3)𝑑𝜆 = 𝑥 + 1.20 − 2,100 = 0 ➔ 𝑥 + 1.20 = 2,100

From (1) and (2) we get ➔ 𝑦 = 2.4𝑥

From 𝑦 = 2,4𝑥 and (3) we get ➔ x* = 700 and y* = 1,680 (as monthly expenditure)

Since x* < I1 = 1,100 ➔ during the first period we have savings equal to I1 - x* = 1,100 – 700 = 400

The answers we have found are expenditure and savings per month. Yet, we care about the yearly
expenditure and savings. To find these we multiply by 12

x* = 700 ∗ 12 = 8,400

y* = 1680 ∗ 12 = 20,160

savings = 400 ∗ 12 = 4,800

To check our original assumption of a binding constraint (ie. λ > 0):

a𝜆 = 𝑦 2 = 1,6802 > 0

1.2) We now show that if the interest rate drops to zero on his savings, Adrian would still lend money
and prefer not to borrow by showing that if, hypothetically, the interest rate was equal to zero for both
borrowing and lending, Adrian would still prefer to lend money. So, at a higher cost of borrowing he would
certainly not borrow.

max U(x,y) = xy2

s.t. : 𝑥 + 𝑦 = 1,100 + 1,200➔ 𝑥 + 𝑦 − 2,300 = 0

Maximize Langrangian: max L(x,y,λ) = 𝑥𝑦 2 − 𝜆 ∗ (𝑥 + 𝑦 − 2,300)

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FOC assuming constraint is binding
𝑑𝐿
(1)
𝑑𝑥
= 𝑦2 − 𝜆 = 0 ➔ 𝑦2 = 𝜆
𝑑𝐿 𝜆
(2)𝑑𝑦 = 2𝑥𝑦 − 𝜆 = 0 ➔ 𝑥𝑦 = 2

𝑑𝐿
(3)𝑑𝜆 = 𝑥 + 𝑦 − 2,300 = 0 ➔ 𝑥 + 𝑦 = 2,300

From (1) and (2) we get ➔ 𝑦 = 2𝑥

2,300 2
From 𝑦 = 2𝑥 and (3) we get ➔ x* = 3
and y* = 3 ∗ 2,300 (as monthly expenditure)
2,300 1,000
Since x* < I1 = 1,100 ➔ during the first period we have savings equal to I1 - x* = 1,100 – 3
= 3

To check our original assumption of a binding constraint (ie. λ > 0):

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a𝜆 = 𝑦 2 = (3 ∗ 2,300)2 > 0

Now imagine the interest rate at which Adrian can borrow goes up to 20%. This will not change his optimal
savings decision. Since Adrian did not borrow any money when the interest rate was 0, he will definitely
not borrow any money now that the cost of borrowing is higher.

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Question 2: Revealed Preferences (2 points)
Adriana has income: I = $600

With (Px,PY) = ($4,$2) ➔ Adriana chooses bundle A: (x,y) = (120,60)

With (Px’,PY’) = ($3,$3) ➔ Adriana chooses bundle B: (x’,y’) = (80,120)

At the original prices (Px,PY) = ($4,$2)

Cost of bundle A: (x,y) = (120,60) ➔ C = 120 ∗ 4 + 60 ∗ 2 = $600

Cost of bundle B: (x’,y’) = (80,120) ➔ C = 80 ∗ 4 + 120 ∗ 2 = $560

Since bundle A cost more than bundle B, and yet Adriana chose A over B, she strictly prefers A ➔ A > B

At the new prices (Px’,PY’) = ($3,$3)

Cost of bundle A: (x,y) = (120,60) ➔ C = 120 ∗ 3 + 60 ∗ 3 = $540

Cost of bundle B: (x’,y’) = (80,120) ➔ C = 80 ∗ 3 + 120 ∗ 3 = $600

Since bundle B cost more than bundle A, and yet Adriana chose B over A, she strictly prefers B ➔ B > A

In the first situation Adriana evaluates A > B and in the second situation she evaluates B > A. Adriana is,
therefore, not a utility maximizer.

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Question 3: Theory of Demand (4 points)
3.1) max U(x,y) = 4xy

s.t.: Px∗ 𝑥 + Py∗ 𝑦 = I

Maximize Langrangian: max L(x,y,λ) = 4xy +𝜆 ∗ (I - Px∗ 𝑥 − Py ∗ 𝑦)

FOC assuming constraint is binding

𝑑𝐿
(1)
𝑑𝑥
= 4𝑦 − 𝜆 ∗ Px = 0 ➔ 4𝑦 = 𝜆 ∗ Px
𝑑𝐿
(2)
𝑑𝑦
= 4𝑥 − 𝜆 ∗ Py = 0 ➔ 4𝑦 = 𝜆 ∗ Py
𝑑𝐿
(3) = I - Px∗ 𝑥 − Py ∗ 𝑦 = 0 ➔ Px∗ 𝑥 + Py∗ 𝑦 = I
𝑑𝜆

From (1) and (2) we get ➔ Px∗ 𝑥 = Py∗ 𝑦

𝑰 𝑰
From Px∗ 𝑥 = Py∗ 𝑦 and (3) we get ➔ x*(Px,Py,I) = 𝟐𝑷𝒙 & y*(Px,Py,I) = 𝟐𝑷𝒚

To check our original assumption of a binding constraint (ie. λ > 0):

4𝑦 4 I 2𝐼
a𝜆 = = ∗ = >0
𝑃𝑥 𝑃𝑥 2Py 𝑃𝑥∗𝑃𝑦

To see if the goods are normal, we need to find the income elasticity of demand
𝑰 dx 1 dx I 1 I 𝐼
x*=
𝟐𝑷𝒙
➔ dI
=
2∗Px
➔ ∗
dI x
= ∗
2∗Px x
➔ εΙ x =
2𝑃𝑥∗𝑥
𝐼
Yet, since Px∗ 𝑥 = Py∗ 𝑦, we know that 2Px∗ 𝑥 = 𝐼 ➔ εΙx = 𝐼 = 1
𝐼 𝐼
The same is true for the income elasticity of demand for good y ➔ εΙy = 2𝑃𝑦∗𝑦 = 𝐼 = 1

Since εΙx = εΙy = 1, both goods are normal.

3.2) To calculate the utility function, we plug x*(Px,Py,I) and x*(Px,Py,I) into U = 4 ∗ 𝒙𝒚
U(x,y) = 4xy
𝐼 𝐼 𝐼2 𝑰𝟐
U( x*(Px,Py,I) , y*(Px,Py,I) ) = 4 ∗ ∗ = ➔ V(Px,Py,I) =
2𝑃𝑥 2𝑃𝑦 𝑃𝑥∗𝑃𝑦 𝑷𝒙∗𝑷𝒚

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3.3) min Px∗ 𝑥 + Py∗ 𝑦

s.t.: 4xy = U

Minimize Langrangian: min L(x,y,λ) = Px∗ 𝑥 + Py∗ 𝑦 + 𝜆 ∗ (U − 4xy )

FOC assuming constraint is binding

𝑑𝐿
(1)
𝑑𝑥
= Px − 4𝜆 ∗ 𝑦 = 0 ➔ Px= 4𝜆 ∗ 𝑦
𝑑𝐿
(2)𝑑𝑦 = Py − 4𝜆 ∗ 𝑥 = 0 ➔ Py = 4𝜆 ∗ 𝑥

𝑑𝐿
(3)𝑑𝜆 = U − 4xy = 0 ➔ 4xy = U

From (1) and (2) we get ➔ Px∗ 𝑥 = Py∗ 𝑦

𝑈 𝑃𝑦 𝑈 𝑃𝑥
From Px∗ 𝑥 = Py∗ 𝑦 and (3) we get ➔ 𝑥 2 = 4
∗ 𝑃𝑥 & 𝑦 2 = 4
∗ 𝑃𝑦

𝟏 𝑷𝒚 .𝟓 𝟏 𝑷𝒙 .𝟓
Thus xH(Px,Py,U) = 𝟐
∗ (𝑷𝒙 ∗ 𝑼) & xY(Px,Py,U) = 𝟐
∗ (𝑷𝒚 ∗ 𝑼)

To check our original assumption of a binding constraint (ie. λ > 0):

1 𝑃𝑥 .5 𝑃𝑥
Px= 4𝜆 ∗ 𝑦 ➔ Px= 4𝜆 ∗ ∗ ( ∗ 𝑈) ➔ Px2= 4𝜆2 ∗ ∗𝑈➔
2 𝑃𝑦 𝑃𝑦

1 𝑃𝑥∗𝑃𝑦 .5
a𝜆 = 2 ∗ ( 𝑈
) >0

To calculate the expenditure function, we plug xH(Px,Py,U) and xY(Px,Py,U) into E = Px∗ 𝒙 + Py∗ 𝒚
𝟏 𝑷𝒚 .𝟓 𝟏 𝑷𝒙 .𝟓
E( xH(Px,Py,U) , xY(Px,Py,U) ) = Px * xH(Px,Py,U) + Py * xY(Px,Py,U) = Px * 𝟐 ∗ (𝑷𝒙 ∗ 𝑼) + Py * 𝟐 ∗ (𝑷𝒚 ∗ 𝑼)

E(Px,Py,U) = (𝑼 ∗ 𝑷𝒙 ∗ 𝑷𝒚).𝟓

𝑰
The Marshallian demand function for x is: x*(Px,Py,I) =𝟐𝑷𝒙 ,

𝟏 𝑷𝒚 .𝟓
While the Hicksian is: xH(Px,Py,U) = 𝟐
∗ (𝑷𝒙 ∗ 𝑼)

In general, these functions are different. They depend on different variables and if we draw them on a
graph, we get different function values. However, at one (and only one) bundle they yield exactly the
𝐼2
same function value: That happens whenever we set U=V(Px,Py,I). To see this, we can substitute U = 𝑃𝑥∗𝑃𝑦
into the Hicksian demand function to get the Marshallian demand function.

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 1 𝑃𝑦 .5 𝐼2
xH(Px,Py,U) = 2
∗ (𝑃𝑥 ∗ 𝑈) & U = 𝑃𝑥∗𝑃𝑦 yield:

.5 .5
1 𝑃𝑦 𝐼2 1 𝐼2 𝐼
x= ∗( ∗ ) = ∗( ) = = x*(Px,Py,I)
2 𝑃𝑥 𝑃𝑥∗𝑃𝑦 2 𝑃𝑥 2 2𝑃𝑥

3.4) Since we have the price of goods x & y and the income as inputs, we use the Marshallian Demand

I = 16, Px = 1, Py = 1
𝐼 16
x*(Px,Py,I) = 2𝑃𝑥 ➔ x*(1,1,16) =2∗1 = 8
𝐼 16
y*(Px,Py,I) = ➔ x*(1,1,16) = =8
2𝑃𝑦 2∗1

Kim will choose x*(Px,Py,I) = y*(Px,Py,I) = 8