Answers to some selected exercises to Consumer

Theory
R Finger
Advanced Microeconomics ECH-32306

September 2012

Please report mistakes in typesetting. The current version is based on inputs

from Thomas Herzfeld.
1.6 Cite a credible example were the preferences of an ‘ordinary consumer’
would be unlikely to satisfy the axiom of convexity.
Answer : Indifference curves representing satiated preferences don’t
satisfy the axiom of convexity. That is, reducing consumption would
result in a higher utility level. Negative utility from consumption of
‘bads’ (too much alcohol, drugs, unhealthy food etc.) would rather
result in concave preferences.
Adapted from J and R Sketch a few level sets for the following utility
functions: y = x1 + x2 and y = min[x1 , x2 ]. Discuss the properties
of the presented preferences. Derive Marshallian demand functions,
indirect utility functions and expenditure functions.
Answer
x2 x2
6 6
@
@@
@ @@
@ @@
x1 x1
@ - -
(a) y = x1 + x2 (b) y = min(x1 , x2 )

Figure 1: Sets to Exercise

See lecture notes and handout on utility functions for other solutions.

Adapted from J and R Suppose f (x1 , x2 ) = (x1 x2 )2 and g(x1 , x2 ) =

(x21 x2 )3 to be utility functions.

1
 (a) f (x1 , x2 ) is homogeneous. What is its degree?
f (tx1 , tx2 ) = t4 (x1 x2 )2 k = 4

(b) g(x1 , x2 ) is homogeneous. What is its degree?

g(tx1 , tx2 ) = t9 (x21 x2 )3 k = 9

(c) h(x1 , x2 ) = f (x1 , x2 )g(x1 , x2 ) is homogeneous. What is its degree?

h(x1 , x2 ) = x81 x52 h(tx1 , tx2 ) = t13 (x81 x52 k = 13 Obviously, when-
ever two functions are homogeneous of degree m and n, their product
must be homogeneous of degree m + n.

(d) k(x1 , x2 ) = g (f (x1 , x2 ), f (x1 , x2 )) is homogeneous. What is its degree?

k(tx1 , tx2 ) = t36 (x1 x2 )18 k = 36

(e) Prove that whenever f (x1 , x2 ) is homogeneous of degree m and g(x1 , x2 )

is homogeneous of degree n, then k(x1 , x2 ) = g (f (x1 , x2 ), f (x1 , x2 )) is
homogeneous of degree mn.
k(tx1 , tx2 ) = [tm (f (x1 , x2 ), f (x1 , x2 ))]n k = mn

1.12 Suppose u(x1 , x2 ) and v(x1 , x2 ) are utility functions.

(a) Prove that if u(x1 , x2 ) and v(x1 , x2 ) are both homogeneous of

degree r, then s(x1 , x2 ) ≡ u(x1 , x2 ) + v(x1 , x2 ) is homogeneous of
degree r.
Answer : Whenever it holds that tr u(x1 , x2 ) = u(tx1 , tx2 ) and
tr v(x1 , x2 ) = v(tx1 , tx2 ) for all r > 0, it must also hold that
tr s(x1 , x2 ) ≡ u(tx1 , tx2 ) + v(tx1 , tx2 ) = tr u(x1 , x2 ) + tr v(x1 , x2 ).
(b) Prove that if u(x1 , x2 ) and v(x1 , x2 ) are quasiconcave, then m(x1 , x2 ) ≡
min{u(x1 , x2 ), v(x1 , x2 )} is also quasiconcave.
Answer : Forming a convex combination of the two functions u
and v and comparing with m(xt ) satisfies the definition of quasi-
concavity:

When u(xt ) ≥ min u(x1 ), u(x2 ) and



v(xt ) ≥ min v(x1 ), v(x2 ) so



m(xt ) ≥ min u(xt ), v(xt ) .



1.20 Suppose preferences are represented by the Cobb-Douglas utility func-

tion, u(x1 , x2 ) = Axα1 x21−α , 0 < α < 1, and A > 0. Assuming an
interior solution, solve for the Marshallian demand functions.

2
 Answer : Use either the Lagrangian or the equality of Marginal Rate
of Substitution and price ratio. The Lagrangian is
L = Axα1 x1−α
2 + λ(y − p1 x1 − p2 x2 ). The first-order conditions (FOC)
are
∂L
= αAxα−1
1 x1−α
2 − λp1 = 0
∂x1
∂L
= (1 − α)Axα1 x−α
2 − λp2 = 0
∂x2
∂L
= y − p1 x1 − p2 x2 = 0
∂λ
By dividing first and second FOC and some rearrangement, we get
αx2 p2
either x1 = (1−α)p 1
or x2 = (1−α)p
αp2
1 x1
. Substituting one of these ex-
pressions into the budget constraint, results in the Marshallian demand
(1−α)y
functions: x1 = αy
p1 and x2 = p2 .

1.21 We’ve noted that u(x) is invariant to positive monotonic transforms.

One common transformation is the logarithmic transform, ln(u(x)).
Take the logarithmic transform of the utility function in 1.20; then,
using that as the utility function, derive the Marshallian demand func-
tions and verify that they are identical to those derived in the preceding
exercise (1.20).
Answer : Either the Lagrangian is used or the equality of Marginal
Rate of Substitution with the price ratio. The Lagrangian is
L = ln(A) + α ln(x1 ) + (1 − α) ln(x2 ) + λ(y − p1 x1 − p2 x2 ). The FOC
are
∂L α
= − λp1 = 0
∂x1 x1
∂L (1 − α)
= − λp2 = 0
∂x2 x2
∂L
= y − p1 x1 − p2 x2 = 0
∂λ
(1−α)y
The Marshallian demand functions are: x1 = αyp1 and x2 = p2 .
They are exactly identical to the demand functions derived in the
preceding exercise.

1.22 We can generalise further the result of the preceding exercise. Suppose
that preferences are represented by the utility function u(x). Assum-
ing an interior solution, the consumer’s demand functions, x(p, y), are
determined implicitly by the conditions in (1.10). Now consider the
utility function f (u(x)), where f 0 > 0, and show that the first–order
conditions characterising the solution to the consumer’s problem in
both cases can be reduced to the same set of equations. Conclude

3
 from this that the consumer’s demand behavior is invariant to posi-
tive monotonic transforms of the utility function.
Answer : The set of first–order conditions for a utility function, as-
suming a linear budget constraint, are as follows:
∂L ∂u
= − λpi
∂xi ∂xi
∂L ∂u
= − λpj
∂xj ∂xj
∂u/∂xi pi
=
∂u/∂xj pj

The set of first–order conditions for a positive monotone transform of

a utility function, assuming a linear budget constraint, are as follows:

∂L ∂f (u) ∂u(x)
= − λpi
∂xi ∂u ∂xi
∂L ∂f (u) ∂u(x)
= − λpj
∂xj ∂u ∂xj
∂f (u)/∂u ∂u/∂xi pi
=
∂f (u)/∂u ∂u/∂xj pj

After forming the Marginal Rate of Substitution, the outer derivative

cancels out. Therefore, the demand function should be unaffected by
the positive monotonic transformation of the utility function.

1.24 Let u(x) represent some consumer’s monotonic preferences over

x ∈ Rn+ . For each of the functions F (x) that follow, state whether
or not f also represents the preferences of this consumer. In each
case, be sure to justify your answer with either an argument or a
counterexample.
Answer :

(a) f (x) = u(x) + (u(x))3 Yes, all arguments of the function u are trans-
formed equally by the third power. Checking the first- and second-
order partial derivatives reveals that, although the second-order partial
is not zero, the sign of the derivatives is always invariant and positive.

∂2f ∂2u ∂u 2
2∂ u
= + 6(u(x)) + 3(u(x)
∂x2i ∂x2i ∂xi ∂x2i

Thus, f represents a monotonic transformation of u.

4
 (b) f (x) = u(x) − (u(x))2 No, function f is decreasing with increasing
consumption for any u(x) < (u(x))2 . Therefore, it can not represent
the preferences of the consumer. It could do so if the minus sign is
replaced by a plus sign.

(c) f (x) = u(x) + ni=1 xi Yes, the transformation is a linear one, as the
P
first partial is a positive constant, here one, and the second partial
of the transforming function is zero. Checking the partial derivatives
∂f ∂u ∂2f 2
proves this statement: ∂x i
= ∂x i
+ 1 and ∂x2
= ∂∂xu2 .
i i

1.38 Complete the proof of Theorem 1.9 by showing that

xh (p, u) = x (p, e(p, u)).
Answer : We know that at the solution of the utility maximisation or
expenditure minimisation problem e(p, u) = y and u = v(p, y). Sub-
stitute the indirect utility function v into the Hicksian demand func-
tion gives xh (p, v(p, y)). As the new function is a function of prices
and income only, it is identical to the Marshallian demand function.
Furthermore, by replacing income by the expenditure function we get
the expression x (p, e(p, u)). Carefully check the proof on page 45 and
try to follow the argumentation also in this case.

1.40 Prove that Hicksian demands are homogeneous of degree zero in

prices.
Answer : We know that the expenditure function must be homoge-
neous of degree one in prices. Because any Hicksian demand function
equals, due to Shephard’s lemma, the first partial derivative of the
expenditure function and, additionally, we know that the derivative’s
degree of homogeneity is k − 1 (Theorem A2.6). The Hicksian demand
functions must be homogeneous of degree 1 − 1 = 0 in prices.

1.42 For expositional purposes, we derived Theorems 1.14 and 1.15 sep-
arately, but really the second one implies the first. Show that when the
substitution matrix σ(p, u) is negative semidefinite, all own–substitution
terms will be nonpositive.
Answer : Theorem 1.15 implies Theorem 1.14 because all elements of
the substitution matrix represent second–order partial derivatives of
the expenditure function. The diagonal elements of this matrix must
be negative because the expenditure function is required to be con-
cave in prices. Subsequently, any compensated demand function is
required to be non–increasing in its own price. With the substitution
matrix being negative semidefinite, all principal minors (not only the
leading ones) will be non-positive. Removing all but one columns and
rows (with the same number) will leave us diagonal elements, i.e. all
own-substitution terms.

5
Giffen behavior Read the article of Jensen and Miller. Giffen Behavior
and Subsistence Consumption. Am Econ Rev. 2008 September 1;
98(4), pp. 1553 to 1577. Recall and discuss the role of substitution
and income effects.

1.43 In a two-good case, show that if one good is inferior, the other good
must be normal.
Answer : The Engel-aggregation in a two-good case is the product of
the income elasticity and the repsective expenditure share s1 η1 +s2 η2 =
1. An inferior good is characterised by a negative income elasticity,
thus, one of the two summands will be less than zero. Therefore, to
secure this aggregation, the other summand must be positive (even
larger one) and the other commodity must be a normal good (even a
luxury item).

1.60 Show that the Slutsky relation can be expressed in elasticity form
as ij = hij − sj ηi , where hij is the elasticity of the Hicksian demand
for xi with respect to price pj , and all other terms are as defined in
Definition 1.6.
Answer : The Slutsky relation is given by

∂xi ∂xhi ∂xi

= − xj .
∂pj ∂pj ∂y

Multiplying the total expression with y/y and pj gives

∂xi ∂xhi pj xj ∂xi

pj = pj − y.
∂pj ∂pj y ∂y

By assuming that xhi = xi before the price change occurs, we can

divide all three terms by xi . The result of this operation is

∂xi pj ∂xhi pj ∂xi y

= − sj
∂pj xi ∂pj xi ∂y xi

This is equivalent to: ij = hij − sj ηi

4.19 A consumer has preferences over the single good x and all other goods
m represented by the utility function, u(x, m) = ln(x) + m. Let the
price of x be p, the price of m be unity, and let income be y.

(a) Derive the Marshallian demands for x and m.

Answer The equality of marginal rate of substitution and price
ratio gives 1/x = p. Thus, the Marshallian demand for x is

6
 x = 1/p. The uncompensated demand for m separates into two
cases depending on the amount of income available:
(
0 when y ≤ 1
m=
y − 1 when y > 1.

(b) Derive the indirect utility function, v(p, y).

Answer Again, depending on the amount of income available
there will be two indirect utility functions:
  
ln 1 when y ≤ 1
p
v(p, y) =  
y − 1 + ln 1
p when y > 1.

Note that +ln(1/p) can be written as ln(1)-ln(p), i.e. -ln(p)

(c) Use the Slutsky equation to decompose the effect of an own-price
change on the demand for x into an income and substitution ef-
fect. Interpret your result briefly.
Answer A well-known property of any demand function derived
from a quasi-linear utility function is the absence of the income
effect. Which can be easily seen in the application of the Slutsky
equation:

∂x ∂xh
∂p = ∂p + x ∂x
∂y

We see (using our Marshallian demand derived above) that the

income effect is zero. Thus:
∂x ∂xh
∂p = ∂p

Therefore, the effect of an own-price change on the demand for

x consists of the substitution effect only, the partial derivative of
the compensated demand function with respect to price.
(d) Suppose that the price of x rises from p0 to p1 > p0 . Show that
the consumer surplus area between p0 and p1 gives an exact mea-
sure of the effect of the price change on consumer welfare.
Answer The consumer surplus area can be calculated by integrat-
ing over the inverse uncompensated demand function of x (we see
from our above derived demand function that this is p = 1/x):
Z p0
1
∆CS = dx = ln p0 − ln p1 .
p1 x
Calculating the change in utility induced by a price change gives:

∆v = v 1 (p1 , y 0 )−v 0 (p0 , y 0 ) = y−1−ln p1 −(y−1−ln p0 ) = − ln p1 +ln p0 .

7
 We here assumed y > 1. However, analyzing the case for y <
1 will lead to the same result. (Alternatively, we could have
used the (direct) utility function to come to this result). As the
two expressions (∆ CS and ∆v) are equal, the consumer surplus
area gives an exact measure of the effect of the price change on
consumer welfare in the case of quasi-linear preferences (this also
means that ∆ CS will equal EV and CV for this type of utility
function).
(e) Carefully illustrate your findings with a set of two diagrams: one
giving the indifference curves and budget constraints on top, and
the other giving the Marshallian and Hicksian demands below.
Be certain that your diagrams reflect all qualitative information
on preferences and demands that you’ve uncovered. Be sure to
consider the two prices p0 and p1 , and identify the Hicksian and
Marshallian demands.
Answer Drawing the figure, note that Hicksian and Marshallian
demands are identical here.