Summer 2020

Department of Economics, East West University

ECO 501: Advanced Microeconomics
Assignment # 4 – Solutions

4-1. Suppose that, in a three good world, quantities and prices of the goods are labeled
xi = (xi1 , xi2 , xi3 ) and pi = (pi1 , pi2 , pi3 ) respectively, where, i = 1, 2, 3. Using the follow-
ing information, check whether the consumer’s preferences satisfy the assumptions of
WARP and transitivity.

p1 = (4, 3, 2) x1 = (2, 2, 2)
p2 = (5, 3, 3) x2 = (1, 3, 3)
p3 = (5, 2, 3) x3 = (1, 3, 2)

Answer: Revealed preference is established by calculating the total expenditure needed

to buy the three bundles at each of the three prices. So, when the consumer faces the
price p1 :

p1 x1 = (4 × 2) + (3 × 2) + (2 × 2) = $18
p1 x2 = (4 × 1) + (3 × 3) + (2 × 3) = $19
p1 x3 = (4 × 1) + (3 × 3) + (2 × 2) = $17

Similarly, we can calculate that, when the consumer faces the price p2 , the expenditure
amounts are p2 x1 = 22, p2 x2 = 23, and p2 x3 = 20. Lastly, when the consumer faces
the price p3 , the expenditure amounts are p3 x1 = 20, p3 x2 = 20, and p3 x3 = 17.

First, we see that x2 is strictly revealed preferred to x1 (following WARP). Because,

when x2 is bought at price p2 , x1 was also affordable (see from the above that p2 x2 >
p2 x1 ). But, when x1 is bought at price p1 , x2 was not affordable (x1 was simply the
cheaper option, see that p1 x1 < p1 x2 ).

Second, we see that x1 is strictly revealed preferred to x3 (following WARP). Because,

when x1 is bought at price p1 , x3 was also affordable (see from the above that p1 x1 >
p1 x3 ). But, when x3 is bought at price p3 , x1 was not affordable (x3 was simply the
cheaper option, see that p3 x3 < p3 x1 ).

Lastly, we see that x2 is strictly revealed preferred to x3 (following WARP). Because,

when x2 is bought at price p2 , x3 was also affordable (see from the above that p2 x2 >
p2 x3 ). But, when x3 is bought at price p3 , x2 was not affordable (x3 was simply the
cheaper option, see that p3 x3 < p3 x2 ). This last revealed relationship also satisfies
the assumption of transitivity, because, x2 is strictly revealed preferred to x1 and x1 is
strictly revealed preferred to x3 . So, WARP and transitivity assumptions are satisfied.
 Alternatively, one could also create the following table and, then, come up with the
same revealed preference conclusions:

p1 p2 p3
x1 $18 $22 $20
x2 $19 $23 $20
x3 $17 $20 $17

1 1
4-2. Consider the utility function u(x1 , x2 ) = x14 x22 with corresponding Marshallian and
Hicksian demand functions
 2
m m h 4 p2 3
x1 = and x1 = u 3
3p1 2p1
 1
m 2m h 4 2p1 3
x2 = and x2 = u 3
3p2 p2
where, (p1 , p2 ) are the two prices and m is income. Now, starting from an initial
situation where (p01 , p02 , m0 ) = (4, 4, 300), calculate the compensating variation (CV)
and equivalent variation (EV) of a price decrease from p01 = 4 to p11 = 2.

Answer: Compensating variation can be calculated as follows

Z p01 Z 4
h 0 0
CV = x1 (p1 , p2 , V )dp1 = xh1 (p1 , p02 , V 0 )dp1 (1)
p11 2

where V 0 is the level of utility at (p01 , p02 , m0 ) = (4, 4, 300). To calculate V 0 , note that
xm m
1 (4, 4, 300)√= 25 and x2 (4, 4, 300) = 50. And, substituting in the utility function
yields V 0 = 250. We can now calculate CV as follows:
Z 4
CV = xh1 (p1 , p02 , V 0 )dp1
2
Z 4"   23 #
4 p 2
= (V 0 ) 3 dp1
2 2p 1
 p  23 Z 4 2
0 34 2 −
= (V ) p1 3 dp1
2 2
√ 4 2
h 1 i4
= ( 250) 3 2 3 3p13
2
2 2
h 1 i4
= (250) 3 2 3 3p13
2
2 1 1
= 3(500) [4 − 2 ]
3 3 3

CV ≈ 61.8898
Equivalent variation can be calculated as follows
Z p01 Z 4
EV = xh1 (p1 , p02 , V 1 )dp1 = xh1 (p1 , p02 , V 1 )dp1 (2)
p11 2

where V 1 is the level of utility at (p11 , p02 , m0 ) = (2, 4, 300). To calculate V 1 , note that
xm m
1 (2, 4, 300) = 50 and x2 (2, 4, 300) = 50. And, substituting in the utility function
3
yields V 1 = 50 4 . We can now calculate EV as follows:
Z 4
EV = xh1 (p1 , p02 , V 1 )dp1
2
Z 4"   23 #
4 p 2
= (V 1 ) 3 dp1
2 2p 1
 p  23 Z 4 2
1 34 2 −
= (V ) p1 3 dp1
2 2
 3  43 2 h 1 i4
= 50 4 2 3 3p13
2
2 1 1
= 150(2) [4 − 2 ] 3 3 3

EV ≈ 77.9763