De La Salle University

School of Economics
MIC1ECO
Term 1, AY 2021 - 2022
Dr. Angelo A. Unite
Assignment 5: Demand Relationships Among Goods; Measurement of
Welfare; Consumer Surplus

1. This assignment is a group effort (minimum of 1 student and maximum of 2 students per group), and thus, there should only
be one set of solutions per group. You are not allowed to consult with nor be consulted by other students currently enrolled in
this group. A FINAL GRADE OF 0.0 WILL BE GIVEN TO THE STUDENTS WHOSE REPORTS ARE PROVEN TO BE
COPIES (IN FULL OR IN PART) OF EACH OTHER.
2. For each main problem (indicated by a Roman numeral), answer the sub-questions (indicated by an Arabic numeral) in their
order of appearance. Start answering each main problem (indicated by a roman numeral) in a new sheet. For each main
problem, be sure to indicate the number of the sub- question you are answering. Read the questions carefully and answer
only what is required. Do not make any assumptions other than those given in the problems.
3. Be sure to show the theoretical justification or basis for your answers to each question in this exam. You should start each
answer with a brief discussion of the basis for your answer. The basis is usually an economic concept, a mathematical
definition, or a set of conditions that provides the framework for your answer. Do not just turn in computations! No
explanation and basis, no credit.
4. Simplify all final answers. For final answers that involve numerical values, round off to the nearest 4 decimal places.
5. For questions that require you to determine the sign of derivatives or mathematical functions, be sure to show the basis for
the sign.
6. Your answers should be word processed (MSWord or Pages) on A4-size document with 1-inch margins all around. You can
generate equations using MathType or MS Word’s build-in Equation Editor. See the pdf document “Guides to Using
MathType” for the instructions on how to use MathType in MS Word or Pages. Graphs can be generated using Mathematica,
MSWord, or MSExcel.
7. Avoid using Google Docs as it sometimes destroys formatting and/or equations when exporting to PDF. Microsoft Word
allows real-time collaborative editing (follow this link for a tutorial https://bit.ly/CollabinMSWord).
8. NO SECTION OF YOUR ASSIGNMENT MAY BE HANDWRITTEN OR IN THE FORM OF SCANNED IMAGES.
Submissions with handwritten or scanned answers (in part or in full) will not be given any credit. Answers involving
equations that were not generated using MS Equation Editor or MathType will not be given any credit.
9. Type, sign and date the Pledge of Academic Honesty Pledge below and make it the cover page of your report.

Pledge of Academic Honesty

This is to certify that we did not consult with anyone, including copying the answered assignments of students who took this
course in previous trimesters, in arriving at our answers to this assignment in MIC1ECO. In addition, we are certifying that
we did not allow ourselves to be consulted by other students who are currently enrolled in this course during their solving the
same assignment. We are aware that a final grade of 0.0 will be given to the students whose reports are confirmed to be
copies (full or partial) of each other and students who violated this pledge.

Julius Balutay
Signature over printed name and date – Group Member 1

Adel He
Signature over printed name and date – Group Member 2

10. Save your Word document in PDF file format. The pdf file should be uploaded in Canvas. Be sure that your signature is on
the pledge of academic honesty. No signature/s, no credit.
11. The Canvas facility for uploading of the pdf copy of your word-processed answers closes at 8:00 am of the last day of
submission specified in this syllabus (SCHEDULE OF ASSIGNMENTS). Submissions made outside the Canvas
Assignment facility will not be accepted nor given any credit.
 12. Any correction on the mark for this assignment must be brought up with my teaching assistant during the week when the
marked version of this assignment is returned to the students. After this one-week period, any correction on the mark shall no
longer be considered.

START ANSWERING PROBLEM II IN A NEW SHEET

𝟏
𝒄 𝑼𝒑𝟏 𝒑𝟐𝟐 𝟑
II. You only consume two goods, good 1 and good 2. Your expenditure function is given 𝑬 = 𝟑 $ %.
𝟒

1. Use the duality theorem to find your indirect utility function, 𝑼∗ = 𝑽(𝒑𝟏 , 𝒑𝟐 , 𝒎). Briefly discuss what is
going on as you answer this question.

According to the duality theorem, when the target utility level (𝑼) is equal to the maximum utility (𝑼∗ ) the
minimum expenditure (𝑬𝒄 ) is equals to income (𝒎):

𝑼 = 𝑼∗
Therefore
𝑬𝒄 = 𝒎
𝟏
𝒄 𝑼𝒑𝟏 𝒑𝟐𝟐 𝟑
And because 𝑬 = 𝒎, this means that 𝒎 = 𝟑 $ 𝟒
%

The next step will be to derive the utility function (𝑼) from the income function (𝒎).
𝟏
𝑼𝒑𝟏 𝒑𝟐𝟐 𝟑
𝒎 = 𝟑- /
𝟒
𝟏
𝒎 𝑼𝒑𝟏 𝒑𝟐𝟐 𝟑
=- /
𝟑 𝟒
𝒎 𝟑 𝑼𝒑𝟏 𝒑𝟐𝟐
0 1 =- /
𝟑 𝟒
𝒎 𝟑
𝟒 0 1 = 2𝑼𝒑𝟏 𝒑𝟐𝟐 3
𝟑
𝒎 𝟑
𝟒0𝟑1
= (𝑼)
𝒑𝟏 𝒑𝟐𝟐

Since according to the duality theorem, the utility function (𝑼) is equals to the indirect utility function
(𝑼∗ ), therefore the indirect utility function is equals to:

𝒎 𝟑
𝟒0𝟑1
𝑼∗ =
𝒑𝟏 𝒑𝟐𝟐

2. Use Roy’s Identity to find your Marshallian demand function for good 2. Simplify your answer.
To find the Marshallian demand function using Roy’s Identity, we must first solve for the partial derivative of the
indirect utility function (𝑼∗ ) with respect to the price of good 2 (𝒑𝟐 ). Then we will divide that function by the partial
derivative of the indirect utility function with respect to the income (𝒎):
𝝏𝑽(𝒑𝟏 , 𝒑𝟐 , 𝒎)
𝒙∗𝒊 = −
𝝏𝒑𝒊
𝝏𝑽(𝒑𝟏 , 𝒑𝟐 , 𝒎)
𝝏𝒎
Through substitution the following will occur:

𝝏𝑽(𝒑𝟏 , 𝒑𝟐 , 𝒎) 𝟖𝒎𝟑 𝟐𝒎
𝒙∗𝟐 = − = −(− )=
𝝏𝒑𝟐 𝟐𝟕𝒑𝟏 𝒑𝟐𝟑 𝟑𝒑𝟐
𝝏𝑽(𝒑𝟏 , 𝒑𝟐 , 𝒎) 𝟒𝒎 𝟐
𝝏𝒎 𝟗𝒑𝟏 𝒑𝟐𝟐

3. Originally, the price per unit of good 1 is ₱1, the price per unit of good 2 is ₱1, and your income is ₱30.
Suppose good 2’s price increases to ₱2, ceteris paribus.

a. Show that you are worse off as a result of the increase in the price of good 2 to ₱2.

First we must substitute the price of good 2 with 1, and substitute the income with 30 in the Marshallian demand
function of good 2.
𝟐(𝟑𝟎)
𝒙∗𝟐 = = 𝟐𝟎
𝟑(𝟏)

Afterwards, we will substitute the price of good 2 with 2, and then compare the maximum utilities
𝟐(𝟑𝟎)
𝒙∗𝟏
𝟐 = = 𝟏𝟎 < 𝒙∗𝟐 = 𝟐𝟎
𝟑(𝟐)

Because the consumer has a monotonic preference, they would prefer 𝒙∗𝟐 to 𝒙∗𝟏
𝟐 because when good 2’s price is
₱1, you will need to consume more of good 2 to achieve the maximum utility.

b. Calculate the equivalent variation of the increase in the price of good 2 to ₱2. Interpret your answer.

Equivalent Variation is the change in income that, at initial prices, determines the utility level (𝑼𝟏 ) where the
consumers would have accepted the change in prices.

Firstly, we must find the utility level with the change in prices (𝑼𝟏 ) and then we will proceed to substitute the
values of 𝒎, 𝒑𝟏 , 𝐚𝐧𝐝 𝒑𝟐 in the utility function

𝟑𝟎 𝟑
𝟒0 𝟑 1
𝑼𝟏 = = 𝟏𝟎𝟎𝟎
(𝟏)(𝟐𝟐 )

Afterwards, to calculate for the equivalent variation, we must subtract the expenditure function from the
income and substitute the values
𝑬𝑽 = 𝒎𝟎 − 𝑬(𝒑𝟎𝟏 , 𝒑𝟎𝟐 , 𝑼𝟏 )
𝑬𝑽 = 𝟑𝟎 − B𝟐(𝟏 × 𝟏 × 𝟏𝟎𝟎𝟎)𝟎.𝟓 D = −𝟑𝟑. 𝟐𝟓

A positive value for the equivalent variation would mean that the price change would benefit the consumer,
however, since the equivalent variation is equals to a negative value, that means that the consumer would be
worse off with the price change since it negatively affects them.
c. Calculate the compensating variation of the increase in the price of good 2 to ₱2. Interpret your
answer.

Compensating Variation is when, after an adjustment in income, the consumers original utility is restored
after a change in prices.

Firstly, we must find the utility level without the change in prices (𝑼𝟎 ) and then we will proceed to substitute
the values of 𝒎, 𝒑𝟏 , 𝐚𝐧𝐝 𝒑𝟐 in the utility function

𝟑𝟎 𝟑
𝟒0 𝟑 1
𝑼𝟎 = = 𝟒𝟎𝟎𝟎
(𝟏)(𝟏𝟐 )

Afterwards, to calculate for the compensating variation after the increase of the price of good 2, we must
subtract the expenditure function 𝑬(𝒑𝟎𝟏 , 𝒑𝟎𝟐 , 𝑼𝟎 ) from the expenditure function 𝑬(𝒑𝟎𝟏 , 𝒑𝟏𝟐 , 𝑼𝟎 ) and substitute the
values

𝑪𝑽 = 𝑬(𝒑𝟎𝟏 , 𝒑𝟏𝟐 , 𝑼𝟎 ) − 𝒎𝟎
𝟎.𝟓
𝑪𝑽 = B𝟐(𝟏 × 𝟏 × 𝟒𝟎𝟎𝟎) D − B𝟐(𝟏 × 𝟐 × 𝟒𝟎𝟎𝟎)𝟎.𝟓 D = 𝟏𝟐𝟔. 𝟓 − 𝟏𝟕𝟖. 𝟖𝟖 = −𝟓𝟐. 𝟑𝟖

Because of the increase in the price of good 2, there is a loss in welfare, however, since the compensating
variation is negative, that means that the consumer is willing to accept the change in prices.

d. What is the equation of the Marshallian demand curve for good 2?

The Marshallian demand curve is equals to 𝒙∗𝟐 = 𝒙𝟐 (𝒑𝟏 , 𝒑𝟐 , 𝒎)

e. Based on your answer in part 3.d and the relevant concept, calculate the change in
Marshallian consumer surplus of the increase in the price of good 2 to ₱2.

The Marshallian consumer surplus is the area below the Marshallian demand curve and above the
current market price.

The formula for the Marshallian consumer surplus with the change of price to good 2 is stated
below:

𝒑𝟏𝟐

∆𝑴𝑪𝑺 = L 𝒙𝟐 (𝒑𝟏 , 𝒑𝟐 , 𝒎)𝒅𝒑𝟐

𝒑𝟎𝟐
𝒑𝟏𝟐 -𝟐
𝟐𝟎
∆𝑴𝑪𝑺 = L N O 𝒅𝒑𝟐
𝒑𝟐
𝒑𝟎𝟐 -𝟏
∆𝑴𝑪𝑺 = 𝟐𝟎[𝒍𝒏(𝟐)] = 𝟏𝟑. 𝟖𝟔
 START ANSWERING PROBLEM I IN A NEW SHEET

𝒎
I. Your Marshallian demand function for good 1 is given by 𝒙 𝟏.𝟓𝒑𝟏 /𝒑𝟐
. Suppose that initially the
price per unit of good 1 is ₱4, the price per unit of good 2 is ₱2, and your income is ₱240. Use these initial values
of prices and income when answering the questions below. Show your basis for your answer to each of the
following questions.

1. How much of good 1 will you buy?

A rational consumer would buy a good such that it will maximize their utility, hence, if I were to buy good 1, I’d
have to substitute the 𝒑𝟏 , 𝒑𝟐 𝐚𝐧𝐝 𝒎 into the Marshallian demand function as the function maximizes my utility.

Base from the answer, I would have to buy 30 units of good 1 to maximize my utility.

2. Calculate your uncompensated own-price elasticity of demand for good 1. Interpret your answer.

The uncompensated own-price elasticity of demand for good 1 is given by the function,

Through substitution,

Since T𝒆𝒙𝟏, 𝒑𝟏 T < 𝟏, then it means that the Marshallian demand for good 1 is price inelastic, which indicates that
price changes have minimal effects and total spending move in the same direction.

3. Calculate your income elasticity of demand for good 1. Is good 1 a normal good or an inferior good for you?
If it is a normal good, is it a necessity or a luxury good?
 The income elasticity of demand for good 1 is given by the function,

Through substitution,

why are you taking the abs value?

Since T𝒆𝒙𝟏, 𝒎 T ≥ 𝟎 and T𝒆𝒙𝟏, 𝒎 T ≤ 𝟏, then we consider good 1 to be a normal good while being a necessity.

4. Calculate your uncompensated cross-price elasticity of demand for good 1 with respect to the price of good
2. Interpret your answer.

The uncompensated cross price elasticity of demand for good 1 with respect to the price of good 2 is given by the
function,

Through substitution

Since T𝒆𝒙𝟏, 𝒑𝟐 T < 𝟎, then we will consider good 1 as a gross complement for good 2.

5. Calculate your compensated own-price elasticity of demand for good 1 and interpret your answer. Explain
the reason for the difference in your uncompensated own-price elasticity of demand and your compensated
price elasticity of demand for good 1.

The compensated own-price elasticity of demand for good 1 is provided by the function,
 where

From 2.) where 𝒆𝒙𝟏, 𝒑𝟏 = 0.75

From 3.) where 𝒆𝒙𝟏, 1 = 0

Acquiring 𝑠2 ,

Through substitution,

Since 𝒆𝒄 𝒙𝟏, 𝒑𝟏 > 0, we can conclude that the demand is elastic for good 1 after removing the income effect. This is
different from the uncompensated own-price elasticity of demand where the price is inelastic. This means that my
compensated own-price elasticity of demand is more sensitive to price change compared to my uncompensated
own-price elasticity of demand.

6. Calculate your compensated cross-price elasticity of demand for good 1 with respect to a change in the
price of good 2. Interpret your answer.

The compensated cross-price elasticity of demand for good 1 with respect to a change in the price of good 2 is
given by the function,

From 3.) where 𝒆𝒙𝟏, 1 = 1

From 4.) where 𝒆𝒙𝟏, 𝒑𝟐 = −0.25
From 5.) where 𝑠2 = 0.5

Acquiring 𝑠3 ,

Through substitution,

Since 𝑒 4 𝒙𝟏, 𝒑& > 0, we can conclude that good 1 is a net substitute for good 2.

7. Calculate your income elasticity of demand for good 2. Is good 2 a normal good or an inferior good for you?
If it is a normal good, is it a necessity or a luxury good?