School of Graduate Studies

College of Business and Economics

Department of Economics

Advanced Microeconomics I (Econ 601) Assignment

Prepared by: Eyuel Sahlu Ayele (GSR/0552/16)

Submitted to: Dr. Saba Yifredew

December, 2023
Question 1: Prove that Lexicographic preferences are rational.

 A preference relation is rational if it is complete and transitive. Hence, to

prove the rationality of lexicographic preferences, we need to show that
they are complete and transitive.
 For the consumption bundles x (x 1 , x 2) and y ( y 1 , y 2) , bundle x is
lexicographically preferred to y i.e. (x 1 , x 2) ≿ ( y 1 , y2 ) if x 1> y 1 or x 1= y 1 and x 2 ≥ y 2.
 Lexicographic preferences are complete if all distinct consumption plans in
the consumption set are comparable i.e. either x ≿ y or y ≿ x .

2 2
{2
x 1> y1 ∨x1 ≤ y 1
Since x 1 , x 2 , y 1∧ y 2 are real numbers, then x > y ∨x ≤ y
2

That means, given the four possible combinations of the cases given above, we
can decide if x ≿ y or y ≿ x . Hence, lexicographic preferences are complete.

 Lexicographic preferences are transitive if the following statement holds

for all distinct consumption plans x, y and z in the consumption set. If x ≿ y
and y ≿ z , then x ≿ z .

x ≿ y means { x 1 > y 1∨¿ x 1= y 1∧x 2 ≥ y 2

y ≿ z means { y 1 > z 1∨¿ y 1=z 1∧ y 2 ≥ z 2

Four cases follow from the above conditions.

Case I: x 1> y 1 and y 1 > z 1

It follows that x 1> z1 and hence x ≿ z

Case II: x 1> y 1 and y 1=z 1∧ y 2 ≥ z 2

It follows that x 1> z1 and hence x ≿ z

1
Case III: x 1= y 1∧x 2 ≥ y 2 and y 1 > z 1

It follows that x 1> z1 and hence x ≿ z

Case IV: x 1= y 1∧x 2 ≥ y 2 and y 1=z 1∧ y 2 ≥ z 2

It follows that x 1=z 1 and x 2 ≥ z 2 and hence x ≿ z .

Therefore, we can conclude that lexicographic binary relations are transitive.

 From the above two proofs we can see that lexicographic preferences are
complete and transitive and hence rational.

Question 2: Can we represent lexicographic function with a utility function?

Provide a proof/intuition.

Since lexicographic functions are not continuous, they cannot be represented

by a utility function.

A preorder is continuous if all of the strict upper and lower contour sets in the
space are open sets or if all of the weak upper and lower contour sets in the
space are closed sets.

Let us use the graphical representation of lexicographic preference relation

above to prove the discontinuity.

2
To show that the strict upper and lower contour sets are open for any point in
the set, we should be able to find an open ball around the point that is itself
contained in the set. In case of lexicographic preference, for the points that lie
exactly on the solid and dashed lines, we find that the open balls that we draw
will contain points that are not in the set. For this reason, we can say the strict
upper and lower contour sets are not open and not continuous and hence
lexicographic preferences cannot be represented by a utility function.

Alternatively, by taking a sequence of points in the weak upper and lower

contour sets as shown in the figure above, we can see that the sequence
converges to points that is not part of the upper and lower contour sets
respectively. This shows that both the weak upper and lower contour sets are
not closed and not continuous and hence lexicographic preferences cannot be
represented by a utility function.

Question 3: Find the Marshallian demand for the following utility functions.

a. U ( x 1 , x 2 )=min ⁡(3 x 1 , x 2) ; subject to 5 x 1+ 4 x 2=200

3
 The two goods are perfect compliments.

3 x 1=x 2 (Substituting this in the budget line)

5 x 1+ 4 ( 3 x 1 )=200

17 x 1=200

x 1=11.7

x 2=3 ×11.7

x 2=35.2

b. U ( x 1 , x 2 )=x 1 + x 2 ; subject to 5 x 1+ 4 x 2=200

The two goods are perfect substitutes.

 The line to the left is budget line and the line to the right is the
indifference curve. The slope of the indifference curve is 1 and the
slope of the budget line is 1.25.
 Since the slope of the indifference curve is than the slope of the
α P1
budget line i.e. β < P , the Marshallian demand is 0 x 1 and 50 x 2.
2

0.6 0.4
c. U ( x 1 , x 2 )=x 1 x 2 ; subject to 5 x 1+ 4 x 2=200

4
 The Marshallian demand for the Cobb Douglas function is given by:

¿ αM 0.6 × 200
x1 = = =24
P1 5

¿ αM 0.4 × 200
x2 = = =20
P2 4

d. U ( x , y ) =min ⁡(2 x + y , x +2 y) ; Subject to 5 Px + 4 P y =200

The two goods are perfect compliments.

To find the line that crosses all the IC maps we equate 2 x+ y∧x+ 2 y

and find y=x .

 Plotting the optimal indifference curve that is tangent to the budget

line we get the graph below. The indifference curve represents the
utility at 22.2 units.

5
  The straight line represents the budget line and the kinked line
represents the indifference curve. Hence the optimal points are
x 1=22.22∧x 2=22.22 .

e. U ( x , y ) =√ x + y ; Subject to 5 Px + 4 P y =200

 The line to the left represents the budget constraint. And the line to
the right represents utility at U =√50 .
 Slope of the indifference curve is 1 and the slope of the budget line is
α 1 P
1.25 implying β < P . Therefore, the Marshallian demand for is 0 x 1
2

and 50 x 2.

6
 1
Question 4: U =4 x 2 + y , P x =1∧P y =1∧M =3 . Find the optimal consumption of x

and y.

Plotting the utility function and the indifference curve on the same plane, we
get the following graph.

We can clearly see that we have corner solutions in the given case. Hence the
optimal consumption is 3 units of x and 0 units of y. This is because the MRS is
greater than the price ratio at the point of tangency implying the consumer
purchases x but not y.

7
Question 5: Derive the Marshallian demands from the given indirect utility
functions.

( )
am bm mu1 mu2
a) v ( p , m )=max P ∨ P if P ≠ P
1 2 1 2

−∂ v
∂ pi '
x i ( p , m )= (Ro y s Identity)
∂v
∂m

am bm
Case I: P > P
1 1

−∂ v am
2
∂ p1 p1 m
x 1 ( p , m )= = =
∂v a p1
∂m p1

am bm
Case II: P < P
1 1

−∂ v bm
2
∂ p2 p2 m
x 2 ( p , m )= = =
∂v b p2
∂m p2

abm 1
b) v ( p , m )= b p + a p =abm b p +a p
1 2 1 2

2
−∂ v am b
2
∂ p1 ( b p 1+ a p 2 ) bm
x 1 ( p , m )= = =
∂v ab b p1 +a p2
∂m b p1 +a p2

2
−∂ v a mb
2
∂ p2 ( b p 1+ a p2 ) am
x 2 ( p , m )= = =
∂v ab b p1 +a p2
∂m b p1 +a p2

8
 1−ρ

( )
ρ ρ
c) v ( p , M )= P1 ρ−1
+ P2 ρ−1
ρ
M

For commodity 1,
1− ρ ρ

( )
ρ ρ − ρ ρ−1
−∂ v 1−ρ ρ ρ ρ −
M P1 ρ−1 + P2 ρ−1 P1 ρ−1 ρ−1
∂ p1 ρ ρ−1
x 1 ( p , m )= =
∂v 1− ρ

( )
ρ ρ
ρ
∂m P1 + P2
ρ−1 ρ−1

1−2 ρ

( )
ρ ρ 1 1
ρ
M P1 ρ−1
+ P2 ρ−1
P1 ρ−1
M P 1 ρ−1
x 1 ( p , m )= =
(P )
1−ρ ρ ρ

(P )
ρ ρ
ρ
1
ρ−1
+ P2 ρ−1
1
ρ−1
+ P2 ρ−1

For commodity 2,
1− ρ ρ

( )
ρ ρ − ρ ρ−1
−∂ v 1−ρ ρ ρ ρ −
M P1 ρ−1 + P2 ρ−1 P2 ρ−1 ρ−1
∂ p1 ρ ρ−1
x 2 ( p , m )= =
∂v 1− ρ

( )
ρ ρ
ρ
∂m P 1
ρ−1
+ P 2
ρ−1

1−2 ρ

( )
ρ ρ 1 1
ρ
M P1 ρ−1
+ P2 ρ−1
P 2 ρ−1 M P2 ρ−1
x 2 ( p , m )= =
(P )
1−ρ ρ ρ

(P )
ρ ρ
ρ
1
ρ−1
+ P2 ρ−1
1
ρ−1
+ P2 ρ−1

Question 6: Prove each of the properties of the indirect utility function.

Property 1: Homogenous of degree zero in (p, m)

9
If prices and income are both multiplied by a positive number, the budget set
does not change at all. Thus v ( tp ,tm )=v ( p , m ) for t> 0.

Property 2: Indirect utility is strictly increasing in m.

Let B= { x : px ≤ M } and B' ={ x : px ≤ M ' } for M ' > M . Then B is contained in B’. Hence
the maximum of U(x) over B’ is greater than the maximum of U(x) over B.

Property 3: Indirect utility is non-decreasing in prices.

Let B= { x : px ≤ M } and B' ={ x : p ' x ≤ M } for p '> p. Then B’ is contained in B. Hence

the maximum of U(x) over B is at least as big as the maximum of U(x) over B’.

Property 4: Indirect utility satisfies Roy’s identity.

−∂ v
∂ pi
x i ( p , m )= for i=1 , 2 ,3 … k
∂v
∂m

Suppose that x* yields a maximal utility of u* at (p*, u*). We know from our
identities that

x (p*, m*) = h (p*, u*) (Identity 1)

From another one of the fundamental identities, we also know that

u* = v (p, e(p, u*))

Differentiating the above equation with respect to piwe get:

¿ ¿ ¿ ¿ ¿ ¿
∂v( p ,m ) ∂v( p ,m ) ∂e( p ,u )
0= +
∂ pi ∂m ∂ pi

Rearranging and combining this with identity (1), we have:

10
 ¿ ¿
∂ v ( p ,m )
−
∂ e( p¿ ,u ¿) ∂ pi
x i ( p ,m )=hi ( p , u ) =
¿ ¿ ¿ ¿
= ¿ ¿
∂ pi ∂v( p ,m )
∂m

Question 7: For the utility function U =min(x , y) subject to x +4 y ≤ 8

a) Find the indirect utility function and the optimal utility.

 The utility function given above represents perfect compliments.
 We know that all the kink points of the IC curves pass through the
line x= y .
 Hence the above identity can be substituted in the budget equation.

X P x + y P y =M

x ( P x + P y )=M

¿ M ¿ M
x= ∧y =
P x+ P y Px + P y

 Then the indirect utility function becomes,

v=( P x , P y , M ) =min ( P M+ P , P M+ P )= P M+ P
x y x y x y

 The utility at the given level of price and income is:

8 8
v=( 1 , 4 , 8 ) = = =1.6
1+ 4 5

b) Consider a 1$ tax on good x and find the indirect utility.

M 8 8
v ( 2 , 4 ,8 )= = = =1.33
P x + P y 2+ 4 6

¿ M
x= =1.33
P x+ P y

 Hence the tax revenue collected is 1.33 $ .

11
 c) Consider the same amount of tax on income and find the indirect utility.

M 6.667 6.667
v ( 1 , 4 , 6.667 )= = = =1.33
P x + P y 1+ 4 5

d) What can you say about the lumpsum principle?

 In the above two cases, we see that the indirect utility is the same
when tax is imposed on a specific good as well as on income. Hence,
the lumpsum principle does not apply to perfect compliments.

Question 8: Find the expenditure minimizing demand for U ( x , y)=x α y β.

Assume prices are given as P x and P y . What is the minimum expenditure?
α β
L=x Px + y P y −λ (x y −U )

∂L α−1 β
=P x −α λx y
∂x

α −1
P x =α λx

Px
λ= α −1 β
(equation 1)
αx y

∂L α β−1
=P y −β λ x y
∂y

α β−1
P y =β λ x y

Py
λ= α β−1
(equation 2)
βx y

From equation 1 and 2 we have

Px Py
β α−1
= α β−1
αy x βx y

P x αy
=
P y βx

12
From the above expressions we have:

αy P y βxP x
x= ∧ y=
βP x α Py

Plugging the above expressions in the utility function we get:

For commodity x,
α β
U ( x , y)=x y

( )
β
βxP x
U =x α
α Py

( ) ( )
β β
βP x
α β βPx α +β
U =x x = x
α Py α Py

( )
β
α Py
x α+ β=U
βPx

[ ( )]
β 1
h α Py α +β
x (P x , P y ,U )= U
βP x

For commodity y,
α β
U ( x , y)=x y

α β
U =( x ) y

( )
α
αy P y β
U= y
βP x

( )
α
α Py
U= y α+ β
βP x

( )
α
α+ β βP x
y =U
α Py

13
 [ ( )]
α 1
h βP x α+ β
y ( P x , P y , U)= U
α Py

We can get the expenditure function by inserting the optimal amounts of

Hicksian demand values in the budget equation.
¿ ¿
e ( P 1 , P2 ,U )=P x x + P y y

([ ( ) ] ) ([ ( ) ] )
β 1 α 1
α Py α+ β βP x α+ β
e ( P 1 , P2 ,U )=P x U +P y U
βP x α Py

1 1
Question 9: Consider the utility function U =2 x 1 2 + 2 x 2 2

a. Find the demand functions for the commodities x 1 and x 2 as they depend on
prices and income.
1 1
2 2
U =2 x 1 + 2 x 2 subject ¿ P1 X 1+ P 2 X 2 =M

1 1
2 2
L=2 x 1 +2 x 2 −λ ( P1 X 1+ P 2 X 2−M )

−1
∂L
=x 1 2 −λ P1=0
∂ x1

1
λ= (equation 1)
P 1 √ x1

−1
∂L
=x 2 2 −λ P2=0
∂ x2

1
λ= (equation 2)
P 2√ x2

From equation (1) and (2) we have

1 1
=
P 1 √ x1 P2 √ x 2

14
From the above equality the following two equations follow:
2 2
P 2 x2 P1 x 1
x 1= 2
∧x 2= 2
P1 P2

The above two expressions can be inserted into the budget equation to find
the Marshallian demand for the two commodities.

For commodity 1,

( )
2
P1 x1
P 1 X 1+ P2 =M
P 22

2
P1 x1
P 1 X 1+ =M
P2

( )
2
P
X 1 P 1+ 1 =M
P2

( )
2
P1 P 2+ P1
X1 =M
P2

M P2
X1= 2
(equation 3)
P1 + P1 P2

For commodity 2,

( )
2
P2 x 2
P1 + P2 X 2=M
P 12

2
P 2 x2
+ P2 X 2=M
P1

( )
2
P2
X2 + P2 =M
P1

15
 ( )
2
P2 + P1 P2
X2 =M
P1

M P1
X2= 2
(equation 4)
P2 + P1 P2

The indirect utility function can be derived using the optimal amounts of the
commodities in equation 3 and 4.

( ) ( )
1 1
M P2 2 M P1 2
v (P1 , P2 , M )=2 2
+2 2
P1 + P1 P2 P2 + P 1 P2

[( ) ( )]
1 1
M P2 2 M P1 2
v (P1 , P2 , M )=2 +
P 12 + P1 P 2 P 22 + P1 P 2

b. Find the Hicksian (compensated) demand function.

1 1
2 2
P1 X 1+ P2 X 2=M subject ¿ U=2 x 1 +2 x 2

1 1
2 2
L=P1 X 1 + P2 X 2−λ (2 x 1 +2 x 2 −U )

∂L λ
=P1− =0
∂ x1 √ x1
λ=P1 √ x 1 (equation 1)

∂L λ
=P2− =0
∂ x2 √ x2
λ=P2 √ x 2 (equation 2 ¿

From equation (1) and (2), we find the relationship below.

P1 √ x 1=P2 √ x 2

2 2
P1 x 1=P2 x2 ( squaring both sides)

16
 2 2
P 2 x2 P1 x 1
x 1= 2
∧x 2= 2
P1 P2

Substituting the above two expression in the utility function we find the
Hicksian (compensated) demand functions.

For commodity 1,

( )
1 2 1
2
P 1 x1 2
U =2 x 1 + 2
P22

P1 √ x 1
U =2 √ x 1+ 2
P2

( )
U =2 √ x 1 1+
P1
P2
=2 √ x 1
P1+ P 2
P2 ( )
U P2
√ x 1= 2
( P1 + P2 )
2 2
h U P2
x1 = 2
4 ( P1 + P2 )

For commodity 2,

( )
2 1 1
P 2 x2 2
U =2 +2 x 2 2
P12

P2 √ x 2
U =2 +2 √ x 2
P1

( )
U =2 √ x 2 1+
P2
P1
=2 √ x 2
P1+ P 2
P1 ( )
U P1
√ x 2= 2
( P1 + P2 )

17
 2 2
h U P1
x2 = 2
4 ( P1 + P2 )

c. Find the expenditure function and verify Shephard’s Lemma.

 We can get the expenditure function by inserting the optimal
amounts of Hicksian demand values in the budget equation.
¿ ¿
e ( P 1 , P2 ,U )=P1 X 1 + P2 X 2

( ) ( )
2 2 2 2
U P2 U P1
e ( P 1 , P2 ,U )=P1 + P2
4 ( P 1+ P 2) 2 4 ( P1 + P2 )2

P1 U 2 P22 P 2 U 2 P 12
e ( P 1 , P2 ,U )= 2
+ 2
4 ( P 1+ P2 ) 4 ( P1 + P2 )

2
U P1 P 2 ( P1 + P 2)
e ( P 1 , P2 ,U )= 2
4 ( P 1+ P2 )

U 2 P1 P 2
e ( P 1 , P2 ,U )=
4 (P1 + P2)

To verify the Shephard’s Lemma, we partially derivate the above equation with
respect to prices.

∂ e ( P1 , P 2 , U ) h
=x i ( P 1 , P2 ,U )
∂ pi

U 2 P1 P 2
e ( P 1 , P2 ,U )=
4 (P1 + P2)

For commodity 1,

( )
2 2
U P1 P 2 U P 2 P1
e ( P 1 , P2 ,U )= =
4 (P1 + P2) 4 P 1+ P 2

( )
∂ e ( P1 , P 2 , U ) U 2 P 2 ( P1 + P2 )−P1
= (applying quotinent rule)
∂ p1 4 ( P1 + P2 )
2

18
 ( )
∂ e ( P1 , P 2 , U ) U 2 P 2 P2
= 2
∂ p1 4 ( P1 + P2 )

∂ e ( P1 , P 2 , U ) h
2
U P2
2
=x 1 ( P 1 , P2 ,U )= 2
∂ p1 4 ( P1 + P2 )

For commodity 2,

( )
2 2
U P1 P 2 U P1 P2
e ( P 1 , P2 ,U )= =
4 (P1 + P2) 4 P 1+ P 2

( )
∂ e ( P1 , P 2 , U ) U 2 P 1 ( P1 + P2 )−P2
= (applying quotinent rule)
∂ p2 4 ( P1 + P2 )
2

( )
∂ e ( P1 , P 2 , U ) U 2 P 1 P1
= 2
∂ p2 4 ( P1 + P2 )

∂ e ( P1 , P 2 , U ) h U 2 P 12
=x 2 ( P 1 , P2 ,U )= 2
∂ p2 4 ( P 1+ P2 )

d. Show that the relationship e ( p , v ( p , m ) )=m and v ( p , e ( p , u ) ) =u hold.

 e ( p , v ( p , m ) )=m

( [( ) ])
2

)(
1 1
M P2 2 M P1 2
2 + P1 P2
2
u P1 P 2 P12+ P 1 P2 P22 + P1 P2
e ( p , v (P1 , P2 , M ) ) = =
4(P1 + P2 ) 4(P 1+ P2 )

[( )]
1 2

) (
1
M P2 2 M P1 2
4 P1 P2 2
+ 2
P1 + P1 P2 P 2 + P1 P 2
e ( p , v (P1 , P2 , M ) ) =
4(P1 + P2 )

[√ ]
2
√ M √ P2 √ M √ P1
P1 P 2 +
e ( p , v (P1 , P2 , M ) ) =
2
P1 + P1 P2 √P 2
2
+ P1 P2
P1 + P2

19
 [√ ]
2
√ M √ P2 √ M √ P1
P1 P 2 +
P1 (P1+ P 2) √ P2 (P1 + P2)
e ( p , v (P1 , P2 , M ) ) =
P 1+ P 2

[√ ]
2
√ M √ P2 √ M √ P1
P1 P 2 +
P1 √ P1 + P2 √ P 2 √ P 1+ P 2
e ( p , v (P1 , P2 , M ) ) =
P1 + P2

[ ]
2
P2 √ M + P1 √ M
P1 P 2
√ P1 √ P2 √ P1 + P2
e ( p , v (P1 , P2 , M ) ) =
P1 + P2

[√ ] [ ]
2 2
√ M (P1+ P 2) √ M √ P 1+ P2
P1 P 2 P1 P 2
P1 √ P2 √ P1 + P2 √ P1 √ P2
e ( p , v (P1 , P2 , M ) ) = =
P1 + P2 P1 + P2

e ( p , v (P1 , P2 , M ) ) =
P1 P 2
( M (P1 + P2 )
P1 P2 ) =
P 1 P2 M (P1 + P2)
=M
P1 + P2 (P1 + P2) P1 P 2

 v ( p , e ( p , u ) ) =u

[( ) ( )]
1 1
M P2 2 M P1 2
v (P1 , P2 , M )=2 +
P 12 + P1 P 2 P 22 + P1 P 2

[( ( )
)( ( )
)]
1 1
u2 P 1 P 2 2 u 2 P1 P 2 2
P2 P1
4 (P1+ P 2) 4 ( P1 + P2 )
v (P1 , P2 , M )=2 +
P 12+ P 1 P2 P 22 + P1 P2

[( ) ( ) ]
u2 P1 P22 12 u2 P12 P2 1
2

1 (P 1+ P 2) (P1+ P 2)
v (P1 , P2 , M )=2 × 2
+
2 P1 + P1 P 2 P 22+ P1 P2

20
 [( )( )]
u √ P 1 P2 u √ P2 P1

v ( P1 , P 2 , M )=
√ P1+ P2 +
√ P1 + P2
√ P 1(P 1+ P2 ) √ P2 (P1 + P2)

u √ P1 √ P2 P2 u √ P 1 √ P2 P1
+
v ( P1 , P 2 , M )=
√ P1 + P2 √ P 1+ P 2
√ P 1 √ P 2 √ P 1+ P 2
u √ P 1 P 2 ( P1+ P 2)
v ( P1 , P 2 , M )= × =
√ P1 + P2
u √ P 1 P 2 ( P 1+ P 2 )
=
√ P1 + P2
√ P1 P2 √ P 1+ P 2
1 u √ P1 P 2 ( P1 + P2 )
=U
√ P 1 P2 √ P1 + P2 √ P1 P 2 ( P1 + P2 )
ρ−1

( )
ρ ρ
Question 10: Given e ( p , u ) = P1 ρ−1
+ P2 ρ−1
ρ
u, Find x 1 and x 2
h h

∂ e( p , u) h
Applying the Shephard’s Lemma i.e. ∂ pi
=x i (p ,u)

∂ e ( p , u)
=x h1 ( p , u )
∂ p1

ρ−1 ρ

( )
ρ ρ − ρ ρ−1
ρ−1 ρ ρ ρ −
¿u P 1 ρ−1 + P 2 ρ−1 P 1 ρ−1 ρ−1 ( ApplyingChain Rule)
ρ ρ−1

−1

( )
ρ ρ 1
∂ e( p , u) h ρ
=x 1 ( p , u )= P1 ρ−1 + P2 ρ−1 P 1 ρ−1 u
∂ p1

∂ e ( p , u)
=x h2 ( p , u )
∂ p2

ρ−1 ρ

( )
ρ ρ − ρ ρ−1
ρ−1 ρ ρ ρ −
¿ P1 ρ−1 + P2 ρ−1 P2 ρ−1 ρ−1 ( ApplyingChain Rule )
ρ ρ−1

−1

( )
ρ ρ 1
∂ e( p , u) h ρ
=x 2 ( p , u )= P1 ρ−1 + P2 ρ−1 P2 ρ−1
u
∂ p2

21
22