EconS 501 - Microeconomic Theory I

Midterm Exam #1 - Answer key

1. Checking properties of preference relations. Consider the following preference

relation de…ned in X = R2+ . A bundle (x1 ; x2 ) is weakly preferred to another bundle
(y1 ; y2 ), i.e., (x1 ; x2 ) % (y1 ; y2 ), if and only if

min f3x1 + 2x2 ; 2x1 + 3x2 g > min f3y1 + 2y2 ; 2y1 + 3y2 g

(a) For any given bundle (y1 ; y2 ), draw the upper contour set, the lower contour set,
and the indi¤erence set of this preference relation.
Upper contour set. Take a bundle (2; 1). Then,

min f3 2 + 2 1; 2 2 + 3 1g = min f8; 7g = 7:

The upper contour set of this bundle is given by

U CS(2; 1) = f(x1 ; x2 ) % (2; 1)g

= fmin f3x1 + 2x2 ; 2x1 + 3x2 g > 7 min f8; 7gg

which is graphically represented by all those bundles in R2+ which are strictly
above both lines 3x1 + 2x2 = 7 and 2x1 + 3x2 = 7. That is, for all (x1 ; x2 )
strictly above both lines
7 3 7 2
x2 = x1 and x2 = x1 :
2 2 3 3
(See …gure 1, which depicts these two lines and shades the set of bundles lying
above both lines.)
Lower contour set. On the other hand, the lower contour set is de…ned as

LCS(2; 1) = f(2; 1) % (x1 ; x2 )g

= f7 > min f3x1 + 2x2 ; 2x1 + 3x2 gg ;

which is graphically represented by all bundles (x1 ; x2 ) strictly below the max-
imum of the lines described above. For instance, bundle (y1 ; y2 ) = (2:5; 0),
which lies on the horizontal axis and between both lines’horizontal intercept,
implies
minf3 2:5 + 2 0; 2 2:5 + 3 0g = minf7:5; 5g = 5
Thus implying that this consumer prefers bundle (x1 ; x2 ) = (2; 1) than (y1 ; y2 ) =
(2:5; 0). A similar argument applies to all other bundles lying above x2 =
7 3
2
x and below x2 = 73 23 x1 , where bundle (2:5; 0) also belongs; see the
2 1
triangle that both lines form at the right-hand side of the …gure. Similarly,
bundles such as (0; 2:5) yield

minf3 0 + 2 2:5; 2 0 + 3 2:5g = minf5; 7:5g = 5

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 which implies that the consumer also prefers bundle (2; 1) to (0; 2:5). An
analogous argument applies to all bundles above line x2 = 72 32 x1 but below
x2 = 73 23 x1 in the triangle at the left-hand side of …gure 1.

Figure 1. UCS and LCS of bundle (2; 1).

Indi¤erence set. Finally, there are no bundles for which the consumer is just
indi¤erent between bundle (2,1) and any other bundle (note that there are
no bundles for which the upper and lower contour set coincide or overlap).
Hence, the indi¤erence set is empty,

IN D(2; 1) = ?

Here is an alternative approach to show that the indi¤erence set is empty.

First, note that both of the elements in the minf g operator are real numbers,
i.e., (3x1 + 2x2 ) 2 R+ and (2x1 + 3x2 ) 2 R+ , thus implying that the minimum

min f3x1 + 2x2 ; 2x1 + 3x2 g = a

exists and it is also a real number, a 2 R+ . Similarly, the minimum

min f3y1 + 2y2 ; 2y1 + 3y2 g = b

exists and b 2 R+ . Therefore, we can easily compare a and b, obtaining

that either a > b, which implies (x1 ; x2 ) % (y1 ; y2 ); or a < b, which implies
(y1 ; y2 ) % (x1 ; x2 ). Finally, note that, for this preference relation, we cannot
…nd that both a > b and b > a. Therefore, we cannot have that the individual
is indi¤erent between bundles x and y, con…rming that the indi¤erence set is
nil.
(b) Check if this preference relation satis…es: (i) completeness, (ii) transitivity, and
(iii) weak convexity.

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Completeness. From our analysis of the UCS, LCS, and IND in …gure 1, we
can claim that two bundles on the lower bound of the UCS, such as (2; 1)
and (3:5; 0), cannot be ranked according to this preference relation. This
occurs because the lower bound of the UCS does not belong to the UCS and,
similarly, the upper bound of the LCS in the …gure does not belong to the
LCS.
Transitivity. We need to show that, for any three bundles (x1 ; x2 ), (y1 ; y2 )
and (z1 ; z2 ) such that
(x1 ; x2 ) % (y1 ; y2 ) and (y1 ; y2 ) % (z1 ; z2 ), then (x1 ; x2 ) % (z1 ; z2 )
First, note that (x1 ; x2 ) % (y1 ; y2 ) implies
a min f3x1 + 2x2 ; 2x1 + 3x2 g > min f3y1 + 2y2 ; 2y1 + 3y2 g b
and (y1 ; y2 ) % (z1 ; z2 ) implies that
b min f3y1 + 2y2 ; 2y1 + 3y2 g > min f3z1 + 2z2 ; 2z1 + 3z2 g c
Combining both conditions we have that a > b > c, which implies that a > c.
Hence, we have that
min f3x1 + 2x2 ; 2x1 + 3x2 g > min f3z1 + 2z2 ; 2z1 + 3z2 g
and thus (x1 ; x2 ) % (z1 ; z2 ), implying that this preference relation is transitive.
Weak Convexity. This property implies that the upper contour set must be
convex. That is, if bundle (x1 ; x2 ) is weakly preferred to (y1 ; y2 ), (x1 ; x2 ) %
(y1 ; y2 ), then the linear combination of these two bundles is also weakly pre-
ferred to (y1 ; y2 ),
(x1 ; x2 ) + (1 ) (y1 ; y2 ) % (y1 ; y2 ) for any 2 [0; 1]
For compactness, let a 3x1 + 2x2 , b 2x1 + 3x2 , c 3y1 + 2y2 and
d 2y1 +3y2 . Hence, the property that (x1 ; x2 ) % (y1 ; y2 ) implies min fa; bg >
min fc; dg. We therefore need to show that
min f a + (1 ) c; b + (1 ) dg > min fc; dg
1. First case: min fa; bg = a, min fc; dg = c and without loss of generality,
a > c. Therefore,
min f a + (1 ) c; b + (1 ) dg = a + (1 )c
and a + (1 ) c > min fc; dg = c. For this case, convexity is satis…ed.
2. Second case: min fa; bg = a, min fc; dg = d and without loss of generality,
a > d. Hence,
min f a + (1 ) c; b + (1 ) dg = a + (1 )c
and a + (1 ) c > min fc; dg = d given that a > d and c > d. For this
case, convexity is satis…ed as well. An analogous argument applies in the
other two cases, in which min fa; bg = b and min fc; dg = c, and in which
min fa; bg = b but min fc; dg = d.

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2. Finding the compensating and equivalent variation with little information.
Consider a consumer who, facing a initial price vector p0 2 Rn++ for n commodities,
purchases a bundle x 2 Rn+ with an income of w dollars. Assume that the price of all
goods experience a common increase measured by factor > 1.

(a) Compute the compensating variation (CV) of this price increase.

Using the expenditure function, the CV is

CV = e(p1 ; u0 ) e(p0 ; u0 )

where p1 and p0 denote the …nal and initial price vector, respectively, and
u0 represents the utility level that the consumer achieves at the initial price-
wealth pair (p0 ; w). In this exercise, we are informed that …nal prices p1 satisfy
p1 = p0 , thus implying that the above expression for CV can be rewritten as

CV = e( p0 ; u0 ) e(p0 ; u0 )

Recall that the expenditure function is homogeneous of degree one in prices,

i.e., e( p0 ; u0 ) = e(p0 ; u0 ). In words, increasing the prices of all goods by a
common factor increases the consumer’s minimal expenditure (the expendi-
ture he needs to reach utility level u0 ) by exactly . In addition, the consumer
spends w dollars, i.e., e(p0 ; u0 ) = w. These properties reduce the expression
of the CV to

CV = e( p0 ; u0 ) e(p0 ; u0 ) =
= e(p0 ; u0 ) e(p0 ; u0 ) =
| {z } | {z }
w w
= w w = w( 1)

For instance, increasing all prices by 50%, i.e., = 1:5, yields a compensating
variation of CV = 0:5w, which implies that the consumer needs to receive
half of his initial wealth in order to be able to reach the same utility level as
before the price change.
(b) Compute the equivalent variation (EV) of this price increase.
Using the expenditure function, the EV is

EV = e(p1 ; u1 ) e(p0 ; u1 )

where u1 represents the utility level that the consumer achieves at the …nal
price-wealth pair (p1 ; w). In this exercise, we are informed that p1 = p0 , or
p0 = 1 p1 , implying that the above expression for EV can be rewritten as

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EV = e(p1 ; u1 ) e p1 ; u0

Since the expenditure function is homogeneous of degree one in prices, i.e.,

e 1 p1 ; u0 = 1 e (p1 ; u0 ), and the consumer spends w dollars, e(p1 ; u1 ) = w.

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 These properties reduce the EV to

1
EV = e(p1 ; u1 ) e p1 ; u0 =
1
= e(p0 ; u0 ) e p1 ; u0 =
| {z } | {z }
w w
1 1
= w w=w 1

Following the same numerical example as in section (a), if all prices experience
a 50% increase, i.e., = 1:5, the equivalent variation would be EV = 0:3w,
thus suggesting that, before the price increase, the consumer would need to
give up a third of his wealth in order to be as worse o¤ as he will be after the
price increase.

3. Marginal cost being independent of an input price. Consider the production

function f (h(z1 ) + z2 ), where f ( ) is increasing, h( ) is an increasing concave function
which satis…es h0 (0) = 1 and h0 (1) = 0.

(a) Given the input price vector w, show that for large enough output levels, the
input demand correspondence of input 2, z2 (w; q), must be strictly positive.
De…ne v = h(z1 ) + z2 : Consider the pro…t maximization problem,

max p f (h(z1 ) + z2 )
z 0

subject to f (z) q
Since we seek to show that z2 (w; q) > 0; let’s operate by contradiction, by
supposing that the optimal level of input 2 is zero. Then z1 > 0 and FOC
are as follows:
@L 0 0
= pf (v)h (z1 ) w1 = 0:
@z1
@L 0
= pf (v) w2 0:
@z2
0 0 0
Solving for the shadow price , it follows that pf (v)h w1
(z1 )
= pf (v)
w2
, or
0 w1 " 0
h (z1 ) w2
: In addition h( ) is concave, i.e, h (z1 ) < 0, and h (1) = 0; as
depict on the …gure below. It follows that for all su¢ ciently large output
0 w1
and hence z1 , h (z1 ) < w 2
(see …gure 2). But this contradicts our earlier
conclusion. Thus for su¢ ciently large output the FOC cannot hold with

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 z2 = 0:

Figure 2. Function h0 (z1 )

(b) Assuming that z2 (w; q) > 0 (as shown in the previous part), write down the …rm’s
cost function as a function of f 1 (q) and z1 alone. Hence, show that the input
demand correspondence of input 1, z1 (w; q), is independent of q.
From part (a), q is su¢ ciently large so both inputs are strictly positive. From
the production function, we obtain f 1 (q) = h(z1 ) + z2 : Solving for z2 , yields
z2 = f 1 (q) h(z1 ) and so total cost is

c = w1 z1 + w2 z2
1
= w1 z1 + w2 (f (q) h(z1 )):
0
The FOC for minimizing total cost is w1 w2 h (z1 ) = 0 or, after rearranging,
0 w1
h (z1 ) = w2
Thus the cost minimizing level of input 1 is a function only of
the input price ratio and not of output.
(c) Show that the marginal cost is independent of w1 .
Appealing to the Envelope Theorem, we can write the marginal cost as
@c d 1
= w2 f (q):
@q dq
which is independent of w1 :