Problem Set 2

Demand and Slutsky Equation

Demand Functions

1. If the consumer is consuming exactly two goods, and she is always

spending all her money , can both of them be inferior goods?
Answer. Consider the budget equation

p1 x1 + p2 x2 = m

Consider an increase in m (keeping p1 and p2 fixed) and suppose that

good x1 is inferior, that is its consumption falls when income increases.
Inspecting the budget equation we see that if the consumer if spending all
her income then we have that x2 must increase. Hence, both goods cannot
be inferior goods.

2. Show that Cobb Douglas preferences are homothetic.

Answer. There are different ways to show this. Recall that the demand
functions for Cobb Douglas preferences (u( x1 , x2 ) = x1a1 x2a2 ) are of the form
a1,2 m
x1,2 =
a1 + a2 p1,2
then, it is clear that when we scale income by t, demand is also scale by
txi . As a result, the Engel curve is linear.

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 Alternatively, we need to demonstrate that the utility function is homo-
geneous of degree 1. This means that multiplying the inputs by a positive
scalar t results in the output being multiplied by the same scalar:

U (tx1 , tx2 ) = tU ( x1 , x2 )

Substitute the Cobb-Douglas function and the scaled quantities:

β
U (tx1 , tx2 ) = (tx1 )α (tx2 ) β = tx1α x2 = tU ( x1 , x2 )

3. Suppose a consumer has preferences for two goods, x1 and x2 . The pref-
erence of the consumer can be described by the following utility u( x1 , x2 ) =
x1 x2 .

(a) Compute the slope of the indifference curve (MRS) at ( x1 , x2 )

Answer. The MRS is

MU1 x
MRS = = 2
MU2 x1

(b) If the indifference curve is tangent to the budget line at ( x1 , x2 ),

compute the following ratio

p1 x1
=
p2 x2

Hint: Compute the equation that equates the MRS with the slope
of the budget constraint.

Answer. At the optimal we have

x2 p
MRS = = 1
x1 p2

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 Hence,
p1 x1
MRS = =1
p2 x2
that is the ratio of expenditures is constant.

(c) Compute the demand functions x1 ( p1 , p2 , m) and x1 ( p1 , p2 , m).

Answer. Arrange the optimality condition

p1
x2 = x1
p2
Plug it into the budget equation

p1
p1 x1 + p2 x1 = m
p2

which results in
m
x1 =
2p1
and plug it again into the optimality condition we have an expres-
sion for x2
m
x2 =
2p2

(d) Compute the following

∂x1
=
∂p2
Please interpret the result.

Answer.The derivative is simply

∂x1
=0
∂p2

which means that there is no cross-price effect in Cobb Douglas

demand functions.

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 4. Annie is a stamp collector. She also cares about eating chocolate. It
turns out that Annie’s preferences are represented by the utility function
u(s, c) = s + log(c), where s is the number of stamps she collects and c
is the number of chocolates she consumes. Let the price of stamps and
chocolates be ps and pc respectively. Annie’s income is m.

(a) Compute the optimality condition for this consumer (MRS=price

ratio) at the bundle (s, c)

Answer. The MRS is

1 ps
=
1/c pc
(b) Compute the demand functions s( ps , pc , m) and xc ( ps , pc , m).

Answer. The optimality condition gives us immediately the de-

mand for chocolates
ps
c=
pc
Plugging into the budget constraint we can find the demand for s
m
s= −1
ps

(c) Compute the effect of changing income on the demand for stamps
and chocolate.

Answer. The demand for s is independent of income. This is in-

deed a property of a quasilinear demand, that the demand for
good 1 remains constant as income increases.

The demand for stamps is increasing in income. A small change

in income will lead to an increase in 1/ps . The Engel curve for this
good is indeed linear.

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 (d) Now suppose that ps > m. What is the demand for stamps? Does
it make sense? Recompute the demand for both goods in this "cor-
ner" solution. (Hint: Since demand cannot be negative set it to
zero.)

Answer. Since demand for stamps is negative we set it to zero.

Then, we have
s = 0.
m
c=
pc
Notice that this is only true for the case ps > m. When ps < m, we
have the demand you derived in part (b).

Slutsy Equation

5. Gentle Charlie, vegetarian that he is, continues to consume apples and

bananas. His utility is u( x A , x B ) = x A x B . The price of apples is $1, the
price of bananas is $2, and Charlie’s income is $40. The price of bananas
suddenly falls to $1.

(a) Compute the optimal choice of apples and bananas before and af-
ter the price change. Plot in a graph the budget line, the utility,
and the optimal choice (before and after).

Answer. As before, the optimal demands are

m 40
xA = = = 20
2p A 2×1
m 40
xB = = = 10
2p B 2×2

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 When the price of good B falls, the demand for B is
m 40
xB = = = 20
2p B 2×1

(b) Compute the substitution effect. That is compute, after the price
change, the amount of income (m′ ) so Charlie would consume the
original bundle. Use this new income to draw a new budget line
that pivots around the original bundle. What is the magnitude of
the substitution effect?

Answer. The new income

m′ = 1 × 20 + 1 × 10 = 30

so now only $30 is needed to afford the original bundle. Compute

the new demand for good B given this hypothetical income
30
x1 ( p1′ , m′ ) = = 15
2×1
The substitution effect is then,

∆x1s = 15 − 10 = 5

(c) Does the substitution effect of the price of bananas make him buy
more or less bananas? How many?

Answer. The consumer consumes 5 more bananas.

(d) Now compute the size of the income effect.

Answer. First, compute the demand for bananas at the new prices
(and old income), is
40
x1 ( p1′ , m) = = 20
2×1

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 ∆x1n = 20 − 15 = 5

(e) Finally, compute the total change in demand.

Answer. The total change in demand is

∆x B = ∆x1s + ∆x1n = 5 + 5 = 10