Universidad Carlos III Microeconomics

CONSUMER THEORY

I. Preferences; indi¤erence curves; utility functions

1. Graph indi¤erence maps consistent with the preferences described:
(a) My welfare is larger the larger my income (x) and the smaller pollution (y):
(b) I need 1000 milligrams of Tylenol (x) to obtain the same relief to my pain I
get with 500 milligrams of Aspirin (y).
(c) I like my martinis with one dose of vermouth (x) and 5 doses of gin (y).
(d) I like hamburgers (x) and beer (y); and I am always willing to exchange one
beer for any amount of hamburgers.
(e) I am always willing to exchange two hamburgers for one beer.
(f) I always drink a beer when I have a hamburger.
(e) I like to drink a beer, but I am allergic to meet.
2. Identify the axioms of the consumer that imply the properties of the indi¤erence
maps described below:
(a) Indi¤erence sets are curves (that is, they are not “thick”).
(b) Every bundle belongs to one indi¤erence curve.
(c) Indi¤erence curves do not cross.
(d) Indi¤erence curves are downward sloping.
3. (a) Two items have been weighted. The …rst one weighs 50 Kilos and the second
55 Kilos. As 55/50=1.1, we say that the second item is 10% heavier than the …rst.
Is that statement still true if the weight is measured in pounds?
(b). The temperature of 2 objects has been measured. The temperature of the
…rst one is 50 degrees Fahrenheit and that of the second is 55 degrees Fahrenheit.
We can say: “the second object is 10% hotter than the …rst”. Can we keep that
statement if the measurement is made in Celsius? The temperature of a third object
is 65 degrees Fahrenheit. We say: “the di¤erence between the temperature of the
third and the second object is twice the di¤erence between the second and the …rst.”
Is this true independently of the scale of measurement?
(c) A consumer whose preferences are represented by the utility function u, whose
values we refer to as utils. Thus, if the consumption bundles A and B are worth 50
and 55 utils, respectively, we can say B conveys a 10% more utility than A. Is that
statement still true if the (same) preferences are represented by the utility function
U = u2 (i.e., U is obtained from u the by squaring the values of u); that is, does B
convey 10% more Utils than B:
(d) In the context of question (c), assume that the utility of a bundle C is 65 utils.
Thus, u(C) u(B) = 2 (u(B) u(A)). Does this equation hold for the function U ?
Is the statement: switching from bundle B to C consumer’s welfare increases twice
as much as switching from bundle A to B correct?
4. Calculate and represent the indi¤erence curves that contain the bundles (x; y) =
(1; 1) and (x; y) = (1; 2) of individuals with preferences represented by the utility
p
functions: (a) u(x; y) = xy. (b) u(x; y) = xy=4. (c) u(x; y) = y + 2 ln x. (d)
u(x; y) = 4(x + 2y)2 : (e) u(x; y) = minfx2 ; 2yg:

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Multiple Choice Questions

I.1. An individual’s preferences over consumption bundles (x; y) 2 R2+ are complete
and transitive (axioms A:1 and A:2). If the individual considers the consumption
of good x to be detrimental to her welfare and the consumption of good y to be
bene…cial, then his indi¤erence curves
cross are increasing
are concave have area.

I.2. If an individual’s preferences over goods x and y are monotonic (axiom A:3),
then its indi¤erence curves
do not cross are increasing
are decreasing are convex.

I.3. Identify the axiom that guarantees that indi¤erence curves do not cross.
Completeness (A:1) Monotonicity (A:3)
Transitivity (A:2) Convexity (A:5)

I.4. The Pareto preference P, de…ned as (x; y) P (x0 ; y 0 ) if x x0 and y y0,

do not satisfy axiom A:1 (completeness) do not satisfy axiom A:3 (monotonicity)
do not satisfy axiom A:2 (transitivity) satisfy axioms A:1 A:3.

I.5. It is known that a consumer’s preferences satisfy axioms A:1; A:2 and A:3; and
that A = (0; 2) B = (1; 1): Therefore, we can infer the following relation between
these bundles and C = (1; 2):
C B CvA
CvB C A:

I.6. A consumer’s preferences for bundles (x; y) 2 R2+ are complete, transitive and
monotonic (axioms A:1; A:2 and A:3). Then the preference relations between A =
(1; 1); B = (2; 2); and C = (1; 2) necesarily satisfy
C B C A
C A B C.
I.7. It is known that a consumer’s preferences satisfy axioms A:1; A:2 and A:3;
and that the consumer is indi¤erent between the bundles A = (1; 2) and B =
(2; 1): Therefore, we can infer the following relation between these bundles and
C = (1; 3):
C B C B
CvB C A:

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II. The Marginal Rate of Substitution
5. The preferences of Juan and María over leisure activities di¤er signi…cantly: Juan
prefers going to the football stadium while María prefers to go to rock concerts.
(a) Graph indi¤erence maps for Juan and María illustrating these di¤ering pref-
erences.
(b) Using the concept of marginal rate of substitution, explain the di¤erent cur-
vature of their indi¤erence curves.

6. The preferences of an individual over clothes (x) and food (y) are represented by
p
the utility function u(x; y) = x + 2 y.
(a) What is the impact of an increase of the individual’s consumption of clothing
over his MRS?
(b) If we want to increase the individual MRS, should we increase the consumption
of clothes or food?
(c) For which bundles is the MRS equal to 4?

7. Calculate the MRS for the preferences represented by the utility functions given
in exercise 4.In each case, determine if an individual with 2 units of each good would
be willing to give 1 in…nitesimal unit of x in exchange of 1; 5 in…nitesimal units of y.
Would he be willing to exchange 1 unit of x for 1,5 units of y? Would he be willing
to do either of these exchanges if he has two units of x and one unit of y?

8. Graph the indi¤erence curve containing the bundle (x; y) = (3; 3) and calculate
the MRS at this bundle and a arbitrary bundle in this curve for individuals with
p
preferences represented by the following utility functions: (a) u(x; y) = xy. (b)
p p
u(x; y) = 2 xy. (c) u(x; y) = 4 + 3 xy. (d) u(x; y) = xy.

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III. The consumer problem: budget set; interior and corner solutions

9. Assume that the price of natural gas is 0.05 euros/m3 and the price of electricity
is 0.06 euros/Kilowatt per hour. However, after buying 1000 Kilowatts per hour it
falls to 0.03 euros. If the consumer has 120 euros at his disposal to spend on energy,
draw his budget set.

10. In some autonomous communities, the water tari¤s have a scheme as follows:
in order to receive any water supply at all, the consumer must pay an initial tax
T , which allows the individual to consume x1 liters of water without extra costs. If
water consumption is x 2 (x1 ; x2 ] the water bill increases by p(x x1 ) units, and if
consumption exceed x2 then the cost per liter becomes p0 .
(a) Graph the corresponding budget constraint for water x and other goods (y,
euros available for consumption of other goods) assuming that the consumer’s income
I satis…es I > T + p(x2 x1 ).
(b) If an individual with preferences satisfying axiom A:3 pays the connection tax
T; would you expect that he consumes an amount of water less than x1 under this
scheme?
(c) Do you think it is possible that, under the axioms A1-A4, an individual be
indi¤erent between two bundles that di¤er in water consumption?

11. A consumer preferences over x and y are described by the utility function u(x; y) =
2x + y: His monetary income is I = 15 euros. Calculate his optimal consumption
bundle when prices of the goods are (px ; py ) = (1; 2); (p0x ; p0y ) = (3; 1) and (p00x ; p00y ) =
(2; 1).

12. A consumer’s preferences for food (x) and clothes (y) are represented by the
p
utility function u(x; y) = x + y. The prices are px = 4 and py = 1 euros per unit,
respectively, and the consumer’s income is I = 10 euros. Represent the consumer’s
budget set and calculate her optimal consumption bundle.

14. An individual owns an income I = 200 that she devotes to buying water (x) and
food (y), whose prices are px = 4 and py = 2. Her preferences over these goods are
represented by the utility function u(x; y) = min fx; yg :
(a) Graph some of his/her indi¤erence curves, the budget constraint and the
optimal choice, and identify her optimal consumption bundle.
(b) Assume now that she must pay a tax t = 1 euro for every unit in excess of 10;
that is, if she consumes 12 units of water, for example, the …rst 10 units are charged
a price px = 4 euros per unit, and the 2 remaining units are charged px + t = 5 euros
per unit. Repeat exercise a).

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Multiple Choice Questions

III.1. If price of good y increases by 20%, then the budget line

maintains its position rotates over its intersection with the y-axis
shifts parallel towards the origin rotates over its intersection with the y-axis.

III.2. If prices increase by 20%, then the budget line

translates parallel towards the origin rotates over its intersection with the x-axis
translates parallel away from the origin maintains its position.

III.3. If a consumer’s income increases by 10%, the price of good x increases by 5%,
and the price of good y increases by 10%, then his budget line

shifts parallel towards the origin rotates over its intersection on the y-axis
shifts parallel away from the origin rotates over its intersection on the x-axis.

III.4. A consumer whose monetary income is I = 4 is considering buying the bundle

(2; 0) : If px = 2; py = 1; and M RS (2; 0) = 3, then the consumer should

buy more x and less y buy more x and y

buy more y and less x buy the bundle (2; 0).

III.5. If a consumer’s marginal rate of substitution is M RS(x; y) = 2 (constant) and

her income is I = 8, then at the prices (px ; py ) = (1; 2) her optimal consumption
bundle is
(2; 3) (8; 0)
(4; 2) (2; 4)

III.6. The optimal bundle (x ; y ) satis…es the budget constraint px x + py y = I as

a consequence of the axiom

A:1 (completeness) A:3 (monotonicity)

A:2 (transitivity) A:5 (convexity).

III.7. If a consumer’s preferences are represented by the utility function u(x; y) =

(x + y)2 ; her income is I = 4, and prices are (px ; py ) = (1; 2), then her optimal
consumption bundle is

(0; 2) (4; 0) (2; 1) (4; 1):

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IV. Demand functions: the income and substitution e¤ects

15. A consumer has preferences described by the utility function u(x; y) = 2xy:
(a) Compute the demand curve for good x. Is good x inferior or normal? Is x a
Gi¤en-good? Which is the price-elasticity of this good? Represent the Engel-curve
of x for px = 2 and py = 3.
(b) Determine and represent the optimal consumption bundle if his income is
I = 15 and the prices of the goods are px = 2 and py = 3. Compute the income and
substitution e¤ects over good x of an increase to p0x = 3.
16. A consumer’s preferences for food (x) and clothes (y) are represented by the
utility function u(x; y) = xy 2 . The prices are px and py euros per unit, respectively,
and the consumer’s income is I euros.
(a) Calculate the consumer’s ordinary demands, x(px ; py ; I) and y(px ; py ; I).
(b) Assume that the consumer’s income is I = 12 and prices are (px ; py ) = (1; 2):
In order to rise revenue to …nance public expenditures, the government levies a 1
euro/unit sales tax on good x: Calculate the substitution and income e¤ects of this
tax on the demand of good x: If the government replaced this tax with an income
tax that rises the same amount, would the consumer be better o¤ or worse o¤ than
with the sales tax on good x?
17. A consumer’s preferences over clothing (x) and food (y) are represented by the
p
utility function u(x; y) = x + 2 y. The price of clothing is px = 1 euro per unit, the
price of food is py = p euros per unit and the consumer’s income is I euros.
(a) Calculate her demand for food y(p; I) for I 1=p and for I < 1=p:
(b) Represent graphically the consumer’s budget set and calculate her optimal
bundle and utility level for p = 1=2 and I = 1. Calculate the income and substitution
e¤ects over the demand for food of a unit tax of 50 cents on the price of food.
Calculate the tax revenue.
18. A consumer preferences for goods x and y are represented by the utility function
u(x; y) = y + 2 ln x.
(a) Calculate her ordinary demand functions. (Use the notation px ; py and I for
prices and income, respectively.)
(b) Assume that the prices are px = py = 1 and the consumer’s monetary income
is I = 30; and that a sale tax of one euro per unit of x is introduced. Show that
the revenue obtained with this sale tax is less than the revenue that can be obtained
with a direct tax on monetary income, R; whose e¤ect on the consumer welfare is
identical to that of the sale tax.
19. A consumer’s preferences over clothing (x) and food (y) are represented by the
utility function u(x; y) = 2 ln x + ln y. The price of clothing is px = 1 euro per unit,
the price of food is py = p euros per unit and the consumer’s income is I euros.
(a) Calculate her ordinary demand functions for food and clothing. Represent
graphically the consumer’s budget set and calculate her optimal bundle and utility
level for (px ; py ) = (2; 1) and income I = 12.
(b) Calculate the substitution and income e¤ects over the demand of clothing (y)
of a unit sale tax of one euro.

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Multiple Choice Questions

IV.1. If a consumer’s preferences are represented by the utility function u(x; y) =

minfx; yg; then a decrease in the price of x causes

a decrease in the demand of x a negative income e¤ect

an ambiguous e¤ect on the demand of x a substitution e¤ect equal to zero.

IV.2. A consumer’s preferences are represented by the utility function u(x; y) = 2x+y,
and market prices are px = py = 2. A decrease in price of good x to p0x = 1 causes

an increase in the demand of y a substitution e¤ect equal to 0

an decrease in the demand of x an income e¤ect equal to 0:

IV.3. If x is and inferior good, then a decrease of px

increases the demand of x increases the demand of y

decreases the demand of x has an ambiguous e¤ect on the demand of x.

IV.4. A consumer likes co¤ee all brands equally. As the price of one of the brands
changes, the price-consumption curve

translates horizontally has a positive slope

translates vertically coincides with the axis of the cheapest brand.

IV.5 If x is a gi¤en good, then the substitution (SE), income (IE) and total (T E)
e¤ects of an increase of its price px are:

SE < 0; IE > 0; T E < 0 SE < 0; IE > 0; T E > 0

SE < 0; IE < 0; T E < 0 SE > 0; IE > 0; T E > 0:

IV.6. An individual preferences are represented by the utility function u(x; y) =

x + 2y; and the prices are px = py = 2. A decrease of the price of y to p0y = 1 causes

an increment of the demand of good x a substitution e¤ect equal to zero

a decrease of the demand of good y an income e¤ect equal to zero.

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V. Applications: the choice of consumption and leisure, labor supply

20. Esther receives a monthly assignment of M euros from her parents. In addition,
her aunt o¤ers her the possibility of day caring her cousins, Elena and Sara, during
the weekend, paying her a daily wage of w euros. Esther’s preferences for leisure
during the weekend (h; measured in days) and p consumption (c; measured in euros)
3
are represented by the utility function u(h; c) = h2 c: Esther is endowed with H = 9
weekend days. Describe Esther’s problem and calculate her demand of consumption
and leisure, and her “labor”supply (number of days she will o¤er to take care of her
cousins) as a function of M and w. Represent Esther’s budget set and calculate her
optimal consumption-leasure bundle for M = 120 and w = 40: If M = 120; what is
the lowest wage w for which Esther’s labor supply is positive? If w = 40; what is the
lowest monthly assignment M for which Esther’s labor supply is zero?

21. A consumer-worker, who receives a non-wage rent of 360 euros every day, has the
following preferences over consumption (c) and leisure (h), represented by the utility
function U (h; c) = c3 h:
(a) Determine which is the lowest wage per hour for which he is willing to work a
positive amount of time.
(b) How many hours will he work at a wage of 4 euros per hour?
(c) How much time will he work at a wage of 9 euros per hour? And at 11.25 per
hour?
(d) Determine the income and substitution e¤ect of an increase in the wage per
hour from 9 to 11.25 euros.

22. The preferences of a worker for leisure (h; measure in hours) and consumption
p
(c; measured in euros) are represented by the utility function u(h; c) = h + 2 c:
The worker has H = 16 hours to use as labor or leisure, and has no other sources
of income than his labor income. Calculate and represent his labor supply. (Note
that pc = 1 since we are measuring consumption in euros). Assume that the wage is
w = 4; and that there is an unemployment subsidy of S euros (that is received only
by those workers who do not work at all). Calculate the leisure-consumption bundle
of the worker assuming that S = 5. What is the smallest value of S for which the
worker would choose not to work?

23. María has a daily endowment of 12 hours (to work or use for leisure activities)
and a monetary (non-labor) income of M euros. Her preferences are represented by
the utility function u(h; c) = 2 ln h + ln c; where h denotes the number of hours of
leisure and c denotes her consumption. Set the price of consumption to pc = 1; and
denote by w the hourly wage.
(a) Describe María’s problem, and calculate her demands of leisure and consump-
tion, as well as her labor supply as functions of M and w.
(b) Using your results in (a), represent María’s budget set and calculate her op-
timal consumption-leisure bundle for M = 6 and w = 4: Calculate income and
substitution e¤ects over the demand of leisure caused a 25% tax on labor income.

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24. Ana is a student whose welfare depends on her average grade m 2 R+ and
her consumption c 2 R+ : (Assume that consumption is measured in euros, so that
pc = 1:) Her preferences are represented by the utility function u(h; c) = ln m + ln c:
Ana has H = 15 hours that she can allocate to study and/or supply as labor. Ana’s
average grade m is determined by the number of hours she studies e according to
the formula m = 32 e: The hourly wage is w 0 euros, and Ana has no other income
(besides her labor income).
(a) Describe Ana’s budget constraint and graph her budget set in the plane (m; c).
Calculate the number of hours she studies and works as a function of w. Assuming
that w = 4, calculate Ana’s optimal average grade and consumption (m ; c ) bundle,
and represent it in the graph.
(b) Assume now that a program is introduced that rewards students with an
average grade m = 7 or above with M = 10 euros. Assuming that w = 4; graph
Ana’s new budget set and determine the impact of this change on her average grade
and consumption.

25. Consider an individual about to retire with preferences for leisure (h; measured
in hours) and consumption (c; measured in euros) represented by the utility function
u(h; c) = hc, whose salary is 15 euros/hour, and has a total of 140 hours per month
available to use as leisure or supply as labour. He is entitled to a monthly pension
1200 euros, but if he continues working, this pension would be reduced by t(15l);
where l is the number of hours he works and t 2 [0; 1=2]. Write down the individual’s
budget constrain, draw his budget set and calculate his labor supply l(t). For which
values of t will he choose to retire altogether?

26. Every consumer-worker has 1 unit of time (one day, for example) he can devote to
leisure or work, and some preferences over leisure (h) and consumption (c) described
by the utility function u(h; c) = h + ln c: Apart from his wage income, the consumer
owns a non-labor income of M euros (that is, the quantity M is independent of the
wage and the time he works). The price of the consumption good is p = 1 and the
wage is w.
(a) Derive the labor supply of each individual as a function of w and M .
(b) Compute the aggregate labor supply, with the assumption that there are 10
identical individuals, 5 of whom with a non-labor income M = 3, and the remaining
5 with M = 0. Given that the aggregate labor demand is LD (w) = 20 w
; compute the
wage, the employment level and the consumer surplus of workers in the competitive
equilibrium. Represent the aggregate-demand and aggregate-supply curves and the
equilibrium situation in a diagram.

9
VI. Applications: consumer surplus, compensated variation, equivalent
variation, price indices

27. Assume that x and y represent housing services, measured in squared meters per
year, and the rest of goods, respectively. A representative consumer has preferences
for those goods represented by the utility function u(x; y) = xy 2 : Prices are px = 3
and py = 1. The government proposes a subsidy of 1 euro per square meter consumed.
The opposition complains arguing that the value of the subsidy to the individual is
inferior to the cost incurred by the State. What would you recommend? Why?

28. Consider the following situation of a pensioner who consumes two goods, food
(x) and clothes (y). When he got retired in 1997, the Social Security awarded a
pension of 15000 euros to him. In that year, the prices of food and clothes were 8
euros and 50 euros, respectively. Suppose that the utility function of the pensioner
p
is u(x; y) = x y:
(a) Determine and represent the pensioner’s choice under those conditions.
(b) Suppose that in 1998 the prices of food and clothes are 10 euros and 75 euros,
respectively. Determine and represent the choice of the pensioner in case that his
pension is not updated.
(c) Which pension should we give the pensioner for him to recover his initial utility
level with the minimum cost for the social security?

29. The preferences of a consumer between 2 goods x and y are described by the
utility function u(x; y) = ln x+ln y: The prices of these goods are px = 1 and py = 1=2.
(a) Determine the solution to the consumer’s problem at those prices for any
income I.
(b) Because of an ecological disaster, the supply of good x decreases and its price
doubles. As a consequence, the welfare of the consumer decreases. Trying to mitigate
the disaster, the local authority is willing to subsidize the consumer. Compute the
monetary quantity S that must be given to the consumer to keep the same utility
level he had before the disaster.
(c) If the authority did not know the preferences of the consumer but had observed
the quantities of both goods consumed before the disaster, they could compensate the
consumer giving him the income variation that would allow him to purchase those
quantities at the new prices. Which would be the cheapest solution for the local
authority?

30. János, the typical consumer from Hungary, only consumes two goods: paprika,
x; and brandy, y. The preferences of János are represented by the utility function
u(x; y) = y + ln x. The price of paprika is px = p euros and the price of brandy is
py = 1 euro. János monetary income is I euros.
(a) Calculate János demand for paprika and brandy as a function of (p; I) for
I > 1:
(b) Represent János’ budget set for (p; I) = (1=2; 10) and calculate his optimal
bundle and utility level.

10
 (c) Calculate the income and substitution e¤ects on the demand of paprika of an
increase of its price from p = 1=2 to p0 = 1:
(d) How much is János willing to pay to avoid the price of paprika to increase
from p = 1=2 to p0 = 1?

31. Let’s classify goods into two groups: clothes and shoes x and food y. The
preferences of a retired person who earns a pension of I = 250 euros are represented
by a utility function u(x; y) = x0:4 y 0:6 : At the prices of 1975 p0 = (1; 1), which will be
taken as a base year, he chooses the bundle q0 = (100; 150). In 1986 the prices were
p1 = (2; 3=2) and our pensioner consumed the combination q1 = (50; 100).
(a) How much should the Government increase the pension to guarantee that the
pensioner keeps the welfare level reached in 1975? We will denote by I1 the new
income.
(b) A true ”price index”, to summarize in a scalar the price evolution between
both dates, could be de…ned in the following way: I(p1 ; p0 ; u0 ) = I1 =I0 , where in this
case I0 = 250. Verify that the Laspeyres price index estimated in the usual way is an
upper bound for this expression.

32. A consumer’s preferences for food (x) and clothes (y) are represented by the utility
p
function u(x; y) = x + y. The prices are px and py euros per unit, respectively, and
the consumer’s income is I euros.
(a) Calculate the consumer’s ordinary demands, x(px ; py ; I) and y(px ; py ; I). Rep-
resent the consumer’s budget set and calculate her optimal consumption bundle if
her income is I = 8 and prices are (px ; py ) = (4; 1):
(b) Assuming that I = 8 and (px ; py ) = (4; 1), calculate the equivalent variation
of a tax of 1 euro per unit of good y; and compare it to the tax revenue. How do you
explain the di¤erence?

The preferences of an individual over leisure (h) and consumption (c) are repre-
sented by the utility function u(h; c) = hc3 : The price of the consumption good is
equal to 1 euro, the wage is 4 euros per hour and the individual can allocate 16 hours
a day between consumption and leisure.
(a) How much leisure does the individual consume every day?
(b) If the individual had to pay one third of his labor income as taxes, which
would be his daily consumption of leisure? Which e¤ect is bigger, the income e¤ect
or the substitution e¤ect?
(c) If instead of a proportional tax over income the individual must pay 16 euros
per day, which would be his daily consumption of leisure?.
(d) Which taxation system will the individual prefer?

11
Multiple Choice Questions

VI.1. Assume that in 2007 prices were (px ; py ) = (3; 2); and in 2008 they were
(p0x ; p0y ) = (2; 4): If the bundle of the representative consumer is (2; 2); and one mea-
sures the CPI (consumer price index) using a Laspeyres Index, then the percentage
change in prices is
25% 20%
30% 50%:
VI.2. Assume that in 2007 prices were (px ; py ) = (2; 3); and in 2008 they were
(p0x ; p0y ) = (3; 4): If the bundle of a consumer in 2007 was (2; 2); then his true CPI
index is
less than 40% exactly 40%
greater than 40% undetermined:
VI.3. Between 2009 and 2010 the prices of both goods, x and y; increased by 10%.
If the consumer income increased by a rate equal to the consumer’s true price index,
then her budget line
shifted parallel towards the origin rotated over its intersection with the x-axis
shifted parallel away from the origin maintained its position.
VI.4. The prices of the goods x and y in the base period were (px ; py ) = (2; 2); and
the optimal bundle of the representative agent was (x ; y ) = (2; 1). If the current
prices are (p0x ; p0y ) = (1; 4), then the Laspeyres CPI is
CP IL = 1 CP IL = 1; 66
CP IL = 1; 5 CP IL = 0; 8:
VI.5. If a consumer’s income is multiplied by the Laspeyres consumers price index,
then
the consumer receives exactly the compensated variation
the consumer’s budget set remains unchanged to be that of the base period
the consumer’s welfare increases relative to that of the base period
the consumer’s welfare remains unchanged to be that of the base period.
VI.6. A consumer’s preferences are described by the utility function u(x; y) = xy: The
prices in the base period were (px ; py ) = (1; 1) and her optimal consumption bundle
0
was (x ; y ) = (1; 1): If the current prices are (px ; p0y ) = (1; 4), then the di¤erence
between her Laspeyres consumer price index (CPI) and her true CPI is:
0,1 0,2 0,5 1.
VI.7. If a consumer’s preferences are represented by the utility function u(x; y) =
2x + y; her income is I = 4 and the prices are px = py = 1; then the equivalent
variation of a sales tax on 1 euro per unit of good x is:
0 1 2 4:

12
V. Consumer Theory under uncertainty
33. A student has just graduated. He has just received an inheritance of 4 millions of
euros and is considering whether to invest 2 millions of euros in a start up business.
If the business is successful, he expects a gross pro…t of 6 millions of euros, but if it
fails he will lose the investment. The probability of success is p = 1=2.
(a) Determine whether the student will make the investment if her preferencesp are
2
represented by the Bernoulli utility function: (i) u(x) = x; u(x) = x ; u(x) = x?.
(b) Suppose now the student’s preferences are represented by the utility function
u(x) = x2 : A study that costs a millions of euros predicts with certainty if the
investment will be lucky or not. Should the student buy the mentioned study if
a = 1? And if a = 0:5?
(c) Suppose …nally
p that the student’s preferences are represented by the utility
function u(x) = x: Let’s suppose that, to a this student; it is o¤ered the possibility
to implement the the previous investment if he receives a tax break of b millions of
euros. Should the student accept this tax break if b = 1? And for b 6= 1?
34. Pedro Banderas has a wealth of 100 thousand euros and is considering whether
to produce a movie whose budget is 250 thousand euros. A …lm company is willing to
…nance the movie but wants Pedro to share some of the risk (and pro…ts); speci…cally
it is willing to …nance 80% of the budget. Assuming that the distributors like the
movie, Pedro expects the movie to generate box o¢ ce revenue of 250 thousand euros
if the reviews are bad, and as much as 1,5 million euros it the reviews are good. It is
known that distributors like 8 out of 10 movies that are produced, and that 1 out of
10 movies that are distributed get good previews. Pedro’s preferences are represented
by the Bernoulli utility function u(x) = x.
(a) Represent the decision problem and determine whether or not Pedro should
produce the movie.
(b) Determine whether Pedro may be willing to …nance 40% (instead of 20%) of
the movies’budget.
35. The oil company Tibitrol has bought some deserted land in Monegros. The
company’s geologist estimates that the probability that they will …nd oil in this land
is 0.2. The drilling of the land in order to check whether or not it really has oil costs
100 millions of euros. If they …nd oil, then the company will make revenues of 300
millions of euros. If they do not …nd oil, then the drilling will be completely useless.
The company has to decide whether or not it will do the drilling. If the company is
risk neutral what will it decide to do in order to maximize its expected utility? And
if the company is risk averse?
36. An individual must decide whether to …nance its house with a mortgage at a …xed
interest rate (FM), or at a variable interest rate (VM). FM involves an annual payment
of P thousands of euros, while a VM involves an annual payment of 17 thousand euros
with probability 12 ; 20 thousand euros with probability 31 , and 30 thousand euros with
probability 16 . The individual’s annual income is 50 thousand euros, and his welfare
depends on his net income x; measured in thousands of euros, which is equal to his
income minus his mortgage payment. The individual’s preferences over lotteries are

13
 p
represented by the Bernoulli utility function u (x) = 2 x: For which values of P
would he prefer to …nance his house with the FM mortgage?
37. A professor is preparing a multiple choice exam in which there are four possible
answers to each question, of which only one is correct. A correct answer is worth
1 point. Students preferences satisfy the usual assumptions, and are described by
a Bernoulli utility function u(x); where x is the number of points obtained in the
exam. Assume that when a student does not know the answer to a question, then he
believes that all answers are equally likely to be correct.
(a) Assuming that there is no penalty for an incorrect answer –that is, an incorrect
answer is worth zero points –describe the alternative decisions (lotteries) of a student
who does not know the answer to a question. If a student is risk neutral, is it optimal
to answer the question randomly? ¿What if she is risk averse?
(b) Assuming that the student is risk neutral, calculate the certainty equivalent
of the lottery of responding to a question the student does not know the answer
to. If it is known that students are either risk averse or risk neutral, which is the
minimum penalty for each incorrect answer that would induce students not to respond
to questions whose answers they do not know?
38. An entrepreneur has an income of 150 thousand euros and is considering intro-
ducing a new touristic product that requires an investment of 200 thousand euros.
An investment fund o¤ers him the possibility of …nancing 50% of the investment in
exchange of 60% of the revenues it generates. The entrepreneur beliefs that if the
weather is favorable during the tourist season, then the new product would generate a
revenue of 200 thousand euros or 500 thousand euros with the same probability, while
if the weather is unfavorable the product would be a …asco (that is, it would generate
no revenue). Historically, the region enjoys a favorable weather with probability 0.6.
The preferences of the entrepreneur are represented by the Bernoulli utility function
u(x) = x2 ; where x is the net disposable income in thousands of euros. Determine
whether the entrepreneur should introduce the new product (I), accepting the o¤er of
the investment fund, or rather abstain form introducing the product (N I) maintain-
ing his current income. Would the entrepreneur be willing to pay 25 thousand euros
to know before making the decision whether the weather will be favorable during
the tourist season? (Your answers would only be valid if they are supported by the
appropriate correct calculations.)
39. Germán Cienfuegos is considering starting a business that requires an investment
of 200 thousand euros, and that may yield a gross income of 300 thousand euros with
probability p and of only 100 thousand euros with probability 1 p. (That is, the
investment will result in gains or losses of 100 thousand euros with probabilities p and
1 p:) Germán only has 100 thousand euros available, but he may get a mortgage
on his house (which has a value of 100 thousand euros) at an interest rate of 5%.
Alternatively, he has a friend that seems willing to share equally (50%) risks and
pro…ts contributing with 100 thousand euros to complete the amount required to
start the business. The problem is that it is unclear whether this friend is cooperative
or con‡ictive. Germán believes that if he manages the …rm himself (that is; if he is
the only investor), then p = 3=4, while if he shares the investment and management

14
with his friend
p then this probability decreases to p = 2=3. Germán’s Bernoulli utility
is u(x) = x; where x is his wealth (that is, the sum of the value of his house and his
cash) measured in thousands of euros. Describe the problem that Germán faces (the
set of lotteries he may choose from) and determine his optimal decision. Assuming
that when his friend is cooperative the probability remains at p = 3=4, determine if
Germán is willing to pay 5 thousand euros to know beforehand whether his friend is
cooperative or con‡ictive.
40. In the market of car insurance, there are two kinds of drivers, good drivers (who
have one accident per year with probability 0.1 and no accident with probability 0.9)
and bad drivers (who have one accident per year with probability 0.1, two accident
with probability 0.05 and no accident with probability 0.85). Repairing a car cost on
average 2,000 euros. The proportion of good and to bad drivers is 2 to 1.
(a) Assume that the insurance companies are risk neutral and they cannot distin-
guish between good and bad drivers. What is the minimum price that these companies
would be willing to o¤er in order to cover the risk of an accident?
(b) Imagine that
p the preferences of the drivers are represented by the utility
function u (x) = x; and that their initial wealth is 5,000 euros. Which type of
drivers (good and/or bad) will subscribe to an insurance policy with the minimum
price determined in part (a)?
41. A risk neutral person needs to put a mortgage on one of his buildings in order to
get 200,000 euros. He has to pay back this amount in 2 annual payments of 100,000
euros, each one with the corresponding interest rate. The mortgage credits among
which he could choose are: (1) Fixed interest rate: 10% per year; (2) Interest rate
9% in the …rst year which can increase to 14%, decrease to 8% or remain the same
in the second year; (3) Interest rate 7% in the …rst year which can increase to 20%,
decrease to 6% or remain the same in the second year.
(a) Determine the decision which maximizes the expected pro…ts knowing that
the interest rate increases with probability 0.6 and decreases with probability 0.2.
(b) How much is this person willing to pay in order to learn whether the interest
rate will increase, decrease or remain the same?
42. A consumer must choose between buying an apartment in Madrid or a house in
the suburb. Both choices would cost him 120,000 euros. He is indi¤erent between the
two options, except for his expectation regarding revaluation. If the housing prices
keep on increasing (event E1 ), the price of the apartment will reach 140,000 euros,
while the price of the house will reach 340,000 euros. The probability that this will
happen is 0.3. If the opposite thing (decrease in the housing prices) happens (event
E2 ), the price of the apartment will be 70,000 euros and the price of the house 20,000.
p
The preferences of the consumer are represented by the utility function u(x) = x,
where x is the wealth expressed in euros. The consumer’s initial wealth is 140,000
euros.
(a) Represent the decision problem and determine whether the consumer should
buy the house or the apartment.
(b) Should he pay 20,000 euros in order to learn whether the housing prices will
decrease or increase?

15
43. The introduction of a new product in the market takes includes three stages:
Design, Experimentation, and Production. 7 out of 10 products do not pass the
design stage. From those that do pass it, only 10% pass the experimentation stage
and are being produced. Only 1 out of 5 products produced has success in the market.
For each new product the costs of each stage are 100,000, 20,000, and 200,000 euros,
respectively. The expected pro…ts from a product that passed successfully the three
stages are 60 millions of euros.
(a) Which is the expected value of constructing a new product?
(b) For 15,000 euros a consultant can predetermine (without any uncertainty)
whether or not a product that has already passed the design stage will pass the
experimentation stage. What is the value of the consultant’s services, assuming the
entrepreneur is risk neutral?
44. The marketing chief of a big computer producer has to decide whether to launch
a new campaign before (d1 ) or after the month of May (d2 ). If he does before, he will
manage to obtain 100 millions Euros of sales. If he does after, there is a risk that its
competitor launches its own campaign before (C), which will occur with probability
0.4. Moreover, the sales also depend on the predictions of the state of the economy,
which can be good (A) with probability 0.5, stable (E) with probability 0.3, and bad
(R). If the economy is good, and the competitor has not launched its campaign,
sales can reach 150 millions Euros, and if its competitor did launch its campaign,
sales would reach a value of 120 millions Euros. If the economy is stable, sales would
reach 90 millions of Euros if the competitor launches its campaign and 110 millions
if it does not. Finally, when the economy is bad, and if the competitor launches its
campaign, sales will reach 70 millions Euros while they would go up to 80 millions
Euros if the competitor does not. Assuming that the producer is risk-neutral, what
is the best decision? How much would be the marketing chief ready to pay in order
to know with certainty all the uncertain variables of the problem? How much would
he be willing to give to an industrial spy who would tell him with certainty whether
the competitive …rm will launch its own campaign or not?
45. A professional has an annual wage of 250; 000 and his income tax rate is 50%.
He considers whether he should declare his full income, declaring half of his income,
or declaring nothing at all. It is known that the probability of a Hacienda inspection
is 0:1. If the inspection detects that he misdeclared his income, he will have to pay
the amount of the missing tax plus the same amount p as a fee. His preferences are
represented by the Bernoulli utility function
p u(r) = r, where r is his income. (For
negative amounts of r it is u(r) = 2 r:)
(a) Draw the decision tree that corresponds to this problem.
(b) Suppose now that he decides not to declare anything and that after doing so he
gets afraid of a possible inspection and asks a friend to help him. In such a situation,
he has to pay m euros in order to be sure that he will not have any problems with
the inspection. How much is he willing to pay for the service of his friend (m)?
(c) p
Would your answer in part (a) change if the utility function was given by
u(r) = r? And if it was given by u(r) = 2r?
(d) Suppose now that Hacienda has already decided (before the professional makes
the declaration) the list of persons that will be inspected. His friend o¤ers to check

16
whether his name is on the list for 20,000 euros. Will the professional accept? Draw
the conditions for …nding out the maximum amount that the professional is willing
to pay for this information.

Multiple Choice Questions

VII.1. An individual’s risk premium for the lottery l = (x; p); that pays x = (0; 4; 16)
with probabilities p = ( 41 ; 12 ; 41 ); is RP (l) = 2. Hence his certainty equivalent is

CE(l) = 2 CE(l) = 1
CE(l) = 3 CE(l) = 4:

VII.2. If the certainty equivalent of a lottery l; which pays 20 thousand euros or 10

thousand euros with the same probability, is 14 thousand euros, then the individual

is risk loving is risk neutral

is risk averse has an indeterminate risk attitude.
3 1 1
VII.3. If an individual’s certainty equivalent of lottery l = (0; 2; 10; 10 ; 2 ; 5 ) is
CE(l) = 2, then his risk premium is

RP (l) = 1 RP (l) = 1
RP (l) = 2 RP (l) = 0:

VII.4. The risk premium of the lottery l = 0; 8; 14 ; 43 for an individual A whose

preferences are represented by the Bernoulli utility function uA (x) is RPA (l) = 2: If
the preferences of an individual B are represented by the Bernoulli utility function
uB (x) = 13 uA (x); then her certainty equivalent of the lottery l is:

CEB (l) = 2 CEB (l) = 6 CEB (l) = 4 CEB (l) = 0:

VII.5. Identify the certainty equivalent and risk premium of the lottery l = (x; p) that
pays x = (0; 2; 4) with probabilities p = ( 41 ; 21 ; 14 ) for an individual with preferences
represented by the Bernoulli utility function u(x) = x2 :
p p
CE(l) = 2;p RP (l) = 6 2
p CE(l) = 2;
p RP (l) = 2 p 6
CE(l) = 6; RP (l) = 2 6 CE(l) = 6; RP (l) = 6 2:

VII.6. A consumer p preferences over lotteries are represented by the Bernoulli utility
function u(x) = x. Identify the expected utility and certainty equivalent of the
lottery l = (x; p) that pays x = (0; 4; 9) with probabilities p = ( 61 ; 21 ; 13 ):

Eu(l) = 1; CE(l) = 1 Eu(l) = 4; CE(l) = 2

Eu(l) = 2; CE(l) = 2 Eu(l) = 2; CE(l) = 4:

17