Solutions to Mid-Sem Exam ECO 202 AY 23-24

II Semester
ECO202 — Instructor: Dr Parikshit De
03 March 2024

Question 1
How is the demand curve derived under the cardinal approach? [10 Marks]

Solution 1
Refer to Pages 12,13,14,15 (Chapter 2) in Microeconomics (Author: Prof.
Satya R. Chakravarty) (2002).India: Allied Publishers Pvt Limited.

Question 2
1. Describe Lexicographic preference relation (≻L ) and elaborate the same
with example on R2+ . [2+2 Marks]
2. Show that it is rational and respects monotonicity. [2 Marks]

3. Does it fail to satisfy strict convexity? [2 Marks]

4. Draw the indifference curve for bundles composed of one good and one
bad item such that the preference relation satisfies strict convexity. [2
Marks]

Solution 2
Let there be a finite number n ∈ N of items (good(s) or bad(s)). A bundle
is the n-tuple (x1 , x2 , . . . , xn ) ∈ Rn+ , where xi denotes the quantity of item-
i ∈ {1, 2, . . . , n}. The labeling scheme is based on some exogenous ordering such
that item-1 is the most important item, item-2 is the second most important
item, and so on.
1. A preference relation is a lexicographic preference relation if given an or-
dering over items, the preference relation compares every two distinct
bundles based on the most important item in which they differ. If this

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 item is a good (alternatively, a bad), then the bundle with more quan-
tity(alternatively, less quantity) of this item is the preferred bundle. Each
point in Rn+ is an indifference curve.
A preference relation ≻L is said to be a lexicographic preference relation if
for any two bundles x := (x1 , x2 , . . . , xn ) and x̂ := (x̂1 , x̂2 , . . . , x̂n ) ∈ Rn+ ,
if item-1 is a good then x̂1 > x1 =⇒ x̂ ≻l x (if item-1 is a bad then
x̂1 < x1 =⇒ x̂ ≻l x) and whenever x̂i = xi for every i ∈ {1, 2, . . . , t} for
any 1 ≤ t < n, then if item-t+1 is a good then x̂t+1 > xt =⇒ x̂ ≻l x
(if item-(t + 1) is a bad then x̂t+1 < xt+1 =⇒ x̂ ≻l x). If x̂i = xi ∀i ∈
{1, 2, . . . , n}, the two bundles are not distinct, and the preference relation
is indifferent, x ∼L x.
Let there be only two items and hence n = 2. Let x = (x1 , x2 ) and
y = (y1 , y2 ) ∈ R2+ be two distinct bundles.
• If both items are goods, then x1 > y1 =⇒ x ≻L y, else if x1 = y1 ,
then x2 ≥ y2 =⇒ x ≻L y.
• If both items are bads, then x1 < y1 =⇒ x ≻L y, else if x1 = y1 ,
then x2 ≤ y2 =⇒ x ≻L y.
• If item-1 is good and item-2 is bad, then x1 > y1 =⇒ x ≻L y, else
if x1 = y1 , then x2 ≤ y2 =⇒ x ≻L y.
• If item-1 is bad and item-2 is good, then x1 < y1 =⇒ x ≻L y, else
if x1 = y1 , then x2 ≥ y2 =⇒ x ≻L y.

2. Let ≻L be a lexicographic preference relation. Let x = (x1 , . . . , xn ), y =

(y1 , . . . , yn ) ∈ Rn+ be any two distinct bundles (x ̸= y). Then, xi = xi , ∀i ∈
{1, . . . , n} =⇒ x ∼L x. Hence, ≻L is reflexive. For any such x and y,
∀i ∈ {1, . . . , n} either xi ≥ yi or yi > xi , hence either x ≻L y or y ≻L x.
So, ≻L is complete. Let z = (z1 , . . . , zn ) ∈ Rn+ be another bundle (̸= x, y)
satisfying x ≻L y and y ≻L z. Let t ∈ {1, . . . , n} be the most important
item in which x and y differ, and without loss of generality let xt > yt
(assuming item-t is good), this implies x ≻L y. Let r ∈ {1, . . . , n} be the
most important item in which y and z differ, yr > zr (assuming item-r is
good), this implies y ≻L z. Let s ∈ {1, . . . , n} be the most important item
in which x and z differ (assuming item-s is good). Such t, r, and s exist
because x,y, and z are distinct.
• If t ≥ r, then s = r. xr = yr > zr and so xs > zs =⇒ x ≻L z.
• If r > t, we have yk = zk , ∀k < r and so yt = zt . Also, xt > yt = zt ,
hence s = t and x ≻L z.
Therefore, x ≻L y and y ≻L z, together imply that x ≻L z. Hence, ≻L is
transitive. This concludes the proof that ≻L is rational. The assumption
of items being good is also without loss of generality. Assuming that items
are bad only reverses the assumptions x ≻L y and y ≻L z, this can be
taken care of within the proof by choosing which bundle to call x, y or z.
The proof for transitivity proceeds the same.

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 Monotonicity demands that any two distinct bundles x = (x1 , . . . , xn ) and
y = (y1 , . . . , yn ) satisfying xt ≥ yt for all goods t ∈ {1, . . . , n}, and xr ≤ yr
for all bads r ∈ {1, . . . , n} with at least one strict inequality x ≻ y. If x and
y are distinct bundles satisfying the above conditions, and s ∈ {1, . . . , n}
is the most important item in which x and y differ, then if item s is a
good, xs > ys =⇒ x ≻L y and if item s is a bad, xs < ys =⇒ x ≻L y.
Hence, ≻L satisfies monotonicity.
3. Strict convexity demands that for any two distinct bundles x = (x1 , . . . , xn )
and y = (y1 , . . . , yn ) satisfying x ∼ y, and the bundle z = (tx1 + (1 −
t)y1 , . . . , txi + (1 − t)yi , . . . , txn + (1 − t)yn ), where 0 < t < 1, z ≻ x. If
x ∼L y, then by definition of ≿L , we have x = y because the indifference
curve for lexicographic preference relation is a point. the antecedent in the
definition of strict convexity is never true. Hence, the conditional claim
of strict convexity holds. ≻L does not fail to satisfy strict convexity.
√
4. Let the utility function be U(x, y) = x − y. Here, y is the bad item and
x is the good item. It can be algebraically checked that the preference
relation satisfies strict convexity. The graph is given below. The utility
values are green curve(-1), red curve(0), and blue curve(1).

Question 3
Consider the preference of the agent is expressed by the following utility function
U(x, y) = 2 ln x + 7 ln y + 9 and px , py and M denote the prices of the respective
goods and income level of the consumer.
1. Show that U(x, y) is strictly quasi-concave. [3 Marks]
2. Assuming px , py = 10 and M = 200, find the Hicksian demand for good
x. [3 Marks]
3. Assume that px , py = 10 and M = 200. Find the Hicksian substitution
effect if the price (of x) increases by 20%. [3 Marks]

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 4. How much is the Slutsky substitution effect? [3 Marks]

Solution 3
1. Note: Ux = δU δx
(x,y)
= x2 ≥ 0 for positive quantities of x. Similarly, Uy =
δU (x,y)
δy = y ≥ 0 for positive quantities of y. Also, Uxx = δUδ(x,y)
2
2x = −2
x2 ,
δU (x,y) −7 δ δU (x,y) δ δU (x,y)
Uyy = δ2 y = y2 ,
Uxy = δx δy = 0 = δy δx = Uy x.
   2 7 
0 Ux Uy 0 x y
H = Ux Uxx Uxy  =  x2 −2 x2 0 (1)
7 −7
Uy Uyx Uyy y 0 y2
2
 
0 2
H 1 = 2 −2 x , det H 1 = −[ ]2 < 0. (2)
x x 2 x
 2 7
2 14
H = −2 x y , det H 2 = [ 2 ] > 0. (3)
x2 0 x y
0 7
 
14
H 3 = 2 y , det H 3 = −[ ] < 0. (4)
x 0 xy
Alternatively, one could use the definition of strict quasi-concavity and
test for it. Keep in mind the concavity of natural log. Note that ln 0 is
not defined hence we do not worry about x, y = 0.
The agent has no utility of money. Hence, a utility maximising agent
chooses to spend his entire budget on items x and y. From the budget
constraint, M = xpx + ypy , we have y = M −xp
py
x
. Plugging this into the
utility function, we write U(x, y) = U(x|px , py , M ) = 2 ln x + 7 ln M −xp
py
x
+
9, where we use the notation U(x|px , py , M ) to mean the agent’s utility
where he exhausts all of his income in buying pMx ≥ x ≥ 0 and M −xp py
x
≥
y ≥ 0. Optimising under the budget constraint, consider two bundles:
(x1 , M −x
py
1 px
) and (x2 , M −x
py
2 px
).
2. Assuming px , py = 10 and M = 200,the budget constraint is x + y = 20.
The optimising agent maximises utility. Solving the problem we get, x∗ =
40 ∗ 140 ∗ ∗ 40 140
9 , y = 9 , and U(x , y ) = 2 ln 9 + 7 ln 9 + 9. Suppose the price of x
were to change. under Hicksian demand, the agent would be compensated
to remain on the same indifference curve.
min xpx + 10y subject to 2 ln x + 7 ln y + 9 = U(x∗ , y ∗ ) (5)
x,y

L = xpx + 10y − λ[2 ln x + 7 ln 7 + 9 − U(x∗ , y ∗ )] (6)

δL 2λ δL 7λ δL
= px − , = 10 − , = 2 ln x + 7 ln y + 9 − U(x∗ , y ∗ ) (7)
δx x δy y δλ
Setting the First order conditions to be equal to zero, we get p10x = 7x
2y
=⇒
20y = 7xpx . Inserting the value of y in the utility equation, and simplify-
7
ing, we get x( p10x ) 9 = 40
9 .

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3. Use the formula, x( p10x ) 9 = 40
9 . The absolute change in quantity is 0.1322.
Relative change is 2.97%.
4. Suppose px = py = 10 and M = 200, x∗ = 40 ∗ 140
9 and y = 9 . If the
∗ ∗
price of x changes to p̄x , the bundle (x , y ) should still be affordable.
p̄x 40
Hence, M̄ = p̄x 40 140 140
9 + 10 9 = p̄x x̄ + 10ȳ. Thus, ȳ = 9 + 10 ( 9 − x̄).
140 p̄x 40
U(x̄, ȳ) = 2 ln x̄ + 7 ln( 9 − 10 ( 9 − x̄)) + 9.

δU(x̄, ȳ) 2 7p̄x

= − 1400 40p̄x (8)
δ x̄ x̄ 9 + 9 − x̄p̄x

p̄∗x ( 80
81 ∗
x̄ − 1) = 35
When px = 10,x∗ = 40 ∗ 940
9 . When p̄x = 12, x̄ = 243 ∼ 3.868. The absolute
change in demand from a 20% rise in the price of x is a decrease of approx.
0.5761 units, and the percentage change is 12.96%.

Question 4
1. Graphically explain the price effect for Giffen Goods. [2 Marks]
2. Clearly show why not all inferior goods are Giffen goods. [3 Marks]

3. In a two-good world where the consumer is spending all his/her income

on both of the goods, can both goods be inferior? [3 Marks]

Solution 4
Refer to Pages 92,93,94 (Chapter 4) in Microeconomics (Author: Prof. Satya
R. Chakravarty) (2002).India: Allied Publishers Pvt Limited.