MICROECONOMICS

PROBLEM SET 2. SOLUTIONS

1. (JR 1.40) Prove that Hicksian demands are homogeneous of degree zero
in prices.
We use the relationship between Hicksian and Marshallian demands. hi (p, u) =
xi (p, e(p, u)) where e(p, u) is the expenditure function. Then we use the fact
that e(p, u) is homogeneous of degree 1 in p, and Marshallian demand xi (p, m)
is homogeneous of degree 0 in (p, m) :
hi (tp, u) = xi (tp, e(tp, u)) = xi (tp, e(tp; u)) = xi (tp, te(p, u)) = xi (p, e(p, u))
This is the same as the original value of hi (p, u), so it is homogeneous of degree
0.
2. (JR 2.3) Derive the consumer's direct utility function if her indirect utility
function has the form v(p, m) = mpα1 pβ2 for negative α and β .
Given v(p, m) = mpα1 pβ2 for α,β < 0. The direct utility is: u(x) = minp v(p, 1)s.t.px =
1
= minp v(p, 1)s.t. p1 x1 + p2 x2 = 1
β
L(p1 , p2 , λ) = pα1 p2 − λ(p1 x1 + p2 x2 − 1)
δL 1−α β
δp1 = αp1 p2 − λx1 = 0
δL α 1−β
δp2 = βp1 p2 − λx2 = 0
δL
δλ1 = p1 x1 + p2 x2 − 1 = 0
α p1 x 1 α x1
, = αβ xx21 p2 ;
β = p2 x2 ⇒ p2 = β x2 p1 p1
Substituting in the restriction:
α x1
p 1 x1 + β x2 p 1 x2 =1
It implies that:
β ,
1
p1 = x (1+
1 α)
p2 = x2 (1+ α ) . Therefore:
1
β
 α  β
u(x1 , x2 ) = 1
β . 1
x2 (1+ α
x1 (1+ α ) β)
3. Pedro's preferences for consumption of goods (c) and leisure (h) are
described by the utility function u(h, c) = h(c + 2): His total time endowment
is T = 18 hours, which he can devote either to leisure or working for a wage of
w euros per hour. Suppose that the price of the consumption good is equal to
one.
a) Graph some of his indierence curves.
b) Compute and represent Pedro's labor-supply curve.
min u(h, c) s.t. c + wh = wT
min h(c + 2) s.t. c + wh = wT
ˆ f.o.c. (1) M RSh,c = w; (2) c + wh = wT .

ˆ f.o.c. (1) c+2

h = w→ c = wh − 2;

ˆ f.o.c. (2) c+wh = wT → wh−2+wh = wT → 2wh = wT +2 → h = wT +2

2w .

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Then h = T
2 + w
1
if w > 19 and h = 18 otherwise.
T 1
c = w( 2 + w ) − 2 if w > 19 and c = 0 otherwise.
L = ( T2 − w1 )if w > 19 and L = 0 otherwise.
c) How much time would he work and how much would he devote to leisure
if the wage is w = 61 ?
d) A relative of Pedro's died, leaving him an inheritance of H = 1 euro.
What will happen with the labor-supply curve and the number of hours he is
willing to work if the wage is still w = 16 ? Comment the result.
min h(c + 2) s.t. c + wh = wT + 1
ˆ f.o.c. (1) M RSh,c = w; (2) c + wh = wT + 1.
ˆ f.o.c. (1) c+2
h = w→ c = wh − 2;
ˆ f.o.c. (2) c + wh = wT + 1 → wh − 2 + wh = wT + 1 → 2wh = wT + 3 →
h = wT2w+3 .
Then h = T 3
2 + 2w if w > 16 and h = 18 otherwise.
T 3
c = w( 2 + 2w ) − 2 if w > 16 and c = 1 otherwise.
L = ( T2 − 2w
3
)if w > 16 and L = 0 otherwise.
4. 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.
min u(h, c) s.t. c + wh = wT + 360
min c3 h s.t. c + wh = wT + 360
ˆ f.o.c. (1) M RSh,c = w; (2) c + wh = wT + 360.
ˆ f.o.c. (1) c
3h = w→ c = 3wh;
ˆ f.o.c. (2) 3wh + wh = wT + 360 → 4wh = wT + 360 → h = 6 + 90
w. This
is assuming that T = 24.
Then h = 6 + 90 w if w > 5 and h = 24 otherwise.
c = 3w(6 + 90w ) if w > 5 and c = 0 otherwise.
w ) if w > 5 and L = 0 otherwise.
l = 24 − (6 + 90
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 eect of an increase in the wage
per hour from 9 to 11.25 euros.
We have compute both leisure and consumption at both prices by substitut-
ing in their respective functions.
The initial bundle was h(9) = 16, c(9) = 432, l(9) = 8, and the nal bundle
h(11.25) = 14, c(11.25) = 472.5, l(11.25) = 10.
To compute the intermediate bundle we solve the following problem:
min c + w0 h s.t. U (h, c) = Ū where w0 is the new wage.

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 ˆ f.o.c. (1) M RSh,c = w0 ; (2) c3 h = (4323 ∗ 16)→ hi = 13.53.li = 10.47.
Then:
ˆ SE = li − l1 = 10.47 − 8 = 2.47.
ˆ IE = l2 − li = 10 − 10.47 = −0.47.
ˆ T E = 2.
5. Assume that the preferences for goods x and y by two people a and b - a
married couple - are given by the utility function u(x, y) = xy . These people
obtain an income r(a) = 200 euros and r(b) = 100 euros, in such a way that
the total income of the couple is denoted by r = 300 euros. The prices of both
goods are px = py = 1.
a) Assume that the common preferences are maximized subject to the married-
couple budget constraint. Verify that when r(a) or r(b) increase by 50 units the
married couple will make the same decision.
max xy s.t. px x + py y = r(a) + r(b)
Therefore, x = r(a)+r(b9
2px , y = r(a)+r(b9
2py . Clearly it does not matter if it is
r(a) or r(b) the income that increases.
b) Assume now that the preferences of person a are represented by the utility
function ua (x, y) = xy ; whereas those of b are given by ub (x, y) = x2 . Assume
also that the couple makes its decisions according to the weighted sum of both
utility functions, with weights equal to 1 and r(b)r ; respectively. That is, the
married-couple utility function is now equal to u(x, y) = xy + r(b) r x . Verify
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that when r(a) increases by 50 euros the couple will make dierent choices than
when r(b) increases by 50 euros.
r(b) 2
max xy + r x s.t. px x + py y = r(a) + r(b)
ˆ f.o.c. (1) M RSx,y = px
py ; (2) px x + py y = r(a) + r(b).
r(b)
ˆ f.o.c. (1) r )x;
y+2 r x
x = px
py → y = ( ppxy − 2 r(b)

ˆ f.o.c. (2) px x + py y = r(a) + r(b) → px x + py ( ppxy − 2 r(b)

r )x = r(a) + r(b) →

ˆ x= r(a)+r(b)
px +py ( p x r(b) and y = ( ppxy − 2 r(b)
r )p
r(a)+r(b)
px r(b) . We evaluate the
py −2 r ) −2 r )
x +py ( py

results using the parameters value.

ˆ x= 300
r(b)
1+(1−2 r )
,

ˆ y = (1 − 2 r(b)
r )
300
r(b)
1+(1−2 r )
.

For r(a) = r(b) we have x = 300 and y = 0.

For r(a) = 200 and r(b) = 100 . Then r(b)
r =
1
3 and we have x = 900
4 = 225
and y = 13 900
4 = 75.
For r(a) + r(b) = 350 we have

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 ˆ x= 350
r(b)
1+(1−2 r )
,

ˆ y = (1 − 2 r(b)
r )
350
r(b)
1+(1−2 r )
.

r = 35 and we have x =
For r(a) = 250 and r(b) = 100 . Then r(b) 10 35∗350
50 = 245
and y = 35 50 = 105.
15 35∗350

r = 35 and we have x =
For r(a) = 200 and r(b) = 150 . Then r(b) 15 35∗350
40 =
306.25 and y = 35 40 = 43.75.
5 35∗350