ECON2111Microeconomics 2 (H) Exercises Topic 2

1
Utility maximization and choice


Multiple choice

1. If an individual's indifference curve map does not obey the assumption of a diminishing MRS,
then
a. the individual will not maximize utility.
b. the individual will buy none of good X.
c. tangencies of indifference curves to the budget constraint may not be points of utility
maximization.*
d. the budget constraint cannot be tangent to an appropriate indifference curve.

2. Suppose an individual's MRS (of steak for beer) is 2:1. That is, at the current consumption
choices he or she is willing to give up 2 beers to get an extra steak. Suppose also that the
price of a steak is $1 and a beer is 25c. Then in order to increase utility the individual should
a. buy more steak and less beer.
b. buy more beer and less steak.*
c. continue with current consumption plans.

3. If an individual's utility function is given by ( , ) U x y = xy and I = 100, p
x
= 1, p
y
= 4, his or
her preferred consumption bundle will be:
a. (20, 20).
b. (50, 12.5).*
c. (40, 15).
d. (30, 15).

4. If an individual's utility function for coffee (x) and cream (y) is given by U(x, y) = min (x, 5y),
the demand function for coffee is given by
a. X = I/2p
x
.
b. X = I/(p
x
+ p
y
).
c. X = I/(p
x
+ 0.2p
y
).*
d. X = I/(p
x
+ p
y
)
2
.


Problems

1. Each day Paul, who is in third grade, eats lunch at school. He only likes Twinkies (t) and soda
(s), and these provide him a utility of ts s t U = ) , ( .
a. If Twinkies cost $0.10 each and soda costs $0.25 per cup, how should Paul spend the $1
his mother gives him to maximize his utility?
Set up Lagrangian
.25 ts + (1.00 .10t s ) . =
FOCs:
ECON2111Microeconomics 2 (H) Exercises Topic 2
2
0.5
0.5

( / ) .10

( / ) .25
s t
t
t s
s

= 1.00 .10t .25s = 0

However, we can start directly from the optimal condition and the budget constraint:
MRS
ts
=p
t
/p
s

25 . 0
10 . 0
=
t
s
or
10 . 0
25 . 0
=
s
t
; hence t=2.5s
Substituting into the budget constraint:
= 0.10t + 0.25s = 0.50s.
s = 2;t = 5 and U = 10
Note that the result can be easily found by noting that this is a Cobb-Douglas with
equal shares. The individual devotes 0.50 cents to each good and at the current prices
0.10 for Twinkies and 0.25 for sodas - consumes 5 Twinkies and 2 sodas.
b. If the school tries to discourage Twinkie consumption by increasing the price to $0.40, by
how much will Pauls mother have to increase his lunch allowance to provide him with
the same level of utility he received in part (a)?
Level of utility achieved in (a): 10 ts U = = or ts = 10
Optimal condition at new prices
s t
s
t
8
5
8
5
40 . 0
25 . 0
= = =
Substituting into the utility constraint:
4 16 10
8
5
2 2
= = = s s s 5 . 2 4
8
5
= = t
The cost of this bundle is 0.4x2.5+0.25x4=2 (1 dollar for each good)
Paul needs an extra dollar.

2. For the Cobb-Douglas function ( ) , U x y = x y

, . 1 = +
a. Calculate the indirect utility function.
The demand functions in this case are
y x
p
I
y
p
I
x

= = , .
Substituting these into the utility function gives
( )

|
|

\
|
|
|

\
|
=
|
|

\
|
|
|

\
|
=
y x y x
y x
p p
I
p
I
p
I
I p p V , ,
Note: we can use that =1 to express it as a function of .
b. Calculate the expenditure function.
( )


|
|

\
|
|

\
|
=
x x
y x
p p
V V p p E , ,
ECON2111Microeconomics 2 (H) Exercises Topic 2
3
c. Show explicitly how the compensation required to offset the effect of an increase in the
price of x is related to the size of the exponent .
The elasticity of expenditures with respect to
x
p is given by the exponent . The more
important x is in the utility function the greater the proportion that expenditures must be
increased to compensate for a proportional rise in the price of x.
Show what is meant by elasticity of expenditures with respect to p
x
: the proportional
change in expenditure when price goes up by 1%.


= = =

E
p
p Vp
E
p
dp
dE
p
dp
E
dE
x
x y
x
x
x
x
1
.
Use to illustrate problem 1.

3. For the CES function:
( )


x x
y x U + = ,
a. Show that the first order conditions for a constrained utility maximum with this function
require individuals to choose goods in the proportion
( ) 1/ 1
x
y
p x
y p

| |
=
|
|
\
.
y
x
xy
p
p
y
x
y U
x U
MRS =
|
|

\
|
=


=
1
/
/

. Then
( ) 1/ 1
x
y
p x
y p

| |
=
|
|
\

This relationship can also be explained in terms of the elasticity of substitution =1/(1-):

|
|

\
|
=
|
|

\
|
=
|
|

\
|
=

x
y
x
y
y
x
p
p
p
p
p
p
y
x
1
1
1
1

b. How does the ratio /
x y
p x p y depend on the value of ? Explain your results intuitively.

|
|

\
|
=
|
|

\
|
=
1
y
x
x
y
y
x
y
x
p
p
p
p
p
p
y p
x p

If left in terms of : 1- =/(-1)
Hence, for 1 < (-<<0) the relative share of income devoted to good x is
positively correlated with its relative price. This is a sign of low substitutability.
For =1 (Cobb-Douglas case; =0) the relative share of income devoted to good x is
constant (i.e. it does not depend on the relative prices).
For 1 > (0<1) the relative share of income devoted to good x is negatively
correlated with its relative price a sign of high substitutability.
c. Derive the indirect utility function and expenditure functions for this case and check your
results by describing the homogeneity properties of the functions you calculated.
The algebra is a bit tricky here, but worth doing once.
Lets solve for demand functions:
ECON2111Microeconomics 2 (H) Exercises Topic 2
4

|
|

\
|
=
|
|

\
|
=
x
y
x
y
p
p
y x
p
p
y
x

Plug in the budget constraint:
y p p p y p p y p p y p
p
p
y p I
y y x y y y x y
x
y
x

) (
1 1 1 1
+ = + = +
|
|

\
|
=

y y x
p p p
I
y
) (
1 1
+
=

x y x
p p p
I
x
) (
1 1
+
=
Plug the optimal values of x and y in the utility function to get the indirect utility function:
( )
(
(

|
|

\
|
+
+
|
|

\
|
+
=

y y x x y x
y x
p p p
I
p p p
I
I p p V
) ( ) (
1
, ,
1 1 1 1

( )
( )

+
+
=
1 1
, ,
y x
y x
y x
p p
p p
I
I p p V
Note that = 1
( )

+ =
1 1 1
) ( , ,
y x y x
p p
I
I p p V
If left in terms of : 1- =/(-1).
The indirect utility function is homogeneous of degree zero in income and prices:
( ) ( ) I p p V I p p V
y x y x
, , , , =
( )
( )
( )( )

+ = + =
1 1 1 1 1 1 1 1
) ( ) ) ( ) (( , ,
y x y x y x
p p
I
p p
I
I p p V
Note that ( )( ) 0 ) 1 ( 1 1 1 1 = = + + = + and 1
0
= .
Inverting the indirect utility function yields the expenditure function:

I p p V
y x
= +
1 1 1
) (

1
1 1 1
] ) ( [

+ =
y x
p p V I
( ) [ ] ( ) ( )

+ = + = + =
1
1
1 1
1
1
1 1
1
1
1 1 1
) ( ) ( ) ( , ,
y x y x y x y x
p p V p p V p p V V p p E
Since 1/(1- )= (-1)/. If left in terms of : 1- =/-1 and 1/(1- )= (-1)/.
The expenditure function is homogeneous of degree one in the prices.
( ) ( ) I p p E V p p E
y x y x
, , , , =
( ) ( ) ( ) ( ) V p p E p p V p p V V p p E
y x y x y x y x
, , ) ( ) ) ( ) (( , ,
1
1
1
1
1 1
1
1
1
1 1
1

= + = + =