CHAPTER 5 INCOME AND SUBSTITUTION EFFECTS, Problems in this chapter focus on comparative statics analyses of inceme and own-price changes, Many of the problems are fairly easy so as to illustrate the ideas involved in shifting budget ‘constrains in simplified setings. Theoretical material is confined mainly to the Extensions here Shephard’s Lemma and Roy’s Identity are illustrated for the Cobb-Douglas case. ‘Comments on Problems 5.1 An example of perfect substitutes, Note thar demand for each good is all or nothing. 5.2 A fixed-propontions example, Ilustrates how the goode used in fixed proportions (peanut bhutter ancl jelly) can he treated as a single good in the comparative statics of utility ‘maximization 5.3. Anexploration of the notion of homothetic functions. This problem shows that Giffen's Paradox cannot occur with homothetic functions. 3.4 This problem pursues the analysis of Example 5.1 10 obtain compensated demand functions. The avalysis essemially duplicates Examples 5.3 and 5.4, 55 Anotherutility maximization example. In this case, uilty is not separable and eross-price ‘effects are imporiant, 5.6 This isa problem focusing on “share elasticities”. It stows that more customary elasticities can often be calculated irom shate elasicities—this is important in empirical work where share elasticities are often used. 5.7 Thisisa problem with no substitution effects. I shows how price elasticities are ‘etermined only by income effects which in tu depend on income shares, 5.8 This problem illustrates a few simple cases where elasticities are directly related 10 parameters of the wilty function 5.9 Thic problem shows how the aggregation relationships deserihed in Chapter 5 for the case of two goods can be generalized to many goods. 5.10 A revealed preference example of inconsistent preferences.SL 52 Solutions: Utility = Quantity of water =.75x + 25. 3 Hck p, xl, ps3 p, sir 3 1 Ipotn, x + P>EM » Pn wy ° a oy, Increases in shifts demand for x outward. Reductions in p, do not affect demand for comity hn dana fas ze ‘The income-compensated demand curve for good x is the single sp point that characterizes current consumption. Any change in p, would change utility from this, point (assuming r > 0). Utiliy maximization requires pb =2/ and the budget constraint is Spb +.1j = 3. Substitution gives pb = 30, j= 15 If pj=S.15 substitution now yields j= 12, pb =24. ‘To continue buying j = 15, pb =30, David would need to buy 3 more ounces of jelly and 6 more ounces of peanut butter. This would require an increase in income of 3418) + 6(05) =.75,4 Pal Pa =2) ES Since David N. uses only pl + j to make sandwiches (in fixed proportions), and because bread is fre, itis just as hougih lie buys sandwiches where Panton = 20 Ps Inpart a p,= 20, q In part b, p= 25, q.= 12s In general, g,=— so the demand curve for sandwiches is a hyperbola, Pe ‘There isno substitution effect due to the fixed proportion, A change in price results in only an income effec. Since vu ‘The expenditure function is then E= B"Up:p, The compensated demand furetion is x° =E/0p,=38'p,”p? Its easiest to show Slutsky Fquation in elasticities by just reading exponents from 7.5,=03 the various demand funetions: ¢,,, =-he,, =he,, = Hence ¢,, ~0.7-03-156 57 aOv.afl 1 _ tp dufal=px T 6 — Sey cl Or Dall roa If, forexample e,, Mpsx/))_p.__ prdsfop ts a a 5. 5505) If, forexample, ,,, = 0.75. Because J may be cancelled out of the derivation in part b, itis also the case that tl Apx/f) _P._ P.2xfOp, PT ae Ps op, pall dS x ap, apps ay _ MODE Use paths 6,9 = SP pal hpi) =. = Ce a OTS op To simplify algebra, let d = pp." k Hence ¢,,, =¢,,, “l= A4 12M 0 Tee ed remembering that e, ,=1 Now use the Slutsky equation, kd-d=1, 1 dk, vg) ‘ Ted ied bed [Recause of the fixed proportions between hand c, know thst the demand far ham is h=I(p, + p.)-Hence , —oh fe at as P)_ =P “Oph (n+p) (ppd Similar algebra shows that ¢, = Seif p,=..€,,, =e, =VS PRD With fixed proportions there are no substitution effects. Here the compensated price clasticties are zero, sa the Slutsky equation shows that ¢,, =0—s, =—D.S With py 2p, para shows tate, IF this person consumes only ham and cheese sandwiches, the price clastcity of demand for those must be -I, Price elasticity forthe components reflects the Proportional effect of « change in the price of the companent on the price the whole58 59 5.10 sandwich. In part a, for evample, a ten percent increase in the price of ham will increase the price of a sandwich by 5 percent and that will cause quantity demanded (ofall by 5 percent buy, SIM SIO“3, ey, =, —5, Hence e,, +6, ‘The sum oquals-2 (trivially) in the Cobb-Douglas ease. Result follows directly from part a. ntuktively, price elssticities are large when s is large and small when s is small ‘A generalization from the multivasiable CES function is possible, but the constraints placed on behavior by this function are probably not tenable. a, Because the demand for any good is homogeneous of degree zero, Buler’s theorem as sais Ep She Mutiplication by If; yields the desired result b. Part and are based onthe budget constraint J ps, =7 Differentiation with respect to I yields: Fp, ax, Mutiplication of ech tem by x//xF_ yields Yose,,=1 ¢. Differentiation of the budget constraint with respect top, =0. Mukiplication by 22. yields La fp, =0, Mutipication by Sy Lee. ‘Year 2's bundle is revealed preferred t Year I's since both cost the same in Year 2's prices. Year 2's bundle is also revealed preferred to Year 3's for the same reason. But in Year 3, Year 2's bundle costs less than Year 3's but is nat chosen. Hence, these violate the