CONSUMER THEORY 1.6 _ EXERCISES Substituting from the definitions completes the proof: Theorems 1.10 through 1.17, together, give us an accounting of some of the logi« cal implications of utility-maximising behaviour. Homogeneity tells us how demand must. respond to an overall, equiproportionate change in all prices and income simultaneously, and budget balancedness requires that demand always exhaust the consumer’s income. The Slutsky equations give us qualitative information, or ‘sign restrictions’, on how the system of demand functions must respond to very general kinds of price changes, as well as giv- ing us analytical insight into the unobservable components of the demand response to a price change: the income and substitution effects, Finally, the aggregation relations provide information on how the quantities demanded — first in response to an income change alone, then in response to a single price change ~ must all ‘hang together’ across the system of demand functions. In the next chapter, we will ask whether there are other implications of the theory we have developed. We end by pulling together all we have leaned so far into Fig. 1.21 Lu 12 Let X = 2. Verify that X satisfies all five properties required of a consumption set in Assumpt i Let & be a preference relation. Prove the following: @Mrcr &) ~ce >uU~ @>n~= Give a proof or convineing argument for each of the following claims made in the text (@) Neither + nor ~ is complete. (b) Forany x! and x in X, only one of the following holds: x! > x2, or x? > x!,orx! ~ x? Prove that if % is a preference relation, then the relation > is transitive and the relation ~ is transitive, Also show that ffx! ~ x? 5°, then x! 3 If = is a preference relation, prove the following: For any x" < X, @ ~@)= ON 30 (b) 5 @°) =~ @)U> @®) ©) ~@)n> @)=8 @ ~@)N<@") =4un Ls 110 113) CHAPTER 1 © <> @) = () <@)n~ an» a) =8 ) < @)U ~ @)U> @%) =X Cite a credible example where the preferences of an ‘ordinary consumer’ would be unlikely to satisfy the axiom of convexity Prove that under Axiom 5’, the set % (x°) is a convex set for any x? © X. ‘Sketch a map of indifference sets that are all parallel, negatively sloped straight lines, with preference increasing north-easterly. We know that preferences such as these satisfy Axioms 1, 2, 3, and 4, Prove that they also satisfy Axiom 5’. Prove that they do not satisfy Axiom 5. Sketch a map of indifference sets that are all parallel right angles that “kink’ on the line xy = x2. If preference increases north-casterly, these preferences will satisfy Axioms 1, 2, 3, and 4. Prove that they also satisfy Axiom 5’. Do they satisfy Axiom 4? Do they satisfy Axiom 5? Sketch a set of preferences that satisfy Axioms 1, 2, 3, and 4, whose indifference sels are convex ‘o the origin in some places and contain ‘linear segments’ in others. Prove that preferences such as these are consistent with Axiom 5’, but violate Axiom 5. Show that if 5 is continuous, then the sets 4 and B defined in the proof of Theorem 1.1 are closed subsets of R. Suppose (xy, 19) and v(x, 12) are utility functions, (@) Prove that if u(xi,x2) and v(xi,x2) are both bomogencous of degree 7, then s(x1,12) = Gz). 82) + vex. 42) is homogencous of degree r () Prove that if u(x,.x2) and v(x1,.x3) are quasiconcave, then mx, x2) = minutes, .x2), vOs1.22)) is also quasiconcave ‘A consumer has lexicographic preferences over x € IR? if the relation > satisfies x! = x? whenever sf > xt ors} xf and x} > 35 (@) Sketch an indifference map for these preferences. (b) Can these preferences be represented by a continuous utility function? Why or why not? Suppose that the preferences satisfies Axioms 1, 2, and 3. ccan be represented by a continuous utility function. Show that > Prove that the budget se, B, is a compact, convex set whenever p >> 0 Prove the assertions made in the text that under Assumption 1.2; (a) Ifx* solves the consumer's problem, then x* is unique () x* will exhaust the consumer's income and satisfy y = p= x7 ‘Suppose that preferences are convex but not strictly convex. Give a clear and convincing argument that a solution to the consumer's problem still exists, but that it need not be unigue. Illustrate your argument with a two-good example Consider a two-good case where x} > 0 and.x} = 0 at the solution to the consumer's prablem. State conditions, similar to those in (1.11), that characterise this solution and illustrate your answer with @ diagram similar to Fig. 1.10.CONSUMER THEORY 119 1.20 121 1.23 124 1.25 1.26 127 1.28 65 Prove Theorem 1.2 Suppose preferences are represonted by the Cobb-Douglas utility function, w(x a2) — Axx!—*, Oa, and A > 0. Assuming an interior solution solve for the Marshalian demand functions We have noted that u(x) is invariant to positive monotonic transforms. One common transformation is the logarithmic transform, In(u(x)). Take the logarithmic transform of the utility funetion in the preceding exercise; then, using that as the utility function, derive the Marshallian demand functions and verify that they arc identical to those derived in the preceding exercise. We can generalise further the result of the preceding exercise, Suppose that preferences are repre- sented by the utility function u(x). Assuming an interior solution, the consumer's demand functions, x(p,3), are determined implicitly by the conditions in (1.10). Now consider the utility function _F(uCo), where f" > 0, and show that the first-order conditions characterising the solution to the con- sumer's problem in both cases can be reduced to the same sct of equations. Conclude from this that the consumer’s demand behaviour is invariant to positive monotonic transforms of the utility function. Prove Theorem 1.3 Let u(x) represent some consumer's monotonic preferences over x € IR. For each of the functions {F) that follow, state whether or not f also represents the preferences of this consumer. In each case, ‘be sure to justify your answer with either an argument or a counterexample @) FO) = ux) + Wo)? (b) F09) = u(x) — (ua)? (©) fo) =u) + DE xr A consumer with convex, monotonic preferences consumes non-negative amounts of x1 and x. (2) Hutsy.x2) = x43" represents those preferences, what restrictions must value of parameter «? Explain. there be on the (b) Given those restrictions, calculate the Marshallian demand functions. A consumer of two goods faces positive prices and has a positive income, His utility funetion is Ger 2) = 1 Derive the Marshallian demand functions, A consumer of two goods faces positive prices and has a positive income. His utility function is u(ey,x2) = maxlaxy, arg] minfetx2], where O> 0, e(p, u) is unbounded above in Complete the proof of Theorem 1.7 by proving property 5 Provide an alternative proof of Roy's identity by completing the following steps: (2) Using the definition of», show that if p >> 0 and x? = x¢p®,y"), then vip, p-x°) = vip, p? x°) Vp > 0. () Conclude that (p) Ap, p-x°) is minimised on 2%, at p =p? . What value must its gradient have at p"? (©) Assume fis differentiable at (d) Prove Roy's identity using parts (a) to (c) Provide an alternative proof of Shephard’s lemma by completing the following steps: (@) Using the definition of e, show that if p> 0 and x° = x*(p", u®), then e(p,u®) < p-x° forall p> O with equality when p = p® (b) Conclude that f(p) = e(p, «) — p-x° is maximised on Rat p =p”. (©) Assume that fis differentiable at p°. What value must its gradient have at p°? (@) Assuming that e(p, 2) is differentiable in p, prove Shephard’s lemma using parts (a) to (e)CONSUMER THEORY 139 1.40 141 1.42 1.43 144 Las 1.46 147 148 149 67 Verify that the expenditure function obtained from the C satisfies all the properties given in Theorem 1.7, direct utility function in Example 1.3 Complete the proof of Theorem 1.9 by showing that x*(p, u) = x(p. e(p. 0) Use Roy’s identity and Theorem A2.6 to give an altemative proof that xi(p,») is homogeneous of degree zero in prices and income. Prove that Hicksian demands are homogeneous of degree zero in prices. Prove the modern Law of Demand given in Theorem 1.13. Prove that the converse of each statement in the Law of Demand is nor true, For expositional purposes, we derived Theorems 1.14 and 1.15 separately, but really the second cone implies the first. Show that when the substitution matrix 0 (p, u) is negative semidefinite, all ‘own-substitution terms will be non-positive. Ina two-good case, show that if one good is inferior, the other good must be normal. Fix x” € R'. Dofine the Slutsky-compensated demand function at x°, x"(p.x°), by x(p,x") = X(p, px"). Thus, Slutsky-compensated demand at x° is that which would be made as prices change and the consumer's income is compensated so that he can always afford bundle x. Let x8 = x(p?, 9). Show that axtip®.x) _ adie". OP; ap; where 1 = u(x"), Thus, the slopes of Hicksian and Slutsky-compensated demands are the same. Consequently, the Slutsky matrix is the matrix of slopes of Slutsky-compensated demands, and this is how it originally received its name, ‘We can derive yet another set of relations that must hold between price and income elasticities in the consumer's demand system. This one follows directly from homogeneity, and in fact can be considered simply a restatement ofthat principle, Prove that 3°" ¢j-+ 1 =0,= 1,47 Suppose that u(x) is a linear homogeneous utility function expenditure function is multiplicatively separable in p and w and can be written in ep, Du. (b) Show that the marginal uility of income depends on p, but is independent of y. ‘Suppose that the expenditure function is multiplicatively separable in p and x so that e(p, w) = K(W)g(p), where k() is some positive monotonic function of a single variable, and g: RR. ‘Show that the income elasticity of (Marshallian) demand for every good is equal to unity You are given the following information about the demand functions and expenditure patterns of a consumer who spends all his inome on two goods: (1) At current prices, the same amount is spent ‘on both goods; (2) at current prices, the own-price elasticity of demand for good | is equal to —3, (@) Atcurtent prices, what isthe elasticity of demand for good 2 with respect to the price of good 1? (b) Can statements (1) and (2) both hold at all prices? Why or why not?68 CHAPTER 1 1,50 Someone consumes a single good x, and his indirect utility function is yin where apy = fx. 5)d8 ~) 40) f Hs 0.9) = oan) and G() is some positive monotonic function of one variable, (a) Derive the consumer's demand for x and show that it has constant income elasticity equal to 7, (b) Suppose the consumer has an income equal to 7, and the price of x rises from p to p! > p ‘Argue that the change inthe consumers utility caused by this price change can be measured by = JF x6, 5)ae <0. loterpret this measure 1.51 Consider the utility funetion, w(x) ,.x2) = (n)"/? + Gy", (@) Compute the demand functions, x/(p1.p2.)).i= 1,2 (©) Compute the substitution term in the Slutsky equation forthe effects on x of changes in p>. (6) Classify x; and x2 as (gross) complements or substitutes. 1.52 Suppose 1 and jj are lower and upper bounds, respectively, on the income elasticity of demand for good x, over all prices and incomes. Then _ 2.9) ay HPD) overall prices and incomes. Show that for any y and y®, 1,53 Agents A and B have the following expenditure functions. In each case, state whether or not the observable market behaviour of the two agents will be identical, Justify your answers, (@) eA(p, 1) and (pw) = e*(p, 20) (0) efep, «) = kwdgp), where K() > 0, and ep, 1) = 241, w. 1.54 The n-good Cobb-Douglas utility function is ues) = AT [xf a where A> Oand ja = 1 (@) Derive the Marshallian demand functions, (©) Derive the indirect utility function (©) Compute the expenditure function (d) Compute the Hicksian demands.CONSUMER THEORY 6 1.55 Suppose u@® = fies a is strictly quasisoncave with (1) > 0 for alli, The consumer faces fixed prices p >> 0 and has income y > 0, Assume x(p, y) > 0. (a) Show that if one good displays increasing marginal utility at x(p, ») all other goods must display diminishing marginal utility there, (b) Prove that if one good displays increasing marginal utility and all others diminishing marginal utility at x(p, ), then one good is normal and all other goods are inferior. (©) Show that if all goods display diminishing marginal utility at x(p, y), then all goods are normal. 1.56 What restrictions must the a, f()), (pi, p2), and 2(P1.p2) satisfy ifeach ofthe following is to be a legitimate indirect utility function? (8) PL. P2.P3.3) = SOIT PY PS ©) »(P1. 72.9) = WPL. pa) +2001. PDD/Y 1,57 The Stone-Geary utility function has the form we) = [en = where bj > 0 and 3 respective commoditi 1. The a; = 0 are often interpreted as ‘subsistence’ levels of the (@) Derive the associated expenditure and indirect utility functions. Note that the former is linear in utility, whereas the latter is proportional to the amount of “discretionary income’, y — 3" , pai (b) Show that b; measures the share of this ‘discretionary income” that will be spent on ‘disere- tionary” purchases of good x; in excess of the subsistence level a; 1.58 The Stone-Geary expenditure function you derived in part (a) of the preceding exercise is a special case of the Gorman polar form: €(, 1) = a(p) + nb), where a(p) and 6(p) are both linear homogeneous and concave, Show that for a consumer with this expenditure function, the income elasticity of demand for every good approaches zero as y>0, and approaches unity as yo. 1,59 If e(p, 1) =2(p,p2dp™, where m > 0, what restrictions must z(p1,p2) satisfy for this to be a legitimate expenditure function? 1,60 Suppose x1(p.y) and x2(p,y) have equal income elasticity at (p", y®). Show that @x)/@p2 = xa /Ap1 at (p°, >").70 CHAPTER 1 1.61 Show that the Slutsky relation can be expressed in elasticity form as is the elasticity of the Hicksian demand for x; with respect to price p, and all other terms are as defined in Definition 1.6. 1,62. According to Hicks’ Third Law: > axh(p. wd x ap) Pj or equivalently, in elasticity form, Ls Prove this and verity it for « consumer withthe n-good Cobb-Douglas ulilityfunetion in Exercise 154 1.63 The substitution matrix ofa utility-maximising consumer's demand system at prices (8, p) is. (3 tn) Find a, band p. 1.64 True or false? (a) When the ratio of goods consumed, xi/, is independent of the level of income for all i and j, then all income elasticities are equal to 1 (b) When income elasticiti are all constant and equal, they must all be equal to (©) Ifthe utility function is homotheti, the marginal utility of income is independent of prices and depends only on income. 1.65 Show that the utility function is homothetie if and only if all demand funetions are multiplicatively separable in prices and income and of the form x(p.)) = ()X(p. P 1.66 A consumer with income y? faces prices p® and enjoys utility « = vip®, )®). When prices change to pl the cost of living i affected. To gauge the impact ofthese price changes, we may define a cost of living index as the ratio ep!) ep.) 1p" phat) (@) Show that /(p°, p!, v°) is greater than (less than) unity as the outlay necessary to maintain base lility,u®, rises (falls),CONSUMER THEORY ” (©) Suppose consumer income also changes from y® toy", Show that the consumer will be better off (vorse off) inthe final period whenever y! /y” is greater (less) than J(p°, p!, 1) 1.67 A cost of living index is introduced in the previous exercise. Suppose the consumer’s direct utility funtion is w(xi.m2) = JT m2 (@) Let base prices be p® = (1, 2), base income be y= 10, and suppose p! = (2, 1), Compute the index J (b) Let base and final period prices be as in part (a), but now let base utility be u®, Show that the value of the index / will vary with the base utility (6) It can be shown that when consumer preferences are homothetie, f will be independent of the ‘base utility for any prices p® and p!. Can you show it? 1.68 Show that the share of income spent on good x; can always be measured by @ Infe(p, u*)]/@ In(p), where u* = vip, ).