EconS 501 - Microeconomic Theory I

Homework #1 - Answer key

1. Exercise from FMG. Chapter 1, exercise 16. Check if the Cobb-Douglas utility
function u(x1 ; x2 ) = x1 x2 , where ; > 0, satis…es the following properties: (a) local
non-satiation; (b) decreasing marginal utility for both goods 1 and 2; (c) quasiconcav-
ity; and (d) homotheticity.

(a) Local non-satiation (LNS). When working with a di¤erentiable utility function we
can check LNS by directly checking for monotonicity (since monotonicity implies
LNS). In order to test for monotonicity, we just need to con…rm that the marginal
utility from additional amounts of goods 1 and 2 are non-negative,

@u(x1 ; x2 ) 1 x1 x2
= x1 x2 = > 0 if and only if >0
@x1 x1
@u(x1 ; x2 ) x1 x2
= x 1 x2 1 = > 0 if and only if > 0
@x2 x2
In fact, since the marginal utility of increasing either good is strictly positive,
the Cobb-Douglas utility function not only satis…es monotonicity, but also strong
monotonicity.
(b) Decreasing marginal utility. We need to show that the marginal utilities we found
above are nonincreasing. That is,
@ 2 u(x1 ; x2 ) 2
= ( 1)x1 x2 0 if and only if 1
@x21
@ 2 u(x1 ; x2 )
= ( 1)x1 x2 2 0 if and only if 1
@x22
Hence, while additional units of good 1 or good 2 increase this individual’s utility,
they do it at a decreasing rate.
(c) Quasiconcavity. Let us …rst simplify the expression of the utility function by
applying a monotonic transformation on u(x1 ; x2 ), since any monotonic transfor-
mation of a utility function maintains the same preference ordering. In this case,
we apply
z1 = ln u( ) = ln x1 + ln x2
We now need to …nd the bordered Hessian matrix, and then …nd its determinant.
If this determinant is greater than (or equal to) zero, then this utility function is
quasiconcave; otherwise it is quasiconvex.1 The bordered Hessian matrix is

0 z1 z2 0 x1 x2
z1 z11 z12 = x1 x21
0
z2 z21 z22 x
0 x22
2

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See Simon and Blume’s Mathematics for Economists for references about the bordered Hessian matrix

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 and the determinant of this matrix is

0+ 0 + 0
x1 x1 x22 x2 x21 x2
2 2
( + )
0+ + = ,
x21 x22 x21 x22
x21 x22
which is positive for all x1 ; x2 2 R+ , ultimately implying that the Cobb-Douglas
utility function u( ) is quasiconcave.
(d) Homothetic preferences. We know that the Cobb-Douglas utility function is home-
geneous, and that all homogeneous functions are homothetic. Hence, the Cobb-
Douglas utility function must be homothetic. For a more algebraic proof, however,
let us …rst …nd the marginal rate of substitution
1
x1 x2
M RS1;2 = 1
:
x 1 x2
Scaling up the amounts of all goods by a common factor t, we obtain
1 1+ 1 1
(tx1 ) (tx2 ) t x1 x2 x1 x2
M RS1;2 = 1
= + 1 1
= 1
(tx1 ) (tx2 ) t x 1 x2 x 1 x2
which shows that the M RS1;2 does not change when we scale up all goods by a
common factor t, i.e., if we depict a ray from the origin (where the ratio between
x1 and x2 is constant), indi¤erence curves would have the same slope at the point
where they are crossed by the ray.
A few remarks on Homothetic preferences. When preferences are homothetic,
the MRS between the two goods is just a function of the consumption ratio
between the goods, xx12 , but it does not depend on the absolute amounts
consumed. As a consequence, if we double the amount of both goods, the
MRS (i.e., the willingness of the individual to substitute one good for another)
does not change; as depicted in the …gure.

Recall that this type of preferences induce wealth expansion paths that are
straight lines from the origin, i.e., if we double the wealth level of the in-
dividual, then his wealth expansion path (the line connecting his demanded

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 bundles for the initial and the new wealth level) are straight lines. A corollary
of this property is that the demand function obtained from homothetic pref-
erences must have an income-elasticity equal to 1, i.e., when the consumer’s
income increases by 1%, the amount he purchases of any good k must increase
by 1% as well.
Examples of preference relations that are homothetic: Cobb-Douglas (as in
the previous example), preferences over goods that are considered perfect
substitutes, preferences over goods that are considered perfect complements,
and CES preferences. In contrast, quasilinear preference relations are not
homothetic.

2. Lexicographic preferences. Show that lexicographic preferences are convex.

Assume that x % y, where x = (x1 ; y1 ) and y = (y1 ; y2 ). We need to consider two

cases:
– If bundle x contains more units of good 1 than bundle y, x1 > y1 , then
the linear combination x1 + (1 )y1 satis…es x1 + (1 )y1 > y1 for all
2 (0; 1), implying that x + (1 )y y. Therefore, convexity holds in
this case.
– If bundle x contains the same units of good 1 than bundle y, x1 = y1 , then
the linear combination x1 + (1 )y1 satis…es x1 + (1 )y1 = y1 for all
2 (0; 1). In this case, bundle x must have more units of good 2 than bundle
y, x2 y2 (otherwise, we wouldn’t have that x % y). As a consequence, the
linear combination x2 + (1 )y2 satis…es x2 + (1 )y2 y2 , implying
that x + (1 )y % y. Therefore, convexity holds in this case as well.

3. Three examples of preference relations. Describe each of the following three

preference relations formally, giving a utility function that represents the preferences
wherever possible, draw some representative indi¤erence sets, and determine whether
the preferences are monotone, continuous, and convex.

(a) The consumer prefers the bundle (x1 ; x2 ) to the bundle (y1 ; y2 ) if and only if
(x1 ; x2 ) is further from (0; 0) than is (y1 ; y2 ), where the distance between two
bundles is measured with the Euclidean distance.
The preference relation is represented by a utility function such as u(x1 ; x2 ) =
x21 +x22 , which exhibits indi¤erence curves that are bowed out from the origin,

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 as the …gure below illustrates.

These preferences are strongly monotone and continuous. However, they are
not convex. To see this point, consider, for instance, bundles (1; 0) and (0; 1),
which satisfy (1; 0) (0; 1). However, (0; 1) is strictly preferred to the linear
combination (0:5; 0:5), which combines (0; 1) and (1; 0) with equal weights on
each bundle, i.e., = 1=2.
(b) The consumer prefers any balanced bundle, containing the same amount of each
good, to any unbalanced bundle. Between balanced bundles, he prefers the one
with the largest quantities. Between unbalanced bundles, he prefers the bundle
with the largest quantity of good 2.
A utility function that represents these preferences is given by

x2 if x1 = x2
u(x) = 1
1+x2
otherwise.

Other utility functions also represent these preferences. First, note that bal-
1
anced bundles are preferred to unbalanced ones since x2 0 > 1+x 2
. Sec-
ond, between balanced bundles, he prefers the one with the largest quan-
tities, that is, x % y if and only if the utility of these bundles satisfy
u(x) = x1 = x2 y1 = y2 = u(y). Third, between unbalanced bundles,
he prefers the bundle with the largest quantity of good 2, that is, if x2 > y2 ,
1 1
then the utilities of these bundles satisfy u(x) = 1+x 2
> 1+y 2
= u(y), since
1 1 1 1
1+x2
> 1+y2 simpli…es to 1+x2 < 1+y2 , and subsequently to 1 + y2 < 1 + x2 ,
which holds because x2 > y2 in this case.
The …gure below illustrates some indi¤erence sets. Each blue disk (on the 45-
degree line where x1 = x2 ) is an indi¤erence set. In addition, each horizontal
line, excluding the disk on it, is another indi¤erence set (corresponding to a

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 di¤erent value of the utility function).

The preferences are not monotonic, since a balanced bundle such as (0; 0)
is strictly preferred to an unbalanced bundle with more units of every good,
such as (1; 2), for instance.
The preferences are not continuous. To proof this point, consider two bal-
anced bundles such as (2; 2) and (1; 1), which satisfy (2; 2) (1; 1). Increas-
ing the amount of either good in bundle (2; 2), we obtain an unbalanced new
bundle (2 + "; 2), where " > 0, which satis…es (1; 1) (2 + "; 2) for every
" > 0.
Finally, the preferences are not convex either. Consider a balanced and an
unbalanced bundle, such as (2; 2) and (0; 4), which satisfy (2; 2) (0; 4).
1 1
Their linear combination 2 (2; 2)+ 2 (0; 4) = (1; 3) yields an unbalanced bundle
with fewer units of good 2, thus not being prefered to (0; 4), that is, we …nd
a preference reversal since (0; 4) (1; 3).
(c) The consumer cares …rst about the sum of the amounts of the goods; if the sum
is the same in two bundles, he prefers the bundle with more of good 1.
This preference relation says that x % y if either: (i) x1 + x2 > y1 + y2 ; or
(ii) x1 + x2 = y1 + y2 and x2 y2 . This preference resembles a lexicographic
preference relation and it cannot be represented with a utility function. Each
indi¤erence set consists of a single bundle, as the lexicographic preferences.
This preference is strongly monotonic: consider bundle (x1 ; x2 ) and increase
the amount of all goods, yielding (x1 + ; x2 + ), which implies that the sums
satisfy (x1 + ) + (x2 + ) = x1 + x2 + 2 > x1 + x2 , so that (x1 + ; x2 + )
(x1 ; x2 ).
The preference is also convex: consider bundles (x1 ; x2 ) and (y1 ; y2 ) such that
(x1 ; x2 ) % (y1 ; y2 ). Their linear combination (x1 ; x2 ) + (1 )(y1 ; y2 ) yields
a sum (x1 + y1 ) + (1 )(x2 + y2 ). We need to consider two cases: (x1 ; x2 ) %
(y1 ; y2 ) holds because (i) x1 + x2 > y1 + y2 ; or because (ii) x1 + x2 = y1 + y2
and x2 y2 . In case (i), x1 + x2 > y1 + y2 implies that

(x1 + y1 ) + (1 )(x2 + y2 ) > y1 + y2

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 holds since this inequality simpli…es to

x1 + (1 )x2 > y2 + (1 )y1

| {z }
<x1 +x2

which we can compare with the initial condition x1 + x2 > y1 + y2 as follows

x1 + x2 > x1 + (1 )x2 and

y1 + y2 > y2 + (1 )y1

ultimately implying that (x1 + y1 ) + (1 )(x2 + y2 ) > y1 + y2 holds. In

case (ii), x1 + x2 = y1 + y2 implies that the linear combination (x1 + y1 ) +
(1 )(x2 + y2 ) simpli…es to [ x1 + (1 )x2 ] + [ y1 + (1 )y2 ], which
further simpli…es to 2 [ x1 + (1 )x2 ] since x1 + x2 = y1 + y2 entails that
x1 + (1 )x2 = y1 + (1 )y2 , as we place the weigh on each good.
Therefore, 2 [ x1 + (1 )x2 ] > y1 + y2 since x2 y2 .
Finally, this preference is not continuous. To see this, consider two unbalanced
bundles, such as (1; 2) and (2; 1), which satisfy (1; 2) (2; 1). Increasing the
amount of good 2 in (2; 1) by a small " > 0, we obtain a preference reversal,
that is, (2; 1 + ") (1; 2).

4. Ideal bundle. The consumer has in mind an ideal bundle x . He prefers bundle x to
y if and only if x is closer to x than y is, that is, x % y if and only if

jx1 x1 j + jx2 x2 j jy1 y1 j + jy2 y2 j .

Show that this preference relation is continuous and convex.

The utility function (jx1 x1 j + jx2 x2 j) that represents the preference rela-
tion is continuous, so the preference relation must also be continuous.
Regarding convexity, assume that bundles y and z satisfy y % z, which implies
that bundle y is closer to the consumer’s ideal point, x , than bundle z is. There-
fore, a linear combination between bundles y and z, y + (1 )z, is closer to x
than bundle z is, implying that y + (1 )z is preferred to z; as required for
convexity.

5. Rationalizable choices. Determine whether each of the following …ve choice func-
tions over a set X is rationalizable. If the answer is positive, …nd a preference relation
that rationalizes the choice function. Otherwise, prove that the choice function is not
rationalizable.

(a) The set X consists of candidates for a job. An individual has a complete ranking of
the candidates. When he has to choose from a set A, he …rst orders the candidates
in A alphabetically, and then examines the list from the beginning. He goes down
the list as long as the new candidate is better than the previous one. If the nth
candidate is the …rst who is better than the (n + 1)th candidate, he stops and
chooses the nth candidate. If in his journey he never gets to a candidate who is
inferior to the previous one, he chooses the last candidate.

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 Assume that X = fa; b; cg and the individual’s preference relation is c a
b. From the entire set he chooses a. From the set fa; cg he chooses c. This
choice function is not rationalizable
(b) The set X consists of n basketball teams, indexed 1 to n. The teams participate
in a round robin tournament. That is, every team plays against every other team.
An individual knows, for every pair of teams, which one wins. When he chooses
a team from a set A, he chooses the one with the largest number of wins among
the games between teams in A. If more than one team has the largest number of
wins, he chooses the team with the lowest index among the tied teams.
This choice function may violate rationality. Assume that n = 5 and that
team 1 beats all teams except 2, and team 2 loses to all teams except 1. Then
the individual chooses team 1 from the entire set of teams but team 2 from
f1; 2g.
(c) The set X consists of pictures. An individual has in mind L binary criteria,
each of which takes the value 0 (the criterion is not met) or 1 (the criterion is
met). Examples of such criteria are whether the painting is modern, whether the
painter is famous, and whether the price is above $1,000. The criteria are ordered:
criterion1 , criterion2 , . . . , criterionL . When the individual chooses a picture
from a subset of X, he rejects those that do not satisfy the …rst criterion. Then,
from those that satisfy the …rst criterion, he rejects those that do not satisfy the
second criterion. And so on, until only one picture remains. Assume that any two
alternatives have a criterion by which they di¤er, so that the procedure always
yields a unique choice.
Let %k be the preference relation that puts the pictures that satisfy criterion
k at the top (with indi¤erences among them) and the pictures that do not
satisfy the criterion at the bottom (with indi¤erences among them).
The choice function is rationalized by lexicographic preferences with the pri-
ority ordering %1 , %2 , ::: , %k . That is, …rst the alternatives ranked highest
according to %1 are selected, then among these alternatives the ones ranked
highest by %2 are selected, and so on.
(d) An individual has in mind two numerical functions, u and v, on the set X. For
any set A X, he …rst looks for the u-maximal alternative in A. If its u value is
at least 10, he selects it. If not, he selects the v-maximal alternative in A.
This choice function is rationalized by a preference relation that puts at the
top the alternatives in set fx 2 X : u(x) 10g with the preference induced
by u. The remaining alternatives are put at the bottom with the preferences
induced by v.
(e) An individual has in mind a preference relation on the set X. Each alternative
is either red or blue. Given a set A X, he chooses the best alternative among
those with the color that is more common in A. In the case of a tie, he chooses
among the red alternatives.
This choice function may not be rationalizable. Let X = fa; b; c; d; eg. As-
sume that the preference relation coincides with alphabetical order, Red =

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fa; bg and Blue = fc; d; eg. From the entire set, the individual chooses c
but from the subset fa; b; cg he chooses a. Thus, the choice function is not
rationalizable.