Economics 500, Fall 2020

Problem Set 4, Due Thursday, September 30

Question 1 Suppose U (x1 , x2 ) = xα1 1 xα2 2 is a Cobb-Douglas utility func-

tion. We use this to explore some questions of comparative statics in a
setting in which the calculations are straightforward. Begin by writing the
first-order conditions for utility maximization. Remember throughout that
you are free to take strictly increasing transformations of utility functions
whenever useful.

1.1 Solve the first-order conditions to find explicit solutions for the demand
functions, and then differentiate these functions to obtain comparative
static results.

1.2 Now instead apply the implicit function theorem to the first-order
conditions and solve for the collection of comparative static results.

1.3 For a third approach, use the budget constraint to write utility as a
function of a x1 , p1 , p2 , and w. Then use monotone comparative statics
to derive comparative static results. Identify the extent to which your
answers to the three approaches agree or disagree.

1.4 Revisit 1.1-1.3 for the case of a Cobb-Douglas utility function of an ar-
bitrary number L of goods rather than just two goods. Explain in each
case why the extension to L goods is straightforward or problematic.

1.5 Now consider a general utility function U (x1 , x2 ). Use the implicit
function theorem to calculate dx1 /dp1 . Then use the implicit function
theorem again to find dx1 /dw. Comparing your two results, explain
how dx1 /dp1 depends on the sign of the income effect, and explain how
your expression for dx1 /dp1 is an example of the Slutzky equation.
Assume throughout that you are dealing with a demand function with
interior solutions.

1.6 Continuing with the setting of 1.5, use the budget constraint to write
utility as a function solely of x1 . Identify what it means for this func-
tion to have increasing differences, in both discrete and differential
form. Using the latter, derive a relationship between the income effect
and increasing differences.
 1.7 We have so far considered comparative static results that vary a sin-
gle exogenous variable. Consider the Cobb-Douglas utility function
of L goods from 1.4. Use the budget constraint to remove one of the
endogenous variables and write utility as a function of the L − 1 re-
maining endogenous variables and the exogenous variables. For what
combinations of variables does this function exhibit strictly increasing
differences? What the the implied comparative statics?

Question 2 This problem examines the concepts of compensating varia-

tion, equilibrating variation, and consumer surplus.

2.1 Which demand function is steeper—the Hicksian or Marshallian de-

mand function? Explain how your answer changes depending on whether
the good in question is a normal good or an inferior good, and provide
an appropriate argument supporting your result. (You may assume
throughout that you are dealing with demand functions, interior solu-
tions, and so on.)

2.2 Give an example in which the equilibrating variation is strictly larger

than the consumer surplus, which is strictly larger than the equilibrat-
ing variation. Give an example in which these three are equal, and an
example in which the equilibrating variation is strictly smaller than
the consumer surplus, which is strictly smaller than the equilibrating
variation. Explain how your results are related to your findings in
2.1 concerning income effects and the relative slopes of Hicksian and
Marshallian demand functions.

2.3 Suppose you are considering a policy that will lower the price of good
1. Implementing the policy requires that you incur a per capita cost
K. You would like to implement the policy if and only if the per
capita benefit to consumers exceeds K. Suppose you calculate the
equilibrating variation and the compensating variation of the policy
change (assume consumers are identical, so that you need do this only
once) and find that the former exceeds K, while that letter falls short
of K. One of your examples in 2.2 should assure you that this can be
the case How would you evaluate the policy?

2.4 Let’s suppose instead that you are considering a potential policy that
will reduce the income of each person i in the economy by amount
Ki . When assessing the benefits, you find that the sum (across people

2
 in the economy) of the compensating variations, as well as the corre-
sponding sum of equilibrating variations, is larger than the total cost.
However, some people in the economy realize higher benefits than oth-
ers, while some incur higher costs than others. Is there a collection
of lump sum taxes and subsidies that will make everyone better off?
The first step in addressing this question is to formulate the question
more precisely; then provide either a proof or a counterexample.

Question 3 We consider here some questions of aggregation. A person

i’s utility function is said to be of Gorman form if it is given by vi (p, wi ) =
ai (p) + bi (p)wi .

3.1 Show (using Roy’s identity) that if person i has such a utility function,
then the income-expansion path for good ℓ is linear. Now argue that
if every person i in an economy has a utility function whose indirect
utility function is given by vi (p, wi ) = ai (p) + b(p)wi (notice that the
subscript on b has disappeared, so we are assuming that this term is
common across people), then their income-expansion paths are paral-
lel. Show that this implies that the aggregate demand x(p, w1 , . . . , wI )
can be written as x(p, w), where w is the sum of the individual wealth
levels.

3.2 In light of the previous result, it is interesting to know when the indi-
rect utility function has the Gorman form. Show that this is the case
for Cobb-Douglas preferences.

3.3 Show that if preferences are homothetic, then the indirect utility func-
tion has Gorman form. Hence, if individual demands are homothetic
and identical, then there exists a representative consumer. Provide
an example of preferences that are not homothetic but that are repre-
sented by a utility function of the Gorman form.

3.4 Suppose we are concerned with the rule wi (p, w) = λi w, where w is

aggregate income, wi (p, w) gives person i’s income as a function of
aggregate income, and λi for i = 1, . . . , I is a collection of positive
numbers that sum to one. Specify a utility function for each person
in the economy and a Bergstrom-Samuelson social welfare function for
which there exists a representative consumer.