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API 111 / Econ 2020a / HBS 4010

Maciej H. Kotowski / Harvard University

Problem Set 2
Due: September 22, 2014 at 13.00

Legibly write your name (and the names of any collaborators) on your independently written-up solutions.
Submit your solutions to the assignment drop box. Do not bring solutions to lecture.
Show your work. Include brief and precise explanations of intuition and derivations as appropriate.
Help us out.

Enclose final answers with a box.

1. CES Preferences (Similar to MWG 3.C.6 & 3.D.5)


Suppose there are two goods. Let p1 > 0 denote the price of good 1 and p2 the price of good 2. A consumer
with wealth w > 0 has the utility function
1/

u(x1 , x2 ) = (x1 + x2 )

(1)

The utility function u(x1 , x2 ) is an example of preferences with a constant elasticity of substitution (CES).
Preferences in this class are the work-horse preferences of many models in macroeconomics or in the study
of international trade. Therefore, understanding their properties is critical. In such applications, they often
1/
R
1/
P
1
L

when there is
x
d
for
the
L-good
case
and
x
appear in their more generalized forms:
=1
0
a continuum of goods. For this question, we will stick with the simple two-good version in (1).
a) Sketch the consumers indifference curves for different values of (, 1]. (You may wish to use a
computer to simplify this step.) Are these preferences convex? Are these preferences homothetic (see
Problem Set 1)?
b) Sketch the consumers indifference curves when = 2. Are these preferences convex?
c) Suppose henceforth that (, 1). Derive the consumers Walrasian demand function for goods 1 and
2.
d) The elasticity of substitution between goods 1 and 2 is defined by
h
h i
i
p1
xx12 (p,w)
(p,w)
p2
i.
h i h
12 (p, w) =
x1 (p,w)
pp12
x2 (p,w)
Show that for the CES utility function, 12 (p, w) =

1
1 .

e) Explain why CES preferences are sometimes written as u(x1 , x2 ) =

P
2

j=1 xj

 1

2. Revealed Preference and Compensated Demand


Suppose there are two goods. Jane has wealth w = 100 and chooses to consume the bundle (x1 , x2 ) = (5, 5)
when prices are p1 = p2 = 10.
a) Janes preferences obey the Law of Compensated Demand (see MWG pp. 32, 62). What bundles of goods
are ruled out if prices change to p1 = 8 and p2 = 12 and wealth stays at 100? What bundles of goods are
ruled out if prices change to p1 = 16 and p2 = 24 and wealth increases to 200?
b) Suppose instead that there are three goods. Janes wealth is now w = 150. When each good costs $10
per unit, Jane consumes (x1 , x2 , x3 ) = (5, 5, 5).
Suppose prices change to (p1 , p2 , p3 ) = (8, 10, 12) and Janes wealth stays at 150. For which of the three
goods, if any, can you determine that demand increases or decreases? Suppose that (5, 5, 5) is not chosen
by Jane at the new prices.
1

3. Maximizing a Maximum
Maximilian consumes two goods. His utility function is
u(x1 , x2 ) = max{x1 + x2 , x2 + x1 }
where , > 0. Let p1 and p2 be the prices of goods 1 and 2, respectively. Let w > 0 be Maximilians
wealth. What are Maximilians Walrasian and Hicksian demand correspondences?
4. Homothetic Preferences and Price Indices
The consumer price index (CPI) measures the change in the price of a fixed basket of goods and services.
Sometimes, media report that the CPI measures the change in the cost of living. This latter statement
is not entirely true. CPI measures neglect the substitution among goods and services that consumers often
make in response to price changes.
Let pt = (pt1 , . . . , ptL ) be the prices of goods 1, . . . , L in period t. Let xt = (xt1 , . . . , xtL ) be the bundle of
goods purchased by a utility-maximizing consumer in period t when pt are the prevailing prices. There are
several ways we can define a price index based on the bundle of goods which serves as a reference point. We
define a Laspeyres Price Index as
PL
p2 x1
p2 x1
CP IL = P=1
= 1 1.
L
1 1
p x
=1 p x
A Paasche Price Index is

PL

CP IP = P=1
L

=1

A Fisher Ideal Index is defined as

CP IF =

p2 x2
p1 x2

p2 x2
.
p1 x2

p
CP IL CP IP .

In contrast with the above measures a cost of living adjustment (COLA) would measure the change in
expenditure necessary for a consumer to maintain/achieve a given level of utility as prices change. We can
define
e(p2 , u2 )
e(p2 , u1 )
and
COLA
=
.
COLA1 =
2
e(p1 , u1 )
e(p1 , u2 )
e(pt , us ) is the minimum expenditure needed to attain utility level us when the prevailing prices are pt . If xt
P
t t
t
t
t
t
is a utility-maximizing bundle, then under our usual assumptions L
=1 p x = e(p , u ) where u = u(x ).
a) While COLAt is an appealing measure, identify at least one practical problem with its use.
b) A natural question to ask is how well the CPI measures approximate the cost of living adjustments.
Show that CP IL overestimates COLA1 and CP IP underestimates COLA2 . What implications for public
policy, if any, do these biases imply? (The syllabus offers some background readings on the CPI.)
Suppose that a consumer has wealth w = 8 in each of two periods and faces prices (p11 , p12 ) = (1, 1) in
period 1 and prices (p21 , p22 ) = (1, 4) in period 2 for goods 1 and 2. The consumer has identical CobbDouglas preferences u(x1 , x2 ) = x1 x2 for consumption in each period and chooses bundles for each period
independently to maximize utility in that period.
c) What are the consumers optimal bundles in periods 1 and 2?
d) Compute the CPI for these bundles and prices based on the Laspeyres index, the Paasche index, and the
Fisher ideal index.
e) Now find the exact change in wealth necessary to achieve period 1s utility in period 2. Do any of the
price indices accurately reflect this change in the cost of living?

Suppose instead that the consumer has a utility function u(x1 , x2 ) = x1 + 8 x2 .


2

f) What are the consumers optimal bundles in periods 1 and 2?


g) Compute the CPI for these bundles and prices based on the Laspeyres index, the Paasche index, and the
Fisher ideal index.
h) Now find the exact change in wealth necessary to achieve period 1s utility in period 2. Do any of the
price indices accurately reflect this change in the cost of living?

Additional Practice Problems (Do Not Hand In)


5. Skiing and Violins
Carol loves skiing and violin lessons, though not at the same time. Her preferences for the activities are
represented by the utility function u(x1 , x2 ) = 10x1 + x22 where x1 is the number of ski trips and x2 is the
number of violin lessons. (Carol can consume fractions of either activity. For instance, the quantities might
measure time devoted to each activity.)
a) Sketch Carols indifference curves.
b) Is Carols utility function quasi-concave?
c) Let p1 be the price of ski trips. Suppose that the price of violin lessons is fixed and normalized to p2 = 1.
Suppose Carol has wealth w > 0. Solve for Carols demand for ski trips and violins as a function of p1
and w.
d) Explain how the non-convexity of preferences affects your answer to part (c).

6. Janices Quasilinear Preferences


Janice has quasilinear preferences for goods 1 and 2. Her utility function is
u(x1 , x2 ) = x2

1
.
x1

Janices income is w > 0 and she faces prices p1 and p2 for the two goods. (Throughout this problem, be
mindful of corner solutions.)
a) Derive Janices Walrasian demand function, x (p, w), for all possible values of p1 , p2 , and w.
b) Derive Janices Hicksian demand function, h (p, u
), for all possible values of p1 , p2 , and u
.
c) Derive Janices expenditure function, e(p, u
). Does the Hicksian demand function equal the derivative of
the expenditure function? (MWG Proposition 3.G.1.)
Parts (c) and (d) are optional, but you should complete them before the midterm exam.
d) Suppose prices on Monday are p01 = 10, p02 = 10 and Janices income is w = 40. On Tuesday, the store
selling good 1 raises its price for good 1 to p11 = 16 dollars. The price of good 2 is unchanged. Use
compensating variation, equivalent variation, and consumer surplus to quantify the change in Janices
well-being. Are these values the same or are they different? Explain.
e) Suppose prices on Monday are p01 = 10, p02 = 10 and Janices income is w = 40. On Tuesday, the
store selling good 2 has a sale and lowers its price for good 2 to p12 = 5 dollars. The price of good 1
is unchanged. Use compensating variation, equivalent variation, and consumer surplus to quantify the
change in Janices well-being. Are these values the same or are they different? Explain.