Economics 401

Test 1
Friday 27th January 2017

Answer all questions. Each question is worth 10 marks.

1. Let X be a choice set, B be a set of budget sets which are subsets of X, and C () be
a choice rule for these budget sets.
(a) Use set-theoretic notation to list all the assumptions, and the conclusion, of the weak
axiom of revealed preference (WARP).
(b) Consider an example where X = {a, b, c}, B = {B1 , B2 , B3 } , B1 = {a, b} , B2 =
{b, c} , B3 = {c, a} , C (B1 ) = {b} , C (B2 ) = {c} , C (B3 ) = {a}. Does this example violate
WARP? Defend your answer.
(c) If a fourth budget, B4 = {a, b, c}, were added to the example in (b) will this new
example violate WARP? Defend your answer.

ANSWER

(a) The assumptions of WARP are: (1) B1 , B2 B; (2) {x, y} B1 B2 ; (3) x C(B1 );
(4) y C(B2 ). The conclusion of WARP is x C(B2 ).

(b) Assumption (2) is not true in this example and so WARP has no leverage and the example
cannot violate WARP.

(c) The addition of B4 to the other three budget sets means that for X = {a, b, c} we have
all the two- and three-element budget sets and so, if WARP were true, there would be a
complete and transitive preference relation that would rationalize the consumers choices
(this is the last proposition in MWG, chapter 1). But from (b) it is clear that any preference
relation consistent with the consumers choices would violate transitivity. So the addition of
B4 must imply a violation of WARP, whatever C(B4 ) is. Recall that the definition of C ()
rules out C (B) = for any B B.

2. Let % be the at least as good as preference relation defined on choice set X = <n+ .
(a) Define the strict preference relation , and then define strong monotonicity, mono-
tonicity, and local nonsatiation.
(b) Prove strong monotonicity implies monotonicity, and monotonicity implies local non-
satiation.

1
 ANSWER

(a) Definitions
For a, b X, a  b means a % b is true and b % a is false.
P 1/2
n j=n 2
Let X = <+ , a X, b X: d (a, b) j=1 (aj bj ) , where we use the positive root.
Let a X: N (a) {x X : d (a, x) < ,  > 0}
Let y (y1 , y2 , ..., yn ) X and z (z1 , z2 , ..., zn ) X. Then y z means yj zj , j =
1, ..., n and y >> z means yj > zj , j = 1, ..., n. Note: y > z is not defined.
Strong monotonicity: suppose a X and b X and b a and b 6= a; then b  a.
Monotonicity: suppose a X and b X and b >> a; then b  a.
Local non-satiation: suppose a X: then every -neighbourhood of a, N (a), contains a
b X such that b  a.

(b) How to structure the proofs

Suppose we have the following statements.

Statement 1: A1 B1
and

Statement 2: A2 B2
and we want to prove that

Statement 1 Statement 2 .
Then start by assuming A2 is true, and argue persuasively that A2 A1 . Since Statement
1 is assumed to be true A1 B1 . The final step is to argue persuasively that B1 B2 .

Proof that strong monotonicity implies monotonicity: Suppose a X and b X and b >> a,
then a X and b X and b a and b 6= a, that is, the assumptions of strong monotonicity
are met. Since we are assuming strong monotonicity is true we know its conclusion holds,
that is, b  a which is what we needed to prove.

Proof that monotonicity implies local non-satiation: Every epsilon-neighbourhood of a con-

tains some b X such that b >> a. Since we are assuming monotonicity is true we know
its conclusion holds, that is, b  a which is what needed to prove.

3. Consider a price-taking consumer in a two-good world. Let w denote money wealth

and (p1 , p2 ) prices; w 0, p1 > 0, p2 > 0. Fill in the following tables as precisely as you can,
and verify the Slutsky equation for changing the price of good 2 on the demand for good 1,
for someone whose preferences are represented by:

u (x1 , x2 ) = min (ax1 , bx2 ) , a, b > 0.

2
 ANSWER

Solution type x1 (p1 , p2 , w) x2 (p1 , p2 , w) V (p1 , p2 , w) Range

Interior bw/(bp1 + ap2 ) aw/(bp1 + ap2 ) abw/(bp1 + ap2 ) p1 > 0, p2 > 0, w 0

Solution type h1 (p1 , p2 , u0 ) h2 (p1 , p2 , u0 ) e (p1 , p2 , u0 ) Range

Interior u0 /a u0 /b u0 (p1 /a + p2 /b) p1 > 0, p2 > 0, u0 0

The Slutsky equation for the effect of a change in the price of good 2 on the demand for
good 1 is:
x1 h1 x1
= x2
p2 p2 w
And then

LHS = abw/(bp1 + ap2 )2

RHS = 0 (aw/(bp1 + ap2 )) (b/(bp1 + ap2 )) = abw/(bp1 + ap2 )2

So LHS equals RHS and this Slutsky equation is verified.