API 111 / Economics 2020a / HBS 4010 Fall 2008, Problem Set #2 Due: Wednesday, October 1, 2008

1. Cobb-Douglas Utility: Consider the utility function:

a u ( x1 , x2 ) = x1a1 x2 2

Let p1 and p2 be the (strictly positive) prices of x1 and x2, respectively, and assume the consumers wealth is w. (a) Is this utility function homogeneous in (x1, x2)? If it is, of what degree? If not, why not? (b) Derive the consumers Walrasian demand functions (c) Derive the value of the Lagrange multiplier.

2. Another Comparative Statics Exercise A consumer consumes only one good, bananas. Let b denote the number of bananas eaten. The consumers willingness to pay (measured in dollars) for b bananas is log(b+1), where log denotes the natural logarithm (as it always does in economics). Let p > 0 denote the price of a banana. Thus, the total surplus (i.e., utility) of the consumer that buys and eats b bananas is given by: u ( b ) = log ( b + 1) pb . (a) Given the consumers objective function, u(b), derive the first-order conditions for the consumers optimal choice of b, which you may denote b*. Note: be sure to address the fact that the optimal choice of b must be non-negative. (b) Explain whether you can be sure that the b* that satisfies the condition you found in part 3a is really a global maximum. (c) How will the consumers optimal choice of b respond to an increase in the price of bananas? Does your answer depend on p? (d) Write down an expression for the optimized value of the consumers objective function, and explain how the optimized level of the consumers utility reacts to a change in p. Does your answer depend on p? Explain and interpret your answer.

3. Perfect Complements: Consider the following utility function: U(x1,x2) = min(ax1,x2), where a is an unknown positive real number. (a) Draw a typical indifference curve for this utility function. (b) Suppose p1 and p2 are the (positive) prices of x1 and x2 respectively. If the consumer has total wealth w>0, state the consumers (Walrasian) demand functions. (c) Consider the utility function: V(x1,x2) = x1 x21- , where is a fixed but unknown positive number. You believe that a consumer has either utility function V() or U() as defined above. You observe that when (p1,p2) = (1,1) and income is w = 2, the consumer chooses consumption bundle (x1,x2) = (1,1). Based on this information, can you determine which utility function represents the consumers preferences? Why or why not. (d) Suppose you observe in addition to the information in (3) above that when prices are (p1,p2) = (2,2) and income is 4, the consumer chooses consumption bundle (1,1). Does the additional information allow you to make any new inferences about which utility function represents the consumers preferences? Why or why not. (e) Suppose you observe in addition to the information in (3) and (4) above that when prices are (p1,p2) = (1,2) and income is 3, the consumer chooses consumption bundle (1,1). Does the additional information allow you to make any new inferences about which utility function represents the consumers preferences? Why or why not. (f) In general, how many data points are necessary to distinguish between utilty function U() and V()? What restrictions must be placed on these data points? OPTIONAL PROBLEMS 4. MWG Problems 2.D.4, 2.E.1 (p. 23), 2.E.2 (p. 28), 2.F.3 (parts (a) through (d)). 5. Continuity and Indifference Curves (a) Consider a two-good world and let A = (2, 2), B = (2, 6), C = (0, 2). Draw a line between B and C and define bundle D = (1, 4), which is on this line. Suppose that (1) if x = (x1, x2) is on this line and x1 > 1, then x is strictly preferred to A and (2) if x = (x1, x2) is on this line and x1 < 1, then A is strictly preferred to x. Show that the continuity axiom in combination with (1) and (2) implies A ~ D. (b) Part (a) demonstrates the existence of a single bundle D on the line between B and C that is on the same indifference curve as bundle A. In this part of the problem, we want to show that the indifference curve including bundle A must be a continuous curve at bundle D. Maintain the assumptions from (a) and now assume that there is a sequence of bundles y1, y2, y3, that converges to a point x on the line between B and C. Argue that the preferences would not be consistent with the continuity axiom if y1 ~ y2 ~ y3 ~ A and x (1, 4).