Topics in Consumer Theory

Problem Set

1. Prove that if ≿ is a preference relation, then the relation ≻ is transitive and the relation ∼ is transitive.
Also show that if x1 ∼ x2 ≿ x3 , then x1 ≿ x3 .

2. (Substitute goods) Sketch a map of indifference sets that are all parallel, negatively sloped straight
lines, with preference increasing north-easterly. These preferences satisfy Axioms 1, 2, 3, and 4.
Prove that they also satisfy Axiom 5′ . Prove that they do not satisfy Axiom 5.

3. (Leontief preferences) Sketch a map of indifference sets that are all parallel right angles that ‘kink’
on the line x1 = x2 . If preference increases north-easterly, these preferences will satisfy Axioms 1, 2,
3, and 4′ . Prove that they also satisfy Axiom 5′ . Do they satisfy Axiom 4? Do they satisfy Axiom 5?

4. Suppose u( x1 , x2 ) and v( x1 , x2 ) are utility functions.

(a) Prove that if u( x1 , x2 ) and v( x1 , x2 ) are both homogeneous of degree r, then s( x1 , x2 ) ≡ u( x1 , x2 ) +

v( x1 , x2 ) is homogeneous of degree r.

(b) Prove that if u( x1 , x2 ) and v( x1 , x2 ) are quasiconcave, then m( x1 , x2 ) ≡ min{u( x1 , x2 ), v( x1 , x2 )}

is also quasiconcave.

5. Consider a two-good case where x1∗ > 0 and x2∗ = 0 at the solution to the consumer’s problem.
State the Kuhn-Tucker conditions that characterize this solution and illustrate your answer with a
diagram.
 6. Suppose preferences are represented by the Cobb-Douglas utility function, u( x1 , x2 ) = Ax1α x21−α ,
0 < α < 1, and A > 0. Assuming an interior solution, solve for the Marshallian demand functions.
Take the logarithmic transform of the utility function and using that as the new utility function,
derive the Marshallian demand functions and verify that they are identical to those derived in the
case of Cobb-Douglas.

7. Suppose that preferences are represented by the utility function u(x). Assuming an interior solution,
the consumer’s demand functions, x(p, y), are determined implicitly by the Kuhn-Tucker conditions.
Now consider the utility function f (u(x)), where f ′ > 0, and show that the first-order conditions
characterizing the solution to the consumer’s problem in both cases can be reduced to the same
set of equations. Conclude from this that the consumer’s demand behavior is invariant to positive
monotonic transforms of the utility function.

8. A consumer of two goods faces positive prices and has a positive income. His utility function is
u( x1 , x2 ) = max[ ax1 , ax2 ] + min[ x1 , x2 ], where 0 < a < 1. Derive the Marshallian demand functions.

n
9. Prove that ∑ ϵij + ηi = 0, i = 1, · · · , n.
i =1

10. Suppose the following is true about a consumer who spends all his income on two goods:

(1) At current prices, the same amount is spent on both goods

(2) at current prices, the own-price elasticity of demand for good 1 is equal to −3

(a) At current prices, what is elasticity of demand for good 2 with respect to the price of good 1?

(b) Can statements (1) and (2) both hold at all prices? Why or why not?

n
11. The n-good Cobb-Douglas utility function is u(x) = A · Πin=1 xi i , where A > 0 and ∑ αi = 1. Derive
α
i =1
the Marshallian demand functions, the indirect utility function, the expenditure function, and the
Hicksian demands.
12. Consider the problem of maximizing the utility function

1 1
u( x, y) = x 2 + y 2

n o
on the budget set ( x, y) ∈ R2+ | px + y = 1 . Show that if the nonnegativity constraints x, y ≥ 0 are
ignored, and the problem is written as an equality-constrained one, the resulting Lagrangean has a
unique critical point. Does this critical point identify a solution to the problem? Why or why not?

13. Consider the problem of maximizing the utility function u( x1 , x2 ) = x1 + x2 on the budget set
n o
B( p, M) = ( x1 , x2 ) | M − p1 x1 − p2 x2 ≥ 0, x1 ≥ 0, x2 ≥ 0 , where M, p1 , and p2 are all strictly
positive terms. There are three inequality constraints that define this problem. Find the solution to
the maximization problem.

n
14. Consider the problem of minimizing w1 x1 + w2 x2 over the feasible set D = ( x1 , x2 ) | x12 + x22 ≥
o
y, x1 ≥ 0, x2 ≥ 0 . There are three inequality constraints that define this problem. Find the solution
to the maximization problem. Find the solution to the minimization problem.

15. Show that the Slutsky relation can be expressed in elasticity form as: ϵij = ϵijh − s j ηi , where ϵijh is the
elasticity of the Hicksian demand for xi with respect to price p j .

16. A consumer with income y0 faces prices p0 and enjoys utility u0 = v(p0 , y0 ). When prices change to
p1 , the cost of living is affected. To gauge the impact of these price changes, define a cost of living
index as the ratio:
e ( p1 , u0 )
I ( p0 , p1 , u0 ) ≡
e ( p0 , u0 )

(a) Show that I (p0 , p1 , u0 ) is greater than (less than) unity as the outlay necessary to maintain base
utility, u0 , rises (falls).

(b) Suppose consumer income also changes from y0 to y1 . Show that the consumer will be better
y1
off (worse off) in the final period whenever y0
is greater (less) than I (p0 , p1 , u0 ).

√
17. Suppose the consumer’s direct utility function is u( x1 , x2 ) = x1 + x2 .
 (a) Let base prices be p0 = (1, 2), base income be y0 = 10, and suppose p1 = (2, 1). Compute the
index I.

(b) Let base and final period prices be as in part (a), but now let base utility be u0 . Show that the
value of the index I will vary with the base utility.

18. Consider the utility maximization problem max x a + y s.t. px + y = m, where the constants p and m
are positive, and the constant a ∈ (0, 1).

(a) Find the demand functions, x ∗ ( p, m) and y∗ ( p, m).

(b) Find the partial derivatives of the demand functions w.r.t. p and m, and check their signs.

(c) How does the optimal expenditure on the x good vary with p?

(d) Put a = 1/2. What are the demand functions in this case? Denote the maximal utility as a
function of p and m by U ∗ ( p, m), the value function, also called the indirect utility function.
∂U ∗
Verify that ∂p = − x ∗ ( p, m).

19. Each week an individual consumes quantities x and y of two goods, and works for l hours. These
three quantities are chosen to maximize the utility function:

U ( x, y) = α ln x + β ln y + (1 − α − β) ln( L − l )

which is defined for 0 ≤ l < L and for x, y > 0. Here α and β are positive parameters satisfying
α + β < 1. The individual faces the budget constraint px + qy = wl, where w is the wage per hour.
α+ β
Define γ = (1− α − β )
. Find the individual’s demands x ∗ , y∗ , and labour supply l ∗ as functions of p, q,
and w.

20. Consider the consumer demand problem:

max U ( x, y) = α ln( x − a) + β ln(y − b) subject to px + qy = m

where α, β, a, b, p, q, and m are positive constants, with α + β = 1 and m > ap + bq.

 (a) Show that if x ∗ , y∗ solve the maximization problem, then expenditure on the two goods is given
by the two linear functions,

px ∗ = αm + pa − α( pa + qb) and qy∗ = βm + qb − β( pa + qb)

∂U ∗
(b) Let U ∗ ( p, q, m) = U ( x ∗ , y∗ ) denote the indirect utility function. Show that ∂m > 0 and verify
Roy’s identities:
∂U ∗ ∂U ∗ ∗ ∂U ∗ ∂U ∗ ∗
=− x and =− y
∂p ∂m ∂q ∂m

21. An agent allocates the H hours of time available to her between labor (l) and leisure (H − l). Her
only source of income is from the wages she obtains by working. She earns w per hour of labor;
thus, if she works l ∈ [0, H ] hours, her total income is wl. She spends her income on food ( f ) and
entertainment (e), which cost p and q per unit respectively. Her utility function is given by u( f , e, l )
and is increasing in f and e, and is decreasing in l (disutility of labor hours).

(a) Describe the consumer’s utility maximization problem. Describe the equations that define the
critical points of the Lagrangean L.

(b) Assuming H = 16, w = 3, and p = q = 1, find the utility-maximizing consumption bundle if

1 1
u( f , e, l ) = f 3 e 3 − l 2 .

+1
22. Suppose that x(p, y) ∈ Rn+ satisfies budget balancedness and homogeneity on Rn++ . Show that for
+1
all (p, y) ∈ Rn++ , s(p, y) · p = 0, where s(p, y) denotes the Slutsky matrix associated with x(p, y).

23. Derive the consumer’s direct utility function if his indirect utility function has the form v(p, y) =
β
yp1α p2 for negative α and β.

p1 p2
24. A consumer has expenditure function e( p1 , p2 , u) = u ( p . Find a direct utility function, u( x1 , x2 ),
1 + p2 )

that rationalizes this person’s demand behaviour.

25. Derive the consumer’s inverse demand functions, p1 ( x1 , x2 ) and p2 ( x1 , x2 ), when the utility function
is of the Cobb-Douglas form, u( x1 , x2 ) = Ax1α x21−α for 0 < α < 1.
26. Suppose there are only two goods and that a consumer’s choice function x(p, y) satisfies budget
balancedness, p · x(p, y) = y for all (p, y). Show the following:

(a) If x(p, y) is homogeneous of degree zero in (p, y), then the Slutsky matrix associated with x(p, y)
is symmetric.

(b) If x(p, y) satisfies WARP, then the ‘revealed preferred to’ relation, R, has no intransitive cycles.
(By definition, x1 Rx2 if and only if x1 is revealed preferred to x2 .)

27. Prove that a continuous preference relation ≿ on (−∞, ∞) × Rn+−1 is quasilinear with respect to the
first commodity if it admits a utility function u(x) of the form u(x) = x1 + ϕ( x2 , · · · , xn ).

αi y
28. Suppose that you observe the Marshallian demand functions xi (p, y) = pi for all i = 1, · · · , n with

∑ nαi = 1. Derive the expenditure function of this demand system. What is the consumer’s utility
i =1
function?

29. There are three commodities (i.e., n = 3), of which the third is a numeraire (let p3 = 1). The mar-
ket demand functionx(p, y) has x1 (p, y) = a + bp1 + cp2 and x2 (p, y) = d + ep1 + gp2 . Give the
parameter restrictions implied by utility maximization.

30. Suppose we are in a three-commodity market (i.e. n = 3). Letting p3 = 1, the demand functions for
goods 1 and 2 are

x1 (p, y) = a1 + b1 p1 + c1 p2 + d1 p1 p2 x2 (p, y) = a2 + b2 p1 + c2 p2 + d2 p1 p2

(a) Note that the demand for goods 1 and 2 does not depend on wealth. Write down the most
general class of utility functions whose demand has this property.

(b) Argue that if the demand functions in (a) are generated from utility maximization, then the
values of the parameters cannot be arbitrary. Write down as exhaustive a list as you can of the
restrictions implied by utility maximization. Justify your answer.