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Harvard Economics 2020a Problem Set 2

Harvard Economics 2020a Problem Set 2

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Economics
Economics

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Published by: J on Nov 21, 2007
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06/16/2009

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API 111 – Econ 2020 – HBS 4010Fall 2007, Problem Set #2Due: Wednesday, October 3, 2007.
Answer the following 5 questions:
1. Cobb-Douglas Utility:
Consider the utility function:
( )
12
1212
,
a a
u x x x x
=
 Let p
1
and p
2
be the (strictly positive) prices of x
1
and x
2
, respectively, and assume the consumer’s wealth is w.1a) Is this utility function homogeneous in (x
1
,x
2
)? If it is, of what degree? If not, why not?1b) Derive the consumer’s Walrasian demand functions1c) Derive the value of the Lagrange multiplier.1d) Derive the consumer’s indirect utility function, v(p,w).1e) Verify that
( )
,
dv p wdw
λ 
=
.1f) ** optional ** Explain why your answer to part e is an application of the envelope theorem.
2. Another Comparative Statics Exercise
A consumer consumes only one good, bananas. Let b denote the number of bananas eaten. The consumer’swillingness to pay (measured in dollars) for b bananas is log(b+1), where “log” denotes the natural logarithm (as italways does in economics). Let p > 0 denote the price of a banana. Thus, the total surplus (i.e., utility) of theconsumer that buys and eats b bananas is given by:
( ) ( )
log1
u b b pb
= +
.2a. Given the consumer’s objective function, u(b), derive the first-order conditions for the consumer’s optimalchoice of b, which you may denote b*. Note: be sure to address the fact that the optimal choice of b must benon-negative.2b. Explain whether you can be sure that the b* that satisfies the condition you found in part 3a is really a globalmaximum.2c. How will the consumer’s optimal choice of b respond to an increase in the price of bananas? Does your answerdepend on p?2d. Write down an expression for the optimized value of the consumer’s objective function, and explain how theoptimized level of the consumer’s utility reacts to a change in p. Does your answer depend on p? Explain andinterpret your answer.
3. Perfect Complements:
Consider the following utility function:U(x
1
,x
2
) = min(ax
1
,x
2
)Where a is an unknown positive real number.3a) Draw a typical indifference curve for this utility function.3b) Suppose p
1
and p
2
are the (positive) prices of x
1
and x
2
respectively. If the consumer has total wealth w>0, statethe consumer’s (Walrasian) demand functions.3c) Consider the utility function: V(x
1
,x
2
) = x
1
α
 
x
21-
α
, where
α
is a fixed but unknown positive number. Youbelieve that a consumer has either utility function V() or U() as defined above. You observe that when (p
1
,p
2
)= (1,1) and income is w = 2, the consumer chooses consumption bundle (x
1
,x
2
) = (1,1). Based on thisinformation, can you determine which utility function represents the consumer’s preferences? Why or whynot.3d) Suppose you observe in addition to the information in (3) above that when prices are (p
1
,p
2
) = (2,2) and incomeis 4, the consumer chooses consumption bundle (1,1). Does the additional information allow you to make anynew inferences about which utility function represents the consumer’s preferences? Why or why not.

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