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Jehle and Reny (2001): Advanced
Microeconomic Theory
Thomas Herzfeld
September 2010
Contents
1 Mathematical Appendix 2
1.1 Chapter A1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Chapter A2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2 Consumer Theory 12
2.1 Preferences and Utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.2 The Consumer’s Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.3 Indirect Utility and Expenditure . . . . . . . . . . . . . . . . . . . . . . . 16
2.4 Properties of Consumer Demand . . . . . . . . . . . . . . . . . . . . . . 18
2.5 Equilibrium and Welfare . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
3 Producer Theory 23
3.1 Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.2 Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
3.3 Duality in production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
3.4 The competitive ﬁrm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
1
1 Mathematical Appendix
1 Mathematical Appendix
1.1 Chapter A1
A1.7 Graph each of the following sets. If the set is convex, give a proof. If it is not
convex, give a counterexample.
Answer
(a) (x, y)y = e
x
This set is not convex.
Any combination of points would be outside the set. For example, (0, 1) and
(1, e) ∈ (x, y)y = e
x
, but combination of the two vectors with t =
1
2
not: (
1
2
,
e+1
2
) / ∈
(x, y)y = e
x
.
(b) (x, y)y ≥ e
x
This set is convex.
Proof: Let (x
1
, y
1
), (x
2
, y
2
) ∈ S = (x, y)y ≥ e
x
. Since y = e
x
is a continuous
function, it is suﬃcient to show that (tx
1
+ (1 − t)x
2
, ty
1
+ (1 − t)y
2
) ∈ S for any
particular t ∈ (0, 1). Set t =
1
2
. Our task is to show that
1
2
(x
1
+ x
2
),
1
2
(y
1
+ y
2
)
∈
S.
1
2
(y
1
+ y
2
) ≥
1
2
(e
x
1
+ e
x
2
), since y
i
≥ e
x
1
for i = 1, 2. Also,
1
2
(e
x
1
+ e
x
2
) ≥ e
1
2
(x
1
+x
2
= e
x
1
2
· e
x
2
2
⇔e
x
1
+ e
x
2
≥ 2e
x
1
2
· e
x
2
2
⇔e
x
1
−2e
x
1
2
· e
x
2
2
+ e
x
2
≥ 0 ⇔(e
x
1
−e
x
2
)
2
≥ 0.
(c) (x, y)y ≥ 2x −x
2
; x > 0, y > 0
This set is not convex.
For example,
1
10
,
1
2
,
1
9
10
,
1
2
∈ S = (x, y)y ≥ 2x −x
2
; x > 0, y > 0. However,
1,
1
2
=
1
2
1
10
,
1
2
+
1
2
1
9
10
,
1
2
/ ∈ S
(d) (x, y)xy ≥ 1; x > 0, y > 0
This set is convex.
Proof: Consider any (x
1
, y
1
), (x
2
, y
2
) ∈ S = (x, y)xy ≥ 1; x > 0, y > 0. For any
t ∈ [0, 1],
(tx
1
+ (1 −t)x
2
)(ty
1
+ (1 −t)y
2
) = t
2
x
1
y
1
+ t(1 −t)(x
1
y
2
+ x
2
y
1
) + (1 −t)
2
x
2
y
2
> t
2
+ (1 −t)
2
+ t(1 −t)(x
1
y
2
+ x
2
y
1
), since x
i
y
i
> 1.
= 1 + 2t
2
−2t + t(1 −t)(x
1
y
2
+ x
2
y
1
)
= 1 + 2t(t −1) + t(1 −t)(x
1
y
2
+ x
2
y
1
)
= 1 + t(1 −t)(x
1
y
2
+ x
2
y
1
−2) ≥ 1 iﬀ x
1
y
2
+ x
2
y
1
≥ 0.
x
1
y
2
+ x
2
y
1
= x
1
y
1
y
2
y
1
+ x
2
y
2
y
1
y
2
−2 ≥
y
2
y
1
+
y
1
y
2
−2 ≥ 0
y −1 −2y
1
y
2
+ y
2
≥ 0
(y
1
−y
2
)
2
≥ 0,
2
1 Mathematical Appendix
which is always true and therefore, (tx
1
+ (1 − t)x
2
, ty
1
+ (1 − t)y
2
) ∈ S which is
convex.
(e) (x, y)y ≤ ln(x)
This set is convex.
Proof. Let (x
1
, y
1
) + (x
2
, y
2
) ∈ S. Then
1
2
(y
1
+ y
2
) ≤ (ln(x
1
) + ln(x
2
)).
S is convex
if
⇒
1
2
ln(x
1
) + ln(x
2
) ≤ ln(
1
2
x
1
+
1
2
x
2
)
⇔
1
2
ln(x
1
x
2
) ≤ ln(
1
2
x
1
+
1
2
x
2
)
⇔(x
1
x
2
)
1/2
≤ (
1
2
x
1
+
1
2
x
2
)
⇔x
1
−2(x
1
x
2
)
1/2
+ x
2
≥ 0
⇔
x
1/2
1
+ x
1/2
2
2
≥ 0
which is always true.
A1.40 Sketch a few level sets for the following functions: y = x
1
x
2
, y = x
1
+ x
2
and
y = min[x
1
, x
2
].
Answer
6

x
1
x
2
(a) y = x
1
x
2
6

x
1
x
2
@
@
@
@
@
@
@
@
@
@
(b) y = x
1
+ x
2
6

x
1
x
2
(c) y = min(x
1
, x
2
)
Figure 1: Sets to Exercise A1.40
A1.42 Let D = [−2, 2] and f : D → R be y = 4 − x
2
. Carefully sketch this function.
Using the deﬁnition of a concave function, prove that f is concave. Demonstrate that
the set A is a convex set.
Answer Proof of concavity: Derive the ﬁrst and second order partial derivative:
∂y
∂x
= −2x
∂
2
y
∂x
2
= −2
The ﬁrst derivative is strictly positive for values x < 0 and negative for values x > 0.
The second order partial derivative is always less than zero. Therefore, the function is
concave.
Proof of convexity: The area below a concave function forms a convex set (Theorem
3
1 Mathematical Appendix
A1.13). Alternatively, from the deﬁnition of convexity the following inequality should
hold 4 − (tx
1
+ (1 − t)x
2
)
2
≥ t(4 − (x
1
)
2
) + (1 − t)(4 − (x
2
)
2
). Multiply out to get
4−(tx
1
+x
2
−tx
2
)
2
≥ 4−x
2
2
+t[(x
1
)
2
−(x
2
)
2
]. Again, the area below the function forms
a convex set.
6

x
y
Figure 2: Graph to Exercise A1.42
A1.46 Consider any linear function f(x) = a · x + b for a ∈ R
n
and b ∈ R.
(a) Show that every linear function is both concave and convex, though neither is strictly
concave nor strictly convex.
Answer The statement is true iﬀ, for any x
1
, x
2
∈ R
n
, t ∈ [0, 1], it is true that
f(tx
1
+ (1 −t)x
2
) = tf(x
1
) + (1 −t)f(x
2
).
Substituting any linear equation in this statement gives
f(tx
1
+(1−t)x
2
) = a[tx
1
+(1−t)x
2
]+b = tax
1
+(1−t)ax
2
+tb+(1−t)b = tf(x
1
)+(1−t)f(x
2
)
for all x
1
, x
2
∈ R
n
, t ∈ [0, 1].
(b) Show that every linear function is both quasiconcave and quasiconvex and, for n > 1,
neither strictly so. (There is a slight inaccuracy in the book.)
Answer As it is shown in (a) that a linear function is concave and convex, it must also
be quasiconcave and quasiconvex (Theorem A1.19). More formally, the statement
is true iﬀ, for any x
1
, x
2
∈ R
n
(x
1
= x
2
) and t ∈ [0, 1], we have
f(tx
1
+ (1 −t)x
2
) ≥ min[f(x
1
), f(x
2
)](quasiconcavity)
f(tx
1
+ (1 −t)x
2
) ≤ max[f(x
1
), f(x
2
)](quasiconvexity)
Again by substituting the equation into the deﬁnition, we get
tf(x
1
) + (1 −t)f(x
2
) ≥ min[f(x
1
), f(x
2
)]
tf(x
1
) + (1 −t)f(x
2
) ≤ max[f(x
1
), f(x
2
)] ∀t ∈ [0, 1]
A1.47 Let f(x) be a concave (convex) realvalued function. Let g(t) be an increas
ing concave (convex) function of a single variable. Show that the composite function,
h(x) = g(f(x)) is a concave (convex) function.
Answer The composition with an aﬃne function preserves concavity (convexity). As
sume that both functions are twice diﬀerentiable. Then the second order partial deriva
tive of the composite function, applying chain rule and product rule, is deﬁned as
h
(x) = g
(f(x)) f
(x)
2
+ g
(f(x)) f
(x)
2
4
1 Mathematical Appendix
For any concave function, ∇
2
f(x) ≤ 0, ∇
2
g(x) ≤ 0, it should hold ∇
2
h(x) ≤ 0. In
the case the two functions are convex: ∇
2
f(x) ≥ 0 and ∇
2
g(x) ≥ 0, it should hold
∇
2
h(x) ≥ 0.
A1.48 Let f(x
1
, x
2
) = −(x
1
−5)
2
−(x
2
−5)
2
. Prove that f is quasiconcave.
Answer Proof: f is concave iﬀ H(x) is negative semideﬁnite and it is strictly concave if
the Hessian is negative deﬁnite.
H =
¸
−2 0
0 −2
z
T
H(x)z = −2z
2
1
−2z
2
2
< 0, for z = (z
1
, z
2
) = 0
Alternatively, we can check the leading principal minors of H: H
1
(x) = −2 < 0 and
H
2
(x) = 4 > 0. The determinants of the Hessian alternate in sign beginning with a
negative value. Therefore, the function is even strictly concave. Since f is concave, it is
also quasiconcave.
A1.49 Answer each of the following questions “yes” or ”no“, and justify your answer.
(a) Suppose f(x) is an increasing function of one variable. Is f(x) quasiconcave?
Answer Yes, an increasing function of one variable is quasiconcave. Any convex
combination of two points on this function will be at least as large as the smallest of
the two points. Using the diﬀerentialbased approach, f is quasiconcave, if for any
x
0
and x
1
, f(x
1
) ≥ f(x
0
) ⇒ ∂f(x
0
)/∂x(x
1
− x
0
) ≥ 0. This must be true for any
increasing function.
(b) Suppose f(x) is a decreasing function of one variable. Is f(x) quasiconcave?
Answer Yes, a decreasing function of one variable is quasiconcave. Similarly to (a),
f is quasiconcave if for any x
0
, x
1
and t ∈ [0, 1], it is true that f(tx
0
+ (1 −t)x
1
) ≥
min[f(x
0
), f(x
1
)].
(c) Suppose f(x) is a function of one variable and there is a real number b such that
f(x) is decreasing on the interval (−inf, b] and increasing on [b, +inf). Is f(x)
quasiconcave?
Answer No, if f is decreasing on (−inf, b] and increasing on [b, +inf) then f(x) is
not quasiconcave.
Proof: Let a < b < c, and let t
b
=
c−b
c−a
∈ [0, 1], t
b
a + (1 −t
b
)c = b. Given the nature
of f, f(b) < min[f(a), f(c)]. Then f(t
b
a + (1 − t
b
)c) < min[f(a), f(c)], so f is not
quasiconcave.
(d) Suppose f(x) is a function of one variable and there is a real number b such that
f(x) is increasing on the interval (−inf, b] and decreasing on [b, +inf). Is f(x)
quasiconcave?
Answer Yes.
Proof: Let a < b < c, for x ∈ [a, b], f(x) ≥ f(a) and for x ∈ [b, c], f(x) ≥ f(c).
Hence, for any x ∈ [a, c], f(x) ≥ min[f(a), f(c)].
5
1 Mathematical Appendix
(e) You should now be able to come up with a characterization of quasiconcave func
tions of one variable involving the words “increasing” and “decreasing”.
Answer Any function of one variable f(x) is quasiconcave if and only if is either con
tinuously increasing, continuously decreasing or ﬁrst increasing and later decreasing.
1.2 Chapter A2
A2.1 Diﬀerentiate the following functions. State whether the function is increasing,
decreasing, or constant at the point x = 2. Classify each as locally concave, convex, or
linear at the point x = 2.
(a) f(x) = 11x
3
−6x + 8 f
1
= 33x
2
−6
increasing locally convex
(b) f(x) = (3x
2
−x)(6x + 1) f
1
= 54x
2
−6x −1
increasing locally convex
(c) f(x) = x
2
−
1
x
3
f
1
= 2x +
3
x
4
increasing locally concave
(d) f(x) = (x
2
+ 2x)
3
f
1
= (6x + 6)(x
2
+ 2x)
2
increasing locally convex
(e) f(x) = [3x/(x
3
+ 1)]
2
f
1
= 18x
x
3
−3x
2
+ 1
(x
3
+ 1)
3
increasing locally concave
(f) f(x) = [(1/x
2
+ 2) −(1/x −2)]
4
f
1
=
4
x
2
−
8
x
3
1
x
2
−
1
x
+ 4
3
increasing locally convex
(g) f(x) =
1
x
e
t
2
dt f
1
= −e
x
2
decreasing locally convex
A2.2 Find all ﬁrstorder partial derivatives.
(a) f(x
1
, x
2
) = 2x
1
−x
2
1
−x
2
2
f
1
= 2 −2x
1
= 2(1 −x
1
) f
2
= −2x
2
(b) f(x
1
, x
2
) = x
2
1
+ 2x
2
2
−4x
2
f
1
= 2x
1
f
2
= 4x
2
−4
6
1 Mathematical Appendix
(c) f(x
1
, x
2
) = x
3
1
−x
2
2
−2x
2
f
1
= 3x
1
f
2
= −2(x
2
+ 1)
(d) f(x
1
, x
2
) = 4x
1
+ 2x
2
−x
2
1
+ x
1
x
2
−x
2
2
f
1
= 4 −2x
1
+ x
2
f
2
= 2 −2x
2
+ x
1
(e) f(x
1
, x
2
) = x
3
1
−6x
1
x
2
+ x
3
2
f
1
= 3x
2
1
−6x
2
f
2
= 3x
2
2
−6x
1
(f) f(x
1
, x
2
) = 3x
2
1
−x
1
x
2
+ x
2
f
1
= 6x
1
−x
2
f
2
= 1 −x
1
(g) g(x
1
, x
2
, x
3
) = ln
x
2
1
−x
2
x
3
−x
2
3
g
1
=
2x
1
x
2
1
−x
2
x
3
−x
2
3
g
2
=
−x
3
x
2
1
−x
2
x
3
−x
2
3
g
3
=
−x
2
−2x
3
x
2
1
−x
2
x
3
−x
2
3
A2.4 Show that y = x
2
1
x
2
+ x
2
2
x
3
+ x
2
3
x
1
satisﬁes the equation
∂y
∂x
1
+
∂y
∂x
2
+
∂y
∂x
3
= (x
1
+ x
2
+ x
3
)
2
.
The ﬁrstorder partial derivatives are ∂y/∂x
1
= 2x
1
x
2
+ x
2
3
,
∂y/∂x
2
= x
2
1
+ 2x
2
x
3
, and ∂y/∂x
3
= x
2
2
+ 2x
3
x
1
. Summing them up gives
∂y
∂x
1
+
∂y
∂x
2
+
∂y
∂x
3
= x
2
1
+ x
2
2
+ x
2
3
+ 2x
1
x
2
+ 2x
1
x
3
+ 2x
2
x
3
= (x
1
+ x
2
+ x
3
)
2
.
A2.5 Find the Hessian matrix and construct the quadratic form, z
T
H(x)z, when
(a) y = 2x
1
−x
2
1
−x
2
2
H =
¸
−2 0
0 −2
z
T
H(x)z = −2z
2
1
+ 2 ∗ 0z
1
z
2
−2z
2
2
(b) y = x
2
1
+ 2x
2
2
−4x
2
H =
¸
2 0
0 4
z
T
H(x)z = 2z
2
1
+ 2 ∗ 0z
1
z
2
+ 4z
2
2
7
1 Mathematical Appendix
(c) y = x
3
1
−x
2
2
+ 2x
2
H =
¸
6x
1
0
0 −2
z
T
H(x)z = 6x
1
z
2
1
−2z
2
2
(d) y = 4x
1
+ 2x
2
−x
2
1
+ x
1
x
2
−x
2
2
H =
¸
−2 1
1 −2
z
T
H(x)z = −2z
2
1
+ 2z
1
z
2
−2z
2
2
(e) y = x
3
1
−6x
1
x
2
−x
3
2
H =
¸
6x
1
−6
−6 6x
2
z
T
H(x)z = 6x
1
z
2
1
−12z
1
z
2
+ 6x
2
z
2
2
A2.8 Suppose f(x
1
, x
2
) =
x
2
1
+ x
2
2
.
(a) Show that f(x
1
, x
2
) is homogeneous of degree 1.
f(tx
1
, tx
2
) =
(tx
1
)
2
+ (tx
2
)
2
=
t
2
(x
2
1
+ x
2
2
) = t
x
2
1
+ x
2
2
.
(b) According to Euler’s theorem, we should have f(x
1
, x
2
) = (∂f/∂x
1
) x
1
+(∂f/∂x
2
) x
2
.
Verify this.
1 · f(x
1
, x
2
) =
x
1
x
2
1
+ x
2
2
x
1
+
x
2
x
2
1
+ x
2
2
x
2
=
x
2
1
+ x
2
2
x
2
1
+ x
2
2
=
x
2
1
+ x
2
2
A2.9 Suppose f(x
1
, x
2
) = (x
1
x
2
)
2
and g(x
1
, x
2
) = (x
2
1
x
2
)
3
.
(a) f(x
1
, x
2
) is homogeneous. What is its degree?
f(tx
1
, tx
2
) = t
4
(x
1
x
2
)
2
k = 4
(b) g(x
1
, x
2
) is homogeneous. What is its degree?
g(tx
1
, tx
2
) = t
9
(x
2
1
x
2
)
3
k = 9
(c) h(x
1
, x
2
) = f(x
1
, x
2
)g(x
1
, x
2
) is homogeneous. What is its degree?
h(x
1
, x
2
) = (x
3
1
x
2
2
)
5
h(tx
1
, tx
2
) = t
25
(x
3
1
x
2
2
)
5
k = 25
8
1 Mathematical Appendix
(d) k(x
1
, x
2
) = g (f(x
1
, x
2
), f(x
1
, x
2
)) is homogeneous. What is its degree?
k(tx
1
, tx
2
) = t
36
(x
1
x
2
)
18
k = 36
(e) Prove that whenever f(x
1
, x
2
) is homogeneous of degree m and g(x
1
, x
2
) is homoge
neous of degree n, then k(x
1
, x
2
) = g (f(x
1
, x
2
), f(x
1
, x
2
)) is homogeneous of degree
mn.
k(tx
1
, tx
2
) = [t
m
(f(x
1
, x
2
), f(x
1
, x
2
))]
n
k = mn
A2.18 Let f(x) be a realvalued function deﬁned on R
n
+
, and consider the matrix
H
∗
=
¸
¸
¸
¸
0 f
1
· · · f
n
f
1
f
11
· · · f
1n
.
.
.
.
.
.
.
.
.
.
.
.
f
n
f
n1
· · · f
nn
.
This is a diﬀerent sort of bordered Hessian than we considered in the text. Here, the
matrix of secondorder partials is bordered by the ﬁrstorder partials and a zero to
complete the square matrix. The principal minors of this matrix are the determinants
D
2
=
0 f
1
f
1
f
11
, D
3
=
0 f
1
f
2
f
1
f
11
f
12
f
2
f
21
f
22
, . . . , D
n
= H
∗
.
Arrow & Enthoven (1961) use the sign pattern of these principal minors to establish the
following useful results:
(i) If f(x) is quasiconcave, these principal minors alternate in sign as follows: D
2
≤ 0,
D
3
≥ 0, . . . .
(ii) If for all x ≥ 0, these principal minors (which depend on x) alternate in sign
beginning with strictly negative: D
2
< 0, D
3
> 0, . . . , then f(x) is quasiconcave
on the nonnegative orthant. Further, it can be shown that if, for all x 0, we
have this same alternating sign pattern on those principal minors, then f(x) is
strictly quasiconcave on the (strictly) positive orthant.
(a) The function f(x
1
, x
2
) = x
1
x
2
+ x
1
is quasiconcave on R
2
+
. Verify that its principal
minors alternate in sign as in (ii).
Answer The bordered Hessian is
H
∗
=
¸
0 x
2
+ 1 x
1
x
2
+ 1 0 1
x
1
1 0
.
9
1 Mathematical Appendix
The two principal minors are D
2
= −(x
2
+1)
2
< 0 and D
3
= 2x
1
x
2
+2x
1
≥ 0. Which
shows that the function will be quasiconcave and will be strictly quasiconcave for
all x
1
, x
2
> 0.
(b) Let f(x
1
, x
2
) = a ln(x
1
+x
2
) +b, where a > 0. Is this function strictly quasiconcave
for x 0? It is quasiconcave? How about for x ≥ 0? Justify.
Answer The bordered Hessian is
H
∗
=
¸
¸
0
a
x
1
+x
2
a
x
1
+x
2
a
x
1
+x
2
−a
(x
1
+x
2
)
2
−a
(x
1
+x
2
)
2
a
x
1
+x
2
−a
(x
1
+x
2
)
2
−a
(x
1
+x
2
)
2
.
The two principal minors are D
2
= −(
a
x
1
+x
2
)
2
< 0 for x
1
, x
2
> 0 and D
3
= 0.
Which shows that the function can not be strictly quasiconcave. However, it can be
quasiconcave following (i). For x
1
= x
2
= 0 the function is not deﬁned. Therefore,
curvature can not be checked in this point.
A2.19 Let f(x
1
, x
2
) = (x
1
x
2
)
2
. Is f(x) concave on R
2
+
? Is it quasiconcave on R
2
+
?
Answer The bordered Hessian is
H
∗
=
¸
0 2x
1
x
2
2
2x
2
1
x
2
2x
1
x
2
2
2x
2
2
4x
1
x
2
2x
2
1
x
2
4x
1
x
2
2x
2
1
.
The two principal minors are D
2
= −(2x
1
x
2
)
2
< 0 and D
3
= 16x
4
1
x
4
2
≥ 0. Which
shows that the function will be strictly quasiconcave. Strict quasiconcavity implies
quasioncavity.
A2.25 Solve the following problems. State the optimised value of the function at the
solution.
(a) min
x
1
,x
2
= x
2
1
+ x
2
2
s.t. x
1
x
2
= 1
x
1
= 1 and x
2
= 1 or x
1
= −1 and x
2
= −1, optimised value= 2
(b) min
x
1
,x
2
= x
1
x
2
s.t. x
2
1
+ x
2
2
= 1
x
1
=
1/2 and x
2
= −
1/2 or x
1
= −
1/2 and x
2
=
1/2, optimised value= −1/2
(c) max
x
1
,x
2
= x
1
x
2
2
s.t. x
2
1
/a
2
+ x
2
2
/b
2
= 1
x
1
=
a
2
/3 and x
2
=
2b
2
/3 or x
2
= −
2b
2
/3, optimised value=
2ab
2
3
3
/2
(d) max
x
1
,x
2
= x
1
+ x
2
s.t. x
4
1
+ x
4
2
= 1
x
1
=
4
1/2 and x
2
=
4
1/2, optimised value=
4
√
2
3
= 2
3/4
(e) max
x
1
,x
2
,x
3
= x
1
x
2
2
x
3
3
s.t. x
1
+ x
2
+ x
3
= 1
x
1
= 1/6 and x
2
= 1/3 = 2/6 and x
3
= 1/2 = 3/6, optimised value= 1/432 = 108/6
6
10
1 Mathematical Appendix
A2.26 Graph f(x) = 6 − x
2
− 4x. Find the point where the function achieves its
unconstrained (global) maximum and calculate the value of the function at that point.
Compare this to the value it achieves when maximized subject to the nonnegativity
constraint x ≥ 0.
Answer This function has a global optimum at x = −2. It is a maximum as the second
order partial derivative is less than zero. Obviously, the global maximum is not a solution
in the presence of a nonnegativity constraint. The constrained maximization problem is
L(x, z, λ) = 6 −x
2
−4x + λ(x −z)
The ﬁrst order conditions and derived equations are:
∂L
∂x
= −2x −4 + λ = 0
∂L
∂z
= −λ ≤ 0
∂L
∂λ
= x −z = 0
λ = x −z z = x λx = 0
If λ = 0, then x = −2 would solve the problem. However, it does not satisfy the non
negativity constraint. If λ = 0, then x = 0. As the function is continuously decreasing
for all values x ≥ 0, it is the only maximizer in this range.
6

x
y
Figure 3: Graph to Exercise A2.26
11
2 Consumer Theory
2 Consumer Theory
2.1 Preferences and Utility
1.6 Cite a credible example were the preferences of an ‘ordinary consumer’ would be
unlikely to satisfy the axiom of convexity.
Answer: Indiﬀerence curves representing satiated preferences don’t satisfy the axiom of
convexity. That is, reducing consumption would result in a higher utility level. Negative
utility from consumption of ‘bads’ (too much alcohol, drugs etc.) would rather result in
concave preferences.
1.8 Sketch a map of indiﬀerence sets that are parallel, negatively sloped straight lines,
with preference increasing northeasterly. We know that preferences such as these satisfy
Axioms 1, 2, 3, and 4. Prove the they also satisfy Axiom 5
. Prove that they do not
satisfy Axiom 5.
Answer: Deﬁnition of convexity (Axiom 5
): If x
1
x
0
, then tx
1
+ (1 − t)x
0
x
0
for
all t ∈ [0, 1]. Strict convexity (Axiom 5) requires that, if x
1
= x
0
and x
1
x
0
, then
tx
1
+ (1 −t)x
0
x
0
for all t ∈ [0, 1].
The map of indiﬀerence sets in the ﬁgure below represent perfect substitues. We know
that those preferences are convex but not stricly convex. Intuitively, all combinations
of two randomly chosen bundles from one indiﬀerence curve will necessarily lie on the
same indiﬀerence curve. Additionally, the marginal rate of substitution does not change
by moving from x
0
to x
1
. To prove the statement more formally, deﬁne x
t
as convex
combination of bundles x
0
to x
1
: x
t
= tx
0
+ (1 − t)x
1
. Rewriting in terms of single
commodities gives us:
x
t
= (tx
0
1
, tx
0
2
) + ((1 −t)x
1
1
, (1 −t)x
1
2
). A little rearrangement and equalising the two
deﬁnitions results in the equality
tx
0
+ (1 −t)x
1
= (tx
0
1
+ (1 −t)x
1
1
), tx
0
2
+ (1 −t)x
1
2
). That is, the consumer is indiﬀerent
with respect to the convex combination and the original bundles, a clear violation of
strict convexity.
12
2 Consumer Theory
6

x
1
x
2
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
HH
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
r
x
0
r
x
t
r
x
1
Figure 4: Indiﬀerence sets to Exercise 1.8
1.9 Sketch a map of indiﬀerence sets that are parallel right angles that “kink” on the
line x
1
= x
2
. If preference increases northeasterly, these preferences will satisfy Axioms
1, 2, 3, and 4’. Prove that they also satisfy Axiom 5’. Do they also satisfy Axiom 4?
Do they satisfy Axiom 5?
Answer: Convexity (Axiom 5
) requires that, if x
1
x
0
, then tx
1
+ (1 − t)x
0
x
0
for
all t ∈ [0, 1].
Take any two vectors x
0
, x
1
such that x
0
∼ x
1
. Given the nature of these preferences, it
must be true that min[x
0
1
, x
0
2
] = min[x
1
1
, x
1
2
]. For any t ∈ [0, 1] consider the point tx
1
+(1−
t)x
2
. If we can show that min[tx
0
1
+(1 −t)x
0
2
, tx
1
1
+(1 −t)x
1
2
] ≥ min[x
0
1
, x
0
2
= min[x
1
1
, x
1
2
],
then we shown that these preferences are convex. min[tx
0
1
+(1 −t)x
0
2
, tx
1
1
+(1 −t)x
1
2
] ≥
min[tx
0
1
, tx
1
1
] + min[(1 − t)x
0
2
, +(1 − t)x
1
2
] = min[x
0
2
, x
1
2
] + t[min(x
0
1
, x
1
1
) − min(x
0
2
, x
1
2
)] =
min[x
0
2
, x
1
2
]
Deﬁnition of strict monotonicity (Axiom 4): For all x
0
, x
1
∈ R
n
+
, if x
0
≥ x
1
, then
x
0
x
1
, while if x
0
x
1
, then x
0
x
1
.
The map of indiﬀerence sets in the ﬁgure below represents perfect complements. Take
two points x
0
, x
1
along one indiﬀerence curve. If x
0
x
1
, “preferences increase north
easterly”, then x
0
x
1
. For any two vectors on the same indiﬀerence curve, that is
x
0
≥ x
1
, it follows x
0
x
1
. Therefore, the deﬁnition of strict monotonicity is satisﬁed
for these indiﬀerence sets.
Strict convexity (Axiom 5) requires that, if x
1
= x
0
and x
1
x
0
, then tx
1
+(1−t)x
0
x
0
for all t ∈ [0, 1].
Take any two points along the horizontal or vertical part of an indiﬀerence curve such
as (x
0
1
, x
0
2
) and (x
0
1
, x
1
2
), where x
0
2
> x
1
2
. Any convex combination x
t
= x
0
1
, tx
0
2
+(1 −t)x
1
2
lies on the same indiﬀerence curve as x
1
and x
0
. Therefore, it is not possible that
x
t
tx
0
+ (1 − t)x
1
. That is, the consumer is indiﬀerent with respect to the convex
combination and the original bundles, a clear violation of strict convexity.
13
2 Consumer Theory
6

x
1
x
2
r
x
0
r
x
1
Figure 5: Indiﬀerence sets to Exercise 1.9
1.12 Suppose u(x
1
, x
2
) and v(x
1
, x
2
) are utility functions.
(a) Prove that if u(x
1
, x
2
) and v(x
1
, x
2
) are both homogeneous of degree r, then s(x
1
, x
2
) ≡
u(x
1
, x
2
) + v(x
1
, x
2
) is homogeneous of degree r.
Answer: Whenever it holds that t
r
u(x
1
, x
2
) = u(tx
1
, tx
2
) and t
r
v(x
1
, x
2
) = v(tx
1
, tx
2
)
for all r > 0, it must also hold that t
r
s(x
1
, x
2
) ≡ u(tx
1
, tx
2
) + v(tx
1
, tx
2
) =
t
r
u(x
1
, x
2
) + t
r
v(x
1
, x
2
).
(b) Prove that if u(x
1
, x
2
) and v(x
1
, x
2
) are quasiconcave, then m(x
1
, x
2
) ≡ u(x
1
, x
2
) +
v(x
1
, x
2
) is also quasiconcave.
Answer: Forming a convex combination of the two functions u and v and comparing
with m(x
t
) satisﬁes the deﬁnition of quasiconcavity:
When u(x
t
) ≥ min
¸
tu(x
1
) + (1 −t)u(x
2
)
¸
and
v(x
t
) ≥ min
¸
tv(x
1
) + (1 −t)v(x
2
)
¸
so
m(x
t
) ≥ min
¸
u(x
t
) + v(x
t
)
¸
=
t(u(x
1
) + v(x
1
)) + (1 −t)(u(x
2
) + v(x
2
))
.
2.2 The Consumer’s Problem
1.20 Suppose preferences are represented by the CobbDouglas utility function, u(x
1
, x
2
) =
Ax
α
1
x
1−α
2
, 0 < α < 1, and A > 0. Assuming an interior solution, solve for the Marshal
lian demand functions.
Answer: Use either the Lagrangian or the equality of Marginal Rate of Substitution and
price ratio. The Lagrangian is
14
2 Consumer Theory
L = Ax
α
1
x
1−α
2
+ λ(y −p
1
x
1
−p
2
x
2
). The ﬁrstorder conditions (FOC) are
∂L
∂x
1
= αAx
α−1
1
x
1−α
2
−λp
1
= 0
∂L
∂x
2
= (1 −α)Ax
α
1
x
−α
2
−λp
2
= 0
∂L
∂λ
= y −p
1
x
1
+ p
2
x
2
= 0
By dividing ﬁrst and second FOC and some rearrangement, we get either x
1
=
αx
2
p
2
(1−α)p
1
or
x
2
=
(1−α)p
1
x
1
αp
2
. Substituting one of these expressions into the budget constraint, results
in the Marshallian demand functions: x
1
=
αy
p
1
and x
2
=
(1−α)y
p
2
.
1.21 We’ve noted that u(x) is invariant to positive monotonic transforms. One com
mon transformation is the logarithmic transform, ln(u(x)). Take the logarithmic trans
form of the utility function in 1.20; then, using that as the utility function, derive the
Marshallian demand functions and verify that they are identical to those derived in the
preceding exercise (1.20).
Answer: Either the Lagrangian is used or the equality of Marginal Rate of Substitution
with the price ratio. The Lagrangian is
L = ln(A) + αln(x
1
) + (1 −α) ln(x
2
) + λ(y −p
1
x
1
−p
2
x
2
). The FOC are
∂L
∂x
1
=
α
x
1
−λp
1
= 0
∂L
∂x
2
=
(1 −α)
x
2
−λp
2
= 0
∂L
∂λ
= y −p
1
x
1
+ p
2
x
2
= 0
The Marshallian demand functions are: x
1
=
αy
p
1
and x
2
=
(1−α)y
p
2
. They are exactly
identical to the demand functions derived in the preceding exercise.
1.24 Let u(x) represent some consumer’s monotonic preferences over
x ∈ R
n
+
. For each of the functions F(x) that follow, state whether or not f also represents
the preferences of this consumer. In each case, be sure to justify your answer with either
an argument or a counterexample.
Answer:
(a) f(x) = u(x) + (u(x))
3
Yes, all arguments of the function u are transformed equally
by the third power. Checking the ﬁrst and secondorder partial derivatives reveals
that, although the secondorder partial
∂
2
f
∂x
2
i
=
∂
2
u
∂x
2
i
+6(u(x))(
∂u
∂x
i
)
2
is not zero, the sign
of the derivatives is always invariant and positive. Thus, f represents a monotonic
transformation of u.
15
2 Consumer Theory
(b) f(x) = u(x) −(u(x))
2
No, function f is decreasing with increasing consumption for
any u(x) < (u(x))
2
. Therefore, it can not represent the preferences of the consumer.
It could do so if the minus sign is replaced by a plus sign.
(c) f(x) = u(x) +
¸
n
i=1
x
i
Yes, the transformation is a linear one, as the ﬁrst partial
is a positive constant, here one, and the second partial of the transforming function
is zero. Checking the partial derivatives proves this statement:
∂f
∂x
i
=
∂u
∂x
i
+ 1 and
∂
2
f
∂x
2
i
=
∂
2
u
∂x
2
i
.
1.28 An inﬁnitely lived agent owns 1 unit of a commodity that she consumes over her
lifetime. The commodity is perfect storable and she will receive no more than she has
now. Consumption of the commodity in period t is denoted x
t
, and her lifetime utility
function is given by
u(x
0
, x
1
, x
2
, . . .) =
∞
¸
t=0
β
t
ln(x
t
), where 0 < β < 1.
Calculate her optimal level of consumption in each period.
Answer: Establish a geometric series to calculate her lifetime utility:
u = β
0
ln(x
0
) + β ln(x
1
) + β
2
ln(x
2
) + . . . + β
t
ln(x
t
)
As β is less than one, this series approaches a ﬁnite value. To ﬁnd the solution, multiply
the expression by β and subtract from the original equation [(1)(2)].
βu = β
1
ln(x
0
) + β
2
ln(x
1
) + β
3
ln(x
2
) + . . . + β
t+1
ln(x
t
)
u −βu = (1 −β)u = ln(x
0
) −β
t+1
ln(x
t
)
u =
ln(x
0
) −β
t+1
ln(x
t
)
1 −β
= ln(x
0
)
Thus, the consumer’s utility maximising consumption will be constant in every period.
2.3 Indirect Utility and Expenditure
1.30 Show that the indirect utility function in Example 1.2 is a quasiconvex function
of prices and income.
Answer: The indirect utility function corresponding to CES preferences is: v(p, y) =
y (p
r
1
+ p
r
2
)
−1/r
, where r ≡ ρ/(ρ −1).
There are several ways. First, using the inequality relationship, let p
t
= tp
0
+(1 −t)p
1
.
We need to show that the indirect utility function fulﬁlls the inequality
y
p
tr
1
+ p
tr
2
−1/r
≤ max[y
p
0r
1
+ p
0r
2
−1/r
, y
p
1r
1
+ p
1r
2
−1/r
]
16
2 Consumer Theory
which gives:
y
t
r
(p
0r
1
+ p
0r
2
) + (1 −t)
r
(p
1r
1
+ p
1r
2
)
−1/r
≤ max[y
p
0r
1
+ p
0r
2
−1/r
, y
p
1r
1
+ p
1r
2
−1/r
].
Second, the bordered Hessian can be derived and their determinants checked. The
determinants will be all negative.
H =
¸
¸
¸
0 p
−1/r
−p
r−1
1
p
−1/r−1
y −p
r−1
2
p
−1/r−1
y
p
−1/r
0 p
−1/r
p
−1/r
−p
r−1
1
p
−1/r−1
y p
−1/r
yp
−1/r−1
p
r−2
1
((1 −r) −rp
r
1
p
−1
) (1 + r)p
r−1
1
p
r−1
2
p
−1/r−2
y
−p
r−1
2
p
−1/r−1
y p
−1/r
(1 + r)p
r−1
1
p
r−1
2
p
−1/r−2
y yp
−1/r−1
p
r−2
2
((1 −r) −rp
r
2
p
−1
)
, where p ≡ (p
r
1
+ p
r
2
).
1.37 Verify that the expenditure function obtained from the CES direct utility function
in Example 1.3 satisﬁes all the properties given in Theorem 1.7.
Answer: The expenditure function for two commodities is e(p, u) = u(p
r
1
+ p
r
2
)
1/r
where
r ≡ ρ/(ρ −1).
1. Zero when u takes on the lowest level of utility in U.
The lowest value in U is u((0)) because the utility function is strictly increasing.
Consequently, 0(p
r
1
+ p
r
2
)
1/r
= 0.
2. Continuous on its domain R
n
++
×U.
This property follows from the Theorem of Maximum. As the CES direct utility
function satisﬁes the axiom of continuity, the derived expenditure function will be
continuous too.
3. For all p >> 0, strictly increasing and unbounded above in u.
Take the ﬁrst partial derivative of the expenditure function with respect to utility:
∂e/∂u = (p
r
1
+p
r
2
)
1/r
. For all strictly positive prices, this expression will be positive.
Alternatively, by the Envelope theorem it is shown that the partial derivative of
the minimumvalue function e with respect to u is equal to the partial derivative
of the Lagrangian with respect to u, evaluated at (x
∗
, λ
∗
), what equals λ. Un
boundness above follows from the functional form of u.
4. Increasing in p.
Again, take all ﬁrst partial derivatives with respect to prices: ∂e/∂p
i
= up
r−1
i
(p
r
1
+ p
r
2
)
(1/r)−1
,
what is, obviously, positive.
5. Homogeneous of degree 1 in p.
e(tp, u) = u((tp
1
)
r
+ (tp
2
)
r
)
1/r
= t
1
u(p
r
1
+ p
r
2
)
1/r
17
2 Consumer Theory
6. Concave in p.
The deﬁnition of concavity in prices requires
t
u
p
0
r
1
+ p
0
r
2
1/r
+ (1 −t)
u
p
1
r
1
+ p
1
r
2
1/r
≤ e(p
t
, u)
for p
t
= tp
0
+(1 −t)p
1
. Plugging in the deﬁnition of the price vector into e(p
t
, u)
yields the relationship
t
u
p
0
r
1
+ p
0
r
2
1/r
+ (1 −t)
u
p
1
r
1
+ p
1
r
2
1/r
≤
u
t(p
0
r
1
+ p
0
r
2
) + (1 −t)(p
1
r
1
+ p
1
r
2
)
1/r
.
Alternatively, we can check the negative semideﬁniteness of the associated Hessian
matrix of all secondorder partial derivatives of the expenditure function. A third
possibility is to check (product rule!)
∂
2
e
∂p
2
i
= u
(r −1)
p
r
i
(p
r
1
+ p
r
2
)
1/r
p
2
1
(p
r
1
+ p
r
2
)
−r
p
2r
i
(p
r
1
+ p
r
2
)
1/r
p
2
i
(p
r
1
+ p
r
2
)
2
< 0 by r < 0.
Homogeneity of degree one, together with Euler’s theorem, implies that ∂
2
e/∂p
2
i
p
i
=
0. Hence the diagonal elements of the Hessian matrix must be zero and the matrix
will be negative semideﬁnite.
7. Shephard’s lemma
∂e/∂u = (p
r
1
+p
r
2
)
1/r
what is exactly the deﬁnition of a CEStype Hicksian demand
function.
1.38 Complete the proof of Theorem 1.9 by showing that
x
h
(p, u) = x (p, e(p, u)).
Answer: We know that at the solution of the utility maximisation or expenditure min
imisation problem e(p, u) = y and u = v(p, y). Substitute the indirect utility function
v into the Hicksian demand function gives x
h
(p, v(p, y)). As the new function is a
function of prices and income only, it is identical to the Marshallian demand function.
Furthermore, by replacing income by the expenditure function we get the expression
x (p, e(p, u)).
2.4 Properties of Consumer Demand
1.40 Prove that Hicksian demands are homogeneous of degree zero in prices.
Answer: We know that the expenditure function must be homogeneous of degree one
in prices. Because any Hicksian demand function equals, due to Shephard’s lemma,
the ﬁrst partial derivative of the expenditure function and, additionally, we know that
the derivative’s degree of homogeneity is k1. The Hicksian demand functions must be
homogeneous of degree 1 −1 = 0 in prices.
18
2 Consumer Theory
1.43 In a twogood case, show that if one good is inferior, the other good must be
normal.
Answer: The Engelaggregation in a twogood case is the product of the income elasticity
and the repsective expenditure share s
1
η
1
+ s
2
η
2
= 1. An inferior good is characterised
by a negative income elasticity, thus, one of the two summands will be less than zero.
Therefore, to secure this aggregation, the other summand must be positive (even larger
one) and the other commodity must be a normal good (even a luxury item).
1.55 What restrictions must the α
i
, f(y), w(p
1
, p
2
), and z(p
1
, p
2
) satisfy if each of the
following is to be a legitimate indirect utility function?
Answer:
(a) v(p
1
, p
2
, p
3
, y) = f(y)p
α
1
1
p
α
2
2
p
α
3
3
The function f(y) must be continuous, strictly in
creasing and homogeneous of degree 0 −
¸
α
i
. Each of the exponents α
i
has to be less
than zero to satisfy v decreasing in prices. Furthermore, negative partial derivatives of
v with respect to each price are required to get positive Marshallian demand functions
by using Roy’s identity.
(b) v(p
1
, p
2
, y) = w(p
1
, p
2
)+z(p
1
, p
2
)/y The functions w and z must be continuous and de
creasing in prices. Function z has to be homogeneous of degree one and w homogeneous
of degree zero: v(tp
1
, tp
2
, ty) = t
0
w(p
1
, p
2
)+(t
1
z(p
1
, p
2
))/(ty) = t
0
(w(p
1
, p
2
) + z(p
1
, p
2
)/y).
To satisfy v increasing in income, z must be < 0.
1.60 Show that the Slutsky relation can be expressed in elasticity form as
ij
=
h
ij
−
s
j
η
i
, where
h
ij
is the elasticity of the Hicksian demand for x
i
with respect to price p
j
,
and all other terms are as deﬁned in Deﬁnition 1.6. Answer: The Slutsky relation is
given by
∂x
i
∂p
j
=
∂x
h
i
∂p
j
−x
j
∂x
i
∂y
.
Multiplying the total expression with y/y and p
j
gives
∂x
i
∂p
j
p
j
=
∂x
h
i
∂p
j
p
j
−
p
j
x
j
y
∂x
i
∂y
y.
By assuming that x
h
i
= x
i
before the price change occurs, we can divide all three terms
by x
i
. The result of this operation is
∂x
i
∂p
j
p
j
x
i
=
∂x
h
i
∂p
j
p
j
x
i
−s
j
∂x
i
∂y
y
x
i
=
ij
=
h
ij
−s
j
η
i
Additional exercise Relationship between utility maximisation and expenditure min
imisation
Let’s explore the relationship with an example of a concrete utility function. A con
sumer’s utility function is u = x
1/2
1
x
1/2
2
. For the derived functions see 1
19
2 Consumer Theory
Start from the utility function Minimise expenditures s.t. u
and derive the Marshallian demand for x
1
to ﬁnd the Hicksian demand function
x
1
= y/2p
1
x
h
1
= u(p
2
/p
1
)
1/2
Plug in the respective demand functions to get the
indirect utility function expenditure function
v = y/(4p
1
p
2
)
1/2
e = u(4p
1
p
2
)
1/2
Substitute the expenditure function Substituting the indirect utility function
into the Marshallian demand function into the Hicksian demand function
to derive the Hicksian demand function to derive the Marshallian demand function
x
1
= (u(4p
1
p
2
)
1/2
)/2p
1
= u(p
2
/p
1
)
1/2
x
h
1
= (p
2
/p
1
)
1/2
y/(4p
1
p
2
)
1/2
= y/2p
1
Invert v and replace y by u Invert e and replace u by v
to get the expenditure function to get the indirect utility function
v
−1
= u(4p
1
p
2
)
1/2
e
−1
= y(4p
1
p
2
)
−1/2
Check Roy’s identity Check Shephard’s lemma
−
∂v/∂p
1
∂v/∂y
=
2y(p
1
p
2
)
1/2
4(p
3
1
p
2
)
1/2
= y/2p
1
∂e
∂p
1
=
u4p
2
2(4p
1
p
2
)
1/2
= u(p
2
/p
1
)
1/2
Establish the Slutsky equation
∂x
1
∂p
2
=
u
2(p
1
p
2
)
1/2
−
y
2p
2
·
1
2p
1
substitute u = v(p, y) into the substitution eﬀect
∂x
1
∂p
2
=
y
4p
1
p
2
−
y
4p
1
p
2
= 0
Table 1: Relationship between UMP and EMP
2.5 Equilibrium and Welfare
4.19 A consumer has preferences over the single good x and all other goods m repre
sented by the utility function, u(x, m) = ln(x) +m. Let the price of x be p, the price of
m be unity, and let income be y.
(a) Derive the Marshallian demands for x and m.
Answer The equality of marginal rate of substitution and price ratio gives 1/x = p.
Thus, the Marshallian demand for x is x = 1/p. The uncompensated demand for m
separates into two cases depending on the amount of income available:
m =
0 when y ≤ 1
y −1 when y > 1.
(b) Derive the indirect utility function, v(p, y).
Answer Again, depending on the amount of income available there will be two
indirect utility functions:
v(p, y) =
ln
1
p
when m ≤ 1
y −1 −ln p when m > 1.
20
2 Consumer Theory
(c) Use the Slutsky equation to decompose the eﬀect of an ownprice change on the
demand for x into an income and substitution eﬀect. Interpret your result brieﬂy.
Answer A wellknown property of any demand function derived from a quasilinear
utility function is the absence of the income eﬀect. Which can be easily seen in the
application of the Slutsky equation:
∂x
h
∂p
=
∂x
∂p
+ x
∂x
∂y
∂x
∂p
= −
1
p
2
+ 0 ·
1
p
=
∂x
h
∂p
.
Therefore, the eﬀect of an ownprice change on the demand for x equals the substi
tution eﬀect.
(d) Suppose that the price of x rises from p
0
to p
1
> p
0
. Show that the consumer surplus
area between p
0
and p
1
gives an exact measure of the eﬀect of the price change on
consumer welfare.
Answer The consumer surplus area can be calculated by integrating over the inverse
demand function of x:
CS =
p
1
p
0
1
x
dx = ln(p
1
−p
0
).
Calculating the change in utility induced by a price change gives:
∆v = v
1
(p
1
, y
1
) −v
0
(p
1
, y
0
) = y −1 −ln p
1
−(y −1 −ln p
0
) = ln(p
1
−p
0
).
As the two expressions are equal, the consumer surplus area gives an exact measure
of the eﬀect of the price change on consumer welfare in the case of quasilinear
preferences.
(e) Carefully illustrate your ﬁndings with a set of two diagrams: one giving the indif
ference curves and budget constraints on top, and the other giving the Marshallian
and Hicksian demands below. Be certain that your diagrams reﬂect all qualitative
information on preferences and demands that you’ve uncovered. Be sure to consider
the two prices p
0
and p
1
, and identify the Hicksian and Marshallian demands.
Answer See Figure 6. Please note, that Hicksian and Marshallian demands are
identical here.
21
2 Consumer Theory
Figure 6: Graph to 4.19
22
3 Producer Theory
3 Producer Theory
3.1 Production
3.1 The elasticity of average product is deﬁned as
∂AP
i
(x)
∂x
i
·
x
i
AP
i
(x)
. Show that this is
equal to µ
i
(x) −1. Show that average product is increasing, constant, or decreasing as
marginal product exceeds, is equal to, or less than average product.
Answer: Applying quotient rule to get the ﬁrst partial derivative of the average product
gives:
∂AP
i
(x)
∂x
i
=
x
i
∂f(x)/∂x
i
−f(x)
x
2
i
=
MP
x
i
−
AP
x
i
=
MP −AP
x
i
Multiply this term with the right part of the deﬁnition (x
i
/AP) gives MP/AP −1 what
is exactly µ
i
(x) −1.
The ﬁrst part of the above deﬁnition equals the slope of the average product: (MP −
AP)/x
i
. It is straightforward to show that whenever marginal product exceeds the
average product the slope has to be positive. The average product reaches a maximum
when the marginal product equals average product. Finally, whenever MP < AP
average product is sloping downwards.
3.3 Prove that when the production function is homogeneous of degree one, it may be
written as the sum f(x) =
¸
MP
i
(x)x
i
, where MP
i
(x) is the marginal product of input
i.
Answer: The answer to this exercise gives a nice application of Euler’s Theorem. The
sum of the partial diﬀerentials of a function multiplied with the level of the respective
inputs is equal to the function times the degree of homogeneity k. The sum of all
marginal products multiplied with input levels gives the production function times k = 1.
3.7 Goldman & Uzawa (1964) have shown that the production function is weakly
separable with respect to the partition {N
1
, . . . , N
S
} if and only if it can be written in
the form
f(x) = g
f
1
(x
(1)
), . . . , f
S
(x
(S)
)
,
where g is some function of S variables, and, for each i, f
i
(x
(i)
) is a function of the
subvector x
(i)
of inputs from group i alone. They have also shown that the production
function will be strongly separable if and only if it is of the form
f(x) = G
f
1
(x
(1)
) +· · · + f
S
(x
(S)
)
,
where G is a strictly increasing function of one variable, and the same conditions on the
subfunctions and subvectors apply. Verify their results by showing that each is separable
as they claim.
Answer To show that the ﬁrst equation is weakly separable with respect to the partitions,
we need to show that
∂[f
i
(x)/f
j
(x)]
∂x
k
= 0 ∀i, j ∈ N
S
and k / ∈ N
S
. Calculate the marginal
23
3 Producer Theory
products of the ﬁrst equation for two arbitrary inputs i and j:
f
i
(x) =
∂g
∂f
S
∂f
S
∂x
i
f
j
(x) =
∂g
∂f
S
∂f
S
∂x
j
.
The marginal rate of technical substitution between these two inputs is
f
i
(x)
f
j
(x)
=
∂f
S
∂x
i
∂f
S
∂x
j
This expression is independent of any other input which is not in the same partition N
S
and, therefore, the production function is weakly separable.
∂(f
i
/f
j
)
∂x
k
= 0 for k / ∈ N
S
To show that the second equation is strongly separable we have to perform the same ex
ercise, however, assuming that the three inputs are elements of three diﬀerent partitions
i ∈ N
S
, j ∈ N
T
and k / ∈ N
S
∪ N
T
. The marginal products of the two inputs i and j are:
f
i
(x) = G
∂f
S
x
(S)
∂x
i
f
j
(x) = G
∂f
T
x
(T)
∂x
j
.
The MRTS is:
f
i
(x)
f
j
(x)
=
∂f
S
/∂x
i
∂f
T
/∂x
j
.
It follows for k / ∈ N
S
∪ N
T
∂(f
i
/f
j
)
∂x
k
= 0.
3.8 A Leontief production function has the form y = min {αx
1
, βx
2
} for α > 0 and
β > 0. Carefully sketch the isoquant map for this technology and verify that the
elasticity of substitution σ = 0, where deﬁned.
Answer: Taking the total diﬀerential of the log of the factor ratio gives d ln (βx
2
/αx
1
) =
β/x
2
dx
2
− α/x
1
dx
1
. However, the MRTS is not deﬁned in the kinks as the function is
discontinuous. Along all other segments of the isoquants the MRTS is zero. Therefore,
the elasticity of substitution is only deﬁned when the input ratio remains constant. In
this case, σ = 0.
3.9 Calculate σ for the CobbDouglas production function y = Ax
α
1
x
β
2
, where A >
0, α > 0 and β > 0.
Answer: The total diﬀerential of the log of the factor ratio gives
d ln(x
2
/x
1
) = β/x
2
dx
2
−α/x
1
dx
1
. The total diﬀerential of the marginal rate of technical
substitution gives
d ln
Aαx
α−1
1
x
β
2
Aβx
α
1
x
β−1
2
= α/β(dx
1
/x
1
−dx
2
/x
2
)
24
3 Producer Theory
6

x
1
x
2
Figure 7: Isoquant map of Leontief technology
Putting both parts together results in
σ =
β/x
2
dx
2
−α/x
1
dx
1
α/β(dx
1
/x
1
−dx
2
/x
2
)
= 1
3.14 Let y = (
¸
n
i=1
α
i
x
ρ
i
)
1/ρ
, where
¸
i
α
i
= 1 and 0 = ρ < 1. Verify that σ
ij
=
1/(1 −ρ) for all i = j.
Answer Apply the deﬁnition of the elasticity of substitution.
σ
ij
=
∂ (ln(x
j
) −ln(x
i
))
∂ ln (f
i
(x)/f
j
(x))
=
1
x
j
∂x
j
−
1
x
i
∂x
i
∂ ln
α
i
x
ρ−1
i
(
i
α
i
x
ρ
i
)
1/ρ−1
α
j
x
ρ−1
j
(sum
i
α
i
x
ρ
i
)
1/ρ−1
=
−
1
x
i
∂x
i
−
1
x
j
∂x
j
ρ −1
1
x
i
∂x
i
−
1
x
j
∂x
j
=
−1
ρ −1
=
1
1 −ρ
3.15 For the generalised CES production function, prove the following claims made in
the text.
y =
n
¸
i=1
α
i
x
ρ
i
1/ρ
, where
n
¸
i=1
α
i
= 1 and 0 = ρ < 1
25
3 Producer Theory
(a)
lim
ρ→0
y =
n
¸
i=1
x
α
i
i
Answer: Write the log of the CES production function ln y = 1/ρ ln
¸
α
i
x
ρ
i
. At ρ = 0,
the value of the function is indeterminate. However, using L’H` opital’s rule we can write
lim
ρ→0
ln y =
¸
α
i
x
ρ
i
ln x
i
¸
α
i
x
ρ
i
.
At ρ = 0 this expression turns into ln y =
¸
α
i
ln x
i
/
¸
α
i
. Because the denominator is
deﬁned to be one, we can write the CES production at this point as y =
¸
x
α
i
i
, what is
exactly the generalised CobbDouglas form.
(b)
lim
ρ→−∞
y = min {x
1
, . . . , x
n
}
Answer: Let us assume that α
i
= α
j
. Then the CES production function has the form
y = (x
ρ
1
+ x
ρ
2
)
1/ρ
. Let us suppose that x
1
= min(
¸
x
i
) and ρ < 0. We want to show
that x
1
= lim
ρ→−∞
(
¸
x
ρ
i
)
1/ρ
. Since all commodities x
i
are required to be nonnegative,
we can establish x
ρ
1
≤
¸
x
ρ
i
. Thus, x
1
≥ (
¸
x
ρ
i
)
1/ρ
. On the other hand,
¸
x
ρ
i
≤ n ∗ x
ρ
1
.
Hence (
¸
x
ρ
i
)
1/ρ
≥ n
1/ρ
∗ x
1
. Letting ρ → −∞, we obtain lim
ρ→−∞
(
¸
x
ρ
i
)
1/ρ
= x
1
,
because lim
ρ→−∞
n
1/ρ
∗ x
1
= x
1
.
3.2 Cost
3.19 What restrictions must there be on the parameters of the CobbDouglas form in
Example 3.4 in order that it be a legitimate cost function?
Answer: The parameters A, w
1
, w
2
and y are required to be larger than zero. A cost
function is required to be increasing in input prices. Therefore, the exponents α and β
must be larger zero. To fulﬁll the property of homogeneity of degree one in input prices,
the exponents have to add up to one. To secure concavity in input prices, the second
order partials should be less than zero. Thus, each of the exponents can not be larger
one.
3.24 Calculate the cost function and conditional input demands for the Leontief pro
duction function in Exercise 3.8.
Answer This problem is identical to the expenditure function and compensated demand
functions in the case of perfect complements in consumer theory.
Because the production is a minfunction, set the inside terms equal to ﬁnd the optimal
relationship between x
1
and x
2
. In other words, αx
1
= βx
2
. For a given level of output
y, we must have y = αx
1
= βx
2
. Rearrange this expression to derive the conditional
input demands:
x
1
(w, y) =
y
α
x
2
(w, y) =
y
β
.
26
3 Producer Theory
The cost function is obtained by substituting the two conditional demands into the
deﬁnition of cost:
c(w, y) = w
1
x
1
(w, y) + w
2
x
2
(w, y) =
w
1
y
α
+
w
2
y
β
.
3.27 In Fig. 3.85, the cost functions of ﬁrms A and B are graphed against the input
price w
1
for ﬁxed values of w
2
and y.
(a) At wage rate w
0
1
, which ﬁrm uses more of input 1? At w
1
? Explain?
Answer: Input demand can be obtained by using Shephard’s lemma, represented by the
slope of the cost function. Therefore, at w
0
1
ﬁrm B demands more of factor 1 and at
wage rate w
1
ﬁrm A has a higher demand of that input.
(b) Which ﬁrm’s production function has the higher elasticity of substitution? Explain.
Answer: The ﬁrstorder conditions for cost minimisation imply that the marginal rate
of technical substitution between input i and j equals the ratio of factor prices w
i
/w
j
. In
the two input case, we can rewrite the original deﬁnition of the elasticity of substitution
as
σ =
d ln(x
2
/x
1
)
d ln(f
1
/f
2
)
=
d ln(x
2
/x
1
)
d ln(w
1
/w
2
)
=
ˆ x
2
− ˆ x
1
ˆ w
1
− ˆ w
2
,
where the circumﬂex denotes percentage change in input levels and input prices, respec
tively. Because ˆ w
2
= 0, the denominator reduces to ˆ w
1
, which is assumed to be the
same for both ﬁrms. In (a) we established that input demand at w
0
1
is larger for ﬁrm B
compared to ﬁrm A. It follows that the numerator will be larger for B and, subsequently,
ﬁrm A’s production function shows the higher elasticity of substitution at w
0
1
.
3.29 The output elasticity of demand for input x
i
is deﬁned as
iy
(w, y) ≡
∂x
i
(w, y)
∂y
y
x
i
(w, y)
.
(a) Show that
iy
(w, y) = φ(y)
iy
(w, 1) when the production function is homothetic.
Given a homothetic production function, the cost function can be written as c(w, y) =
φ(y)c(w, 1). Shephard’s lemma states that the ﬁrst order partial derivative with re
spect to the price of input i gives demand of x
i
and to obtain the elasticity we need to
take take the secondorder crosspartial derivative of the cost function with respect
to output. However, by Young’s theorem it is known that the order of diﬀerentiation
does not matter. Therefore, the following partial derivatives should be equal:
∂
2
c(w, y)
∂w
i
∂y
=
∂mc
∂w
i
=
∂x
i
∂y
.
Putting everything together gives:
iy
(w, y) =
∂
2
c
∂y∂w
i
y
∂c
∂w
i
=
∂φ(y)
∂y
x
i
(w, 1)
y
φ(y)x
i
(w, 1)
=
1
φ
(y)
iy
(w, 1).
Unfortunately, this is not the result we should get.
27
3 Producer Theory
(b) Show that
iy
= 1, for i = 1, . . . , n, when the production function has constant
returns to scale.
Answer For any production function with constant returns to scale, the conditional
input demand x
i
is linear in output level y (see Theorem 3.4). More formally, the
conditional input demand of a production function homogeneous of degree α > 0
can be written as x
i
(w, y) = y
1/α
x
i
(w, 1). By deﬁnition, a constant returns to scale
technology requires a production function homogeneous of degree 1. Therefore, the
conditional input demand reduces to x
i
(w, y) = yx
i
(w, 1). Calculating the output
elasticity of demand for input x
i
results in:
iy
(w, y) ≡
∂x
i
(w, y)
∂y
y
x
i
(w, y)
= x
i
(w, 1)
y
yx
i
(w, 1)
= 1.
3.33 Calculate the cost function and the conditional input demands for the linear
production function y =
¸
n
i=1
α
i
x
i
.
Answer Because the production function is linear, the inputs can be substituted for
another. The most eﬃcient input (i.e. input with the greatest marginal product/ price)
will be used and the other inputs will not be used.
x
i
(w, y) =
y
α
i
if
α
i
w
i
>
α
j
w
j
∀j = i, j ∈ {1, . . . , n}
0 if
α
i
w
i
<
α
j
w
j
for at least one j = i, j ∈ {1, . . . , n}.
The cost function is then c(w, y) =
w
i
y
α
i
, where i is the input where
α
i
w
i
>
α
j
w
j
∀j = i, j ∈ 1, . . . , n.
3.3 Duality in production
Additional exercise (Varian (1992) 1.6) For the following “cost functions” indicate
which if any of properties of the cost function fails; e.g. homogeneity, concavity, mono
tonicity, or continuity. Where possible derive a production function.
(a) c(w, y) = y
1/2
(w
1
w
2
)
3/4
Homogeneity: c(tw, y) = y
1/2
(tw
1
tw
2
)
3/4
= t
3/2
y
1/2
(w
1
w
2
)
3/4
The function is not
homogeneous of degree one.
Monotonicity:
∂c(w, y)
∂w
1
= 3/4y
1/2
w
−1/4
1
w
3/4
2
> 0
∂c(w, y)
∂w
2
= 3/4y
1/2
w
3/4
1
w
−1/4
2
> 0
The function is monotonically increasing in input prices.
28
3 Producer Theory
Concavity:
H =
¸
−
3
16
y
1/2
w
−5/4
1
w
3/4
2
9
16
y
1/2
w
−1/4
1
w
−1/4
2
9
16
y
1/2
w
−
1/4
1
w
−1/4
2
−
3
16
y
1/2
w
3/4
1
w
−5/4
2
¸
H
1
 < 0
H
2
 = −
72
256
y
√
w
1
w
2
< 0
The function is not concave in input prices.
Continuity: Yes
(b) c(w, y) =
√
y(2w
1/2
1
w
1/2
2
)
The function satisﬁes all properties. The underlying technology is represented by
y = x
1
x
2
.
(c) c(w, y) = y(w
1
+
√
w
1
w
2
+ w
2
)
The function satisﬁes all properties. The underlying technology is represented by
y = 2/3
(x
1
+ x
2
) +
x
2
1
−x
1
x
2
+ x
2
2
.
(d) c(w, y) = y(w
1
e
−w
1
+ w
2
)
The function is not homogeneous of degree one. Using Euler’s Theorem we get
the result
¸
∂c
∂w
i
w
i
= y(w
1
e
−w
1
+ w
2
1
e
−w
1
+ w
2
) what is clearly not equal to the
original cost function. Alternatively, it becomes clear from the expression c(tw, y) =
ty(w
1
e
−tw
1
+ w
2
). The function is not monotonically increasing in input prices as
the ﬁrst partial derivative with respect to w
1
is only positive for prices less than one:
∂c/∂w
1
= ye
−w
1
(1−w
1
). Furthermore the function is only concave for prices w
1
< 2,
what can be seen from the ﬁrst determinant of the Hessian matrix: H
1
 = y(w
1
−
2)e
−w
1
.
(e) c(w, y) = y(w
1
−
√
w
1
w
2
+ w
2
)
Monotonicity of the cost function holds only for a narrow set of input prices with
the characteristics 1/4w
2
< w
1
< 4
4
. The conclusion can be derived from the ﬁrst
partial derivatives and a combination of the two inequalities.
∂c
∂w
1
= y
1 −
1
2
w
2
w
1
positive for 1 >
1
2
w
2
w
1
∂c
∂w
2
= y
1 −
1
2
w
1
w
2
positive for 1 >
1
2
w
1
w
2
or 2 >
w
2
w
1
The function is not concave as the ﬁrst partial derivatives with respect to both
input prices are negative and the secondorder partial derivatives are positive. The
determinants of the Hessian matrix are H
1
 > 0 and H
2
 = 0. Thus, the function
is convex.
29
3 Producer Theory
(f) c(w, y) = (y + 1/y)
√
w
1
w
2
The function satisﬁes all properties, except continuity in y = 0.
3.40 We have seen that every CobbDouglas production function,
y = Ax
α
1
x
1−α
2
, gives rise to a CobbDouglas cost function,
c(w, y) = yAw
α
1
w
1−α
2
, and every CES production function, y = A(x
ρ
1
+ x
ρ
2
)
1/ρ
, gives rise
to a CES cost function, c(w, y) = yA(x
r
1
+ x
r
2
)
1/r
. For each pair of functions, show that
the converse is also true. That is, starting with the respective cost functions, “work
backward” to the underlying production function and show that it is of the indicated
form. Justify your approach.
Answer: Using Shephard’s lemma we can derive the conditional input demand func
tions. The ﬁrst step to solve this exercise for a CobbDouglas cost function is to derive
Shephard’s lemma and to rearrange all input demands in such a way to isolate the ratio
of input prices on one side, i.e. lefthand side of the expression. On the righthand side
we have the quantity of input(s) and output. Second, equalise the two expressions and
solve for y. The result will be the corresponding production function.
x
1
=
∂c(w, y)
∂w
1
= αyA
w
2
w
1
1−α
w
2
w
1
=
x
1
Aαy
1/(1−α)
x
2
=
∂c(w, y)
∂w
2
= (1 −α)yA
w
2
w
1
−α
w
2
w
1
=
x
2
A(1 −α)y
−1/α
(Aαy)
α
x
α
1
=
x
1−α
2
(A(1 −α)y)
1−α
y =
x
α
1
x
1−α
2
α
α
(1 −α)
1−α
= ax
α
1
x
1−α
2
where a = (Aα
α
(1 −α)
1−α
)
−1
For the CES cost function a shortcut is used: Derive the conditional input demand
functions and substitute them into the production function.
x
1
=
∂c(w, y)
∂w
1
= yAw
r−1
1
(w
r
1
+ w
r
2
)
1
r
−1
x
2
=
∂c(w, y)
∂w
2
= yAw
r−1
2
(w
r
1
+ w
r
2
)
1
r
−1
y =
¸
(Ay)
ρ
w
−r
1
+ w
−r
2
w
−r
1
+ w
−r
2
1/ρ
= Ay
3.4 The competitive ﬁrm
Additional exercise (Varian (1992) 1.21) Given the following production function
y = 100x
1/2
1
x
1/4
2
.
(a) Find c(w
1
, w
2
, y).
Answer: Starting from the equality of MRTS and ratio of factor prices, we get
30
3 Producer Theory
w
1
/w
2
= 2x
2
/x
1
. Solving for one of the inputs, substituting back in the production
function and rearranging, we derive the conditional input demand functions:
x
1
=
y
100
4/3
2w
2
w
1
1/3
and
x
2
=
y
100
4/3
2w
2
w
1
−2/3
.
Substituting the two functions in the deﬁnition of costs, the resulting cost function
is:
c(w
1
, w
2
, y) =
y
100
4/3
w
2/3
1
(2w
2
)
1/3
+
y
100
4/3
w
1/3
2
w
2/3
1
2
−2/3
=
2
1/3
+ 2
−2/3
y
100
4/3
w
2/3
1
w
1/3
2
.
(b) Find the eﬀect of an increase in output on marginal cost, and verify that λ =
marginal cost.
Answer: Marginal costs are
MC = ∂c/∂y =
1
75
(y/100)
1/3
w
2/3
1
w
1/3
2
2
1/3
+ 2
−2/3
. Marginal costs are increasing
with output which is shown by
∂MC
∂y
=
∂
2
c
∂y
2
=
1
150
2
(y/100)
−2/3
w
2/3
1
w
1/3
2
2
1/3
+ 2
−2/3
. From the FOC of the La
grangian we can derive that λ
∗
=
w
1
x
1/2
1
50x
1/4
2
=
w
2
x
3/4
2
25x
1/2
1
. Substituting the conditional input
demand functions into one of those expressions gives
λ
∗
=
w
1
50
(y/100)
4/3
(2w
2
/w
1
)
1/3
1/2
(y/100)
4/3
(2w
2
/w
1
)
−2/3
−1/4
=
2
1/3
50
(
y
100
)
1/3
w
2/3
1
w
1/3
2
When you solve the ratios, this expression will be equal to the marginal cost function.
(c) Given p = price of output, ﬁnd x
1
(w, p), x
2
(w, p) and π(w, p). Use Hotelling’s
lemma to derive the supply function y(w, p).
Answer: By maximising π = py −c(w, y) the ﬁrstorder condition is
∂π
∂y
=p −
1
75
y
100
1/3
w
2/3
1
w
1/3
2
(2
1/3
+ 2
−2/3
) = 0
y =100
75
2
1/3
+ 2
−2/3
3
p
w
2/3
1
w
1/3
2
3
The ﬁrst expression aﬃrms the equality of price and marginal cost as the proﬁt
maximum for any competitive ﬁrm. The last expression gives already the proﬁt
31
3 Producer Theory
maximising supply function. Furthermore, the two following unconditional demand
functions emerge as solution of this optimisation problem:
x
1
=
75p
2
1/3
+ 2
−2/3
3
w
−2
1
w
−1
2
4/3
2w
2
w
1
1/3
=
75
2
1/3
+ 2
−2/3
4
2
1/3
p
4
w
3
1
w
2
x
2
=
75p
2
1/3
+ 2
−2/3
3
w
−2
1
w
−1
2
4/3
w
1
2w
2
2/3
=
75
2
1/3
+ 2
−2/3
p
4
2
2/3
w
2
1
w
2
2
.
The proﬁt function is
π =
75
2
1/3
+ 2
−2/3
3
100p
4
w
2
1
w
2
−
75p
2
1/3
+ 2
−2/3
4
2
1/3
w
1
w
3
1
w
2
+
w
2
2
2/3
w
2
1
w
2
2
=
75
2
1/3
+ 2
−2/3
3
p
4
w
2
1
w
2
(100 −75)
= 25
75
2
1/3
+ 2
−2/3
3
p
4
w
2
1
w
2
.
Hotelling’s lemma conﬁrms the output supply function shown above.
(d) Derive the unconditional input demand functions from the conditional input de
mands.
Answer One, among several, way is to substitute the conditional input demands
into the deﬁnition of cost to obtain the cost function. Calculating marginal cost and
equalising with output price, gives, after rearrangement, the output supply func
tion. Substitution of the output supply function into the conditional input demands
results in the unconditional input demand functions. Using the example at hand,
and starting from the equality ∂c/∂y = p gives:
p =
1
75
2
1/3
+ 2
−2/3
y
100
1/3
w
2/3
1
w
1/3
2
y = 75
3
2
1/3
+ 2
−2/3
−3
p
3
w
−2
1
w
−1
2
· 100
x
1
(w, p) =
75
2
1/3
+ 2
−2/3
4
p
4
w
−3
1
w
−1
2
(e) Verify that the production function is homothetic.
Answer: The cost function is a factor of a function of output and input prices.
Similarly, the conditional input demand functions are products of a function of y
and input prices. Therefore, the possibility to separate the two functions multiplica
tively and following Theorem 3.4 shows that the production function has to be a
homothetic function.
(f) Show that the proﬁt function is convex.
Answer: In order to simply this step, I write the constant part of the proﬁt function
32
References
as K = 25
75
2
1/3
+2
−2/3
3
Calculating the secondorder partial derivatives of the proﬁt
function with respect to all prices gives the following Hessian matrix. Be aware of
the doubble sign change after each derivative with respect to the input price (check
Theorem 3.8).
H =
12Kp
2
w
2
1
w
2
−8Kp
3
w
3
1
w
2
−4Kp
3
w
2
1
w
2
2
−
−8Kp
3
w
3
1
w
2
−
−6Kp
4
w
4
1
w
2
−
−2Kp
4
w
3
1
w
2
2
−
−4Kp
3
w
2
1
w
2
2
−
−2Kp
4
w
3
1
w
2
2
−
−2Kp
4
w
2
1
w
3
2
¸
¸
¸
¸
The own supply eﬀect is positive, the own demand eﬀects are negative and all cross
price eﬀects are symmmetric. Checking the determinants becomes quite tedious.
Intuituively, it should become clear that they all have to be positive.
(g) Assume x
2
as a ﬁxed factor in the short run and calculate shortrun total cost,
shortrun marginal cost, shortrun average cost and shortrun proﬁt function.
Shortrun total cost are obtained by rearranging the production function to get
x
1
on the lefthand side and plugging in into the deﬁnition of cost c(w, y) =
(y/100)
2
w
1
/x
1/2
2
+ w
2
x
2
. The ﬁrstpartial derivative gives the shortrun marginal
cost function smc =
1
50
y
100
w
1
/x
1/2
2
. The shortrun average costs are equal to sac =
y
100
2
w
1
/x
1/2
2
+
w
2
x
2
y
.
Final remark: Some answers might not be the most elegant ones from a mathemat
ical perspective. Any comment and suggestion, also in case of obscurities, are highly
welcome.
References
Arrow, K. J. & Enthoven, A. C. (1961), ‘Quasiconcave programming’, Econometrica
29(4), 779–800.
Goldman, S. M. & Uzawa, H. (1964), ‘A note on separability in demand analysis’,
Econometrica 32(3), 387–398.
Varian, H. R. (1992), Microeconomic Analysis, 3rd edn, W. W. Norton & Company,
New York.
33
1 Mathematical Appendix
1 Mathematical Appendix
1.1 Chapter A1
A1.7 Graph each of the following sets. If the set is convex, give a proof. If it is not convex, give a counterexample. Answer (a) (x, y)y = ex This set is not convex. Any combination of points would be outside the set. For example, (0, 1) and 1 / (1, e) ∈ (x, y)y = ex , but combination of the two vectors with t = 2 not: ( 1 , e+1 ) ∈ 2 2 x (x, y)y = e . (b) (x, y)y ≥ ex This set is convex. Proof: Let (x1 , y1 ), (x2 , y2 ) ∈ S = (x, y)y ≥ ex . Since y = ex is a continuous function, it is suﬃcient to show that (tx1 + (1 − t)x2 , ty1 + (1 − t)y2 ) ∈ S for any particular t ∈ (0, 1). Set t = 1 . Our task is to show that 1 (x1 + x2 ), 1 (y1 + y2 ) ∈ 2 2 2 1 S. 2 (y1 + y2 ) ≥ 1 (ex1 + ex2 ), since yi ≥ ex1 for i = 1, 2. Also, 2
x2 x1 1 1 x1 (e + ex2 ) ≥ e 2 (x1 +x2 = e 2 · e 2 2 x2 x1 ⇔ ex1 + ex2 ≥ 2e 2 · e 2
⇔ ex1 − 2e 2 · e 2 + ex2 ≥ 0 ⇔ (ex1 − ex2 )2 ≥ 0. (c) (x, y)y ≥ 2x − x2 ; x > 0, y > 0 This set is not convex. 9 1 For example, 10 , 1 , 1 10 , 1 ∈ S = (x, y)y ≥ 2x − x2 ; x > 0, y > 0. However, 2 2 1 1 1 9 1, 2 = 2 10 , 1 + 1 1 10 , 1 ∈ S / 2 2 2 (d) (x, y)xy ≥ 1; x > 0, y > 0 This set is convex. Proof: Consider any (x1 , y1 ), (x2 , y2 ) ∈ S = (x, y)xy ≥ 1; x > 0, y > 0. For any t ∈ [0, 1], (tx1 + (1 − t)x2 )(ty1 + (1 − t)y2 ) = t2 x1 y1 + t(1 − t)(x1 y2 + x2 y1 ) + (1 − t)2 x2 y2 > t2 + (1 − t)2 + t(1 − t)(x1 y2 + x2 y1 ), since xi yi > 1. = 1 + 2t2 − 2t + t(1 − t)(x1 y2 + x2 y1 ) = 1 + 2t(t − 1) + t(1 − t)(x1 y2 + x2 y1 ) = 1 + t(1 − t)(x1 y2 + x2 y1 − 2) ≥ 1 iﬀ x1 y2 + x2 y1 ≥ 0. y1 y2 y1 y2 + −2≥0 x1 y2 + x2 y1 = x1 y1 + x2 y2 − 2 ≥ y1 y2 y1 y2 y − 1 − 2y1 y2 + y2 ≥ 0 (y1 − y2 )2 ≥ 0,
x1
x2
2
1 Mathematical Appendix which is always true and therefore, (tx1 + (1 − t)x2 , ty1 + (1 − t)y2 ) ∈ S which is convex. (e) (x, y)y ≤ ln(x) This set is convex. 1 Proof. Let (x1 , y1 ) + (x2 , y2 ) ∈ S. Then 2 (y1 + y2 ) ≤ (ln(x1 ) + ln(x2 )). S is convex ⇒
if
1 2
1 1 ln(x1 ) + ln(x2 ) ≤ ln( x1 + x2 ) 2 2 1 1 1 ⇔ ln(x1 x2 ) ≤ ln( x1 + x2 ) 2 2 2 1 1 1/2 ⇔ (x1 x2 ) ≤ ( x1 + x2 ) 2 2 ⇔ x1 − 2(x1 x2 )1/2 + x2 ≥ 0 ⇔ x1 + x2
1/2 1/2 2
≥0
which is always true. A1.40 Sketch a few level sets for the following functions: y = x1 x2 , y = x1 + x2 and y = min[x1 , x2 ]. Answer x2
6
x2
6 @ @@ @ @@@ @ @ @
x2
6
(a) y = x1 x2
x1
x1

x1
(b) y = x1 + x2
(c) y = min(x1 , x2 )
Figure 1: Sets to Exercise A1.40 A1.42 Let D = [−2, 2] and f : D → R be y = 4 − x2 . Carefully sketch this function. Using the deﬁnition of a concave function, prove that f is concave. Demonstrate that the set A is a convex set. Answer Proof of concavity: Derive the ﬁrst and second order partial derivative: ∂y = −2x ∂x ∂ 2y = −2 ∂x2
The ﬁrst derivative is strictly positive for values x < 0 and negative for values x > 0. The second order partial derivative is always less than zero. Therefore, the function is concave. Proof of convexity: The area below a concave function forms a convex set (Theorem
3
(There is a slight inaccuracy in the book.19). for any x1 . (b) Show that every linear function is both quasiconcave and quasiconvex and. from the deﬁnition of convexity the following inequality should hold 4 − (tx1 + (1 − t)x2 )2 ≥ t(4 − (x1 )2 ) + (1 − t)(4 − (x2 )2 ). we get tf (x1 ) + (1 − t)f (x2 ) ≥ min[f (x1 ). x2 ∈ Rn . y 6 x Figure 2: Graph to Exercise A1. is deﬁned as h (x) = g (f (x)) f (x)2 + g (f (x)) f (x)2 4 .42 A1. Assume that both functions are twice diﬀerentiable. Answer The composition with an aﬃne function preserves concavity (convexity). Show that the composite function. Multiply out to get 4 − (tx1 + x2 − tx2 )2 ≥ 4 − x2 + t[(x1 )2 − (x2 )2 ]. Then the second order partial derivative of the composite function. applying chain rule and product rule. Answer The statement is true iﬀ. t ∈ [0. the statement is true iﬀ. for any x1 . f (x2 )](quasiconvexity) Again by substituting the equation into the deﬁnition. 1]. the area below the function forms 2 a convex set. we have f (tx1 + (1 − t)x2 ) ≥ min[f (x1 ). 1]. x2 ∈ Rn . though neither is strictly concave nor strictly convex.1 Mathematical Appendix A1. f (x2 )] ∀t ∈ [0. it is true that f (tx1 + (1 − t)x2 ) = tf (x1 ) + (1 − t)f (x2 ). More formally.13). 1]. Substituting any linear equation in this statement gives f (tx1 +(1−t)x2 ) = a[tx1 +(1−t)x2 ]+b = tax1 +(1−t)ax2 +tb+(1−t)b = tf (x1 )+(1−t)f (x2 ) for all x1 .46 Consider any linear function f (x) = a · x + b for a ∈ Rn and b ∈ R.47 Let f (x) be a concave (convex) realvalued function. f (x2 )] tf (x1 ) + (1 − t)f (x2 ) ≤ max[f (x1 ). f (x2 )](quasiconcavity) f (tx1 + (1 − t)x2 ) ≤ max[f (x1 ). Again. h(x) = g(f (x)) is a concave (convex) function. Alternatively. Let g(t) be an increasing concave (convex) function of a single variable. t ∈ [0. it must also be quasiconcave and quasiconvex (Theorem A1. neither strictly so. for n > 1.) Answer As it is shown in (a) that a linear function is concave and convex. (a) Show that every linear function is both concave and convex. 1] A1. x2 ∈ Rn (x1 = x2 ) and t ∈ [0.
x2 ) = −(x1 − 5)2 − (x2 − 5)2 . tb a + (1 − tb )c = b. z2 ) = 0 Alternatively. 2 f (x) ≤ 0. 5 . and justify your answer. A1. + inf). the function is even strictly concave.48 Let f (x1 . Given the nature of f . (c) Suppose f (x) is a function of one variable and there is a real number b such that f (x) is decreasing on the interval (− inf. Hence. f (x1 ) ≥ f (x0 ) ⇒ ∂f (x0 )/∂x(x1 − x0 ) ≥ 0.49 Answer each of the following questions “yes” or ”no“. Prove that f is quasiconcave. for x ∈ [a. Using the diﬀerentialbased approach. and let tb = c−a ∈ [0. f (c)]. f (b) < min[f (a). Similarly to (a). f (x) ≥ f (a) and for x ∈ [b. (d) Suppose f (x) is a function of one variable and there is a real number b such that f (x) is increasing on the interval (− inf. for any x ∈ [a. a decreasing function of one variable is quasiconcave. In 2 f (x) ≥ 0 and 2 g(x) ≥ 0. if for any x0 and x1 . Is f (x) quasiconcave? Answer Yes. c]. f (x) ≥ f (c). Since f is concave. (a) Suppose f (x) is an increasing function of one variable. f (c)]. b] and increasing on [b. Proof: Let a < b < c. Is f (x) quasiconcave? Answer No. This must be true for any increasing function. f (x) ≥ min[f (a). (b) Suppose f (x) is a decreasing function of one variable. Is f (x) quasiconcave? Answer Yes. an increasing function of one variable is quasiconcave. b] and decreasing on [b. Any convex combination of two points on this function will be at least as large as the smallest of the two points. Therefore.1 Mathematical Appendix For any concave function. 1]. it should hold 2 A1. c−b Proof: Let a < b < c. f is quasiconcave. f (x1 )]. so f is not quasiconcave. H= −2 0 0 −2 2 2 zT H(x)z = −2z1 − 2z2 < 0. Answer Proof: f is concave iﬀ H(x) is negative semideﬁnite and it is strictly concave if the Hessian is negative deﬁnite. we can check the leading principal minors of H: H1 (x) = −2 < 0 and H2 (x) = 4 > 0. The determinants of the Hessian alternate in sign beginning with a negative value. c]. f (c)]. it is also quasiconcave. it should hold 2 h(x) ≤ 0. 1]. g(x) ≤ 0. b] and increasing on [b. Is f (x) quasiconcave? Answer Yes. if f is decreasing on (− inf. the case the two functions are convex: 2 h(x) ≥ 0. + inf) then f (x) is not quasiconcave. + inf). it is true that f (tx0 + (1 − t)x1 ) ≥ min[f (x0 ). b]. for z = (z1 . f is quasiconcave if for any x0 . x1 and t ∈ [0. Then f (tb a + (1 − tb )c) < min[f (a).
Answer Any function of one variable f (x) is quasiconcave if and only if is either continuously increasing. convex. x2 ) = x2 + 2x2 − 4x2 1 2 f1 = 2x1 f2 = 4x2 − 4 6 . State whether the function is increasing.1 Diﬀerentiate the following functions. or constant at the point x = 2. Classify each as locally concave. or linear at the point x = 2. 1. decreasing. (a) f (x1 . continuously decreasing or ﬁrst increasing and later decreasing. (a) f (x) = 11x3 − 6x + 8 f1 = 33x2 − 6 increasing locally convex (b) f (x) = (3x2 − x)(6x + 1) f1 = 54x2 − 6x − 1 increasing locally convex (c) f (x) = x2 − 1 x3 3 x4 increasing locally concave f1 = 2x + f1 = (6x + 6)(x2 + 2x)2 increasing locally convex f1 = 18x x3 − 3x2 + 1 (x3 + 1)3 increasing locally concave 4 (d) f (x) = (x2 + 2x)3 (e) f (x) = [3x/(x3 + 1)]2 (f) f (x) = [(1/x + 2) − (1/x − 2)] 2 8 1 1 4 − 3 − +4 f1 = 2 2 x x x x increasing locally convex 3 1 (g) f (x) = x et dt f1 = −ex 2 2 decreasing locally convex A2. x2 ) = 2x1 − x2 − x2 1 2 f1 = 2 − 2x1 = 2(1 − x1 ) f2 = −2x2 (b) f (x1 .1 Mathematical Appendix (e) You should now be able to come up with a characterization of quasiconcave functions of one variable involving the words “increasing” and “decreasing”.2 Find all ﬁrstorder partial derivatives.2 Chapter A2 A2.
1 Mathematical Appendix (c) f (x1 . ∂x1 ∂x2 ∂x3 The ﬁrstorder partial derivatives are ∂y/∂x1 = 2x1 x2 + x2 . x2 ) = x3 − x2 − 2x2 2 1 f1 = 3x1 f2 = −2(x2 + 1) (d) f (x1 . x2 ) = 4x1 + 2x2 − x2 + x1 x2 − x2 2 1 f1 = 4 − 2x1 + x2 f2 = 2 − 2x2 + x1 (e) f (x1 . x2 .4 Show that y = x2 x2 + x2 x3 + x2 x1 satisﬁes the equation 3 2 1 ∂y ∂y ∂y + + = (x1 + x2 + x3 )2 . zT H(x)z. and ∂y/∂x3 = x2 + 2x3 x1 . x2 ) = x3 − 6x1 x2 + x3 2 1 2 f1 = 3x1 − 6x2 f2 = 3x2 − 6x1 2 (f) f (x1 .5 Find the Hessian matrix and construct the quadratic form. 1 2 3 ∂x1 ∂x2 ∂x3 A2. x3 ) = ln x2 − x2 x3 − x2 1 3 2x1 g1 = 2 x1 − x 2 x3 − x2 3 −x2 − 2x3 g3 = 2 x1 − x 2 x3 − x2 3 g2 = x2 1 −x3 − x2 x3 − x2 3 A2. when (a) y = 2x1 − x2 − x2 1 2 H= −2 0 0 −2 2 2 zT H(x)z = −2z1 + 2 ∗ 0z1 z2 − 2z2 (b) y = x2 + 2x2 − 4x2 1 2 H= 2 0 0 4 2 2 zT H(x)z = 2z1 + 2 ∗ 0z1 z2 + 4z2 7 . x2 ) = 3x2 − x1 x2 + x2 1 f1 = 6x1 − x2 f 2 = 1 − x1 (g) g(x1 . 3 ∂y/∂x2 = x2 + 2x2 x3 . Summing them up gives 1 2 ∂y ∂y ∂y + + = x2 + x2 + x2 + 2x1 x2 + 2x1 x3 + 2x2 x3 = (x1 + x2 + x3 )2 .
1 2 (a) Show that f (x1 . tx2 ) = t9 (x2 x2 )3 k = 9 1 (c) h(x1 . x2 ) = (x3 x2 )5 h(tx1 .1 Mathematical Appendix (c) y = x3 − x2 + 2x2 2 1 6x1 0 0 −2 H= 2 2 zT H(x)z = 6x1 z1 − 2z2 (d) y = 4x1 + 2x2 − x2 + x1 x2 − x2 1 2 −2 1 1 −2 H= 2 2 zT H(x)z = −2z1 + 2z1 z2 − 2z2 (e) y = x3 − 6x1 x2 − x3 1 2 H= 6x1 −6 −6 6x2 2 2 zT H(x)z = 6x1 z1 − 12z1 z2 + 6x2 z2 A2. Verify this.8 Suppose f (x1 . 1 2 1 2 (b) According to Euler’s theorem. f (tx1 . x2 ) = x1 x1 + 2 x2 x2 = 2 x2 + x2 2 1 x2 + x2 2 1 = x2 + x2 1 2 x2 + x 2 1 x2 + x2 1 A2. tx2 ) = t25 (x3 x2 )5 k = 25 1 2 1 2 8 . What is its degree? h(x1 . x2 )g(x1 . x2 ) = (∂f /∂x1 ) x1 +(∂f /∂x2 ) x2 . What is its degree? g(tx1 . tx2 ) = (tx1 )2 + (tx2 )2 = t2 (x2 + x2 ) = t x2 + x2 . x2 ) = f (x1 . x2 ) = (x1 x2 )2 and g(x1 . x2 ) = (x2 x2 )3 . x2 ) is homogeneous.9 Suppose f (x1 . x2 ) is homogeneous of degree 1. 1 · f (x1 . What is its degree? f (tx1 . x2 ) is homogeneous. x2 ) is homogeneous. x2 ) = x2 + x2 . tx2 ) = t4 (x1 x2 )2 k = 4 (b) g(x1 . we should have f (x1 . 1 (a) f (x1 .
(a) The function f (x1 . f (x1 . these principal minors alternate in sign as follows: D2 ≤ 0. . .. x2 ) is homogeneous of degree n. tx2 ) = t36 (x1 x2 )18 k = 36 (e) Prove that whenever f (x1 . . D3 ≥ 0. f (x1 . f2 f21 f22 Arrow & Enthoven (1961) use the sign pattern of these principal minors to establish the following useful results: (i) If f (x) is quasiconcave. Further. Here. x2 ). The principal minors of this matrix are the determinants D2 = 0 f1 . x2 )) is homogeneous of degree mn. x2 )) is homogeneous. . Dn = H∗ . these principal minors (which depend on x) alternate in sign beginning with strictly negative: D2 < 0. x2 ))]n k = mn A2. . (ii) If for all x ≥ 0. it can be shown that if. . then k(x1 . . . x2 ) = x1 x2 + x1 is quasiconcave on R2 . . fn fn1 · · · on Rn . . x2 ) = g (f (x1 . Answer The bordered Hessian is 0 x2 + 1 x1 0 1 . H ∗ = x2 + 1 x1 1 0 9 . f (x1 . x2 ) = g (f (x1 . we have this same alternating sign pattern on those principal minors. . . . . then f (x) is quasiconcave on the nonnegative orthant. and consider the matrix + fn f1n .1 Mathematical Appendix (d) k(x1 . . . x2 ). for all x 0. D3 f1 f11 0 f1 f2 = f1 f11 f12 . then f (x) is strictly quasiconcave on the (strictly) positive orthant. . fnn This is a diﬀerent sort of bordered Hessian than we considered in the text. . . x2 ) is homogeneous of degree m and g(x1 . What is its degree? k(tx1 . x2 ). tx2 ) = [tm (f (x1 . Verify that its principal + minors alternate in sign as in (ii). . . .18 Let f (x) be a realvalued function deﬁned 0 f1 · · · f1 f11 · · · H∗ = . the matrix of secondorder partials is bordered by the ﬁrstorder partials and a zero to complete the square matrix. k(tx1 . D3 > 0.
t. optimised value= 33 /2 (d) maxx1 .x2 = x1 x2 s. State the optimised value of the function at the solution. Is f (x) concave on R2 ? Is it quasiconcave on R2 ? + + Answer The bordered Hessian is 0 2x1 x2 2x2 x2 2 1 H∗ = 2x1 x2 2x2 4x1 x2 . x2 + x2 = 1 1 2 x1 = 1/2 and x2 = − 1/2 or x1 = − 1/2 and x2 = 1/2. Which shows that the function can not be strictly quasiconcave.x2 = x2 + x2 s.x2 = x1 + x2 s. optimised value= −1/2 (c) maxx1 .t. x4 + x4 = 1 1 2 √ 4 x1 = 4 1/2 and x2 = 4 1/2. Answer The bordered Hessian is a a 0 x1 +x2 x1 +x2 a −a −a H∗ = x1 +x2 (x1 +x2 )2 (x1 +x2 )2 . Strict quasiconcavity implies quasioncavity. x2 > 0. A2. Which shows that the function will be quasiconcave and will be strictly quasiconcave for all x1 . where a > 0. optimised value= 23 = 23/4 (e) maxx1 . optimised value= 2 (b) minx1 .1 Mathematical Appendix The two principal minors are D2 = −(x2 +1)2 < 0 and D3 = 2x1 x2 +2x1 ≥ 0. x1 x2 = 1 1 2 x1 = 1 and x2 = 1 or x1 = −1 and x2 = −1. For x1 = x2 = 0 the function is not deﬁned. 2 2 2x2 x2 4x1 x2 2x2 1 1 The two principal minors are D2 = −(2x1 x2 )2 < 0 and D3 = 16x4 x4 ≥ 0. it can be quasiconcave following (i). a x1 +x2 −a (x1 +x2 )2 −a (x1 +x2 )2 a The two principal minors are D2 = −( x1 +x2 )2 < 0 for x1 .t. x2 /a2 + x2 /b2 = 1 2 1 2 2ab2 x1 = a2 /3 and x2 = 2b2 /3 or x2 = − 2b2 /3. Which 1 2 shows that the function will be strictly quasiconcave. x2 ) = a ln(x1 + x2 ) + b. curvature can not be checked in this point. x2 > 0 and D3 = 0.x3 = x1 x2 x3 s. Therefore. However.19 Let f (x1 . A2. Is this function strictly quasiconcave for x 0? It is quasiconcave? How about for x ≥ 0? Justify. x1 + x2 + x3 = 1 2 3 x1 = 1/6 and x2 = 1/3 = 2/6 and x3 = 1/2 = 3/6.x2 = x1 x2 s.x2 . x2 ) = (x1 x2 )2 .25 Solve the following problems. (a) minx1 . optimised value= 1/432 = 108/66 10 .t.t. (b) Let f (x1 .
Obviously. Find the point where the function achieves its unconstrained (global) maximum and calculate the value of the function at that point. y 6  x Figure 3: Graph to Exercise A2.26 Graph f (x) = 6 − x2 − 4x. Compare this to the value it achieves when maximized subject to the nonnegativity constraint x ≥ 0. the global maximum is not a solution in the presence of a nonnegativity constraint. It is a maximum as the secondorder partial derivative is less than zero. However. λ) = 6 − x2 − 4x + λ(x − z) The ﬁrst order conditions and derived equations are: ∂L ∂L = −2x − 4 + λ = 0 = −λ ≤ 0 ∂x ∂z λ=x−z z =x ∂L =x−z =0 ∂λ λx = 0 If λ = 0. As the function is continuously decreasing for all values x ≥ 0. The constrained maximization problem is L(x. then x = 0. then x = −2 would solve the problem.26 11 .1 Mathematical Appendix A2. it does not satisfy the nonnegativity constraint. Answer This function has a global optimum at x = −2. z. If λ = 0. it is the only maximizer in this range.
deﬁne xt as convex combination of bundles x0 to x1 : xt = tx0 + (1 − t)x1 .2 Consumer Theory 2 Consumer Theory 2. That is. (1 − t)x1 ). if x1 = x0 and x1 x0 . 3. A little rearrangement and equalising the two 1 2 1 2 deﬁnitions results in the equality tx0 + (1 − t)x1 = (tx0 + (1 − t)x1 ). Additionally. We know that preferences such as these satisfy Axioms 1. 12 . Answer : Deﬁnition of convexity (Axiom 5 ): If x1 x0 . the consumer is indiﬀerent 2 2 1 1 with respect to the convex combination and the original bundles. the marginal rate of substitution does not change by moving from x0 to x1 . Intuitively. with preference increasing northeasterly. Prove that they do not satisfy Axiom 5. negatively sloped straight lines. 2. tx0 ) + ((1 − t)x1 . Prove the they also satisfy Axiom 5 . tx0 + (1 − t)x1 ). Answer : Indiﬀerence curves representing satiated preferences don’t satisfy the axiom of convexity. 1]. drugs etc. Strict convexity (Axiom 5) requires that. then 1 0 0 tx + (1 − t)x x for all t ∈ [0. Rewriting in terms of single commodities gives us: xt = (tx0 . then tx1 + (1 − t)x0 x0 for all t ∈ [0. To prove the statement more formally.6 Cite a credible example were the preferences of an ‘ordinary consumer’ would be unlikely to satisfy the axiom of convexity. 1.1 Preferences and Utility 1. and 4. The map of indiﬀerence sets in the ﬁgure below represent perfect substitues. 1]. That is. a clear violation of strict convexity.8 Sketch a map of indiﬀerence sets that are parallel. We know that those preferences are convex but not stricly convex. all combinations of two randomly chosen bundles from one indiﬀerence curve will necessarily lie on the same indiﬀerence curve. reducing consumption would result in a higher utility level. Negative utility from consumption of ‘bads’ (too much alcohol.) would rather result in concave preferences.
x1 along one indiﬀerence curve. while if x0 x1 . where x0 > x1 . x1 ]. then x0 x1 . x1 )] = 2 2 1 1 2 2 2 2 1 1 min[x0 . If x0 x1 . 13 . the deﬁnition of strict monotonicity is satisﬁed for these indiﬀerence sets. x1 ). x0 = min[x1 . 1] consider the point tx1 +(1− 1 2 1 2 t)x2 . x1 ) − min(x0 . Take any two vectors x0 . x1 ] 2 2 Deﬁnition of strict monotonicity (Axiom 4): For all x0 . If preference increases northeasterly. tx1 + (1 − t)x1 ] ≥ min[x0 . 1]. x1 ∈ Rn . these preferences will satisfy Axioms 1. 2 1 2 1 2 1 2 1 then we shown that these preferences are convex. Take any two points along the horizontal or vertical part of an indiﬀerence curve such as (x0 . That is. Do they also satisfy Axiom 4? Do they satisfy Axiom 5? Answer : Convexity (Axiom 5 ) requires that. x1 such that x0 ∼ x1 .9 Sketch a map of indiﬀerence sets that are parallel right angles that “kink” on the line x1 = x2 .2 Consumer Theory x2 6 HH H HH H HH H HH H x HH r HH H HH HH HH x t H HH r HH H HH HH H H HH H HH x H r 1 HH HH H H HH H H H H H H 0 HH H  x1 Figure 4: Indiﬀerence sets to Exercise 1. For any two vectors on the same indiﬀerence curve. Strict convexity (Axiom 5) requires that. +(1 − t)x1 ] = min[x0 . tx0 + (1 − t)x1 1 2 1 2 2 2 1 2 2 lies on the same indiﬀerence curve as x1 and x0 . 3. The map of indiﬀerence sets in the ﬁgure below represents perfect complements. x1 ]. 2. min[tx0 + (1 − t)x0 . if x1 x0 . For any t ∈ [0. x1 ] + t[min(x0 . that is x0 ≥ x1 . Therefore. it must be true that min[x0 . it follows x0 x1 . “preferences increase north0 1 easterly”. if x1 = x0 and x1 x0 . and 4’. Therefore. x0 ) and (x0 . 1]. then + x0 x1 . x0 ] = min[x1 . a clear violation of strict convexity. Given the nature of these preferences. Prove that they also satisfy Axiom 5’. Any convex combination xt = x0 . the consumer is indiﬀerent with respect to the convex combination and the original bundles. Take two points x0 . then x x . tx1 ] + min[(1 − t)x0 . tx1 + (1 − t)x1 ] ≥ 2 1 2 1 min[tx0 . if x0 ≥ x1 .8 1. If we can show that min[tx0 + (1 − t)x0 . it is not possible that xt tx0 + (1 − t)x1 . then tx1 + (1 − t)x0 x0 for all t ∈ [0. then tx1 +(1−t)x0 x0 for all t ∈ [0.
2. x2 ) = v(tx1 . x2 ) are quasiconcave. x2 ). x2 ) and v(x1 . x2 ) + v(x1 . (b) Prove that if u(x1 .2 Consumer Theory x2 6 rx rx 0 1  x1 Figure 5: Indiﬀerence sets to Exercise 1. x2 ) ≡ u(x1 . Answer : Use either the Lagrangian or the equality of Marginal Rate of Substitution and price ratio. Answer : Whenever it holds that tr u(x1 . x2 ) ≡ u(x1 . x2 ) and v(x1 . x2 ) and v(x1 . x2 ) ≡ u(tx1 . x2 ) = u(tx1 . x2 ) is also quasiconcave.12 Suppose u(x1 . The Lagrangian is 14 . Answer : Forming a convex combination of the two functions u and v and comparing with m(xt ) satisﬁes the deﬁnition of quasiconcavity: When u(xt ) v(x ) m(xt ) t ≥ min tu(x1 ) + (1 − t)u(x2 ) ≥ min tv(x ) + (1 − t)v(x ) 1 2 and so ≥ min u(xt ) + v(xt ) = t(u(x1 ) + v(x1 )) + (1 − t)(u(x2 ) + v(x2 )) . x2 ) + v(x1 . x2 ) = Axα x1−α . x2 ) is homogeneous of degree r. tx2 ) = tr u(x1 . 0 < α < 1.2 The Consumer’s Problem 1. solve for the Marshal1 2 lian demand functions. x2 ) are both homogeneous of degree r. x2 ) + tr v(x1 . then s(x1 . it must also hold that tr s(x1 . tx2 ) + v(tx1 . then m(x1 . x2 ) are utility functions. Assuming an interior solution. tx2 ) and tr v(x1 .20 Suppose preferences are represented by the CobbDouglas utility function.9 1. (a) Prove that if u(x1 . and A > 0. tx2 ) for all r > 0. u(x1 .
results αy p1 in the Marshallian demand functions: x1 = and x2 = (1−α)y . The ﬁrstorder conditions (FOC) are 1 ∂L = αAxα−1 x1−α − λp1 = 0 2 1 ∂x1 ∂L = (1 − α)Axα x−α − λp2 = 0 1 2 ∂x2 ∂L = y − p 1 x1 + p 2 x2 = 0 ∂λ By dividing ﬁrst and second FOC and some rearrangement. In each case. derive the Marshallian demand functions and verify that they are identical to those derived in the preceding exercise (1. Thus. The FOC are α ∂L = − λp1 = 0 ∂x1 x1 (1 − α) ∂L = − λp2 = 0 ∂x2 x2 ∂L = y − p 1 x1 + p 2 x2 = 0 ∂λ The Marshallian demand functions are: x1 = αy and x2 = (1−α)y . although the secondorder partial ∂ f = ∂ u +6(u(x))( ∂xi )2 is not zero. we get either x1 = x2 = (1−α)p1 x1 . αp2 αx2 p2 (1−α)p1 or Substituting one of these expressions into the budget constraint.24 Let u(x) represent some consumer’s monotonic preferences over x ∈ Rn . The Lagrangian is L = ln(A) + α ln(x1 ) + (1 − α) ln(x2 ) + λ(y − p1 x1 − p2 x2 ).and secondorder partial derivatives reveals 2 2 ∂u that. 1. Answer : (a) f (x) = u(x) + (u(x))3 Yes.21 We’ve noted that u(x) is invariant to positive monotonic transforms. 15 . f represents a monotonic transformation of u. the sign ∂x2 ∂x2 i i of the derivatives is always invariant and positive.2 Consumer Theory 1−α L = Axα x2 + λ(y − p1 x1 − p2 x2 ). state whether or not f also represents + the preferences of this consumer. all arguments of the function u are transformed equally by the third power. One common transformation is the logarithmic transform. Answer : Either the Lagrangian is used or the equality of Marginal Rate of Substitution with the price ratio. then.20). Checking the ﬁrst. be sure to justify your answer with either an argument or a counterexample. They are exactly p1 p2 identical to the demand functions derived in the preceding exercise. ln(u(x)). Take the logarithmic transform of the utility function in 1. For each of the functions F (x) that follow.20. p2 1. using that as the utility function.
Checking the partial derivatives proves this statement: ∂xi = ∂xi + 1 and ∂2f ∂x2 i = ∂2u . x2 .28 An inﬁnitely lived agent owns 1 unit of a commodity that she consumes over her lifetime. the consumer’s utility maximising consumption will be constant in every period.2 Consumer Theory (b) f (x) = u(x) − (u(x))2 No. . The commodity is perfect storable and she will receive no more than she has now. and the second partial of the transforming function ∂f ∂u is zero. First. βu = β 1 ln(x0 ) + β 2 ln(x1 ) + β 3 ln(x2 ) + . the transformation is a linear one. . y p1r + p1r 1 2 −1/r ] 16 . function f is decreasing with increasing consumption for any u(x) < (u(x))2 . . and her lifetime utility function is given by ∞ u(x0 . where r ≡ ρ/(ρ − 1). Consumption of the commodity in period t is denoted xt . .30 Show that the indirect utility function in Example 1. Answer : Establish a geometric series to calculate her lifetime utility: u = β 0 ln(x0 ) + β ln(x1 ) + β 2 ln(x2 ) + . here one. where 0 < β < 1. this series approaches a ﬁnite value. Calculate her optimal level of consumption in each period. Therefore. Answer : The indirect utility function corresponding to CES preferences is: v(p. We need to show that the indirect utility function fulﬁlls the inequality y ptr + ptr 1 2 −1/r ≤ max[y p0r + p0r 2 1 −1/r . 2.2 is a quasiconvex function of prices and income. . . using the inequality relationship. 1 2 There are several ways. (c) f (x) = u(x) + n xi Yes. let pt = tp0 + (1 − t)p1 . ∂x2 i 1.3 Indirect Utility and Expenditure 1. multiply the expression by β and subtract from the original equation [(1)(2)]. + β t ln(xt ) As β is less than one. y) = y (pr + pr )−1/r . it can not represent the preferences of the consumer.) = t=0 β t ln(xt ). x1 . as the ﬁrst partial i=1 is a positive constant. + β t+1 ln(xt ) u − βu = (1 − β)u = ln(x0 ) − β t+1 ln(xt ) ln(x0 ) − β t+1 ln(xt ) = ln(x0 ) u= 1−β Thus. . It could do so if the minus sign is replaced by a plus sign. To ﬁnd the solution.
obviously. For all strictly positive prices. e(tp. evaluated at (x∗ . Second.2 Consumer Theory which gives: y tr (p0r + p0r ) + (1 − t)r (p1r + p1r ) 1 2 1 2 −1/r ≤ max[y p0r + p0r 1 2 −1/r . 4. Again. 3. The lowest value in U is u((0)) because the utility function is strictly increasing. Continuous on its domain Rn × U . λ∗ ). by the Envelope theorem it is shown that the partial derivative of the minimumvalue function e with respect to u is equal to the partial derivative of the Lagrangian with respect to u. strictly increasing and unbounded above in u. positive. As the CES direct utility function satisﬁes the axiom of continuity. Answer : The expenditure function for two commodities is e(p. the bordered Hessian can be derived and their determinants checked. where p ≡ (pr + pr ). Unboundness above follows from the functional form of u. 1. u) = u (pr + pr )1/r where 2 1 r ≡ ρ/(ρ − 1). 0 p−1/r −pr−1 p−1/r−1 y −pr−1 p−1/r−1 y 1 2 p−1/r 0 p−1/r p−1/r H = r−1 −1/r−1 r−1 r−1 −1/r−2 −1/r −1/r−1 r−2 r −1 −p1 p y p yp p1 ((1 − r) − rp1 p ) (1 + r)p1 p2 p y r−1 −1/r−1 r−1 r−1 −1/r−2 −1/r −1/r−1 r−2 r −1 −p2 p y p (1 + r)p1 p2 p y yp p2 ((1 − r) − rp2 p ) . The determinants will be all negative. 0(pr + pr )1/r = 0. 1 2 i what is. Increasing in p. 2 1 2. ++ This property follows from the Theorem of Maximum. 5. For all p >> 0. 1 2 Alternatively. y p1r + p1r 1 2 −1/r ]. this expression will be positive. u) = u ((tp1 )r + (tp2 )r )1/r = t1 u (pr + pr )1/r 1 2 17 .37 Verify that the expenditure function obtained from the CES direct utility function in Example 1. 2 1 1. the derived expenditure function will be continuous too.7. Take the ﬁrst partial derivative of the expenditure function with respect to utility: ∂e/∂u = (pr +pr )1/r . Zero when u takes on the lowest level of utility in U . what equals λ. take all ﬁrst partial derivatives with respect to prices: ∂e/∂pi = upr−1 (pr + pr )(1/r)−1 . Consequently. Homogeneous of degree 1 in p.3 satisﬁes all the properties given in Theorem 1.
7. we know that the derivative’s degree of homogeneity is k1. e(p. the ﬁrst partial derivative of the expenditure function and. v(p. u) yields the relationship t u p0 1 + p0 2 r r 1/r r + (1 − t) u p1 1 + p1 2 r r r r 1/r r ≤ 1/r u t(p0 1 + p0 2 ) + (1 − t)(p1 1 + p1 2 ) . Substitute the indirect utility function v into the Hicksian demand function gives xh (p. Answer : We know that the expenditure function must be homogeneous of degree one in prices. y)). implies that ∂ 2 e/∂p2 pi = i 0. Alternatively. Answer : We know that at the solution of the utility maximisation or expenditure minimisation problem e(p.4 Properties of Consumer Demand 1. Furthermore. it is identical to the Marshallian demand function.2 Consumer Theory 6. e(p. Shephard’s lemma ∂e/∂u = (pr + pr )1/r what is exactly the deﬁnition of a CEStype Hicksian demand 1 2 function. y). u) for pt = tp0 + (1 − t)p1 . u) = x (p. A third possibility is to check (product rule!) p2r (pr + pr )1/r pr (pr + pr )1/r ∂ 2e 2 i 1 2 − r i 2 1r = u (r − 1) 2 r r 2 ∂pi p1 (p1 + p2 ) pi (p1 + pr )2 2 < 0 by r < 0. u) = y and u = v(p. together with Euler’s theorem. Plugging in the deﬁnition of the price vector into e(pt . due to Shephard’s lemma. 18 . u)). The Hicksian demand functions must be homogeneous of degree 1 − 1 = 0 in prices. Hence the diagonal elements of the Hessian matrix must be zero and the matrix will be negative semideﬁnite.40 Prove that Hicksian demands are homogeneous of degree zero in prices. by replacing income by the expenditure function we get the expression x (p. Homogeneity of degree one. Because any Hicksian demand function equals.9 by showing that xh (p. Concave in p. u)).38 Complete the proof of Theorem 1. The deﬁnition of concavity in prices requires t u p 0 1 + p0 2 r r 1/r + (1 − t) u p1 1 + p1 2 r r 1/r ≤ e(pt . 1. As the new function is a function of prices and income only. additionally. 2. we can check the negative semideﬁniteness of the associated Hessian matrix of all secondorder partial derivatives of the expenditure function.
and z(p1 . p2 ))/(ty) = t0 (w(p1 .43 In a twogood case. p2 ) satisfy if each of the following is to be a legitimate indirect utility function? Answer : (a) v(p1 .55 What restrictions must the αi . p2 ) + z(p1 . Answer : The Engelaggregation in a twogood case is the product of the income elasticity and the repsective expenditure share s1 η1 + s2 η2 = 1. p2 ). w(p1 . we can divide all three terms i by xi . f (y). To satisfy v increasing in income. (b) v(p1 . p2 )+(t1 z(p1 . Each of the exponents αi has to be less than zero to satisfy v decreasing in prices. p2 . tp2 . ∂pj ∂pj y ∂y By assuming that xh = xi before the price change occurs. ij and all other terms are as deﬁned in Deﬁnition 1. ∂pj ∂pj ∂y Multiplying the total expression with y/y and pj gives ∂xi ∂xh pj xj ∂xi i pj = pj − y. Function z has to be homogeneous of degree one and w homogeneous of degree zero: v(tp1 . 1. show that if one good is inferior. z must be < 0. Answer : The Slutsky relation is given by ∂xh ∂xi ∂xi i = − xj .6. p2 .2 Consumer Theory 1. An inferior good is characterised by a negative income elasticity. thus. y) = f (y)pα1 pα2 pα3 The function f (y) must be continuous. A con1/2 1/2 sumer’s utility function is u = x1 x2 . the other summand must be positive (even larger one) and the other commodity must be a normal good (even a luxury item). the other good must be normal. Therefore. The result of this operation is ∂xi pj ∂xh pj ∂xi y i = − sj = ∂pj xi ∂pj xi ∂y xi ij = h ij − sj η i Additional exercise Relationship between utility maximisation and expenditure minimisation Let’s explore the relationship with an example of a concrete utility function.60 Show that the Slutsky relation can be expressed in elasticity form as ij = h − ij sj ηi . 1. one of the two summands will be less than zero. p2 )/y The functions w and z must be continuous and decreasing in prices. p2 )/y). For the derived functions see 1 19 . p3 . negative partial derivatives of v with respect to each price are required to get positive Marshallian demand functions by using Roy’s identity. where h is the elasticity of the Hicksian demand for xi with respect to price pj . Furthermore. p2 )+z(p1 . to secure this aggregation. ty) = t0 w(p1 . strictly in1 2 3 creasing and homogeneous of degree 0 − αi . y) = w(p1 .
t. (b) Derive the indirect utility function. Answer Again. the Marshallian demand for x is x = 1/p. (a) Derive the Marshallian demands for x and m. The uncompensated demand for m separates into two cases depending on the amount of income available: m= 0 when y ≤ 1 y − 1 when y > 1. Let the price of x be p. the price of m be unity. Thus. depending on the amount of income available there will be two indirect utility functions: v(p. v(p. y). and let income be y.5 Equilibrium and Welfare 4. m) = ln(x) + m. u to ﬁnd the Hicksian demand function and derive the Marshallian demand for x1 x1 = y/2p1 xh = u (p2 /p1 )1/2 1 Plug in the respective demand functions to get the indirect utility function expenditure function e = u(4p1 p2 )1/2 v = y/(4p1 p2 )1/2 Substitute the expenditure function Substituting the indirect utility function into the Hicksian demand function into the Marshallian demand function to derive the Hicksian demand function to derive the Marshallian demand function x1 = (u(4p1 p2 )1/2 )/2p1 = u(p2 /p1 )1/2 xh = (p2 /p1 )1/2 y/(4p1 p2 )1/2 = y/2p1 1 Invert v and replace y by u Invert e and replace u by v to get the expenditure function to get the indirect utility function e−1 = y(4p1 p2 )−1/2 v −1 = u(4p1 p2 )1/2 Check Roy’s identity Check Shephard’s lemma ∂v/∂p1 2y(p1 p2 )1/2 u4p ∂e − ∂v/∂y = 4(p3 p2 )1/2 = y/2p1 = 2(4p1 p22)1/2 = u(p2 /p1 )1/2 ∂p1 1 Establish the Slutsky equation y ∂x1 u 1 = 2(p1 p2 )1/2 − 2p2 · 2p1 ∂p2 substitute u = v(p. y − 1 − ln p 20 .19 A consumer has preferences over the single good x and all other goods m represented by the utility function. y) into the substitution eﬀect ∂x1 = 4pyp2 − 4pyp2 = 0 ∂p2 1 1 Table 1: Relationship between UMP and EMP 2. u(x.2 Consumer Theory Start from the utility function Minimise expenditures s. y) = ln 1 p when m ≤ 1 when m > 1. Answer The equality of marginal rate of substitution and price ratio gives 1/x = p.
(d) Suppose that the price of x rises from p0 to p1 > p0 . (e) Carefully illustrate your ﬁndings with a set of two diagrams: one giving the indifference curves and budget constraints on top. the eﬀect of an ownprice change on the demand for x equals the substitution eﬀect. that Hicksian and Marshallian demands are identical here. 21 . As the two expressions are equal. Which can be easily seen in the application of the Slutsky equation: ∂x ∂x ∂xh = +x ∂p ∂p ∂y 1 ∂xh ∂x 1 =− 2 +0· = . and identify the Hicksian and Marshallian demands. x 0 p Calculating the change in utility induced by a price change gives: ∆v = v 1 (p1 . the consumer surplus area gives an exact measure of the eﬀect of the price change on consumer welfare in the case of quasilinear preferences. Answer The consumer surplus area can be calculated by integrating over the inverse demand function of x: p1 1 CS = dx = ln(p1 − p0 ). Interpret your result brieﬂy. Be certain that your diagrams reﬂect all qualitative information on preferences and demands that you’ve uncovered. Answer See Figure 6. Please note. Answer A wellknown property of any demand function derived from a quasilinear utility function is the absence of the income eﬀect.2 Consumer Theory (c) Use the Slutsky equation to decompose the eﬀect of an ownprice change on the demand for x into an income and substitution eﬀect. y 1 ) − v 0 (p1 . ∂p p p ∂p Therefore. Be sure to consider the two prices p0 and p1 . Show that the consumer surplus area between p0 and p1 gives an exact measure of the eﬀect of the price change on consumer welfare. and the other giving the Marshallian and Hicksian demands below. y 0 ) = y − 1 − ln p1 − (y − 1 − ln p0 ) = ln(p1 − p0 ).
19 22 .2 Consumer Theory Figure 6: Graph to 4.
it may be written as the sum f (x) = M Pi (x)xi . . Show that this is ∂x i equal to µi (x) − 1. is equal to. . for each i. They have also shown that the production function will be strongly separable if and only if it is of the form f (x) = G f 1 (x(1) ) + · · · + f S (x(S) ) .1 The elasticity of average product is deﬁned as ∂APii(x) · APxi(x) . The sum of all marginal products multiplied with input levels gives the production function times k = 1. where M Pi (x) is the marginal product of input i. . Calculate the marginal / we need to show that i ∂xk j 23 . where G is a strictly increasing function of one variable. Verify their results by showing that each is separable as they claim. 3. where g is some function of S variables. Answer : Applying quotient rule to get the ﬁrst partial derivative of the average product gives: ∂APi (x) xi ∂f (x)/∂xi − f (x) MP AP M P − AP = = − = 2 ∂xi xi xi xi xi Multiply this term with the right part of the deﬁnition (xi /AP ) gives M P/AP − 1 what is exactly µi (x) − 1. f i (x(i) ) is a function of the subvector x(i) of inputs from group i alone. constant.3 Prove that when the production function is homogeneous of degree one. . and. The average product reaches a maximum when the marginal product equals average product. The sum of the partial diﬀerentials of a function multiplied with the level of the respective inputs is equal to the function times the degree of homogeneity k.3 Producer Theory 3 Producer Theory 3. . . Answer : The answer to this exercise gives a nice application of Euler’s Theorem. whenever M P < AP average product is sloping downwards. or less than average product. Answer To show that the ﬁrst equation is weakly separable with respect to the partitions. Finally. j ∈ NS and k ∈ NS . . ∂[f (x)/f (x)] = 0 ∀i.7 Goldman & Uzawa (1964) have shown that the production function is weakly separable with respect to the partition {N1 . It is straightforward to show that whenever marginal product exceeds the average product the slope has to be positive. NS } if and only if it can be written in the form f (x) = g f 1 (x(1) ). The ﬁrst part of the above deﬁnition equals the slope of the average product: (M P − AP )/xi . and the same conditions on the subfunctions and subvectors apply. Show that average product is increasing. 3.1 Production 3. f S (x(S) ) . . or decreasing as marginal product exceeds.
The total diﬀerential of the marginal rate of technical substitution gives d ln Aαxα−1 xβ 2 1 β−1 Aβxα x2 1 = α/β(dx1 /x1 − dx2 /x2 ) 24 . assuming that the three inputs are elements of three diﬀerent partitions i ∈ NS . Therefore. σ = 0. where A > 1 2 0. Answer : The total diﬀerential of the log of the factor ratio gives d ln(x2 /x1 ) = β/x2 dx2 − α/x1 dx1 . j ∈ NT and k ∈ NS ∪ NT . The marginal products of the two inputs i and j are: / fi (x) = G The MRTS is: ∂f S x(S) ∂xi fj (x) = G ∂f T x(T ) .3 Producer Theory products of the ﬁrst equation for two arbitrary inputs i and j: fi (x) = ∂g ∂f S ∂f S ∂xi fj (x) = ∂g ∂f S . the MRTS is not deﬁned in the kinks as the function is discontinuous. 3. the elasticity of substitution is only deﬁned when the input ratio remains constant. ∂xj fi (x) ∂f S /∂xi . the production function is weakly separable. however. Answer : Taking the total diﬀerential of the log of the factor ratio gives d ln (βx2 /αx1 ) = β/x2 dx2 − α/x1 dx1 .8 A Leontief production function has the form y = min {αx1 . = fj (x) ∂f T /∂xj ∂(fi /fj ) = 0. βx2 } for α > 0 and β > 0. ∂(fi /fj ) = 0 for k ∈ N S / ∂xk To show that the second equation is strongly separable we have to perform the same exercise. ∂f S ∂xj The marginal rate of technical substitution between these two inputs is fi (x) = fj (x) ∂f S ∂xi ∂f S ∂xj This expression is independent of any other input which is not in the same partition N S and. therefore. where deﬁned. Carefully sketch the isoquant map for this technology and verify that the elasticity of substitution σ = 0.9 Calculate σ for the CobbDouglas production function y = Axα xβ . ∂xk It follows for k ∈ NS ∪ NT / 3. However. Along all other segments of the isoquants the MRTS is zero. In this case. α > 0 and β > 0.
14 Let y = ( n αi xρ ) . where i=1 αi = 1 and 0 = ρ < 1 25 . Verify that σij = i i=1 1/(1 − ρ) for all i = j.15 For the generalised CES production function. prove the following claims made in the text. where i αi = 1 and 0 = ρ < 1.3 Producer Theory x2 6  x1 Figure 7: Isoquant map of Leontief technology Putting both parts together results in σ= 1/ρ β/x2 dx2 − α/x1 dx1 =1 α/β(dx1 /x1 − dx2 /x2 ) 3. Answer Apply the deﬁnition of the elasticity of substitution. n 1/ρ n y= i=1 αi xρ i . σij = = ∂ (ln(xj ) − ln(xi )) ∂ ln (fi (x)/fj (x)) 1 1 ∂xj − xi ∂xi xj ∂ ln − = ρ−1 = αi xρ−1 ( i αi xρ )1/ρ−1 i i αj xρ−1 (sumi αi xρ )1/ρ−1 j i 1 ∂xi xi − 1 ∂xj xj 1 ∂xj xj 1 ∂xi xi − −1 1 = ρ−1 1−ρ 3.
Then the CES production function has the form y = (xρ + xρ )1/ρ . Thus. On the other hand. To secure concavity in input prices.4 in order that it be a legitimate cost function? Answer : The parameters A. . Thus. the exponents have to add up to one. we must have y = αx1 = βx2 . αx1 = βx2 . Rearrange this expression to derive the conditional input demands: y y x2 (w. . Therefore. y) = . . Answer This problem is identical to the expenditure function and compensated demand functions in the case of perfect complements in consumer theory. At ρ = 0. w1 . Because the production is a minfunction.2 Cost 3. each of the exponents can not be larger one. x1 ≥ ( xρ )1/ρ . Because the denominator is deﬁned to be one.24 Calculate the cost function and conditional input demands for the Leontief production function in Exercise 3.3 Producer Theory (a) n ρ→0 lim y = i=1 xα i i Answer : Write the log of the CES production function ln y = 1/ρ ln αi xρ . . 1 1 i i i Hence ( xρ )1/ρ ≥ n1/ρ ∗ x1 . We want to show 1 2 that x1 = limρ→−∞ ( xρ )1/ρ . i the value of the function is indeterminate. y) = α β 26 . we can write the CES production at this point as y = xαi . xn } ρ→−∞ Answer : Let us assume that αi = αj . i we can establish xρ ≤ xρ . 3. Let us suppose that x1 = min( xi ) and ρ < 0. the exponents α and β must be larger zero. Letting ρ → −∞. x1 (w. α i xρ i ρ→0 At ρ = 0 this expression turns into ln y = αi ln xi / αi . w2 and y are required to be larger than zero. For a given level of output y. xρ ≤ n ∗ x ρ . the second order partials should be less than zero. A cost function is required to be increasing in input prices. 3. In other words. set the inside terms equal to ﬁnd the optimal relationship between x1 and x2 .8.19 What restrictions must there be on the parameters of the CobbDouglas form in Example 3. (b) lim y = min {x1 . what is i exactly the generalised CobbDouglas form. However. we obtain limρ→−∞ ( xρ )1/ρ = x1 . using L’H`pital’s rule we can write o lim ln y = αi xρ ln xi i . To fulﬁll the property of homogeneity of degree one in input prices. Since all commodities xi are required to be nonnegative. i i because limρ→−∞ n1/ρ ∗ x1 = x1 .
y) = w1 x1 (w. the cost functions of ﬁrms A and B are graphed against the input price w1 for ﬁxed values of w2 and y. by Young’s theorem it is known that the order of diﬀerentiation does not matter. Answer : The ﬁrstorder conditions for cost minimisation imply that the marginal rate of technical substitution between input i and j equals the ratio of factor prices wi /wj . the denominator reduces to w1 . 1) = ∂y∂wi ∂c ∂y φ(y)xi (w. ∂wi ∂y ∂wi ∂y Putting everything together gives: iy (w. 1) when the production function is homothetic. represented by the 0 slope of the cost function. σ= d ln(f1 /f2 ) d ln(w1 /w2 ) w1 − w2 ˆ ˆ where the circumﬂex denotes percentage change in input levels and input prices. ∂y xi (w. the cost function can be written as c(w. which ﬁrm uses more of input 1? At w1 ? Explain? Answer : Input demand can be obtained by using Shephard’s lemma. at w1 ﬁrm B demands more of factor 1 and at wage rate w1 ﬁrm A has a higher demand of that input. y) ≡ ∂xi (w. Unfortunately. the following partial derivatives should be equal: ∂mc ∂xi ∂ 2 c(w. y) = = . y) + w2 x2 (w.85. In (a) we established that input demand at w1 is larger for ﬁrm B compared to ﬁrm A. Therefore.3 Producer Theory The cost function is obtained by substituting the two conditional demands into the deﬁnition of cost: w1 y w2 y + . c(w. respectively. y) = ∂ 2c y ∂φ(y) y 1 ∂wi = xi (w.29 The output elasticity of demand for input xi is deﬁned as iy (w. y) (a) Show that iy (w. subsequently. y) = φ(y)c(w. In the two input case. Given a homothetic production function. 1) φ (y) iy (w. 1). Because w2 = 0. 3. 3. Therefore. which is assumed to be the ˆ ˆ 0 same for both ﬁrms.27 In Fig. 0 ﬁrm A’s production function shows the higher elasticity of substitution at w1 . this is not the result we should get. 27 . 1). y) y . However. (b) Which ﬁrm’s production function has the higher elasticity of substitution? Explain. y) = φ(y) iy (w. 0 (a) At wage rate w1 . we can rewrite the original deﬁnition of the elasticity of substitution as d ln(x2 /x1 ) x2 − x1 ˆ ˆ d ln(x2 /x1 ) = = . It follows that the numerator will be larger for B and. Shephard’s lemma states that the ﬁrst order partial derivative with respect to the price of input i gives demand of xi and to obtain the elasticity we need to take take the secondorder crosspartial derivative of the cost function with respect to output. y) = α β 3.
y) = where i is the input where αj αi > ∀j = i. ∂y xi (w. . . when the production function has constant returns to scale. Monotonicity: ∂c(w. . More formally. the conditional input demand reduces to xi (w. y) = yxi (w. . . 1) = 1. . Answer For any production function with constant returns to scale. 1). Therefore. monotonicity. y) = y 1/2 (tw1 tw2 )3/4 = t3/2 y 1/2 (w1 w2 )3/4 The function is not homogeneous of degree one. The cost function is then c(w. y) = y 1/α xi (w. wj wi y . . y) = y 1/2 (w1 w2 )3/4 Homogeneity: c(tw. y) ≡ y y ∂xi (w. . xi (w. The most eﬃcient input (i. i=1 Answer Because the production function is linear.e. . or continuity. . Where possible derive a production function. wi wj 3. n}. y) −1/4 3/4 3/4 −1/4 = 3/4y 1/2 w1 w2 > 0 = 3/4y 1/2 w1 w2 >0 ∂w1 ∂w2 The function is monotonically increasing in input prices. .6) For the following “cost functions” indicate which if any of properties of the cost function fails.g. j ∈ 1.4). the conditional input demand xi is linear in output level y (see Theorem 3. e. . 1) 3. j ∈ {1. y) ∂c(w. (a) c(w. . n} wj αj for at least one j = i. homogeneity. . y) = xi (w. for i = 1. 28 .3 Duality in production Additional exercise (Varian (1992) 1. the conditional input demand of a production function homogeneous of degree α > 0 can be written as xi (w. αi j ∈ {1. . n. n. y) yxi (w. a constant returns to scale technology requires a production function homogeneous of degree 1.33 Calculate the cost function and the conditional input demands for the linear production function y = n αi xi . the inputs can be substituted for another. . By deﬁnition. y) = y αi if if 0 αi wi αi wi > < αj ∀j = i. Calculating the output elasticity of demand for input xi results in: iy (w. input with the greatest marginal product/ price) will be used and the other inputs will not be used. 1). concavity.3 Producer Theory (b) Show that iy = 1.
The underlying technology is represented by y = 2/3 (x1 + x2 ) + x2 − x1 x2 + x2 . y) = y(w1 − w1 w2 + w2 ) Monotonicity of the cost function holds only for a narrow set of input prices with the characteristics 1/4w2 < w1 < 44 . The conclusion can be derived from the ﬁrst partial derivatives and a combination of the two inequalities. the function is convex. it becomes clear from the expression c(tw. 1 ∂c =y 1− ∂w1 2 ∂c 1 =y 1− ∂w2 2 w2 w1 w1 w2 1 2 1 positive for 1 > 2 positive for 1 > w2 w1 w1 or 2 > w2 w2 w1 The function is not concave as the ﬁrst partial derivatives with respect to both input prices are negative and the secondorder partial derivatives are positive. The determinants of the Hessian matrix are H1  > 0 and H2  = 0. 29 . The underlying technology is represented by y = x1 x 2 .3 Producer Theory Concavity: H= H1  < 0 H2  = − y 72 <0 √ 256 w1 w2 9 1/2 3 y w1 w2 − 16 y 1/2 w1 w2 16 −1/4 3/4 −5/4 9 1/2 − 3 y w 1/41 w2 − 16 y 1/2 w1 w2 16 −5/4 3/4 −1/4 −1/4 The function is not concave in input prices. what can be seen from the ﬁrst determinant of the Hessian matrix: H1  = y(w1 − 2)e−w1 . √ (e) c(w. y) = ty(w1 e−tw1 + w2 ). 2 1 (d) c(w. y) = y(w1 e−w1 + w2 ) The function is not homogeneous of degree one. Furthermore the function is only concave for prices w1 < 2. The function is not monotonically increasing in input prices as the ﬁrst partial derivative with respect to w1 is only positive for prices less than one: ∂c/∂w1 = ye−w1 (1−w1 ). y) = y(w1 + w1 w2 + w2 ) The function satisﬁes all properties. Alternatively. y) = y(2w1 w2 ) The function satisﬁes all properties. √ (c) c(w. Using Euler’s Theorem we get ∂c 2 the result w = y(w1 e−w1 + w1 e−w1 + w2 ) what is clearly not equal to the ∂wi i original cost function. Continuity: Yes √ 1/2 1/2 (b) c(w. Thus.
That is. Answer : Starting from the equality of MRTS and ratio of factor prices. except continuity in y = 0. Justify your approach. show that 2 1 the converse is also true. equalise the two expressions and solve for y. Second. On the righthand side we have the quantity of input(s) and output. lefthand side of the expression. y) r−1 r r = yAw1 (w1 + w2 ) r −1 ∂w1 1 ∂c(w. Answer : Using Shephard’s lemma we can derive the conditional input demand functions. c(w. The ﬁrst step to solve this exercise for a CobbDouglas cost function is to derive Shephard’s lemma and to rearrange all input demands in such a way to isolate the ratio of input prices on one side. gives rise 1 2 to a CES cost function. y) = (1 − α)yA x2 = ∂w2 w1 1−α α (Aαy) x2 = α x1 (A(1 − α)y)1−α y= w2 = w1 x2 A(1 − α)y −1/α xα x1−α 1 2 = axα x1−α where a = (Aαα (1 − α)1−α )−1 1 2 αα (1 − α)1−α For the CES cost function a shortcut is used: Derive the conditional input demand functions and substitute them into the production function. x1 = ∂c(w. y). y) = yA (xr + xr )1/r . y) = αyA ∂w1 w2 w1 1−α w2 = w1 −α x1 Aαy 1/(1−α) w2 ∂c(w. y = A (xρ + xρ )1/ρ . 1 α 1−α c(w. i. y) = (y + 1/y) w1 w2 The function satisﬁes all properties. y) = yAw1 w2 . gives rise to a CobbDouglas cost function. (a) Find c(w1 . starting with the respective cost functions. 1 ∂c(w. w2 . y) r−1 r r x2 = = yAw2 (w1 + w2 ) r −1 ∂w2 x1 = y = (Ay)ρ −r −r w1 + w2 −r −r w1 + w2 1/ρ = Ay 3. “work backward” to the underlying production function and show that it is of the indicated form. 3.40 We have seen that every CobbDouglas production function.4 The competitive ﬁrm Additional exercise (Varian (1992) 1. 1−α y = Axα x2 . The result will be the corresponding production function. and every CES production function.21) Given the following production function 1/2 1/4 y = 100x1 x2 .e. For each pair of functions.3 Producer Theory √ (f) c(w. we get 30 .
Solving for one of the inputs. y) the ﬁrstorder condition is y ∂π 1 =p − ∂y 75 100 y =100 1/3 w1 w2 (21/3 + 2−2/3 ) = 0 3 2/3 1/3 75 21/3 + 2−2/3 p w1 w2 2/3 1/3 3 The ﬁrst expression aﬃrms the equality of price and marginal cost as the proﬁt maximum for any competitive ﬁrm. p). Substituting the two functions in the deﬁnition of costs. the resulting cost function is: c(w1 . (c) Given p = price of output. y) = y 100 4/3 w1 (2w2 )1/3 + y 100 4/3 2/3 y 100 2/3 4/3 w2 w1 2−2/3 1/3 2/3 = 21/3 + 2−2/3 w1 w2 . and verify that λ = marginal cost.3 Producer Theory w1 /w2 = 2x2 /x1 . 1/3 (b) Find the eﬀect of an increase in output on marginal cost. p). p) and π(w. Use Hotelling’s lemma to derive the supply function y(w. substituting back in the production function and rearranging. From the FOC of the La∂y grangian we can derive that λ∗ = w1 x1 1/2 demand functions into one of those expressions gives λ∗ = w1 (y/100)4/3 (2w2 /w1 )1/3 50 21/3 y 1/3 2/3 1/3 = ( ) w1 w2 50 100 1/2 1/4 50x2 = w2 x2 3/4 1/2 25x1 . w2 . ﬁnd x1 (w. Answer : By maximising π = py − c(w. Substituting the conditional input (y/100)4/3 (2w2 /w1 )−2/3 −1/4 When you solve the ratios. this expression will be equal to the marginal cost function. x2 (w. Answer : Marginal costs are 2/3 1/3 1 M C = ∂c/∂y = 75 (y/100)1/3 w1 w2 21/3 + 2−2/3 . Marginal costs are increasing with output which is shown by 2/3 1/3 1 2 ∂M C ∂2c = ∂y2 = 150 (y/100)−2/3 w1 w2 21/3 + 2−2/3 . p). we derive the conditional input demand functions: x1 = x2 = y 100 y 100 4/3 2w2 w1 2w2 w1 1/3 and −2/3 4/3 . The last expression gives already the proﬁt 31 .
Answer : The cost function is a factor of a function of output and input prices. Substitution of the output supply function into the conditional input demands results in the unconditional input demand functions.3 Producer Theory maximising supply function. Therefore. (f) Show that the proﬁt function is convex. the possibility to separate the two functions multiplicatively and following Theorem 3. 2 2 21/3 + 2−2/3 22/3 w1 w2 The proﬁt function is π= 75 1/3 + 2−2/3 2 = 3 100p4 − 2 w1 w2 3 75p 1/3 + 2−2/3 2 4 w2 21/3 w1 + 2/3 2 2 3 w1 w2 2 w1 w2 75 1/3 + 2−2/3 2 p4 (100 − 75) 2 w1 w2 3 = 25 75 1/3 + 2−2/3 2 p4 . gives. the two following unconditional demand functions emerge as solution of this optimisation problem: x1 = 75p 1/3 + 2−2/3 2 75p 1/3 + 2−2/3 2 3 −2 −1 w1 w2 3 −2 −1 w1 w2 4/3 4/3 2w2 w1 w1 2w2 1/3 = 2/3 75 1/3 + 2−2/3 2 4 21/3 p4 3 w1 w2 x2 = = 75 p4 . I write the constant part of the proﬁt function 32 . 2 w1 w2 Hotelling’s lemma conﬁrms the output supply function shown above. way is to substitute the conditional input demands into the deﬁnition of cost to obtain the cost function.4 shows that the production function has to be a homothetic function. Furthermore. (d) Derive the unconditional input demand functions from the conditional input demands. after rearrangement. the conditional input demand functions are products of a function of y and input prices. Answer One. Using the example at hand. among several. the output supply function. Answer : In order to simply this step. p) = 75 21/3 + 2−2/3 4 −3 −1 p4 w 1 w 2 y 1/3 2/3 1/3 w1 w2 100 −3 3 −2 −1 p w1 w2 · 100 (e) Verify that the production function is homothetic. Calculating marginal cost and equalising with output price. Similarly. and starting from the equality ∂c/∂y = p gives: 1 1/3 2 + 2−2/3 75 y = 753 21/3 + 2−2/3 p= x1 (w.
‘A note on separability in demand analysis’. Shortrun total cost are obtained by rearranging the production function to get x1 on the lefthand side and plugging in into the deﬁnition of cost c(w. (1964).References 75 as K = 25 21/3 +2−2/3 Calculating the secondorder partial derivatives of the proﬁt function with respect to all prices gives the following Hessian matrix. The ﬁrstpartial derivative gives the shortrun marginal 1/2 1 y cost function smc = 50 100 w1 /x2 . K. Be aware of the doubble sign change after each derivative with respect to the input price (check Theorem 3. S. M.8). C. W. 1002 1 y Final remark: Some answers might not be the most elegant ones from a mathematical perspective. (1961). Checking the determinants becomes quite tedious. (g) Assume x2 as a ﬁxed factor in the short run and calculate shortrun total cost. it should become clear that they all have to be positive. 3 H= 12Kp2 2 w1 w2 3 −8Kp − 3 w1 w23 − −4Kp 2 2 w1 w2 −8Kp3 3 w1 w2 −6Kp4 − w4 w2 1 4 − −2Kp 3 2 w1 w2 −4Kp3 2 2 w1 w2 −2Kp4 − w3 w2 1 2 4 − −2Kp 2 3 w1 w2 The own supply eﬀect is positive. H. are highly welcome. H. Any comment and suggestion. also in case of obscurities. Goldman. 387–398. References Arrow. Econometrica 32(3). shortrun average cost and shortrun proﬁt function. 3rd edn. 779–800. shortrun marginal cost. Intuituively. W. & Uzawa. 33 . Norton & Company. Varian. Econometrica 29(4). y) = 1/2 (y/100)2 w1 /x2 + w2 x2 . The shortrun average costs are equal to sac = 1/2 y w /x2 + w2 x2 . & Enthoven. New York. J. ‘Quasiconcave programming’. Microeconomic Analysis. the own demand eﬀects are negative and all crossprice eﬀects are symmmetric. A. (1992). R.
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