ECON 5113 Advanced Microeconomics

Winter 2011
Answers to Selected Exercises Instructor: Kam Yu
The following questions are taken from Georey A. Jehle
and Philip J. Reny (2001) Advanced Microeconomic The-
ory, Second Edition, Boston: Addison Wesley. The up-
dated version is available at the course web page:
http://ash.lakeheadu.ca/kyu/E5113/Main.html
Ex. 1.14 Let U be a continuous utility function that
represents . Then for all x, y R
n
+
, x y if and only
if U(x) U(y).
First, suppose x, y R
n
+
. Then U(x) U(y) or
U(y) U(x), which means that x y or y x. There-
fore is complete.
Second, suppose x y and y z. Then U(x) U(y)
and U(y) U(z). This implies that U(x) U(z) and
so x z, which shows that is transitive.
Finally, let x R
n
+
and U(x) = u. Then
U
1
([u, )) = {z R
n
+
: U(z) u}
= {z R
n
+
: z x}
= (x).
Since [u, ) is closed and U is continuous, (x) is
closed. Similarly (I suggest you to try this), (x) is
also closed. This shows that is continuous.
Ex. 1.33
1
Suppose on the contrary that E is bounded
above in u, that is, for some p 0, there exists M > 0
such that M E(p, u) for all u in the domain of E.
Let u

= V (p, M). Then

E(p, u

) = E(p, V (p, M)) = M = p

T
x

,
where x

is the optimal bundle. Since U is continuous,

there exists a bundle x

in the neighbourhood of x

such
that U(x

) = u

> u

. Since U strictly increasing, E is

strictly increasing in u, so that E(p, u

) > E(p, u

) =
M. This contradicts the assumption that M is an upper
bound.
1
It may be helpful to review the proof of Theorem 1.8.
Ex. 1.45 Since d
i
is homogeneous of degree zero in p
and y, for any > 0 and for i = 1, . . . , n,
d
i
(p, y) = d
i
(p, y).
Dierentiate both sides with respect to , we have

p
d
i
(p, y)
T
p +
d
i
(p, y)
y
y = 0.
Put = 1 and rewrite the dot product in summation
form, the above equation becomes
n

j=1
d
i
(p, y)
p
j
p
j
+
d
i
(p, y)
y
y = 0. (1)
Dividing each term by d
i
(p, y) yields the result.
Ex. 1.46 Suppose that U(x) is a linearly homogeneous
utility function.
(a) Then
E(p, u) = min
x
{p
T
x : U(x) u}
= min
x
{up
T
x/u : U(x/u) 1}
= umin
x
{p
T
x/u : U(x/u) 1}
= umin
x/u
{p
T
x/u : U(x/u) 1} (2)
= umin
z
{p
T
z : U(z) 1} (3)
= uE(p, 1)
= ue(p)
In (2) above it does not matter if we choose x or x/u
directly as long as the objective function and the con-
straint remain the same. We can do this because of the
objective function is linear in x. In (3) we simply rewrite
x/u as z.
(b) Using the duality relation between V and E and
the result from Part (a) we have
y = E(p, V (p, y)) = V (p, y)e(p)
so that
V (p, y) =
y
e(p)
= v(p)y,
where we have let v(p) = 1/e(p). The marginal utility
of income is
V (p, y)
y
= v(p),
which depends on p but not on y.
Ex. 1.65 (b) By denition y
0
= E(p
0
, u
0
), Therefore
y
1
y
0
>
E(p
1
, u
0
)
E(p
0
, u
0
)
means that y
1
> E(p
1
, u
0
). Since the indirect utility
function V is increasing in income y, it follows that
u
1
= V (p
1
, y
1
) > V (p
1
, E(p
1
, u
0
)) = u
0
.
Ex. 1.65 It is straight forward to derive the expenditure
function, which is
E(p, u) = p
2
u
p
2
2
4p
1
. (4)
(a) For p
0
= (1, 2) and y
0
= 10, we can use (4) to
obtain u
0
= 11/2. Therefore, with p
1
= (2, 1),
I =
u
0
1/8
2u
0
1
=
43
80
.
(b) It is clear from part (a) that I depends on u
0
.
(c) Using the technique similar to Exercise 1.46, it can
be shown that if U is homothetic, E(p, u) = e(p)g(u),
where g is an increasing function. Then
I =
e(p
1
)g(u
0
)
e(p
0
)g(u
0
)
=
e(p
1
)
e(p
0
)
,
which means that I is independent of the reference utility
level.
Ex. 2.2 For i = 1, . . . , n, the i-th row of the matrix
multiplication S(p, y)p is
n

j=i
_
d
i
(p, y)
p
j
p
j
+
d
i
(p, y)
y
p
j
d
j
(p, y)
_
=
n

j=i
d
i
(p, y)
p
j
p
j
+
d
i
(p, y)
y
n

j=i
p
j
d
j
(p, y)
=
n

j=i
d
i
(p, y)
p
j
p
j
+
d
i
(p, y)
y
y (5)
= 0 (6)
where in (5) we have used the budget balancedness and
(6) holds because of homogeneity and (1) in Ex. 1.45.
Ex. 2.3 By (T.1) on p. 78
U(x) = min
pR
n
++
{V (p, 1) : p x = 1} .
The Lagrangian is
L = p

1
p

2
(1 p
1
x
1
p
2
x
2
),
with the rst-order conditions
p
1
1
p

2
+ x
1
= 0
and
p

1
p
1
2
+ x
2
= 0.
Eliminating from the rst-order conditions gives
p
2
=

x
1
x
2
p
1
.
Substitute this p
2
into the constraint equation, we get
p
1
=

+
1
x
1
,
and
p
2
=

+
1
x
2
.
The utility function is therefore
U(x) =
_

( + )
+
_
x

1
x

2
,
which is a Cobb-Douglas function.
Ex. 2.6 We want to maximize utility u subject to the
constraint p
T
x E(p, u) for all p R
n
++
. That is,
p
1
x
1
+ p
2
x
2

up
1
p
2
p
1
+ p
2
.
Rearranging gives
u
p
1
+ p
2
p
2
x
1
+
p
1
+ p
2
p
1
x
2
for all p R
n
++
. This implies that
u min
p1,p2
_
p
1
+ p
2
p
2
x
1
+
p
1
+ p
2
p
1
x
2
_
. (7)
Therefore u attains its maximum value when equality
holds in (7). To nd the minimum value on the right-
hand side of (7), write = p
2
/(p
1
+p
2
) so that 1 =
p
1
/(p
1
+ p
2
) and 0 < < 1. The minimization problem
becomes
min

_
x
1

+
x
2
1
: 0 < < 1
_
. (8)
2
Notice that for any x
1
> 0 and x
2
> 0,
lim
0
_
x
1

+
x
2
1
_
=
and
lim
1
_
x
1

+
x
2
1
_
=
so that the minimum value exists when 0 < < 1. The
rst-order condition for minimization is

x
1

2
+
x
2
(1 )
2
= 0,
which can be written as

2
x
2
= (1 )
2
x
1
.
Taking the square root on both sides gives
x
1/2
2
= (1 )x
1/2
1
.
Rearranging gives
=
x
1/2
1
x
1/2
1
+ x
1/2
2
and 1 =
x
1/2
2
x
1/2
1
+ x
1/2
2
.
It is clear that is indeed between 0 and 1. Putting
and 1 into the objective function in (8) give the
direct utility function
U(x
1
, x
2
) =
_
x
1/2
1
+ x
1/2
2
_
2
,
which is the CES function with = 1/2. You should
verify with Example 1.3 on p. 3839 that the expenditure
function is indeed as given.
Ex. 3.2 Constant returns-to-scale means that f is lin-
early homogeneous. So by Eulers theorem
x
1
y/x
1
+ x
2
y/x
2
= y. (9)
Since average product y/x
1
is rising, its derivative re-
spect to x
1
is positive, that is,
(x
1
y/x
1
y)/x
2
1
> 0.
From (9) we have
x
2
y/x
2
= (x
1
y/x
1
y) < 0,
which means that the marginal product y/x
2
is neg-
ative.
Ex. 4.5 Let w be the vector of factor prices and p
be the output price. Then the cost function of a typ-
ical rm with constant returns-to-scale technology is
C(w, y) = c(w)y where c is the unit cost function. The
prot maximization problem can be written as
max
y
py c(w)y = max
y
y[p c(w)].
For a competitive rm, as long as p > c(w), the rm will
increase output level y indenitely. If p < c(w), prot
is negative at any level of output except when y = 0.
If p = c(w), prot is zero at any level of output. In
fact, market price, average cost, and marginal cost are
all equal so that the inverse supply function is a constant
function of y. Therefore the supply function of the rm
does not exist and the number of rm is indeterminate.
Ex. 4.14 The prot maximization problem for a typical
rm is
max
q
[10 15q (J 1) q]q (q
2
+ 1),
with necessary condition
10 15q (J 1) q 15q 2q = 0.
(a) Since all rms are identical, by symmetry q = q.
This gives the Cournot equilibrium of each rm q

=
10/(J + 31), with market price p

= 170/(J + 31).
(b) Short-run prot of each rm is = [40/(J+31)]
2

1. In the long-run = 0 so that J = 9.

Ex. 5.11 (a) The necessary condition for a Pareto-
ecient allocation is that the consumers MRS are equal.
Therefore
U
1
(x
1
1
, x
1
2
)/x
1
1
U
1
(x
1
1
, x
1
2
)/x
1
2
=
U
2
(x
2
1
, x
2
2
)/x
2
1
U
2
(x
2
1
, x
2
2
)/x
2
2
,
or
x
1
2
x
1
1
=
x
2
2
2x
2
1
. (10)
The feasibility conditions for the two goods are
x
1
1
+ x
2
1
= e
1
1
+ e
2
1
= 18 + 3 = 21, (11)
x
1
2
+ x
2
2
= e
1
2
+ e
2
2
= 4 + 6 = 10. (12)
Express x
2
1
in (11) and x
2
2
in (12) in terms of x
1
1
and x
1
2
respectively, (10) becomes
x
1
2
x
1
1
=
10 x
1
2
2(21 x
1
1
)
,
or
x
1
2
=
10x
1
1
42 x
1
1
. (13)
Eq. (13) with domain 0 x
1
1
21, (11), and (12) com-
pletely characterize the set of Pareto-ecient allocations
A (contract curve). That is,
A =
_
(x
1
1
, x
1
2
, x
2
1
, x
2
2
) : x
1
2
=
10x
1
1
42 x
1
1
, 0 x
1
1
21,
x
1
1
+ x
2
1
= 21, x
1
2
+ x
2
2
= 10.
_
3
Figure 1: Contract Curve and the Core
(b) The core is the section of the curve in (13) be-
tween the points of intersections with the consumers in-
dierence curves passing through the endowment point.
For example, in Figure 1, if G is the endowment point,
the core is the portion of the contract curve between
points W and Z. Consumer 1s indierence curve pass-
ing through the endowment is
(x
1
1
x
1
2
)
2
= (18 4)
2
,
or x
1
2
= 72/x
1
1
. Substituting this into (13) and rearrang-
ing give
5(x
1
1
)
2
+ 36x
1
1
1512 = 0.
Solving the quadratic equation gives one positive value
of 14.16. Consumer 2s utility function can be written
as x
2
1
(x
2
2
)
2
. This can be expressed in terms of x
1
1
and
x
1
2
using (11) and (12). The indierence curve passing
through endowment becomes
(21 x
1
1
)(10 x
1
2
)
2
= (21 18)(10 4)
2
= 108.
Putting x
1
2
in (13) into the above equation and solving
for x
1
1
give x
1
1
= 15.21. Therefore the core of the econ-
omy is given by
C(e) =
_
(x
1
1
, x
1
2
, x
2
1
, x
2
2
) : x
1
2
=
10x
1
1
42 x
1
1
,
14.16 x
1
1
15.21, x
1
1
+ x
2
1
= 21,
x
1
2
+ x
2
2
= 10.
_
(c) Normalize the price of good 2 to p
2
= 1. The
demand functions of the two consumers are:
x
1
1
=
y
1
2p
1
=
p
1
e
1
1
+ p
2
e
1
2
2p
1
=
18p
1
+ 4
2p
1
x
1
2
=
y
1
2p
2
=
p
1
e
1
1
+ p
2
e
1
2
2p
2
=
18p
1
+ 4
2
x
2
1
=
y
2
3p
1
=
p
1
e
2
1
+ p
2
e
2
2
3p
1
=
3p
1
+ 6
3p
1
x
2
2
=
2y
2
3p
2
=
2(p
1
e
2
1
+ p
2
e
2
2
)
3p
2
=
2(3p
1
+ 6)
3
In equilibrium, excess demand z
1
(p) for good 1 is zero.
Therefore
18p
1
+ 4
2p
1
+
3p
1
+ 6
3p
1
18 3 = 0,
which gives p
1
= 4/11 (check that market 2 also clears).
The Walrasian equilibrium is p = (p
1
, p
2
) = (4/11, 1).
From the demand functions above, the WEA is
x = (x
1
1
, x
1
2
, x
2
1
, x
2
2
) = (14.5, 5.27, 5.6, 4.73).
(d) It is easy to verify that x C(e).
Ex. 5.21 Let Y R
n
be a strongly convex production
set. For any p R
n
++
, let y
1
Y and y
2
Y be two
distinct prot-maximizing production plans. Therefore
p y
1
= p y
2
p y for all y Y . Since Y is strongly
convex, there exists a y Y such that for all t (0, 1),
y > ty
1
+ (1 t)y
2
.
Thus
p y > tp y
1
+ (1 t)p y
2
= tp y
1
+ (1 t)p y
1
= p y
1
,
which contradicts the assumption that y
1
is prot-
maximizing. Therefore y
1
= y
2
.
Ex. 5.29 Let E = {(U
i
, e
i
,
ij
, Y
j
)|i I, j J} be
the production economy and p R
n
++
be the Walrasian
equilibrium.
(a) For any consumer i I, the utility maximization
problem is
max
x
U
i
(x) s. t. p x = p e
i
+

jJ

ij

j
(p),
with necessary condition
U
i
(x) = p.
The MRS between two goods l and m is therefore
U
i
(x)/x
l
U
i
(x)/x
m
=
p
l
p
m
.
4
Since all consumers observe the same prices, the MRS is
the same for each consumer.
(b) Similar to part (a) by considering the prot max-
imization problem of any rm.
(c) This shows that the Walrasian equilibrium prices
play the key role in the functioning of a production econ-
omy. Exchanges are impersonal. Each consumer only
need to know her preferences and each rm its produc-
tion set. All agents in the economy observe the common
price signal and make their own decisions. This mini-
mal information requirement leads to the lowest possible
transaction costs of the economy.
c 2011 The Pigman Inc. All Rights Reserved.
5