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1
London School of Economics Dr Francesco Nava
Department of Economics Office LIF 3.20
EC411 2013/2014
Answers to Problem Set 1
1. (a) The consumer chooses (x,y) to maximise x+y s.t.
y y
M M y p x 2 + s + and
M x 2 s .
(b) If 2 p
y
< , x=0, and
y
y
p
M M
y
+
= . If 2 p
y
> ,
2
M
x = , and
y
y
p
M
y = .
2.
(i) Initial price ratio p
1
1
: p
2
1
= 1 : 1; new price ratio p
1
2
: p
2
2
= 3 : 2.
(ii) Bundle bought in week 2 was available in week 1. Thus, week 1
consumption is revealed to be superior to week 2 consumption.
(iii) Set prices at p
2
and increase income from m = p
2
x
2
to m + Am = p
2
x
1
(the
dashed line). By revealed preference the optimal choice must lie along
EC411 Microeconomics
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dashed line to northwest of x
1
. This follows by LNS and quasi‐concavity,
since the indifference curve of the consumer is tangent to the flatter BC at
(5.3). Hence when income rises consumption of x
1
falls. Thus x
1
must be
an inferior good.
(iv) The price of good 1 has gone up. Consumption of good 1 has also gone up.
This observation is not sufficient to show Giffen because income has
changed.
Remember
δm
δx
x
δm
δx
x
δp
δh
δp
δx
1
1
1
1
1
1
1
1
+ ÷ = where
1
x = 4 is the weekly
endowment of good x
1
, and
1
1
δp
δx
means the effect of a change in p
1
holding
everything else constant.
In terms of good 2 however, p
1
has gone up from 1 to 1½ and income has
gone up from 1×4 + 1×4 = 8 to 1½×4
+ 1×4 = 10. We also know from (iii)
that good 1 is inferior. Therefore, this rise in income must make demand
for good 1 fall holding all else constant. Therefore, if income had not
increased the demand for good 1 would have increased even more than it
did. Therefore this good must be Giffen.
3. (a) Note that the indifference curve is a circle with centre at the origin (as in
problem set 1, question 1(ii)). Hence, only boundary solutions exist. If
2 1
p p > ,
2
2 1
p
m
x , 0 x = = . If
2 1
p p < ,
1
1 2
p
m
x , 0 x = = . If
2 1
p p = , either
2
2 1
p
m
x , 0 x = = or
1
1 2
p
m
x , 0 x = = .
EC411 Microeconomics
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(b) True
Old budget set = OAB
New budget set = OACD
For the family to be indifferent, butter consumption must have fallen
(x
0
÷ x
1
).
In order to afford x
1
, the family must be receiving a net subsidy of AM > 0.
(c) False. Consider the following example. Let clothing be the numeraire.
The ration‐point system that the consumer faces an additional (linear)
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constant RS : e.g.
Before the increase in income, the allowed consumption set is ORAC. The
consumer’s choice is
0
xˆ (point A).
After the increase (AM) in income, the allowed consumption set is ORBD. The
consumer’s choice is
1
xˆ (point B).
Consumption of clothing has decreased.
Yet: Without the ration‐point constraint RS, consumption would change from
x
0
to x
1
: an increase in clothing. That is, clothing is a normal good.
(d) Let m be income and
i
p the price of good i. If (m/(
1
p ))≤3, the optimal choice is
1
x =(m/(
1
p )) and 0 x
2
= . If (m/(
1
p ))>3, utility maximisation implies that
2 1
x 3 x + = . Hence, ) p p /( ) p 3 m ( x
2 1 2 1
+ + = and ) p p /( ) p 3 m ( x
2 1 1 2
+ ÷ = .
4. (i) Marshall: 1 = ìp
1
, 
1
(q
2
) = ìp
2
¬ 
1
(q
2
) = p
2
/ p
1
Hicks: p
1
= µ , p
2
= µ
1
(q
2
) ¬ 
1
(q
2
) = p
2
/ p
1
Observe that the absence of an income effect for good 2 is a consequence
of this form of the utility function.
Significance: area under Marshallian (market) demand function is
precisely the CV and the EV.
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(ii)
( )
( )
2 2p
dp p dp
p
1
CV
/p p q
q
1
) (q φ
1
4
2
1
2
2
2
1
1
4
2 2
1
4
2
1
2
2
1
2 1 2
2
2
1
÷ =
(
¸
(
¸
=
=


.

\

=
= ÷ =
÷
} }
5. The indirect utility function, v(p,m), is non‐decreasing in m. The claim then
follows noting that ) u , p ( h
p
e
i
i
=
c
c
and )) m , p ( v , p ( h ) m , p ( x
i i
= (by hypothesis,
) u , p ( h
i
is increasing in u).
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