Utility Maximization

Choice

Exercises of Microeconomics
Utility Maximization - Choice (Ch. 7-8 Varian)

Fabio Tramontana (University of Pavia)

slides available at: http://tramontana.altervista.org/teaching.html

PhD in Economics at L.A.S.E.R.

Tramontana Exercises Micro

 Utility Maximization
Choice

Outline

1 Utility Maximization
Exercise 7.1
Exercise 7.2
Exercise 7.3
Exercise 7.4
Exercise 7.5

2 Choice
Exercise 8.5
Exercise 8.6
Exercise 8.7
Exercise

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Outline

1 Utility Maximization
Exercise 7.1
Exercise 7.2
Exercise 7.3
Exercise 7.4
Exercise 7.5

2 Choice
Exercise 8.5
Exercise 8.6
Exercise 8.7
Exercise

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Exercise 7.1

Consider preferences dened over the nonnegative orthant by

(x1 , x2 )  (y1 , y2 ) if x1 + x2 < y1 + y2 . Do these preferences exhibit
local nonsatiation?
If these are the only two consumption goods and the consumer
faces positive prices, will the consumer spend all of his income?
Explain.

What does local nonsatiation mean?

Local Nonsatiation

given any x in X and any > 0, then there is some bundle y in X

with |x y | < such that y  x.

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Solution

In other words, there must always exist a better

bundle. Maybe it cannot be reached (it costs too much),
but it exists.

In our case the bundle (0, 0) is the best one and no better bundle
exists.

So our consumer does not spend any amount of income.

It is not a real good what we are talking about.

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Outline

1 Utility Maximization
Exercise 7.1
Exercise 7.2
Exercise 7.3
Exercise 7.4
Exercise 7.5

2 Choice
Exercise 8.5
Exercise 8.6
Exercise 8.7
Exercise

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Exercise 7.2

A consumer has a utility function u (x1 , x2 ) = max {x1 , x2 }. What is

the consumer's demand function for good 1? What is his indirect
utility function? What is his expenditure function?

The meaning of this kind of utility function is obvious. Only a good

is important, the one whose amount is the highest.
So, if prices dier, the better choice for the consumer is to spend
all the income for the lowest priced good.
Otherwise, with the same prices, the better choice is the spend all
the income for only one good, randomly chosen.

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Solution

So, the demand functions are

m/pi if pi < pj
xi = 0 or m /pi if pi = pj
if pi > pj

0

We can also build the indirect utility function:

v (p1 , p2 , m) = max {m/p1 , m/p2 }

The expenditure function relates income with utility and prices:

e (p , u ). In our case:

e (p1 , p2 , u ) = u min {p1 , p2 } .

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Outline

1 Utility Maximization
Exercise 7.1
Exercise 7.2
Exercise 7.3
Exercise 7.4
Exercise 7.5

2 Choice
Exercise 8.5
Exercise 8.6
Exercise 8.7
Exercise

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Exercise 7.3

A consumer has an indirect utility function of the form

m
v (p1 , p2 , m) = .
min {p1 , p2 }

What is the form of the expediture function for this consumer?

What is the form of a (quasiconcave) utility function for this
consumer? What is the form of the demand function for good 1?

Let us start by writing down the indirect utility function in a

dierent way:

m/p1 if p1 < p2
v (p1 , p2 , m) = m/p if p1 = p2
m/p2 if p1 > p2

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Solution

The best thing consists in starting from the demand function.

In fact, it is clear that the consumer will use all his income for the
good with the lowest price:

m/p1 if p1 < p2
x1 = any x1 and x2 such that p1 x1 + p2 x2 =m if p1 = p2
if p1 > p2

0

and similarly for the demand function of the good 2.

This means that we have a corner solution, that is typical of a

linear utility function (or any monotonic transformation):

u (x1 , x2 ) = x1 + x2

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Solution

Finally, we must obtain the expenditure function, so a measure of

how much the consumer should spend in order to reach a certain
level of utility, given the goods' prices.
Our consumer spends:
xi pi

where i denotes the good with the lowest price.

But the quantity of the good i is equal to m /pi that is also the
amount of utility reached.
In other words:

e (p1 , p2 , u ) = u min {p1 , p2 } .

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Outline

1 Utility Maximization
Exercise 7.1
Exercise 7.2
Exercise 7.3
Exercise 7.4
Exercise 7.5

2 Choice
Exercise 8.5
Exercise 8.6
Exercise 8.7
Exercise

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Exercise 7.4

Consider the indirect utility function given by

m
v (p1 , p2 , m) = .
p1 + p2

(a) What are the demand functions? (b) What is the expenditure
function? (c) What is the direct utility function?

The standard way to obtain the (Marshallian) demand functions

given the indirect utility function is by using the Roy's identity:

Roy's identity

v (p ,m)
pi
xi (p , m) =
v (p ,m)
m
Tramontana Exercises Micro
 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Solution

So we need to calculate the partial derivatives of the indirect utility

function with respect to prices and income:

v
p1 = pv = (p
2 1
m
+p2 )2
v
m = p +1 p
1 2

and by using the Roy's identity we obtain:

m
x1 (m, p ) = x2 (m, p ) =
p1 + p2

so the goods are equally consumed.

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Solution

The expenditure function e (p , u ) gives the information about how

much it costs to obtain a certain level of utility given the market
prices.
Costs substained by the consumer are generally of the following
form:
c = x1 p1 + x2 p2
We can use the demand functions to obtain:

m m
c = p1 + p2
p1 + p2 p1 + p2

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Solution

m
We know that the level of utility rechaed is exactly u = p1 +p2 , so
we have:

e (p1 , p2 , u ) = (p1 + p2 )u

The direct utility function relates the level of utility with the
amount of goods consumed: u (x1 , x2 ).
We know that the consumer buys the same amount of the two
goods:
m
x1 = x2 =
p1 + p2

that also corresponds to the level of utility reached, given the

indirect utility function.

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Solution

In other words we can write down:

u (x1 , x2 ) = min {x1 , x2 } .

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Outline

1 Utility Maximization
Exercise 7.1
Exercise 7.2
Exercise 7.3
Exercise 7.4
Exercise 7.5

2 Choice
Exercise 8.5
Exercise 8.6
Exercise 8.7
Exercise

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Exercise 7.5

A consumer has a direct utility function of the form

U (x1 , x2 ) = u (x1 ) + x2 .

Good 1 is a discrete good; the only possible levels of consumption

of good 1 are x1 =0 and x1 = 1.
For convenience, assume that u (0) = 0 and p2 = 1.
(a) What kind of preferences does this consumer have?

These preferences are called quasi-linear, because they are

additive and linear in at least one good.

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Exercise 7.5(b)

(b) The consumer will denitely choose x1 =1 if p1 is strictly less

than what?

In order to answer to this question, let us consider the maximum

utility that can be reached with x1 =0 and with x1 = 1.
If the consumer only consumes the good 2, given that its price is
equal to 1 and given that (from the utility function) there is 1-1
correspondence between level of utility and amount of good 2, we
have:
u |x =0 =m
1

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Solution

On the other hand, one unit of good 1 gives to the consumer an

utility of u (1).
The consumer now can only buy an amount equal to m p1 of the,
that is also the value of the utility brought by good 2.
So we have:
u |x =1 = u (1) + m p1
1

Now, in order to make the consumer preferer the situation with one
unity of good 1, this condition must be realized:

u |x =0 < u |x =1
1 1

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Solution

That is:

p1 < u (1).

Tramontana Exercises Micro

 Exercise 7.1
Exercise 7.2
Utility Maximization
Exercise 7.3
Choice
Exercise 7.4
Exercise 7.5

Exercise 7.5(c)

(c) What is the algebraic form of the indirect utility function

associated with this direct utility function?

It is a consequence of the previous point that the utility reached

will be the higher between the two considered, that is:

v (p1 , p2 , m) = max {m p1 + u (1), m} .

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Outline

1 Utility Maximization
Exercise 7.1
Exercise 7.2
Exercise 7.3
Exercise 7.4
Exercise 7.5

2 Choice
Exercise 8.5
Exercise 8.6
Exercise 8.7
Exercise

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Exercise 8.5

Find the demand bundle for a consumer whose utility function is

3

u (x1 , x2 ) = x12 x2 and her budget constraint is 3x1 + 4x2 = 100.

The Lagrangian function for this optimization problem is the

following:
3

L (x , ) = x1 x2 (3x1 + 4x2 100)

2

But it is more useful to see the utility function in logaritmic form

3
L (x , ) = ln x1 + ln x2 (3x1 + 4x2 100)
2

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Solution

The rst order conditions are obtained by dierentiating the

Lagrangian function with respect to x1 , x2 and . These derivatives
are equal to zero for the optimum bundle values:

3
3 = 0
2x1
1
x
4 = 0
2

3x1 + 4x2 100 = 0

The rst two equation can be seen as:

1
= 2x1
1
= 4x2

from which we obtain:

x1 = 2x2
Tramontana Exercises Micro
 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Solution

By substituting x1 = 2x2 in the third f.o.c. we get:

6x2 + 4x2 = 100

x2 = 10

and then:

x1 x2 = 10; = 1
= 20; 40

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Outline

1 Utility Maximization
Exercise 7.1
Exercise 7.2
Exercise 7.3
Exercise 7.4
Exercise 7.5

2 Choice
Exercise 8.5
Exercise 8.6
Exercise 8.7
Exercise

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Exercise 8.6

1 1

Use the utility function u (x1 , x2 ) = x1 x2 and the budget constraint

2 3

m = p1 x1 + p2 x2 to calculate x (p , m), v (p , m), h(p , u ) and e (p , u ).

The Lagrangian function is the following:

1 1

L (x , ) = x1 x2 (p1 x1 + p2 x2 m)
2 3

while the f.o.c. are:

1 21 1

2
x1 x23 = p1
1
1 23
3
x12 x2 = p2
p1 x1 + p1 x2 =m

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Solution

by following a procedure similar to the one followed in the previous

exercise we obtain the Marshallian demand functions:

3 m
x1 (p , m) = 5 p1
2 m
x2 (p , m) = 5 p2

The indirect utility function can be obtained if we put the

Marshallian demand functions into the utility function:

1 1 1 1
5
    m    
3 m 2
2 m 3
6 3 2
2 3

v (p , m ) = =
5 p1 5 p2 5 p1 p2

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Solution

It is now simple to obtain the expenditure function.

It is sucient to take the indirect utility function and replace
 v (p , m ) with  u  and  m  with  e (p , u ):

 5
   1  1

e (p , u ) 6
3 2
2 3

u =
5 p1 p2

and solve it for e (p , u ):

3
p  p  2
1 5 2 5 6
e (p , u ) = 5 u5
3 2

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Solution

One of the properties of the expenditure function is the following:

Property of e (p , u )

If h (p , u ) is the expenditure-minimizing bundle necessary to achieve

utility level u at prices p (Hicksian demand), then

e (p , u )
hi (p , u ) = for i = 1, ..., k
pi

so we need to calculate the partial derivatives of the expenditure

function, obtaining:

2 2
e (p ,u ) p1 p2

6
h1 (p , u ) = p1 = 3
5
2
5
u5
e (p ,u ) 3
3
6
.
p1 p2


h2 (p , u ) = p2 = 3
5
2
5
u5

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Outline

1 Utility Maximization
Exercise 7.1
Exercise 7.2
Exercise 7.3
Exercise 7.4
Exercise 7.5

2 Choice
Exercise 8.5
Exercise 8.6
Exercise 8.7
Exercise

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Exercise 8.7

Extend the previous exercise to the case where

u (x1 , x2 ) = (x1 1 )1 (x2 2 )2 andcheck the symmetry of the
hj (p ,u )
matrix of substitution terms .
pi

An alternative way to solve this problem consists in considering the

expenditure minimization problem, whose Lagrangian is:
h i
L (x , ) = p1 x1 + p2 x2 (x1 1 ) (x2 2 ) u
1 2

from which we can derive the f.o.c.:

p1 = 1 (x1 1 ) 1 (x2 2 )
1 2

p2 = 2 (x1 1 ) (x2 2 ) 1
1 2

(x1 1 ) (x2 2 ) = u
1 2

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Solution

If we divide the rst equation by the second we obtain:

p1 2 x2 2
=
p2 1 x1 1

The term x2 2 can be obtained from the third equation:

h i 1

= (x1 1 ) u
2
x2 2 1

We can substitute it in the ratio between the rst two equations

and solve it for x1 , obtaining the Hicksian demand:

  2
p2 1 1 1 +2
h1 (p , u ) = 1 + u 2
p1 2

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Solution

The other demand is:

  1
p1 2 1 1 +2
h2 (p , u ) = 2 + u 1
p2 1

The symmetry of the substitution matrix is proved by showing that:

" 1
    # 1 +2
h1 (p , u ) h2 (p , u ) u 1 2 2 1

= =
p2 p1 1 + 2 p1 p2

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Solution

The expenditure function is obtained by using the Hicksian

demands in p1 x1 + p2 x2 :

2
1

   
p2 1 1 1 +2 p1 2 1 1 +2
e (p , u ) = p1 1 + u 2 + p2 2 + u 1
p1 2 p2 1

The following step consists in substituting  e (p , u ) with  m  and

 u  with  v (p , m ) in the expenditure function and solve it for
v (p , m) to obtain the indirect utility function:

     
1 m 2 p2 1
2 m 1 p1 2

v (p , m ) = 1 2
1 + 2 p1 1 + 2 p2

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Solution

Finally, we can use Roy's law to get the Marshallian demands:

 
x1 (p , m) = +
1 2
1
1 2 + 2 m
p
1 p1

2
  .
1 m 2 p2
x2 (p , m) = + 2 1 + 1 p
1 2 1

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Outline

1 Utility Maximization
Exercise 7.1
Exercise 7.2
Exercise 7.3
Exercise 7.4
Exercise 7.5

2 Choice
Exercise 8.5
Exercise 8.6
Exercise 8.7
Exercise

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Exercise (not from Varian)

Let there be two commodities, x1 and a composite commodity

called money M . assume a utility function

U = log(x1 ) + M

and income level Y . The price of x1 is p1 and the price of M is 1.

(a) Derive the Marshallian demand function for x1 .

We can write down the constrained maximization problem:

(
maxU = log(x1 ) + M
,
x1 M

s .t . Y = M + p1 x1

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Solution

The Lagrangian is the following:

L (x1 , M , ) = log(x1 ) + M (M + p1 x1 Y )

The f.o.c. are:

L


x1 = x p1 = 0
1
L
M = = 0
L

= Y M p1 x1 = 0

from the rse f.o.c. we have that:

x1 =
p1

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Solution

from the second we have that = , so:

x1 = .
p1

Note that the demand for the good 1 is independent of income (has
zero income elasticity).

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Exercise (b)

(b) Derive the Hicksian demand curve for x1 .

To answer to this question it is better to write down the

constrained minimization problem:

(
min M + p1 x1
,
x1 M

s .t . u = log(x1 ) + M

The Lagrangian is the following:

L (x1 , M , ) = M + p1 x1 + [ log(x1 ) + M u ]

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Solution

The f.o.c. are:

L


x1 = p1 x = 0 1
L
M = 1 = 0
L
= u log(x1 ) M = 0

from the rst f.o.c. we have that:

x1 =
p1
given that, from the second f.o.c., we know that = 1/ :

x1 =
p1
that is the demand for good 1 is indipendent of the level of utility
reachable.
Tramontana Exercises Micro
 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Exercise (c)

(c) What is the relationship between the Marshallian and the

Hicksian demands?
Is this a general relationship which holds for all utility functions
and, if not, why does it hold in this case?

Marshallian and Hicksian demands are the same;

In the Marshallian demand function, the quantity of good

demand depends upon its price and the income of the
consumer, while in the Hicksian demand function it depends
upon its price and the utility that the consumer wants to reach;

Tramontana Exercises Micro

 Exercise 8.5
Utility Maximization Exercise 8.6
Choice Exercise 8.7
Exercise

Solution

In our case the demand for the good 1 has zero elasticity (that
is, it's independent) both with respect to income and to
respect to utility. It only depends on the parameters and on
the price of the good. This is why the two demands are equal;

Obviously, this cannot be considered a general result, but only

what happens in this peculiar case.

Tramontana Exercises Micro