API-111 / Economics 2020a / HBS 4010

Fall 2008
Solution for Problem Set 1

1. Putting a Price on Art

(a) Under alternative 2, it is possible to attend 6 shows at a cost of 90, but instead
citizens choose 4 shows at a cost of 80. Therefore, (4, 80) is (weakly) preferred to (6,
90) which in turn is (strictly) preferred to (6, 100). The conclusion that (4, 80) is
preferred to (6, 100) requires both transitivity and the Weak Axiom of Revealed
Preference.

Under alternative 3, it is possible to attend 4 shows at a cost of 80, but instead citizens
choose 3 shows at a cost of 70. Therefore, (3, 70) is weakly preferred to (4, 80). By
transitivity, (3, 70) is strictly preferred to (6, 100).

Under alternative 4, it is possible to attend 3 shows at a cost of 65, but instead citizens
choose 2 shows at a cost of 50. Therefore, (2, 50) is weakly preferred to (3, 65) and
strictly preferred to (3, 70), (4, 80), and (6, 100).

The best of these choices is alternative 4 because its outcome (2, 50) is strictly
preferred to the most preferred outcomes under each other alternative.

(b) With a ticket price of 20 and no tax, it is possible to attend 2 shows at a cost of 40.
Since (2, 40) is strictly preferred to (2, 50) and (2, 50) is strictly preferred to the
choices for alternatives 1 through 3, the new plan is better for citizens than any of the
original alternatives. Although (6, 100) is not available under the new plan, it is clear
by inference from the other alternatives that the citizens would prefer the new plan to
alternative 1.

2. Revealed Preference and Compensated Demand

(a) Suppose that the new bundle chosen by the consumer is (x*, y*). The Law of
Compensated Demand says that (x* - 5)(8 – 10) + (y* - 5)(12 – 10) < 0 for the first
case where prices change to p1 = 8 and p2 = 12 and wealth stays at 100. This
simplifies to the equation 2 (y* - 5) – 2(x* - 5) < 0, or x* > y*. The original bundle
(5, 5) is still available under these conditions. So, the Law of Compensated Demand
rules out all bundles with x* < 5.

The Law of Compensated Demand says that (x* - 5)(16 – 10) + (y* - 5)(24 – 10) < 0
for the first case where prices change to p1 = 16 and p2 = 24 and wealth increases to
200. This simplifies to the equation 6x* + 14y* - 100 < 0. The budget constraint is
given by 16 x* + 24 y* = 200 since the consumer spends all money on goods.
Rearranging terms to isolate y*, we find y* = 25 / 3 – 2x* / 3. Substituting back into
the inequality, we find

6 x* - 14 (2/3) x* + 14 * 25 / 3 – 100 < 0,

which simplifies to x* > 5. Once again, the Law of Compensated Demand rules out
all bundles with x* < 5.

(b) In both cases, the Weak Axiom of Revealed Preference rules out bundles other
than (5, 5) that could have been chosen under the original conditions since (5, 5) is
available under both of the new conditions.

Note that the budget constraint under both sets of conditions is the same since prices
and wealth are just doubled from the first set of conditions to the second: 8 x* + 12
y* < 100.

A graphical argument shows that all alternatives with x* < 5 are ruled out by WARP
for the new conditions.

(c) Let (x*, y*, z*) be the bundle chosen under the new conditions. By the Law of
Compensated Demand,

(x*-5)(8 – 10) + (y* - 10) (10 – 10) + (z* - 10) (12 – 10) < 0,

which simplifies to x* > z*.

But it is possible for demand for any individual good to increase or decrease. For
example, the bundle (2, 13.4, 0) satisfies this inequality with demand for good 1
falling despite its drop in price, while demand for good 2 increases and demand for
good 3 falls. Similarly, the bundle (11, 0, 31/6) satisfies this inequality with demand
for goods 1 and 3 increasing while demand for good 2 falls.

Note that (2, 13.4, 0) and (11, 0, 31/6) were not available at the original prices, so
WARP does not rule out the possibility of choosing either of them over (5, 5, 5), the
bundle selected at the original prices.

While we cannot conclude that demand for any one particular good must increase or
fall, we can rule out some combinations of changes. If demand for good 3 rises, then
demand for good 1 must rise even more, while if demand for good 1 falls, then
demand for good 3 must fall even more. It seems natural that demand for good 1
would rise and demand for good 3 would fall, but this need not happen.
3. Who Cares if the Budget Set is Convex?

(a) With x1 > x2, (x1, x2) is equivalent in preference to (z, z), where z = x1 - 2(x1- x2)/ 3.
Similarly, (x1’, x2’) is equivalent in preference to (z’, z’), where z’ = x2’ - 2 (x2’ – x1’)
/ 3.

Bundle 1 is strictly preferred to bundle 2 if z > z’, which occurs if

x1 - 2 (x1- x2) / 3 > x1’ - 2 (x1’ – x2’) / 3
or x1 + 2 x2 > x1’ + 2 x2’

That is, to determine the consumer’s preference for the bundles, we can simply
compare x1 + 2 x2 to y1 + 2y2.

(b) Omitted. The slope of the indifference curves is –2 for x1 < x2, and – 1/2 for x1 > x2.

(c) At these prices, the consumer can adjust the levels of goods 1 and 2 at a one-for-
one rate. Since the consumer is penalized, in effect, for consuming different levels of
these goods then the preferred point in the budget set is the one that consumes both
equally and at the maximum level – that is, (5, 5).

(d) The most preferred bundle would start at (0, 0) for wealth 0 and then increase
consumption of each good equally as wealth increases. For wealth W, the consumer
would spend W / 2 on each good and the bundle (W / 10, W / 10) would be the most
preferred choice in the budget set.

(e) The budget set is non-convex as soon as the consumer can take advantage of the
quantity discount – that is, for W > 100. For example, if W = 200, the consumer
could purchase (70, 0) devoting the entire budget to good 1 or (0, 40) devoting the
entire budget to good 2. The convex combination that averages these two bundles,
(35, 20) is not in the budget set (this would cost 130 for good 1 and 100 for good 2),
so the budget set is non-convex.

(f) Let option 1 be spending all money on good 1, and option 2 be equal consumption.
We consider three different situations: 0<W<100, 100≤W<200, and W≥200.
When 0<W<100, the bundle under option 1 is (W/5, 0)~(W/15, W/15)<(W/10,
W/10), where “~” denotes the equivalence in utility. So, when 0<W<100, the
consumer always prefer the equal consumption bundle.

When 100≤W<200, the bundle under option 1 is

(20+(W-100)/2, 0) ~ ((W-60)/6, (W-60)/6).
Compare with (W/10, W/10), we find that the consumer prefers option 2 if and only if
W<150.
Similarly, we find that for all W>150, the consumer prefers option 1 to equal
consumption bundle.

(g) The equal consumption bundle is (W/10, W/10)

We know that x1 - 2 (x1- x2) / 3 > W/10, by assumption.
Also, for feasible (x1, x2) with x1 > 20 > x2, we know that 100 + 2(x1 - 20) + 5 x2 ≤W,
by budget constraint.
Thus, we could show that (W-60)/6 > x1 - 2 (x1- x2) / 3 , which exactly says that the
consumer prefers spending all money on good 1 to the bundle (x1, x2).

(h) In this utility function, holding prices constant, the consumer is willing to give up
2 units of the more abundant good and increase 1 unit of the other good. On the other
hand, when he has enough wealth and purchases more than 20 units of good 1, he gets
a discount on it (from $5 to $2). This implies that when he gives up 1 unit of good 2,
he could actually get 2.5 units of good 1. No matter which good is more abundant, he
always earns extra utility under this tradeoff. So, he is willing to switch to good 1
when he has enough wealth.

4. Preference Representations (Easy)

(a) These are lines with slope -1 (omitted).

(b) U (x1, x2) = (x1+ x2)/2.

(c) Can be easily checked. Omitted.

(d) V (x1, x2) = (x1+ x2)/3.

(e) Can be easily checked. Omitted.

(f) f (x) = 2x/3

5. Who Cares, Part Two (Medium Difficulty)

(a) Omitted.
(b) If α = 0, U(x1, x2) = max (x1, x2). If α = 1, U(x1, x2) = min (x1, x2). If α = 1/2,
U(x1, x2) = (x1 + x2) / 2. If α = 0, the consumer wants to specialize to one good or to
the other. If α = 1, the consumer must purchase both goods in tandem to
benefit from them. If α = 1/2, the goods are interchangeable, regardless of
how much the consumer has purchased of either good.

(c) For α < 1/2, the consumer places more value on the higher of the two quantities
for the two goods. For α > 1/2, the opposite is true. This means that for α < 1/2,
the consumer will always consume just one good. For α > 1/2, the consumer may
consume just one good, but might also consume an equal amount of both goods.

(For (d) and (e), see full analysis in (f), which contains (d) and (e) as specific cases. )

(f) Suppose that p1 < p2 (the same general analysis holds for the opposite case).
The consumer chooses bundle (x1, x2), where we must have x1 ≥x2 (otherwise, she
would choose the opposite bundle with less cost but the same utility).
Now, we have W= p1x1 + p2 x2 (*).
The bundle (x1, x2) ~ (x1 - α (x1 - x2), x1 - α (x1 - x2)); so we need to choose (x1, x2)
to maximize x1 - α (x1 - x2).

Using equation (*), we get

x1 - α (x1 - x2) = (1+α )x1 + α x2 = [(1-α ) p2 +-α p1] x1/ p2.
Looking at the sign of (1-α ) p2 +-α p1, we get to the conclusion that it is preferable
to consume only good 1 if α < p2 / (p1 + p2), otherwise, it is preferable to choose
equal consumption.