MIT 14.

04 Intermediate Microeconomic Theory

Fall 2003

Answer keys for problem set 5

Exercise 9.8
In order to determine the indirect utility function v(p, m), you can start to
solve for the indirect money metric function µ(p; q, m).

∂µ
(p; q, m) = ea−bp+cµ(p;q,m)
∂p
µ(q; q, m) = m

The solution to this differential equation with this initial condition is:
1 � c �
µ(p; q, m) = − ln e−cm + (ea−bp − ea−bq )
c b
From µ(p; q, m) = e(p, v(q, m)) and the fact that when m increases v cannot
decrease:
c a−bq
v(q, m) e = − e−cm
b
1 �c �
e(p, u) = − ln ea−bp − u
c b
If you are interested in computing the direct utility function, you need to
solve:

u(x, y) = min v(p, m)

p
px + y = m
c
= min ea−bp − e−c(px+y)
p b

ln x−cy−a
The FOC is p∗ = cx−b and the SOC is b ≥ cx. Hence the direct utility
function is:
b − cx acx−bcx−b
ln x+bcy
u(x, y) = − e
bx

Exercise 9.10
From the budget constraint p1 x1 + x2 = y, you get the demand for good 2:

x2 = y − p1 (10 − p1 )

1
 • Slutsky compensation: original bundle is still affordable

x1 (p, y)(p1 + ∆p1 ) + x2 (p, y) = m + ∆m

Hence the income compensation function is

∆m = (10 − p1 )∆p1

• Hicks compensation: original utility level is achievable

m + ∆m = e(p + ∆p, v(p, m)) = µ(p + ∆p; p, m)

To get the indirect money metric function, you solve

∂µ
(p; q, m) = 10 − p
∂p
Using the initial condition you find:

1 1
µ(p; q, m) = 10p − p2 + m − 10q + q 2

2 2

Hence the income compensation function is

∆m = 10∆p − ∆p(p + ∆p)

2

Exercise 10.2
With the utility function min(x, y), Ellsworth will consume the same quanti-
m
ties of the two goods. His indirect utility is v(1, p2 , m) = 1+p2
.

v(1, 1, 150) = 75
v(1, 2, 150) = 50
v(1, 1, 150 − A) = 50 hence A = 50
v(1, 2, 150 + B) = 75 hence B = 75