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ECONOMICS 8451–MICROECONOMIC THEORY 3
Lecture 1: Introduction
Recall the circular flow of income:
Figure 1.1: The Circular Flow of Income
Basic microeconomics develops theories of the product and factor markets. A good theory has three
properties:
1. As simple as possible
2. Generates refutable hypotheses–i.e., has predictive power
3. NOT about “truth” in some metaphysical sense
Our basic behavioral postulate is:
“Rational actors make choices that maximize their objective.”
• These actors are usually either consumers or producers
• They may or may not be perfectly informed
• They may or may not be perfect competitors (price-takers)

4 LECTURE 1: INTRODUCTION
This leads immediately into the mathematical theory of maximization:
• objective is f(x, p) (e.g., utility, profit)
• x is a vector of choice variables (e.g., quantities to consume, factor inputs to production)
• p is a vector of parameters (e.g., prices, income)
• g(x, p) = 0 is a constraint (this is the general form, examples of which are budget constraints or
production feasibility)
There are two results from this maximization:
• The optimal choices x∗ (p) (e.g., demands, supplies)
• The optimal value f ∗ (p) = f(x∗ (p), p) (e.g., indirect utility, cost, or profit)
We ask:
“What does the fact that x∗ (p) and f ∗ (p) are consequences of optimization imply about these functions?”
The answers are the refutable hypotheses from a theory of optimizing behavior.
We find x∗ (p) by setting up a Lagrangian function
L(x, λ; p) = f(x, p) − λg(x, p)
and solving the first order conditions (assuming an interior optimum):
Lxi (x, λ; p) = 0, i = 1, . . . , n
Lλ (x, λ; p) = 0
• With explicit functions: solve these equations for x∗ and λ∗ .
• More generally: these equations implicitly define x∗ and λ∗ .
In either case, they are identities that hold for all p (again, assuming an interior optimum):
Lxi (x∗ (p), λ∗ (p); p) ≡ 0, i = 1, . . . , n
Lλ (x∗ (p), λ∗ (p); p) ≡ 0
At the maximum, g(x∗ (p), p) ≡ 0. So
L(x∗ (p), λ∗ (p); p) ≡ f(x∗ (p), p) ≡ f ∗ (p)
and we can differentiate this identity to find how the optimal value f ∗ varies with pj :

n
∂x∗i ∂λ∗
fp∗j (p) = Lxi (x∗ (p), λ∗ (p); p) + Lλ (x∗ (p), λ∗ (p); p) + Lpj (x∗ (p), λ∗ (p); p)
∂pj ∂pj
i=1
= Lpj (x∗ (p), λ∗ (p); p)
This result is known as the envelope theorem. It potentially yields refutable hypotheses about f ∗ .
We can differentiate again to obtain refutable hypotheses about x∗ :

n
∂x∗i ∂λ∗
fp∗j pk (p) = Lpj xi + Lpj λ + Lpj pk
∂pk ∂pk
i=1
There is potentially interesting information here about how x∗i changes with pk –a refutable hypothesis. Three
facts usually help us extract this information from this equation:
1. Concavity of the function f ∗ − L in p: this gives the sign of fp∗j pj − Lpj pj , so the remaining part of the
∂x∗
equation has a known sign when j = k, and hence maybe i
∂pk does too. Such results become the “laws”
of supply and demand.
2. Equality of mixed second derivatives of f ∗ − L: this gives equality of the two remaining parts of the
∂x∗
two equations when the order of differentiation is reversed, and hence maybe some ∂pk ’s
i
are equal. Such
results become the “reciprocity” or “symmetry” results.
3. Presence of many zero second derivatives of L, which simplifies the above expression.
This is the general view. We will repeatedly encounter special cases of it.
6 LECTURE 1: INTRODUCTION
Exercises for Lecture 1 (Introduction)
1. Give a verbal statement of the envelope theorem.

Lecture 2: Technologies
Readings: Chapter 1 of Varian; Sections 5.A and 5.B of MWG.
We begin the study of product markets with the supply side. The actors that supply final products are
called firms. Before considering their objectives, we first consider their constraints. These take the form of
the physical limitations on their ability to transform inputs into outputs. That is, their constraint is the
technical capabilities, or technology, currently at their disposal to use in producing output. To make any
progress, we must place some minimal structure on these “capabilities.” This is an engineering black box for
us–we seek only to describe its essential properties for economic purposes.
Often, we simply write down a production function. But this approach does not make it clear exactly
what we are assuming about technical capabilities, and also does not accommodate multiple outputs. We
can begin with a more primitive concept, called the production set, and then build up to the more convenient
representation in the form of a production function if that is convenient for some purpose.
Suppose there are n goods in the world. Let z ∈ Rn specify an amount of each of the goods. A production
set Z ⊂ Rn specifies the combinations of the n goods that can be produced. That is, Z is the set of all
“feasible” combinations of the goods. The convention is to measure outputs positively and inputs negatively.
So, for example, the vector (2, −1, −3) indicates that one unit of good 2 and three units of good 3 are used
to produce two units of good 1. This notation does not capture intermediate goods that the firm produces
and then uses to produce final outputs. It is only the net use of goods or production of goods that is
represented by a vector z. Hence these vectors are called netput vectors, rather than input-output vectors.
Some examples of production sets are illustrated in Figure 2.1.
The minimal properties we frequently place on a production set Z are:
1. Z is nonempty–something is feasible.
2. Z is closed–this assures existence of optima in some cases.
• Together, items 1 and 2 are what Varian calls “regularity.”
3. There is no free lunch: Z ∩ Rn+ ⊂ {0}.
4. Inaction is always possible: 0 ∈ Z. Note that this makes item 1 redundant and, in conjunction with item
3, implies Z ∩ Rn+ = {0}. When this is violated, we say there is a “sunk” input.
8 LECTURE 2: TECHNOLOGIES
Figure 2.1: Production Sets. In (a), both z1 and z2 can be both inputs and outputs. In
(b), z1 can only be an input, while in (c) z2 can only be an input.
5. There is free disposal: z ∈ Z ⇒ z ∈ Z ∀z ≤ z. This implies Varian’s “monotonicity,” and is an
assumption that has more content than 1-3 (think of radioactive material as an input to electricity
production–can it be disposed of freely?). Free disposal may seem to imply infinite resources, but it
doesn’t. The assumptions here are only about technical ability, not about availability of resources. It is
up to the market to ration potentially scarce inputs by placing positive prices on them.
The examples in Figure 2.1 possess all five of these properties. If the boundary of Z passes to the southwest
of the origin then the possibility of inaction is violated and we have a sunk input. Such an input can be
“partially” sunk as well. A variant of this is a “fixed” input.
Two other properties we sometimes place on a production set Z are:
6. Global returns to scale:
a. nonincreasing: z ∈ Z ⇒ αz ∈ Z ∀α ∈ [0, 1].
b. nondecreasing: z ∈ Z ⇒ αz ∈ Z ∀α ≥ 1.
c. constant: z ∈ Z ⇒ αz ∈ Z ∀α ≥ 0.
7. Convexity: Z is a convex set.
Often we are concerned with technologies that have only one output. This simplest case is our focus in
this class. We can think of Z for this case as being a subset of Rn+1 and for convenience label the first
element of a netput z as the output. Then, for any z we can define y and x by (y, −x) = z, thereby defining a
separate notation for the output y and the n-dimensional input vector −x, and also conveniently measuring
inputs x as positive rather than negative quantities. Z is a single-output technology if (y, −x) ∈ Z ⇒ x ≥ 0.
In the single-output case we can describe a production set Z in two other ways that are sometimes more
convenient:
• Input requirement sets: Let V (y) = {x ∈ Rn+ : (y, −x) ∈ Z} for y ≥ 0. This is the input requirement set
for output level y.
• Production function: Let f(x) = max{y ∈ R1 : (y, −x) ∈ Z} for x ≥ 0. This is the production function
for the technology Z. Its existence relies on this set being nonempty (assured by possibility of inaction
and free disposal since then (0, −x) ∈ Z, but just Z ⊃ Rn+1
− is enough), closed (assured by Z closed), and
bounded (assured by convexity of Z–see the exercises following this lecture).
Note that V (y) ⊂ {x ∈ Rn+ : f(x) ≥ y}, by definition. The converse can fail without free disposal.
Free disposal, and the presence or absence of fixed or sunk inputs, can be conveniently illustrated in terms
of both input requirement sets and production functions.
Occasionally we make use of an additional assumption for the single-output case:
8. Lower hemicontinuity:
a. Lower hemicontinuity in inputs: If (y0 , −x0 ) ∈ Z and xi → x0 then there exists yi → y0 such that
(yi , −xi ) ∈ Z. This rules out production sets like this:

Figure 2.2: A production set that violates lower hemicontinuity in inputs
This property implies that the production function is lower semicontinuous (see the exercises following
this lecture).
b. Lower hemicontinuity in output: If (y0 , −x0 ) ∈ Z and yi → y0 then there exists xi → x0 such that
(yi , −xi ) ∈ Z. This rules out production sets like this:
Figure 2.3: A production set that violates lower hemicontinuity in output

Let f be the production function for a single-output technology Z. The isoquant for output level y is
then defined as {x ∈ Rn+ : f(x) = y}. It is all input vectors that are capable of producing the output level y,
but no more. None of our assumptions rule out the possibility that an isoquant is “thick,” but free disposal
implies that the boundaries of an isoquant cannot slope upward.
Isoquants can be conveniently illustrated on a graph of input requirement sets.
If f is strictly increasing, the isoquants have no thickness and the equation f(x) = y implicitly defines
any one component of x, say xi , as a function of the other components, so we can think of the isoquant for
output level y as this implicit function. In this case, if f is also differentiable then the slope of the implicit
function with respect to some other component is
∂xi (x−i ) fj (x)

=− < 0.
∂xj fi (x)
This slope is called the marginal rate of technical substitution of input i for input j (MRTSij ), since it gives
the rate at which it is technically possible to substitute input i for input j while maintaining constant output.
Convexity implies that the MRTS is nondecreasing in x−i .

Exercises for Lecture 2 (Technologies)
1. Determine whether each of these technologies satisfies: i) no free lunch, ii) possibility of inaction, iii) free
disposal, iv) convexity (Assume V (0) = R2+ in (e)):

In (e) and (f) the figures show the typical shape of input requirement sets.
2. Give a geometric example of a single-output production set Z that is closed and satisfies no free lunch,
free disposal, and possibility of inaction; yet the corresponding production function can take on infinite
values. Prove that convexity solves this problem.
3. Assume a single-output production set Z is closed and satisfies no free lunch, free disposal, and possibility
of inaction. Prove the following properties of the corresponding production function f:
i. f(0) = 0.
ii. f is nondecreasing.
iii. For any x, f(αx) ≥ αf(x) ∀α ∈ [0, 1] when Z has nonincreasing returns to scale.
iv. For any x, f(αx) ≥ αf(x) ∀α ≥ 1 when Z has nondecreasing returns to scale.
v. For any x, f(αx) = αf(x) ∀α ≥ 0 when Z has constant returns to scale.
vi. A function f is called quasiconcave if, for any two points x and x in its domain, the following property
holds:
f(λx + (1 − λ)x ) ≥ min{f(x), f(x )} ∀λ ∈ (0, 1).
Show that the production function f is quasiconcave if and only if V (y) is convex for every y.
vii. A function f is called upper semicontinuous at a point x0 if the function is not much larger than f(x0 )
for x near x0 . Formally, for every δ > 0 we require an > 0 such that x − x0 < ⇒ f(x) < f(x0 ) + δ.
Similarly, a function f is lower semicontinuous at x0 if the function is not much smaller than f(x0 ) for
x near x0 . That is, for every δ > 0 we require an > 0 such that x − x0 < ⇒ f(x) > f(x0 ) − δ.
Together, upper and lower semicontinuity are equivalent to continuity. Also, upper semicontinuity is
equivalent to {x : f(x) ≥ y} being a closed set for every y, and lower semicontinuity is equivalent to
{x : f(x) ≤ y} being a closed set for every y.
a. Show that f is upper semicontinuous.
b. Assume that Z satisfies lower hemicontinuity in output. Show that f is lower semicontinuous (This is
difficult–the important thing is to know that production functions are lower semicontinuous when Z has
this property).
4. Four common production functions for single-output technologies with two inputs are:
a. Cobb-Douglas: f(x1 , x2) = Axα 1 α2

1 x2 , where A, α1, α2 > 0.
b. Leontief (fixed input proportions): f(x1 , x2 ) = min{a1 x1 , a2 x2 }, where a1 , a2 > 0.
c. Perfect substitutes: f(x1 , x2 ) = a1 x1 + a2 x2 , where a1 , a2 > 0.
d. Constant Elasticity of Substitution (CES): f(x1 , x2) = [a1 xρ1 + a2 xρ2 ]/ρ , where ρ ≤ 1 (ρ = 0) and
a1 , a2 , > 0.
For each of these, give the corresponding production set Z, input requirement sets V (y), isoquants, and
MRTS. Sketch a typical isoquant for each production function. For the CES production function, what
happens to the isoquants as ρ approaches 1? What happens as ρ approaches 0? What happens as ρ
approaches −∞?

5. Let f(x1 , x2) = (a1 xρ1 +a2 xρ2 ) ρ . For what values of does this have constant returns to scale, nondecreasing
returns to scale, nonincreasing returns to scale? Why?

Lecture 3: Profit Maximization: Setup, Calculus, and Traditional Comparative Statics
Readings: Chapter 2 of Varian; pp. 135-139 of MWG.
Now we continue with the supply side of product markets by adding an objective to the firm’s technological
constraint. We begin with the behavioral postulate that firms choose a netput vector to maximize profit,
subject to technical feasibility of the netput vector. We will also assume for now that the firm is a perfect
competitor.
Hence, let Z be the firm’s technology. Assume it satisfies properties 1-5. Since there are n goods, a
nonnegative n-dimensional vector p can represent the prices for the n goods. Then the profit generated by
a netput z is just π(z; p) = p · z, and hence the firm’s problem is
max p · z subject to z ∈ Z.
{z}
Note the role of the sign convention on inputs and outputs here. Inputs are measured negatively, and so
contribute negatively to the profit expression, while outputs are measured positively and thus contribute
positively to profit. The choice variables are z and the parameters are p. This leads to an optimal choice
z ∗ (p) and an optimal value π ∗ (p), which in this context are the net supply/demand function and profit
function, respectively, of the firm.
In the two dimensional case, the maximization can be illustrated as in Figure 3.1. The firm’s objective is
to choose that value of z that places it on the highest isoprofit line while still staying in the production set
Z.
With one output, the firm’s problem is equivalently written
max (p, w) · (y, −x) subject to x ∈ V (y),

{(y,x)}
where we have partitioned the price and netput vectors into their corresponding output and input compo-
nents. We will henceforth assume for notational convenience that x and w are n-dimensional (so there are
really n + 1 goods in the world). If the output price is positive, this is equivalent to
max π(x; p, w) = pf(x) − w · x subject to x ≥ 0,

{x}
16 LECTURE 3: PROFIT MAXIMIZATION (BASICS)
Figure 3.1: Profit Maximization. The intercept of the isoprofit line is optimal profit in
units of good 2.
since for any given x, no choice of y that is less than f(x) can be optimal. Note that this way of incorporating
the constraint into the profit maximization problem only depends on free disposal to ensure that f is defined
on Rn+ . It suffices to assume Z ⊃ Rn+1

− instead.
The optimal choices for the single-output case are z ∗ (p, w) = (y∗ (p, w), −x∗(p, w)). We call y∗ (p, w) the
output supply and x∗ (p, w) the input or factor demand.
If we further assume that f is differentiable, then calculus can be used to describe the maximum. The
first order conditions are:
pfi (x∗ ) ≡ wi for i = 1, . . . , n,
which just says that the MRP must equal the wage for every input. Dividing any two of these yields
fi (x∗ ) wi
= ,
fj (x∗ ) wj
which is the familiar condition that the MRTS between any two inputs must equal their price ratio (slope
of the isocost line) at the firm’s optimal choice. That is, the firm must choose its inputs so that its isoquant
is tangent to its isocost.
These first order conditions are the basis for our investigation of how the optimal choices x∗(p, w) and
y∗ (p, w) = f(x∗ (p, w)) change when a price changes. These responses are of primary interest to economists
because they tell the shape of the input demand and output supply functions of the firm. The jargon for
this type of exercise is comparative statics. Since the first order conditions are identities when evaluated at
x∗ , we can differentiate them with respect to a price to obtain:

n
∂x∗i
p f1i (x∗ ) = 0 or 1
∂wj
i=1
..
.

n
∂x∗i
p fni (x∗ ) = 0 or 1.
i=1
∂wj
Organizing these equations into matrices yields:

 
   ∂x∗1  0
pf11 (x∗ ) ... pf1n (x∗)  .. 
 
∂wj
  .
.. .. 
  ... = 
← j th line.
 . . 
 .
1

pfn1 (x∗ ) . . . pfnn (x∗) ∂x∗ n  .. 
∂wj
0
By Cramer’s Rule:
pf11 (x∗ ) . . . 0 . . . pf1n (x∗ )

.. .. ..
. . .

.. ..
. 1 .
. . .
.. .. ..

∗
∂xi pfn1 (x ) . . . 0 . . . pfnn (x )
∗ ∗
= ,
∂wj pf11 (x∗ ) . . . pf1n (x∗ )

.. ..
. .

pfn1 (x∗ ) . . . pfnn (x∗ )
where the 1 appears in the j th row and ith column of the numerator.
The matrices involved in these derivatives are composed of second derivatives of the objective function π
with respect to the choice variables x. Hence, if the maximum is a proper interior maximum then second order
conditions convey some information about the signs of various pieces. Briefly, the second order conditions
for a proper interior unconstrained optimization of a function π(x) are as follows. The Hessian Matrix of π
is the matrix of second derivatives:

 ∂2π ∂2π 
∂x1∂x1 ... ∂x1∂xn
 .. .. 
Hπ(x) =  . . .
∂2π ∂2π
∂xn ∂x1
... ∂xn ∂xn
A principal submatrix of Hπ(x) is any matrix obtained from Hπ(x) by deleting any number of rows and the
same columns. The order of a principal submatrix is just the size of the submatrix. For example, if 2 rows
and columns are deleted then the order is n−2. The determinant of a principal submatrix is called a principal
minor of H, with order the same as the principal submatrix. The principal minors obtained by deleting the
last row and column, and then the last two rows and columns, and then the last 3 rows and columns, until
only the (1, 1) element is left, are called the naturally ordered principal minors. The sufficient second order
conditions for an unconstrained maximum are that the sign of all principal minors of Hπ(x) of order k be
(−1)k , for k = 1, . . . , n. So, for example, the diagonal elements of Hπ(x) must be negative and |Hπ(x) | must
have sign (−1)n . It can be shown that an equivalent condition is that only the naturally ordered principal
minors of order k have sign (−1)k . Since many fewer determinants are involved, this latter condition is
convenient for checking second order conditions in any particular problem. However, the knowledge that all
principal minors have a known sign at a proper interior maximum is useful for performing comparative statics
and so we state the second order conditions in terms of all principal minors. These conditions are really just
an algebraic way of checking that the objective function π is strictly concave in the choice variables x, for
which the matrix Hπ(x) must be negative definite, meaning that a Hπ(x) a < 0 for every conformable vector
a = 0. Similarly, the sufficient second order conditions for an unconstrained minimum are that all principal
minors of Hπ(x) be positive regardless of order. An equivalent condition is that all naturally ordered principal
minors be positive. This is just an algebraic way of assuring that the objective function π is strictly convex
in the choice variables x, for which the matrix Hπ(x) must be positive definite, meaning that a Hπ(x) a > 0
for every conformable vector a = 0.
Returning to the profit maximization problem, the objective function is π(x; p, w) = pf(x) − w · x, so the
Hessian is  
pf11 (x∗ ) ... pf1n (x∗ )
 .. .. 
Hπ(x) = . . ,
pfn1 (x∗ ) ... pfnn (x∗ )
∂x∗
which is exactly the matrix in the denominator of our expression for i
∂wj
(NOTE: the Hessian we are
examining here is only with respect to the choice variables). Hence we know the sign of our denominator is
(−1)n , assuming we have a proper interior maximum. For the numerator, let Hji denote the submatrix of
Hπ(x) of order n − 1 that results when row j and column i are deleted. Then, evaluating the numerator by
cofactor expansion yields

∂x∗i (−1)i+j |Hji |
= .
∂wj |Hπ(x) |
What is the sign of |Hji|? In general, we don’t know because Hji is not a principal submatrix. But,
∂x∗
if i = j then it is a principal submatrix and so the minor has sign (−1)n−1 . Hence the sign of i
∂wi is
(−1)i+i (−1)n−1
(−1)n < 0. This is natural: own price effects are negative, while cross-price effects are indeterminate
in general. Hence the law of demand for the input demand of profit-maximizing firms is a direct consequence
of the behavioral postulate, and nothing more. The ambiguous cross-price effects are usually categorized by
comparison with the negative own-price effect. If x∗j moves in the same direction as x∗i when wi changes
∂x∗
j
(i.e., if ∂wi
< 0) then we say inputs i and j are gross complements in production. If the two inputs move in
∂x∗
j
opposite directions (i.e., if ∂wi > 0) then we say inputs i and j are gross substitutes in production.
These methods can be used to study the effect of a change in the output price p on x∗ , and also to study
the effects of changes in p and w on y∗ , by noting that

n
dy∗ = fi (x∗ (p, w))dx∗i .
i=1
This is pursued further in the exercises and, like the results derived here, only the own-price effect of p on y
∂x∗ ∂x∗
is known in general (it is positive). If ∂p
i
≥ 0 we say input i is normal in production, while if ∂p
i
< 0 we
say input i is inferior in production.
We have proceeded here as if we have a proper interior maximum. There are several cautions that must
be adhered to regarding this:
1. Since x ≥ 0 is required, we can have corner solutions of the form x∗i = 0. Then the first derivative can be
negative: pfi (x∗ ) < wi .
2. Existence is a real issue for the profit maximization problem. With nondecreasing RTS it is possible for
there to be no maximum, depending on the prices. For convenience, we will henceforth assume π ∗ is
defined on p ≥ 0 and w >> 0 when discussing profit functions, but the domain of π ∗ can actually be
something smaller than this.
3. Uniqueness is also a real issue unless the technology is strictly convex.

Exercises for Lecture 3 (Profit Maximization: Basics)
1. Let π be the profit-maximizing function for a firm, p be the output price, (w1 , w2 ) be the input price
vector, and f(x1 , x2 ) = x1 x2 . Describe the input choices this firm makes.
Try the following problems from the books:
2. MWG #5.C.1.
3. MWG #5.C.6(a) and (b).
4. MWG #5.C.9.
5. Varian #2.3.
6. Varian #2.7.
Lecture 4: Profit Maximization: Envelope Properties of π ∗ and y∗ and x∗
In this lecture we continue our study of the properties of a profit maximum, but make use of the envelope
theorem rather than using the somewhat cumbersome traditional comparative statics. The optimal choices
are y∗ (p, w) and x∗ (p, w), and the optimal value of the profit function is
π ∗ (p, w) = pf(x∗ (p, w)) − w · x∗ (p, w), for p ≥ 0 and w >> 0.
These functions have some remarkable properties due solely to the fact that they are the maximizing choices
and maximal value, respectively, of pf(x) − w · x.
Theorem (Hotelling’s Lemma–Relationship between the Profit Function and the Supply/Factor
∂π∗ ∂π∗
Demand). If π ∗ is differentiable at (p, w) (almost assured by convexity) then ∂p
= y∗ (p, w) and ∂wi
=
−x∗i (p, w).
Proof. Differentiate π ∗ (p, w) with respect to p, using the envelope theorem so that this is obtained by
differentiating π and then evaluating at the optimum, to get y∗ (p, w). Likewise, differentiate with respect to
wi to get −x∗i (p, w).
Theorem (Properties of the Profit Function).
1. (Homogeneity) π ∗ is homogeneous of degree 1.
2. (Convexity) π ∗ is convex (and hence continuous at (p, w) >> 0).
3. (Monotonicity) π ∗ is nondecreasing in p and nonincreasing in w.
4. (Nonnegativity) π ∗ ≥ 0 ∀(p, w) and π ∗ (0, w) = 0 ∀w >> 0.
Proof.
1. We will show below that y∗ and x∗ are homogeneous of degree zero. Substitution then yields
π ∗ (λp, λw) = (λp)y∗ (λp, λw) − (λw) · x∗ (λp, λw)
= (λp)y∗ (p, w) − (λw) · x∗ (p, w)
= λπ ∗ (p, w).
22 LECTURE 4: PROFIT MAXIMIZATION (ADVANCED)
2. Fix (p, w) and (p , w ). By definition,
π ∗ (p, w) ≥ pf(x) − w · x ∀x ≥ 0,
π ∗ (p , w ) ≥ p f(x) − w · x ∀x ≥ 0.
Multiply the first of these by λ and the second by (1 − λ) and add to get
λπ ∗ (p, w) + (1 − λ)π ∗ (p , w ) ≥ (λp + (1 − λ)p )f(x) − (λw + (1 − λ)w ) · x ∀x ≥ 0
= π(x; λp + (1 − λ)p , λw + (1 − λ)w ) ∀x ≥ 0,
so the left side is an upper bound of the right side profit objective across all feasible input vectors x.
Hence λπ ∗ (p, w) + (1 − λ)π ∗ (p , w ) ≥ π ∗ (λp + (1 − λ)p , λw + (1 − λ)w ).
3. Select p ≥ p and w ≤ w. By definition,
π ∗ (p , w ) ≥ p f(x) − w · x ≥ pf(x) − w · x ∀x ≥ 0.
Hence, using the upper bound logic again, π ∗ (p , w ) ≥ π ∗ (p, w).
4. By the possibility of inaction, f(0) ≥ 0. Hence π ∗ (p, w) ≥ pf(0)−w · 0 ≥ 0. Also, 0f(x)−w · x ≤ 0 ∀x ≥ 0,
so π ∗ (0, w) ≤ 0. Combining this with π ∗ (p, w) ≥ 0 yields π ∗ (0, w) = 0.
• Note that the convexity of π ∗ implies continuity of π ∗ , at least on (p, w) >> 0.
Theorem (Properties of the Supply and Factor Demand).
1. (Homogeneity) y∗ and x∗ are homogenous of degree 0.
2. (Symmetry and Semidefiniteness) The matrix of slopes

 ∂y ∗ ∂y ∗ ∂y ∗ 
∂p ∂w1
... ∂wn
 ∂x∗1 ∂x∗ ∂x∗ 
 − ∂p − ∂w11 ... − ∂w1n 
 
 .. .. .. .. 
 . . . . 
∂x∗ ∂x∗ ∂x∗
− ∂p
n
− n
∂w1 ... − ∂wnn
is symmetric and positive semidefinite for (p, w) >> 0.
3. (Nonnegativity) py∗ (p, w) − w · x∗ (p, w) ≥ 0 ∀(p, w), (y∗ (0, w), x∗(0, w)) = ((−∞, 0], 0) ∀w >> 0, and
(y∗ , x∗) ≥ 0 ∀(p, w) >> 0.
Proof.
1. λπ(x; p, w) is a monotonic transformation of the objective function π(x; p, w) for λ > 0, and due to
linearity is equal to π(x; λp, λw). Hence y∗ (λp, λw) = y∗ (p, w) and x∗ (λp, λw) = x∗ (p, w).
2. Differentiating Hotelling’s Lemma, this matrix is just the matrix of second derivatives of the profit func-
tion:    
∂y ∗ ∂y ∗ ∂y ∗ ∂ 2 π∗ ∂ 2 π∗ ∂ 2 π∗
∂p ∂w1 ... ∂wn ∂p∂p ∂p∂w1
... ∂p∂wn
 ∂x∗1 ∂x∗ ∂x∗   ∂ 2 π∗ ∂ 2 π∗ ∂ 2 π∗ 
 − ∂p − ∂w11 ... − ∂w1n   ... 
 = ∂w1∂p ∂w1∂w1 ∂w1∂wn .
 .. .. .. ..   .. .. .. .. 
 . . . .   . . . . 
∂x∗ ∂x∗ ∂x∗ 2 ∗ 2 ∗
∂ π∗
2
− ∂p
n
− n
∂w1 ... − n
∂wn
∂ π
∂wn∂p
∂ π
∂wn∂w1
... ∂wn ∂wn
Order invariance of second partial derivatives implies symmetry of this matrix. Convexity of the profit
function implies positive semidefiniteness.
3. py∗ − w · x∗ ≥ 0 and x∗ (0, w) = 0 for w >> 0 are just nonnegativity of the profit function again. Then,
by possibility of inaction, 0 is a feasible value for y∗ (0, w), and by no free lunch no positive value of y is
feasible. Free disposal then yields y∗ (0, w) = (−∞, 0] ∀w >> 0. x∗ ≥ 0 is by assumption that x ≥ 0 for
any (y, −x) ∈ Z (the single-output case). y∗ ≥ 0 is due to π ∗ ≥ 0 since, with strictly positive prices and
nonnegative inputs, profit is strictly negative if y∗ < 0.
• Note, in particular, that cross-price effects on supply/demand are symmetric and that own-price effects
are nonnegative for supply and nonpositive for demand. Hence the comparative statics results we derived in
the previous lecture arise as a consequence of the general properties of the maximum here.
• Second, homogeneity is the mathematical statement of the claim that “only relative prices matter.”
• Third, Euler’s Theorem for the homogeneous of degree zero supply/factor demand yields
∂y∗ (p, w) ∂y∗ (p, w)

n
p + wj =0
∂p ∂wj
j=1
∂x∗i (p, w) n
∂x∗i (p, w)
−p − wj = 0 for i = 1, . . . , n.
∂p ∂wj
j=1
Hence  
∂y ∗ ∂y ∗ ∂y ∗    
∂p ∂w1
... ∂wn p 0

 ∂x∗1 ∂x∗ ∂x∗ 
p  − ∂p − ∂w11 ... − ∂w1n   w1   0 
Hπ∗ (p,w) =   .  =  . ,
w .. .. .. ..   .   .. 
 . . . .  .
∂x∗ ∂x∗ ∂x∗ wn 0
− n
∂p
− n
∂w1
... − ∂wnn
and we see that the Hessian of the profit function with respect to (p, w) is singular, possessing a zero
eigenvalue.
• Note finally that the only property of the technology we really rely on here is that a maximum exists
(related to regularity, but regularity isn’t sufficient), except that nonnegativity relies in addition on the
possibility of inaction and no free lunch. We used free disposal as well for the definition of f on all of Rn+
but this is not essential – we could work directly with the netput vectors instead. Hence, as long as the
maximum exists, the profit function and the supply/demand function have these basic properties, essentially
just because they maximize.

Exercises for Lecture 4 (Profit Maximization: Advanced)
1. Let zi∗ (p, w) be one component of the supply/factor demand vector. Use Euler’s Theorem to obtain

n
ij + ip = 0,
j=1
∂zi∗ wj ∂zi∗ p
where ij = ∂wj zi∗ is the elasticity of zi∗ with respect to wj and ip = ∂p zi∗ is the elasticity of zi∗ with
respect to p. This shows that the price elasticities of any profit-maximizing supply/demand function sum
to zero.
2. Varian #3.1.
3. Varian #3.2.
4. Varian #3.5.
Lecture 5: Cost Minimization: Setup, Calculus, and Traditional Comparative Statics
Now we begin consideration of an alternative behavioral postulate for firms. Sometimes the profit maxi-
mization behavioral postulate is not useful, for example if there is:
• Nondecreasing RTS with π > 0 possible, or
• Imperfect competition in the output market.
In these cases we can still study the implications of cost minimization:
min c(x; w) = w · x subject to (y, −x) ∈ Z,

{x}
for y that is feasible (i.e., V (y) = ∅). If ỹ is feasible then y ∈ [0, ỹ] is feasible, by free disposal. Thus the set
of feasible y’s is an interval of the form [0, ỹ] or [0, ỹ), where ỹ = ∞ is possible. We henceforth denote the
upper endpoint of the interval of feasible y’s by ỹ, and denote the interval by Y .
The constraint can be written in several equivalent forms. First is x ∈ V (y), by definition of V (y).
Or, again using free disposal, the constraint can be written f(x) ≥ y and x ≥ 0 (assuming possibility of
inaction, so that f is defined on Rn+ ). To see that this version is equivalent to the first two, note that
V (y) ⊂ {x ∈ Rn+ : f(x) ≥ y} by definition of f. Conversely, if f(x) ≥ y for some x ≥ 0 then x ∈ V (f(x))
(by regularity) and V (f(x)) ⊂ V (y) by free disposal. Hence {x ∈ Rn+ : f(x) ≥ y} = V (y). Finally, if f is
also continuous and w >> 0 then the constraint can be written without loss of generality as f(x) = y and
x ≥ 0. This last version follows from continuity of f since we already know f(x) ≥ y for any x ∈ V (y), but
if f(x) > y then by continuity there exists x < x (note that x > 0 by no free lunch since f(x) > y ≥ 0) such
that f(x ) > y and w · x < w · x (since w >> 0). Hence if f(x) > y then x cannot minimize w · x subject to
f(x) ≥ y, and therefore nothing is lost by just assuming the constraint is f(x) = y.
The choice variables in the cost minimization problem are x and the parameters are (w, y). The fact that
y is a parameter is what distinguishes this behavioral postulate from the profit maximization behavioral
postulate. Note, however, the following:
Theorem. Every profit maximizing firm also minimizes cost.
So, the cost minimization behavioral postulate is worth studying just as a way of better understanding profit
maximization. The proof is as follows:

28 LECTURE 5: COST MINIMIZATION (BASICS)
Proof. Let (y∗ , x∗ ) be profit-maximizing choices, and suppose cost is not minimized at these choices. Then
there exists x ∈ V (y∗ ) such that w · x < w · x∗ . But then py∗ − w · x > py∗ − w · x∗ = π ∗ while x ∈ V (y∗ ),
which contradicts that (y∗ , x∗ ) maximizes profit.
Cost minimization leads to an optimal choice x∗(w, y) and an optimal value c∗ (w, y), which are the
conditional factor demand function and cost function, respectively, of the firm. Note that this x∗ is different
from the profit-maximizing x∗, in that the former is conditional on y while the latter is not (the latter is
sometimes called an unconditional factor demand).
With two inputs, the minimization can be illustrated as in Figure 5.1. The firm’s objective is to choose
that value of x that places it on the lowest isocost line while still staying in the input requirement set V (y).
Figure 5.1: Cost Minimization
Assuming that f is strictly increasing, and further assuming that f is differentiable, calculus can be used
to describe the minimum. The Lagrangian function is then
L(x, λ; w, y) = w · x − λ(f(x) − y),
so the first order conditions are
wi − λ∗ fi (x∗ ) ≡ 0 for i = 1, . . . , n
−(f(x∗ ) − y) ≡ 0.
Dividing any two of these yields
fi (x∗ ) wi
∗
= ,
fj (x ) wj
which again is the familiar tangency condition that the MRTS between any two inputs must equal their price
ratio (slope of the isocost line) at the firm’s optimal choice. That is, the firm must choose its inputs so that
its isoquant is tangent to its isocost.
These first order conditions are the basis for our investigation of how the optimal choices x∗(w, y) change
when either an input price or the output level changes. These responses tell the shape of the conditional
factor demand functions of the firm. Once again noting that the first order conditions evaluated at the
maximum are identities, we can differentiate with respect to an input price wj to obtain:
∂λ∗ n
∂x∗
− f1 (x∗ ) − λ∗ f1i (x∗ ) i = 0 or − 1
∂wj i=1
∂wj
..
.
∂λ∗ n
∂x∗
− fn (x∗ ) − λ∗ fni (x∗ ) i = 0 or − 1
∂wj ∂wj
i=1
n
∂x∗i
− fi (x∗ ) = 0.
∂wj
i=1
Organizing these equations into matrices yields:
 
0
 .
 . 
∂x∗ 
   . 
1
−λ∗ f11 ... −λ∗ f1n −f1
  0 
∂wj
 .. .. ..  
 ..   
 . . .   .∗  =  
−1  ← j th line.
   ∂xn  
−λ∗ fn1 ... −λ∗ fnn −fn  ∂wj   0 


−f1 ... −fn 0 ∂λ∗  . 
∂wj  .. 
0
Once again, this is just

 
0
 ∂x∗1   .. 
 . 
 .   
∂wj
 .   
0 

 . 
HL(x,λ)  ∂x∗  =  −1  ,
 ∂wnj   0 

∂λ∗  . 
∂wj  .. 
0
so by Cramer’s Rule

−λ∗ f11 ... 0 ... −λ∗ f1n −f1

.. .. .. ..
. . . .
.. .. ..

. −1 . .
.. .. .. ..

. . . .
−λ∗ f 0 . . . −λ∗ fnn −fn
n1 ...
∂x∗i −f ... 0 ... −fn 0
1
= .
∂wj |HL(x,λ)|
Once again, if the minimum is a proper interior minimum then second order conditions will help us sign
this, but we must recall what these conditions are for constrained optimization. The Hessian matrix of
the Lagrangian function L is known as a bordered Hessian. The “border” contains second derivatives of
L with respect to the Lagrangian multiplier λ. If there is more than one constraint then there is more
than one Lagrangian multiplier and hence the “border” has more than one row and column. We can define
principal minors of this matrix in the same way that we do for unconstrained optimization, but the sufficient
second order conditions apply only to border-preserving principal minors, and are affected by the number of
constraints. The sufficient second order conditions for a proper interior constrained maximum are that all
border-preserving principal minors of order k > 2r have sign (−1)k−r , where r is the number of constraints
and k counts the rows and columns in the border. These conditions are really just an algebraic way of checking
that the objective function c is strictly concave in the choice variables subject to constraint (i.e., along the
path of choices that the constraint allows), or negative definiteness of the Hessian of the objective subject
to constraint. When the objective is linear, this is equivalent to strict quasiconcavity of the constraint in
the choice variables: full concavity isn’t needed because y isn’t being chosen. Similarly, the sufficient second
order conditions for a proper interior constrained minimum are that all border-preserving principal minors of
order k > 2r have sign (−1)r . This is just an algebraic way of checking that the objective c is strictly convex
in the choice variables subject to constraint, or positive definiteness of the Hessian of the objective subject
to constraint, which is strict quasiconvexity of the constraint in the choice variables when the objective is
linear. NOTE: These conditions agree with our statement of second order conditions for unconstrained
optimization if we just set r = 0. Also, as in the unconstrained case an equivalent condition is that only the
naturally-ordered border preserving principal minors of order k > 2r have sign (−1)k−r (maximum) or (−1)r
(minimum). Since many fewer determinants are involved, these latter conditions are convenient for checking
second order conditions in any particular problem. However, the knowledge that all principal minors have
a known sign at a proper interior optimum is useful for performing comparative statics and so we state the
second order conditions in terms of all principal minors.
Applying these conditions to the cost minimization problem, if we have a proper interior minimum then
|HL(x,λ)| must have sign (−1)1 since there is one constraint. Using cofactor expansion on the numerator of
∂x∗
our expression for i
∂wj
yields (−1)(−1)i+j |Hji |, where Hji is the submatrix of HL(x,λ) of order n that results
when row j and column i are deleted. This has unknown sign when i = j because |Hji| is not a principal
minor (or because Hji is not border-preserving if either i or j is n + 1). However, if i = j < n + 1 then
∂x∗
|Hji| has sign (−1)1 , so i
∂wi
< 0. Again, this is natural: own price effects are negative, while cross-price
effects are indeterminate in general. Hence the law of demand holds for the conditional factor demand of a
cost-minimizing firm and is a direct consequence of the behavioral postulate, and nothing more. As with the
unconditional demands, the ambiguous cross-price effects are usually categorized by comparison with the
∂x∗
negative own-price effect. If x∗j moves in the same direction as x∗i when wi changes (i.e., if j
∂wi < 0) then we
say inputs i and j are (net) complements in production. If the two inputs move in opposite directions (i.e.,
∂x∗
j
if ∂wi > 0) then we say inputs i and j are (net) substitutes in production. These labels are “net” because
the changes under study here are net of any changes in output, but usually the complement/substitute
nature of conditional factor demands is described without using the word “net” (as compared to the “gross”
complements or substitutes characterization of profit maximizing demands, which are gross of changes in
the optimal output level, and which are usually described by explicit use of the word “gross”).
These methods can be used to study the effect of a change in the output level y on x∗ , and for finding
the effects of changes in w and y on λ∗ . This is pursued in the exercises, but none of these effects are known
∂x∗ ∂x∗
in general. If ∂y
i
≥ 0 we say input i is normal in production, while if ∂y
i
< 0 we say input i is inferior in
production. Applying the chain rule to differentiate x∗∗ ∗ ∗∗

j (p, w) ≡ xj (w, y (p, w)) with respect to p (where
the double asterisk indicates profit-maximizing choices), and recalling that y∗ is increasing in its own-price
p, we see that these labels are consistent with the normal/inferior labels given for the unconditional factor
demands.
We have proceeded here as if we have a proper interior minimum. There are several cautions that must
be adhered to regarding this:
1. Since x ≥ 0 is required, we can have corner solutions of the form x∗i = 0. Then the first derivative can be
positive: wi − λ∗ fi (x∗ ) > 0.
2. Existence is not much of a problem here, because we have a continuous objective on a nonempty, closed
and bounded constraint set (when w >> 0 and y ∈ Y , if we throw out the upper part of V (y)). Henceforth
we will assume w >> 0 and y ∈ Y .
3. Uniqueness is a real issue unless the technology is strictly convex.

Exercises for Lecture 5 (Cost Minimization: Basics)
1. Use the comparative statics methodology to derive expressions for the slope of the conditional factor
demand with respect to output, and the slope of the optimal Lagrange multiplier with respect to input
price i and also with respect to output. Can the sign of any of these be determined? Why?
2. Assume that the conditional factor demand and unconditional demand/supply choices are unique.
a. Prove the following identity:
x∗∗ (p, w) ≡ x∗ (w, y∗∗ (p, w)).
b. Use this identity to show that complements that are either both normal or both inferior in production
are gross complements, but the converse need not hold (Hint: Use symmetry of the demand/supply
derivatives). Similarly, show that substitutes, when one is normal and the other is inferior, are gross
substitutes, but the converse need not hold. Can you begin with a gross characterization and infer a
net characterization if certain normal/inferior combinations hold?
3. Suppose f(x1 , x2 ) = x1 x2 is a production function. Find x∗ and c∗ .
4. MWG #5.C.10.
5. Varian #5.4.
6. Varian #5.17.
Lecture 6: Cost Minimization: Envelope Properties of c∗ and x∗
Readings: Sections 5.4-5.6 of Varian; pp. 139-143 of MWG.
In this lecture we continue our study of the properties of a cost minimum, but make use of the envelope
theorem rather than using the somewhat cumbersome traditional comparative statics. The optimal choice
is x∗ (w, y) and the optimal value of the cost function is
c∗ (w, y) = w · x∗ (w, y), for w >> 0 and y ∈ Y.
Like the profit and supply/demand functions, these functions have some remarkable properties due solely to
the fact that they are the minimizing choices and minimal value, respectively, of w · x.
Theorem (Shephard’s Lemma–Relationship between the Cost Function and the Conditional
∂c∗
Factor Demand). If c∗ is differentiable at (w, y) (almost assured by concavity) then ∂wi
= x∗i (w, y) and
∂c∗
∂y = λ∗ (w, y).
Proof. Differentiate c∗ (w, y) with respect to wi , using the envelope theorem so that this is obtained by
differentiating the Lagrangian function and then evaluating at the optimum, to get x∗i (w, y). Likewise,
differentiate with respect to y to get λ∗ (w, y).
Theorem (Properties of the Cost Function).
1. (Homogeneity) c∗ is homogeneous of degree 1 in w.
2. (Concavity) c∗ is concave in w.
3. (Monotonicity) c∗ is nondecreasing in (w, y). If f is lower semicontinuous, the monotonicity in y is strict.
4. (Continuity) c∗ is lower semicontinuous in (w, y) and is fully continuous in w for fixed y at w >> 0. If Z
is lower hemicontinuous in output, the continuity is full in (w, y) at w >> 0.
5. (Nonnegativity) c∗ > 0 ∀w >> 0 and ∀y ∈ Y − {0}, and c∗ (w, 0) = 0 ∀w >> 0.
Proof.
1. We will show below that x∗ is homogeneous of degree 0 in w. Substitution then yields
c∗ (λw, y) = (λw) · x∗ (λw, y) = (λw) · x∗ (w, y) = λc∗ (w, y).

36 LECTURE 6: COST MINIMIZATION (ADVANCED)
2. Fix (w, y) and (w , y). By definition,
c∗ (w, y) ≤ w · x ∀x ∈ V (y),
c∗ (w , y) ≤ w · x ∀x ∈ V (y).
Multiply the first of these by λ and the second by (1 − λ) and add to get
λc∗ (w, y) + (1 − λ)c∗ (w , y) ≤ (λw + (1 − λ)w ) · x ∀x ∈ V (y)
= c(x; λw + (1 − λ)w ) ∀x ∈ V (y),
so the left side is a lower bound of the right side cost objective across all feasible input vectors x. Hence
λc∗ (w, y) + (1 − λ)c∗ (w , y) ≤ c∗ (λw + (1 − λ)w , y).
3. Select w ≤ w and y ≤ y. By definition,
c∗ (w , y ) ≤ w · x ≤ w · x ∀x ∈ V (y ).
By free disposal, V (y) ⊂ V (y ), so
c∗ (w , y ) ≤ w · x ∀x ∈ V (y).
Hence, using the lower bound logic again, c∗ (w , y ) ≤ c∗ (w, y). To establish that the monotonicity in y
is strict when f is lower semicontinuous, let y < y and suppose w · x∗ (w, y) = c∗ (w, y) ≤ c∗ (w, y ). Since
V (y) ⊂ {x ∈ Rn+ : f(x) ≥ y}, we know f(x∗ (w, y)) ≥ y > y . But, since f is lower semicontinuous and
w >> 0, we know the constraint must be satisfied with equality at the minimum. Therefore, x∗ (w, y)
does not minimize w · x subject to x ∈ V (y ): it is possible to achieve lower cost. This contradicts that
c∗ (w, y ) is a minimum.
4. Suppose c∗ is not lower semicontinuous at (w 0 , y0 ), where w 0 >> 0. Then there exists ε > 0 and a sequence
(w i , yi ) → (w 0 , y0 ) such that c∗ (w i , yi ) ≤ c∗ (w 0 , y0 ) − ε for every i = 1, 2, . . . . A cost minimum always
exists when the input price vector is strictly positive and the output level is feasible, so there exists a
sequence xi such that (yi , −xi ) ∈ Z and w i · xi = c∗ (w i , yi ). The sequence xi is bounded because (1) w i · xi
is bounded by c∗ (w 0 , y0 ) − ε, and (2) w i is bounded away from zero since it converges to w 0 >> 0. Hence
xi has a convergent subsequence xki → x0 , implying c∗ (w ki , yki ) = w ki · xki → w 0 · x0 ≤ c∗ (w 0 , y0 ) − ε.

But (y0 , −x0 ) ∈ Z because Z is closed, so w 0 ·x0 ≤ c∗ (w 0 , y0 )−ε contradicts that c∗ (w 0 , y0 ) is a minimum.
This establishes lower semicontinuity of c∗ . Full continuity of c∗ in w for fixed y is implied by concavity.
Full continuity of c∗ in (w, y) when Z is lower hemicontinuous in output is a consequence of the Theorem
of the Maximum (see MWG Theorem M.K.6).
5. By no free lunch, x∗ (w, y) > 0 when y > 0. Hence c∗ (w, y) = w · x∗ (w, y) > 0 when (w, y) >> 0. By the
possibility of inaction, 0 ∈ V (0). Hence c∗ (w, 0) ≤ w · 0. But x, w ≥ 0 for all feasible x, so c∗ (w, y) ≥ 0
for any (w, y) ≥ 0. Combine to get c∗ (w, 0) = 0.
Theorem (Properties of the Conditional Factor Demand).
1. (Homogeneity) x∗ is homogenous of degree 0 in w.

 ∂λ∗ ∂λ∗ ∂λ∗ 
∂y ∂w1
... ∂wn
 ∂x∗ ∂x∗ ∂x∗ 
 1 1
... 1

 ∂y ∂w1 ∂wn 
 .. .. .. .. 
 . . . .∗ 
∗
∂xn ∂x∗ ∂xn
∂y
n
∂w1 ... ∂wn
is symmetric for y ∈ (0, ỹ), and the lower right (n × n) submatrix is negative semidefinite.
3. (Monotonicity) w · x∗ is nondecreasing in (w, y). If f is lower semicontinuous, the monotonicity in y is
strict.
4. (Continuity) w · x∗ is lower semicontinuous in (w, y) and is fully continuous in w for fixed y at w >> 0.
If Z is lower hemicontinuous in output, the continuity is full in (w, y) at w >> 0.
5. (Nonnegativity) x∗ ≥ 0 ∀w >> 0 and ∀y ∈ Y , w · x∗ (w, 0) = 0, and x∗ (w, y) > 0 ∀w >> 0 and
∀y ∈ Y − {0}.
Proof.
1. λc(x; w) is a monotonic transformation of the objective function c(x; w) for λ > 0, and due to linearity is
equal to c(x; λw). Since w is not part of the constraint, x∗ (λw, y) = x∗(w, y).
2. Differentiating Shephard’s Lemma, this matrix is just the matrix of second derivatives of the cost function:
 ∂λ∗ ∂λ∗ ∂λ∗   ∂ 2 c∗ ∂ 2 c∗ ∂ 2 c∗

∂y ∂w1
... ∂wn ∂y∂y ∂y∂w1 ... ∂y∂wn
 ∂x∗ ∂x∗ ∂x∗   ∂ 2 c∗ ∂ 2 c∗ ∂ 2 c∗ 
 1 1
... 1
  ... 
 ∂y ∂w1 ∂wn   ∂w1 ∂y ∂w1∂w1 ∂w1∂wn .
 .. .. .. ..  =  .. .. .. .. 
 . .∗ . .∗   . . . . 
∗ 2 ∗ 2 ∗ 2 ∗
∂xn ∂xn ∂xn ∂ c ∂ c ∂ c
∂y ∂w1
... ∂wn ∂wn ∂y ∂wn∂w1 ... ∂wn ∂wn
Order invariance of second partial derivatives implies symmetry of this matrix. Concavity of the cost
function in w implies negative semidefiniteness of the lower (n × n) submatrix.
3. This is just monotonicity of the cost function.
4. This is just continuity of the cost function.
5. x∗ (w, y) ≥ 0 because x∗ is chosen from Rn+ . w · x∗ (w, 0) = 0 is just c∗ (w, 0) = 0 again. x∗(w, y) >
0 ∀w >> 0 and ∀y ∈ Y − {0} is just c∗ (w, y) > 0 again for these (w, y) points.
• Note, in particular, that cross-price effects on the conditional factor demand are symmetric and that
own-price effects are nonpositive. Hence the comparative statics results we derived in the previous lecture
arise as a consequence of the general properties of the minimum here.
• Second, marginal cost is equal to the optimal Lagrange multiplier, which is nonnegative due to mono-
tonicity.
• Third, homogeneity is again the mathematical statement of the claim that “only relative prices matter.”
• Fourth, Euler’s Theorem for the homogeneous of degree zero conditional factor demands yields

n
∂x∗i (w, y)
wj = 0 for i = 1, . . . , n.
j=1
∂wj
Hence  
∂x∗
1
...
∂x∗
1   
∂w1 ∂wn w1 0
 
..   .  =  ..  ,
.
Hc∗(w) w =  ... ..
. . . .
∗
∂xn ∂x∗ wn 0
∂w1 ... ∂wn
n
and we see that the Hessian of the cost function with respect to w is singular, possessing a zero eigenvalue.
• Note also that the main property of the technology we really rely on here is that a minimum exists, which
is guaranteed by regularity, w >> 0, and y ∈ Y . Thus, the cost function and the conditional factor demand
function have these basic properties, essentially just because they minimize, except that monotonicity in y
relies on free disposal and no free lunch (strict monotonicity relies in addition on the possibility of inaction
and lower hemicontinuity in inputs), while nonnegativity relies on no free lunch and the possibility of inaction.
Exercises for Lecture 6 (Cost Minimization: Advanced)
1. Use Euler’s Theorem to show that the price elasticities of a conditional factor demand sum to zero.
√
2. Suppose c∗ (w1 , w2, y) = 2 yw1 w2 and x∗ (w1 , w2 , y) = yw2
w1 , y w1 ∗
w2 . Verify that c has the properties
of a cost function and that Shephard’s Lemma holds.
3. Varian #4.8.
4. Varian #5.6.
5. Varian #5.12.
Lecture 7: Duality of the Cost Function
Readings: Chapter 6 of Varian; Section 3.F of MWG.
We have now studied two optimization problems for firms: profit maximization and cost minimization.
In each case we found that the optimal value function necessarily has some properties (homogeneity, concav-
ity/convexity, monotonicity, continuity, and nonnegativity), mostly for no reason other than its definition
as an optimum of a particular objective. Similarly, in each case we found that the optimal choice func-
tion necessarily has some properties (homogeneity, symmetry/semidefiniteness, monotonicity and continuity
(for conditional demands), and nonnegativity), again basically because of its definition as an optimizer of a
particular objective. Hence, these properties are necessary conditions for cost, profit, supply, and demand
functions.
A natural question is to ask now whether these properties are sufficient for their respective functions.
That is, for example, given a function possessing the 5 properties of a cost function, is that function a cost
function for some firm? This question is really of more importance for economic research than the derivation
of the necessary conditions, because its affirmative answer enables us to use cost functions without regard
for the underlying production function/technology. In each of the cases we have studied, the properties we
have derived are both necessary and sufficient for the function. To get the idea of the sufficiency argument,
we will focus on the cost function. The sufficiency is referred to as duality, since it says that the cost function
is dual to the technology, in the sense that for every well-behaved technology there is a cost function with
the 5 properties, and vice-versa.
The algebra of the argument can get involved, but the geometry is straightforward. Given a cost function
c∗ , we wish to find the underlying input requirement sets V (y). To do so, fix output at y and, for some input
price vector w, draw the isocost line for cost level c∗ (w, y). The input requirement set must lie everywhere
above this isocost, for otherwise a cost level smaller than c∗ (w, y) would be possible. The input requirement
set must also touch the isocost somewhere, for otherwise a cost level as small as c∗ (w, y) would not be
attainable. Repeat this argument for all different input price vectors and then intersect the areas to obtain
V (y). This is illustrated in Figure 7.1.

42 LECTURE 7: DUALITY OF THE COST FUNCTION
Figure 7.1: Recovering the Input Requirement Set from the Cost Function
The algebraic statement of this is to form a “hypothetical” input requirement set
H(y) ≡ {x ∈ Rn+ : w · x ≥ c∗ (w, y) ∀w >> 0}.
We then must ask whether we can formally show that H(y) is equal to V (y). To do so, we must show that
each set contains the other. The containment H(y) ⊃ V (y) is easy, for if x ∈ V (y) then w · x can be no
smaller than c∗ (w, y), by definition of c∗ . Since this statement holds for every w, x ∈ H(y). But the opposite
containment is not true in general. The problem that can arise here is due to potential nonconvexity of V (y),
as illustrated in Figure 7.2.
If V (y) is convex then it can be shown that H(y) ⊂ V (y), so the two sets are actually equal. In this case,
H recovers the true underlying technology from c∗ , even if all one knows is c∗ . The tool for showing this is
an important theorem from convex analysis, known as the separating hyperplane theorem:
Separating Hyperplane Theorem. Let V be a closed, convex, nonempty set in Rn and x̄ be a point not
in V . Then there exists a hyperplane that separates V and x̄.
Algebraically, a hyperplane is determined by a slope vector w = 0 and an intercept scalar c. It is the set of
points that satisfy the linear equation defined by w and c:
H(w, c) = {x ∈ Rn : w · x = c}.
Figure 7.2: The Input Requirement Set can be a Proper Subset of the “Hypothet-
ical” Version Recovered from the Cost Function
Hence, a hyperplane is a point in R1 , a line in R2 , a plane in R3 , and the n-dimensional generalization of a
plane in Rn . Note that many different (w, c) pairs define the same hyperplane, since if x satisfies w · x = c
then x also satisfies λw · x = λc for any scalar λ = 0. Thus (λw, λc) defines the same hyperplane as (w, c).
Hyperplanes are illustrated in Figure 7.3.
Figure 7.3: Hyperplanes in R1 and R2
A hyperplane separates two sets if all points in one set lie on one side of the hyperplane while all points in
the other set lie on the other side of the hyperplane. Algebraically, a point x lies on one side of the hyperplane
if w · x > c and lies on the other side if w · x < c. So, the theorem claims that there exists an n-dimensional
vector w = 0 and a scalar c such that w · x > c > w · x̄ ∀x ∈ V . Note that it makes no difference which
direction of inequality we use here, since we can always multiply by the scalar λ = −1 and still be describing
the same hyperplane. Note also that the conditions of the separating hyperplane theorem are sufficient
for the existence of a separating hyperplane, but are not necessary. It is easy to draw counterexamples to
necessity. Also, the theorem is only about existence. There is no claim that the separating hyperplane is
unique (indeed, it is not unique). Figure 7.4 illustrates the separating hyperplane theorem.
Figure 7.4: Separating Hyperplane Theorem in R2 . In (a), the conditions of the theorem
hold and a hyperplane H that separates x̄ and V is illustrated. In (b), no hyperplane can be
drawn between x̄ and V because V is not convex. In (c), no hyperplane can be drawn between x̄
and V because V is not closed (here, x̄ is on the boundary of V ). By requiring that V be closed,
we obtain strict inequalities in the statement of the theorem. Clearly a hyperplane can be drawn
in (c) that passes through x̄ and is just tangent to V . Such a hyperplane would “separate” V
and x̄ with a weak inequality.
How does this theorem prove H(y) ⊂ V (y) when V (y) is convex? Suppose otherwise. Then there exists
x̄ ∈ H(y) that is not in V (y). So, by the separating hyperplane theorem there exists w = 0 and c such that
w · x > c > w · x̄ ∀x ∈ V (y).
Note that we must have w > 0, for otherwise we can use free disposal to set x so large that these inequalities
must be violated. Moreover, we may assume w >> 0, since doing so can only increase the left side while
increasing the right side an arbitrarily small amount. Since x̄ ∈ H(y), w · x̄ ≥ c∗ (w, y). Hence
w · x > c > c∗ (w, y) ∀x ∈ V (y).
This inequality says that the objective w ·x cannot be smaller than c > c∗ (w, y) on x ∈ V (y). Thus c∗ (w, y) is
a cost level that cannot be attained (or even approached) among the feasible input vectors. This contradicts
that c∗ (w, y) is the minimum of w · x on V (y), whence the supposition that H(y) is not contained in V (y)
must be incorrect.
What we have just shown is:
If c∗ is a cost function, in that it is the minimum of w · x subject to x ∈ V (y), then we can recover
V (y) even if all we know is c∗ (assuming V (y) is convex).
This presumes that c∗ is indeed a cost function. What if all we have is a function c∗ (w, y) that is known to
have some properties? We can try to derive H(y) from c∗ , but do we then know that H(y) is a legitimate
input requirement set? And, if so, do we know that c∗ is the cost function one gets by minimizing w ·x subject
to x ∈ H(y)? The answers to these questions are “yes,” but to show them we must avoid any reference to
V (y) or to the interpretation of c∗ as a cost function. Rather, we must rely solely on the properties of c∗ .
So, assume only that we have a real-valued function c∗ (w, y) of a strictly positive n-dimensional vector w
and a scalar y in an interval Y whose minimum is zero; and that this function satisfies the homogeneity,
concavity, monotonicity, continuity, and nonnegativity properties of a cost function (but that it may not
be a cost function–at least, we do not know this in advance). For convenience we will also assume that c∗
is continuously differentiable, although this assumption is not really needed. Then, the properties of our
“hypothetical” technology Z = {(y, −x) : x ∈ H(y) and y ∈ Y } are:
1. Z is nonempty. This is automatic from the possibility of inaction (item 4 below).
2. Z is closed. Consider any sequence (yi , −xi ) → (y0 , −x0 ) such that (yi , −xi ) ∈ Z for i = 1, 2, . . .. We
must show w · x0 ≥ c∗ (w, y0 ) for every w >> 0. Fix ε > 0. By definition of Z and lower semicontinuity
of c∗ in y, there exists Iε such that w · xi ≥ c∗ (w, yi ) > c∗ (w, y0 ) − ε for i ≥ Iε . Taking the limit as
i → ∞ yields w · x0 ≥ c∗ (w, y0 ) − ε. This holds for arbitrary ε > 0, so taking the limit as ε ↑ 0 yields
w · x0 ≥ c∗ (w, y0 ).
3. H(y) satisfies no free lunch. Select any w >> 0. When y > 0 we have c∗ (w, y) > 0 by nonnegativity.
Hence w · x > 0 ∀x ∈ H(y). This rules out 0 as an element of H(y).
4. H(y) satisfies the possibility of inaction. By nonnegativity, c∗ (w, 0) = 0 ∀w >> 0. Hence w · 0 ≥
c∗ (w, 0) ∀w >> 0, so 0 ∈ H(0).
5. H(y) satisfies free disposal. Let x ∈ H(y), and suppose x ≥ x and y ≤ y. Then, using monotonicity of
c∗ in y, w · x ≥ w · x ≥ c∗ (w, y) ≥ c∗ (w, y ) ∀w >> 0. Hence, x ∈ H(y ).
7. H(y) is always convex. Let x, x ∈ H(y). Then w · x ≥ c∗ (w, y) and w · x ≥ c∗ (w, y), both for all w >> 0.
Multiply the first by λ and the second by (1 −λ) and add to obtain w · [λx +(1 −λ)x ] ≥ c∗ (w, y) ∀w >> 0.
Thus λx + (1 − λ)x ∈ H(y).
8. If c∗ is strictly increasing in y, then Z is lower hemicontinuous in inputs. That is, Z has the property:
x0 ∈ H(y0 ) and xi → x0 implies existence of yi → y0 such that xi ∈ H(yi ). The proof is tedious, and is
relegated to the Appendix.
So, H(y) has all of the properties of an input requirement set, and thus we can define a cost function as
the minimum of w · x subject to x ∈ H(y). Is the cost function we define in this way the same function we
started with? That is, do we have
c∗ (w, y) = min w · x subject to x ∈ H(y)?

{x}
To show this, fix w0 arbitrarily. By definition, w0 · x ≥ c∗ (w0 , y) ∀x ∈ H(y). That is, c∗ (w0 , y) is a lower
bound for w0 · x among those x vectors in H(y), so certainly
c∗ (w0 , y) ≤ min w0 · x subject to x ∈ H(y).

{x}
It remains to show the opposite inequality. Since c∗ is homogeneous of degree one in w, by Euler’s Theorem
we have

n
∂c∗ (w0 , y)
w0i = c∗ (w0 , y),
∂wi
i=1
∂c∗ (w0 ,y)
so by setting x0i = ∂wi we have a vector x0 (nonnegative by monotonicity of c∗ in w) such that
w0 · x0 = c∗ (w0 , y). By concavity of c∗ in w,

n
∂c∗ (w0 , y)
c∗ (w, y) ≤ c∗ (w0 , y) + (wi − w0i )
∂wi
i=1
= c∗ (w0 , y) + (w − w0 ) · x0
= w · x0 .
Since this holds for every w >> 0, we have x0 ∈ H(y). That is, we have derived an x0 such that w0 · x0 =
c∗ (w0 , y) and x0 ∈ H(y). Hence
min w0 · x subject to x ∈ H(y) ≤ w0 · x0 = c∗ (w0 , y).

{x}
Hence c∗ is indeed the cost function for the well-behaved input requirement sets H(y). That is, the 4
properties of a cost function are sufficient as well as necessary. Hence we can use any function satisfying
these properties as a cost function without actually deriving it from some underlying technology. This also
shows that H(y) is the economically relevant technology for a firm with cost function c∗ , even if H(y) differs
from V (y). Nonconvexities in production are irrelevant for the cost function.
Appendix to Lecture 7: Lower Hemicontinuity of Z
Assume c∗ strictly increasing in y on Y . To show: If x0 ∈ H(y0 ) and xi → x0 then there exists yi → y0
such that xi ∈ H(yi ), where
H(y) = {x ∈ Rn+ : w · x ≥ c∗ (w, y) ∀w >> 0}.
Fix xi and w >> 0. By monotonicity of c∗ in y, {y ∈ Y : w · xi ≥ c∗ (w, y)} is an interval from 0 to some
upper bound (perhaps ∞), with 0 included (by nonnegativity of c∗ ) and the inclusion of the upper bound
unimportant. As we vary w >> 0, the collection of these upper bounds is nonempty and bounded below
by zero, so it has an infimum (perhaps ∞). Let ȳi denote the infimum, so that xi ∈ H(y) ∀y < ȳi and
/ H(y) ∀y > ȳi at which c∗ is defined.

xi ∈
Now consider the claim: For every > 0 there exists I such that
i ≥ I ⇒ ȳi > y0 − .
i
To show this, fix > 0 and suppose otherwise. Then there exists a subsequence ȳk ≤ y0 − ∀i. So, by
i i
definition of ȳk , there exists w k >> 0 such that
c∗ (w k , y) > w k · xk ∀y > y0 − .
i i i
−1
By homogeneity of c∗ , this statement holds for λk w k as well, where λk =
i i i n i
j=1 wjk > 0. Thus,
i i
we may assume that w k is on the unit simplex for every i. Then w k has a convergent subsequence
ki ki ki
w → w 0 . Since w · x → w 0 · x0 ≥ c∗ (w 0 , y0 ), we can use continuity1 of c∗ in w to conclude
c∗ (w 0 , y) ≥ c∗ (w 0 , y0 ) ∀y > y0 − . However, c∗ (w 0 , y) < c∗ (w 0 , y0 ) for y < y0 by strict monotonicity of c∗ ,
a contradiction. This proves existence of I .
Now define yi = min{ȳi , y0 } − 1i . Then yi < ȳi , so xi ∈ H(yi ). And for any > 0, y0 − − 1i < yi ≤ y0 − 1i
for i ≥ I . Hence yi → y0 .
1 If
wj0 = 0 for some j then we don’t have continuity of c∗ . In fact, the present treatment doesn’t even establish existence of
c∗ at such a w0 . To deal with this requires defining c∗ as an infimum on the boundaries of Rn + and then utilizing the limiting
continuity of c∗ at these edges.
Exercises for Lecture 7 (Duality of the Cost Function)
1. Varian #5.16.
2. Varian #6.2.
3. Varian #6.3.
Lecture 8: Duality of Supply, Demands, and Profit
Readings: Chapter 6 of Varian; Section 3.F of MWG.
Having now studied the sufficiency of the properties of a cost function, we can proceed to show that the
properties of the conditional factor demand are sufficient as well. Assume we have an n-dimensional vector-
valued function x∗ (w, y) of a strictly positive n-dimensional vector w and a scalar y in an interval Y whose
minimum is zero; and that this function satisfies the homogeneity, symmetry/semidefiniteness, monotonicity,
continuity, and nonnegativity properties of a conditional factor demand function (but that it may not be a
conditional factor demand function–at least, we do not know this in advance). Once again we will assume
differentiability for convenience only. Can we show that x∗ is indeed the conditional factor demand for some
firm?
Begin by setting c∗ (w, y) = w · x∗ (w, y). If this defined function c∗ has the 5 properties of a cost function
then we know from our previous sufficiency proof that c∗ is actually a cost function for the input requirement
sets H(y). If so, then by Shephard’s Lemma the conditional factor demands associated with this cost function
are
∂c∗
n
∂x∗j
= x∗i (w, y) + wj
∂wi ∂wi
j=1

n
∂x∗i
= x∗i (w, y) + wj for i = 1, . . . , n, by symmetry.
∂wj
j=1
Note that we are not using the envelope theorem here, since we don’t yet know that x∗ is the optimal choice
for minimizing w · x subject to x ∈ H(y). Hence we can only differentiate by brute-force at this point. But,
by homogeneity of x∗ and Euler’s Theorem (this time for a HOD 0 function) we have

n
∂x∗i (w, y)
wj = 0.
∂wj
j=1
∂c∗
Hence ∂wi = x∗i . That is, x∗ is the conditional factor demand associated with the cost function c∗ , provided
c∗ is indeed a cost function.
All that remains, then, is to use the properties of x∗ to verify that c∗ satisfies the 5 properties of a cost
function.
1. c∗ is homogeneous. By homogeneity of x∗ , c∗ (λw, y) = (λw) · x∗(λw, y) = λw · x∗ (w, y) = λc∗ (w, y).

52 LECTURE 8: DUALITY OF SUPPLY, DEMANDS, AND PROFIT
∂c∗
2. c∗ is concave. Since ∂wi = x∗i , the Hessian of c∗ in w is the matrix of first derivatives of x∗ with respect
to w, which is negative semidefinite by the semidefiniteness property of x∗ .
∂c∗
3. c∗ is monotonic. Again, since ∂wi
= x∗i and x∗ is a nonnegative function, we have the monotonicity in w.
Moreover, monotonicity in y follows directly from the monotonicity property of x∗ . If the monotonicity
property of x∗ is strict, then c∗ is strictly increasing in y and so H(y) is lower hemicontinuous in inputs.
4. c∗ is lower semicontinuous. This follows directly from the continuity property of x∗ .
5. c∗ is nonnegative. When w >> 0 and y ∈ Y − {0} we have c∗ = w · x∗ > 0 because x∗ > 0 due to
nonnegativity of x∗ . Similarly, when y = 0 we have c∗ = 0 because w · x∗ = 0 by nonnegativity of x∗ .
That is, the 5 properties of a conditional factor demand function are sufficient as well as necessary. Hence
we can use any function satisfying these properties as a conditional factor demand function without actually
deriving it from some underlying technology.
These same techniques can be used to show that the 4 properties of a profit function and the 3 properties of
the demand/supply function are sufficient. Assume we have a real-valued function π ∗ (p, w) of a nonnegative
scalar p and a strictly positive n-dimensional vector w, and that this function satisfies the homogeneity,
convexity, monotonicity, and nonnegativity properties of a profit function (but that it may not be a profit
function–at least, we do not know this in advance). From π ∗ , define a hypothetical production set
H = {(y, x) ∈ R1 × Rn+ : (p, w) · (y, −x) ≤ π ∗ (p, w) ∀p ≥ 0 and w >> 0}.
The geometry of this is identical to the cost function case. Draw the isoprofit line for some p. The production
set must lie below this. Repeat this argument for all different price vectors p and then intersect the areas to
obtain H. This is illustrated in Figure 8.1. The H so obtained has the properties of a production set:
1. H is nonempty. By nonnegativity of π ∗ , π ∗ (p, w) ≥ 0 ∀(p, w). Hence (0, 0) ∈ H.
2. H is closed. This is again trivial, since any sequence of (y, x)’s that satisfies py − w · x ≤ π ∗ (p, w) must
also satisfy this inequality in the limit.
3. H need not satisfy no free lunch. The set H can have a positive y-intercept without violating the properties
of π ∗ .
4. H satisfies the possibility of inaction. This is already done in item 1.

5. H satisfies free disposal. Let (y, x) ∈ H and y ≤ y, x ≥ x. Then py − w · x ≤ py − w · x ≤ π ∗ (p, w), so
(y , x ) ∈ H.
7. H is always convex. Let (y, x), (y , x ) ∈ H. Then (p, w) · (y, −x) ≤ π ∗ (p, w) and (p, w) · (y , −x ) ≤
π ∗ (p, w), both for all (p, w). Multiply the first by λ and the second by (1 − λ) and add to obtain
(p, w) · [λ(y, −x) + (1 − λ)(y , −x )] ≤ π ∗ (p, w) ∀(p, w).
Figure 8.1: Recovering the Production Set from the Profit Function
Just as in the duality arguments used for cost functions, if we began by assuming that π ∗ is a profit
function then the production set H just obtained would be identical to the original production set Z from
which π ∗ was derived, provided Z is convex. The proof is the same as the cost function case. For (y, −x) ∈ Z
we have π ∗ (p, w) ≥ py −w · x by definition of π ∗ , so (y, −x) ∈ H. On the other hand, if there is a (ȳ, −x̄) ∈ H
that is not in Z, then by the separating hyperplane theorem there exists a slope vector (p, w) = 0 and an
intercept π such that (p, w) · (y, −x) < π < (p, w) · (ȳ, −x̄) ∀(y, −x) ∈ Z. By free disposal (p, w) > 0 since
otherwise these inequalities would be violated for some (y, −x) ∈ Z, and we may assume w >> 0 since
this only decreases the left side while decreasing the right side an arbitrarily small amount. Then, since
(ȳ, −x̄) ∈ H,
(p, w) · (y, −x) < π < π ∗ (p, w), ∀(y, −x) ∈ Z,
which contradicts that π ∗ (p, w) is the maximum of (p, w) · (y, −x) over Z.
Irrespective of whether we begin by assuming π ∗ is a profit function, we can show by relying only on the
properties of π ∗ that π ∗ is the optimal value function for maximizing profit subject to the production set H.
That is,
π ∗ (p, w) = max py − w · x subject to (y, −x) ∈ H.

{(y,−x)}
For convenience assume π ∗ is continuously differentiable. Fix (p0 , w0 ) >> 0. As with cost functions, the
fact that π ∗ is at least as large as this maximum is trivial: By definition of H, π ∗ (p0 , w0 ) ≥ p0 y − w0 · x
for any (y, −x) ∈ H, so π ∗ (p0 , w0) is an upper bound for the objective and hence is at least as large as the
maximum. The opposite inequality requires more effort. Let
∂π ∗ (p0 , w0)
y0 =
∂p
∂π ∗ (p0 , w0 )
x0i =− for i = 1, · · · , n,
∂wi
and note that (y0 , x0 ) ≥ 0 by monotonicity of π ∗ . By homogeneity of degree one of π ∗ , Euler’s Theorem
yields
∂π ∗ (p0 , w0 )
n
∂π ∗ (p0 , w0 )
p0 + w0i = π ∗ (p0 , w0 ).
∂p ∂wi
i=1
That is, (p0 , w0) · (y0 , −x0 ) = π ∗ (p0 , w0 ). Since π ∗ is a convex function of (p, w),
∂π ∗ (p0 , w0 ) ∂π ∗ (p0 , w0)

n
π ∗ (p, w) ≥ π ∗ (p0 , w0 ) + (p − p0 ) + (wi − w0i ) ∀(p, w)
∂p i=1
∂wi
= (p0 , w0 ) · (y0 , −x0 ) + (p − p0 , w − w0 ) · (y0 , −x0 ) ∀(p, w)
= (p, w) · (y0 , −x0 ) ∀(p, w).
Hence (y0 , −x0 ) ∈ H, and this means that the maximum of p0 y − w0 · x over H is at least as large as
p0 y0 − w0 · x0 = π ∗ (p0 , w0 ). Combining inequalities shows that π ∗ (p0 , w0 ) is the maximum of p0 y − w0 · x
over H.
That is, the 4 properties of a profit function are sufficient as well as necessary. Hence we can use any
function satisfying these properties as a profit function without actually deriving it from some underlying
technology. This also shows that H is the economically relevant technology for a firm with profit function π ∗ ,
even if H differs from Z. Nonconvexities in production are irrelevant for the profit function.
NOTE: This proof does not work if p0 = 0, since then we cannot simply differentiate π ∗ . However, we
know from nonnegativity of π ∗ that π ∗ (0, w0) = 0 ∀w0 >> 0. On the other hand, since (0, 0) ∈ H the
maximum of (p0 , w0) · (y, −x) over H is at least (p0 , w0 ) · (0, 0) = 0, so the maximum of (0, w0) · (y, −x) over
H is at least as large as π ∗ (0, w0). That is, π ∗ (p0 , w0 ) is the maximal profit for the production set H even
when p0 = 0.
Finally we consider the sufficiency of the 3 properties of the supply and (unconditional) factor demand.
Assume we have an n + 1-dimensional vector-valued function (y∗ (p, w), −x∗(p, w)) of a nonnegative scalar
p and a strictly positive n-dimensional vector w, and that this function satisfies the homogeneity, symme-
try/semidefiniteness, and nonnegativity properties of a combined supply/factor demand function (but that it
may not be a combined supply/factor demand function–at least, we do not know this in advance). Once again
we will assume differentiability for convenience only. Can we show that (y∗ , −x∗) is indeed the combined
supply/factor demand for some firm?
Begin by setting π ∗ (p, w) = (p, w) · (y∗ (p, w), −x∗(p, w)). If this defined function π ∗ has the 4 properties
of a profit function then we know from our previous sufficiency proof that π ∗ is actually a profit function
for the production set H. If so, then by Hotelling’s Lemma and symmetry the supply and factor demands
associated with this profit function are
∂y∗ ∂x∗j ∂y∗ ∂y∗

n n
∂π ∗
= y∗ + p − wj = y∗ + p + wj
∂p ∂p ∂p ∂p ∂wj
j=1 j=1
∂π ∗
∂y ∗ n
∂x∗j ∂x∗ ∂x∗i
n
= −x∗i + p − wj = −x∗i − p − wj i for i = 1, . . . , n.
∂wi ∂wi j=1 ∂wi ∂p j=1
∂wj
Again, we have not used the envelope theorem here because we do not yet know that (y∗ , −x∗ ) is the
optimal choice for maximizing py − w · x subject to (y, −x) ∈ H. However, we do know that y∗ and x∗i are
homogeneous of degree zero functions, so Euler’s Theorem yields
∂y∗ ∂y∗
n
p + wj =0
∂p j=1
∂wj
∂x∗i ∂x∗i
n
p + wj = 0 for i = 1, . . . , n.
∂p j=1
∂wj
∂π∗ ∂π∗
Hence ∂p = y∗ and ∂wi = −x∗i for i = 1, . . . , n. That is, (y∗ , −x∗ ) is the combined supply/factor demand
associated with the profit function π ∗ , provided π ∗ is indeed a profit function.
All that remains, then, is to use the properties of (y∗ , −x∗ ) to verify that π ∗ satisfies the 4 properties of
a profit function.
1. π ∗ is homogeneous. By homogeneity of (y∗ , −x∗ ), π ∗ (λp, λw) = λpy∗ (λp, λw) − (λw) · x∗(λp, λw) =
λpy∗ (p, w) − λw · x∗ (p, w) = λπ ∗ (p, w).
∂π∗ ∂π∗
2. π ∗ is convex. Since ∂p
= y∗ and ∂wi
= −x∗i , the Hessian of π ∗ is the matrix of first derivatives of (y∗ , −x∗ )
with respect to (p, w), which is positive semidefinite by the semidefiniteness property of (y∗ , −x∗).
∂π∗ ∂π∗
3. π ∗ is monotonic. Again, since ∂p = y∗ and ∂wi = −x∗i , and y∗ and x∗ are nonnegative functions, we
have the monotonicity.
4. π ∗ is nonnegative. π ∗ ≥ 0 is immediate from nonnegativity of (y∗ , −x∗ ). Also, since x∗ (w, 0) = 0 we have
π ∗ (0, w) = 0y∗ (0, w) − w · 0 = 0.
That is, the 3 properties of a combined supply/factor demand function are sufficient as well as necessary.
Hence we can use any function satisfying these properties as a combined supply/factor demand function
without actually deriving it from some underlying technology.
NOTE: This proof does not work if p = 0, since then we cannot simply differentiate (y∗ , −x∗ ) and
π ∗ . Differentiability is used in two places in this proof. First, it is used to show that (y∗ , −x∗) is the
combined supply/factor demand associated with the profit function π ∗ . If p = 0 then by nonnegativity
(y∗ , −x∗ ) = ((−∞, 0], 0), which is the value that the combined supply/factor demand associated with any
profit function must take on at p = 0. Hence (y∗ , −x∗ ) is indeed the combined supply/factor demand
associated with the profit function π ∗ even at p = 0. Second, differentiability is used to show that π ∗ is
convex, because convexity is inferred from the Hessian of π ∗ . To show convexity when p = 0, first observe
that the proofs of nonnegativity, monotonicity, and homogeneity of π ∗ are all valid for p = 0. Given these,
fix (p, w) and (p , w ) with p = 0. Then:
λπ ∗ (p, w) + (1 − λ)π ∗ (p , w ) = (1 − λ)π ∗ (p , w ) by nonnegativity of π ∗

λ
≥ (1 − λ)π ∗ p , w + w by monotonicity of π ∗
1−λ
= π ∗ ((1 − λ)p , (1 − λ)w + λw) by homogeneity of π ∗
= π ∗ (λp + (1 − λ)p , λw + (1 − λ)w ).
That is, π ∗ is convex even at p = 0.
The applications of Euler’s Theorem used here reveal another useful property of the optimal value and
optimal choice functions. From the homogeneity, by Euler’s Theorem we have

 ∂y ∗ ∂y ∗ ∂y ∗   ∂y∗ n ∂y ∗ 
...   p ∂p + j=1 wj ∂w  
∂p ∂w1 ∂wn p n
j 0

 ∂x∗1 ∂x∗ ∂x∗   ∂x∗ ∂x∗ 
p  − ∂p − ∂w11 ... − ∂w1n   w1   −p ∂p1 − j=1 wj ∂w1j  0
Hπ∗ (p,w) =   .  =   =  . .
w .. .. .. ..  .   ..   .. 
 . . . .  .  . 
∂x∗ ∂x∗ ∂x∗ wn ∂x ∗ n ∂x∗ 0
− ∂p
n
− n
∂w1 ... − ∂wnn −p ∂pn − j=1 wj ∂wnj

p
Thus [ p w ] Hπ∗ (p,w) = 0 ∀(p, w), and we see that the matrix H is not positive definite. In particular,
w

p p
Hπ∗ (p,w) =0 ,
w w

p
so is an eigenvector of Hπ∗ (p,w) and 0 is an eigenvalue. Since Hπ∗ (p,w) has a zero eigenvalue, its
w
determinant is zero and the Hessian matrix is therefore singular. Similar arguments show that the Hessian
matrix of the cost function with respect to w, multiplied by the input price vector w, is the zero vector; and
therefore 0 is an eigenvalue and the matrix is singular.

Exercises for Lecture 8 (Duality of Supply, Demands, and Profit)
1. Suppose
α β
∗ w2 w1
x (w1 , w2, y) = [e − 1]
y
, .
w1 w2
a. For what values of α and β is x∗ a conditional factor demand function?
b. For those values of α and β, find the
i. cost function.
ii. supply/demand function.
iii. profit function.
iv. production function.
2. Suppose
  p2
 0, w1 > w2 
 , w1 > w2
p   4w22
∗ ∗ 2 2
y (p, w) = , x1 (p, w) = [0, p /4w 1 ], w1 = w2 , x∗2 (p, w) = p 2
− x∗1 , w1 = w2 .
2 min{w1 , w2} 
 p2 
 4w12
, w1 < w2 
4w 21 0, w1 < w2
a. Verify that (y∗ , −x∗ ) is a supply/demand function for some technology.
b. What is the profit function?
c. What is the production function?
d. What is the conditional demand function?
e. What is the cost function?
3. Suppose
p2
π ∗ (p, w1 , w2 ) = ,
4A
where A = w11−α w2α + w1β w21−β .
a. For what values of α and β is π ∗ a profit function?
b. For those values of α and β, find the
i. supply/demand function.
ii. conditional demand function.
iii. cost function.
iv. production function.

Lecture 9: Cost Analysis
Readings: Sections 5.1-5.3 of Varian; Section 5.D of MWG.
In the previous two lectures we studied the cost function c∗ (w, y) and discovered that it has the properties
of homogeneity, concavity, monotonicity, continuity, and nonnegativity. The cost function is very useful for
studying imperfectly competitive output markets. If the firm is not a price-taker in its output market then
the firm’s profit objective is
max R(y) − w · x subject to x ∈ V (y)

{(x,y)}
for some revenue function R(y), where R(y) may not take the simple form R(y) = py as in the perfectly
competitive case. Although this is a new objective for us, it is not necessary to start all over and analyze
this problem from the beginning because we know that every profit maximizing firm also minimizes cost.
Thus, we can summarize the firm’s technology by simply using its cost function, rather than by going all the
way back to the production function or the production set. Then the objective becomes
max R(y) − c∗ (w, y).

{y}
Really, for economic purposes the only sense in which properties of the technology are interesting is when they
lead to some property of the cost function. In imperfectly competitive output markets the most important
aspect of cost is its shape as a function of output. Hence, we usually just suppress the input price vector
w (i.e., assume these prices aren’t changing) and write c∗ (y) or just c(y). For purposes of this lecture we
will assume that we have nice, unique, proper interior cost minima and that all needed derivatives exist.
Nonnegativity and monotonicity tell us that c∗ (y) is zero when y = 0 and is increasing, so c∗ (y) appears as
in Figure 9.1.
There are several useful cost concepts that are defined from c∗ (y):
1. Average cost: ac(y) = c∗ (y)/y for y > 0.
∂c∗
2. Marginal cost: mc(y) = ∂y for y > 0.
3. Fixed cost: fc is that part of c∗ (y) that doesn’t vary with y (if any). A fixed cost can be sunk, partially
sunk, or not sunk.

60 LECTURE 9: COST ANALYSIS
Figure 9.1: Cost as a Function of Output
4. Variable cost: vc(y) is that part of c∗ (y) that varies with y.
So, c∗ (y) = fc + vc(y)
mc(y) = vc (y).
5. Average fixed cost: afc(y) = fc/y for y > 0.
6. Average variable cost: avc(y) = vc(y)/y for y > 0.
So, ac(y) = afc(y) + avc(y)
The relationship between average and marginal cost is seen from ac (y) = mc−ac
y for y > 0, as in Figure
9.2. The same relationship holds between avc and mc, since mc is the derivative of vc.
Fixed costs appear as in Figure 9.3. Here, c∗ (y) = w1 x̄1 + w1 (x∗1 (w, y) − x̄1 ), so fc = w1 x̄1 and vc =
w1 (x∗1 (w, y)− x̄1 ). If the fixed cost were sunk, then the production set would not have the horizontal segment
and the cost function would take on the value w1 x̄1 at y = 0. Similarly, if the fixed cost were partially sunk
then the production set would have only part of the horizontal segment and the cost function would take on
a value between zero and w1 x̄1 at y = 0.
If fc > 0 then afc is everywhere strictly decreasing as a function of y. Thus, if in addition avc is eventually
rising then the relationship ac = afc + avc shows that ac curves are roughly U-shaped. This is illustrated
Figure 9.2: Average and Marginal Cost
Figure 9.3: Fixed Cost
in Figure 9.4. The smallest output at which ac reaches its minimum is called the minimum efficient scale
(mes). There can be more than one output at which ac takes on its minimum value, and they are all efficient
scales, but only the smallest such output is the mes.
Usually we think of sunk costs as arising in the short- or intermediate-run, when some input(s) cannot
be freely varied. In this scenario, we can study the relationship between short-run and long-run costs.
Presumably the fixed input level(s) were chosen with some feasible output level in mind. Call this output
Figure 9.4: U-Shaped Average Cost and the MES
level ȳ and suppose the fixed input is input 1, fixed at x∗1 (w, ȳ). Then the short-run problem is
min w1 x∗1 (w, ȳ) + w−1 · x−1 subject to (x∗1 (w, ȳ), x−1 ) ∈ V (y).
{x−1 }
Thus, the sunk cost is w1 x∗1 (w, ȳ), and since x1 is fixed the solution will generally be different from x∗−1 (w, y).
For example, in two dimensions the choice of x2 might appear as in Figure 9.5.
Figure 9.5: Short-Run Cost Minimization

So, let x∗−1 (w, y|x∗1 (w, ȳ)) be the solution. Then the short-run cost function is
c∗ (w, y|x∗1 (w, ȳ)) = w1 x∗1 (w, ȳ) + w−1 · x∗−1 (w, y|x∗1 (w, ȳ)).
There are four relationships between the short-run and long-run cost functions. These hold for all feasible
ȳ:
1. c∗ (w, y|x∗1 (w, ȳ)) ≥ c∗ (w, y) ∀y (feasible).
2. c∗ (w, ȳ|x∗1 (w, ȳ)) = c∗ (w, ȳ).
3. mc(ȳ|x∗1 (w, ȳ)) = mc(ȳ).
4. mc (ȳ|x∗1 (w, ȳ)) ≥ mc (ȳ).
Item 1 is by definition: The short-run problem has an additional constraint, so the minimum must be no
smaller. Items 2 and 3 are also immediate: If y = ȳ then x∗−1 (w, y|x∗1 (w, ȳ)) and λ∗ (w, y|x∗1 (w, ȳ)) satisfy the
same set of first order conditions as x∗−1 (w, y) and λ∗ (w, y) (with x∗1 (w, y|x∗1 (w, ȳ)) = x∗1 (w, ȳ)), so they are
equal. This makes the two costs equal at ȳ. And, since λ∗ is marginal cost in both cases, the two marginal
costs are equal as well. Item 4 requires some work with second-order Taylor Series representations of the
cost functions:
1
c∗ (y) = c∗ (ȳ) + mc(ȳ)(y − ȳ) + mc (ŷ)(y − ȳ)2
2
1
c∗ (y|x∗1 (w, ȳ)) = c∗ (ȳ|x∗1 (w, ȳ)) + mc(ȳ|x∗1 (w, ȳ))(y − ȳ) + mc (ỹ|x∗1 (w, ȳ))(y − ȳ)2
2
for some ŷ and ỹ between y and ȳ. Subtract the second from the first and note that the first two terms of
each right side are equal by items 2 and 3, while the difference on the left side is nonpositive by item 1. Thus
mc (ŷ) − mc (ỹ|x∗1 (w, ȳ)) ≤ 0 ∀y.
Let y → ȳ and note that ŷ → y and ỹ → y as well. Thus, if the cost functions have continuous second
derivatives then item 4 follows. With these four items established, we know a lot about the relative positions
of the two cost functions, as illustrated in Figure 9.6.

Figure 9.6: The Short- and Long-Run Cost Functions
From the definition of average cost, these same relationships must hold between the short- and long-run
average cost curves, as in Figure 9.7.
Figure 9.7: The Short- and Long-Run Average and Marginal Cost Functions
Now that we know the shape of the cost curves, we can return to the firm’s optimization problem stated
in terms of the cost function:
max R(y) − c∗ (y).

{y}
The first order condition is R (y) = mc(y). This condition defines the optimal output choice y∗ provided
that the solution is an interior maximum. Since R (y) is the change in revenue resulting from a change in
output, we call it the firm’s marginal revenue. The first order condition thus states the familiar condition
that a profit-maximizing firm chooses its output level to equate marginal revenue with marginal cost. The
second order condition is R (y) < mc (y) at y∗ . This says that the marginal cost curve must cross the
marginal revenue curve from below as y increases, at the optimal y.
If the firm is a perfect competitor in its output market then R(y) = py for some fixed price p. In this case
marginal revenue is R (y) = p, a constant for all y, and we have R (y) = 0. Thus the first order condition
is p = mc(y) and the second order condition for a proper maximum is mc (y) > 0. Again, the first order
condition defines the optimal choice y∗ if we have a nice interior maximum. Since the output price is a
parameter for the perfectly competitive firm the y∗ choice is a function of p, the supply function, implicitly
defined by
p ≡ mc(y∗ (p)).
This shows that a perfectly competitive firm chooses the output level that equates price with marginal cost.
The comparative statics of price changes require that the firm adjust its supply choice to maintain the p = mc
condition as price changes. Thus, geometrically, the perfectly competitive firm’s supply curve is its marginal
cost curve, as illustrated in Figure 9.8. Algebraically, the supply function is the inverse of the marginal cost
function evaluated at the price:
y∗ (p) = mc−1 (p).
This statement presumes that the inverse exists (i.e., mc is strictly monotonic) and that the second order
condition holds. Since marginal revenue is constant, the second order condition requires that mc be strictly
increasing.
A major exception to this depiction of a perfect competitor’s supply curve occurs if there is a non-sunk or
partially sunk fixed cost. In that case, as illustrated in Figure 9.3, the cost function has an upward disconti-
nuity and thus it cannot be convex. This means that the profit objective cannot be concave, and therefore
there is a chance that the local first and second order conditions do not describe the global maximum. Figure
9.9 illustrates this case. Here, the ac and avc curves are U-shaped because there is a fixed cost and increasing
Figure 9.8: Supply for a Perfectly Competitive Firm. At price p0 , the firm’s optimal
output choice is y0 because mc equals p0 at this output level. At a different price, say p1 , the
firm’s optimal output choice adjusts to y1 so that the p = mc condition is maintained. Thus, as
p varies the mc curve traces out the optimal output choices.
marginal cost. At prices below p2 , the local conditions indicate that the optimal supply choice is along the
mc curve, for example at y1 when price is p1 . But at this output choice revenue per unit is p1 , which is
below cost per unit of ac(y1 ), and so the firm is earning negative profit. This negative profit is due to the
fixed cost. Since the fixed cost is not fully sunk, the firm might be better off choosing an output of zero and
just incurring whatever part of the fixed cost is sunk.
Figure 9.9: Shutdown for a Perfectly Competitive Firm with Fixed Costs
The simplest case of this occurs when all of the fixed cost is sunk. In that case, the firm avoids only
its variable costs when it chooses zero output. If a positive output is chosen, the first and second order
conditions indicate that it must be along the mc curve. So the decision about whether to produce positive
or zero output is based on whether the price line intersects the mc curve above the avc curve. If so, then
revenue is more than variable cost and so the firm can recoup at least some of its fixed cost by producing
something. This is the situation at price p1 in Figure 7.9. However, if price is below p0 then revenue is less
than variable cost and so the firm is better off (incurs a smaller loss) choosing zero output. In this situation,
price p0 is called the shutdown point for the firm. Note that the avc curve may lie below the mc curve at all
output levels, since fixed cost is not included in avc. If this is the case and all of the fixed cost is sunk, then
the firm always chooses output to satisfy p = mc (assuming this is possible and the second order condition
holds).
The other polar extreme occurs when none of the fixed cost is sunk. Then the firm avoids both its variable
and fixed costs when it chooses zero output. Hence, the firm chooses zero output whenever price is below
p2 , and p2 is the shutdown point.
If the fixed cost is partially sunk, then the firm avoids some but not all of it by choosing zero output. In
this case there is a shutdown price between p0 and p2 , depending on how much of the fixed cost is sunk.
In all cases, the optimal supply behavior of the firm is to choose y along the mc curve when price is
above the shutdown price and y = 0 when price is below the shutdown price. When price is exactly equal
to the shutdown price the firm is indifferent between y = 0 and the output level where p = mc, but the
intermediate output levels are not optimal because they generate less profit than the two extremes (unless mc
has a horizontal segment at the shutdown price). This is illustrated in Figure 9.10.
Figure 9.10: Supply for a Perfectly Competitive Firm with Fixed Costs. ps is the
shutdown price for this firm. The supply curve is the dark line. It is discontinuous, jumping from
zero to ys at ps . Output levels between 0 and ys are not optimal at price ps .
Exercises for Lecture 9 (Cost Analysis)
1. Consider a firm that produces one output.
a. Prove that average cost is nonincreasing as a function of output when there is global nondecreasing
returns to scale. Draw a production set, average cost/marginal cost graph, and total cost graph that all
reflect global nondecreasing returns to scale. Now draw a production set and total cost graph indicating
why marginal cost can increase even when there is global nondecreasing returns to scale.
b. Redo question a for the case of global nonincreasing returns to scale (nondecreasing average cost).
c. What do average and marginal cost look like when there is global constant returns to scale?
d. It is possible to define local returns to scale through a measurement called the elasticity of scale. Read
the discussion on elasticity of scale on pages 16-17 and 88-89 of Varian. Using the relationship between
average and marginal cost, compare the characterization of local returns to scale provided by the cost
function with the global characterizations given in parts a-c above.
2. Suppose a single-output perfectly competitive firm has cost function

∗ F + y2 , y > 0
c (y) =
αF, y = 0.
Here, F > 0 is fixed cost and α ∈ [0, 1] is the proportion of fixed cost that is sunk.
a. Graph the average, average variable, and marginal cost curves for this firm.
Now find the supply curve for this firm when
b. α = 1.
c. 0 < α < 1.
d. α = 0.
In each case, graph the supply curve.

√
3. Given a production function f(x1 , x2 ) = x1 x2 , cost function c∗ (w, y) = 2 yw1 w2 , and conditional factor

demand x∗1 (w, y) = yw2 /w1 :
a. Find short-run cost c∗ (w, y|x̄1 ) for some fixed x̄1 .
b. Verify c∗ (w, ȳ|x̄1 ) = c∗ (w, ȳ) (hint: find ȳ first!).
4. Varian #5.2.
5. Varian #5.8.
6. MWG #5.D.2.
7. MWG #5.D.4(a).
Lecture 10: Applied Production Analysis
Readings: None.
Suppose we are faced with the empirical problem of estimating the technology of a firm or group of firms
in an industry. For example, we might want estimates of how input usage varies when input prices change,
the returns to scale of the technology, or the efficiency of the firm(s). One approach is to collect data on
input quantities (x1 , . . . , xn ) and output levels (y) and then use the data to directly estimate the production
function y = f(x1 , . . . , xn ). This would involve assuming a functional form for f, defining an “error”
e = y − f(x1 , . . . , xn ) in the production relationship based on that functional form, making assumptions
about the statistical properties of e, and then using some estimation procedure (such as Ordinary Least
Squares or Maximum Likelihood) to estimate the parameters of the assumed functional form f.
Before proceeding, it should be noted that a crucial statistical assumption typically made is that
E(e|x1 , . . . , xn ) = 0,
which says that the error in the assumed relationship between y and (x1 , . . . , xn ) is not related to the
value of the input vector x = (x1 , . . . , xn ). This is usually implausible: The observed values of inputs and
outputs all result from optimizing behavior by the same economic actor(s), hence any errors of observation
or specification by the analyst, or mistakes by the economic actor(s), are very likely related to each other
in a given observation on (y, x1 , . . . , xn ). If so, technology parameter estimates obtained by using simple
estimation procedures will be biased. Moreover, the statistical “fixes” for this problem are unlikely to be
helpful in this setting. One would need instruments for ALL inputs to effectively perform instrumental
variables estimation, or a complicated fully-specified joint distribution for the n + 1 observed variables
(y, x1 , . . . , xn) to effectively perform maximum likelihood.
Nonetheless, production functions have been (and still are) estimated by many researchers, and much
of the jargon surrounding empirical discussions of production stems from this practice, hence it is worth
reviewing.
Simple Parametric Forms for Production Functions;

Hicks Elasticity of Substitution; Elasticity of Scale
Four common functional forms for the production function f are:

72 LECTURE 10: APPLIED PRODUCTION ANALYSIS
n n
1 · · · xn , which is equivalent to ln f = ln A +
1. Cobb-Douglas: f(x1 , . . . , xn) = Axα 1 α
i=1 αi ln xi .

2. Leontief (fixed proportions production): f(x1 , . . . , xn ) = [min{α1 x1 , . . . , αnxn }] .

3. Perfect Substitutes: f(x1 , . . . , xn) = [α1 x1 + · · · + αn xn ] .
/ρ
4. Constant Elasticity of Substitution (CES): f(x1 , . . . , xn ) = [α1 xρ1 + · · · + αn xρn ] .
Here, αi > 0 and > 0 are unknown parameters of each assumed functional form. In the Cobb-Douglas
form, A > 0 is an efficiency parameter (a larger value of A means that any given input vector x produces
a larger amount of output). A is actually a redundant parameter since it can be normalized to unity by
rescaling the units in which output is measured, but the Cobb-Douglas form has the empirically convenient
property that it is linear in logarithms and in that form ln A is convenient because it gives the function a
non-zero intercept. αi in the Cobb-Douglas form is the (constant) elasticity of output with respect to input
αi
i.2 In the Leontief form, αj is the (constant) ratio of xj over xi in any efficient production plan. In the
αi
perfect substitutes form, αj
is the (constant) slope of the isoquant between inputs j and i. In the CES
form, αi
αj enters the slope of the isoquant in the same was as the Cobb-Douglas form and ρ ≤ 1 (ρ = 0) is
an unknown parameter that measures the (constant) elasticity of substitution (discussed below). > 0 is
an unknown parameter that measures economies of scale in all forms (an exponent could be placed on the
Cobb-Douglas function but it would be empirically indistinguishable from the αi exponents).
All four of these functional forms severely limit the substitution and returns to scale possibilities. To see
the limitations, define the following two measures that are often of interest in empirical work.
Definition. Let f(x1 , . . . , xn ) be a production function. Then (i) the (Hicks) elasticity of substitution
of input i for input j at input vector x is

f (x)
d xxji d fji (x) fij (x)[fi (x)xi + fj (x)xj ]
σij (x) ≡ =− ,
xi fj (x) xi xj [fjj (x)fi (x) − 2fij (x)fi (x)fj (x) + fii (x)fj2 (x)]
2
xj fi (x)
and (ii) the elasticity of scale at x is

df(λx) n
f(λx) df(λx) λ fi (x)xi

dλ = = i=1 .

dλ f(λx) λ=1 f(x)
λ
λ=1
that every elasticity can be expressed as a logarithmic derivative so that ∂∂ln

2 Recall ln y
xi
= αi is the elasticity of y with
respect to xi . To see that an elasticity is a logarithmic derivative, suppose z is a function of w: z = g(w). Then the point
0
elasticity of z with respect w at the point (w0 , z0 ) is defined to be g (w0 ) w
z0
. Now suppose we express the relationship between
w and z in terms of logarithms by writing w = eln w and z = eln z , so that eln z = g(eln w ), or ln z = ln g(eln w ), and then
∂ ln z 1 1 0
regard the logarithms as the variables. Then ∂ ln w
= g(eln w )
g (eln w )eln w = g(w)
g (w)w. Evaluating at w0 yields g (w0 ) w
z0
,
the elasticity.
The (Hicks) elasticity of substitution is the percent change in an input mix that results from a percent
change in the (absolute value of the) corresponding marginal rate of technical substitution, evaluated at
input vector x and holding output constant. It measures the curvature of the isoquant at x. To see this,
consider two possible isoquants at a point x, having the same MRTS at x, but one of which is more curved
than the other:
Figure 10.1: The Hicks Elasticity of Substitution
x2
The slope of the line from the origin to x is the input ratio x1 at x. If this input ratio changes to the
steeper slope illustrated above, and the isoquant is the curve through x0 , then the change in the MRTS
(slope of the isoquant) for the given change in the input ratio is relatively small. On the other hand, if the
isoquant is the curve through x1 , then the change in the MRTS for the given change in the input ratio is
relatively large. Hence the elasticity of substitution at x for the isoquant through x1 is smaller than the
elasticity of substitution at x for the isoquant through x0 (recall that the percent change in the MRTS is in
the denominator of the elasticity of substitution). That is, the more curved isoquant is less elastic – a given
percent change in the MRTS along the more curved isoquant yields a smaller percent change in the input
ratio. Intuitively, it is “harder” to change the input ratio along the more curved isoquant (i.e., it would take
a larger change in relative prices).
In the limit, if the elasticity of substitution approaches infinity at all x on an isoquant then the isoquant
approaches a straight line. Conversely, if the elasticity of substitution approaches zero at some x while
approaching infinity at all other x on the isoquant then the isoquant approaches an L-shaped Leontief form.
Now consider the elasticity of scale. The elasticity of scale is the percent change in output that results
from a percent change in the scale of all inputs, evaluated at input vector x. It is a local measure of returns
to scale that can be used to describe a technology at a particular input vector even though the technology
may not have any specific global returns to scale. It is clear from the definition that the elasticity of scale
may change as x changes, so it can only be a measure of returns to scale for infinitesimal changes in scale at
a particular input vector x. If the technology possesses global constant returns to scale then the production
n
function is linear homogenous, so Euler’s Theorem yields i=1 fxi (x)xi = f(x). Hence, global constant
returns to scale implies a unit elasticity of scale everywhere, and so a technology is said to possess constant
returns to scale at input vector x if the elasticity of scale is 1 at x. Similarly, a technology is said to possess
decreasing returns to scale at input vector x if the elasticity of scale is less than 1 at x, and increasing returns
to scale at input vector x if the elasticity of scale is greater than 1 at x.
Now return to the four functional forms presented above. The Leontief form has L-shaped isoquants and
the perfect substitutes form has linear isoquants, hence the restrictions on substitution possibilities imposed
by these two functional forms are obvious: The Leontief form imposes a zero elasticity of substitution and
the perfect substitutes form imposes an infinite elasticity of substitution. For the Cobb-Douglas form, it
d(x2 /x1 )
is straightforward to derive M RT S21 = − αα12xx21 when there are two inputs (n = 2). Hence d|M RT S|
= α2
α1
.
|M RT S|
Multiplying by x2 /x1 yields 1. That is, the Cobb-Douglas form imposes a unit elasticity of substitution.
Similar manipulations reveal that the elasticity of substitution for the CES form is 1 − ρ. This is more
flexible than Cobb-Douglas, in that the CES elasticity of substitution can range from zero to −∞ depending
on the value of the parameter ρ, which presumably would be estimated based on data (so the data can
determine the elasticity of substitution in the CES form). However, the elasticity of substitution in the CES
form is still a constant across all output levels, and across all input vectors along a given isoquant (hence the
name “Constant Elasticity of Substitution”). In short, all four of these functional forms are quite restrictive
regarding the ability to estimate the elasticity of substitution from the data. The first three assume a
particular value that is unrelated to the data, while the CES form assumes the elasticity is a constant but
permits that constant to be estimated.
The CES form is sometimes described as encompassing the other three functional forms under discussion
here. This is because the CES is exactly the perfect substitutes form if ρ = 1, and the CES elasticity of
substitution approaches the Leontief elasticity of substitution (∞) as ρ → −∞ and approaches the Cobb-
Douglas elasticity of substitution (1) as ρ → 0 (even though the CES function is not defined if ρ is exactly
zero). The CES form essentially lets the data determine which of these forms, or some intermediate case of
constant elasticity, applies to the technology under study.
These functional forms impose similar restrictions on the elasticity of scale. It is straightforward to
differentiate each of the four functional forms to show that the elasticity of scale for the Cobb-Douglas is
n
i=1 αi , while the elasticity of scale for the other three forms is . In short, all four functional forms impose
a constant elasticity of scale across all output levels and across all input vectors along a given isoquant;
and the elasticity of scale for the Cobb-Douglas form is not a separate parameter from the various output
elasticities. The elasticity of scale for these functional forms can be estimated from the data but the estimate
is constrained to be the same everywhere on the production surface. We cannot, for example, estimate a
U-shaped AC curve from a data set using any of these functional forms.
“Flexible” Functional Forms
The limitations of the simple functional forms considered above led to development of more flexible
functional forms, particularly functional forms that permit the elasticities of substitution and scale to be
different at different input vectors. The two most common functional forms with additional flexibility for
production functions are:

n n n
1. Translog: ln f(x1 , . . . , xn ) = α0 + i=1 αi ln xi + i=1 j=1 αij ln xi ln xj .
n
n 1/2 1/2
2. Generalized Linear: f(x1 , . . . , xn ) = i=1 j=1 αij xi xj .
The translog (short for “transcendental logarithmic”) form is quadratic in the logs of output and the inputs.
This form naturally permits elasticities that vary with the input vector, since elasticities are logarithmic
derivatives and the first logarithmic derivatives depend on the (log) input levels when the function is quadratic
in logs. Indeed, a quadratic in logs is the simplest functional form that allows for nonlinearity in logs. The
generalized linear form is the same idea except it is quadratic in levels rather than logs.
For reasons that will be explained below, we will not derive the Hicks elasticities of substitution for these
two functional forms, but the elasticities of scale are straightforward. Letting z denote the right side of the
translog, we have f(x1 , . . . , xn ) = ez so

∂z f(x1 , . . . , xn ) n
z
fk = e = αk + (αik + αki) ln xi .
∂xk xk i=1
Using this in the definition of the elasticity of scale yields

n
n
αk + (αik + αki) ln xi ,
k=1 i=1
which clearly depends upon the entire (log) input vector. Similarly, letting z denote the bracketed term on
the right side of the generalized linear form we have
−1/2
n
1/2
fk = z −1 xk (αki + αik )xi .
2
i=1
Therefore
n

n
−1 1/2
n
1/2

n n
1/2 1/2
fk xk = z xk (αki + αik )xi = z −1 αkixk xi = z .
2 i=1 i=1
k=1 k=1 k=1
Hence the elasticity of substitution for the generalized linear form is , which is still invariant across input
vectors despite the added complexity of the quadratic functional form.
Using Duality Theory in Applied Production Analysis
Recall that duality theory guarantees there is a well-behaved technology underlying every cost function
provided the cost function satisfies homogeneity, concavity, monotonicity, continuity, and nonnegativity; and
vice-versa. Therefore any technology we might want to consider can be estimated by estimating a cost
function that has these five properties rather than by estimating a production function. To do so, we collect
data on input prices (w1 , . . . , wn), output levels y and total costs c; and use the data to estimate the cost
function c = g(w1 , . . . , wn , y) by assuming a functional form for g, defining the error u = c − g(w1 , . . . , wn , y)
in the cost relationship based on that functional form, making assumptions about the statistical properties
of u, and then using some estimation procedure (such as Ordinary Least Squares or Maximum Likelihood)
to estimate the parameters of the assumed functional form g taking care to ensure that the estimated g
function has the five properties of a cost function. From a procedural perspective, this is not much different
from estimating a production function except that we are working with input price and cost observations
rather than input quantity observations; and we have some known properties to impose on the estimated g.
Data availability may create an advantage to estimating a cost function rather than a production function.
Input prices may be easier to observe than input quantities. However, this is not always true.
Even when there is no data advantage, cost estimation is superior because of its statistical properties. As
in the estimation of production functions, the key statistical assumption for unbiased parameter estimators
is that the expected value of the error in the cost relationship be unrelated to the values of the observable
variables on the right side of the relationship. That is, E(u|w1 , . . . , wn, y) = 0. If the firm(s) under study can
be reasonably regarded as price-takers in the markets for their inputs (if not, a cost function is not a correct
representation of the technology even from a purely theoretical perspective) then the assumption that input
prices are exogenous to errors of observation or specification by the analyst, and mistakes by the economic
actor(s), is much more plausible than the assumption that input quantities are exogenous to unobservable
errors. In short, it is much more likely the analyst will obtain unbiased estimates of technology parameters
using cost function estimation than production function estimation.
Cost estimation has the further advantage that it leads very directly to estimates of factor demands. Once
a cost function is estimated, the implied estimates of factor demands are immediately obtained through
simple differentiation via Shephard’s Lemma. Estimates of factor demands can, of course, be derived from
an estimated production function as well but doing so requires that the cost minimization problem be solved
explicitly, and the difficulty of deriving a closed-form solution increases with the flexibility of the assumed
functional form.
Note there may still be an endogeneity problem in cost estimation because output is on the right side of
the cost relationship and output is often chosen by the same economic actor(s) that make cost decisions.
However, the endogeneity problem is greatly reduced since inputs are no longer an issue. It may be possible
to find an instrument for output, or it may be plausible to argue that output is not under the firm’s control in
the short-run. In some cases, such as a regulated public utility with carrier-of-last-resort obligations, output
is clearly not chosen by the firm. If endogeneity of output cannot be addressed in these ways then the
same arguments in favor of cost estimation over production function estimation suggest the analyst should
collect data on output prices and estimate a profit function rather than a cost function, assuming the firm
is a price-taker in its output market. This removes output as a variable in the analysis and relies, through
duality, on the profit representation of technology.
Another way to estimate a production relationship using duality theory is to estimate the conditional
factor demands (or, if endogeneity of output is an issue, the unconditional factor demands and output
supply). Duality theory guarantees there is a well-behaved technology underlying every set of conditional
factor demands that satisfies homogeneity, symmetry and semidefiniteness, monotonicity, continuity, and
nonnegativity; and vice-versa. Estimating demands requires data on input quantities as well as input prices
and output, assumptions about the functional forms of the demands, and assumptions about the statistical
properties of the errors; after which some appropriate estimation procedure is used and restrictions are
imposed to ensure that the estimated demands satisfy the five properties of conditional factor demand
functions.
A once-common functional form assumption is that the conditional factor demands are linear in logs:

n
ln xi = αi + αij ln wj + αiy ln y + ui for i = 1, . . . , n,
j=1
where the α’s are the demand parameters to be estimated and ui is the error in the assumed relationship
for input i. This functional form has the appealing feature that the demand elasticities are constant and
directly estimated: αij is the elasticity of demand for input i with respect to price j and αiy is the elasticity
of demand for input i with respect to output. This appeal is misleading, however. It is instructive to apply
duality theory to this functional form. Doing so reveals that this functional form imposes severe unappealing
restrictions on demand.
Consider first the implications of homogeneity. If each input price shifts from wj to λwj then demand at
the new input price vector is

n
n
n
αi + αij ln(λwj ) + αiy ln y + ui = αi + αij ln wj + αiy ln y + ui + λ αij .
j=1 j=1 j=1
Homogeneity requires that this shift in input prices leave demand unchanged for every λ > 0; hence the
n
parameters of the ith equation must satisfy j=1 αij = 0 in order for this function to be a conditional
factor demand. Some computer programs have options to impose this type of parameter constraint on the
estimation. Alternatively, the constraint can be substituted for one of the price elasticities, say the nth , to
obtain

n−1
n−1
ln xi = αi + αij (ln wj − ln wn ) + αiy ln y + ui = αi + αij (ln(wj /wn ) + αiy ln y + ui .
j=1 j=1
This way of writing the equation essentially declares input n as the numeraire. Estimation proceeds by
defining new, normalized, price observations ŵj = wj /wn and using the logs of these along with logged
output as independent variables.

n
Note that xi > 0 with this functional form since xi = exp[αi + j=1 αij ln wj + αiy ln y + ui ], and the
exponential function is always positive. Hence the nonnegativity property is automatically satisfied by this
functional form, except the part requiring that cost be zero when output is zero. The latter cannot be
addressed when log output appears in the specification because the log function is not defined at zero.
Note also that this functional form is continuous in all strictly positive input prices and output except,
again, it is not defined at the boundary where output is zero. Hence the continuity property is automatically
satisfied if all n demands have this functional form, except at zero output where cost is not defined.
Some empirical projects focus on the demand for only one input. The only other requirement imposed by
duality theory on the parameters of a single conditional factor demand is the part of semidefiniteness that
ensures the demand is downward-sloping in its own price. That is, αii ≤ 0 is required. All other duality
requirements involve the parameters of multiple demands and therefore cannot be imposed when only one
demand is under study. As αii ≤ 0 is an inequality constraint, it cannot be imposed as part of a linear
estimation procedure. The usual practice is to estimate the demand without imposing this inequality and
then check that the estimated value of αii is non-positive, with much concern generated about the assumed
specification and the data if the estimated value of αii is positive.
Hence, if only one demand is under study then the dictates of duality theory can be incorporated with
only minor inconsistencies. If, however, the demand for more than one factor is under study then symmetry,
the remainder of semidefiniteness, and monotonicity must be considered; and these properties reveal serious
weaknesses of demands that are assumed to be linear in logs.

∂xi
Consider conditional factor demands for inputs i and j that are linear in logs. Symmetry requires ∂wj =
∂xj ∂xi αij

∂wi , while the functional form yields ∂wj = αij wxij , so symmetry with this functional form requires αji = wi xi
wj xj
wi xi
for all input price vectors and output levels. That is, wj xj , which is the amount spent on input i relative
to the amount spent on input j, must be invariant to input prices and output levels. There is no reason to
expect this in general and, indeed, it would be a peculiar feature of a demand system. It is straightforward
to take the log of this ratio and substitute the demands to conclude that the following expression would have
to be constant across all input prices and output levels:

n
(1 + αjj − αji ) ln wj − (1 + αii − αij ) ln wi + (αjk − αik ) ln wk + (αjy − αiy ) ln y.
k=1 (k=i,j)
Since the input prices and output levels can vary independently, this expression is constant if and only if all
of the following hold:
1. 1 + αjj − αji = 0,
2. 1 + αii − αij = 0,
3. αjk = αik for all k = i, j, and
4. αjy = αiy .
That is, the cross-price elasticities of inputs i and j with respect to any other price must be equal, the output
elasticities of inputs i and j must be equal, and the own- versus cross-price elasticities of each of these inputs
must satisfy a special relationship. If all factor demands were linear in logs then these observations must hold
for every i, j pair. Adding item 1 across i and using homogeneity would then yield αjj = −1. Substituting
back into item 1 would then give αji = 0 for every i. In other words, the functional form would impose
that all demands are unit elastic with respect to the own-price and all cross-price elasticities are zero. The
only parameter left to estimate would then be the (common) output elasticity. In short, assuming the linear
in logs functional form for the entire demand system amounts to assuming particular values for all price
elasticities and that all inputs have the same output elasticity, irrespective of the data.
This is hardly a useful demand system but it would be very difficult to perceive the weaknesses without
duality theory. This is one example of the power of duality theory. The theory can guide our choice of
functional form to avoid absurd assumptions, even when a functional form has superficial appeal. There is
some now-dated empirical work that purports to “reject” neoclassical demand theory by estimating demand
systems with particular functional forms, some of which were linear in logs, and then observing that the
results easily reject the null hypothesis that the estimated parameters satisfy the duality restrictions. We
now see that the problem with some (but not all) of this literature is that the assumed functional forms did
not permit sensible demand estimation, so the apparent “rejection” of neoclassical demand theory was, in
some cases, nothing more than unreasonable assumptions in the empirical specification.
These problems led to development of functional forms for cost functions (and implicitly, conditional
factor demands, by Shephard’s Lemma) that are sufficiently flexible to avoid de facto absurdities. Four such
functional forms are:

n
1. Linear Expenditure System: g(w1 , . . . , wn , y) = i=1 αi wi + y w1β1 w2β2 · · · wnβn .
n n 1/2 1/2
2. Generalized Leontief: g(w1 , . . . , wn, y) = h(y) i=1 j=1 αij wi wj .
n 1
n n
3. Translog: ln g(w1 , . . . , wn , y) = α0 + i=1 αi ln wi + 2 i=1 j=1 αij ln wi ln wj + αy ln y + αyy (ln y)2 +
n
i=1 αiy ln wi ln y.
n 1
n n
4. Almost Ideal Demand System: ln g(w1 , . . . , wn, y) = α0 + i=1 αi ln wi + 2 i=1 j=1 αij ln wi ln wj +

yβ0 w1β1 w2β2 · · · wnβn .
Here, the α’s and β’s are unknown parameters of each assumed functional form. These parameters have
different interpretations in each functional form and must satisfy various restrictions in each form to ensure
that each cost function has the five properties required by duality theory (homogeneity of degree 1 and
concavity in input prices, monotonicity, continuity, and nonnegativity). h in the generalized Leontief form
is a continuous and strictly increasing function satisfying h(0) = 0. These four functional forms for cost are
all obviously continuous in all strictly positive input prices and output except, as above, the translog is not
defined at the boundary where output is zero. They are all also strictly increasing in y under obvious minor
assumptions, except the translog which cannot be globally monotonic in y (unless αyy = α1y = · · · = αny = 0)
because the derivative with respect to y involves logarithms, which can be arbitrarily large in both the
positive and negative directions at positive input prices and output levels. This is a shortcoming of the
translog functional form.
Consider first the linear expenditure system. Applying Shephard’s Lemma, the implied conditional factor
demands are
∂g yβj β1 β2
= xj = α j + w1 w2 · · · wnβn for j = 1, . . . , n.
∂wj wj
Multiplying both sides by wj and substituting g yields

n
wj xj = αj wj + βj g(w1 , . . . , wn , y) − α i wi ,
i=1
which shows why this is called the “linear expenditure system”: Total spending on each input is a linear
function of all input prices and total expenditure. Substituting λwi for wi in g shows that g is homogeneous
n
of degree 1 if and only if i=1 βi
= 1. Concavity of g is checked by examining the Hessian matrix with

respect to the input prices. The ith diagonal element is βi (βwi2−1) y w1β1 w2β2 · · · wnβn and the (i, j) off-diagonal
i

βi βj β1 β2
element is wi wj y w1 w2 · · · wn . Concavity requires that the naturally-ordered principal minor of order k
βn

have sign (−1)k . Every element has y w1β1 w2β2 · · · wnβn so this part factors out and can be ignored. The k = 1
β1 (β1 −1) n
minor is w12
which is negative if and only if β1 ≥ 0 (using the homogeneity requirement i=1 βi = 1).
β1 β2 (1−β1−β2 )
The k = 2 minor is w12 w22
which, given homogeneity and β1 ≥ 0, is positive if and only if β2 ≥ 0.
This pattern continues for k = 3, . . . , n; with the end result being that g is concave if and only if βi ≥ 0 for
all i (given homogeneity). Note that βi ≥ 0 implies all inputs are substitutes (∂xj /∂wi ≥ 0 for i = j); the
functional form does not permit complementary inputs. Looking at ∂g

∂wj = xj , we see that αj ≥ 0 is required
to ensure that g is nondecreasing in wj at all values of input prices and output (the second term is positive
when y > 0 but tends to zero as y → 0, so there exist values of y and the input prices that make the entire
expression negative if αj < 0). Hence, given homogeneity and concavity, g is monotonic if and only if αj ≥ 0
for all j. Nonnegativity of g is obvious except for the fact that g is not zero at y = 0 unless αi = 0 for
all i. Essentially, αi measures the amount of input i that is sunk; if it is positive then there is a sunk cost
and total cost is therefore not zero even when output is zero. Given this interpretation of αi , looking at the
expression for wj xj reveals that βj measures how total spending on input j responds to changes in variable
n
cost. To summarize, g is a cost function provided βi ≥ 0 for all i, i=1 βi = 1, and αi ≥ 0 for all i; with
the further restriction that αi = 0 for all i if we want to insist that the technology satisfies the possibility of
inaction.
Now consider the generalized Leontief. This function is automatically homogeneous of degree 1 in input
prices. The implied conditional factor demands are
h(y)
n
∂g 1/2
= xj = 1/2
(αij + αji )wi for j = 1, . . . , n.
∂wj 2wj i=1
If αij = 0 when i = j then the conditional factor demand is xj = h(y)αjj , which is the functional form of
the factor demands for a Leontief production function, hence the name “generalized Leontief.” Note that
1/2 1/2
the coefficient on wi wj is always αij + αji , so we lose nothing but gain parsimony by calling this one
parameter or, equivalently, by assuming αij = αji . The demands can then be written
h(y)
n
1/2
xj = 1/2
αij wi .
wj i=1
Since this is ∂g
∂wj
, it is clear that g is monotonic in input prices if and only if αij ≥ 0. For concavity, note
1/2 1/2
that g is a sum of terms that take the form h(y)αij wi wj and recall that a sum of concave functions is
concave; hence it suffices to show that an arbitrary term of this form is a concave function. The Hessian of
this one term is

−3/2 1/2 −1/2 −1/2

h(y)αij −wi wj wi wj
−1/2 −1/2 1/2 −3/2 .
4 wi wj −wi wj
The (1, 1) element is nonpositive at all positive input prices because αij ≥ 0, and the determinant is
1/2 1/2
identically zero, hence the monotonicity restriction implies that h(y)αij wi wj , and hence g, are concave
functions. Finally, note that the restrictions on h(y) assure that g is nonnegative. In short, g is a cost
function provided αij ≥ 0, where we have eliminated redundant parameters by assuming αij = αji (we
could, equivalently, define a new set of parameters by βij = αij + αji and require βij ≥ 0). Similar to
the linear expenditure system, the requirement αij ≥ 0 implies all inputs are substitutes; once again the
functional form does not permit complementary inputs. Estimation requires that some functional form be
assumed for h. A simple functional form that satisfies the assumptions and that has an easy interpretation
(discussed below) is h(y) = y .
The translog functional form is more complicated. Differentiating yields the factor demands:

1
n
∂g g ∂ ln g g
xj = = = αj + (αij + αji ) ln wi + αjy ln y for j = 1, . . . , n.
∂wj wj ∂ ln wj wj 2 i=1
These factor demands are often written as “cost share” equations:
1
n
wj xj
sj ≡ = αj + (αij + αji ) ln wi + αjy ln y,
g 2 i=1
since the fraction on the left side of this equation is the share of total cost spent on input j. The cost share
form is convenient because the right side is linear in parameters and involves no endogenous variables (unless
endogeneity of output is an issue); hence it can be easily estimated with a linear estimation procedure. As
with the generalized Leontief, αij and αji are redundant parameters; we could just as well assume αij = αji
and write the demands in the form:

g n
xj = αj + αij ln wi + αjy ln y .
wj i=1
Substituting λwi for wi in the demand equations and factoring out the terms involving λ reveals that,
assuming momentarily g is homogeneous of degree 1 so that g(λw1 , . . . , λwn , y) = λg(w1 , . . . , wn, y), the
n
demand for input j is homogeneous of degree 0 if and only if i=1 αij = 0. Looking back at g and imposing
n
the condition i=1 αij = 0 for j = 1, . . . , n, we see that g is homogeneous of degree 1 if and only if
n n n
i=1 αi = 1 and i=1 αiy = 0 (in addition to i=1 αij = 0 for each j).
For concavity of the translog, differentiate xj and collect terms to obtain:
∂g2
g
wj wi
[si sj + αij ] i = j
= .
∂wj ∂wi g
wj2
[sj (sj − 1) + αjj ] i=j
g
The coefficients wi wj
are not relevant to negative semidefiniteness of the Hessian (g factors out of the
entire matrix and every term of each principal minor has the same product of w’s in the denominator so
the denominator factors out of each principal minor). Hence negative semidefiniteness is determined by
examining two matrices: One with elements sj (sj − 1) on the diagonal and elements si sj off of the diagonal;
and one with elements αij . If each of these matrices is negative semidefinite then the Hessian is negative
semidefinite because the sum of negative semidefinite matrices is negative semidefinite. The naturally-ordered
principal minor of order k = 1 of the first matrix is s1 (s1 − 1), which is nonpositive because, by definition,
all cost shares are nonnegative and they sum to one. The naturally-ordered principal minor of order k = 2
is s1 s2 (1 − s1 − s2 ) ≥ 0. The naturally-ordered principal minor of order k = 3 is s1 s2 s3 (s1 + s2 + s3 − 1) ≤ 0.
This pattern continues for k = 4, . . . , n; hence the first matrix is negative semidefinite. This argument is
essentially the same argument used to establish negative semidefiniteness of the Hessian for the generalized
linear form. Therefore a necessary and sufficient condition for global concavity of g is that the matrix of αij
parameters be negative semidefinite (this is clearly sufficient; it is also necessary because the cost shares vary
between zero and one on the input price space, so there will be values of the input price vector for which the
Hessian is not negative semidefinite if the matrix of αij parameters is not negative semidefinite). We have
assumed the matrix of αij parameters is symmetric. Still, the constraint that it be negative semidefinite
is nonlinear and therefore cannot be imposed within a linear estimation procedure. The usual practice is
to estimate the translog cost function without imposing concavity and then check whether the estimated
matrix of αij parameters is negative semidefinite. Note that there is no requirement imposed on the sign
of αij for i = j (negative semidefiniteness of course imposes that αii be nonpositive so that the demand for
input i slopes downward in its own price). Hence the translog has an advantage over the other functional
forms considered so far: The translog does not impose any restrictions on whether inputs are substitutes
or complements. Indeed, whether two inputs are substitutes or complements can vary across different parts
of the input price/output space due to the presence of the cost shares si sj in the cross-price derivatives of
demands.
Turning now to monotonicity, we noted above that the translog cannot be globally monotonic in y. The
same problem arises regarding monotonicity in each wj , for the same reason (the derivatives xj involve
logs, which can vary over the entire real line). This guaranteed lack of global monotonicity is the most
serious weakness of the translog functional form; all that can be done is to check whether the estimated first
derivatives are nonnegative at each point in the data set, in which case we at least know that the estimated
cost function satisfies the monotonicity requirement locally at relevant data points.
Finally, as with the log-linear demand, the translog cost function is an exponential and is therefore
automatically nonnegative except that it is not defined at y = 0 and therefore cannot satisfy the possibility
of inaction.
n n n
To summarize, the translog form is a cost function provided i=1 αi = 1, i=1 αiy = 0, i=1 αij = 0
for each j, and the matrix of αij parameters is negative semidefinite; where we have assumed without loss of
generality that αij = αji ; and with the understanding that it is not globally monotonic but the monotonicity
can be checked over the range of observed data.
The almost ideal demand system (AIDS) is a hybrid of the linear expenditure system and the translog.
The factor demands are:

∂g g ∂ ln g g 1
n
β1
xj = = = αj + (αij + αji ) ln wi + βj yβ0 w1 · · · wn
βn
for j = 1, . . . , n.
∂wj wj ∂ ln wj wj 2 i=1
As with the translog, it may be more convenient to write these demands as cost share equations by multiplying
wj
through by g . αij and αji are once again redundant parameters, so we assume αij = αji without loss of
generality, and add and subtract the first part of the cost function to obtain
n
wj xj g
sj = = αj + αij ln wi + βj ln n n n .
g i=1
α0 + i=1 αi ln wi + 12 i=1 k=1 αik ln wi ln wk
n n n
The AIDS is sometimes estimated in this form by replacing α0 + i=1 αi ln wi + 12 i=1 k=1 αik ln wi ln wk ,
which is a weighted quadratic of logged prices, with a pre-specified price index and then estimating sj as
a linear function of the ln wi ’s and the logged ratio of total cost to the pre-specified price index. This is
only an approximation to the AIDS cost function since the parameters to be estimated are actually in the
true price index. Some type of complication is unavoidable, however, because the true AIDS is not linear
in the parameters even in cost share form. Hence the alternative to the price index approximation is a
nonlinear estimation procedure. A perhaps more serious problem with the rewritten cost shares is that
the algebraic manipulation replaces the potentially endogenous variable y with the certainly endogenous
variable g on the right side of the estimating equation, which is undesirable from an econometric viewpoint;
an instrumental variable is needed (note, however, that this would not be a problem in a consumption
application involving consumers whose budgets are exogenous). This system of demands is called “Almost
Ideal” primarily because the functional form is consistent with quantities and expenditures being aggregates
over groups of maximizing economic actors. In other words, there is a theoretical foundation for using this
functional form with data that is reported for groups rather than individuals.
Substituting λwi for wi in the demand equations and factoring out the terms involving λ reveals that,
assuming momentarily g is homogeneous of degree 1, the demand for input j is homogeneous of degree 0 if
n n
and only if i=1 αij = 0 and i=1 βi = 0. Looking back at g and imposing these two conditions for all j,
n n
we see that g is homogeneous of degree 1 if and only if i=1 αi = 1 (in addition to i=1 αij = 0 for each j
n
and i=1 βi = 0).
For concavity of the AIDS cost function, differentiate xj and collect terms in a manner similar to the
translog to obtain:

∂g 2  g
wj wi si sj + αij + βi βj yβ0 w1β1 · · · wnβn i = j
= .
∂wj ∂wi  g
sj (sj − 1) + αjj + βj2 yβ0 w1β1 · · · wnβn i=j
wj2
This is very similar to the translog and negative semidefiniteness can again be studied by examining the
Hessian in multiple parts. We have already discussed that the matrix with diagonal elements sj (sj − 1) and
off-diagonal elements si sj is negative semidefinite; and that negative semidefiniteness of the matrix with
entries αij can be checked with the estimated values or imposed on the estimation in a more ambitious
nonlinear estimation procedure. The new consideration here is a third matrix with entries βi βj (the product

yβ0 w1β1 · · · wnβn factors out of the entire matrix). The diagonal elements of this third matrix are squares,
and therefore the matrix cannot be negative semidefinite except in the trivial case of all βj ’s equal to zero.
Hence there will necessarily exist points in the price/output space at which the Hessian of the AIDS cost
function is not negative semidefinite. In short, the AIDS cost function cannot be globally concave and
therefore cannot be consistent with theory (unless the last term of the function is reduced to β0 y). This
is a shortcoming of the AIDS functional form, but it is still possible for an estimated AIDS cost function
to be negative semidefinite at all values of prices and output observed in the data and to therefore regard
the estimated AIDS function as consistent with duality theory over a relevant range of prices and output.
As with the translog, the AIDS is flexible enough to permit both substitutes and complements among the
inputs and for this relationship to vary over the price/output space.
Turning now to monotonicity, the AIDS cost function is strictly increasing in output provided only that
β0 > 0. Like the translog, however, the AIDS cannot be globally monotonic in input prices because of the
presence of logged prices in the first derivatives xj . This is another weakness of the AIDS and, again, all
that can be done is to check whether the estimated first derivatives are nonnegative at each point in the
data set.
Nonnegativity is automatic with the AIDS cost function since it is an exponential, except that cost cannot
be zero at zero output (even though the AIDS function is defined at y = 0) since the exponential function
is never zero.
n n
To summarize, the AIDS form is a cost function provided i=1 αi = 1, i=1 αij = 0 for each j, and
n
i=1 βi = 0; where we have assumed without loss of generality that αij = αji ; and with the understanding
that it is neither globally concave nor globally monotonic in input prices but these can be checked over the
range of observed data (negative semidefiniteness of the estimated αij matrix limits the concavity issue to
the estimate βi βj matrix).
Most statistical software packages include options for imposing linear constraints on the parameters to
be estimated. Hence the parameter restrictions that involve sums of parameters (mostly the homogeneity
restrictions) can usually be imposed on the estimation of each of these four functional forms with little
difficulty. Some of the homogeneity restrictions are sometimes referred to as “adding up” or “cost exhaustion”
restrictions. This terminology arises when the presentation is exclusively in terms of the demand or share
equations, in which case it is necessary to ensure that the shares sum to unity (or the demands, weighted
by their own-prices, sum to total cost) in addition to homogeneity of degree zero of the demands. For
example, looking exclusively at the translog demands without thinking explicitly about the cost function,
n
the demands are homogeneous of degree zero if i=1 αij = 0 for every j provided we presume the cost
function g is homogeneous of degree 1. But the associated cost function is not homogeneous of degree 1
n n
unless, in addition, i=1 αi = 1 and i=1 αiy = 0. These last two constraints could alternatively be derived
n
by examining j=1 sj and noting that these shares do not sum to unity for every value of output unless
the two additional conditions we identified hold. Inequality constraints, including those that would ensure
negative semidefiniteness of a matrix, cannot be imposed within a linear estimation algorithm. The options
are to pursue a nonlinear estimation, such as maximum likelihood, or estimate without imposing inequality
constraints and hope that the estimates satisfy the relevant inequalities.
Let us return to a discussion of elasticities of substitution and scale in the context of a technology
estimation based on a cost function. The Hicks elasticity of substitution measures the percent change in
an input mix resulting from a percent change in a technical rate of substitution along a two-dimensional
isoquant. Although this describes the curvature of the isoquant in the particular two-dimensional plane, it
does not describe optimal input mix changes for a cost-minimizing firm because the Hicks elasticity does
not permit all inputs to change at once, which is generally what happens to the cost-minimizing input
bundle in response to a relative price change. Relating an input mix change to a change in a technical
rate of substitution restricts the firm to a two-dimensional isoquant rather than the n-dimensional isoquant
on which a cost-minimizing firm actually substitutes inputs. Thus, while the technical rate of substitution
equals the price ratio in the (xi , xj ) plane at an optimal input mix, this slope may not be the relevant
direction for calculating a change in an optimal input mix. R. G. D. Allen proposed partial (also called
Allen) elasticities of substitution for the case of n inputs and it has been common practice in some empirical
studies to report estimates of these partial elasticities. Partial elasticities of substitution acknowledge that
all inputs may change in response to a relative price change but do not measure the input mix change as
a response to a change in a particular price. For the Hicks elasticity, it is enough to simply examine the
consequences of a change in an input price ratio (optimally, a technical rate of substitution) because the
direction of change is presumed to be along the isoquant in a two-dimensional plane. This is not sufficient for
a partial elasticity; all inputs are allowed to change hence there is no presumption of a direction of change.
The change in an optimal input mix will generally depend on which price is changing. This led Morishima
to propose the following measure of substitution.
Definition. The Morishima elasticity of substitution of input i for input j (in the direction wi ) at any
(w, y) 0 is
∗
x (w,y) w
∗
d xi∗ (w,y) d wji ∂x∗j (w, y) wi ∂x∗i (w, y) wi
σij (w, y) ≡ ∗ j
= − ,
xi (w,y)
∗
wj ∂wi x∗j (w, y) ∂wi x∗i (w, y)
xj (w,y) wi
where it is understood that the differentiation is with respect to wi .
∗ ∗
Note that in general σij (w, y) = σji (w, y) since the latter is in a different direction, wj , than the former.
It is straightforward to apply this definition to any of the conditional factor demands derived above. For
∗ αij
example, after simplification we obtain for the translog σij (w, y) = 1 + sj + αsiii . Note that the translog cost
functional form is sufficiently flexible to impose no prior restrictions on the elasticity of substitution and to
permit the elasticity of substitution to vary over the input price/output space.
The elasticity of scale of the underlying technology, at an input x∗(w, y) that minimizes cost for some
(w, y) 0, can be calculated directly from the cost function as the ratio of average to marginal cost. Hence
there is no need to derive the production function in order to investigate local returns to scale, at least at any
optimal (i.e., economically relevant) input vector. To see this, recall that the elasticity of scale at input x can
n
fxi (x)xi
be expressed as i=1
f(x) , where f is the production function. So, at an optimal input vector x∗ (w, y),
w·x∗ (w,y)
fxi (x∗ ) = wi /λ∗ can be substituted from the first order conditions to obtain λ∗ (w,y)f(x∗ (w,y)) . Since x∗ (w, y)
is cost minimizing, c∗ (w, y) = w · x∗(w, y) and by Shephard’s Lemma (applied to output), λ∗ (w, y) = mc(y).
Finally, we have y = f(x∗ (w, y)) due to continuity of f, so substituting yields the elasticity of scale at
c∗ (w,y)
x∗ (w, y) as mc(y)y = ac(y)
mc(y) . This ratio is easily calculated for any of the functional forms considered above.
n −1
For example, the elasticity of scale for the translog is [αy + 2αyy ln y + i=1 αiy ln wi ] . Note that the
translog cost functional form is sufficiently flexible to impose no prior restrictions on the elasticity of scale
and to permit the elasticity of scale to vary over the input price/output space.
Exercises for Lecture 10 (Applied Production Analysis)

Lecture 11: Preferences
Readings: Section 7.1 of Varian; Sections 1.A-1.B, 2.A-2.C, 3.A-3.C of MWG.
Until now we have been studying the supply side of product markets and the demand side of factor
markets. The economic agent, or actor, has been the firm. Now we switch to the demand side of the product
markets and the supply side of the factor markets, and begin studying consumers, which is the name we use
for these final demanders and factor suppliers. The study of consumer supply behavior in factor markets
is specialized and is studied in courses on general equilibrium and labor economics. Thus, we focus here
only on consumer demand behavior in product markets. As with all economic agents, there are two basic
pieces to consumer behavior: The objective and the constraints. When studying firms, we began with the
technological constraint since it was the primitive that required explanation. For consumers the constraint
is relatively straightforward, merely requiring that the consumer stay within a budget. But the objective
requires some explanation, so we begin with it.
There are 2 basic components of a consumer’s objective:
• The consumption set X. This is the set of all possible bundles the consumer might consume. This
set includes everything that exists or might conceivably exist, not merely those things that satisfy some
individual or aggregate resource constraint. The description here is only about preferences, not about
availability of resources. It is up to the market to ration potentially scarce commodities by placing positive
prices on them.
• The preference ordering . This is known as a binary relation. It expresses the preference of the consumer
∼
between two bundles in X. x y means “x is at least as desirable as y” for the consumer under study.
∼
For convenience, we sometimes write y ≺ x to denote x y. Note that the preference ordering is weak. We
∼ ∼
can define strict preference and indifference from , rather than introducing them as new primitive concepts,
∼
as follows:
x y means not(y x) (“x is (strictly) prefered to y”)

∼
x ∼ y means both x y and y x (“indifference” between x and y).

∼ ∼
For convenience, we sometimes write y ≺ x to denote x y.

94 LECTURE 11: PREFERENCES
We must make some assumptions about X and in order to get anywhere. The two main assumptions
∼
are
1. (Completeness) For every x, y ∈ X, either x y or y x, or both. Note that this includes reflexivity as
∼ ∼
a special case.
2. (Transitivity) For x, y, z ∈ X, if x y and y z, then x z.

∼ ∼ ∼
These seem obvious, but are in fact assumptions of substance. For example, set containment is a binary
relation that is not complete, and “defeated” among teams in a sports league is a binary relation that need
not be transitive.
These assumptions are primitive, but cumbersome. It would be much more convenient if we could replace
with a system of index numbers that expresses the same information. Such a system of index numbers is
∼
called a utility function. It is a real-valued function on X whose values give the same ordering as . If there
∼
is a utility function for any given preference relation then we can use all of our standard optimization tools
on the utility function in order to describe consumer behavior, thereby avoiding direct consideration of the
preference relation. Hence our first task is to determine what properties a preference relation must possess
in order to assure that a utility function exists.
Definition. Let X be a consumption set and be a preference ordering on X. We say a function U : X → R1

∼
represents if and only if, for every x, y ∈ X,

∼
U (x) ≥ U (y) ⇔ x y.
∼
Theorem. If U represents , then is complete and transitive.

∼ ∼
Proof. Fix x, y, z ∈ X. Since ≥ is complete on R1 , either U (x) ≥ U (y) or U (y) ≥ U (x). Hence, either
x y or y x (completeness). Now assume x y and y z. Then U (x) ≥ U (y) and U (y) ≥ U (z), so
∼ ∼ ∼ ∼
U (x) ≥ U (z) since ≥ is transitive on R1 . Hence x z (transitivity).

∼
A more difficult question is whether there is a converse to this theorem. That is, if we have a preference
relation that is complete and transitive, is there necessarily a utility function that represents it? The answer
is NO, as established by the following famous counter-example.

Example: Lexicographic Preference Relation. Let X = R2+ and define as follows:

∼
(x1 , x2 ) (y1 , y2 ) if and only if either x1 > y1

∼
or x1 = y1 and x2 ≥ y2 .
The basic idea of the lexicographic relation is that it assigns a unique position to every point in R2+ , so
that there is no indifference. The lexicographic ordering does this by proceeding hierarchically: If the
first component is decisive, then the ordering is established. If not, proceed to the second component.
Geometrically, it appears as follows:
Figure 11.1: Lexicographic Preference Relation
Any attempt to represent this with a real-valued utility function is trying to map R2+ into unique values of
R1 , which cannot be done because R2 is an order of magnitude “larger” than R1 . However, this preference
relation is complete and transitive. Thus, this example shows that some additional property must be imposed
on a preference relation if we want to ensure existence of a utility representation.
For most applications it suffices to assume X = Rn+ . Then an element x ∈ X is an n-dimensional vector,
and we can think of each component as being the quantity of a commodity that is included in the bundle.
Thus, there are n commodities. This notion of commodities is quite general. Each component can have a
place and time stamp, so that spatial and dynamic problems can be encompassed. In some contexts it is
necessary to consider continuous space and/or time, in which case an infinite-dimensional commodity space
must be considered. This makes things more complicated. For our purposes, we will henceforth assume
X = Rn+ for n finite. With this assumption on X, the representation problem can be solved with a third
assumption on :
∼
3. (Continuity) Let xi be a sequence in Rn+ and y be any element of Rn+ . If xi → x0 and xi y then x0 y.
∼ ∼
In other words, {x ∈ Rn+ : x y} is a closed set. Similarly, {x ∈ Rn+ : x ≺ y} is a closed set.

∼ ∼
Note that the lexicographic preference relation violates this assumption.
Theorem (Debreu Representation Theorem). If is complete, transitive, and continuous on X = Rn+

∼
then there exists a continuous utility function U that represents .

∼
The proof is difficult, and actually does not require that X be a Euclidean space. Any topological space will
do. For those interested, the proof is on pp. 56-59 of Theory of Value by G. Debreu, Cowles Foundation for
Research in Economics Monograph 17, Wiley: New York (1959).
The Debreu Representation Theorem shows that we need only assume X and satisfy completeness,
∼
transitivity, and continuity to know that we can discuss consumer choice in terms of a utility function. Note,
however, that the representation is not unique: If U represents and h is a strictly increasing function from
∼
R1 to R1 , then h(U ) also represents . This is to be expected. merely orders the points in X. It does
∼ ∼
not express a strength of preference. Hence the distance between U (x) and U (y) cannot be informative, for
this would mean that the utility representation of conveys more information than the original preference
∼
ordering. Only the ordering that U (x) ≥ U (y) or U (y) ≥ U (x) is informative, whence we say that utility
is an ordinal, not a cardinal, concept. Note also that, while the conditions of the Debreu Representation
Theorem are sufficient for existence of a utility representation, the continuity condition is not necessary
(our first theorem showed that completeness and transitivity are necessary, however). A counter-example to
necessity of continuity is included in the exercises.
We sometimes need to speak of the commodity bundles that are all at least as desirable as a given bundle,
or of the bundles that are the same as a given bundle. Hence we define the “preferred-to” or “upper contour”
set, and also the “indifference curve:”
{x ∈ X : x y} (the set of bundles that are (weakly) preferred to a given y)

∼
{x ∈ X : x ∼ y} (the indifference curve for a given y)
An indifference curve need not be a “curve” at all. By definition, it consists of all points x in Rn+ such that
U (x) = U (y), so it is a level curve of U just as an isoquant is a level curve of a production function. But a
level curve of U is only a curve in some conventional sense if U is a “nicely-behaved” function.
Even though completeness, transitivity, and continuity are sufficient for a utility representation of a
preference ordering, we sometimes need other assumptions. Let x, x , y ∈ X. The most important additional
assumptions are:
4. (Free Disposal, or Weak Monotonicity) x ≥ y ⇒ x y.

∼
5. (Strong Monotonicity) x > y ⇒ x y.
6. (Local Nonsatiation) For every x ∈ X and > 0, there exists y ∈ X such that y − x ≤ and y x.
7. (Convexity) x y and x y together imply λx + (1 − λ)x y for every λ ∈ (0, 1).

∼ ∼ ∼
8. (Strict Convexity) x y and x y (x = x ) together imply λx + (1 − λ)x y for every λ ∈ (0, 1).
∼ ∼
These properties can be conveniently illustrated on a graph of preferred-to sets and indifference curves. Note
that free disposal implies that the boundary of a preferred-to set cannot slope upward.
If U is differentiable and its partials are nonzero (strong monotonicity), then the indifference curve for y
is indeed a curve that defines any one component of x, say xi , as a function of the other components, so we
can think of the indifference curve for y as this implicit function. Since this implicit function is defined by
U (xi (x−i ), x−i ) ≡ U (y), its slope in the (xi , xj ) space at some point x is found by implicit differentiation to
be
∂xi (x−i ) Uj (x)
=− < 0.
∂xj Ui (x)
This slope is called the marginal rate of substitution of good i for good j (MRSij ), since it gives the rate at
which the consumer can substitute xi for xj while maintaining a constant level of satisfaction. Hence strong
monotonicity is associated with a negative MRS, while convexity is associated with a nondecreasing MRS
in x−i . Note that the MRS is a basic property of the preference relation, in that the same MRS arises no
matter which utility representation is utilized.

Exercises for Lecture 11 (Preferences)
1. Let X be a consumption set and be a complete and transitive preference relation on X. Define x y
∼
to mean “not(y x)” and x ∼ y to mean “both x y and y x.” Using only the completeness and
∼ ∼ ∼
transitivity assumptions, show for x, y, z ∈ X:
a. x y and y x cannot both hold.
b. x x cannot hold (i.e., is irreflexive).
c. is transitive.
d. x y and y z together imply x z.

∼
e. x y and y z together imply x z.

∼
f. x ∼ x (i.e., ∼ is reflexive).
g. ∼ is transitive.
h. If x ∼ y then y ∼ x (i.e., ∼ is symmetric).
2. Let X = Rn+ , be a complete, transitive, and continuous preference relation on X, and U represent .
∼ ∼
Prove the following:
a. x y if and only if U (x) > U (y).
b. x ∼ y if and only if U (x) = U (y).
c. If satisfies free disposal, then U is nondecreasing.

∼
d. If satisfies strong monotonicity, then U is strictly increasing.

∼
e. If satisfies local nonsatiation, then for every x ∈ X and > 0 there exists y ∈ X such that y −x ≤
∼
and U (y) > U (x) (i.e., U is locally non-maximal).
f. If satisfies convexity, then U is a quasiconcave function.

∼
g. If satisfies strict convexity, then U is a strictly quasiconcave function.

∼
3. Let be the lexicographic preference relation on R2+ :

∼
(x1 , x2 ) (y1 , y2 ) if and only if either x1 > y1

∼
or x1 = y1 and x2 ≥ y2 .
Show that is strongly monotonic and strictly convex.

∼
4. MWG #3.B.3.
5. MWG #3.C.4.
Lecture 12: Utility Maximization: Setup, Calculus, and Traditional Comparative Statics
Readings: Sections 7.2, 8.4 of Varian; Sections 2.D, 3.D of MWG.
Last lecture, we described basic properties of a preference ordering on a consumption set X. Now it is
time to add the constraint to the problem and then study the maximum. We continue to assume X = Rn+ , so
that a vector x ∈ X is a commodity bundle. We also assume the preference ordering is complete, transitive,
and continuous on X; so that we can proceed by using a utility representation U of the preference ordering.
Let p ∈ Rn+ be a vector of prices, one for each of the commodities, and m ≥ 0 be (fixed) money income.
We begin with the behavioral postulate that a perfectly competitive (price-taking) consumer chooses the
commodity bundle x ∈ X that maximizes U , subject to x being affordable. Here, “affordable” means that
p · x ≤ m, or in set notation that x ∈ B(p, m) where B(p, m) ≡ {x ∈ Rn+ : p · x ≤ m}. B is called the budget
set of the consumer for price p and income m, and x ∈ B(p, m) is the constraint for the consumer. So, we
must study the problem
max U (x) subject to x ∈ B(p, m).

{x}
As in all optimal choice problems, there are two results from this that we may be able to derive refutable
hypotheses about: the optimal choice x∗ (p, m) and the optimal value U ∗ (p, m). The former is known as the
Marshallian demand and the latter is called the indirect utility function.
Geometrically, the objective is to get on the highest indifference curve possible while staying in the budget
set. When there are two commodities the maximization can be illustrated as in Figure 12.1.
Without more assumptions, not much can be said about this. Usually we assume, in addition to com-
pleteness, transitivity, and continuity, at least local nonsatiation. This implies that the optimal choice is on
the budget line (see the exercises following this lecture). Hence, with local nonsatiation we lose no generality
by just considering the equality-constrained problem
max U (x) subject to p · x = m.

{x∈Rn
+}
If this is a nice well-behaved calculus problem the Lagrangian function is
L(x, λ; p, m) = U (x) − λ(p · x − m),

102 LECTURE 12: UTILITY MAXIMIZATION (BASICS)
Figure 12.1: Utility Maximization. The budget set must appear as illustrated, but without
additional assumptions the indifference curves and preferred-to sets could take almost any shape.
and so the first order conditions are
Ui (x∗ (p, m)) − λ∗ (p, m)pi ≡ 0 for i = 1, . . . , n
−p · x∗ (p, m) + m ≡ 0.
Forming a ratio yields the condition that the negative of each MRS must equal the corresponding price ratio:
Ui (x∗ ) pi
= ,
Uj (x∗ ) pj
which is just the algebraic statement that the indifference curve must be tangent to the budget line at
the maximum (assuming a nice interior calculus maximum). Note that only the MRS is involved in this
condition, not the individual utility derivatives. Hence, this description of the maximal choice is independent
of the utility representation used. Another way of saying this is to note that different representations are
just monotonic transformations of each other, so the maximal choice is independent of which representation
is used.
As always, the first order conditions can be thought of as defining x∗ and λ∗ , as denoted above. Then
there are n + 1 equations in the n + 1 unknowns x∗ and λ∗ , so we can at least hope to solve for these
unknowns. But it is really the slopes of x∗ and λ∗ in which we are most interested. We can study these
slopes by doing the usual comparative statics exercise of differentiating the entire system with respect to pj
(for example):
 
0
  ..
 ∂x∗   .
1
 
∂pj
 .   ∗  0 
 .   λ (p, m)   ← j th row,
HL(x,λ)  . 
 ∂x∗n  =  
 ∂pj   
0
.


∗  .
. 
∂λ
 
∂pj  0 
∗
xj (p, m)
where  
U11 ... U1n −p1
 .. .. .. 
HL(x,λ) = 

. . . 

Un1 . . . Unn −pn
−p1 . . . −pn 0
is the (n + 1) × (n + 1) bordered Hessian of the maximization problem. Since this is a maximization
problem with r = 1 constraints, at a proper interior maximum the border-preserving principal minors of
∂x∗
order k > 2r = 2 have sign (−1)k−r . Applying Cramer’s Rule to solve for i
∂pj
and then performing cofactor
expansion on the ith column of the numerator yields:
∂x∗i (−1)j+i λ∗ |Hji | + (−1)n+1+i x∗j |Hn+1,i|

= .
∂pj |HL(x,λ)|
From the second order conditions |HL(x,λ)| has sign (−1)n+1−1 , but neither of the minors in the numerator are
principal unless i = j. When i = j, |Hji| has sign (−1)(n+1−1)−1 , which is opposite that of the denominator.
But even then Hn+1,i is neither border-preserving nor a principal submatrix, so its sign is unknown. Hence,
in general we cannot sign the slopes of Marshallian demand curves, even with respect to the own-price.
That is, the law of demand need not hold here. The reason is that the price change brings about a change
in spending of x∗j ∂pj , and this income effect introduces another term, whose sign is unknown, into the
∂x∗
expression for i
∂pj
.
To see that this term really is due to an implicit change in income, investigate the effects of a change in
income m via comparative statics:

 ∂x∗
1
  
∂m 0
 .   .. 
 .   . .
HL(x,λ)  ∂x. ∗ =
 n  0 
∂m
∂λ∗ −1
∂m
Hence
∂x∗i (−1)n+1+i (−1)|Hn+1,i |
= .
∂m |HL(x,λ)|
In general, the sign of this is unknown since Hn+1,i is neither border-preserving nor a principal submatrix.
If ∂pj > 0, for example, then spending increases by x∗j ∂pj , so it’s as if the consumer received a decrease in
income of ∂m = −x∗j ∂pj . Substituting this in place of ∂m above shows that the extra term in the original
∂x∗
expression for i
∂pj
is precisely the effect of a change in income of −x∗j ∂pj , whose sign is not known in general.
∂λ∗ ∂λ∗
Similarly, we can find (but cannot sign) expressions for ∂pj and ∂m . See the exercises following this
lecture.
As always with these optimization problems, there are three cautions to worry about:
1. (Existence) If p >> 0 then we are maximizing a continuous function U on the closed and bounded set
B(p, m), so a maximum exists (note the role of having a continuous, or at least upper continuous (so
U is upper semicontinuous, as shown by T. Rader in “The Existence of a Utility Function to Represent
Preferences,” Review of Economic Studies 30 (1963), pp. 229-232), representation U here). If pi = 0 for
some i then existence can fail, as for example with a Cobb-Douglas utility function.
2. (Uniqueness) This is determined by the convexity of . If is not convex, or is convex but not strictly
∼ ∼
convex, then there can be multiple optima. A complete failure of convexity is somewhat problematic
because this leads to discontinuous demand curves, which can cause an existence failure for equilibrium
prices (this comment applies to firms’ demands and supplies as well).
3. (Corners) Since we did not explicitly incorporate the n constraints x ≥ 0, the above calculus conditions
can fail if the maximum occurs where some xi = 0. This can lead to Ui (x∗ ) − λ∗ pi < 0. The calculus
condition is suggesting that a decrease in xi would improve things, but the consumer cannot pursue this
because of the constraint.

Exercises for Lecture 12 (Utility Maximization: Basics)
∂λ∗ ∂λ∗
1. Use comparative statics methodology to find expressions for ∂pj and ∂m . Can either of these be signed?
∂λ∗
Why/why not? Give an economic interpretation of ∂m
.
2. (From W. Nicholson, Microeconomic Theory, 6th edition (1994), p. 758) This exercise introduces how
standard utility theory can be used to study the choice of labor and leisure for a family. A welfare
program for low-income people offers a family a basic grant of $6,000 per year. This grant is reduced by
$0.75 for each $1 of other income the family has.
a. How much in welfare benefits does the family receive if it has no other income? If the head of the
family earns $2,000 per year? How about $4,000 per year?
b. At what level of earnings does the welfare grant become zero?
c. Assume that the head of this family can earn $4 per hour and that the family has no other income.
What is the annual budget constraint for this family if it does not participate in the welfare program?
That is, how are dollars of consumption (C) and hours of leisure (H) related?
d. What is the budget constraint if the family opts to participate in the welfare program (the grant cannot
be negative)?
e. Graph your results from parts (c) and (d).
f. Suppose the government changes the rules of the welfare program to permit families to keep 50 percent
of what they earn. How would this change your answers to parts (d) and (e)?
g. Using your results from part (f), can you predict whether the head of this family will work more or
less under the new rules described in part (f)?
3. (From E. Silberberg, The Structure of Economics, 2nd edition (1990), p. 358) This exercise introduces
how standard utility theory can be used to study the allocation of consumption over time. Suppose a
consumer will have income $m1 this year and $m2 next year. He or she consumes $x1 this year and $x2
next year, and is able to borrow or lend at interest rate r provided the two-period budget constraint is
met. Assume the consumer maximizes the utility U (x1 , x2) of consumption over these two years.
a. Write the consumer’s budget constraint.
b. Derive the comparative statics for this problem. Will an increase in this year’s income necessarily lead
to an increase in consumption this year?
c. Prove that the consumer is better off (worse off) when the interest rate rises if he or she was a net
saver (dissaver) this year before the interest rate increase.

√
4. Suppose a consumer of two goods, x1 and x2 , has utility function U (x1 , x2 ) = x1 + 4 + x2 .
a. Carefully draw a typical indifference curve for utility level Ū (note: Ū ≥ 2 since U (0) = 2).
b. Find the Marshallian demands.
5. Varian #7.2 (ignore the expenditure function part).
6. Varian #7.5.
7. Varian #8.5.
8. Varian #8.13.
9. MWG #2.E.1.
10. MWG #2.E.2.
11. MWG #2.E.8.

Lecture 13: Utility Maximization: Envelope Properties of U ∗ and x∗
Readings: Section 7.3 of Varian; Sections 2.E, 3.D of MWG.
In this lecture we continue our study of the properties of a utility maximum, but make use of the envelope
theorem rather than using the cumbersome traditional comparative statics. The optimal choice is x∗ (p, m)
and the optimal value of the utility function is U ∗ (p, m) = U (x∗ (p, m)), both for p >> 0 and m ≥ 0.
There is an interval of feasible utility levels that plays a role analogous to the interval of feasible output
levels from producer theory. So, we use the producer theory notation and denote this interval by Y , and
let ỹ = sup{x} U (x) (possibly ∞) denote the upper end of Y . By continuity, Y is an interval from U (0)
(inclusive) to ỹ (perhaps inclusive, perhaps not, depending on whether U achieves its supremum). Actually,
since we have not assumed monotonicity of , there may be feasible utility levels smaller than U (0), but
∼
they are economically irrelevant since no utility-maximizing consumer would ever choose them, so we omit
them from Y .
The optimal choice x∗ and optimal value U ∗ functions have some remarkable properties due solely to the
fact that they are the maximizing choice and maximal value, respectively, of U (x) subject to p · x ≤ m.
Theorem (Roy’s Identity–Relationship between the Indirect Utility Function and the Mar-
∂U ∗ ∂U ∗
shallian Demand). If U ∗ is differentiable at (p, m) then ∂m
= λ∗ (p, m) and, if ∂m
= 0 at (p, m), then:
∂U ∗
= x∗i (p, m).
∂pi
− ∂U ∗
∂m
Proof. Differentiate U ∗(p, m) with respect to m, using the envelope theorem so that this is obtained by dif-
ferentiating the Lagrangian function and then evaluating at the optimum, to get λ∗ (p, m). Then differentiate
U ∗ (p, m) with respect to pi , using the envelope again, to get −λ∗ (p, m)x∗i (p, m). Solve this for x∗i and then
substitute ∂U ∗ /∂m for λ∗ .
• Note that λ∗ is the marginal utility of income.
Theorem (Properties of the Marshallian Demand).
1. (Homogeneity) x∗ is homogeneous of degree 0.
2. (Symmetry and Semidefiniteness) To be announced.
3. (Nonnegativity) x∗ (p, m) ≥ 0 ∀(p, m).

108 LECTURE 13: UTILITY MAXIMIZATION (ADVANCED)
4. (Walras’ Law) If the underlying preference relation is locally nonsatiated, then p · x∗ (p, m) = m ∀(p, m).
Proof.
1. U is unaffected by p and m. Moreover, B(p, m) = B(λp, λm). So, the maximization problem is the same
when the parameters are (λp, λm) as when the parameters are (p, m), whence x∗ (p, m) = x∗ (λp, λm).
2. Note that x∗i is not a derivative of U ∗ , so we do not automatically have symmetry of slopes of x∗ . There
is, however, another symmetry property that will arise later in the study of expenditure minimization.
3. x∗ (p, m) ≥ 0 since x∗ is chosen from Rn+ .
4. By definition, x∗ (p, m) ∈ B(p, m), so p · x∗(p, m) ≤ m. If p · x∗(p, m) < m, then by local nonsatiation
m−p·x∗ (p,m)
there exists x ∈ Rn+ such that U (x) > U (x∗ (p, m)) and x − x∗ (p, m) < , where = p
> 0.
Hence, using the Cauchy-Schwarz inequality,
p · (x − x∗ (p, m)) ≤ p x − x∗ (p, m) < p = m − p · x∗ (p, m),
or p · x < m. That is, x ∈ B(p, m), which contradicts that x∗ (p, m) maximizes U .
Theorem (Properties of the Indirect Utility Function).
1. (Homogeneity) U ∗ is homogeneous of degree 0.
2. (Quasiconvexity) U ∗ is quasiconvex.
3. (Monotonicity) U ∗ is nondecreasing in m and nonincreasing in p. If the underlying preference relation is
locally nonsatiated, then U ∗ is strictly increasing in m.
4. (Continuity) U ∗ (p, m) is continuous, and U ∗ (p, R1+ ) = Y ∀p >> 0.
Proof.
1. By homogeneity of x∗ , U ∗ (λp, λm) = U (x∗ (λp, λm)) = U (x∗ (p, m)) = U ∗ (p, m).
2. Fix (p, m), (p , m ) ≥ 0. By definition,
[λp + (1 − λ)p ] · x∗ (λp + (1 − λ)p , λm + (1 − λ)m ) ≤ λm + (1 − λ)m .
Hence, either p · x∗ (λp + (1 − λ)p , λm + (1 − λ)m ) ≤ m or p · x∗ (λp + (1 − λ)p , λm + (1 − λ)m ) ≤ m ,
or both. That is, x∗ (λp + (1 − λ)p , λm + (1 − λ)m ) is feasible when prices and income are either
(p, m) or (p , m ). Hence, either U ∗ (p, m) ≥ U (x∗ (λp + (1 − λ)p , λm + (1 − λ)m )) or U ∗ (p , m ) ≥
U (x∗ (λp + (1 − λ)p , λm + (1 − λ)m )). Either way,
U (x∗ (λp + (1 − λ)p , λm + (1 − λ)m )) ≤ max{U ∗ (p, m), U ∗(p , m )}.
3. Let m ≥ m and p ≤ p. Then p · x∗ (p, m) ≤ p · x∗ (p, m) ≤ m ≤ m . So, x∗(p, m) is feasible when
prices and income are (p , m ), whence U ∗ (p , m ) ≥ U (x∗ (p, m)) = U ∗ (p, m). If the underlying preference
relation is locally nonsatiated and m > m, then x∗ (p, m) cannot maximize U when prices are (p , m ),
since the inequality p · x∗ (p, m) < m becomes strict while Walras’ Law requires p · x∗ (p , m ) = m .
Hence U ∗ (p , m ) > U (x∗ (p, m)) = U ∗ (p, m).
4. Continuity follows from the Theorem of the Maximum (see MWG Theorem M.K.6). Clearly U ∗ (p, R1+ ) ⊂
Y . Moreover, for any p >> 0 and Ū ∈ Y , we have U ∗ (p, 0) = U (0) ≤ Ū since B(p, 0) = {0}; and since
Ū ∈ Y there exists x ∈ Rn+ such that U (x) ≥ Ū . So for m = p · x we have x ∈ B(p, m), and therefore
U ∗ (p, m) ≥ U (x) ≥ Ū . Thus, by continuity of U ∗ we have Ū ∈ U ∗ (p, R1+ ), establishing U ∗ (p, R1+ ) ⊃ Y .
• Note, in particular, that there is no semidefiniteness property for x∗ here, because we only know
quasiconvexity of U ∗ , not full convexity, so we do not know the slopes of x∗ and λ∗ in general (also, x∗ is
not a derivative of U ∗ , as noted above). This is consistent with the lack of comparative statics results we
noted in the previous lecture.
• Homogeneity means that consumers do not have “money illusion.” If all prices and income are inflated
by the same amount, neither behavior nor satisfaction change. Again we see that “only relative prices and
income matter.”
• Note also that the only property of preferences that we really rely on here is that a maximum exists
(guaranteed by completeness, transitivity, and continuity for p >> 0 and m ≥ 0), except for Walras’ Law
and strict monotonicity of U ∗ in m, which rely on local nonsatiation.
• Note finally that Euler’s Theorem for the homogeneous of degree zero Marshallian demand yields

n
∂x∗i (p, m) ∂x∗ (p, m)
pj +m i = 0 for i = 1, . . . , n.
∂pj ∂m
j=1
Hence
 ∂x∗
1 ∂x∗
1 ∂x∗
1
  p1   0 
...
 .
∂p1 ∂pn ∂m
 ..   ... 
 .. .. .. ..   .   
∗
. . . p  = 0.
∂xn ∂x∗ ∂x∗ n
∂p1
... n
∂pn ∂m
n
m 0
Exercises for Lecture 13 (Utility Maximization: Advanced)
1. Suppose a consumer’s preferences are homothetic, in addition to being complete, transitive, continuous,
and locally nonsatiable on Rn+ . This means that the utility function is a monotonic transformation of
a function that is homogeneous of degree r > 0 (i.e., U (x) = f(g(x)), where f : R1 → R1 is strictly
increasing and g : Rn+ → R1 is homogeneous of degree r).
a. Show that there is no loss of generality in just assuming that the consumer’s utility function is homo-
geneous of degree 1. Assume this henceforth.
b. Use Euler’s Theorem to show that U ∗ (p, m) = λ∗ (p, m)m.

∂λ∗ λ ∗ x∗
c. Differentiate to show that ∂pi =− m .
i
d. Now use part c and the usual approach to deriving symmetry results to show that the matrix of price
derivatives of the Marshallian demand is symmetric when preferences are homothetic (even though it
is not symmetric in general).
2. Varian #7.4(a).
3. MWG #3.D.1.
4. MWG #3.D.2 (show the quasiconvexity only as a function of p – as a function of m it is more difficult).
5. MWG #3.D.5 (again, show the quasiconvexity only as a function of p).

Lecture 14: Expenditure Minimization:
Setup, Calculus, Traditional Comparative Statics, and Envelope Properties of e∗ and h∗
Readings: Sections 7.3, 8.3 of Varian; Section 3.E of MWG.
In this lecture we consider an alternative behavioral postulate for consumers. As we saw, a Marshallian
demand has few definite comparative statics properties that arise naturally from the utility maximization
behavioral postulate. Marshallian demand does in fact possess a symmetry/semidefiniteness property, that
we can derive by studying the expenditure minimization behavioral postulate:
min e(x; p) = p · x subject to U (x) ≥ Ū and x ≥ 0.

{x}
That is, the behavioral postulate is that a consumer chooses the commodity bundle that minimizes the
expenditure required to achieve a given level of utility. The consumer is still perfectly competitive since this
minimization assumes price-taking behavior, and we continue to assume the consumer’s preference relation
is complete, transitive, and continuous so that we can represent it with a utility function.
The parameters of this optimization are p ∈ Rn++ and a feasible utility level Ū ∈ Y . Thus the resulting
optimal choice of x and optimal value of e depend on the parameters (p, Ū) ∈ Rn++ × Y . We depart
from convention here and denote the optimal choice of x by h∗ (p, Ū), as a reminder that the expenditure-
minimizing demands are called Hicksian, or compensated, demands. The optimal value of e is denoted
e∗ (p, Ū ) = p · h∗ (p, Ū), and is called the expenditure function.
Geometrically, the objective is to get on the lowest isoexpenditure line while staying on or above the
indifference curve for utility level Ū . With two commodities, the minimization can be illustrated as in
Figure 13.1.
As usual, we can simplify somewhat by writing the constraint as an equality. In this problem, we can
do this for essentially the same reasons we could write the constraint as f(x) = y in the cost minimization
problem. U is continuous (in particular, lower semicontinuous), so for any x such that U (x) > Ū we can
reduce x slightly to x (note that x > 0 since Ū ≥ U (0)) and still obtain utility U (x ) ≥ Ū . Since x < x
we have p · x < p · x as long as p >> 0. Hence, the minimum never occurs at an x that yields more utility
than Ū , and so nothing is lost by just assuming the constraint is U (x) = Ū . Using this way of writing the
constraint, if U is differentiable we can write the Lagrangian function L(x, λ; p, Ū) = p · x − λ(U (x) − Ū ) and
114 LECTURE 14: EXPENDITURE MINIMIZATION
Figure 14.1: Expenditure Minimization. The indifference curve and the preferred-to set
need not have the conventional shape.
proceed to describe the minimum with calculus. Alternatively, we can use the envelope theorem to derive
properties of e∗ and h∗ .
It is unnecessary to grind through all of this, however, because in fact the problem is identical to cost
minimization in all important respects, and we already know the properties of a cost minimum. Recall that
the cost minimization problem is
min w · x subject to f(x) = y and x ≥ 0

{x}
for some lower semicontinuous production function f(x) that is defined on Rn+ . Hence, all that is changed is
the symbols: we are now using p in place of w, U in place of f, and Ū in place of y. Therefore, any properties
of a cost minimum that derive solely from that fact that we are minimizing are immediately present here.
In particular, with regard to the standard calculus approach, a nice proper interior calculus minimum is
characterized by tangency between the indifference curve for utility level Ū and an isoexpenditure line, which
is algebraically described by equality between each MRS and the corresponding price ratio. Also, the law of
∂h∗
demand holds here: i
∂pi ≤ 0, since this comparative static result depends only on the first- and second-order
conditions. Finally, the same cautions are relevant here about existence (assured since the objective e is
continuous on a constraint set that is nonempty (as long as Ū ∈ Y ), closed (by continuity of U ), and bounded
(provided p >> 0 so that we can throw out the upper part of the preferred-to set)), uniqueness (assured
when the preferred-to set is strictly convex, i.e., strictly convex), and corners (pi −λ∗ Ui (h∗ ) > 0 is possible
∼
if h∗i = 0).
Similarly, with regard to the envelope approach, we immediately get Shephard’s Lemma, since it is
obtained by just differentiating the Lagrangian function.
Theorem (Shephard’s Lemma–Relationship Between the Expenditure Function and the Hick-
∂e∗
sian Demand). If e∗ is differentiable at (p, Ū ) (almost assured by concavity) then ∂pi = h∗i (p, Ū) for
∂e∗
i = 1, . . . , n and ∂ Ū
= λ∗ (p, Ū ).
And we immediately get the properties of e∗ and h∗ as well.
Theorem (Properties of the Expenditure Function).
1. (Homogeneity) e∗ is homogeneous of degree 1 in p.
2. (Concavity) e∗ is concave in p (and hence continuous at p >> 0).
3. (Monotonicity) e∗ is nondecreasing in p, and is strictly increasing in Ū .
4. (Continuity) e∗ is fully continuous in (p, Ū ) at p >> 0.
5. (Nonnegativity) e∗ > 0 ∀p >> 0 and ∀Ū ∈ Y − {U (0)}, and e∗ (p, U (0)) = 0 ∀p >> 0.
Proof. Properties 1 – 5 of a cost function depend mainly on existence of a minimum, which is guaranteed
here by continuity of U , p >> 0, and Ū ∈ Y . Thus properties 1 and 2 of e∗ hold simply because the cost
function has these properties whenever the cost minima exist.
A few additional observations are needed to show properties 3 – 5 of e∗ , because strict monotonicity in
output, continuity, and nonnegativity of cost rely on some additional properties of the technology. Specifi-
cally; free disposal, the possibility of inaction, no free lunch, and lower hemicontinuity in inputs and output
are used to show these properties of cost. Free disposal need not hold here (unless we assume monotonicity
of ), but the only role played by free disposal in showing strict monotonicity in output, continuity, and
∼
nonnegativity of cost is to assure existence of f on all of Rn+ . In the present context, existence of U on all
of Rn+ is assured by the Debreu Representation Theorem and the assumption that X = Rn+ . The possibility
of inaction and no free lunch hold in the present context provided U (0) is regarded as output level 0. To see
this, simply note that U (0) is by assumption a feasible utility level since x = 0 is in the consumption set.
This is the possibility of inaction. Since U is a function, to achieve a utility level Ū > U (0) some bundle
other than x = 0 must be consumed. Since the consumption set is Rn+ , this means x > 0 is required in order
for U (x) ≥ Ū > U (0). This is no free lunch.
Continuity of the cost function is an application of the Theorem of the Maximum (see MWG Theorem
M.K.6), which requires that the constraint correspondence be both lower and upper hemicontinuous. Lower
hemicontinuity in output (i.e., in utility levels Ū ) is assured in the present context by the continuity of
, which implies continuity of U as shown by the Debreu Representation Theorem. Lower hemicontinuity
∼
in inputs (i.e., in commodity bundles x) is assured in the present context by local nonsatiation of , as
∼
follows. Given a sequence Ū i → Ū 0 and a point x0 satisfying U (x0 ) ≥ Ū 0 , we must show existence of a
sequence xi → x0 such that U (xi ) ≥ Ū i ∀i. By local nonsatiation, there exists a sequence yj → x0 such that
U (yj ) > U (x0 ) ∀j, and it can be assumed without loss of generality that U (yj ) ≥ U (yj+1 ) for j = 1, 2, . . ..
Consider any yj . As Ū i → Ū 0 , there exists k j such that U (yj ) ≥ Ū i ∀i ≥ k j , and it can be assumed without
loss of generality that k 1 < k 2 < · · · . Now construct the xi sequence as follows:

i any x satisfying U (x) ≥ Ū i for i = 1, . . . , k 1 − 1 (if any – such x exist provided Ū i ∈ Y ∀i)
x =
yj for i = k j , . . . , k j+1 − 1; j = 1, 2, . . .
This xi has the required properties. By construction, U (xi ) = U (yj ) > Ū i when k j ≤ i < k j+1 . Moreover, for

any > 0 there exists J such that yj − x0 < for j ≥ J. Letting I = k J , we have i ≥ I ⇒ i ≥ k J ⇒ xi = yj

for some j ≥ J. So i ≥ I ⇒ xi − x0 < .
Hence, by regarding U (0) as output level 0 we obtain strict monotonicity of e∗ in Ū , continuity of e∗ , and
nonnegativity of e∗ directly from the analogous properties of the cost function.
Theorem (Properties of the Hicksian Demand).
1. (Homogeneity) h∗ is homogeneous of degree 0 in p.

 ∂λ∗ ∂λ∗ ∂λ∗ 
∂ Ū ∂p1 ... ∂pn
 ∂h∗1 ∂h∗1 ∂h∗ 
 ∂ Ū ... 1

 ∂p1 ∂pn 
 .. .. .. .. 
 . .∗ . .∗ 
∗
∂hn ∂hn ∂hn
∂ Ū ∂p1 . . . ∂pn
is symmetric for Ū ∈ (U (0), ỹ), and the lower right (n × n) submatrix is negative semidefinite.
3. (Monotonicity) p · h∗ is nondecreasing in p, and is strictly increasing in Ū .

4. (Continuity) p · h∗ is fully continuous in (p, Ū) at p >> 0.
5. (Nonnegativity) h∗ ≥ 0 ∀p >> 0 and ∀Ū ∈ Y , p · h∗ (p, U (0)) = 0, and h∗ (p, Ū) > 0 ∀p >> 0 and
∀Ū ∈ Y − {U (0)}.
Proof. Properties 1 – 5 of a conditional factor demand depend only on existence of a minimum over some
subset of Rn+ , Shephard’s Lemma, and the properties of a cost function. Since all of these conditions hold in
the present context once U (0) is regarded as output level 0, properties 1 – 5 of h∗ hold simply because the
conditional factor demand has these properties.
• So, as with cost minimization, cross-price effects on Hicksian demands are symmetric and own-price
effects are nonpositive, and the optimal Lagrange multiplier is the marginal cost of obtaining higher utility.
• Also as with cost minimization, Euler’s Theorem for the homogeneous of degree zero Hicksian demand
yields

n
∂h∗i (p, Ū)
pj = 0 for i = 1, . . . , n.
j=1
∂pj
Hence     
∂h∗
1 ∂h∗
1
∂p1
... ∂pn p1 0
 ..   ..   .. 
He∗(p) p =  ... ..
. .   .  = . ,
∗
∂hn ∂h∗ pn 0
∂p1 ... ∂pn
n
and we see that the Hessian of the expenditure function with respect to p is singular, possessing a zero
eigenvalue.
• Finally, homogeneity again shows that “only relative prices matter.”

Exercises for Lecture 14 (Expenditure Minimization)
1. Let e∗ (p, Ū) = pŪ be an expenditure function, where p is a scalar.
a. Verify that e∗ has the properties of an expenditure function.
b. Find the Hicksian demand, h∗ .
c. Verify that h∗ has the properties of a Hicksian demand.
2. Finish Varian #7.2.
3. Varian #8.8.
4. MWG #3.E.2.
5. MWG #3.E.6.
6. MWG #3.G.3 except parts (c) and (e).
7. MWG #3.G.14 (note that when they say “Walrasian” substitution matrix they mean the substitution
matrix of the Hicksian demands).
8. MWG #3.G.15.
Lecture 15: Relationships between Utility Maximization and Expenditure Minimization
Readings: Sections 7.4, 8.2, 8.5 of Varian; Section 3.G of MWG.
We now know that Hicksian demands slope downward, while Marshallian demands may not. Unfortu-
nately, Hicksian demands are not observable since they depend on unobservable utility. However, we can
use the information about Hicksian demands to further explore Marshallian demands, by establishing the
relationship between utility maximization and expenditure minimization. We continue to assume the con-
sumer has a complete, transitive, and continuous preference relation, so that it is represented by a continuous
utility function U ; and that p >> 0, m ≥ 0, and Ū ∈ Y .
First we show that a utility-maximizing consumer also minimizes the expenditure of achieving the optimal
level of utility, provided preferences are locally nonsatiated. This means
1. x∗ (p, m) = h∗ (p, U ∗(p, m)), and
2. m = e∗ (p, U ∗(p, m)).
This is illustrated in Figure 15.1.
Figure 15.1: Utility maximization implies expenditure minimization. x∗ is the optimal

choice for income m. If the light shading is the preferred-to set for x∗ then we obtain the lowest
possible isoexpenditure line subject to this preferred-to set by choosing x∗ as our Hicksian demand
point, in which case expenditure minimization coincides with utility maximization. Note, however,
that if the indifference curve for utility level U ∗ (p, m) were “thick,” for example the dark shaded
area, then x∗ still maximizes utility but expenditure minimization occurs at the illustrated h∗ .
Thick indifference curves are inconsistent with local nonsatiation. Thus the graph shows that local
nonsatiation is central to the coincidence of utility maximization and expenditure minimization.
120 LECTURE 15: UTILITY AND EXPENDITURE RELATIONSHIPS
Then we show the converse, that an expenditure-minimizing consumer also maximizes the utility from
spending the expenditure-minimizing level of income. This means
3. h∗ (p, Ū) = x∗(p, e∗ (p, Ū )), and
4. Ū = U ∗ (p, e∗ (p, Ū)).
This is illustrated in Figure 15.2.
Figure 15.2: Expenditure minimization implies utility maximization. If the preferred-

to set for utility level Ū is both the light and dark shaded areas, then the lowest possible iso-
expenditure line subject to this preferred-to set occurs at h∗ . Now given income level e∗ , the
choice h∗ maximizes utility since it is not possible to attain any other point in the preferred set
to this point (i.e., in the shaded areas). Hence utility maximization coincides with expenditure
minimization. If the indifference curve is “thick” like the dark shaded area then there may be
other points above the isoexpenditure line for e∗ that deliver the same utility at these prices, for
example the illustrated x∗ , but such points cost more than e∗ (m > e∗ ) and thus are not in the
budget set for income e∗ . Thus local nonsatiation is not needed to establish that expenditure
minimization implies utility maximization. However, as the proof in the text shows, lower semi-
continuity of utility is needed instead of local nonsatiation (otherwise, there could be points along
the isoexpenditure line e∗ that deliver utility Ū but that deliver less utility than some other point
along the isoexpenditure line).
Equations 1–4 hold for every p >> 0, m ≥ 0, and Ū ∈ Y , and so are identities that describe the equivalence
of utility maximization and expenditure minimization (at the corresponding points).
To show the first two identities, suppose that x∗ (p, m) does not minimize p· x subject to U (x) ≥ U ∗ (p, m).
p·(x∗ (p,m)−x)
Then there exists x ∈ Rn+ such that p · x < p · x∗ (p, m) and U (x) ≥ U ∗ (p, m). Let = p
> 0.
By local nonsatiation, there exists x ∈ Rn+ such that U (x ) > U (x) and x − x < . By feasibility,
p · x∗ (p, m) ≤ m. So
p · x = p · (x − x) + p · x ≤ px − x + p · x by the Cauchy-Schwarz Inequality
< p + p · x
= p · (x∗ (p, m) − x) + p · x
= p · x∗ (p, m) ≤ m.
That is, x can be purchased with income m at price p, and delivers utility U (x ) strictly greater than
U (x∗ (p, m)). This contradicts that U ∗ (p, m) is the maximal utility. Hence x∗ (p, m) must minimize p·x subject
to U (x) ≥ U ∗ (p, m). That is, x∗ (p, m) = h∗ (p, U ∗(p, m)), establishing identity 1 (if the optimal choices
are non-unique, this argument shows that any utility-maximizing choice must also minimize expenditure).
Moreover, by definition e∗ (p, U ∗(p, m)) = p · h∗ (p, U ∗(p, m)) = p · x∗(p, m) = m, where the last equality is
Walras’ Law (local nonsatiation), establishing identity 2.
To show the second two identities, consider first the Ū = U (0) case. Then, since p >> 0 we have
h∗ (p, Ū) = 0 and e∗ (p, Ū) = 0. Hence, the budget set B(p, e∗ (p, Ū)) is the singleton {0} (again using p >> 0).
Therefore x∗(p, e∗ (p, Ū )) = 0 = h∗ (p, Ū ) and U ∗ (p, e∗ (p, Ū )) = U (x∗ (p, e∗ (p, Ū))) = U (0) = Ū . Now consider
the Ū ∈ Y − {U (0)} case. Suppose that h∗ (p, Ū) does not maximize U (x) subject to p · x ≤ e∗ (p, Ū). Then
there exists x ∈ Rn+ such that U (x) > U (h∗ (p, Ū)) ≥ Ū and p · x ≤ e∗ (p, Ū ). Note that, since Ū > U (0),
we know x > 0. Therefore, by lower semicontinuity of U , there exists x < x such that U (x ) > Ū , and so
p·x < e∗ (p, Ū) (using p >> 0). But this contradicts that e∗ (p, Ū) is the minimal expenditure. Hence h∗ (p, Ū)
must maximize U (x) subject to p · x ≤ e∗ (p, Ū). That is, h∗ (p, Ū ) = x∗ (p, e∗ (p, Ū)), establishing identity 3
(again, if the optimal choices are non-unique, this argument shows that any expenditure-minimizing choice
must also maximize utility). Moreover, by definition U ∗ (p, e∗ (p, Ū)) = U (x∗ (p, e∗(p, Ū ))) = U (h∗ (p, Ū)) = Ū,
where the last equality follows because the Hicksian demand must satisfy the constraint with equality (by
lower semicontinuity), establishing identity 4.
We can use these identities to further investigate the slopes of Marshallian demands. Differentiating
identity 3 for demand x∗i with respect to pj yields:

∂h∗i (p, Ū) ∂x∗i (p, m) ∂x∗ (p, e∗ (p, Ū )) ∂e∗ (p, Ū)
= + i .
∂pj ∂pj m=e∗ (p,Ū) ∂m ∂pj
∂e∗
By Shephard’s Lemma ∂pj = h∗j (p, Ū), so

∂x∗i (p, m) ∂h∗i (p, Ū) ∗ ∂x∗i (p, e∗ (p, Ū))
= − h j (p, Ū) .
∂pj m=e∗ (p,Ū ) ∂pj ∂m
Now evaluate this at Ū = U ∗ (p, m) for some arbitrary income level m ≥ 0, and substitute identities 1 and 2
to obtain:

∂x∗i (p, m) ∂h∗i (p, Ū) ∗ ∂x∗i (p, m)
= − x j (p, m) . (SD)
∂pj ∂pj Ū =U ∗ (p,m) ∂m
∂x∗
When we consider the case i = j this equation shows explicitly why we cannot sign i
∂pi
. The own-price
slope of the Marshallian demand is composed of two terms, the first of which is known to be nonpositive
but the second of which has unknown sign. The second term is the income effect of the price change, since
it tells how much the Marshallian demand for good i changes when income changes by ∂m = −x∗i ∂pi . We
already knew from the comparative statics analysis that this term represents the effect on demand of the
implicit income change that occurs whenever a price changes. However, the current notation illuminates the
role of the first term as well. It is the change in demand that occurs when we do not hold income fixed as
the price changes, but instead allow income to change in whatever way is necessary (i.e., according to e∗ ) to
keep utility constant. This substitution effect is known to be nonpositive, simply because the law of demand
holds for expenditure-minimizing (i.e., cost-minimizing) demands. The very important two-term expression
(SD) for the slope of a Marshallian demand is known as the Slutsky Decomposition of the price change. It is
illustrated in Figure 15.3.

Figure 15.3: The Slutsky Decomposition. When p1 increases from p1 to p1 the budget
line swings down, as indicated by the arrow. The new price ratio determines the slope of the new
budget line. At this new price ratio, the consumer cannot afford any bundle that yields the original
utility level Ū . Rather, at the new price, income would have to be increased enough to make point
h∗ (p1 , p2 , Ū) affordable in order for the consumer to maintain the original level of utility. Hence
the price increase imposes an implicit income decrease corresponding to the distance between the
two parallel budget lines, and the change in demand from point h∗ (p1 , p2 , Ū) to point x∗ (p1 , p2 , m)
that would occur from such an income change is the income effect of the price change. The change
in demand from x∗ (p1 , p2 , m) to h∗ (p1 , p2 , Ū) that would occur if there were no implicit income
change is the pure substitution effect of the price change, and it is always nonpositive on the good
whose price is changing (note that x1 decreases as we move from x∗ (p1 , p2 , m) to h∗ (p1 , p2 , Ū )).
Point h∗ (p1 , p2 , Ū) is the Hicksian demand point for the original utility level Ū and the new higher
price. Since the consumer would have to be compensated for the implicit income loss in order
to buy point h∗ (p1 , p2 , Ū), the Hicksian demand is sometimes called the (income) compensated
demand (and, likewise, the Marshallian demand is sometimes called the uncompensated demand).
The Slutsky Decomposition allows us to characterize the situations in which Marshallian demands will
indeed obey the law of demand:

∂x∗
• If ∂m
i
≥ 0 we say xi is a normal good, and we then know that its Marshallian demand slopes downward.
The Hicksian demand curve is at least as steep as the Marshallian demand curve in this case (the Hicksian
demand changes no more than the Marshallian demand when price changes, but since price is on the
vertical axis in a conventional demand graph this means the Hicksian curve is at least as steep as the
Marshallian curve). In Figure 14.3, x1 decreases as we move from h∗ (p1 , p2 , Ū) to x∗ (p1 , p2, m), so x1 is
normal in that graph. The corresponding demand curves are illustrated in Figure 15.4.
Figure 15.4: Hicksian and Marshallian Demands for a Normal Good
∂x∗
• If ∂m
i
< 0 we say xi is an inferior good. If this income derivative, weighted by x∗i , is smaller in absolute
∂h∗
value than i
∂pi then the Marshallian demand still slopes downward but is now steeper than the Hicksian
demand. This is illustrated in Figure 15.5. If not, then the Marshallian demand slopes upward, and we
say xi is a Giffen good. A Giffen good is illustrated in Figure 15.6.
• Note that it is not possible in general to classify goods as substitutes or complements based on the
Marshallian demands. Due to income effects, which need not be symmetric between two goods, the price
∂x∗ ∂x∗
j
derivatives of Marshallian demands are not symmetric. Hence it is possible that i
∂pj > 0 while ∂pi < 0, in
which case any classification is arbitrary. Since the Hicksian demand slopes are symmetric, it is possible
to classify substitutes and complements based on Hicksian demands (or equivalently based on the Slutsky
matrix, which is observable). This approach essentially removes the ambiguous income effects, but is not
pursued very frequently.

Figure 15.5: Hicksian and Marshallian Demands for an Inferior (non-Giffen) Good
Figure 15.6: Hicksian and Marshallian Demands for a Giffen Good
Another use of the Slutsky decomposition is that it allows us to express the slope of the Hicksian demand
in terms of entirely observable components:

∂h∗i (p, Ū ) ∂x∗i (p, m) ∂x∗ (p, m)
= + x∗j (p, m) i .
∂pj Ū=U ∗ (p,m) ∂pj ∂m
Hence, from the properties of the Hicksian demand we now know a symmetry/semidefiniteness property of
the Marshallian demand:
Theorem (Addendum to Properties of the Marshallian Demand).

 ∂x∗ ∗
∗ ∗

1 ∗ ∂x1 ∂x1 ∗ ∂x1
∂p1 + x 1 ∂m . . . ∂pn + x n ∂m
 
 .. .. .. 
 . . ∗ . 
∗ ∗ ∗
+ x∗1 ∂mn + x∗n ∂mn
∂xn ∂x ∂xn ∂x
∂p1
... ∂pn
is symmetric and negative semidefinite for m > 0.
We can summarize the relationships between utility maximization and expenditure minimization that we
have derived so far with the following diagram:
Figure 15.7: Relationships between Utility Maximization and Expenditure Mini-

mization. The dark arrows at the bottom are identities 1 and 3, respectively. The other dark
arrows are other relationships already established. The gray arrows are relationships not yet
established.
There are two types of relationships illustrated in this diagram that we have not yet addressed. First, how
do we derive U ∗ from e∗ , and vice-versa? Identities 2 and 4 establish the relationship. Given U ∗ , by strict
monotonicity in m (from local nonsatiation) we know there is an inverse function U ∗−1 on Y (U ∗−1 is defined
on Y for any p >> 0, by continuity of U ∗ ) such that U ∗−1 (U ∗ (p, m)) = m (the dependence of U ∗−1 on p is
suppressed for convenience). So, from identity 4 we have U ∗−1 (Ū ) = U ∗−1 (U ∗ (p, e∗ (p, Ū))) = e∗ (p, Ū) for
Ū ∈ Y . That is, if we set the given U ∗ equal to Ū and invert the resulting expression to solve for m, the
end result is e∗ (p, Ū ). Similarly, given e∗ , by strict monotonicity in Ū (from lower semicontinuity of U ) we
know there is an inverse function e∗−1 on R1+ (assuming local nonsatiation, so that e∗ (p, Ū) is onto R1+ as
a function of Ū ∈ Y , for every p >> 0) such that e∗−1 (e∗ (p, Ū )) = Ū (dependence of e∗−1 on p is again
suppressed). So, from identity 2 we have e∗−1 (m) = e∗−1 (e∗ (p, U ∗(p, m))) = U ∗ (p, m) for m ≥ 0. That is, if
we set the given e∗ equal to m and invert the resulting expression to solve for Ū , the end result is U ∗ (p, m).
The second type of relationship we have not yet addressed is more substantial, involving movement from
x∗ to U ∗ . This is known as the integrability problem and is quite important, since the only truly observable
function here is the Marshallian demand x∗ . The easiest approach is to convert x∗ to e∗ and then just invert
e∗ , as above, to find U ∗ . It is tempting to imagine that we could convert x∗ to h∗ and then use e∗ = p · h∗ ,
but this logic is circular because we have to know e∗ in order to convert x∗ into h∗ , and if we knew e∗ we
would essentially already know U ∗ by inversion. We are interested in finding a way to derive U ∗ (and e∗
and h∗ ) from x∗ , when all that we know to start with is x∗ . To do this, use identity 3 along with Shephard’s
Lemma to get
∂e∗ (p, Ū)
x∗i (p, e∗ (p, Ū)) = h∗i (p, Ū) = for i = 1, . . . , n.
∂pi
That is, we know that the given x∗ vector forms a system of partial differential equations of the e∗ function
(involving both e∗ and its partial derivatives). To find e∗ we must solve this system, whence the term
“integrability.” There are known necessary and sufficient conditions for there to be a solution for such
systems, which, as we will see in Lecture 16, can be expected to hold here. Thus, we can generally expect
that the expenditure function can be derived from the Marshallian demands. Actually performing the
integration can be quite tedious, however.

Exercises for Lecture 15 (Relationships between Utility Maximization and Expenditure Minimization)
√
1. Suppose a consumer has expenditure function e∗ (p1 , p2 , Ū) = Ū p1 p2 . Find the Marshallian demands.
2. Suppose preferences are homothetic. Can we classify complements and substitutes based on Marshallian
demands? (Refer to exercise 1 of Lecture 12)
3. Varian #7.3.
4. Varian #7.4(b) and (c).
5. Varian #8.1.
6. Varian #8.15. Note: The question should read “What is the slope of the supply function of labor?”
7. MWG #2.F.10(a).
8. MWG #3.G.2.
9. MWG #3.G.3(c) and (e).
10. MWG #3.H.5.
11. MWG #3.H.6.

Lecture 16: Consumer Welfare
Readings: Chapter 10 of Varian; Section 3.I of MWG.
The welfare a consumer receives from a particular price vector and income endowment is measured by
the indirect utility function. This welfare measurement is merely a utility index, stated in arbitrary units
depending on the particular utility representation we happen to use for the consumer’s preferences. For
many purposes it is convenient to obtain a monetary measure of welfare. Such a measure allows us to
calculate the fixed-dollar (lump-sum) tax or subsidy we would have to impose on a consumer in order to
achieve a particular welfare goal. The most pressing need for such calculations is in evaluating the welfare
consequences of a change in the price of one good, so we focus here on calculating monetary measures of
such price changes. For notational ease we suppress the subscripts and other prices, and just denote the
price of the good in question by p, its Marshallian demand by x∗ (p, m), its Hicksian demand by h∗ (p, Ū),
the indirect utility function by U ∗ (p, m), and the expenditure function by e∗ (p, Ū ).
Consider Figure 16.1, which illustrates an increase in the price of a normal good from p0 to p1 . Quantity
demanded drops from x∗(p0 , m) to x∗(p1 , m) and indirect utility drops from U ∗ (p0 , m) to U ∗(p1 , m). Thus,
in utility terms, the damage to welfare from the price increase is U ∗ (p1 , m) − U ∗ (p0 , m) < 0. One way to
place this change in utility into monetary units is to ask
“By how much would we have to reduce the consumer’s income, rather than increasing the price,
in order to impose the same welfare loss as the price increase?”
On the graph, the lower utility U ∗ (p1 , m) places the consumer on the lower Hicksian demand h∗ (p, U ∗ (p1 , m)).
Utility is constant at the new lower level all along this Hicksian demand, so our new income level must shift
the Marshallian demand at the old price p0 left to this lower Hicksian demand. The income level that
accomplishes this is e∗ (p0 , U ∗ (p1 , m)), so the reduction in consumer’s income that is equivalent in welfare
terms to the price increase is e∗ (p0 , U ∗ (p1 , m)) − m. Since m = e∗ (p1 , U ∗(p1 , m)), this change is
EV ≡ e∗ (p0 , U ∗ (p1 , m)) − e∗ (p1 , U ∗ (p1 , m))

! p0 ∗
∂e (p, U ∗(p1 , m))
= dp
p1 ∂p
! p1
=− h∗ (p, U ∗ (p1 , m)) dp.
p0
132 LECTURE 16: CONSUMER WELFARE
This shows that the change in income that is equivalent in welfare terms to the price increase is the (negative)
area to the left of the Hicksian demand for the new utility level U ∗ (p1 , m). Since this area gives a monetary
equivalent to the price increase, it is called the equivalent variation (EV) of the price increase.
Figure 16.1: Equivalent and Compensating Variations from a Price Increase. EV

is the (negative) lightly shaded area. CV is both the lightly and darkly shaded areas.
Another way to place the change in utility from the price increase into monetary units is to ask
“By how much would we have to increase the consumer’s income, after the price increase, in order
to neutralize the welfare effect of the price increase?”
On the graph, this means we must give the consumer income that returns utility to U ∗ (p0 , m) despite
the fact that the price has risen to p1 , so we must place the consumer on the original Hicksian demand
h∗ (p, U ∗(p0 , m)) at price p1 . Thus our new income level must shift the Marshallian demand at p1 right to
the original Hicksian demand. The income level that accomplishes this is e∗ (p1 , U ∗(p0 , m)), so the increase
in consumer’s income that compensates in welfare terms for the price increase is e∗ (p1 , U ∗ (p0 , m)) − m. Since
m = e∗ (p0 , U ∗(p0 , m)), this change is
CV ≡ e∗ (p1 , U ∗ (p0 , m)) − e∗ (p0 , U ∗ (p0 , m))

! p1 ∗
∂e (p, U ∗(p0 , m))
= dp
p0 ∂p
! p1
= h∗ (p, U ∗(p0 , m)) dp.
p0
This shows that the change in income that compensates in welfare terms for the price increase is the area
to the left of the Hicksian demand for the original utility level U ∗ (p0 , m). Since this area gives a monetary
compensation for the price increase, it is called the compensating variation (CV) of the price increase.
For a price increase, the CV is positive (we must give income to the consumer in order to “compensate”
for the price increase) while the EV is negative (we must take income from the consumer in order to generate
the same utility decrease as the price increase would generate). Also, in this case the CV is larger in absolute
value than the EV.
Both the equivalent and compensating variations give theoretically correct monetary comparisons of the
welfare levels at the two prices. They differ in the utility level they use as the basis for comparison. The
equivalent variation uses as a basis the utility level that would occur if the price change were imposed, while
the compensating variation uses as a basis the utility level that occurs with no price change. The former
corresponds to using the new price as the base and the latter corresponds to using the original price as the
base. There are, in principle, many other monetary measures that could be proposed, each using a different
price for the base and therefore a different base utility level. EV and CV simply use the most natural bases,
since they are the bases actually under consideration.
Notice, however, that the area to the left of the Marshallian demand does not generally give a theoretically
correct monetary comparison of the two welfare levels. This is because welfare varies along the Marshallian
demand as the consumer continuously shifts across Hicksian demands, each one corresponding to a different
utility level. In other words, the welfare basis is constantly changing as we move along a Marshallian
demand. This is unfortunate, since the Marshallian demand is the observable component here. It would
be very convenient if we could simply examine the area to the left of a Marshallian demand to obtain a
monetary measure of a welfare change. Indeed, there is a long tradition in economics of studying consumer’s
surplus, which is usually defined to be exactly the area to the left of a Marshallian demand.
The fact that consumer’s surplus measures the wrong area is not an insurmountable problem, as there are
several approaches to overcoming this. First, we can simply note that consumer’s surplus is bounded above
and below by the EV and CV. Thus, consumer’s surplus is between two theoretically correct measures. It
is possible to state bounds on the size of the error committed when consumer’s surplus is used in lieu of
either the EV or CV, and thus to state upper and lower bounds on a theoretically correct monetary measure.
Second, we can use the relationships between utility maximization and expenditure minimization discussed
in the last lecture to derive the EV and CV from a known Marshallian demand. To do this, we must integrate
the Marshallian demand to obtain the expenditure function, and then find the difference between the two
relevant expenditure levels. Third, we can identify a condition under which consumer’s surplus coincides
with the EV or CV, or is at least very close to these correct measures. Then, assuming this condition holds,
consumer’s surplus is indeed a theoretically correct measure. Since the entire problem here arises because
the Marshallian and Hicksian demands do not coincide, the needed condition is that the source of difference
between Marshallian and Hicksian demands be zero. From the Slutsky Decomposition, we know that the
difference between these two demands is the income effect. The two demands coincide at the original utility
level and price, and the Slutsky Decomposition tells us that they have the same slope as we move away
from this point whenever the income effect is zero. So the two demands must coincide over the entire range
of prices at which the income effect is zero. Thus, if there is no income effect on the good under study
over the range of prices and income under study, then consumer’s surplus is an exact monetary measure of
the welfare consequences of a price change. Moreover, if the income effect is “small” over this range, then
consumer’s surplus is an approximate monetary measure of the welfare change. The preference structure
that results in a zero income effect is the quasilinear structure U (x) = xi + g(x−i ) for some commodity xi
and some function g. That is, if the utility function can be factored into two terms, one of which is linear in
one commodity (the ith ), then the income effect on all other commodities is zero (assuming that the optimal
choice of xi is positive).
These area-based measures of welfare lead to area-based measures of the so-called “deadweight loss”
associated with a price change. Consider Figure 16.2. If we forego the price increase and instead impose an
equivalent variation on the consumer, we take from the consumer area EV on the graph. On the other hand,
if we impose the price increase then consumption drops from the original level to x∗ (p1 , m), and so we take
from the consumer only the extra revenue from these sales at the higher price p1 . That is, our take from the
consumer is just (p1 − p0 )x∗ (p1 , m). Because the Hicksian demand is downward-sloping, our revenue from
the consumer is necessarily larger when we impose an equivalent variation than when we simply raise the
price, even though the consumer is left with the same utility in either case. In other words, the EV is a more
efficient way for us to impose the utility decrease on the consumer. The difference between the two areas is
the dark shaded triangle on the graph, and this triangle is called the deadweight loss of the price increase.
Figure 16.2: Deadweight Loss from a Price Increase based on the EV. EV is both
the (negative) light and dark shaded areas. Revenue from the price increase is only the light
shaded area. Hence the deadweight loss of the price increase is the dark shaded area.
The deadweight loss can be illustrated in terms of the CV as well, as in Figure 16.3. If we impose
the price increase and then compensate the consumer for the price increase, consumption still drops to
x∗ (p1 , e∗ (p1 , U ∗(p0 , m))) due to the negative slope of the Hicksian demand. We collect extra revenue from
the consumer of (p1 − p0 )x∗ ((p1 , e∗ (p1 , U ∗ (p0 , m))), but the compensation to the consumer costs the area
CV. So we have to pay a net amount equal to the difference between the two areas, illustrated as the dark
shaded triangle on the graph, even though the consumer’s utility is unchanged. This dark shaded area is
once again the deadweight loss of the price increase.
These deadweight losses may or may not be offset by other savings, for example cost savings from lower
production. If such savings exceed the deadweight loss then the price increase may be beneficial overall.
The welfare analysis of a price decrease is not substantially different. But, since utility increases with a
price decrease, and since EV is based on the new utility level while CV is based on the original utility level,
the two measures switch positions on the graph when the price change is a decrease rather than an increase.
Figure 16.3: Deadweight Loss from a Price Increase Based on the CV. CV is both
the light and dark shaded areas. Revenue from the price increase is only the light shaded area.
Hence the deadweight loss of the price increase is the dark shaded area.
In this case EV is larger in absolute value than CV, and CV is negative (we must take income from the
consumer in order to “uncompensate” for the price decrease) while EV is positive (we must give income to
the consumer in order to generate the same utility increase as the price decrease would generate).
The welfare analysis of an inferior good is also not substantially different. For a price increase, the EV is
still negative and the CV is still positive, but when the good is inferior the EV is larger in absolute value
than the CV.

Exercises for Lecture 16 (Consumer Welfare)
1. Carefully graph the EV and CV for a price decrease of a normal good. Place the Marshallian demands
after both variations on your graph. Illustrate the deadweight losses based on both the EV and CV.
2. Carefully graph the EV and CV for a price increase of an inferior good. Place the Marshallian demands
after both variations on your graph. Illustrate the deadweight losses based on both the EV and CV.
3. MWG #3.D.4.
4. Varian #10.2.
5. MWG #3.I.2.
Lecture 17: Duality of Expenditure, Indirect Utility, and Marshallian and Hicksian Demands
Readings: Sections 8.5 and 8.6 of Varian; Section 3.H of MWG.
Our preceeding discussions of utility maximization and expenditure minimization presume that the func-
tions U ∗ , x∗ , e∗ , and h∗ arise from some optimization problem with a well-behaved underlying preference
relation. That is, all of the properties we have derived are necessary for their respective functions. We want
to know whether these properties are sufficient as well, so that we can regard any function with these prop-
erties as an indirect utility, Marshallian demand, expenditure, or Hicksian demand function, respectively,
even if we never derived it from some underlying optimization.
Suppose we begin with a real-valued function e∗ (p, Ū ) of a strictly positive n-dimensional vector p and a
scalar Ū in some interval Y from some U (0) (inclusive) to some ỹ (perhaps inclusive, perhaps not); and that
this function satisfies the homogeneity, concavity, monotonicity, continuity, and nonnegativity properties of
an expenditure function (but that it may not be an expenditure function–at least, we do now know this in
advance). For convenience we will also assume that e∗ is continuously differentiable, although this assumption
is not really needed. This is the same list of properties that a cost function possesses (provided we regard
U (0) as output level 0), and we know that these properties are sufficient for a cost function. So for Ū ∈ Y ,
as we have already shown,
H(Ū) ≡ {x ∈ Rn+ : p · x ≥ e∗ (p, Ū) ∀p >> 0}
is a well-behaved “input requirement set,” possessing the following properties: {(x, Ū) : x ∈ H(Ū )} is
nonempty and closed; there is no free lunch (an inability to “produce” “output” levels greater than U (0) with
x = 0, i.e., 0 ∈
/ H(Ū ) for Ū > U (0)), possibility of inaction (that U (0) can be “produced” from x = 0, i.e.,
0 ∈ H(U (0))), free disposal, and convexity of H(Ū ); and lower hemicontinuity in “inputs” x and “output”
Ū .
If e∗ indeed came from minimization of p · x subject to U (x) ≥ Ū for some “production function” U , then
H(Ū ) ⊃ {x ∈ R+
n : U (x) ≥ Ū } just as in the production context. Unlike the production context, however,
convexity of the preference relation does not imply H(Ū ) ⊂ {x ∈ R+

n : U (x) ≥ Ū } because we have not
assumed monotonicity of , which is the preference counterpart to free disposal. Figure 17.1 shows why a
∼
lack of monotonicity allows {x ∈ R+

n : U (x) ≥ Ū } to be a proper subset of H(Ū ) even when is convex.
∼
140 LECTURE 17: CONSUMER DUALITY
Formally, the application of the separating hyperplane theorem that we used in the production context can
fail here because we used free disposal to assure that the hyperplane had a strictly positive slope vector.
Without this, we do not know that the slope vector is one of the price vectors used in the definition of
H and so there can be points in H(Ū) that are not in {x ∈ Rn+ : U (x) ≥ Ū }. However, as illustrated in
Figure 16.1, if there are extra bundles included in H such bundles are economically irrelevant in that no
maximizing consumer would ever choose them at positive prices. Most importantly, the proof from the
production context that
e∗ (p, Ū) = min p · x subject to x ∈ H(Ū )

{x}
in no way relies upon H recovering the true underlying input requirement sets. Rather, all that matters is
that H recovers economically relevant input requirement sets. Hence e∗ is indeed the minimum cost for the
technology H, irrespective of whether we know in advance that e∗ is a minimum over {x ∈ Rn+ : U (x) ≥ Ū }
for some function U . That is, H(Ū ) are the “input requirement sets” underlying the “cost function” e∗ , and
therefore a “production function” U (x) underlying e∗ is defined by U (x) ≡ max{Ū : x ∈ H(Ū )}. Since H(Ū )
has the properties of an input requirement set, this derived U has the properties of a production function
(including continuity, since H(Ū ) satisfies lower hemicontinuity in inputs), except that U (0) is the value of
Ū where the original e∗ is zero, rather than being zero.
Now suppose we just change our interpretation of the symbols and regard the sets H(Ū ) as preferred-to
sets and U (x) as a utility function for some preference relation . That is, define a preference relation on
∼ ∼
Rn+ as follows: For any x, y ∈ Rn+ , x y if and only if U (x) ≥ U (y). This preference relation is complete,
∼
transitive, and continuous on Rn+ since it is represented by a continuous function U on Rn+ . And since U is
the production function for H, for Ū ∈ Y we have e∗ (p, Ū) = min{x} p·x subject to U (x) ≥ Ū , so e∗ is indeed
the expenditure function for the utility function U (i.e., the preference relation ). That is, the properties of
∼
∗
an expenditure function are sufficient for e to be an expenditure function for some well-behaved underlying
preference relation on Rn+ .
This discussion indicates exactly how to proceed when we begin with an n-dimensional vector-valued
function h∗ (p, Ū) of a strictly positive n-dimensional vector p and a scalar Ū in some interval Y ; that
satisfies the homogeneity, symmetry/semidefiniteness, monotonicity, continuity, and nonnegativity properties

Figure 17.1: Failure of H(Ū ) to Recover the True Preferred-to Set when the
Preference Relation is Convex but not Monotonic. The true preferred-to set for
utility level Ū is the lightly shaded area. H(Ū ) includes the dark shading as well, because H is
only defined in terms of strictly positive prices. The true preferred-to set is convex, but omits the
dark shaded areas because is not monotonic.
∼
of a Hicksian demand (but may not be a Hicksian demand–at least, we do not know this in advance). Again
we assume differentiability for convenience only. Since this is the same list of properties that are sufficient for
a conditional factor demand (provided we again regard U (0) as output level 0), they are sufficient to ensure
that the derived function e∗ (p, Ū ) ≡ p · h∗ (p, Ū) is the expenditure function for the underlying preferred-to
sets H(Ū ) and that h∗ is the Hicksian demand corresponding to this expenditure function. We simply note
that U (0) is output level 0 and proceed as above. So h∗ is indeed a Hicksian demand for the utility function
U above, and we see that the properties of a Hicksian demand are sufficient for h∗ to be a Hicksian demand
for some well-behaved underlying preference relation on Rn+ .
Now we can proceed to establish sufficiency of the properties of the indirect utility function. Start with
a real-valued function U ∗ (p, m) of a strictly positive n-dimensional vector p and a nonnegative scalar m;
that satisfies the homogeneity, quasiconvexity, monotonicity, and continuity properties of an indirect utility
function (but that is not known to be an indirect utility function). Since U ∗ (p, R1+ ) = Y ∀p >> 0, we can
implicitly define a proposed expenditure function e∗ according to identity 4 from Lecture 14. That is, for
Ū ∈ Y , define e∗ implicitly by
U ∗ (p, e∗ (p, Ū)) ≡ Ū .
This defines a real-valued function e∗ provided the monotonicity property in m of the original U ∗ is strict. If
we can verify that this defined e∗ possesses the properties of an expenditure function, then we know from the
sufficiency discussion above that it is indeed an expenditure function for some underlying preference relation
. And if so, then U ∗ must be the corresponding indirect utility function since U ∗ is just the inverse of our
∼
defined e∗ . However, in verifying that e∗ has the sufficient properties of an expenditure function we have
only the properties of U ∗ to work with, since the initial U ∗ function is not known in advance to be an indirect
utility function. These properties of U ∗ are indeed sufficient for e∗ to possess the following properties:
1. (Homogeneity) U ∗ (λp, e∗ (λp, Ū)) = Ū by definition of e∗ , while U ∗ (λp, λe∗ (p, Ū )) = Ū by homogeneity
of U ∗ . Hence U ∗ (λp, e∗ (λp, Ū )) = U ∗ (λp, λe∗ (p, Ū )). Since U ∗ is strictly increasing in m, this implies
e∗ (λp, Ū ) = λe∗ (p, Ū).
2. (Concavity) Fix p, p , and Ū . Since U ∗ is quasiconvex,
U ∗ (λp + (1 − λ)p , λe∗ (p, Ū ) + (1 − λ)e∗ (p , Ū)) ≤ max{U ∗(p, e∗ (p, Ū )), U ∗(p , e∗ (p , Ū))} for λ ∈ (0, 1).
By definition of e∗ ,
max{U ∗ (p, e∗ (p, Ū)), U ∗ (p , e∗ (p , Ū))} = Ū = U ∗ (λp + (1 − λ)p , e∗ (λp + (1 − λ)p , Ū)).
Hence
U ∗ (λp + (1 − λ)p , λe∗ (p, Ū) + (1 − λ)e∗ (p , Ū)) ≤ U ∗ (λp + (1 − λ)p , e∗ (λp + (1 − λ)p , Ū)).
By strict monotonicity of U ∗ in m,
λe∗ (p, Ū ) + (1 − λ)e∗ (p , Ū) ≤ e∗ (λp + (1 − λ)p , Ū ) for λ ∈ (0, 1).
3. (Monotonicity) Let p ≥ p and Ū > Ū . By definition of e∗ ,
U ∗ (p, e∗ (p, Ū)) = Ū > Ū = U ∗ (p, e∗ (p, Ū )).

Since U ∗ is strictly increasing in m, this implies e∗ (p, Ū ) > e∗ (p, Ū ). Similarly, using monotonicity of U ∗
in p,
U ∗(p, e∗ (p, Ū )) = Ū = U ∗(p , e∗ (p , Ū)) ≥ U ∗ (p, e∗(p , Ū)).
So, again using strict monotonicity of U ∗ in m, e∗ (p, Ū) ≥ e∗ (p , Ū).
4. (Continuity) This is immediate from continuity of U ∗ and strict monotonicity of U ∗ in m.
5. (Nonnegativity) By continuity and strict monotonicity in m of U ∗ , U ∗ (p, 0) = U (0) ∀p >> 0. Thus, by
definition U ∗ (p, e∗ (p, U (0))) = U (0) = U ∗ (p, 0). So strict monotonicity of U ∗ in m implies e∗ (p, U (0)) = 0.
Moreover, for Ū ∈ Y − {U (0)} we have U ∗ (p, e∗ (p, Ū )) = Ū > U (0) = U ∗ (p, e∗ (p, U (0))) = U ∗ (p, 0). So
strict monotonicity of U ∗ in m again implies e∗ (p, Ū) > 0 for Ū > U (0).
Since e∗ satisfies the sufficient conditions for an expenditure function, it is indeed an expenditure function.
Inverting this e∗ yields the corresponding indirect utility function, which is precisely the U ∗ function we
started with, since e∗ was obtained by just inverting U ∗ . Thus the properties of an indirect utility function
are indeed sufficient for U ∗ to be an indirect utility function for some well-behaved underlying preference
relation on Rn+ .
Finally, suppose x∗ (p, m) is an n-dimensional vector-valued function of a strictly positive vector p and a
nonnegative scalar m that satisfies the homogeneity, symmetry/semidefiniteness, nonnegativity, and Walras’
Law properties of a Marshallian demand, but is not known to be a Marshallian demand. Can we show
that x∗ is indeed a Marshallian demand for some underlying preference relation? Hurwicz and Uzawa (“On
the Integrability of Demand Functions,” in Preferences, Utility, and Demand, edited by Chipman, Hurwicz,
Richter, and Sonnenschein, New York: Harcourt Brace Jovanovich, 1971) prove the following:
Lemma (Hurwicz and Uzawa, Lemma 1 (p. 124)). Suppose x∗ (p, m) is an n-dimensional vector-
valued function defined for p ∈ Rn++ and m ∈ R1+ , satisfying:
1. x∗ is differentiable on Rn++ × R1+ (one-sided when m = 0).
∂x∗
i (p,m)
2. ∂m is bounded on A × Rn+ , where A is any compact subset of Rn++ .
∂x∗ ∂x∗
3. The matrix of derivatives i (p,m)
∂pj
+ x∗j (p, m) i (p,m)
∂m
for i, j = 1, . . . , n is symmetric at every (p, m) ∈
Rn++ × R1+ .
Then, for each (p0 , m0 ) ∈ Rn++ × R1+ there exists a unique function g(p; p0 , m0 ) such that
∂g(p; p0 , m0 )
x∗i (p, g(p; p0 , m0 )) = for i = 1, . . . , n; ∀p >> 0, and
∂pi
g(p0 ; p0 , m0 ) = m0 .
NOTE: This result is a variant of Frobenius’ Theorem for this particular set of partial differential equations.
The variant here gives a unique global solution to the system of partial differential equations. The condition
g(p0 ; p0 , m0 ) = m0 is the “initial condition” for the system.
Since condition 3 of this lemma is symmetry of our Slutsky matrix, if we just add to the list of properties
of x∗ the assumptions that x∗ is differentiable, and that its income derivatives do not explode, then the
function x∗ satisfies the conditions of Hurwicz and Uzawa’s lemma.
Hurwicz and Uzawa also establish an important property of the solution g:
Lemma (Hurwicz and Uzawa, Lemma 3 (p. 125)). Let (p0 , m0 ), (p1 , m1 ) ∈ Rn++ × R1+ be two initial
conditions. If g(p2 ; p0 , m0 ) < g(p2 ; p1 , m1 ) for some p2 >> 0, then
g(p; p0 , m0 ) < g(p; p1 , m1 ) ∀p >> 0.
Proof. Suppose not, so there exists p3 >> 0 such that g(p3 ; p0 , m0 ) ≥ g(p3 ; p1 , m1 ). Then, by continuity of
g (follows from differentiability), there exists p4 between p2 and p3 such that
g(p4 ; p0 , m0 ) = g(p4 ; p1 , m1 ).
Since g is a unique solution to the system of partial differential equations (Lemma 1), we then have
g(p; p0 , m0 ) = g(p; p1 , m1 ) for all p >> 0 (i.e., the two solutions g(p; p0 , m0 ) and g(p; p1 , m1 ) to the
system are equal at a point p4 , and their values as we depart from that point are determined by the
derivatives, which are the same at all points, so the “two” solutions must be the same). This contradicts
g(p2 ; p0 , m0 ) < g(p2 ; p1 , m1 ).
Now assume x∗ is differentiable and has bounded income derivatives. Suppose we set Ū = m0 (actually,
we only need a strictly increasing (1-1) mapping Ū (m0 ) of income values m0 into utility values Ū ) and define
a hypothetical expenditure function by e∗ (p, Ū; p0 ) = g(p; p0 , Ū). Then e∗ is indeed an expenditure function
for any arbitrary p0 >> 0 (suppressed below for convenience) because it satisfies the sufficient conditions:
1. (Homogeneity) Walras’ Law says p · x∗ (p, e∗ (p, Ū)) = e∗ (p, Ū ). Substituting from the partial differential
equations that define e∗ , this is

n
∂e∗ (p, Ū)
pi = e∗ (p, Ū ).
∂pi
i=1
But this is Euler’s equation for a function e∗ that is homogeneous of degree one in p. Since Euler’s
equation is both necessary and sufficient for homogeneity, e∗ is homogeneous of degree 1.
2. (Concavity) The Hessian matrix of e∗ with respect to p is just the Slutsky matrix, which is negative
semidefinite by the semidefiniteness property of x∗ .
∂e∗
3. (Monotonicity) By nonnegativity of x∗ , ∂pi = x∗i ≥ 0. For strict monotonicity in Ū , let Ū 0 < Ū 1 and
note that, from the initial condition defining g,
e∗ (p0 , Ū 0 ) = g(p0 ; p0 , Ū 0) = Ū 0 < Ū 1 = g(p0 ; p0 , Ū 1) = e∗ (p0 , Ū 1 ).
By Hurwicz and Uzawa’s Lemma 3, this holds at every p >> 0. That is, e∗ (p, Ū 0 ) < e∗ (p, Ū 1 ), or e∗ is
strictly increasing in Ū .
4. (Continuity) By definition, e∗ (p, Ū ) = g(p; p0 , Ū ), and g(p; p0 , m0 ) is continuous in (p, m0 ) by its definition
in Hurwicz and Uzawa’s Lemma 1. Therefore e∗ is continuous.
5. (Nonnegativity) First we show e∗ (p, Ū) ≥ 0 ∀p >> 0 and ∀Ū ≥ 0 (or, for a different choice of Ū (m0 ), for
all Ū ≥ Ū(0)). Suppose otherwise. Then there exists p >> 0 and Ū ≥ 0 such that e∗ (p, Ū) < 0. Select
λ > 0 such that λp > p0 . Then, from the definition of e∗ and the initial condition defining g, and using
the monotonicity and homogeneity of e∗ , we have
0 ≤ Ū = e∗ (p0 , Ū) ≤ e∗ (λp, Ū ) = λe∗ (p, Ū) < 0,
a contradiction. Using this, we now show that e∗ (p, 0) = 0 ∀p >> 0, so that U (0) = 0 (or, for a different
choice of Ū (m0 ), U (0) = Ū (0)). Suppose otherwise. Then, since e∗ ≥ 0, there exists p1 >> 0 such that
e∗ (p1 , 0) = g(p1 ; p0 , 0) > 0. From the initial condition defining g, g(p1 ; p1 , 0) = 0 < g(p1 ; p0 , 0), so by
Hurwicz and Uzawa’s Lemma 3 we have g(p; p1 , 0) < g(p; p0 , 0) for every p >> 0. But, again using the
initial condition, this implies g(p0 ; p1 , 0) < g(p0 ; p0 , 0) = 0, a contradiction to e∗ ≥ 0. Finally, since e∗ is
strictly increasing in Ū , e∗ (p, 0) = 0 ∀p >> 0 immediately implies e∗ (p, Ū ) > 0 for p >> 0 and Ū > 0
(i.e., Y = R1+ for this choice of U ).

Since e∗ is an expenditure function, we know that there is an underlying preference relation such that
e∗ (p, Ū ) is the minimum cost of obtaining utility Ū , that the indirect utility U ∗ corresponding to e∗ is
∂e∗(p,Ū )
just the inverse of e∗ , that the corresponding Hicksian demands are h∗i (p, Ū) = ∂pi , and that the
corresponding Marshallian demands are h∗i (p, U ∗(p, m)) (from identity 1 of the Lecture 14). But, from the
definition of e∗ and identity 2 of Lecture 14, these Marshallian demands are

∂e∗ (p, Ū)
= x∗i (p, e∗ (p, U ∗(p, m))) = x∗i (p, m),
∂pi Ū =U ∗ (p,m)
which are the original x∗i functions that we began with. That is, x∗ is indeed a Marshallian demand for
some underlying preference relation. The properties of a Marshallian demand, along with assumptions 1 and
2 of Hurwicz and Uzawa’s Lemma 1, are sufficient for x∗ to be a Marshallian demand for some well-behaved
underlying preference relation on Rn+ .

Exercises for Lecture 17 (Consumer Duality)
1. Varian #9.8.
2. MWG #3.G.10.
3. MWG #3.G.11.
SOLUTIONS TO EXERCISES
150
Solutions to Exercises for Lecture 1 (Introduction)
1. Envelope Theorem: The derivative of an optimized function when a parameter changes equals the deriva-
tive of the corresponding Lagrangian function with respect to the parameter, evaluated at the maximum.
152 SOLUTIONS TO EXERCISES FOR LECTURE 2 (TECHNOLOGIES)
Solutions to Exercises for Lecture 2 (Technologies)
1.
(i) (ii) (iii) (iv)
(a) no yes no yes
(b) yes yes yes no
(c) yes yes yes yes
(d) no yes yes no
(e) yes yes yes yes
(f) yes no yes yes
2.
A “well-behaved” single-output production set whose production function can

take on infinite values
The boundary of Z has a vertical asymptote at z1 , so f(z1 ) = max{z2 : (z1 , z2 ) ∈ Z} = ∞ for any z1 ≤ z1 .
Note that Z is not convex in this figure. If Z is convex, an infinite value for f(z1 ) cannot occur. To prove
this claim formally, suppose otherwise. That is, suppose Z is convex but there is a value of z1 , as in the
figure, for which (z1 , z2 ) ∈ Z for z2 arbitrarily large. Then there is a sequence z2i such that z2i > 1 ∀i,
limi→∞ z2i = ∞, and (z1 , z2i ) ∈ Z ∀i. By convexity and the possibility of inaction,
α(z1 , z2i ) + (1 − α)(0, 0) ∈ Z ∀α ∈ [0, 1].
Now set αi = 1/z2i (αi ∈ (0, 1) since z2i > 1), so that
αi (z1 , z2i ) + (1 − αi )(0, 0) = (z1 /z2i , 1) ∈ Z.
Letting i → ∞, we get (0, 1) ∈ Z since Z is a closed set. But this contradicts the no free lunch property.
3.
i. f(0) = max{y : (y, 0) ∈ Z} by definition. By possibility of inaction, (0, 0) ∈ Z. Hence f(0) ≥ 0. By no
free lunch, f(0) ≤ 0. Combining, f(0) = 0.
ii. Let x ≥ x . By free disposal, if (y, −x ) ∈ Z then (y, −x) ∈ Z too. Hence f(x) ≥ f(x ).
iii. Fix x and consider any y such that (y, −x) ∈ Z. Then (αy, −αx) ∈ Z for α ∈ [0, 1]. So, by definition
of f, f(αx) ≥ αy. This holds for any y such that (y, −x) ∈ Z. Hence f(αx) is an upper bound for
{αy : (y, −x) ∈ Z}, implying f(αx) ≥ αf(x).
iv. The proof is identical to part iii., except for a different specification of α.
v. Same as part iii.
vi. Necessity: Fix y and consider any x, x ∈ V (y). By quasiconcavity, f(αx+(1−α)x ) ≥ min{f(x), f(x )}.
Since x, x ∈ V (y), f(x) ≥ y and f(x ) ≥ y. Thus f(αx + (1 − α)x ) ≥ y. By free disposal, this implies
αx + (1 − α)x ∈ V (y), so V (y) is convex.
Sufficiency: Fix any x and x . Set y = min{f(x), f(x )} so that f(x) ≥ y and f(x ) ≥ y. By free
disposal, y ≤ y ⇒ V (y) ⊂ V (y ), so y ≤ f(x ) ⇒ V (f(x )) ⊂ V (y), and thus x ∈ V (y). This same
argument yields x ∈ V (y). Then by convexity αx + (1 − α)x ∈ V (y). Finally, by the definition of f,
f(αx + (1 − α)x ) ≥ y, so f is quasiconcave.
vii. a. We must show that {x : f(x) ≥ y} is a closed set for arbitrary y. Let xi be a sequence that converges
to x0 , satisfying f(xi ) ≥ y. We must show that f(x0 ) ≥ y. By free disposal,
{x : f(x) ≥ y} = V (y).
So, xi ∈ V (y) for every i. By closedness of Z, V (y) is closed. Hence x0 ∈ V (y), so f(x0 ) ≥ y.
b. We must show that {x : f(x) ≤ y} is a closed set for arbitrary y. Let xi be a sequence that
converges to x0 , satisfying f(xi ) ≤ y. We must show f(x0 ) ≤ y. Since f(xi ) is a bounded sequence,
i i i
there exists a convergent subsequence f(xk ) → f 0 ≤ y. We know (f(xk ), −xk ) ∈ Z ∀i. Since Z is
closed, this implies (f 0 , −x0 ) ∈ Z. Thus f(x0 ) ≥ f 0 , from the definition of f, and free disposal then
gives (f(x0 ), −x0 ) ∈ Z.

i
Now suppose f(x0 ) > f 0 , and set = f(x0 ) − f 0 > 0. Since (f(x0 ), −x0 ) ∈ Z and xk → x0 ,
i i i
by lower hemicontinuity of Z in output there exists yk → f(x0 ) such that (yk , −xk ) ∈ Z. By
i i i i
convergence, for i large we have yk > f(x0 ) −
2 and, since (yk , −xk ) ∈ Z, we have f(xk ) ≥
i i
yk > f(x0 ) −
2 = 1 0
2 (f(x ) + f 0 ) for i large. But since f(xk ) → f 0 , for i large we must also have
i
f(xk ) < f 0 =
2 + 12 (f(x0 ) + f 0 ), a contradiction. Hence f(x0 ) = f 0 ≤ y.
4.
a.
Z = {(y, x1 , x2 ) : y ≤ A(−x1 )α1 (−x2 )α2 and x1 , x2 ≤ 0}.
V (y) = {(x1 , x2 ) : y ≤ Axα

1 x2 and x1 , x2 ≥ 0}.
1 α2
1 x2 and x1 , x2 ≥ 0}.
The isoquant for y is {(x1 , x2 ) : y = Axα 1 α2
α −1 α
Aα1 x1 1 x2 2
The MRTS at (x1 , x2) is − ff12 = − α1 α2 −1 = −α 1 x2
α 2 x1 .
Aα2 x1 x2
All isoquants are asymptotic to both axes, except for the y = 0 isoquant (which is both axes). Higher values
of y produce isoquants to the northeast of the one illustrated:
Typical isoquant for Cobb-Douglas technology
b.
Z = {(y, x1 , x2 ) : y ≤ min{a1 (−x1 ), a2 (−x2 )} and x1 , x2 ≤ 0}.
V (y) = {(x1 , x2 ) : y ≤ min{a1 x1 , a2 x2 } and x1 , x2 ≥ 0}.
The isoquant for y is {(x1 , x2 ) : y = min{a1 x1 , a2 x2 } and x1 , x2 ≥ 0}.
The MRTS at (x1 , x2) is −∞ if x2 > a1

a2 x1 and is 0 if x2 < a1
a2 x1 . The MRTS is undefined if x2 = a1
a2 x1 .
All isoquants are L-shaped, with the vertex along the line through the origin with slope a1 /a2 . Higher values
of y produce isoquants to the northeast of the one illustrated:
Typical isoquant for Leontief technology
c.
Z = {(y, x1 , x2 ) : y ≤ a1 (−x1 ) + a2 (−x2 ) and x1 , x2 ≤ 0}.
V (y) = {(x1 , x2 ) : y ≤ a1 x1 + a2 x2 and x1 , x2 ≥ 0}.
The isoquant for y is {(x1 , x2 ) : y = a1 x1 + a2 x2 and x1 , x2 ≥ 0}.
The MRTS at (x1 , x2) is − aa12 .
All isoquants are straight lines with slope −a1 /a2 . Higher values of y produce isoquants to the northeast of
the one illustrated:

Typical isoquant for perfect substitutes technology
d.
Z = {(y, x1 , x2 ) : y ≤ [a1 (−x1 )ρ + a2 (−x2 )ρ ]/ρ and x1 , x2 ≤ 0}.
V (y) = {(x1 , x2 ) : y ≤ [a1 xρ1 + a2 xρ2 ]/ρ and x1 , x2 ≥ 0}.
The isoquant for y is {(x1 , x2 ) : y = [a1 xρ1 + a2 xρ2 ]/ρ and x1 , x2 ≥ 0}.
The MRTS at (x1 , x2) is
ρ−1
f1 (/ρ)[a1 xρ1 + a2 xρ2 ]/ρ a1 ρxρ−1 a1 x1
− =− 1
=− .
f2 (/ρ)[a1 xρ1 + a2 xρ2 ]/ρ a2 ρxρ−1
2
a2 x2
The shape of the isoquants depends on ρ. See Varian pp. 19-20 for a discussion.
5. Note that

f(αx1 , αx2 ) = [a1 (αx1 )ρ + a2 (αx2 )ρ ] ρ ] = α[a1 xρ1 + a2 xρ2 ] ρ ] = α f(x1 , x2 ).
a. We have constant returns to scale when the function is homogeneous of degree one, that is, when
f(αx1 , αx2) = αf(x1 , x2). Thus α = α, and = 1.
b. We have nondecreasing returns to scale when the function is homogeneous of degree greater than one,
that is, when f(αx1 , αx2 ) ≥ αf(x1 , x2 ). Thus α ≥ α, and ≥ 1.
c. We have nonincreasing returns to scale when the function is homogeneous of degree less than one, that
is, when f(αx1 , αx2 ) ≤ αf(x1 , x2 ). Thus α ≤ α, and ≤ 1.

Solutions to Exercises for Lecture 3 (Profit Maximization: Basics)
1. This is an IRTS Cobb-Douglas function. So, −M RT S = w1

w2 ⇒ x2
x1 = w1
w2 , so x2 = w1
w2 x1 .
w1 2
π=p x − 2w1 x1 .
w2 1
Now let x1 → ∞, which implies that π → ∞. Hence x2 = w1

x
w2 1
and x2 → ∞.
2. (MWG #5.C.1)
Proof. Suppose not, so that 0 < π ∗ (p) < ∞. Then there exists a feasible netput z ∗ (p) such that π ∗ (p) =
p· z ∗(p). By nondecreasing returns to scale, αz ∗ (p) ∈ Z ∀α ≥ 1, since z ∗ (p) ∈ Z. Thus, profit of p· (αz ∗(p)) =
απ ∗ (p) ≥ π ∗ (p) can be obtained. Since π ∗ (p) > 0, limα→∞ απ ∗ (p) = ∞, contradicting that 0 < π ∗ (p) < ∞
can be optimal.
3. (MWG #5.C.6)
a. Since y∗ (p, w) = f(x∗ (p, w)), we have
∂y∗ n
∂x∗
= fi (x∗ ) i .
∂p i=1
∂p
Differentiating the first order conditions pfi (x∗ ) − wi = 0 for i = 1, ..., n with respect to p yields
 ∂x∗
1
  
∂p f1
   . 
Hπ(x)  ...  = −  ..  .
∂x∗n fn
∂p
" ∂x∗ ∂x∗ #
Multiply both sides of this equation by the row vector ∂p
1
··· n
∂p
≡ a to get

n
∂x∗i
a Hπ(x) a = − fi (x∗ ) .
∂p
i=1
∂y ∗
Hence ∂p
= −a Hπ(x) a > 0, since Hπ(x) is negative definite by the sufficient second order conditions.
∂y ∗ n ∂x∗ ∂x∗
b. Since 0 < ∂p = i=1 fi (x∗ ) ∂p
i
and fi ≥ 0 ∀i, it follows that ∂p
i
> 0 for at least one i.
4. (MWG #5.C.9)
1
a. f(z) = (z1 + z2 ) 2 . As seen in the figure below, the isoquants are linear. So, the max occurs at a corner
unless w1 = w2 , in which case any point on the isoquant is optimal.
Assume w1
w2 > 1. Then z1∗ = 0 and z2∗ = y2 , so π = py − w2 y2 , ∂π
∂y = p − 2w2 y, and therefore y∗ = p
2w2 .
Similarly, y∗ = p
2w1 if w1
w2 < 1. If w1
w2 = 1, then any point on the isoquant will do, so just use one of the
158 SOLUTIONS TO EXERCISES FOR LECTURE 3 (PROFIT MAXIMIZATION: BASICS)
endpoints to calculate y∗ . In general,

p
if w1
≥1
y∗ (p, w1 , w2 ) =
2w2 w2
p w1
2w1 if w2 <1
p2
if w1
≥1
π ∗ (p, w1 , w2 ) =
4w2 w2
2
p w1
4w1 if w2 < 1.
Isoquant for output level y (Perfect substitutes technology)
1
b. f(z) = [min(z1 , z2 )] 2 . As seen in the figure above, the isoquants are L-shaped. So, the maximum
occurs at z1∗ = z2∗ = y2 , irrespective of what the input prices are. Thus, π = py − (w1 + w2 )y2 , ∂π
∂y =
p − 2(w1 + w2 )y, and therefore
p
y∗ =
2(w1 + w2 )
p2 p2 p2
π∗ = − (w1 + w2 ) 2
= .
2(w1 + w2 ) 4(w1 + w2 ) 4(w1 + w2 )
1
c. f(z) = (z1ρ + z2ρ ) ρ , which is constant returns CES. Since this is constant returns to scale, either π ∗ = 0
or π ∗ = ∞. For a given output level y, the firm sets -MRTS = w1

w2 :
ρ−1
z1 w1
= .
z2 w2
ρ−1
ρ ρ−1
ρ
ρ1
1
So, for this given y = (z1ρ
+ z2ρ ) ρ
we can substitute to get = z1ρ
and y = w1
w2 z2ρ
+ 1 z2 . w1
w2
ρ
− ρ
1 ρ
− ρ
1
ρ−1 w2 ρ−1
Thus, z2 = y w 1
w2 + 1 and similarly z1 = y w1 + 1 . However, these are only
Isoquant for output level y (Leontief technology)
solutions for z1 and z2 conditional on y. The level of y that is optimal is completely arbitrary if π = 0
and is infinite (giving z1∗ = z2∗ = ∞ too) if π > 0 is possible. Substituting for z1 and z2 in the profit
expression yields
 − ρ1 − 1ρ 
ρ−1
ρ ρ−1
ρ
w2 w1
π = py − y w1 +1 + w2 +1 .
w1 w2
Setting this to zero yields

ρ−1
ρ − 1ρ ρ−1
ρ − 1ρ
w2 w1
p = w1 +1 + w2 +1 . (*)
w1 w2
If the prices are related in this way then π ∗ = 0 and y∗ is anything. Otherwise, either y∗ = 0 and
π ∗ = 0 or y∗ = ∞ and π ∗ = ∞. Summary:


0 if p < (*)
y∗ (p, w1 , w2) = [0, ∞) if p = (*)


∞ if p > (*)

0 if p ≤ (*)
π ∗ (p, w1 , w2) =
∞ if p > (*).
5. (Varian # 2.3) The FOC is paxa−1 = w, and the SOC is pa(a − 1)xa−2 < 0, which holds for x ≥ 0 since
a−1
1
0 < a < 1. The FOC yields x∗ (p, w) = ap

w
. The supply function is given by
a−1
a
∗ ∗ w
y (p, w) = f(x (p, w)) = ,
ap
160 SOLUTIONS TO EXERCISES FOR LECTURE 3 (PROFIT MAXIMIZATION: BASICS)
and the profit function is given by
a−1
a a−1
1
∗ ∗ ∗ w w
π (p, w) = py (p, w) − wx (p, w) = p −w .
ap ap
To check for homogeneity:
a−1
a a−1
1 a−1
a a−1
1
∗ αw αw w w
π (αp, αw) = αp − αw = αp − αw = απ ∗ (p, w).
aαp aαp ap ap
1 a a 1
To check for convexity: Rearrange π ∗ so that π ∗ = Ap 1−a w a−1 , where A = a 1−a − a 1−a . Then

∂π ∗ 1 a a
=A p 1−a w a−1
∂p 1−a

∂π ∗ a 1 1
=A p 1−a w a−1 .
∂w a−1
The Hessian matrix can now be written as:

∂ 2 π∗ (p,w) ∂ 2 π∗ (p,w)
2a−1 a a 1
∂p2 ∂p∂w
a
(1−a)2 p
1−a w a−1 − (1−a)
a
2p
1−a w a−1
Hπ∗ (p,w) = ∂ 2 π∗ (p,w) ∂ 2 π∗ (p,w)

=A a 1 1 2−a .
∂w∂p ∂w 2
− (1−a)
a
2p
1−a w a−1 a
(1−a)2 p
1−a w a−1
The naturally-ordered principal minors of this matrix are
a 2a−1 a
A p 1−a w a−1 > 0, and 0.
(1 − a)2
Thus, the Hessian is a positive semidefinite matrix, which implies that π ∗ (p, w) is convex in (p, w).
6. (Varian # 2.7)
a. We want to maximize 20x − x2 − wx. The first-order condition is 20 − 2x − w = 0.
b. For x∗ = 0, the derivative of profit with respect to x must be nonpositive at x = 0: 20 − 2x − w ≤ 0
when x = 0, or w ≥ 20.
c. The optimal x will be 10 when w = 0.
d. The factor demand function is x∗ = 10 − w

2 or, to be more precise, x∗ = max{10 − w
2 , 0}.
e. Profits are 20x − x2 − wx = (20 − w − x)x. Substitute x∗ = 10 − w

2 to get

w 2
10 − , w < 20
π ∗ (w) = 2
0, w ≥ 20.
f. The derivative of profit with respect to w is w

2
− 10 = −x∗ for w < 20.
Solutions to Exercises for Lecture 4 (Profit Maximization: Advanced)
1. We know zi∗ (p, w) is homogeneous of degree 0 in (p, w). So, Euler’s Theorem says

n
∂z ∗ (p, w) ∂zi∗ (p, w)
i
wj + p = 0.
∂wj ∂p
j=1
Divide this by zi∗ to obtain

n
∂z ∗ (p, w) wj ∂zi∗ (p, w) p
i
+ = 0.
∂wj zi∗ ∂p zi∗
j=1
n
Therefore, j=1 ij + ip = 0.
2. (Varian #3.1)
∂ 2 φi
a. ∂wi2
≥ 0 due to convexity; ∂φi
∂wi ≤ 0 due to monotonicity.
∂x∗
b. −x∗i (w1 , w2 ) = ∂φi
∂wi , so i
∂wj = 0.
c. FOC’s are:
f1 (x∗1 , x∗2 ) = w1
f2 (x∗1 , x∗2 ) = w2
Differentiate these to get

∂x∗
1

f11 f12 ∂w2 0

∂x∗ = .
f21 f22 2 1
∂w2
So by Cramer’s Rule,
∂x∗1 (−1)f12
= = 0 from above.
∂w2 f11 f12

f21 f22
Thus f12 = 0 at all optima. This implies f1 is independent of x2 , so f(x1 , x2) must be an additively
separable form: f(x1 , x2 ) = g(x1 ) + h(x2 ).
3. (Varian #3.2)

p ln x − wx if x > 1
max pf(x) − wx =
x −wx if x ≤ 1
" #
p x1 − w = 0 ⇒ x∗ = p
w
, and −px−2 < 0, so the SOC holds. So, π ∗ (p, w) = p ln( w
p
) − p = p ln( wp ) − 1
when this is > 0:

∗
0 p
≤e
π (p, w) = " # w
p ln( wp ) −1 p
w
> e.
162 SOLUTIONS TO EXERCISES FOR LECTURE 4 (PROFIT MAXIMIZATION: ADVANCED)
4. (Varian #3.5) If w >> 0, the firm will never use more of factor i than it needs to, which implies x1 = x2 .
Hence the profit maximization problem can be written as
max pxa1 − (w1 + w2 )x1 .

x
The first-order condition is
paxa−1
1 − (w1 + w2 ) = 0.
The factor demand function and the profit function are the same as if the production function were
f(x) = xa , but the factor price is w1 + w2 rather than w. See Varian #2.3 from Lecture 3 for the solution.
In order for a maximum to exist, a < 1 is needed (or a = 1 with p = w1 + w2 ). Otherwise this is an IRS
technology and profit is infinite.

Solutions to Exercises for Lecture 5 (Cost Minimization: Basics)
1. Differentiating the FOC’s with respect to y yields:

 ∂x∗ 
1  
∂y 0
 .  .. 
 .  
HL(x,λ)  .
 ∂x∗n
=
 
. 
 ∂y  0 
∂λ∗ −1
∂y
So,
∂x∗i
i+(n+1)
(−1)(−1) |Hn+1,i |
=
∂y |HL(x,λ)|
where Hn+1,i is the submatrix of HL(x,λ) obtained by deleting row n + 1 and column i. Since i < n + 1,
∂x∗
Hn+1,i is neither a principal submatrix nor border-preserving. Thus, ∂y
i
cannot be signed in general.
Similarly,
∂λ∗
2(n+1)
(−1)(−1) |Hn+1,n+1|
= ,
∂y |HL(x,λ)|
which cannot be signed because Hn+1,n+1 is not border-preserving (it is a principal submatrix). Applying
this methodology to the expression derived in class for differentiation of the FOC’s with respect to wi ,
∂λ∗
i+(n+1)
(1)(−1) |Hi,n+1|
= .
∂wi |HL(x,λ)|
∂x∗
This suffers from the same problem as ∂y .
i
2.
a. By definition,
py∗∗ − w · x∗∗ ≥ py − w · x ∀ (y, −x) ∈ Z.
So, if (y∗∗ , −x) ∈ Z, then
py∗∗ − w · x∗∗ ≥ py∗∗ − w · x
⇒ w · x∗∗ ≤ w · x.
This holds ∀ x ∈ V (y∗∗ ). So w · x∗∗ is a lower bound for w · x on V (y∗∗ ). Hence, w · x∗∗ ≤ w · x∗(w, y∗∗ ).
However, by definition x∗∗ ∈ V (y∗∗ ), so w · x∗ (w, y∗∗ ) ≤ w · x∗∗ . Thus w · x∗ = w · x∗∗ . Uniqueness
then implies x∗ = x∗∗ .

164 SOLUTIONS TO EXERCISES FOR LECTURE 5 (COST MINIMIZATION: BASICS)
b. Differentiate with respect to wj :

∂x∗∗
i ∂x∗i ∂x∗ ∂y∗∗
= + i .
∂wj ∂wj ∂y ∂wj
By symmetry of the substitution matrix,
∂y∗∗ ∂x∗∗
j
=− .
∂wj ∂p
Now differentiate the identity with respect to p:
∂x∗∗
j ∂x∗j ∂y∗∗
= .
∂p ∂y ∂p
So,
∂x∗∗ ∂x∗i ∂x∗i ∂x∗j ∂y∗∗
i
= − . (*)
∂wj ∂wj ∂y ∂y ∂p
∂y ∗∗ ∂x∗ ∂x∗ ∂x∗

We know ∂p
≥ 0. Complements means i
∂wj
≤ 0. So, if ∂y
i
and ∂y
j
have the same sign (either both
normal or both inferior) then

∂x∗∗
i
≤ 0 (Gross complements).
∂wj
∂x∗∗ ∂x∗ ∂x∗
The converse fails: If we have i
∂wj ≤ 0 and i
∂y ∂y
j
≥ 0 we cannot conclude that
∂x∗i
≤ 0.
∂wj
∂x∗ ∂x∗ ∂x∗

Substitutes case: i
∂wj ≥ 0, so from (*) if ∂y
i
and ∂y
j
have opposite signs (one is normal and the other
is inferior) then
∂x∗∗
i
≥ 0 (Gross Substitutes).
∂wj
∂x∗∗ ∂x∗ ∂x∗
The converse fails: If we have i
∂wj ≥ 0 and i
∂y ∂y
j
≤ 0 we cannot conclude that
∂x∗i
≥ 0.
∂wj
∂x∗ ∂x∗
Similarly, from (*) if inputs i and j are gross complements and i
∂y ∂y
j
≤ 0 then inputs i and j are
∂x∗ ∂x∗
complements. If inputs i and j are gross substitutes and i
∂y ∂y
j
≥ 0 then inputs i and j are substitutes.
3.
x2 w1 w1
M RT S = − =− or x2 = x1 .
x1 w2 w2
w1
x1 x2 = y, substitute in x2 , to get x1 x1 = y
w2
1
w2 2
⇒ = y x∗1
w1
1
∗ w1 2
x2 = y
w2
12 12
w2 w1 1
c∗ = w 1 y + w2 y = 2 (yw1 w2 ) 2
w1 w2
4. (MWG #5.C.10)
a. As shown in the figure below, when the isocost line has steeper than −1 slope we get an optimal choice
at z1∗ = 0 and z2∗ = y; when the isocost slope is flatter than −1 we get z1∗ = y and z2∗ = 0; when the
isocost slope = −1, any point on the isocost is optimal.
Isoquant for output level y is linear with slope −1 (perfect substitutes technol-
ogy)
Summary: 

0 if w1
w2 > 1
z1∗ (w1 , w2, y) = y if w1
w2 < 1


[0, y] if w1
w2
=1
 w2

0 if w1 > 1
∗
z2 (w1 , w2 , y) = y if w2
w1 < 1


y − z1∗ if w 2
w1
=1
So,

∗
w1 y if w1
≤1
c (w1 , w2 , y) = w1 z1∗ + w2 z2∗ = w2
w1
w2 y if w2
> 1.
Isoquant for output level y (Leontief Technology)
b. Isoquant is L-shaped, so minimal (z1 , z2 ) combination is always at the corner z1 =z2 .
Summary:
z1∗ (w1 , w2 , y) = y ∀w1 , w2 >> 0
z2∗ (w1 , w2 , y) = y ∀w1 , w2 >> 0
c∗ (w1 , w2 , y) = w1 z1∗ + w2 z2∗ = (w1 + w2 )y.
c. If ρ = 1, then it’s (a) and CES isn’t defined for ρ = 0. So, assume ρ < 1 and ρ = 0. Then the
1
Lagrangian function is L = w1 z1 + w2 z2 − λ((z1ρ + z2ρ ) ρ − y). FOC’s are:
λ ρ 1
−1
w1 − (z1 + z2ρ ) ρ ρz1ρ−1 = 0
ρ
λ 1
−1
w2 − (z1ρ + z2ρ ) ρ ρz2ρ−1 = 0
ρ
ρ−1 1
w1 z1 w1
Forming the ratio yields w2
= z2
or z1 = w2
ρ−1 z2 . Substitute into the constraint to get
ρ−1
ρ ρ1 ρ−1
ρ − 1ρ
w1 w1
z2ρ + z2ρ = y, or z2∗ = y +1 .
w2 w2
ρ−1
ρ
− 1ρ
Similar substitution yields z1∗ =y w2
w1 +1 . Thus
 − 1ρ − 1ρ 
ρ−1
ρ ρ−1
ρ
w2 w1
c∗ (w1 , w2 , y) = y w1 +1 + w2 +1 .
w1 w2
5. (Varian #5.4) The lines y = 2x1 + x2 and y = x1 + 2x2 cross at x1 = x2 . Above the x2 = x1 line, 2x1 + x2
is smaller. Below, x1 + 2x2 is smaller:

Typical isoquant for output level y
Cases:
w1
> 2 ⇒ x∗2 = y and x∗1 = 0
w2
w1 y 1
= 2 ⇒ x∗2 ∈ , y and x∗1 = (y − x∗2 )
w2 3 2
w1 1 y
2> > ⇒ x∗1 = x∗2 =
w2 2 3
w1 1 y
= ⇒ x∗2 ∈ 0, and x∗1 = y − 2x∗2
w2 2 3
1 w1
> ⇒ x∗2 = 0 and x∗1 = y.
2 w2
So factor demands are:

 w1  w1

 0 if >2 
 y if >2

 " y#
w2


w2

 0, 3 if w1
=2 
 y − 2x∗1 if w1
=2

 w2 
 w2
x∗1 = x∗2 =
y w1 1 y w1 1
if 2 > > if 2 > >


3
"y #
w2 2


3 w2 2

 w1 1 
 1
− x∗1 ) w1 1

 3, y if = 
 2 (y if w2 = 2


w2
w1
2

 w1 1
1 0 if < ,
y if w2
< 2 w2 2
and the cost function is
c∗ (w1 , w2 , y) = w1 x∗1 + w2 x∗2 .
6. (Varian # 5.17)
1
a. y = (ax1 + bx2 ) 2
b.
Typical isoquant for output level y
So

 0 if w 1
w2 > b
a


2
x∗1 = 0, ya if w 1
= ab


w2
 y2
a
if w
w2
1
< ab
 y2

 b if w 1 a
w2 > b

x∗2 = 1
y2 − ax∗1 if w 1 a
w2 = b

 b
0 if w 1 a
w2 < b
c.
2
∗
w2 yb if w1
w2
≥ a
b
c = 2
w1 ya if w1
w2 < a
b
170 SOLUTIONS TO EXERCISES FOR LECTURE 6 (COST MINIMIZATION: ADVANCED)
Solutions to Exercises for Lecture 6 (Cost Minimization: Advanced)
1. We know x∗i (w, y) is homogeneous of degree zero in w. So, Euler’s Theorem says

n
∂x∗ (w, y) i
wj = 0.
∂wj
j=1
Divide this by x∗i to obtain

n
∂x∗ (w, y) wj
i
= 0.
∂wj x∗i
j=1
n
That is, j=1 ij = 0.
2.
a. HOD 1 in w:
1 1
c∗ (αw1 , αw2 , y) = 2(y(αw1 )(αw2 )) 2 = α2(yw1 w2 ) 2 = αc∗(w1 , w2 , y).
b. Shephard’s Lemma:
12
∂c∗ 1 w2
= (yw1 w2 )− 2 yw2 = y = x∗1 .
∂w1 w1
12
∂c∗ 1 w1
= (yw1 w2 )− 2 yw1 = y = x∗2 .
∂w2 w2
c. Concave in w:
1 − 32

1 12 − 12
− 12 (yw2 ) 2 w1 2 y (w1 w2 )
Hc∗ (w) = −3
1 12 − 12 1
2 y (w1 w2 ) − 12 (yw1 ) 2 w2 2

The diagonal elements are less than 0, and |Hc∗(w) | = 1
4
y
w1 w2
− y
w1 w2
= 0. So, Hc∗(w) is negative
semidefinite ⇒ c∗ is concave.
∂c∗ ∂c∗
d. Monotonic in y and w: From above, ∂w1 ≥ 0 and ∂w2 ≥ 0. Also,
12
∂c∗ w1 w2
= >0
∂y y
e. Continuity: c∗ is the composition of the square root function and a product, both of which are contin-
uous.
f. Nonnegativity:
1
c∗ = 2(yw1 w2 ) 2 > 0 when (y, w1 , w2 ) >> 0.
1
c∗ (w, 0) = 2(0 · w1 w2 ) 2 = 0.
∂x1 ) along an isoquant. MRTS= − x1 = − w2 = −1. So, at

3. (Varian #4.8) y = x1 x2 , so 0 = x2 + x1 ( ∂x 2 x2 w1
minimum, x∗2 = x∗1 . Thus, c∗ = w1 x∗1 + w2 x∗2 = 2x∗1 = 4, or x∗1 = x∗2 = 2. Then, y = x∗1 x∗2 = 2 · 2 = 4.
4. (Varian #5.6) a = 12 , c = − 12 by homogeneity. And b = 3 since ∂x1

∂w2 = ∂x2
∂w1 .
5. (Varian #5.12)
a.
x1 is an inferior input
b. Constant returns to scale implies HOD 1 of c∗ in y: c∗ (w, αy) = αc∗(w, y) (see Varian, p. 67). Since
this holds for all w >> 0, the derivatives with respect to w must also be equal for all w >> 0:
∂c∗(w,αy) ∗
∂wi
= α ∂c∂w
(w,y)
i
. By Shepard’s Lemma, x∗i (w, αy) = αx∗i (w, y). Now differentiate with respect to
∂x∗ ∂x∗ x∗
α: i (w,αy)
∂y y = x∗i (w, y). Evaluate at α = 1 to get ∂y
i
= y
i
≥ 0.
∂λ∗ ∂x∗
c. Use Shepard’s Lemma to show that λ∗ (w, y) is marginal cost. Then use symmetry to show ∂wi = ∂y .
i
∂λ∗ ∂x∗
So, if ∂wi < 0, then ∂y
i
< 0.
172 SOLUTIONS TO EXERCISES FOR LECTURE 7 (DUALITY OF THE COST FUNCTION)
Solutions to Exercises for Lecture 7 (Duality of the Cost Function)
1. (Varian #5.16)
a. Homogeneous of Degree 1?
1 3
c(αw, y) = y 2 ((αw1 )(αw2 )) 4
3 1 3
= α 2 y 2 (w1 w2 ) 4 = αc(w, y), so NO.
Monotonic?
∂c 1 3 −1 3
= y 2 wi 4 wj4 > 0,
∂wi 4
∂c 1 1 3
= y− 2 (w1 w2 ) 4 > 0
∂y 2
Concave?
1 − 54 43 1 −1 − 14

−y 2 3
16 w1 w2
9
y 2 16 w1 4 w2
H= 1 −1 −1 1 3
− 54
y2 9
w 4 w2 4
16 1
−y 2 16
3
w14 w2
1 − 54 43
The (1, 1) “naturally ordered” principal minor is −y 2 3
16 w1 w2 < 0. The other one is
9 1 92 1
|H| = y 2
(w1 w2 )− 2 − y 2 (w1 w2 )− 2
16 16
9y 1 72y 1
= 2 (w1 w2 )− 2 [1 − 9] = − 2 (w1 w2 )− 2 < 0.
16 16
The principal minor of order 2 is not positive, so c is not concave.
Continuous? c involves only positive exponents and products, so it is continuous.
Nonnegative? c(w, y) > 0 for (w, y) >> 0 and c(w, 0) = 0 are obvious.
b. Homogeneous of Degree 1?
1
c(αw, y) = y(αw1 + (αw1 αw2 ) 2 + αw2 )
1
= αy(w1 + (w1 w2 ) 2 + w2 ) = αc(w, y)
Monotonic?
∂c 1 −1 1
= y(1 + wi 2 wj2 ) > 0,
∂wi 2
∂c 1
= (w1 + (w1 w2 ) 2 + w2 ) > 0
∂y
Concave?
−3 1 1 1
y −2 −2
− y4 w1 2 w22 w w2
4 1
H= 1 1 1
−3
y −2 −2
4 w1 w2 − y4 w12 w2 2
−3 1 y 2
The (1, 1) “naturally ordered” principal is − y4 w1 2 w22 < 0 . The other one is |H| = 4
(w1 w2 )−1 −
y 2
4 (w1 w2 )−1 = 0 .
Continuous? c involves only positive exponents, products, and sums, so it is continuous.
c. Homogeneous of Degree 1?
c(αw, y) = y((αw1 )e−αw1 + αw2 )
= αy(w1 e−αw1 + w2 ) = αc(w, y), so NO.
Monotonic?
∂c
= y[e−w1 − w1 e−w1 ] > 0 for w1 < 1, < 0 for w1 > 1, NO
∂w1
∂c
=y>0
∂w2
∂c
= w1 e−w1 + w2 > 0
∂y
Concave?

ye−w1 [w1 − 2] 0
H=
0 0
The (1, 1) “naturally ordered” principal minor is ye−w1 [w1 − 2], which is positive if w1 > 2 but negative
if w1 < 2, so this function is not concave.
Continuous ? c involves only sums, products, and the exponential function, so it is continuous.
d. Homogeneous of Degree 1?
1

c(αw, y) = y αw1 − (αw1 αw2 ) 2 + αw2
1

= αy w1 − (w1 w2 ) 2 + w2 = αc(w, y)
Monotonic?

∂c 1 − 12 12
= y 1 − wi wj 0, NO
∂wi 2
∂c 1 1 1 1
= w1 − (w1 w2 ) 2 + w2 = (w12 − w22 )2 + (w1 w2 ) 2 > 0
∂y
174 SOLUTIONS TO EXERCISES FOR LECTURE 7 (DUALITY OF THE COST FUNCTION)
Concave?
3 1
−1 − 12

y −2 2
4 w1 w2 − y4 w1 2 w2
H= −1 −1 1 3 .
y 2 −2
− y4 w1 2 w2 2 w w
4 1 2
3 1
y −2 2
The (1, 1) “naturally ordered” principal minor is 4 w1 w2 > 0, so NO. The other one is |H| =
y 2 y 2
4
(w1 w2 )−1 − 4
(w1 w2 )−1 = 0 .
Continuous? c involves only positive exponents, products, and sums, so it is continuous.
∂c
Nonnegative? From ∂y
, we see that c(w, y) > 0 for (w, y) >> 0. c(w, 0) = 0 is obvious.
e. Homogeneous of degree 1?

1 1 1 1
c(αw, y) = y+ (αw1 αw2 ) 2 = α y + (w1 w2 ) 2 = αc(w, y)
y y
Monotonic?

∂c 1 1 −1 1
= y+ wi 2 wj2 > 0
∂wi 2 y

∂c 1 1
= 1 − 2 (w1 w2 ) 2
∂y y
> 0 if y > 1
< 0 if y < 1, so NO.
Concave?
−3 1
−1 −1
− 14 (y + 1y )w1 2 w22 1
4
(y + 1y )w1 2 w2 2
H= −1 − 12 1
−3
1
4
(y + 1y )w1 2 w2 − 14 (y + 1y )w12 w2 2

−3 1
The (1, 1) “naturally ordered” principal minor is − 14 y + y1 w1 2 w22 < 0 . The other one is |H| =
0 .
Continuous? c involves only sums, products, and positive exponents except for the 1/y term. So c is
continuous everywhere 1/y is defined, but we cannot address continuity at y = 0 because c(w, 0) is not
defined.
Nonnegative? c(w, y) > 0 for (w, y) >> 0 is obvious, but c(w, 0) is not defined.
Summary: So, the only function that is a cost function is (b.). By Shephard’s Lemma,
12
1 −1 1 1 wj
x∗i = y 1 + wi 2 wj2 =y 1+ for i, j = 1, 2.
2 2 wi
w2
Use these two equations to solve for y in terms of (x1 , x2) by eliminating w1 :
2 −2
x∗1 w2 1 x∗2 w2
4 −1 = and −1 =
y w1 4 y w1
y2
⇒ (x∗1 − y)(x∗2 − y) = .
4
Use the quadratic formula to get
2
y= (x1 + x2 ) + (x1 + x2 )2 − 3x1 x2 .
3
∂c∗ ∂c∗
2. (Varian #6.2) c∗ = y[w1 + w2 ], x∗1 = ∂w1
= y, and x∗2 = ∂w2
= y. So, the production function is
y = x∗1 = x∗2 at the optimum. This happens when y = min{x1 , x2 } is the production function.
3. (Varian #6.3) The cost function must be nondecreasing in both prices, so a and b are both nonnegative.
The cost function must be concave in both prices, so a and b are both no greater than 1. Finally, the cost
function must be homogeneous of degree 1, so a = 1 − b.

176 SOLUTIONS TO EXERCISES FOR LECTURE 8 (DUALITY OF SUPPLY, DEMANDS, AND PROFIT)
Solutions to Exercises for Lecture 8 (Duality of Supply, Demands, and Profit)
1.
∂x∗
a. 1
∂w1 = (ey − 1)(−α)w1−α−1 w2α ≤ 0 ⇔ α ≥ 0 (semidefiniteness)
∂x∗
2
∂w2
= (ey − 1)(−β)w1β w2−β−1 ≤ 0 ⇔ β ≥ 0 (semidefiniteness)
∂x∗1
= (ey − 1)αw1−α w2α−1
∂w2
∂x∗2
= (ey − 1)βw1β−1 w2−β
∂w1
∂x∗ ∂x∗
So, 1
∂w2 = 2
∂w1 (symmetry) ⇔ αw1−α w2α−1 = βw1β−1 w2−β . This must hold ∀ w >> 0, which can only
work if
α = β, −α = β − 1, α − 1 = −β.
Combine to get α = β = 12 . Also, x∗ is homogeneous for any α, β, so

∗
∂x1 ∂x∗
1
∂w1
∂x∗2 ∂w2
∂x∗ = 0,
2
∂w1 ∂w2
1 1
∂(w·x∗)
verifying the remaining part of semidefiniteness. Monotonicity in y is clear: ∂y = ey 2w12 w22 > 0.
Continuity is also clear since when α = β = 12 , since w · x∗ then involves only positive exponents. For
nonnegativity, x∗ ≥ 0 is obvious for y ≥ 0 and x∗ (w, 0) = 0 is also obvious, as is x∗ (w, y) > 0 for y > 0.
1 1
b. i. c∗ (w, y) = w · x∗ (w, y) = (ey − 1)2w12 w22
1 1
ii. maxy py − c∗ (w, y) = maxy py − (ey − 1)2w12 w22

∂ 1 1 p p
= p − ey 2w12 w22 = 0 ⇒ ey = 1 1 ⇒ y = ln 1 1
∂y 2w12 w22 2w12 w22
∂2 1 1
= −e y
2w 2
1 w 2
2
< 0 ⇒ max .
∂y2
So,  1 1

 0, for p < 2w12 w22

y∗ (p, w) = 1 1

 ln 1
p
1 , for p ≥ 2w12 w22 .
2w12 w22
Then,
 1 1

 0, for p < 2w12 w22
∗ ∗ ∗ 12 12
x (p, w) = x (w, y (p, w)) = 1 1


 1
p
1 −1 w2
, w1
, for p ≥ 2w12 w22
w1 w2
2w12 w22
iii.  1 1

 0, for p < 2w12 w22

π ∗ (p, w) = 1 1 1 1

 p ln
p
1 1 − p
1 1 − 1 2w12 w22 , for p ≥ 2w12 w22
2w12 w22 2w12 w22
1 1 1 1
iv. From x∗ , x∗1 x∗2 = (ey − 1)2 , thereby eliminating w. So, ey = x12 x22 + 1 or y = ln(x12 x22 + 1).
2.
a. Homogeneity:
λp p
y∗ (λp, λw) = = = y∗ (p, w)
2 min{λw1 , λw2 } 2 min{w1 , w2 }
   
 0, for λw1 > λw2   0, for w1 > w2 

 
   p2 

(λp)2
∗
x1 (λp, λw) = 0, 4(λw1 ) 2 , for λw1 = λw2 = 0, 4w2 , for w1 = w2 = x∗1 (p, w)

 
 

1


 (λp) 2   p2 
4(λw1 )2 , for λw1 < λw2 4w 2
, for w1 < w2
1
x∗2 is the same. So, (y∗ , −x∗) is HOD 0.
Nonnegativity:

 p2 p2
2 min{w1 ,w2 } − 4w1 , w1 ≤ w2
∗ ∗ ∗
π = py − w · x =
 p 2
− p 2
, w1 ≥ w2
2 min{w1 ,w2 } 4w2
2
p p2
= −
2 min{w1 , w2 } 4 min{w1 , w2 }
p2
= ≥ 0.
4 min{w1 , w2 }
y∗ (0, w) = 0 and x∗(0, w) = 0; and (y∗ , x∗) ≥ 0; are obvious.
Symmetry and Semidefiniteness:
∂y∗ 1 ∂y∗ − 2w
p
2, for w1 < w2 ∂y∗ 0, for w1 < w2
= > 0; = 1 ; =
∂p 2 min{w1 , w2 } ∂w1 0, for w1 > w2 ∂w2 − 2wp 2 , for w1 > w2 .
2

∂x∗1 0, for w1 > w2 ∂x∗1 0, for w1 > w2 ∂x∗1 0, for w1 > w2
= p ; = 2 ; =
∂p 2w 2
, for w1 < w2 ∂w1 − 2w
p
3, for w1 < w2 ∂w2 0, for w1 < w2
1 1
p 2
∂x∗2 ∂x∗2 ∂x∗2 − 2w
, for w1 > w2 p
2w22 0, for w1 > w2 3, for w1 > w2
= ; = ; = 2
∂p 0, for w1 < w2 ∂w1 0, for w1 < w2 ∂w2 0, for w1 < w2
∂y ∗ ∂y ∗ ∂x∗ ∂x∗
Except for ∂p , none of these are defined when w1 = w2 . Clearly ∂p > 0, − ∂w11 ≥ 0, − ∂w22 ≥ 0. Also,
∂y∗
∂y ∗ 0, w1 > w2
∂p ∂w1
∂x∗1 ∂x∗ = p2 p2
− − ∂w11 − 4w 4 + 4w14
= 0, w1 < w2 .
∂p 1
178 SOLUTIONS TO EXERCISES FOR LECTURE 8 (DUALITY OF SUPPLY, DEMANDS, AND PROFIT)
It is not necessary to check the whole 3x3 determinant (it is zero, due to homogeneity). Hence, the
∂y ∗ ∂x∗
matrix of derivatives is positive semidefinite (when it is defined). For symmetry, ∂wi = − ∂p
i
and
∂x∗
1 ∂x∗
2
∂w2 = ∂w1 both hold by inspection.
p2
b. π ∗ = 4 min{w1 ,w2 }
, from above.
c. The demands take on only corner values, with the switch occurring at w1 = w2 . This means the
isoquant must be linear with slope −1 :
A typical isoquant
√
The intercepts are obtained by noticing that y∗ 2 = x∗i . So, y2 = x1 + x2 , or y = x1 + x2 .
d. From c,
 2

y , for w1 < w2
∗ 2
x1 (w, y) = [0, y ], for w1 = w2


0, for w1 > w2


 0, for w1 < w2
∗ ∗
x2 (w, y) = y − x1 , for w1 = w2
2

 2
y , for w1 > w2
e. c∗ = w · x∗ = min{w1 , w2 }y2
3.
(λp)2 λp2
a. Homogeneity: π ∗ (λp, λw) = 4[(λw1 )1−α (λw2 )α +(λw1 )β (λw2 )1−β ]
= 4A
= λπ ∗ (p, w), where
" #
A = (λw1 )1−α (λw2 )α + (λw1 )β (λw2 )1−β .
So, HOD 1 holds ∀ α, β.
Monotonicity: π ∗ is ↑ in p. π ∗ is ↓ in w provided α, β ∈ [0, 1]
Nonnegativity: π ∗ ≥ 0 and π ∗ (0, w) = 0 are obvious.
Convexity:
∂π ∗ p ∂π ∗ p2 ∂A ∂π ∗ p2 ∂A
y∗ = = ; −x∗1 = =− 2 ; −x∗2 = =− 2 .
∂p 2A ∂w1 4A ∂w1 ∂w2 4A ∂w2
∂ 2 π∗ 1 ∂ 2 π∗ p ∂A ∂ 2 π∗ p ∂A
2
= ; =− 2 ; =− 2
∂p 2A ∂p∂w1 2A ∂w1 ∂p∂w2 2A ∂w2

2
∂ 2 π∗ p2 ∂A p2 ∂ 2 A ∂ 2 π∗ p2 ∂A ∂A p2 ∂2A
= − ; = − .
∂w12 2A3 ∂w1 4A2 ∂w12 ∂w1 ∂w2 3
2A ∂w1 ∂w2 2
4A ∂w1 ∂w2
∂2A 2 ∗
Here, ∂w12
= −α(1 − α)w1−α−1w2α + (β − 1)βw1β−2 w21−β ≤ 0 for α, β ∈ [0, 1]. Since A > 0, ∂∂pπ2 > 0. And
2 ∗ 2 2
∂ π2 ∂ 2 π∗ p2 p2 ∂ 2 A p2
∂p ∂p∂w1 ∂A ∂A
∂ 2 π∗ ∂ 2 π∗ = − −
∂w ∂p ∂w12
4A4 ∂w1 8A3 ∂w12 4A4 ∂w1
1
p2 ∂ 2 A
=− ≥ 0.
8A3 ∂w12
It is unnecessary to check the 3x3 determinant due to homogeneity (it is zero), so the Hessian of π ∗ is
positive semidefinite and thus π ∗ is convex. Therefore, the only restrictions on α, β are α, β ∈ [0, 1].
b. i. See the first derivatives above, by Hotelling’s Lemma. Must substitute
∂A
= (1 − α)w1−α w2α + βw1β−1 w21−β
∂w1
∂A
= αw11−α w2α−1 + (1 − β)w1β w2−β .
∂w2
ii. Note that x∗i = y∗ 2 ∂w

∂A
i
. So x∗i (w, y) = y2 ∂w
∂A
i
.

iii. c∗ = w · x∗ = y2 w1 ∂w∂A
1
+ w 2
∂A
∂w2
= y 2
w 1−α α
1 w 2 + w β 1−β
1 w 2 = y2 A.
" # " #
iv. Use x∗1 = y2 (1 − α)w −α + βw β−1 , x∗2 = y2 αw 1−α + (1 − β)w β , where w = w1
w2 is the relative
price. In principle these two equations can be substituted to eliminate w, leaving only the relationship
between y, x1 , and x2 . But this is messy in practice because of the presence of terms with different
powers of w. This is a good example of being able to verify cost, profit, demand, and supply functions
by duality even though the production function is complicated.

180 SOLUTIONS TO EXERCISES FOR LECTURE 9 (COST ANALYSIS)
Solutions to Exercises for Lecture 9 (Cost Analysis)
1.
y
a. Assume f(αx) ≥ αf(x) for α ≥ 1, where f is the production function. Fix y ≥ y and define α = y ≥ 1.
If x∗(y) is an optimal choice when output is y, then by feasibility f(x∗ (y)) ≥ y. Hence αf(x∗ (y)) ≥
αy = y , so by nondecreasing returns f(αx∗ (y)) ≥ y . That is, αx∗ (y) is feasible for producing y . Then
by definition of the minimum
y ∗
c∗ (y ) ≤ w · (αx∗ (y)) = αc∗ (y) = c (y).
y
Divide by y to get ac(y ) ≤ ac(y).
Nondecreasing returns. Note that mc lies below ac, but mc has no particular shape. Note
also that the slope of a ray to c∗ is average cost at that point, so the slope of such rays must
decrease as y increases.
Nondecreasing returns, nontraditional case. This is nondecreasing returns, since all

rays remain in Z once they pass inside Z, as illustrated. Similarly, the slopes of rays from the
origin to c∗ fall as y increases, as illustrated. But the nonconvexity in the boundary of Z creates a
nonconcavity in c∗ , so that mc clearly increases over the range of y values where c∗ is nonconcave.
b. Assume f(αx) ≥ αf(x) for α ∈ (0, 1], where f is the production function. Fix y ≤ y and define
y
α= y ≤ 1. By feasibility, f(x∗ (y)) ≥ y. Hence f(αx∗ (y)) ≥ αf(x∗ (y)) ≥ αy = y . That is, αx∗(y) is
feasible for producing y . Hence,
y ∗
c ∗ (y ) ≤ w · (αx∗ (y)) = αc∗ (y) = c (y).
y
Divide by y to get ac(y ) ≤ ac(y).

Nonincreasing returns. Note that mc lies above ac, but mc has no particular shape. Note
also that the slope of a ray to c∗ is average cost at that point, so the slope of such rays must
increase as y increases.
Nonincreasing returns, nontraditional case. This is nonincreasing returns, since all

rays remain out of Z once they pass outside Z, as illustrated. Similarly, the slopes of rays from
the origin to c∗ increase as y increases, as illustrated. But the nonconvexity in Z creates a
nonconvexity in c∗ , so that mc clearly decreases over the range of y values where c∗ is nonconvex.
c. Combine a and b to conclude ac is constant. Then use 0 = ac = 1

y (mc − ac) to conclude ac = mc
everywhere, so mc is constant also.

ac(y)
d. From Varian pp. 88-89, the elasticity of scale at output level y equals mc(y) . So, if there is local
increasing returns to scale at output y then ac(y) > mc(y). This means that ac(y) is decreasing locally
at output level y, which is the local counterpart to part a of the question. Similarly, if there is local
decreasing returns to scale at output y then ac(y) < mc(y), so ac(y) is increasing locally, which is the
local counterpart to part b of the question. Finally, if there is local constant returns to scale then
ac(y) = mc(y), so ac(y) is stationary at y, which is the local counterpart to part c of the question.
2.
a.
c∗ (y) F
ac = = + y for y > 0
y y
vc(y) y2
avc = = = y for y > 0
y y
∂c(y)
mc = = 2y for y > 0
∂y
Average, Average variable, and Marginal cost curves

b.
Supply curve when α = 1. It consists of the entire marginal cost curve above avc because no
fixed cost can be saved by shutting down.
c. When 0 < α < 1, for purposes of determining the shutdown point it is as if fixed cost is (1 − α)F in
the average cost curve, since this is the fixed cost that is avoidable (non-sunk). Thus, the average cost
(1−α)F
curve that is relevant for determining the shutdown point is ac = y + y for y > 0 (Note: this is
NOT the true average cost curve. The true average cost curve is illustrated in part a. This curve is
just a tool for finding the shutdown point when fixed costs are partially sunk). Then the supply curve
is
Supply curve when 0 < α < 1
d. The graph for part c provides a general framework for deriving the supply curve. If we let α = 1 in
that graph we get the supply curve illustrated in part b. If we let α = 0 in that graph we obtain the
usual undergraduate illustration of shutdown, which implicitly assumes that no fixed costs are sunk:
Supply curve when α = 0
3.
y
a. y = x1 x2 , so x2 = x1 . So,

y
c∗ (w, y|x1 ) = w1 x1 + w2 .
x1

b. x1 = x∗1 (w, ȳ) = yw2
w1 , so y = x21 w1
w2 . Then
'
w1
c∗ (w, y) = 2 x21 w1 w2 = 2x1 w1 .
w2
On the other hand,

1 w1
c∗ (w, y|x1 ) = w1 x1 + w2 x21 = w1 x1 + w1 x1 = 2w1 x1 .
x1 w2
4. (Varian #5.2) y = y1 + y2 . We want to min{y1 ,y2 } c1 (y1 ) + c2 (y2 ) subject to y = y1 + y2 :
min 3y12 + (y − y1 )2
y1
FOC:
6y1 + 2(y − y1 )(−1) = 0
y 3y
y1 = , ⇒ y2 = y − y1 =
4 4
SOC:
8 > 0, ⇒ minimum
y y 2 2
3y 3y 3y2
c∗ (y) = c1 + c2 =3 + = .
4 4 4 4 4
5. (Varian #5.8) If p = 2, then a nonnegative profit is possible, so set p = c to obtain 2 = 2y or y∗ = 1.
Since profit is zero at this price, y∗ = 0 is also optimal (i.e., y∗ = {0, 1}). If p = 1 then positive profit is

2
impossible, so y∗ = 0. Setting p = c to obtain y∗ = 12 is incorrect since π ∗ = 12 − 12 + 1 = − 34 < 0.
6. (MWG #5.D.2) Assume cv (q) is strictly convex, for specificity. The part of cost that can be avoided by
choosing q = 0 is cv (q) + [K − c(0)], so shutdown is determined by looking at the average cost curve from
cv (q)
this. q
is upward-sloping whenever it is relevant (i.e., when marginal cost is above average cost) and
1
q [K − c(0)] is downward-sloping. Thus a U-shape emerges:
J
7. (MWG #5.D.4(a)) Fix q and let qj be a partition of q such that j=1 qj = q (qj > 0; J > 1). Then

J
J
J
c(qj ) = qj ac(qj ) > qj ac(q) since qj < q and ac is falling
j=1 j=1 j=1

J
= ac(q) qj = ac(q)q = c(q).
j=1
Supply with partially sunk costs
Solutions to Exercises for Lecture 10 (Applied Production Analysis)

188 SOLUTIONS TO EXERCISES FOR LECTURE 11 (PREFERENCES)
Solutions to Exercises for Lecture 11 (Preferences)
1.
a. Suppose x y. By definition of , we have not(y x). By completeness of , x y (NOTE: We

∼ ∼ ∼
have just shown that x y implies x y, a property we will use below). Then, by definition of , we
∼
cannot have y x since this means not(x y).

∼
b. This is a special case of part a, with x replacing y (there is no use of the idea that x = y in the solution
of part a).
c. Let x y and y z. Suppose x z does not hold. Then not(z x) does not hold, so z x. Since
∼ ∼
x y (from above), transitivity of yields z y. But we also have not(z y), a contradiction.
∼ ∼ ∼ ∼
d. Proof is identical to part c.
e. Suppose not. Then z x. Now apply the result in part d to z x and x y to obtain z y. That
∼ ∼
is, not(y z), a contradiction.

∼
f. For clarity, let y = x. Then, by completeness, either y x or x y (or both). If the former fails,
∼ ∼
then we have not(y x), or not(x x), which violates the latter. Similarly, if the latter fails then the
∼ ∼
former is violated. Hence, we have both y x and x y, or y ∼ x. Since y = x, x ∼ x.

∼ ∼
g. Let x ∼ y and y ∼ z. Then, by definition of ∼, x y and y z, so by transitivity of , x z.

∼ ∼ ∼ ∼
Similarly, z y and y x, so z x. Combining, x ∼ z.

∼ ∼ ∼
h. If x ∼ y, then both x y and y x. Hence y ∼ x.

∼ ∼
2. Throughout the solution, assume x, x , y ∈ X.
a. Let x y. Then not(y x). If U (y) ≥ U (x) then, since U represents , y x, a contradiction. So
∼ ∼ ∼
U (x) > U (y). Now the converse: assume U (x) > U (y). If y x then U (y) ≥ U (x), a contradiction, so
∼
not(y x), or x y.
∼
b. Let x ∼ y. Then x y and y x. Since U represents , U (x) ≥ U (y) and U (y) ≥ U (x), so
∼ ∼ ∼
U (x) = U (y). Now the converse: assume U (x) = U (y). Then U (x) ≥ U (y) and U (y) ≥ U (x). Since U
represents , x y and y x, so x ∼ y.
∼ ∼ ∼
c. Let x ≥ y (weak vector inequality). Then, by free disposal, x y. Since U represents , U (x) ≥ U (y).
∼ ∼
d. Let x > y Then, by strong monotonicity, x y, so by part a U (x) > U (y).

e. Fix > 0. By local nonsatiation, there exists y ∈ X such that y − x < and y x. Hence
U (y) > U (x) (from above).
f. By completeness, either x y or y x. For concreteness, assume x y. Then, since U represents

∼ ∼ ∼
, U (x) ≥ U (y), so U (y) = min{U (x), U (y)}. Using completeness, y y. So, by convexity of
∼ ∼

, λx + (1 − λ)y y (setting x = y in the definition of convexity of ). Since U represents ,
∼ ∼ ∼ ∼
U (λx + (1 − λ)y) ≥ U (y) = min{U (x), U (y)}. The argument is the same if y x–just interchange the
∼
roles of x and y.
g. Assume x = y and proceed as in part d, obtaining λx + (1 − λ)y y from strict convexity of , so

∼
that U (λx + (1 − λ)y)) > U (y) (from part a).
3. Strong Monotonicity: Let x > y. If x1 > y1 , then x y, as desired. Moreover, not(y1 ≥ x1 ), so not(y x).
∼ ∼
Hence x y. If x1 = y1 , then x2 > y2 , so again x y. And again not(y2 ≥ x2 ), so not (y x). Hence
∼ ∼
x y.
Strict Convexity: Let x z and y z, where x = y. Hence x1 ≥ z1 and y1 ≥ z1 . If either of these is strict,
∼ ∼
then λx1 + (1 − λ)y1 > z1 , so λx + (1 − λ)y z. If x1 = y1 = z1 , then x2 ≥ z2 and y2 ≥ z2 , and one of
these must be strict since x = y. So λx2 + (1 − λ)y2 > z2 while λx1 + (1 − λ)y1 = z1 , or λx + (1 − λ)y z.
4. (MWG #3.B.3) Suppose the indifference curves are as follows, with utility increasing in the direction of
the arrows:
This is strictly convex since a convex combination of any two points on or above an indifference curve lies
everywhere (strictly) above that indifference curve. It is also locally nonsatiated since the -ball around
any point includes points above the indifference curve through the point. However, it is not monotone
since any point due east of another point is on a lower indifference curve.
5. (MWG #3.C.4) Suppose X = R1+ and x y if either y = 1 or x = 1. The utility function U (x) = 1 for
∼
x = 1 and U (1) = 0 represents . To check this, suppose first that y = 1. Then x y. Also, U (y) = 0
∼ ∼
and U (x) is either 1 or 0, so U (x) ≥ U (y), as desired. Now suppose y = 1 and x = 1. Then x y. And
∼
U (x) = 1 = U (y), so U (x) ≥ U (y), as desired. Finally suppose y = 1 and x = 1. Then y x. And
∼
U (y) = 1 while U (x) = 0, so U (y) ≥ U (x), as desired. Hence, by the theorem presented in class we know
is complete and transitive. However, is not closed, because the “preferred-to” set {x ∈ X : x y}
∼ ∼ ∼
190 SOLUTIONS TO EXERCISES FOR LECTURE 11 (PREFERENCES)
A strictly convex preference relation that is locally nonsatiated but not mono-
tone
for y = 1 has a “hole” in it at x = 1.

Solutions to Exercises for Lecture 12 (Utility Maximization: Basics)
1. We know, for L = U (x) − λ(p · x − m), that


0
 ∂x∗  .
1  . 
∂pj  . 
 .   
 .   0 
 .   ∗
   λ  ← j th row
HL(x,λ)  ... =  .
 ∗   0 
 ∂xn   . 
 ∂pj   .. 
∂λ∗
 
 0 
∂pj
x∗j
∂λ∗
" #
So, ∂pj = 1
|HL(x,λ) | (−1)j+(n+1) λ∗ |Hj,n+1| + (−1)2(n+1)x∗j |Hn+1,n+1| . This cannot be signed because
neither Hj,n+1 nor Hn+1,n+1 are border-preserving (Hj,n+1 also is not a principal submatrix). Similarly,
 ∂x∗
1
  
∂m 0
 .   .. 
 .   . .
HL(x,λ)  ∂x. ∗ =
 n  0 
∂m
∂λ∗ −1
∂m
∂λ∗
So, ∂m = 1
|HL(x,λ) | (−1)
2(n+1)
(−1)|Hn+1,n+1|, which cannot be signed because Hn+1,n+1 is not border-
∂λ∗
preserving. Since λ∗ is the marginal utility of income, the sign of ∂m
determines whether there is
diminishing or increasing marginal utility of income. Either is possible.
2.
a.
g = 6, 000, if no income.
g = 4, 500, when m = 2, 000.
g = 3, 000, when m = 4, 000.
b. 6, 000 − 0.75m = 0. Therefore m = 8, 000.
c.
P C + 4 × 365H = 24 × 4 × 365,
where P is a price of consumption and H is hours of leisure per day. This is
P C + 1, 460H = 35, 040.

192 SOLUTIONS TO EXERCISES FOR LECTURE 12 (UTILITY MAXIMIZATION: BASICS)
d.
P C + 1, 460H = 35, 040 + [6, 000 − 365 × 4 × 0.75(24 − H)]
subject to 1, 460 × 0.75 × (24 − H) ≤ 6, 000.
This means H ≥ 18.52.

e.
Budget constraint under old rule
f. With the grant, the budget constraint is
P C + 1, 460H = 35, 040 + [6, 000 − 365 × 4 × 0.5(24 − H)]
subject to 1, 460 × 0.5 × (24 − H) ≤ 6, 000.
This means H ≥ 15.78.

Budget constraint under new rule
g. Whether the head of this family will work more or less under the new rule depends on the utility
function. A complete answer requires that we discuss income and substitution effects, which we do
not cover until Lecture 14, so it may be useful to revisit this solution after reading Lecture 14. In the
graph, we can divide the H-axis into three regions. If the utility function is tangent in region (a), the
new rule does not change anything (assuming the indifference curve is not so flat that it crosses the
kinked part of the new budget constraint). If the tangency is in region (b), the budget line becomes
flatter relative to the part of the budget line the consumer is on under the old rule. Thus, effectively,
the relative price of H (leisure) has decreased. The substitution effect causes the head of the family to
consume more leisure and work less, and the income effect also causes more consumption of leisure if
leisure is normal. Even if leisure is inferior, more leisure is consumed and the head works less unless
leisure is Giffen. If the tangency is in region (c), the budget line becomes steeper relative to the part of
the budget line the consumer is on under the old rule. Thus, effectively, the relative price of H (leisure)
has increased. In this case the substitution effect causes the head of the family to consume less leisure
and work more, and the income effect causes more consumption of leisure if leisure is normal (note
that the implicit change in income is an increase since the budget line moves out). Thus, in region (c)
we cannot predict what happens to the level of work if leisure is normal, but if leisure is inferior then
work increases.
Utility maximization under old and new rule
3.
a.
1 m2
x1 + x2 = m1 + .
1+r 1+r
b.

1 m2
L = U (x1 , x2 ) − λ x1 + x2 − m1 −
1+r 1+r
FOCs:
U1 = λ
1
U2 = λ
1+r
1 m2
−x1 − x2 + m1 + = 0.
1+r 1+r
Differentiating the FOC’s with respect to m1 yields:
∂x1 ∂x2 ∂λ
U11 + U12 − =0
∂m1 ∂m1 ∂m1
∂x1 ∂x2 1 ∂λ
U21 + U22 − =0
∂m1 ∂m1 1 + r ∂m1
∂x1 1 ∂x2
− − + 1 = 0.
∂m1 1 + r ∂m1
In matrix form,
   ∂x1   
U11 U12 −1 ∂m1 0
 U21 −1   ∂x2 
U22 1+r  ∂m1  =  0  .
−1 −1
−1 1+r 0 ∂λ
∂m1
So by Cramer’s Rule,
0 U12 −1

0 U22 −1
1+r
∂x1 −1 −1
0 U12 1 − U22
= 1+r = 1+r .
∂m1 HL(x,λ) HL(x,λ)
∂x1
This implies that if U12 > 0, ∂m1 > 0, in which case an increase in this year’s income leads to an
increase in consumption this year. But this need not be true generally, even for a strictly quasiconvex
utility function.
c. By the envelope theorem,

∂U ∗ (r, m1 , m2 ) ∂L λ∗
= = (x∗ − m2 ).
∂r ∂r x=x∗ , λ=λ∗ (1 + r)2 2
Since λ∗ > 0 given the way L is formulated (i.e., the marginal utility of income must be positive), we
have indirect utility increasing in r if x∗2 > m2 and decreasing in r if x∗2 < m2 . These cases correspond
to saving and dissaving, respectively. Geometrically, if r > r then the graph is:
Intertemporal choice of consumption. In (a) we have c1 < m1 so the consumer is a

saver. When r increases, points above the original indifference curve become feasible, so utility
increases. Exactly the opposite happens in (b), where the consumer is a dissaver.
4.
√
a. x2 = U − x1 + 4
dx2 1 1
= − (x1 + 4)− 2 < 0 for x1 ≥ 0
dx1 2
d 2 x2 1 3
2
= (x1 + 4)− 2 > 0 for x1 ≥ 0.
dx1 4
So, the indifference curve is decreasing and convex. At x1 = 0, the value is x2 = U − 2 and the slope
2 −1
is − 14 . At x2 = 0, the value is x1 = U − 4 and the slope is 2U
.

b. If p1
p2 ≥ 1
4 then x∗1 = 0 and x∗2 = m
p2 . When x2 = 0 and x1 = m
p1 we have U = m
p1 + 4, so if p1
p2 ≤ 2√ 1m +4
p1
then x∗1 = m
p1 and x∗2 = 0. If 1
4 > p1
p2 > √1
m then set -MRS= pp12 :
2 p1 +4
2
1 p1 p2
√ = ⇒ x∗1 = − 4.
2 x1 + 4 p2 2p1
Then x∗2 = m
p2 − p1 ∗
p2 x1 = m
p2 − p2
4p1 + 4p1
p2 .
A typical indifference curve
Summary:
 

m
p1 , if p1
≤ 2√ 1m +4  0, if p1
≤ 2√ 1m +4


p2 
 p2
 
p1
2
p1
x∗1 = p2
− 4, if 2√ 1m +4 < p1
< 1 ; x∗2 = m+4p1
− p2
, if √1 < p1
< 1
  p2 4p1 m p2 4
2 +4


2p1 p1
p2 4


p1
 
0, if p1
≥ 1 m
p2
, if p1
p2
≥ 14 .
p2 4
5. (Varian #7.2) A typical indifference curve appears in the graph below. So, the maximum occurs at the
p1 p1 p1
corners. If p2 > 1 then only consume x2 . If p2 < 1 then only consume x1 . If p2 = 1, then consume either
good, but not both. So,

 m p1

 p1 , if p2 <1
( ) ( )
x∗1 (p, m) = 0, m
, if p1
= 1 (and x∗2 = m
p2 , 0 , respectively)


p1 p2
 p1
0, if p2
>1
Hence,  ( )
 max pm , 0 , when p1
≤1 *
1 p2 m m
U ∗ (p, m) = ( ) = max , .
 max 0, m , when p1
>1 p1 p2
p2 p2
A typical indifference curve
6. (Varian #7.5)
a. Quasilinear preferences.
b. Less than u(1).
c. v(p1 , p2 , m) = max{u(1) − p1 + m, m}
−3 − 52
7. (Varian #8.5) A typical indifference curve is x2 = U x1 2 , with slope ∂x2
∂x1 = − 32 U x1 and curvature
∂ 2 x2 15 −7
∂x21
= 4
U x1 2 . So, it has the shape shown in the graph below. This assures us that the FOC’s will
describe the maximum. They amount to setting the MRS equal to the negative price ratio and also using
the budget constraint:

3U p1
5 = and p1 x1 + p2 x2 = m.
2
2x1 p2
3
5
3x12
x∗2 = ⇒ x∗1 =
x2 p2
So, x12 = 3U p2
2p1 = 2p1 , or x1 = 3x2p2
2p1 . Hence, p1 3x2p2p1 2 + p2 x2 = m ⇒ 2m
5p2
3m
5p1 .
When p1 = 3, p2 = 4, and m = 100, we have x∗1 = 20 and x∗2 = 10.

An indifference curve where axes are asymptotes when U > 0
8. (Varian #8.13)
a. Draw the lines x2 + 2x1 = 20 and x1 + 2x2 = 20. The indifference curve is the northeast boundary of
this X. The area where u ≥ 20 is on and above this X.
b. The slope of a budget line is −p1 /p2 . If the budget line is steeper than 2, x1 = 0. Hence the condition
is p1 /p2 > 2.
c. Similarly, if the budget line is flatter than 1/2, x2 will equal 0, so the condition is p1 /p2 < 1/2.
d. If the optimum is unique, it must occur where x2 + 2x1 = x1 + 2x2 . This implies that x1 = x2 , so that
x1 /x2 = 1.
9. (MWG #r) It follows from the definition that the demand function satisfies homogeneity of degree zero
for β > 0. To check whether the demand function satisfies Walras’ Law, we have to calculate px:
p2 w + p3 w + βp1 w p2 + p3 + βp1
px = = w.
p2 + p3 + p1 p2 + p3 + p1
Hence, px = w iff β = 1. Therefore the demand function satisfies Walras’ Law iff β = 1.
10. (MWG #2.E.2) Multiplying both sides of equation (2.E.4) of Proposition 2.E.2 by pk /w, we obtain

L
∂x
(p x (p, w)/w) (p, w)(pk /x(p, w)) + pk xk (p, w)/w = 0.
∂pk
=1
L
Hence, =1 b (p, w)k (p, w) + bk (p, w) = 0. It follows from (2.E.6) of Proposition 2.E.3 that

L
∂x
(p x (p, w)/w) (p, w)(w/x(p, w)) = 1.
∂w
=1
L
Hence, =1 b (p, w)w (p, w) = 1.
11. (MWG #2.E.8) For the first part, note that
ln x (p, w) = ln x (eln p1 , · · · , eln pL , eln w ).
Thus, by the chain rule,
∂x ln pk ∂x
∂pk (p, w)e ∂pk (p, w)pk
d ln x (p, w)/d ln pk = = = k (p, w).
x (p, w) x(p, w)
Similarly,
∂x ln w ∂x
∂w (p, w)e ∂w (p, w)w
d ln x(p, w)/d ln w = = = w (p, w).
x (p, w) x (p, w)
Since α1 = d ln x(p, w)/d ln p1 , α2 = d ln x (p, w)/d ln p2 , and γ = d ln x (p, w)/d ln w, the last conclusion
is established.
Solutions to Exercises for Lecture 13 (Utility Maximization: Advanced)
1.
a. A homothetic function is a monotonic transformation of a homogeneous function. So, the preferences
can be represented by a function of the form U (x) = f(g(x)), where f is strictly increasing and g is
homogeneous of degree r. Clearly g(x) ≡ f −1 (U (x)) also represents these preferences, since f −1 is
1
monotonic. Similarly, h(x) ≡ [g(x)] r also represents these preferences. But h is homogeneous of degree
one:
1 1 1
h(λx) = [g(λx)] r = [λr g(x)] r = λ[g(x)] r = λh(x).
b. From part a, assume U is homogeneous of degree one. The first order conditions are Ui (x∗ ) = λ∗ pi for
i = 1, . . . , n. Multiplying by x∗i and summing across i yields

n
n
Ui (x∗ )x∗i = λ∗ pi x∗i = λ∗ m,
i=1 i=1
where the last equality is Walras’ Law. By Euler’s Theorem, the left side is U (x∗ ) = U ∗ (p, m).
c. Differentiating this with respect to pi yields
∂U ∗ ∂λ∗
= m.
∂pi ∂pi
Divide both sides by λ∗ and then note that the resulting left side is −x∗i , by Roy’s Identity. Rearrange
∂λ∗ λ ∗ x∗
to obtain ∂pi =− m .
i
∂U ∗
d. Rearranging Roy’s Identity yields ∂pi = −λ∗ x∗i . Differentiating this with respect to pj yields
∂2U ∗ ∂λ∗ ∗ ∂x∗

=− xi − λ∗ i .
∂pi ∂pj ∂pj ∂pj
Now reverse the order of differentiation and use the invariance of the cross partials of U ∗ to the order
of differentiation to obtain
∂λ∗ ∗ ∂x∗ ∂λ∗ ∗ ∂x∗j
− xi − λ∗ i = − xj − λ∗ .
∂pj ∂pj ∂pi ∂pi
Substitute for the derivatives of λ∗ from part c to obtain
λ∗ x∗j x∗i ∂x∗ λ∗ x∗i x∗j ∂x∗j

− λ∗ i = − λ∗ .
m ∂pj m ∂pi
202 SOLUTIONS TO EXERCISES FOR LECTURE 13 (UTILITY MAXIMIZATION: ADVANCED)
∂x∗ ∂x∗
j
Canceling terms yields i
∂pj
= ∂pi
.
2. (Varian #7.4(a)) Use Roy’s Identity:
∂v m ∂v m ∂v 1
=− ; =− ; = .
∂p1 (p1 + p2 )2 ∂p2 (p1 + p2 )2 ∂m p1 + p2
So,
− (p1 +p
m
2 m m
x∗1 = − 2)
1 = and x∗2 = .
p1 +p2
p1 + p2 p1 + p2
3. (MWG #3.D.1) x∗i = αi m

pi ; where α1 + α2 = 1, α1, α2 > 0, and U = Kxα 1 α2
1 x2 .
Homogeneous of degree 0?
αi (λm) αi m
x∗i (λp, λm) = = = x∗i (p, m)
(λpi ) pi
Walras Law?
α1 m α2 m
p · x ∗ = p1 + p2 = (α1 + α2 )m = m
p1 p2
Uniqueness? There’s only one (x∗1 , x∗2 ) pair that maximizes U , because U is strictly quasiconcave. To
1 x2 , Ky1 y2 }. We must show

verify this, set U = min{Kxα 1 α2 α1 α2
α
K(λx1 + (1 − λ)y1 ) 1 (λx2 + (1 − λ)y2 )α2 > U .
The function f(z) = z α is strictly concave because 0 < α < 1. This is verified by noting that f (z) =
α(α − 1)z α−2 < 0 for z > 0. Thus,
(λx1 + (1 − λ)y1 )α1 > λxα

1 + (1 − λ)y1
1 α1
(λx2 + (1 − λ)y2 )α2 > λxα

2 + (1 − λ)y2 .
2 α2
Multiplying these together yields
α
K(λx1 + (1 − λ)y1 ) 1 (λx2 + (1 − λ)y2 )α2
1 x2 + (1 − λ) y1 y2 + λ(1 − λ)(x1 y2 + y1 x2 )]
> K[λ2 xα 1 α2 2 α1 α2 α1 α2 α1 α2
≥ [λ2 + (1 − λ)2 ]U + Kλ(1 − λ)(xα 1 α2 α1 α2

1 y2 + y1 x2 ).
1 y2 + y1 x2 ) ≥ 2U. Then we have

Suppose we can show K(xα 1 α2 α1 α2
U (λx + (1 − λ)y) > [λ2 + (1 − λ)2 + 2λ(1 − λ)]U
= [λ + (1 − λ)]2 U = U ,
1 ≥
and we’re done. To show this, use Kxα and Ky1α1 ≥
1 U U
α
x2 2
α
y2 2
to write
1
1 y2 + y1 x2 ) ≥ U (z
K (xα 1 α2 α1 α2 α2
+ ),
z α2
where z = y2
x2 . The expression z α2 + 1
z α2 (*) is always ≥ 2 ∀ z > 0. To see this, minimize it:
∂(∗) 1
= α2 z α2−1 − α2 z −α2 −1 = 0 ⇒ z α2 −1 = α2 +1 .
∂z z
1
This FOC can only hold if z = 1, in which case z α2 + z α2 = 1 + 1 = 2. To verify the second order
∂ 2(∗)
condition, note that ∂z 2 = α2 (α2 − 1)z α2 −2 + α2 (α2 + 1)z −α2 −2 , which is 2α22 > 0 at z = 1.
Nonnegativity? x∗ ≥ 0 is obvious.
4. (MWG #3.D.2)
i. Homogeneous of Degree 0?
U ∗ (λp, λm) = [α ln(α) + (1 − α) ln(1 − α)] + ln(λm) − α ln(λp1 ) − (1 − α) ln(λp2 )
= A + ln(λ) − α ln(λ) − (1 − α) ln(λ) + ln(m) − α ln(p1 ) − (1 − α) ln(p2 )
= A + ln(m) − α ln(p1 ) − (1 − α) ln(p2 )
= U ∗ (p, m), where A = α ln(α) + (1 − α) ln(1 − α).
ii. Monotonicity?
∂U ∗ 1
= > 0 for m > 0.
∂m m
Note that we must define U ∗ (p, 0) = −∞ to have U ∗ defined for m ≥ 0 while preserving monotonicity
(i.e., U (0, 0) = −∞). This is because the representation used (i.e., natural log form) is not bounded
1−α
below. It is of no consequence, since another representation like xα
1 x2 is bounded below.
∂U ∗ α 1−α
=− or − , which are both negative for 0 < α < 1.
∂pi p1 p2
iii. Quasiconvex in (p, m)? We will only show this in p. The Hessian is
α

p21
0
1−α ,
0 p22
which is positive semidefinite since all principal minors are ≥ 0. Thus, U ∗ is convex in p, which implies
quasiconvexity automatically.
iv. Continuity? This is obvious, except when m = 0. The definition U ∗ (p, 0) = −∞ preserves the
continuity at m = 0. Note that we then have U ∗ (p, R1+ ) = [−∞, ∞) ∀p >> 0, so Y = [−∞, ∞).
5. (MWG#3.D.5)
ρ
a. An indifference curve is xρ1 + xρ2 = U , so
ρ−1
dx2 dx2 x1
ρxρ−1
1 + ρxρ−1
2 =0⇒ =− < 0.
dx1 dx1 x2
ρ−2
d 2 x2 x1 x2 − x1 dx
dx1
2
= −(ρ − 1)
dx12 x2 x22

> 0, if ρ < 1
= 0, if ρ = 1.
So, the slope and curvature of the indifference curves are right for an interior solution, but there are
corners to worry about. If ρ > 0 then the indifference curve looks like the figure above. Since the slope
at the corners is 0 and −∞, the optimal choice will never occur at these corners.
A typical indifference curve for ρ > 0

When ρ < 0 the indifference curves look like the figure below. Once again, corners are not optimal.
So, assuming ρ < 1 we can use the FOCs to describe the maximum. Set -MRS=price ratio and use the
budget line:
ρ−1 ρ−1
1
x1 p1 p1
= ⇒ x1 = x2 .
x2 p2 p2
A typical indifference curve for ρ < 0
ρ−1
1
p1
So, p1 p2 x2 + p2 x2 = m, or
1
m mp2ρ−1
x∗2 = ρ−1
1 = ρ ρ
p1 p1
+ p2 p1ρ−1 + p2ρ−1
p2
ρ−1
1 1 1
p1 mp2ρ−1 mp1ρ−1
x∗1 = ρ ρ = ρ ρ .
p2 p1ρ−1 + p2ρ−1 p1ρ−1 + p2ρ−1
Substitute into U to get
m ρ ρ 1 ρ ρ
1−ρ
U ∗ (p, m) =
ρ ρ
ρ ρ p1ρ−1 + p2ρ−1 = m p1ρ−1 + p2ρ−1 .
p1ρ−1 + p2ρ−1
b. First check the properties of x∗ :
Homogeneity?
1 ρ 1
λm(λpi ) ρ−1 λ ρ−1 mpiρ−1
x∗i (λp, λm) = ρ ρ = ρ
ρ ∗
ρ = xi (p, m)
(λpi ) ρ−1 + (λpj ) ρ−1 λ ρ−1 ρ−1
pi + pj ρ−1
Walras’ Law?
ρ ρ
mp1ρ−1 + mp2ρ−1
p1 x∗1 + p2 x∗2 = ρ ρ =m
p1ρ−1 + p2ρ−1
Uniqueness?
There is only one (x∗1 , x∗2 ) pair that maximizes U, because U is strictly quasiconcave. We already
verified this geometrically. To see it analytically, consider two cases:
Case 1 ρ > 0. We must show
1ρ 1 1
(λx1 + (1 − λ)y1 )ρ + (λx2 + (1 − λ)y2 )ρ > min{(xρ1 + xρ2 ) ρ , (y1ρ + y2ρ ) ρ }
for λ ∈ (0, 1) and x = y. We already argued in question 3 that the function z ρ is strictly concave for
0 < ρ < 1. So,
(λx1 + (1 − λ)y1 )ρ ≥ λxρ1 + (1 − λ)y1ρ
(λx2 + (1 − λ)y2 )ρ ≥ λxρ2 + (1 − λ)y2ρ ,
and one of these inequalities is strict since x = y. Hence,
(λx1 + (1 − λ)y1 )ρ + (λx2 + (1 − λ)y2 )ρ > λ(xρ1 + xρ2 ) + (1 − λ)(y1ρ + y2ρ ).
1
Since ρ > 0, the function z ρ is strictly increasing in z. So,
1 1
[(λx1 + (1 − λ)y1 )ρ + (λx2 + (1 − λ)y2 )ρ ] ρ > [λ(xρ1 + xρ2 ) + (1 − λ)(y1ρ + y2ρ )] ρ
1
≥ [λ min{xρ1 + xρ2 , y1ρ + y2ρ } + (1 − λ) min{xρ1 + xρ2 , y1ρ + y2ρ }] ρ
1
= [min{xρ1 + xρ2 , y1ρ + y2ρ }] ρ
1 1
= min{(xρ1 + xρ2 ) ρ , (y1ρ + y2ρ ) ρ }.
Case 2 ρ < 0. Now z ρ is strictly convex, so using the same reasoning as above yields
(λx1 + (1 − λ)y1 )ρ + (λx2 + (1 − λ)y2 )ρ < λ(xρ1 + xρ2 ) + (1 − λ)(y1ρ + y2ρ )
≤ max{xρ1 + xρ2 , y1ρ + y2ρ }.
1
Since ρ < 0, z ρ is strictly decreasing, so
1 1
[(λx1 + (1 − λ)y1 )ρ + (λx2 + (1 − λ)y2 )ρ ] ρ > [max{xρ1 + xρ2 , y1ρ + y2ρ }] ρ .
Suppose xρ1 + xρ2 ≥ y1ρ + y2ρ . Then
1 1
[max{xρ1 + xρ2 , y1ρ + y2ρ }] ρ = (xρ1 + xρ2 ) ρ .
1 1 1
( 1 1
)
But, since ρ < 0, (xρ1 + xρ2 ) ρ ≤ (y1ρ + y2ρ ) ρ , so (xρ1 + xρ2 ) ρ = min (xρ1 + xρ2 ) ρ , (y1ρ + y2ρ ) ρ . The same
argument applies if xρ1 + xρ2 < y1ρ + y2ρ . Generally,
1
( 1 1
)
[max{xρ1 + xρ2 , y1ρ + y2ρ }] ρ = min (xρ1 + xρ2 ) ρ , (y1ρ + y2ρ ) ρ ,
yielding the result.
Nonnegativity? x∗ ≥ 0 is obvious.
Now check the properties of U ∗ :
Homogeneity?
ρ ρ
1−ρ
U ∗ (αp, αm) = (αm) (αp1 ) ρ−1 + (αp2 ) ρ−1
ρ
ρ ρ 1−ρ
= (αm)α−1 p1ρ−1 + p2ρ−1

ρ
= U ∗ (p, m)
Monotonicity?
∂U ∗ ρ ρ
1−ρ
ρ
= p1ρ−1 + p2ρ−1 >0
∂m
1−2ρ 1
∂U ∗ 1 − ρ ρ−1ρ ρ
ρ ρ
=m p1 + p2ρ−1 piρ−1
∂pi ρ ρ−1
ρ ρ
1−2ρ
ρ 1
= −m p1 + p2
ρ−1 ρ−1
piρ−1 < 0.
Quasiconvex in (p, m)?

" #− 1
We will only show this in p. Let δ = ρ
ρ−1 so that U ∗ = m pδ1 + pδ2 δ . δ ranges between −∞ and 0 as
ρ moves from 1 to 0, and δ ranges from 0 to 1 as ρ moves from 0 to −∞. So, consider two cases:
Case 1 δ ∈ (0, 1). Then, as before, pδ1 + pδ2 is a strictly concave function of (p1 , p2 ), since the Hessian
is

δ(δ − 1)pδ−2
1 0
,
0 δ(δ − 1)pδ−2
2
which is negative semidefinite. So, for any two price vectors (p1 , p2 ) = (q1 , q2 ) we have

(λp1 + (1 − λ)q1 )δ + (λp2 + (1 − λ)q2 )δ > λ pδ1 + pδ2 + (1 − λ) q1δ + q2δ for λ ∈ (0, 1).
Thus, since δ > 0,
" #− 1 " #− 1
m (λp1 + (1 − λ)q1 )δ + (λp2 + (1 − λ)q2 )δ δ ≤ m λ(pδ1 + pδ2 ) + (1 − λ)(q1δ + q2δ ) δ .
1 1
Also, the function z − δ is strictly convex since its second derivative is − 1δ (− 1δ − 1)z − δ −2 > 0. So,
" δ #− 1 − 1 − 1
λ(p1 + pδ2 ) + (1 − λ)(q1δ + q2δ ) δ < λ pδ1 + pδ2 δ + (1 − λ) q1δ + q2δ δ .
Combining inequalities shows that U ∗ is convex in p.
Case 2 δ < 0. Then pδ1 + pδ2 is strictly convex in (p1 , p2 ), so
(λp1 + (1 − λ)q1 )δ + (λp2 + (1 − λ)q2 )δ < λ(pδ1 + pδ2 ) + (1 − λ)(q1δ + q2δ ).
Since − 1δ > 0, this inequality is unchanged when we raise both sides to the − 1δ power:
− 1δ δ − 1δ
δ
(λp1 + (1 − λ)q1 )δ + (λp2 + (1 − λ)q2 ) < λ pδ1 + pδ2 + (1 − λ) q1δ + q2
" + , + ,#− 1δ
≤ λ max pδ1 + pδ2 , q1δ + q2δ + (1 − λ) max pδ1 + pδ2 , q1δ + q2δ
( − 1 − 1 )
= max pδ1 + pδ2 δ , q1δ + q2δ δ ,
so U ∗ is quasiconvex in p.
Continuity? This is clear by inspection, provided ρ = 0 and ρ = 1. Note that U ∗ (p, R1+ ) = [0, ∞) =
Y ∀p >> 0.
c. For linear utility, the problem is just like problem 5 from Lecture 11 (when α1 = α2 –that is, the slope
of the indifference curve is −1), except that all points on the budget line are optimal when p1 = p2 .
Hence,
 m p1 


, if <1
 0, if p1
<1
 p1
p2
 p2 m p1
≤1
p1 , if
x∗1 = x∗2 x∗1 , p2
p2 −
p1
0, pm1 , if p1
=1; = m
if =1; U∗ =


p2 

p2 m
p2 , if p1
>1
 p1 m
, if p1
>1 p2
0, if p2
>1 p2 p2
m
= .
min{p1 , p2 }
For the comparison to CES, write

m
x∗1 = 1 .
ρ ρ−1
p2
p1 + p1
Letting ρ go to 1 yields m −∞ . If p2 > p1 this is m

p p1 , while p2 < p1 yields 0. If p2 = p1 then
p1 + p2
1
x∗1 = m
2p1 , the middle of the budget line. The same arguments work for x∗2 . Similarly, factor out p2 in
U ∗ to get
ρ−1
ρ 1−ρ
ρ
m
∗ p1
U = +1 .
p2 p2
ρ−1
ρ
1−ρ
ρ
Letting ρ go to 1 sends the exponent ρ
ρ−1 to −∞, so p1
p2 +1 → 1 when p1 > p2 . Since
1−ρ
ρ → 1, we get m
p2 . Just reverse the argument for p1 < p2 .
For Leontief utility, U = min{x1 , x2 } and so the indifference curves are as shown below. So, x∗1 = x∗2 =
m
p1 +p2 and U ∗ = m
p1 +p2 .
A typical indifference curve for Leontief utility
For the comparison to CES, note that 1

ρ−1
→ 0 as ρ → −∞ and ρ
ρ−1
→ 1. So,
1
mp1ρ−1 mp01 m
x∗1 = ρ ρ → = ,
ρ−1
p1 + p2 ρ−1 p1 + p2 p1 + p2
and the same for x∗2 . Also, 1−ρ

ρ → −1 so
ρ ρ 1−ρ
ρ
∗
U = m p1 ρ−1
+ p2 ρ−1
→ m[p1 + p2 ]−1 .

x∗
ρ−1
1 ∂ 1
x∗
ρ−1
1
−1
x∗ p1 p1
d. 1
= . So, 2 = 1
.
x∗
2 p2 p
∂ p1 ρ−1 p2
2
ρ−1
1
−1 ρ−1
1
−1 p1 p1 p2 −1
⇒ ξ12 = = .
ρ−1 p2 p2 p1 ρ−1
Note that this does not vary with p1 , p2 .
The linear case is obtained by letting ρ go to 1, so ξ12 = ∞.
The Leontief case lets ρ → −∞, so ξ12 = 0.
The Cobb-Douglas case lets ρ → 0, so ξ12 = 1. Note that x∗1 → m

2p1
and x∗2 → m
2p2
as ρ → 0, which
are the C-D demands when the exponents are 12 .

Solutions to Exercises for Lecture 14 (Expenditure Minimization)
1.
a. Homogeneity: e∗ (αp, U) = αpU = αe∗ (p, U)
∂ 2 e∗
Concavity: ∂p2 =0
∂e∗ ∂e∗
Monotonicity: ∂p = U ≥ 0 for U ≥ 0, which is where e∗ ≥ 0. ∂U
= p > 0 for p > 0
Continuity: e∗ only involves products, so it is continuous.
Nonnegativity: e∗ > 0 ∀ p > 0 when U > 0. e∗ = 0 ∀ p when U = 0
∂e∗
b. h∗ = ∂p
=U
c. Homogeneity: h∗ (αp, U) = U = h∗ (p, U)
∂h∗
Symmetry and Semidefiniteness: ∂p = 0, which is symmetric and negative semidefinite.
Monotonicity: p · h∗ = pŪ , which is strictly increasing in Ū for p > 0.
Continuity: p · h∗ = pŪ, which only involves products.
Nonnegativity: h∗ = U ≥ 0 ∀ U ≥ 0. ph∗ = 0 when U = 0, and h∗ > 0 when p > 0 and U > 0.
2. (Varian #7.2) For given U , the indifference curve is
So,  ∗

 h = 0 and h∗2 = U , when p1
>1
 1 p2
h∗1 = U and h∗2 = 0, when p1

<1


p2
 h∗ = either 0 or U and h∗ = either U or 0, respectively, when p1
= 1.
1 2 p2
212 SOLUTIONS TO EXERCISES FOR LECTURE 14 (EXPENDITURE MINIMIZATION)
Therefore,
p1 · 0 + p2 U , when p1
p2 ≥1
e∗ (p, Ū) = = U min{p1 , p2 }.
p1 U + p2 · 0, when p1
p2
<1
3. (Varian #8.8) To do this, we must first do problem 8.6:
1 1
L = x12 x23 − λ(p1 x1 + p2 x2 − m)
The FOC’s are

1 − 12 13 1 21 − 23
x x = λp1 ; x x = λp2 .
2 1 2 3 1 2
So
3x2 p1
=
2x1 p2
From the budget constraint:

p1 2 3m 2m
p1 x 1 + p2 x1 = m ⇒ x∗1 = ; x∗2 = .
p2 3 5p1 5p2
12 13 m 56 3 36 2 26
3m 2m
⇒ U∗ = = .
5p1 5p2 5 p1 p2
Solve for m to get e∗ :
35
2
∗ m 6 3 2 5
(U ) = 5
5 p1
p2
6
p1 5 p2 5
3 2
m = 5(U ∗ ) 5
3 2
6 p 5 p 5
3 2
e∗ (p, U ) = 5U 5
1 2
.
3 2
Use Shephard’s Lemma to get h∗ :
25
∂e∗ 6 p − 5 p 5
2 2
13 6 3p2
h∗1
1 2
= = 5U 5 = U5
∂p1 3 2 35 2p1
35
∂e∗ 6
3
p1 5 p2 − 35
12 6 2p1
h∗2 = = 5U 5 = U5 .
∂p2 3 2 25 3p2
Now proceed to problem 8.8:
Since U ∗ is a monotonic transform of U, we know x∗1 and x∗2 are unchanged. We can verify this, if desired:
1 1
L= ln(x1 ) + ln(x2 ) − λ(p1 x1 + p2 x2 − m).
2 3
The FOC’s are:

1 1
= λp1 ; = λp2 .
2x1 3x2
So
3x2 p1
= .
2x1 p2
This is the same condition as before, so x∗1 = 3m

5p1 and x∗2 = 2m
5p2 .

1 3m 1 2m
⇒ U∗ = ln + ln
2 5p1 3 5p2
12 1
3m 2m 3
= ln + ln .
5p1 5p2
∗
12 13
So eU = 3m
5p1
2m
5p2 , which is U ∗ in problem 8.6. To find e∗ , we must solve U ∗ for m. This involves
taking the exponential above and then solving for m, which is the same derivation we did before. Thus,
it yields
6
p 35 p 25
e∗ (p, U) = 5(eU ) 5
1 2
.
3 2
Obviously, differentiating this yields the same Hicksian demands as before, with U replaced by eU .
4. (MWG #3.E.2) First, check the expenditure function: e∗ (p, Ū) = α−α (1 − α)α−1 pα 1−α
1 p2 Ū . Note that
U (0) = 0 and Y = [0, ∞).
Homogeneous?
e∗ (λp, U ) = α−α (1 − α)α−1 (λp1 )α (λp2 )1−α U
= λα−α (1 − α)α−1 pα 1−α

1 p2 U
= λe∗ (p, U)
Monotonicity?
∂e∗
= α1−α (1 − α)α−1 pα−1
1 p1−α
2 U ≥ 0 for Ū ≥ 0
∂p1
∂e∗
= α−α (1 − α)α pα −α
1 p2 U ≥ 0 for Ū ≥ 0
∂p2
∂e∗
= α−α (1 − α)α−1 pα 1−α
1 p2 >0
∂U
Concavity?
∂ 2 e∗
= −α1−α (1 − α)α pα−2
1 p1−α
2 U ≤ 0 for Ū ≥ 0.
∂p21
It is unnecessary to check the Hessian determinant (it is zero, by homogeneity). So, e∗ is concave.
Continuity? Obvious by inspection.
Nonnegativity? e∗ (p, Ū) > 0 for (p, Ū) >> 0 and e∗ (p, 0) = 0 are obvious.
Now check the Hicksian demands:
Homogeneity?
1−α 1−α
αλp2 αp2
h∗1 (λp, U)= U = U = h∗1 (p, U)
(1 − α)λp1 (1 − α)p1
α α
∗ (1 − α)λp1 (1 − α)p1
h2 (λp, U) = U= U = h∗2 (p, U)
αλp2 αp2
Symmetry and Semidefiniteness? We know the Hessian of e∗ is negative semidefinite for Ū ≥ 0 from
above. Symmetry is verified by checking
1−α
∂h∗1 α ∂h∗2
= (1 − α)pα−1 p−α
2 Ū = .
∂p2 1−α 1
∂p1
Monotonicity?
1−α α
∗ αp2 (1 − α)p1
p·h = p1 h∗1 + p2 h∗2 = α
p1 Ū + p1−α Ū
1−α α 2
1−α α
α 1−α
= + pα 1−α
1 p2 Ū = e∗ ,
1−α α
which we already showed is strictly increasing in Ū .
Nonnegativity? h∗ ≥ 0 ∀p >> 0 and Ū ≥ 0; p · h∗ (p, 0) = 0; and h∗ (p, Ū) > 0 for Ū > 0 and p >> 0
are clear by inspection.
Excess Utility?
α(1−α) α(1−α)
αp (1 − α)p α 1−α
U (h∗1 , h∗2 ) =
2 1
U U
(1 − α)p1 αp2
α(1−α)−α(1−α)
αp2 α+1−α
= U =U
(1 − α)p1
Uniqueness? h∗ is unique because U is strictly quasiconcave. We verified this for the Cobb-Douglas
utility function in problem 3 of the exercises for Lecture 12.

1
5. (MWG #3.E.6) We want to min p1 x1 + p2 x2 subject to [xρ1 + xρ2 ] ρ ≥ U . We verified in problem 5 of the
exercises for Lecture 12 that the solution is interior for ρ = 1 and ρ = 0. We also derived the MRS as
−( xx12 )ρ−1 so that the tangency condition gives

ρ−1
1
p1
x1 = x2 .
p2
ρ
ρ−1
ρ
ρ
Substitute into the indifference curve xρ1 + xρ2 = U to get p1
p2 xρ2 + xρ2 = U . So
1
U U p2ρ−1 Ū pδ−1 ρ
h∗2 =
= ρ ρ
= "
2
# 1 , where δ = .
ρ−1
ρ
1
ρ
1
ρ δ δ 1− δ ρ−1
p1 ρ−1 ρ−1
p1 + p2 p 1 + p 2
p2
+1
So,
ρ−1
1 1
p1 U U U p1ρ−1 Ū pδ−1
h∗1 =
ρ1 =
ρ1 = ρ = "
1
# 1.
p2 ρ−1
ρ ρ−1
ρ ρ 1
ρ δ δ 1− δ
p1 p2 ρ−1 ρ−1
p2 + p1 p 1 + p 2
p2
+1 p1
+1
Therefore,
Ū " δ # " #1
e∗ (p, Ū) = " #1− 1 p1 + pδ2 = Ū pδ1 + pδ2 δ .
pδ1 + pδ2 δ
Properties of e∗ : Note first that U (0) = 0 and Y = [0, ∞).
Homogeneity?
" #1 " #1
e∗ (αp, U) = U (αp1 )δ + (αp2 )δ δ = U α pδ1 + pδ2 δ = αe∗ (p, U)
Monotonicity?
∂e∗ U " δ # 1 −1 ∂e∗ " #1

= p1 + pδ2 δ δpδ−1
i ≥ 0 for Ū ≥ 0; = pδ1 + pδ2 δ > 0.
∂pi δ ∂U
Concavity?

∂ 2 e∗ " δ #1
δ δ −2 1 2(δ−1) " # 1 −1
2 = U p 1 + p 2 − 1 δpi + U pδ1 + pδ2 δ (δ − 1)pδ−2 i
∂pi δ
" # 1 −1 " δ #
= U pδ1 + pδ2 δ (1 − δ)pδ−2 i (p1 + pδ2 )−1 pδi − 1 ≤ 0 for Ū ≥ 0.
It is unnecessary to check the Hessian determinant (it is zero, by homogeneity). So, e∗ is concave.
Continuity? Clear by inspection.
Nonnegativity? e∗ (p, Ū) > 0 for (p, Ū) >> 0 and e∗ (p, 0) = 0 are obvious.
Properties of h∗ :
Homogeneity?
U (αpi )δ−1 αδ−1 Ū pδ−1

h∗i (αp, U) = 1− 1δ
= " δ
i ∗
#1− 1δ = hi (p, Ū)
[(αp1 )δ + (αp2 )δ ] α δ−1 p1 + p2 δ
Symmetry and Semidefiniteness?
∂h∗i " # 1 −1 " δ #

= U pδ1 + pδ2 δ (1 − δ)pδ−2
i (p1 + pδ2 )−1 pδi − 1 ≤ 0 for Ū ≥ 0
∂pi

∂h∗1 1 " # 1 −2 ∂h∗2
=U − 1 pδ1 + pδ2 δ δ(p1 p2 )δ−1 = .
∂p2 δ ∂p1
So the determinant is
∂h∗1 ∂h∗2 ∂h∗ ∂h∗ 2 3

− 1 2 = U [pδ1 + pδ2 ] δ −2 (1 − δ)2 (p1 p2 )δ−2
∂p1 ∂p2 ∂p2 ∂p1

pδ1 pδ2 δ −2
−1 − 1 − (p1 + p2 ) (p1 p2 )
δ δ
pδ1 + pδ2 pδ1 + pδ2
2 3
= U [pδ1 + pδ2 ] δ −2 (1 − δ)2 (p1 p2 )δ−2 [0] = 0.
" # 1 −1 " δ # " #1

Monotonicity? p · h∗ = p1 h∗1 + p2 h∗2 = Ū pδ1 + pδ2 δ p1 + pδ2 = Ū pδ1 + pδ2 δ . This, of course, is e∗ ,
which we already verified is strictly increasing in Ū .
Nonnegativity? h∗ ≥ 0 for p >> 0 and Ū ≥ 0; p · h∗ (p, 0) = 0; and h∗ (p, Ū ) > 0 for (p, Ū ) >> 0 are all
clear by inspection.
Excess utility?
" ∗ρ # ρ
1
U (h∗ ) = h∗ρ
1 + h2
ρ ρ 1
ρ
U p1ρ−1 + p2ρ−1
= ρ ρ 1
=U
ρ
p1ρ−1 + p2ρ−1
Uniqueness? Again, h∗ is unique because U is strictly quasiconcave, as verified in problem 5 of the
exercises for Lecture 12.
6. (MWG #3.G.3 except (c) and (e))
a. Since u(x) = (x1 − b1 )α (x2 − b2 )β (x3 − b3 )γ , we can use a monotonic transformation of the given utility
function to get ln u(x) = α ln(x1 − b1 ) + β ln(x2 − b2 ) + γ ln(x3 − b3 ). The first order condition of the
EMP yield the Hicksian demand function
h(p, u) = (b1 , b2 , b3 ) + u(α/p1)−α (β/p2 )−β (γ/p3 )−γ (α/p1 , β/p2 , γ/p3 ).
Multiplying p · h(p, u), we obtain the expenditure function
e(p, u) = p · b + u(α/p1 )−α (β/p2 )−β (γ/p3 )−γ ,

where b = ( b1 b2 b3 ) and we have used α + β + γ = 1. Now we can check Proposition 3.E.2:
i.
e(λp, u) = λpb + (1/λ)−(α+β+γ) u(α/p1 )−α (β/p2 )−β (γ/p3 )−γ = λe(p, u)
ii.
∂e(p, u)
= (α/p1 )−α (β/p2 )−β (γ/p3 )−γ > 0
∂u
∂e(p, u)
= h(p, u) = (b1 , b2 , b3 ) + u(α/p1 )−α (β/p2 )−β (γ/p3 )−γ (α/p1 , β/p2 , γ/p3 ) ≥ 0.
∂p
iii.
 
α(α − 1)/p21 αβ/p1 p2 αγ/p1 p3
γ
2 α β
Dp e(p, u) = Dp h(p, u) = u(p1 /α) (p2 /β) (p3 /γ) αβ/p1 p2 β(β − 1)/p22 βγ/p2 p3  .
αγ/p1 p3 βγ/p2 p3 γ(γ − 1)/p23
We must show that this matrix is negative semidefinite. The diagonal elements are negative because
αβ(1−α−β)
α, β, γ < 1. The 2 × 2 naturally-ordered principal minor is |H2| = p21 p22
> 0. The 3 × 3 naturally-
ordered principal minor is
1
|H3| = [αβγ(α − 1)(β − 1)(γ − 1) + α2 β 2 γ 2 + α2 β 2 γ 2
p21 p22 p33
− α2 βγ 2 (β − 1) − α2 β 2 γ(γ − 1) − αβ 2 γ 2 (α − 1)] = 0.
So H is negative semidefinite.
iv. Continuity of e in p and u is clear by inspection, provided p >> 0.
Finally, check Proposition 3.E.3:
i.
h(λp1 , u) = b1 + u(α/λp1 )−α (β/λp2 )−β (γ/λp3 )−γ α/λp1 = h(p1 , u)
ii. Let A = (α/p1 )−α (β/p2 )−β (γ/p3 )−γ . Then
U (h) =[uA(α/p1)]α [uA(β/p2 )]β [uA(γ/p3 )]γ
(uA)α+β+γ (α/p1 )α (β/p2 )β (γ/p3 )γ
(uA)1 A−1 = u.
iii. h is clearly unique (it only takes on one value for each p and u. To see that this is due to the strict
quasiconcavity of u, we can check the Hessian of ln u:

 −α 
(x1 −b1 )2
 −β 
Hu =  (x2 −b2 )2 .
−γ
(x3 −b3 )2
This matrix is obviously negative definite, so u is strictly concave (and hence strictly quasiconcave).
b.
∂e(p, u)
= h(p, u) = (b1 , b2 , b3 ) + u(α/p1 )−α (β/p2 )−β (γ/p3 )−γ (α/p1 , β/p2 , γ/p3 ).
∂p
d. The Hessian of e derived above is clearly symmetric (the compensated cross-price effects are symmetric),
and all diagonal elements are negative (the own substitution terms are negative).
7. (MWG #3.G.14) Symmetry immediately yields

 
−10 ? 3
 ? −4 ?  .
3 ? ?
By homogeneity of degree 0 of h∗ and Euler’s Theorem:

n
∂h∗i
pj = 0 for i = 1, · · · , n (i.e., (iv) from proposition 3.G.2)
j=1
∂pj
Thus, for i = 1 we have 1(−10) + 2(?) + 6(3) = 0, or ? = −4. Applying symmetry again yields
 
−10 −4 3
 −4 −4 ?  .
3 ? ?
Now, using row 2, 1(−4)+2(−4)+6(?) = 0, so ? = 2. Symmetry and row 3 then gives 1(3)+2(2)+6(?) = 0,
so ? = − 76 . Thus we have  
−10 −4 3
 −4 −4 2  .
3 2 − 76
This is symmetric by construction and is negative semidefinite because the naturally-ordered principal
minors alternate in sign:
−10 < 0; (−10)(−4) − (−4)(−4) = 24 > 0; (−20) 73 − 24 − 24 + 36 + 40 + 8( 73 ) = 0.

1/2 1/2
8. (MWG #3.G.15) First, check the shape of utility function u(x) = 2x1 + 4x2 :
1/2
dx2 x2
= −(1/2) < 0.
dx1 x1
So
−1/2 ∂x2
d 2 x2 x2 ∂x1 x1 − x2
= −(1/4) > 0.
dx21 x1 x21
Note also that ∂x2

∂x1
approaches infinity as x1 → 0 and approaches 0 as x1 → ∞. Therefore, calculus will
always describe the optimum.
a.
1/2 1/2
max u = 2x1 + 4x2 , s.t. p1 x1 + p2 x2 = m.
1/2 1/2
L = 2x1 + 4x2 − λ(p1 x1 + p2 x2 − m).
FOC’s:
−1/2
x1 : x1 − λp1 = 0, (1)
−1/2
x2 : 2x2 − λp2 = 0, (2)
λ : p1 x1 + p2 x2 = m, (3)
4x1 p21
From (1) and (2), x2 = p22
. So
4x1 p21
p1 x 1 + p2 =m
p22
m mp2
x∗1 (p, m) = =
p1 + 4p21 /p2 p1 (p2 + 4p1 )
m 4mp1
x∗2 (p, m) = = .
p2 + p22 /4p1 p2 (p2 + 4p1 )
b.
1/2 1/2
min p1 x1 + p2 x2 , s.t. 2x1 + 4x2 ≥ ū
1/2 1/2
L = p1 x1 + p2 x2 − λ(2x1 + 4x2 − ū).
FOC’s:
−1/2
x1 : p1 − λx1 = 0, (1)
−1/2
x2 : p2 − 2λx2 = 0, (2)
1/2 1/2
λ : 2x1 + 4x2 = ū, (3)
4x1 p21
From (1) and (2), x2 = p22
. So
1/2 2p1 1/2

2x1 +4 x = ū
p2 1
ū2 p22 ū2
h∗1 (p, ū) = 2
=
(2 + 8p1 /p2 ) 4(p2 + 4p1 )2
ū2 p21 ū2
h∗2 (p, ū) = 2
= .
(4 + p2 /p1 ) (p2 + 4p1 )2
c. The expenditure function is
e∗ (p, ū) = p1 h1 (p, ū) + p2 h2 (p, ū)
ū2
= (p1 p22 + 4p2 p21 )
4(p2 + 4p1 )2
ū2 p1 p2
= .
4(p2 + 4p1 )
Differentiating e∗ yields
∂e∗ ū2 p2 (p2 + 4p1 ) − ū2 p1 p2 4 ū2 p22

= = = h∗1
∂p1 4(p2 + 4p1 )2 4(p2 + 4p1 )2
∂e∗ ū2 p1 (p2 + 4p1 ) − ū2 p1 p2 ū2 p21
= = = h∗2
∂p2 4(p2 + 4p1 )2 (p2 + 4p1 )2
d. Invert e∗ from part c to obtain

1/2
∗ m 4m
u (p, m) = 2 + .
p1 p2
To verify Roy’s identity, first find the partials of u∗ :

1/2
∂u∗ −1/2 1 4
=m +
∂m p1 p2

−1/2
∂u∗ 1 4 1
= m1/2 + − 2 .
∂p1 p1 p2 p1
So
∂u∗
−1
m 1 4 mp2
= x∗1 .
∂p1
− ∂u∗
= 2
+ =
∂m
p1 p1 p2 p1 (p2 + 4p1 )
x∗2 is similar.
Solutions to Exercises for Lecture 15 (Utility and Expenditure Relationships)

√ 1
1. Indirect utility is m = U ∗ p1 p2 , or U ∗ = m(p1 p2 )− 2 . Now use Roy’s Identity:
∂U ∗ 1 m ∂U ∗ 1 m ∂U ∗ 1
=− 3 1; =− 1 3; = 1 1.
∂p1 2 p2 p2 ∂p2 2 p2 p2 ∂m p12 p22
1 2 1 2
So,
− 12 m
3 1
p12 p22 m m
x∗1 = − 1 = and x∗2 = .
1 1 2p1 2p2
p12 p22
2. Yes, because the matrix of price derivatives of the Marshallian demands is symmetric when preferences
are homothetic. So, there is no ambiguity in the definition of a substitute or complement in this case.
3. (Varian #7.3) Invert indirect utility to get the expenditure function: e(p1 , p2 , u) = u min{p1 , p2 }. By
Roy’s identity, the Marshallian demands are:
m
p1 , p1 < p2 0, p1 < p2
x1 = , x2 = m
0, p1 > p2 p2 , p1 > p2
Substitute these into indirect utility to get

x 1 , p1 < p2
u(x1 , x2) =
x 2 , p1 > p2
The only way utility can take on these values is if the indifference curve is linear with a slope of -1 and an
intercept of u (or strictly concave with intercepts on the two axes both equal to u). So u(x1 , x2 ) = x1 + x2
is the simplest utility function that is consistent with the given indirect utility function.
4. (Varian #7.4(b) and (c))
e∗
b. U = p1 +p2 , so e∗ = (p1 + p2 )U .
c. By Shephard’s Lemma, h∗1 = U and h∗2 = U . So, the system from which we must “eliminate” price is
x1 = U and x2 = U .
Since the prices don’t appear in this system, we know that expenditure minimizing choices must satisfy
x1 = x2 = U no matter what the prices are. This can only happen if U (x1 , x2 ) = min{x1 , x2}.
5. (Varian #8.1) We know that
xj (p, m) ≡ hj (p, v(p, m)) ≡ ∂e(p, v(p, m))/∂pj .

222 SOLUTIONS TO EXERCISES FOR LECTURE 15 (UTILITY AND EXPENDITURE RELATIONSHIPS)
Differentiating with respect to m gives us
∂xj ∂ 2 e(p, v(p, m)) ∂v(p, m)

= .
∂m ∂pj ∂u ∂m
Since the marginal utility of income, ∂v/∂m, must be positive, the result follows.
6. (Varian #8.15) Let L be the Marshallian demand for leisure, Ls be the Hicksian demand for leisure, w
be the price of leisure (i.e., w is the wage rate), and L̄ be the time endowment. “Income” is m + w L̄
(see the discussion on pages 145-6 of Varian), which complicates things because a change in the price of
leisure affects money income. So, if we think of L as a function of prices and income in the usual way,
the relevant arguments of L are (w, m + w L̄). Thus the total effect of a change in w on L is
∂L
= L1 + L2 L̄.
∂w
From Slutsky’s equation,

∂Ls
L1 = − LL2 .
∂w
Substituting yields
∂L ∂Ls
= + L2 (L̄ − L).
∂w ∂w
Now note that the substitution effect is always negative, (L̄−L) is always nonnegative, and hence if leisure
∂L
is inferior, ∂w is necessarily negative. This says that the slope of the demand for leisure is negative when
leisure is inferior. Since the supply of labor is just L̄ − L, the slope of the labor supply curve is positive
in this circumstance.
7. (MWG #2.F.10(a)) Consider x1 . Its derivatives are
∂x1 p2 p2 1 1 4
= − 2 (p1 + p2 + p3 )−1 − (p1 + p2 + p3 )−2 = − − = −
∂p1 p1 p1 3 9 9
∂x1 1 p2 2
= (p1 + p2 + p3 )−1 − (p1 + p2 + p3 )−2 =
∂p2 p1 p1 9
∂x1 p2 1
= − (p1 + p2 + p3 )−2 = − .
∂p3 p1 9
So the first row of the (Marshallian) substitution matrix is:
∂x1
∂p1
∂x1
∂p2
∂x1
∂p3 = ( − 49 2
9 − 19 ) .
Similar exercises on x2 and x3 yield the second and third rows, respectively, of the substitution matrix.
The final result is  

−4 2 −1
1
−1 −4 2 .
9
2 −1 −4
Hence the substitution matrix is clearly not symmetric. The diagonal elements are negative, the 2 × 2
naturally-ordered principle minor is |H2 | = 2/9 > 0, and the 3 × 3 naturally-ordered principle minor is
|H3| = −1/9 < 0. So, the substitution matrix is negative definite.
8. (MWG #3.G.2) Use example 3.D.1 to get the Marshallian Demands for the general Cobb-Douglas U =
1−α
Kxα
1 x2 :
α 1−α
αm (1 − α)m αm (1 − α)m
x∗1 = ; x∗2 = ; U∗ = K .
p1 p2 p1 p2
Use example 3.E.1 to get

1−α α
αp2 (1 − α)p1
h∗1 = U ; h∗2 = U ; e∗ = α−α (1 − α)α−1 pα 1−α
1 p2 U.
(1 − α)p1 αp2
Verify Prop. 3.G.1:

α−1
∂e∗ p1
= α−α (1 − α)α−1 Uα
∂p1 p2
α−1 α−1
1−α p1
= U = h∗1
α p2
α
∂e∗ −α α−1 p1
= α (1 − α) U (1 − α)
∂p2 p2
α α
1−α p1
= U = h∗2
α p2
Verify Prop. 3.G.2:
Hessian of e∗ is
 −α −α 
−αp2
(1 − α) αp2
(1−α)p21
U (1 − α) (1−α)p
αp2 α
U
 (1−α)p1
−α
1
−α−1
(1−α)p1
.
(1 − α) αp2
(1−α)p1
α
(1−α)p1 U
αp2
(−α) (1−α)p1 α
(1−α)p1 U
i. The fact that this is the Jacobian of h∗ is obvious from the definitions, as is (iii) symmetry.
ii. The diagonal elements are clearly negative, and

−2α−1 2 −2α 2
αp2 α 3 p2 U αp2 α2 U
|H| = −
(1 − α)p1 (1 − α)p31 (1 − α)p1 p21
−2α 2 2

αp2 (1 − α)p1 α3 p2 U α2 U
= − = 0.
(1 − α)p1 αp2 (1 − α)p13 p21
So, H is negative semidefinite.
iv.
αp2 −α αp2 U αp2 −α αp2 U

− (1−α)p p1
+ (1−α)p1 p1
Hp = αp −α 1
αp2 −α−1 α2 p2 U
2
(1−α)p1
αU − (1−α)p1 (1−α)p1

0 0
= αp2 −α = .
(1−α)p1 [αU − αU 0
Verify Prop. 3.G.3:

∂x∗ ∂x∗ −αm ∂x∗ −(1−α)m ∂x∗ ∂x∗
From above, i
∂pj
= 0 for i = j and 1
∂p1
= p21
; 2
∂p2
= p22
. Also, ∂m
1
= α
p1
and ∂m
2
= 1−α
p2
.
∂x∗ ∂x∗ ∂h∗ −α αU
So, for example, 1
∂p2 + x∗2 ∂m1 = 0 + (1−α)m α
p2 p1 . From the Hessian above, 1
∂p2 = αp2
(1−α)p1 p1 .
(1−α)m 1−α
Evaluating at U = U ∗ (p, m) = ( αm
p1 )
α
p2 yields
−α α
∂h∗1 αp2 α αp2 (1 − α)
= m
∂p2 (1 − α)p1 p1 (1 − α)p1 p2
∗ ∗
αm(1 − α) ∂x1 ∂x
= = + x∗2 1
p1 p2 ∂p2 ∂m
The others are verified analogously.
Verify Prop. 3.G.4:
α−1 1−α α−1 1−α 2

∂U ∗ αm (1 − α)m αm α 1−α α m
=α − 2 =−
∂p1 p1 p2 p1 p1 p2 p1

∂U ∗
α 1−α
α 1−α
= .
∂m p1 p2
So,
∂U ∗ −1
α2 m α αm
= x∗1
∂p1
− ∂U ∗
= 2 =
∂m
p1 p1 p1
Similar for x∗2 .
9. (MWG #3.G.3(c) and (e))
c. From exercise 5 of lecture 13,

 
α(α − 1)/p21 αβ/p1 p2 αγ/p1 p3
γ
α β
Dp h(p, u) = u(p1 /α) (p2 /β) (p3 /γ) αβ/p1 p2 β(β − 1)/p22 βγ/p2 p3  .
αγ/p1 p3 βγ/p2 p3 γ(γ − 1)/p23
We will verify the Slutsky equation for the slope of the demand for commodity 1 with respect to the
price of commodity 2:
∂x1 ∂h1 ∂x1
= − x2 .
∂p2 ∂p2 ∂w
The first step is to derive the Marshallian demands, which are
α
x1 = b1 + (w − p · b)
p1
β
x2 = b2 + (w − p · b)
p2
γ
x3 = b3 + (w − p · b) ,
p3
where b = ( b1 b2 b3 ). Therefore, for the Slutsky Equation we must check whether

α αβ β α
−b2 = u(p1 /α)α (p2 /β)β (p3 /γ)γ − b2 + (w − p · b) ,
p1 p1 p2 p2 p1
where u = u∗ (p, w) = [w − p · b][(α/p1)α (β/p2 )β (γ/p3 )γ ] (from inversion of the e∗ obtained in exercise
5 of lecture 13). Substituting for u makes the condition to be checked become

α [w − p · b]αβ β α
−b2 = − b2 + (w − p · b)
p1 p1 p2 p2 p1
α α
−b2 = −b2 ,
p1 p1
which is clearly true. The others are verified analogously.
e. Once we have verified the Slutsky equation for all three commodities with respect to all three prices,
the matrix we are dealing with is just the Hessian of e reproduced above. We already showed in exercise
5a of Lecture 13 that this matrix is negative semidefinite. Although we did not explicitly note that
its rank is 2, we observed: 1) the 1 × 1 naturally-ordered principle minor is strictly negative, 2) the
2 × 2 naturally-ordered principle minor is strictly positive, and 3) the 3 × 3 naturally-ordered principle
minor is zero. This means the rank is 2.
10. (MWG #3.H.5) By equation (3.E.1), we can recover the expenditure function by simply inverting the
indirect utility function. To get the direct utility function, first use Roy’s identity to obtain the Marshallian
demands. Now we have U ∗ and x∗ . We are then looking for a function U (x) such that U (x∗ ) = U ∗ . To
find U , we must eliminate the prices and income from our system of equations. Set x = x∗ and solve this
system of n equations for the n relative prices pi /m, for i = 1, . . . , n. The solutions will depend only on
x, due to the homogeneity of x∗. Now substitute these “solutions” for the relative prices into U ∗ . Due to
homogeneity, U ∗ only depends on relative prices, so after the substitution we have U ∗ depending only on
x. This is the direct utility function. Alternatively (actually, equivalently), we can set x = h∗ and solve
this system of n equations for the n prices. The solution will depend on x and Ū , so call it p(x, Ū). Then
write the identity p(x, Ū) · x = e∗ (p(x, Ū), Ū ) and solve this for Ū . The solution depends only on x, and
is the direct utility function.
11. (MWG #3.H.6) By equation (3.H.2), ∂e(p, u)/∂p = αe(p, u)/p . The derivatives of e bear this relation-
α
ship with the value of e when e takes the form e(p, u) = β(ΠL
=1 p ) for some β that does not depend on
−α
prices. A convenient choice of β is β = (ΠL
=1 α )u, because then we obtain e(p, u) = (ΠL α
=1 (p /α ) )u.
α
This is the expenditure function of the Cobb-Douglas utility function u(x) = ΠL
=1 x .
Solutions to Exercises for Lecture 16 (Consumer Welfare)

1.
EV for a Price Decrease (Normal Good). The dark shaded area is the Deadweight Loss.
EV is both the light and dark shaded areas.
CV for a Price Decrease (Normal Good). The dark shaded area is the Deadweight Loss.
CV is both the (negative) light and dark shaded areas.
228 SOLUTIONS TO EXERCISES FOR LECTURE 16 (CONSUMER WELFARE)
2.
EV for a Price Increase (Inferior Good). The dark shaded area is the Deadweight Loss.
EV is both the (negative) light and dark shaded areas.
CV for a Price Increase (Inferior Good). The dark shaded area is the Deadweight Loss.
CV is both the light and dark shaded areas.
3. (MWG #3.D.4)
a. A utility function that represents the preference relation takes the form (MWG, p. 50)
U (x) = x1 + φ(x2 , · · · , xn ).
We wish to maximize this subject to p · x = m. Solve the budget constraint for x1 and substitute into
U to obtain the alternative problem
m pi
L
max − xi + φ(x2 , · · · , xL).
(x2 ,··· ,xL ) p1 p
i=2 1
Call this objective function f(x2 , · · · , xL), and consider the transformation of f given by
m
h(f) = f − .
p1
This transformation is strictly increasing in f, so it makes no difference whether we maximize f or
h(f). But,
L
pi
h(f) = − xi + φ(x2 , · · · , xL),
p
i=2 1
which does not depend on m. Hence, the optimal choices of x2 , · · · , xL cannot depend on m. This is
because of the linearity of U in x1 , which causes m to drop out of the optimization. From the budget
constraint,

L
∂x∗i
pi = 1.
∂m
i=1
∂x∗
Since x∗i is independent of m for i = 2, · · · , L, this means ∂m
1
= 1
p1 .
b. From the alternate formulation of the maximization problem,
m pi ∗
L
U ∗(p, m) = − x + φ(x∗2 , · · · , x∗L).
p1 p1 i
i=2
Since x∗2 , · · · , x∗L do not depend on m, only the first term here depends on m. Hence, just let everything
else be some function of p, say g(p), so that
m
U ∗ (p, m) = + g(p).
p1
With p1 normalized to one, this is the specified form.

L
c. In the alternative formulation of the problem, the constraint x1 ≥ 0 becomes m
p1 − pi
i=2 p1 xi ≥ 0.
Hence, even with the transformation h, m is still present in the problem through this constraint. As
long as the constraint does not bind at the optimum, the demands for x2 , · · · , xL will be (locally)
independent of m. In particular, for the L = 2 case we have an FOC of
p2
− + η (x∗2 ) = 0
p1
230 SOLUTIONS TO EXERCISES FOR LECTURE 16 (CONSUMER WELFARE)
(assuming η is increasing and concave). Hence, as long as this yields x∗2 < m
p2 the constraint is not
binding and therefore x∗2 is locally independent of m. A sufficient condition for this is η ( pm2 ) < p2
p1 ,
m
because then the choice of x2 = p2 yields a negative derivative, so it is optimal to reduce x2 and
thereby satisfy the constraint automatically. Thus, assuming η is concave and η (0) > p2
p1
(otherwise
the consumer never buys x2 ), we have
m
p2 , when m
≤ x̄2
x∗2 =
p2
m
x̄2 , when p2 > x̄2 ,
where x̄2 is the value of x2 satisfying − pp21 + η (x̄2 ) = 0 (unique if η is strictly concave).
4. (Varian #10.2) Ellsworth’s demand functions for the x-good and the y-good take the form
150
x=y= .
px + py
Plugging this into the utility function, we find that the indirect utility function takes the form
150
v(px , py , 150) = .
px + py
Hence A is the solution to

150 − A 150
= .
1+1 1+2
and B is the solution to

150 150 + B
= .
1+1 1+2
Solving, we have A = 50 and B = 75. Of course, A is the equivalent variation of the price increase and
B is the compensating variation of the price increase.
5. (MWG #3.I.2) Denote the deadweight loss given in equation (3.I.5) by DW1 (t) and the one in equation
(3.I.6) by DW0 (t). Then

∂h1 (p01 + t, p̄−1 , u1 )
DW1 (t) = h1 (p01 + t, p̄−1 , u1 ) − h1 (p01 + t, p̄−1 , u1 ) + t
∂p1
0 1
∂h1 (p1 + t, p̄−1, u )
= −t .
∂p1

Hence DW1 (t) ≥ 0 for all t ≥ 0 and DW1 (0) = 0. It can be similarly shown that DW0 (t) ≥ 0 for all t ≥ 0
∂h1 (p,u0 )
and DW0 (0) = 0. Note that if h1 (p, u) is strictly decreasing, then ∂p1 < 0 and the derivative above
is then strictly positive for t > 0. If we look at the graph, we see that the deadweight loss comes from the
change in quantity along the Hicksian demand that occurs when the price changes. Hence, there is always
deadweight loss when the Hicksian demand is strictly downward-sloping, but if the Hicksian demand is
vertical then quantity does not change and so there is no deadweight loss.
232 SOLUTIONS TO EXERCISES FOR LECTURE 17 (CONSUMER DUALITY)
Solutions to Exercises for Lecture 17 (Consumer Duality)
1. (Varian #9.8)
a.
∂e∗
= exp(a − bp + ce∗ ).
∂p
Then invert to get U ∗ .
b. Using the normalization Ū 0 = m0 in the notes, e∗ (p0 , Ū 0 ; p0 ) = Ū 0 for some given (p0 , Ū 0 ) >> 0.
2. (MWG #3.G.10)
1. Homogeneous of degree 0 in (p, m) :
a(p) must be homogeneous of degree 0 in p
b(p) must be homogeneous of degree −1 in p
2. Monotonicity:
a(p) and b(p) must both be nonincreasing
b(p) must be positive when p >> 0.
3. Quasiconvexity:
Since a(p) is homogeneous, Euler’s equation yields

n
∂a(p)
pi = 0.
∂pi
i=1
∂a(p)
Since a(p) is nonincreasing, ∂pi ≤ 0. So, at p >> 0 we have ∂a
∂pi = 0. That is, a(p) is a constant,
independent of p. Thus, for quasiconvexity we must have b(p) quasiconvex.
4. Continuity: Since a(p) is constant, it is continuous. So, we need b(p) continuous. This automatically
yields U ∗ (p, R1+ ) an interval from 0 to some ỹ ∀p >> 0.
3. (MWG #3.G.11) We want x∗2 as a function of x∗1 for a given p, with m varying parametrically in the
background. By Roy’s Identity,
∂a ∂b ∂a ∂b
+ m ∂p + m ∂p
x∗1 = − x∗2 = −
∂p1 1 ∂p2 2
; .
b(p) b(p)
Solving for m:

−1 ∂a −1 ∂a
m= ∂b
x∗1 b(p) + ; m= ∂b
x∗2 b(p) + .
∂p1
∂p1 ∂p2
∂p2

So, ∂b
∂p2 x∗1 b(p) + ∂a
∂p1 = ∂b
∂p1 x∗2 b(p) + ∂a
∂p2 .
Solving for x∗2 :

∂b

∂a ∂a 1
x∗2 [x∗1 b(p)
∂p2
= ∂b
+ ]−
∂p1
∂p1 ∂p2 b(p)
∂b
∂b
1 ∂a ∂p2 ∂a
+ ∂b2 x∗1 .
∂p
= ∂b
−
b(p) ∂p1 ∂p ∂p2 ∂p
1 1
Since b and a depend on neither m nor x∗ , this is a linear function of x∗1 .

234
PAST TESTS
236
Test 3: December 11, 2007
Throughout, assume market inverse (Marshallian) demand is P = 100 − Q for 0 ≤ P ≤ 100 and Q = 0 for
P > 100, where P is the price per unit and Q is the number of units sold. Assume also there are two firms
whose only costs are the constant marginal costs c1 = 50 and c2 = 72.
1. (15) Suppose the two firms compete as Cournot duopolists. Carefully draw the reaction curves, labeling
slopes, intercepts, and the equilibrium values. What is the aggregate quantity in equilibrium? What is
the equilibrium price? How much profit does each firm earn in equilibrium?
2. (5) If firm 1 is a monopoly, how much does it produce? What price does it charge? How much profit does
it earn?
3. (5) Carefully draw a graph of market demand. Mark the prices and aggregate quantities from questions
1 and 2 on your graph.
4. (10) Assume consumers’ income effects are zero at all prices under consideration. On your graph from
question 3, shade the equivalent variation when the market moves from the monopoly in question 2 to
the duopoly in question 1. Calculate this equivalent variation. Does the Cournot competition in question
1 improve social welfare relative to the monopoly situation in question 2? Explain why or why not.
5. (5) If the two firms compete as Bertrand duopolists, what price does each firm charge in equilibrium?
How much does each firm produce? What is the aggregate quantity?
6. (15) Put the price and aggregate quantity from question 5 on your graph from question 3. Continuing to
assume consumers’ income effects are zero, is society better off under Bertrand competition than under
the monopoly in question 2? Why? Contrast your answer with your answer about social welfare from
question 4.
7. (10) Suppose the two firms find a way to collude. How much should each firm produce in order to maximize
collusive profit? Suppose each firm believes they will end up in the Cournot equilibrium if they don’t
collude. How should the collusive profit be divided in order to enforce collusion?
8. (15) Suppose the two firms compete as Stackelberg duopolists with firm 1 the leader and firm 2 the follower.
Find the subgame perfect equilibrium. Use isoprofit lines to illustrate this equilibrium on your graph from
question 1. What is the equilibrium price? How much profit does each firm earn in equilibrium? Still
238 TEST 3: DECEMBER 11, 2007
assuming consumers’ income effects are zero, is society better off under this Stackelberg competition than
under the monopoly situation in question 2? Explain why. Contrast your answer with your answer about
social welfare from question 4.
9. (5) Suppose the two firms are each price-takers. What are the equilibrium price and market quantity?
How much does each firm produce in equilibrium?
10. (15) Now change the assumption that income effects are zero. In particular, suppose the good is normal.
Does this change your answer from question 4 about whether society is better off under Cournot competi-
tion than the monopoly in question 2? Does it change your answer from question 6 about social welfare?
Does it change your answer from question 8 about social welfare? Draw graphs to illustrate and explain
your answers.
Test 2: November 6, 2007
1. (20) Consider a price-taking firm with cost function

y when y ≤ 1
c(y) = 1 +
2y2 − 1 when y > 1
where y ≥ 0 is the level of output and the input prices are constant and therefore suppressed. Assume
α% of the fixed cost are avoidable.
a. Derive the avoidable, average, marginal, and average avoidable cost expressions. Carefully graph the
latter three curves, labeling important points on the graph.
b. Derive the supply curve for this firm.
2. (25) Consider a price-taking consumer with fixed money income and utility function U (x1 , x2 ) = x1 +g(x2 )
on the consumption set R2+ , where g is a twice differentiable function with g > 0 and g < 0.
a. Write the first order conditions for utility maximization.
b. Manipulate the conditions from part a to obtain an equation that implicitly defines the Marshallian
demand for x2 (assuming both x1 and x2 are positive at the optimum).
c. From your equation in part b, how does a change in income affect consumption of x2 ?
d. What do you conclude from this about the Hicksian demands for x2 ?
3. (30) Here is an incompletely defined function that we suspect might be a cost function:

∗
3w2 y when w1
w2 ≥2
c (w1 , w2, y) = .
3w1 y when w2
w1 ≥2
We want to retrieve an implied input requirement set
H(y) = {(x1 , x2 ) ∈ R2+ : w1 x1 + w2 x2 ≥ c∗ (w1 , w2 , y) ∀(w1 , w2) >> 0}
that would yield c∗ as a cost function.
a. First consider price pairs satisfying w2

w1
≥ 2. Which among such pairs make w1 x1 + w2 x2 smallest for
any given (x1 , x2 )? Infer from this a condition that every (x1 , x2 ) pair in H(y) must satisfy.
b. Now do the same thing for price pairs satisfying w1

w2 ≥ 2. Specifically, state a condition that every
(x1 , x2 ) pair in H(y) must satisfy from the w1

w2
≥ 2 scenario.
c. Combine your answers to parts a and b to give a proposed H(y) set. Graph your proposed H(y).
240 TEST 2: NOVEMBER 6, 2007
d. Using your proposed H(y), define c∗ (w1 , w2 , y) when 1

2 < w1
w2 < 2 so that c∗ really is the cost function
associated with H(y).
4. (25) Consider a price-taking consumer with utility function on R2+ given by

x1 + x2 x2
when x1 =
U (x1 , x2 ) = .
x1 + x2 + 1 when x1 = x2
a. Carefully draw the indifference curve for utility level Ū > 1. Label the intercepts and any other
important points.
b. Comment on the properties of this consumer’s preferences.
c. Derive the expenditure function for values of Ū exceeding 1.

Test 1: October 4, 2007
1. (40) Here is a production set: Z = {(0, 0), (−1, 2), (−3, 3), (−4, 5))} (i.e., 4 points in R2 ).
a. (3) Carefully draw Z.
b. (3) Does Z possess the possibility of inaction property? Why?
c. (3) Does Z possess the no free lunch property? Why?
d. (3) Does Z possess the free disposal property? Why?
e. (18) Let p1 be the price of the first commodity and p2 be the price of the second commodity. Derive
the profit function.
f. (10) Suppose the following points were added to Z:
{(z1 , z2 ) : (z1 , z2 ) < (0, 0) or (z1 , z2 ) < (−1, 2) or (z1 , z2 ) < (−3, 3) or (z1 , z2 ) < (−4, 5)}.
How would your answers to a-e change, if at all?
2. (30) Consider the following optimization problem:
min K subject to g(K, L) ≥ q,

{K,L}
where g is a “well-behaved” real-valued function of the two variables K and L, and q is a parameter.
Suppose we write the Lagrangian function as
L = K − λ[g(K, L) − q].
Let (K ∗ , L∗ , λ∗ ) be the unique interior solution to this problem. What does λ∗ measure? What property
would the choice of K and L have if λ were above λ∗ ? What property would the choice of K and L have
if λ were below λ∗ ? Why?
3. (30) Suppose there are two inputs, x1 and x2 , and that w1 and w2 are the prices of one logarithmic unit
of x1 and x2 , respectively, so that the cost minimization problem is
min w1 ln x1 + w2 ln x2 subject to f(x1 , x2 ) ≥ y.

{(x1 ,x2 )≥0}
Is the resulting cost function homogeneous and concave in (w1 , w2)? Why or why not?
1. (20) Suppose there is a consumer whose preferences do not have the local nonsatiation property. Draw
an Edgeworth box showing why the first welfare theorem might not hold. Fully explain your drawing.
2. (15) A monopolist produces output y with constant marginal cost c ≥ 0. The inverse demand for y is
p = α − βy for y ≥ 0, where α > c and β > 0. Find the monopoly output, price, and profit. Also find the
deadweight loss caused by the monopoly under the assumption that there are no income effects on this
good.
3. (30) Two homogeneous-products Bertrand duopolists each have constant marginal cost c = 4 and compete
for market inverse demand p = 20 − y for y ≥ 0. These two sellers choose prices simultaneously (they split
the market if they charge the same price). However, the only possible prices they can choose are either
p = 10 or p = 6 (i.e., each sellers’ strategy space is the doubleton {10, 6}).
a. Describe Nash equilibrium in this model.
b. What, if anything, about equilibrium changes if the two possible prices are p = 10 and p = 7? Why?
c. Now suppose the players move sequentially, with one of them (the leader) credibly committing to a
price that is observed before the other (the follower) makes a price choice. Describe equilibrium if the
only possible prices are p = 10 and p = 6. Describe equilibrium if the only possible prices are p = 10
and p = 7.
4. (35) Consider the following economy. There are two commodities, x1 and x2 . Let p denote the price of x1
√
and assume the price of x2 is normalized to one. There is one firm with production function x1 = 2 x2
3/2
2/3 2/3
for x2 ≥ 0. There is one consumer with utility function U = x1 + x2 . This consumer is endowed
with x̄2 = 3 units of good x2 . This consumer is also the sole owner of the firm. Suppose the firm and the
consumer each acts (separately) as a price-taker. Find the equilibrium value of p.

1. (35) Here is a utility function on R2+ : U (x1 , x2) = x2 − (x1 − 1)2 .
a. (10) Carefully graph a few indifference curves, labeling the utility level of each curve, and also labeling
the coordinates of and slopes at points on the axes, if any.
b. (15) State whether the preferences represented by this utility function have each of the following
properties, and explain why:
Completeness
Transitivity
Continuity
Local Nonsatiation
Weak Monotonicity
Convexity
c. (10) Find the Marshallian demands.
2. (35) Here is a utility function on R2+ : U (x1 , x2) = x1 x2 + x1 . Let pi denote the price of commodity i and
m denote money income. Assume p1 = 1 and m = 50. Find the deadweight loss in consumer welfare due
to an increase in p2 from p̂2 = 2 to p̃2 = 4.
3. (30) Consider a consumer whose preferences on R3+ satisfy completeness, transitivity, continuity, and local
nonsatiation. Let x∗i denote the Marshallian demand for good i, h∗i the Hicksian demand for good i, pi the
price of good i, and m money income. Here is some information about this consumer’s demand behavior
at prices p1 = 1, p2 = 2, p3 = 6 and income m = 10:
∂x∗1 ∂x∗1 ∂h∗1

= −5, = 2, and = −10.
∂p2 ∂p3 ∂p1
Suppose further that the income effect on the Marshallian demand for commodities 2 and 3 are zero at
these prices and income level. What is the Marshallian quantity demanded of commodity 1 at these prices
and income level?

244 TEST 1: OCTOBER 5, 2006
1. (20) Here is an optimization problem:
f ∗ (a) =
1/3 1/9 1/5 2/7
max x1 x2 x3 x4 x5 + x1 x2 x54 x5 + x3 x4 x5 + a2 x 3
{x1 ,x2 ,x3 ,x4 ,x5 }

5
subject to pi xi = y and xi ≥ 0,
i=1
where a, pi , and y are all positive numbers. Assume there is an interior solution.
a. What happens to the optimal choice of x3 when a changes? Why?
b. What happens to f ∗ when a changes? Why?
c. Give an explanation for why f ∗ (a) ≥ 2x∗3 (a).
2. (20) Here is a production function for a price-taking seller that can use the inputs x1 and x2 :

0 if x1 ≤ 1
f(x1 , x2 ) = .
min{x1 − 1, x2} if x1 > 1
a. Find the cost function c∗ (w1 , w2 , y), where wi is the price of xi and y is the output level.
b. Use the cost function to describe the optimal supply behavior of this seller.
3. (25) Suppose the only thing you know about a production set Z is that it is sufficiently well-behaved to
ensure that a profit maximum exists for every price vector. Which of the standard properties of the profit
function hold, and why? Which properties do not hold, and why?
4. (35) Suppose the real-valued function g(θ, γ) has the following properties: Homogeneous of degree 1,
concave, and nondecreasing in θ; strictly increasing in γ; and differentiable in (θ, γ) (recall that differen-
tiability of a function implies continuity). Here, θ ∈ RN

++ and γ ∈ R+ . Define:
1
H(γ) = {x ∈ R+
n : θ · x ≥ g(θ, γ) ∀θ >> 0}.
Think of H as a hypothetical production technology expressed in terms of input requirement sets.
a. Identify which standard properties of technologies this hypothetical technology necessarily has, and which
properties might not hold. Explain why for each property.
b. Is g(θ, γ) the minimum over x of θ · x subject to x ∈ H(γ)? Why/why not?

1. (45) Consider a market with 10 identical sellers, each of which has cost function c(q) = q 2 , where q is the
quantity produced by one seller. Market demand is

780 − p, 0 ≤ p ≤ 780
Q= ,
0, 780 < p
where Q is aggregate quantity and p is price per unit.
a. (5) Derive the market equilibrium price and quantity when each seller behaves as a price-taker.
b. (10) Derive the market equilibrium price and quantity when each seller behaves as a Cournot competi-
tor.
c. (10) How much deadweight loss is created by Cournot behavior?
d. (5) What will happen in this market if there is free entry and a large number of identical potential
entrants?
e. (15) Suppose additional sellers with identical cost function can enter this market except that each
entrant incurs a $1,000 sunk cost of entry. Each potential entrant anticipates before entry that, after
entry, Cournot equilibrium will occur among the firms that have entered. How many firms will be in
the market in equilibrium?
2. (15) Suppose there is only 1 seller in question 1 who behaves as a monopolist. What price and quantity
will the seller choose? What is the price elasticity of demand at the seller’s choice? Based on the elasticity,
what is the seller’s percent markup (Lerner Index)?
3. (40) Suppose all buyers and sellers in a private-ownership economy have “well-behaved” production sets
and preferences, except that there is a consumer whose preferences do not satisfy local nonsatiation.
a. (20) Is it possible that a competitive equilibrium is Pareto efficient? If so, give an example of a Pareto
efficient competitive equilibrium (a graph will suffice). If not, explain why not.
b. (20) Is it possible that a competitive equilibrium is not Pareto efficient? If so, give an example of a
competitive equilibrium that is not Pareto efficient (a graph will suffice). If not, explain why not.
1. (30) Assume the consumption set is R3+ and the preferences of a consumer are as follows: Utility increases
√
by x1 units when consumption of good 1 is x1 units; utility increases by x2 units when consumption of
good 2 is x2 units; utility decreases by x3 units when consumption of good 3 is x3 units.
a. (15) Explain whether the preferences are complete, transitive, continuous, locally nonsatiable, convex,
and monotonic.
b. (15) Find the Marshallian demands and the indirect utility function.
2. (35)

a. (10) Here is a proposed Marshallian demand: x∗ (p1 , p2 , m) = m 2m
3p1 , 3p2 . Can this be a Marshallian
demand for a consumer with complete, transitive, and continuous preferences on R2+ ? Explain why.

b. (10) Here is a proposed Hicksian demand: h∗ (p1 , p2 , Ū) = Ū pp21 , Ū pp12 . Can this be a Hicksian
demand for a consumer with complete, transitive, and continuous preferences on R2+ ? Explain why.
c. (15) Can the proposed Marshallian demand given in question a be for the same consumer as the
proposed Hicksian demand given in question b? Explain why.
3. (35) Suppose a consumer has Hicksian demand h∗ as defined in question 2.b. The government is consider-
ing the following two taxes for this consumer. Tax A charges t% on the amount spent on good 1. That is,
if the price received by the seller is p1 then the price paid by the consumer is (1 + t)p1 . Tax B reduces the
consumer’s income by an amount T . That is, if income is m before paying the tax then income is m − T
after paying the tax. Suppose prices p1 and p2 are not affected by these taxes, and that the government
calculates T so that the consumer is indifferent between Tax A and Tax B.
a. (10) Derive an expression for the government’s revenue from Tax A in terms of income m, prices p1
and p2 , and the tax rate t.
b. (15) Derive an expression for the government’s revenue from Tax B in terms of income m, prices p1
and p2 , and the tax rate t.
c. (10) Show which tax collects more revenue for the government.
1. (25) Here is an optimization problem:
g∗ (a) = min g(x; a), where g(x; a) = 2x4 − a3 x.

{x}
a. (5) Find x∗ (a), the optimal choice of x.
b. (5) Graph g as a function of a, with x fixed at an arbitrary positive value. Take care to label the
intercepts and to correctly depict the slope and curvature.
c. (10) Now suppose that the fixed value of x in part b is x∗ (a0 ) for some particular value a0 of a. Add
g∗ (a) to your graph in part b without actually deriving g∗ (a).
d. (5) Based only on your graph in part c, can you tell whether g∗ (a) a concave function? Why/why not?
2. (25) Here is a graph of a production set Z:
a. (20) Which of the properties 1-7 discussed in class does this technology have? Explain why for each
property.
b. (5) Does the “abnormality” in Z affect the profit function? Why/why not?
√
3. (25) Here is a cost function: c∗ (w1 , w2 , w3, y) = w1 + w2 w3 (ey − 1).
a. (5) Find the conditional factor demands.
b. (20) Verify that the matrix of demand slopes is symmetric and negative semidefinite. Also verify that
the change in marginal cost when a price changes equals the change in the corresponding input when
output changes.
4. (25) Here is a production function:

0, 1
4
≤ x1 < 1 1
f(x1 , x2 ) = √ (x1 < is impossible).
x2 , x1 ≥ 1 4
a. (10) Find the cost function.
b. (15) Suppose w1 = 12 and w2 = 1. Find the supply curve for a firm that is a price-taker in the output
market. Carefully graph the supply curve.

Throughout this test, assume:
• We are studying a market with aggregate inverse demand P = 10 − 2Q for 0 ≤ Q ≤ 5, where P is market
price and Q is market quantity.
• All firms produce homogeneous products and are identical with cost function

6q − q 2 , 0 ≤ q ≤ 2
C= ,
4 + 2q, 2≤q
where q is the output of one firm and C is the cost of one firm.
• Consumer welfare can be measured by Marshallian consumer surplus.
1. (5) Carefully draw the demand, marginal cost, and (market) marginal revenue curves on one graph. Label
the intercepts, slopes and points where the curves cross.
2. (5) Is there a pure price-taking equilibrium in this market? If so, what is it?
3. (10) What is the monopoly output and price?
4. (10) What is the socially efficient output level?
5. (5) Compare your answers to questions 2 and 4. Explain why your answers are consistent with the First
Theorem of Welfare Economics.
6. (10) Calculate the deadweight loss in the monopoly outcome.
7. (10) Find the Cournot duopoly symmetric Nash equilibrium output of each firm, and the equilibrium
price.
8. (10) Calculate the deadweight loss in the Cournot duopoly Nash equilibrium (be careful!).
9. (10) Compare your answers to questions 6 and 8, and give an economic explanation.
10. (5) At what price does a single seller make zero profit?
11. (10) Is the price you found in question 10 a Nash equilibrium price in a Bertrand duopoly? Explain why
or why not.
12. (10) Suppose firm 1 is the leader and firm 2 is the follower in a Stackelberg duopoly. Find the subgame
perfect Nash equilibrium strategy profile (state the equilibrium strategies carefully!).
1. (35) Suppose the consumption set is X = R2+ , and for (x1 , x2 ) ∈ R2+ and (y1 , y2 ) ∈ R2+ we have preference
defined as follows:
∼
(x1 , x2 ) (y1 , y2 ) ⇔ either x1 + x2 ≥ 1 or y1 < 1.

∼
State whether these preferences have each of the following properties, and explain why in each case (5
points each):
a. Complete?
b. Transitive?
c. Continuous?
d. Local Nonsatiation?
e. (Weak) Monotonicity?
f. Convexity?
g. Is there a utility function that represents on R2+ ? If so, give one such function. If not, explain why
∼
not.
2. (45) Here is a utility function for a price-taking consumer of two commodities x1 ≥ 0 and x2 ≥ 0:

min{x1 , x2 } when 0 ≤ min{x1 , x2 } ≤ 1
U (x1 , x2 ) = .
min{2x1 − 1, x2 } otherwise
Let m be money income, p1 be the price of x1 , and p2 be the price of x2 .
a. (20) Suppose income is m = 5 and the price of x2 is p2 = 1. Carefully draw a graph illustrating the
substitution and income effects of a decrease in the price of good 1 from p1 = 9 to p1 = 1. Calculate
the substitution and income effects on the quantity demanded of x1 .
b. (15) Derive the Hicksian demand functions and the expenditure function for this consumer.
c. (10) Verify that the expenditure function you derived in part b has the 4 properties required of every
expenditure function.
3. (20) Here is a pair of Marshallian demands for a consumer of two goods, in standard notation:
m 3m
x∗1 (p1 , p2 , m) = , x∗2 (p1 , p2 , m) = .
4p1 4p2
Here is an indirect utility function for a consumer of two goods, also in standard notation:
m3
U ∗ (p1 , p2 , m) = .
p1 p22
Is it possible that the given Marshallian demands are for the same consumer (i.e., same preferences) as
the given indirect utility function? Explain why or why not.

1. (30) Suppose there are two commodities in the world and a production set consists of the following five
pairs of the two commodities:
Z = {(0, 0), (−1, 1), (1, −2), (−3, 2), (−4, 3)}.
a. (15) Determine whether this technology has the following properties, and explain why in each case:
Closed, Nonempty, Possibility of Inaction, Convexity, No Free Lunch, and Free Disposal.
b. (15) Let p1 and p2 denote the prices of commodities 1 and 2, respectively. Find the profit function
π ∗ (p1 , p2) for a profit-maximizing price-taking producer.
2. (20) Here is a Hessian matrix with respect to (w1 , w2 , w3 ) of a function that depends on (w1 , w2 , w3 ) and
y, evaluated at a particular point where (w1 , w2, w3 ) and y are all positive:
 
−1 1 0
 1 −3 0 .
0 0 −1
If we interpret (w1 , w2, w3 ) as input prices, can the function be a cost function for a price-taking cost-
minimizing producer? Explain why or why not.
3. (40) Here is a production function for a single-output (y) producer who uses the two inputs x1 ≥ 0 and
x2 ≥ 0:

min{x1 , x2} when 0 ≤ y ≤ 1
y= .
min{2x1 − 1, x2 } when 1 < y
a. (10) Draw enough isoquants to make clear the basic shape of the isoquant family.
b. (15) Let w1 denote the price of x1 and w2 denote the price of x2 . Find the cost function for a price-taking
cost-minimizing producer.
c. (10) Plot the average and marginal cost functions on one graph. Label important points on the graph.
d. (5) Suppose w1 = 4, w2 = 1, and the price of output is p = 4. How much will a profit-maximizing
price-taking seller produce?
4. (10) Use the envelope theorem to prove that standard profit functions are homogeneous of degree one.

1. (50) Suppose there are a large number N of buyers of a final product. The buyers each buy at most one
unit and are each willing to pay up to $A for that one unit (A is the same for all N buyers).
a. (5) Draw the aggregate demand curve for the final product.
b. (5) Assume sellers are price-takers who all have constant marginal cost C and no other cost. Is there
a competitive equilibrium in this market? Why? If so, what is it?
c. (5) Now assume one of the sellers described in item b is a monopolist. What will the monopolist do?
d. (5) Compare and contrast the efficiency (Marshallian consumer surplus plus profit) of the equilibria in
items b and c.
e. (8) Now assume there are two sellers who compete by choosing quantities simultaneously and nonco-
operatively. Seller 1 has constant marginal cost C1 and seller 2 has constant marginal cost C2 . Assume
C1 < C2 < A, there are no other costs, and both sellers know all these parameters. Find all Nash
Equilibria and explain why they are equilibria.
f. (7) Now assume the duopolists described in item e compete by choosing prices simultaneously and
noncooperatively rather than quantities. Find all Nash Equilibria, and explain why they are equilibria.
g. (7) Now assume seller 1 described in item e is a Stackelberg leader and seller 2 is a Stackelberg follower.
Find all Nash Equilibria. What happens if the roles of leader and follower are reversed?
h. (8) Compare and contrast the efficiency (Marshallian consumer surplus plus profit) of the equilibria in
items e, f, and g.
2. (15) Suppose a small city sells licenses to taxi drivers. A taxi cannot operate in the city without a license.
The licensed taxis compete as identical Cournot competitors with aggregate inverse demand P = α − 10
1
y,
where P is the market price and y is aggregate output. Each taxi has total cost c(yi ) = yi2 , where yi is the
output of taxi i. Suppose the city wants to maximize its revenue from license sales. How many licenses
should the city sell?
3. (35) One way the problems with potential nonexistence of long-run perfectly competitive equilibrium
might be ameliorated is if the sellers’ collective use of scarce inputs drives up the price of those inputs.
This increases all costs as the size of the industry grows, and thereby limits the size of the industry.
" #
To model this, suppose there are many identical potential sellers with cost function c(y) = F + 12 y2 n,
where y is the output of one seller and n is the number of sellers who are producing positive quantity.
a. (5) Carefully draw the AC and M C curves when there is one active producer.
b. (5) Carefully draw the AC and M C curves where there are two active producers. What is the long-run
supply of two producers?
c. (10) What is the long-run supply curve of the industry, and how does it differ from the long-run industry
supply that we would have if cost did not depend on n?
d. (15) Suppose market inverse demand is p(Y ) = α − Y , where Y is aggregate industry output. For what
values of α is there a perfectly competitive equilibrium? How does this differ from the values of α for
which there would be a perfectly competitive equilibrium if cost did not depend on n?
1. (35) A consumer has the following utility function on the consumption set R2+ :
1
3 x1 + 23 x2 , if x2 ≥ x1
U (x1 , x2 ) = .
2
3 x1 + 13 x2 , if x2 ≤ x1
a. (5) Carefully draw the indifference curve for utility level Ū = 1.
b. (10) Derive the Marshallian demands and the indirect utility function.
c. (10) Derive the Hicksian demands and the expenditure function.
d. (10) Suppose p2 = 1. Carefully draw a graph that illustrates the substitution and income effects of a
1
change in p1 from p01 = 2 to p11 = 2.
1/2 1/2
2. (30) A consumer of two goods has Hicksian demands h∗1 = p2 Ū
p1 e and h∗2 = p1 Ū
p2 e . Suppose
p2 = 1 and money income is m = 8. Consider a change in p1 from p01 = 1 to p11 = 2. Calculate the
percent error if the change in Marshallian surplus is used to measure the welfare change rather than the
compensating variation.
PLEASE SEE THE BACK FOR QUESTION 3

3. (35) Suppose the consumption set is R2+ , which contains the following subsets:
In the graph, C and B ∩ C both include their boundaries, and B is all of R2+ except the part labeled C.
A consumer has the following preferences on R+

2 : y x if and only if either 1) x ∈ B and y ∈ B, or 2)
∼
x ∈ C. State whether these preferences have each of the following properties, and explain why in each
case (5 points each):
a. Complete?
b. Transitive?
c. Continuous?
d. Local Nonsatiation?
e. (Weak) Monotonicity?
f. Convexity?
g. Is there a utility function that represents on R2+ ? If so, give one such utility function. If not, explain
∼
why not.
1. (50) A price-taking firm produces output y from inputs x1 and x2 according to the production function

ln(6x1 + 6x2 + 1), if x2 ≤ 4x1
y= .
ln(10x1 + 5x2 + 1), if x2 ≥ 4x1
a. (10) Derive the conditional factor demand functions for x1 and x2 .
b. (5) Derive the cost function.
c. (10) Derive the supply function.
d. (10) Derive the profit function.
e. (5) Write an expression for the production set Z.
f. (10) Does this firm’s technology possess the 5 basic properties of technologies? Why?
2. (50) Here is a possible cost function for a price-taking firm, in standard notation:
c∗ (w1 , w2 , y) = 8y2 (w1 w2 )1/2 .
a. (10) Verify that this function is indeed a cost function.
b. (5) Derive the conditional factor demands.
c. (10) Assume the input prices are w1 = 2 and w2 = 8. Derive and graph the marginal and average cost
curves as functions of output y.
d. (25) Continue to assume the input prices are w1 = 2 and w2 = 8, and take as given that the production
function for this cost function is y = 12 (x1 x2 )1/4 . Derive the short-run cost function when input x1 is
fixed at x̄1 = x∗1 (2, 8, 1). Now derive the corresponding short-run marginal and average cost curves, and
graph them on the same graph with the long-run marginal and average cost curves. Be careful to draw
the curves in the correct relative positions and to label ALL important points of intersection. How
much will this firm supply in the short-run and long-run if the output price is p = 8? Give an economic
explanation for the short-run supply decision, in particular compared to fixed cost the long-run supply
decision.
1. (20) Suppose n identical firms compete by simultaneously choosing quantities of their homogeneous prod-
ucts. Market demand is P = 100 − Q for 0 ≤ Q ≤ 100 and the only non-sunk cost is constant marginal
cost equal to 20. How large must n be to assure that the Nash Equilibrium price-cost margin satisfies the
Justice Department’s guideline of being no larger than 5%? Show why.
2. (20) Suppose, in addition to the n firms described in question 1, there is an additional firm (label it
firm 0). This firm has marginal cost of 20 like all of the other firms, but selects its quantity before the
other n firms. In other words, this firm behaves as a Stackelberg leader and the other n firms behave as
simultaneous followers.
∂π0∗
a. (15) Let π0∗ (n) be the equilibrium profit of firm 0. Use the envelope theorem to show that ∂n =
−(n + 1)−1 π0∗ (n) (ignore the integer constraint on n when doing this). Only answers that use the
envelope theorem to show this will receive credit.
b. (5) How much does firm 0 produce in equilibrium?
3. (20) Suppose two firms compete by simultaneously setting prices for their homogeneous products. Market
inverse demand is P = 100 − Q for 0 ≤ Q ≤ 100. Firm 1 has constant marginal cost of C1 = 30. Firm
2 has constant marginal cost of C2 = 40. These are the only costs. Find the Nash Equilibrium prices.
Explain why your prices are equilibrium. How much does each firm sell in equilibrium?
4. (20) Suppose we have a perfectly competitive market and that all firms are identical with average cost

 10 − y,
 0<y≤5
ac(y) = 5, 5≤y≤6


y − 1, 6 ≤ y,
where y is the output of an individual firm. The market inverse demand is p(Y ) = a − Y for 0 ≤ Y ≤ a,
where Y is market quantity.
a. (5) If there is a long-run equilibrium, what must the price be?
b. (15) How large must a be in order to guarantee that there is a long-run equilibrium?
5. (20) Suppose n = 2 in question 1 and there is no possibility of entry by additional firms. How much is
one of the firms willing to pay to acquire the other firm before the quantity-setting occurs? Assume there
are no income effects. How much deadweight loss would be created by an acquisition like this?
1. (20) Suppose utility is U (x1 , x2 ) = x21 + x2 . Find the Hicksian demands and the expenditure function.
2. (25) Suppose the consumption set X is the set of nonnegative integers and a consumer has the following
preference relation: For x ∈ X and y ∈ X, x y if and only if x is an even number.

∼
a. (10) Is this preference relation complete? Why?
b. (10) Is this preference relation transitive? Why?
c. (5) Does this preference relation satisfy free disposal? Why?
3. (25) Suppose U ∗ = m(p1 +p2 )

p1 p2 is an indirect utility function. Find a utility function U (x1 , x2 ) such that U ∗
is the maximum of U (x1 , x2 ) over x1 , x2 ≥ 0, subject to p1 x1 + p2 x2 ≤ m.

√
4. (15) A consumer has expenditure function e∗ = p1 for some particular level of utility. The price p1
increases from 1 to 100. What is the compensating variation of this price change? Why?
5. (15) Suppose utility is U (x1 , x2 ) = x2 (x1 + 1). Find the Marshallian demands.
NOTATION. y =quantity of output, xi =quantity of input i, p =price per unit of y, wi =price per unit
of xi .
1. (20) Consider a price-taking firm with production function f(x1 , x2 ) = Ax1 x2 , where A > 0 is a parameter
that captures technical progress (a higher value of A means a more advanced technology). Use the
envelope theorem to show that the effect of a technical advance on the cost of producing output level y is
−mc(y)y/A.
2. (20) A price-taking firm has cost function
y y2
F+ y+1
+ 4
, y>0
c(y) =
αF, y=0
where α ∈ [0, 1] is the proportion of fixed costs that are sunk.
a. (10) Suppose α = 1. Carefully graph the firm’s supply function.
b. (10) Illustrate in qualitative terms what happens to the supply function if α < 1.
3. (30) Suppose a typical input requirement set is:
Comment on any unusual properties of this technology. Then find the profit function for a price-taking
firm with this technology.

260 TEST 1: OCTOBER 10, 2002
4. (30) Suppose c∗ (w1 , w2 , y) = yw1 .
a. (10) Verify that c∗ could be the cost function of a price-taking firm that can use two inputs to produce
output.
b. (10) Draw the economically relevant input requirement set H(y) in R2+ for arbitrary y > 0.
c. (10) Draw another input requirement set in R2+ that is consistent with c∗ but that perhaps violates
some of the standard assumptions on technologies. Which assumption(s) are violated by your input
requirement set?
1. (50) Suppose market demand is

100 − P 0 ≤ P ≤ 100
Q=
0 P > 100
where P is the price per unit and Q is the number of units sold. Assume there are two firms whose only
costs are the constant marginal costs c1 and c2 .
a. (5) If firm 1 is a monopoly, how much does it produce? What price does it charge? How much profit
does it earn?
b. (10) If the two firms compete as Cournot-Nash duopolists, how much does each firm produce at an
interior equilibrium? What is the aggregate quantity? What is the equilibrium price? How much profit
does each firm earn?
c. (15) Let P1 denote the monopoly price charged by firm 1 in part a. How much does firm 2 produce in
the Cournot-Nash equilibrium if c2 = P1 ? Assume the area under the Marshallian demand measures
consumer welfare. What happens to aggregate welfare (sum of consumer surplus and profit) in the
Cournot-Nash equilibrium when there is a small decrease in c2 from the level c2 = P1 ? Does the
introduction of Cournot competition benefit society (compared with monopoly) when the new firm has
marginal cost near the existing monopoly price? Why? What if the new firm has marginal cost near
the marginal cost of the existing monopolist? Why?
d. (10) If the two firms compete as Bertrand-Nash duopolists, what price does each firm charge in equi-
librium? How much does each firm produce? What is the aggregate quantity?
e. (10) Is society better off under Bertrand competition than under monopoly? Why? Is the conclusion
different from when the duopolists compete in quantities? Why?

2. (15) Suppose the most efficient technology looks like this:
a. (5) Is there a long-run perfectly competitive equilibrium? Why?
b. (10) What is the maximum number of firms that can produce positive output in a long-run perfectly
competitive equilibrium? What is the minimum number?
3. (35) Suppose market demand is as given in question 1. Assume there is a dominant firm with cost
function cd (Qd ) = Qd and a competitive fringe with n identical firms, each of which has cost function
cf (qf ) = 10qf + 10qf2 , where Qd is the output of the dominant firm and qf is the output of a typical fringe
firm (so Q = Qd + nqf ).
a. (15) Assume n < 180. How much does the dominant firm produce, and what price does it charge?
b. (10) What happens to the output of the dominant firm in part a if n increases? Give a graphical and
verbal explanation for this.
c. (10) How much does the dominant firm produce and what price does it charge if n > 180?
1. (20) Consider the following function for Ū ≥ 0 and pi > 0, in the notation used in class:
p1 p2 Ū
e∗ (p1 , p2 , Ū) = .
p1 + p2
Is there a complete, transitive, continuous, and locally nonsatiated preference relation on R2+ for which
∼
this equation is the expenditure function? Why?
2. (20) Consider the following system of equations for m ≥ 0 and pi > 0, in the notation used in class:
p2 m p1 m
x∗1 (p1 , p2 , m) = x∗2 (p1 , p2 , m) = .
p1 (p1 + p2 ) p2 (p1 + p2 )
Is there a complete, transitive, continuous, and locally nonsatiated preference relation on R2+ for which
∼
these equations are the Marshallian demands? Why?
3. (15) According to the function given in question 1, what is the Compensating Variation of an increase in
p1 from p01 to p11 , for given m and p2 ?
4. (10) Does the consumer in question 1 have the same preferences as the consumer in question 2? Why?
5. (20) Derive a utility function for which the equation given in question 1 is the expenditure function.
6. (15) Suppose X = {Tree, Grass, Iron, Flower} is a consumption set and is a binary relation defined on
∼
X as follows: For a ∈ X and b ∈ X, a b if and only if a is a plant.

∼
a. (8) Is complete on X? Why?

∼
b. (7) Is transitive on X? Why?

∼
264 TEST 1: OCTOBER 10, 2001
1. (30) Is the following system of equations a set of conditional factor demands for a technology that satisfies
the five basic assumptions? Why? If not, which of the five basic assumption(s) are violated by the
underlying technology? Why?

w2
w1 (y − 1) for y ≥ 1 w1
w2 (y − 1) for y ≥ 1
x∗1 (w1 , w2 , y) = ; x∗2 (w1 , w2 , y) = .
0 for 0 ≤ y < 1 0 for 0 ≤ y < 1
2. (70) Suppose a price-taking firm has the production set Z = {(y, −x) ∈ R2 : x ≥ 0 & y ≤ −2x & y ≤ 1−x}.
a. (5) Carefully draw Z, labeling slopes and critical points.
b. (5) Does Z satisfy the five basic assumptions of a technology? Why?
c. (5) Characterize the returns to scale of Z.
d. (5) Is Z convex? Why?
e. (5) What are the input requirement sets V (y) for y ≥ 0?
f. (10) Find the supply/demand function and the profit function.
g. (10) Find the conditional factor demand function and the cost function.
h. (10) Verify that your cost function has the properties of a cost function.
i. (10) Use your cost function to find average cost and marginal cost for some fixed value w >> 0 of the
input price. Graph these curves as a function of output y.
j. (5) Where is the supply function on your graph? Reconcile this graphical derivation of the supply
function with the supply function you found in part f.


1. (50) Suppose two firms compete as Cournot duopolists for aggregate inverse demand P = 150 − Q. Firm
1 has a non-sunk fixed cost of F1 = $1, 600 and a constant marginal cost of M C1 = $10. Firm 2 has a
non-sunk fixed cost of F2 = $900 and a constant marginal cost of M C2 = $20.
a. (15) Derive the reaction curves of the two firms. Graph them, labeling slopes and all critical points.
b. (10) Find all Cournot-Nash equilibria.
c. Suppose all income effects are zero for this good.
i. (10) If the market is unregulated, what is the best equilibrium aggregate welfare outcome? Why?
ii. (5) Can the outcome you identified in part i. be assured by enacting a law that makes it illegal for
one of the firms to produce, but does nothing else to regulate the firms? Why?
iii. (5) Is the outcome you identified in part i. Pareto Efficient? Why?
d. (5) Discuss equilibrium if the firms were to behave as perfect competitors.
2. (50) Suppose there are k identical price-taking consumers, each with income m and utility function
U (x, y) = ln x + ln y. Let p denote the price of x and assume the price of y has been normalized to one.
Suppose also there are E identical producers of x, each with constant marginal cost c > 0 and no fixed
costs.
a. (10) Derive the aggregate demand for x.
b. (5) Write the revenue function for the monopolist when E = 1. What is unusual about this revenue
function? What does this imply about the monopolist’s optimal behavior?
c. (5) If the firm(s) behave as perfect competitors, what is the equilibrium price of x?
d. (10) Suppose for the remainder of this problem that E ≥ 2. Derive the Cournot-Nash equilibrium
price of x as a function of the number of firms E. How many firms are required to drive the Cournot
equilibrium price down to within 10% of the perfectly competitive price?
e. (20) Derive an expression for the deadweight loss that is incurred if the government compensates
consumers for the higher price caused by the non-price-taking behavior of the Cournot oligopolists.
(HINT: From your calculations in part a, find the indirect utility function for one consumer and invert
it to obtain the expenditure function. Evaluate the expenditure function at arbitrary p and at the
optimal utility level for the perfectly competitive price, and then multiply by k to obtain the aggregate
expenditure function for the perfectly competitive utility level. Use this to derive deadweight loss.)
Suppose there are k = 1 million consumers who each have income of m = $30 thousand, and there are
enough firms to make the Cournot equilibrium price no more than 10% above the perfectly competitive
price. How large is the deadweight loss?
1. (35) Consider the preference relation defined by the following utility function for (x, y) ∈ R2+ :

U (x, y) = x2 + (y − 10)2 .
a. Carefully draw the indifference curves for utility levels Ū = 1 and Ū = 2.
b. Briefly explain why this preference relation is complete, transitive, and continuous on R2+ .
c. Is this preference relation (briefly explain why in each case)
i. Locally nonsatiated?
ii. Monotonic (strong or weak)?
iii. Convex?
d. Find the Marshallian demands.
2. (25) Consider the following system of equations defined for (p1 , p2) >> 0 and m ≥ 0:

m2
p1 p2 , if m ≤ p2 m
1− m
, if m ≤ p2
x∗1 = m
x∗2 = p2 p2
p1
, if m > p2 0, if m > p2
Demonstrate whether these equations are or are not Marshallian demands.

2 1/4
3. (20) Given the indirect utility function U ∗ (p1 , p2 , m) = pm
1 p2
, find the
a. Expenditure function.
b. Hicksian demands.
c. Marshallian demands.
4. (20) Suppose you have estimated the Hicksian demands h∗1 = Ū pp21 and h∗2 = Ū pp12 . What is the equivalent
variation of a change in p1 from p1 = 1 to p1 = 31 when income is m = 160 and p2 = 1?

1. (25) Consider the set Z = R1− .
a. (10) Demonstrate whether Z satisfies the five basic properties of a production set.
b. (5) Is Z convex? Why?
c. (5) What returns to scale does Z display? Why?
d. (5) Derive the optimal netput function and the profit function.
2. (15) Consider a firm with production function f(x1 , x2 ) = α ln(x1 +1)+(1−α) ln(x2 +1), where α ∈ (0, 1).
Take as given that the factor demands for this firm are x∗1 = pα
w1 − 1 and x∗2 = p(1−α)
w2 − 1. USE THE
ENVELOPE THEOREM to show that profit increases with a small increase in α if and only if
w2 1−α
w1 > α (Note: You will not receive credit for a proof of this unless your proof applies the envelope
theorem).
3. (25) Consider the function π ∗ (p, w) = p for p ≥ 0 and w >> 0.
a. (10) Verify that π ∗ is a profit function.
b. (15) For simplicity, suppose w is a scalar (i.e., w ∈ R1++ ). Use algebraic and geometric arguments
to draw a production set H such that π ∗ (p, w) = max py − wx subject to (y, −x) ∈ H. Does your
production set satisfy no free lunch?
PLEASE SEE THE BACK FOR THE LAST QUESTION

268 TEST 1: OCTOBER 12, 2000
4. (35) Suppose a price-taking firm has the following production set:
a. (5) What are the input requirement sets V (y) for y ≥ 0?
b. (10) Find the supply/demand function and the profit function.
c. (5) Find the conditional factor demand function and the cost function.
d. (10) Use your cost function to find average cost, average variable cost, and average fixed cost for some
fixed value w >> 0 of the input price. Graph these curves as a function of output y.
e. (5) What is the effective “marginal cost curve” of this firm? Use this to illustrate your supply function
on your graph.
1. (20) Consider a market with inverse demand p = 100 − y, where y is market output, and a large number
of potential firms who all behave as perfect competitors and who all have cost function c(yi ) = 1 + yi2 ,
where yi is the output of firm i.
a. If there is a long-run equilibrium, what is the price?
b. Is there a long-run equilibrium? If so, find it.
2. (30) Consider an economy with one firm and one consumer. The consumer’s welfare is accurately measured
by the Marshallian surplus for good 1. The only endowment is x̄2 = $m, possessed by the consumer. The
firm produces good 1 from good 2. The consumer’s Marshallian demand and the firm’s costs are:
a. Is the allocation (x̂1 , m − AC(x̂1 )) for the consumer and (x̂1 , AC(x̂1 )) for the firm feasible? Why?
b. Is the allocation in part (a) Pareto Efficient? Why?
c. Is the allocation in part (a) a (competitive) equilibrium allocation? Why?
d. Is the allocation (x̄1 , m) for the consumer and (x̄1 , 0) for the firm feasible? Why?
e. Is the allocation in part (d) Pareto Efficient? Why?
f. Is the allocation in part (d) a (competitive) equilibrium allocation? Why?
g. Relate your answers to parts (b),(c) and parts (e),(f) to the First Fundamental Theorem of Welfare
Economics.
3. (20) Consider a monopolist facing inverse demand p(y) = 100 − y with cost

0, y=0
c(y) = 2
.
1500 + y , y > 0
How much will this firm produce, and what price will it charge? How much profit will it earn?
4. (30) Suppose we have a symmetric Cournot duopoly with aggregate inverse demand p(y) = 100 − y, where
y = y1 + y2 , and cost

0, yi = 0
c(yi ) = for i = 1, 2.
1200 + yi , yi > 0
a. Derive the reaction curves for these duopolists, and graph them.
b. What do you notice about Nash Equilibrium?

1. Let X = R2+ be a consumption set and consider the following preference relation on X:
(x1 , x2) (y1 , y2 ) if and only if |x1 − 10| + |x2 − 10| ≥ |y1 − 10| + |y2 − 10|.
∼
Is this relation (say why in each case)

a. Complete?
b. Transitive?
c. Continuous?
d. Monotonic?
e. Locally nonsatiated?
f. Convex?
2. Consider the following functions

 

Ū
2, if p1
<2  0, if pp12 < 2
 p2 
h∗1 = Ū
or 0, if p1
=2 h∗2 = 0 or Ū , if pp12 = 2

 2 p2 

0, otherwise Ū , otherwise
a. Verify that these are Hicksian demands.
b. Find the corresponding Marshallian demands.
c. Verify the Slutsky Decomposition for x∗1 in response to a change in p1 .
3. Consider a consumer with utility function U (x1 , x2 , x3 ) = x1 x2 + x3 . Assume a fixed amount of good 3
is given to the consumer by the government at no charge, and the consumer cannot buy or sell good 3 at
any price. Also assume that prices p1 and p2 are fixed, and money income is fixed at m.
a. Suppose the government gift is x3 = 0. Find the Marshallian demands for x1 and x2 .
b. Use your result from part a to obtain the Marshallian demands when x3 > 0. Be sure your solution
method plainly relies on your solution to part a, and is NOT obtained by simply resolving the problem.
c. Find the indirect utility function for a fixed arbitrary level of x3 .
d. Use your result for part c to obtain the expenditure function. Again, DO NOT simply resolve the
problem.
e. Suppose income is m = 10, both prices are p1 = p2 = 1, and the amount of good 3 provided by the
government is x3 = 11. If the government wants to eliminate the gift of x3 and give income instead,
how much income must the government transfer to the consumer in order to leave utility unchanged?
272 TEST 1: OCTOBER 14, 1999
1 (25). Suppose we have a production function for a single-input technology given by f(x) = (50 − x)(2 + x).
a (15). Describe the properties of the technology in terms of the standard assumptions on production sets.
b (10). Based on your answer to part a, what standard properties will the profit function possess? Which of
the standard properties will not hold for the profit function? Answer this question by referring to the
reasons that the profit function possesses certain properties, not by deriving the profit function and
checking its properties.
2 (25). Consider a profit-maximizing firm that is not a perfect competitor in its output market. Instead, the firm
faces an inverse demand curve p(y; r), where p is its price, y is its output level, and r is the price charged by
a rival firm whose product is regarded by consumers as a substitute product. Hence the revenue function
is R(y; r) = p(y; r)y.
a (15). Use the envelope theorem to determine the effect on optimal profit of a change in the rival’s price.
b (10). Use the traditional comparative statics methodology to show that the effect on optimal output of a
change in the rival’s price depends on how the change in the rival’s price affects the slope of the inverse
demand (with respect to output).
3 (25). Suppose c∗ (w1 , w2 , y) = (y + y2 )(w1 + (w1 w2 )1/2 + w2 ). Is c∗ a cost function? Why?
4 (25). Suppose c∗ (w1 , w2 , y|x1 = x̄1 ) is a short-run cost function.
a (5). Illustrate the short-run optimal choice of x2 on an isoquant/isocost graph.
b (10). Use your graph to argue geometrically that the value of x̄1 that minimizes c∗ (w1 , w2 , y|x1 = x̄1 ) is the
long-run cost-minimizing choice of x1 , for the given w and y.
c (10). Use the result in part b to find the long-run cost function when c∗ (w1 , w2 , y|x1 = x̄1 ) = w1 x̄1 + w2 y
x̄1 .
1. Suppose aggregate inverse demand is p = 12 −y for y ≤ 12 and there are two firms. Firm one has constant
marginal cost of 4 and firm two has constant marginal cost of 10. There are no fixed costs.
a. Find the Cournot-Nash equilibrium quantities and market price.
b. Suppose firm one is a monopolist. Find the quantity and price for this monopolist.
c. Compare your answers to questions a and b, and explain the relationship.
2. Suppose the city of New York requires that each taxicab have a license. Inverse demand for taxi service is
p = 510 − y for y ≤ 510, where y is the quantity of taxi services consumed. Each taxi has cost c = 1 + y2 ,
not including the cost of the license, and each taxi behaves as a perfect competitor. There is a large
number of potential sellers of taxi services.
a. If the city auctions 100 licenses, what will the auction price of the licenses be? How much revenue does
the city receive?
b. If the city issues a license to anybody that wants one, how many licenses will be issued?
c. How much consumer surplus is lost due to the supply restriction of only 100 licenses?
d. Suppose the city gives all of the revenue from selling the 100 licenses to consumers, in a way that does
not depend on the quantity of taxi services consumed. Can the city fully reimburse consumers for their
lost surplus? If not, how much surplus is still lost after the rebate?
e. Now suppose the city wants to maximize revenue from auctioning the licenses. Let n be the number
of licenses offered for sale, so that the city’s problem is to choose the optimal n. For an individual
supplier of taxi services, the price depends on n and so the optimal profit of each supplier depends on
n. Denote this by π ∗ (n). In this notation, what is the city’s revenue from offering n licenses for sale?
(NOTE: do not attempt to find π ∗ (n)). Explain how you would use the envelope theorem in finding
the optimal number of licenses for the city (but do not actually try to find the optimal n).
3. Suppose the matrix of derivatives of a consumer’s Hicksian demands is

a b
,
2 − 12
and the prices are (8, p2 ). Find a, b, and p2 .

4. Suppose income is fixed. Can a Marshallian demand look like this?
Explain why/why not.
5. Consider the following functions:

1/2
p2
h1 = Ū b11 + b12
p1
1/2
p1
h2 = Ū b22 + b21
p2
a. Verify that these form a system of Hicksian demands if the bij parameters satisfy certain restrictions.
What are the restrictions?
b. Find the Marshallian demands.
6. Suppose is a complete preference relation on the consumption set X = Rn+ . Two properties that
∼ ∼
might possess are
NONSATIATION: For every y ∈ X, there exists x ∈ X such that x y. NOTE: This is NOT local,
since there is no requirement that x be “close” to y.
SEMI-STRICT CONVEXITY: If x y and x y then λx + (1 − λ)x y for every λ ∈ (0, 1).

∼
Assume has the nonsatiation and semi-strict convexity properties. Show that then also satisfies local
∼ ∼
nonsatiation.
1. Suppose a consumer of two goods, x1 and x2 , has utility function U (x1 , x2) = x2 − 1
x1 . Note that U can
be negative at positive values of x1 and x2 .
a. Draw a typical indifference curve for a utility level Ū that is nonnegative.
b. Find the Hicksian demands for values of Ū that are nonnegative.
c. Use your answer to b. to find the indirect utility function for values of income m and prices p1 and p2
that satisfy a certain condition. What is the condition?
d. Use your answer to c. to find the Marshallian demands for values of income and prices that satisfy
your condition.
2. Suppose is a complete preference relation on the consumption set X = Rn+ . Two properties that
∼ ∼
might possess are
NONSATIATION: For every y ∈ X, there exists x ∈ X such that x y. NOTE: This is NOT local,
since there is no requirement that x be “close” to y.
SEMI-STRICT CONVEXITY: If x y and x y then λx + (1 − λ)x y for every λ ∈ (0, 1).

∼
Assume has the nonsatiation and semi-strict convexity properties. Show that then also satisfies local
∼ ∼
nonsatiation.
3. Suppose there are two commodities (x1 , x2 ) ≥ 0, with prices (p1 , p2 ) >> 0. Consider the functions:
m m
x∗1 = and x∗2 = .
ap1 bp2
For what value(s) of the parameters a and b are these functions Marshallian demands of x1 and x2 for
some consumer with income m and locally nonsatiated preferences?
4. Let x∗i (p, m) be a differentiable Marshallian demand for good i. Fix prices p at p0 >> 0. Suppose Mr.
Giffen makes the following claim:
“There must exist an income level m0 > 0 such that x∗i is not upward-sloping in pi at (p0 , m0 ).”
Is Mr. Giffen right or wrong? Explain why.

276 TEST 1: OCTOBER 15, 1998
1. Suppose the production function for a free disposal technology is f(x1 , x2) = (x1 + x2 )2 for (x1 , x2 ) ≥ 0.
a. Draw a typical isoquant.
b. Find the cost function.
c. Suppose input 1 is fixed at x̄1 = 10. Find the short-run cost function c∗ (w1 , w2 , y|x̄1 ).
2. Consider the function c∗ (w1 , w2 , y) = (2w1α + w2 )(ey − 1) for (w1 , w2 , y) ≥ 0.
a. For what value(s) of α is c∗ a cost function? Why?
b. For these value(s) of α, characterize the returns to scale of the technology underlying c∗ . Explain why
you think the returns to scale are as you describe.
c. For these value(s) of α, find the conditional factor demands.
3. Consider the production set Z = {(z1 , z2 ) ∈ R2 : z2 ≤ 1 − (1 + z1 )2 }. Demonstrate geometrically whether
Z has each of the following properties (HINT: Carefully plot the curve z2 = 1 − (1 + z1 )2 ):
a. Nonempty.
b. Closed.
c. Possibility of inaction.
d. No free lunch.
e. Free disposal.
f. Convex.
4. Consider the functions (for p ≥ 0 and (w1 , w2 ) >> 0):

∗ p 1 1
y (p, w1 , w2 ) = +
2 w1 w2
2
p
x∗1 (p, w1 , w2 ) =
2w1
2
∗ p
x2 (p, w1 , w2 ) = .
2w2
a. Demonstrate formally that these are profit-maximizing supply and demand functions.
b. Find the profit function.

1. A consumer has utility function U (x1 , x2 ) = (x1 + x2 )2 . Find the Hicksian demand functions.
2. Suppose a consumer has Hicksian demands:
1/2
1 p2
h∗1 (p1 , p2 , Ū ) =− +1
Ū p1
1/2
1 p1
h∗2 (p1 , p2 , Ū ) =− +1 .
Ū p2
Find the Marshallian demands (note: Ū < 0 here).
3. Consider a perfectly competitive market with demand curve D(p) and an arbitrarily large number of
actual and potential firms who all have average cost curve

 11 − y, 0 < y ≤ 10

ac(y) = 1, 10 ≤ y ≤ 11


y − 10, 11 ≤ y.
Suppose also that c(0) = 0 (i.e., their technologies have the possibility of inaction). Give a lower bound
on demand that ensures existence of a long-run perfectly competitive equilibrium with free entry and exit.
4. Consider a monopolist with inverse demand function p(y) = 7 − 12 y and cost function

10y − y2 , 0 ≤ y ≤ 5
c(y) =
∞, 5 < y.
Find the optimal output level and price for this monopolist.
5. Suppose there are three commodities in the world: Guns, Butter, and Mayonnaise. Ann, Beth, and Carol
each have complete and transitive preferences over these three goods. Pop U. List is a politician elected
by Ann, Beth, and Carol; who has the following preferences:
”I think commodity 1 is at least as good as commodity 2 if and only if a majority of my
constituents think commodity 1 is at least as good as commodity 2.”
Are Pop’s preferences necessarily complete and transitive? Why or why not?
6. Given x∗1 (p1 , p2 , m) = 2m

3p1
and x∗2 (p1 , p2 , m) = m
3p2
, demonstrate that these functions are Marshallian
demands.
7. Suppose prices on three goods are p1 = 1, p2 = 2, and p3 = 4. At these prices, the following observations
are made:
∂h∗1 ∂h∗1 ∂h∗2
= −1 =1 = −2.
∂p1 ∂p2 ∂p2
Find the Hicksian substitution matrix among these three goods at the stated prices.
1. (15) Suppose the production function is CES: f(x1 , x2) = (xρ1 + xρ2 )/ρ (ρ = 0). Find the conditional factor
demands and the cost function.
2. (10) Draw a production set that satisfies no free lunch, possibility of inaction, convexity, and regularity; but
violates free disposal.
3. (10) Draw a production set that has decreasing returns to scale but that is not convex.
4. (20) Suppose we have the function c∗ (w1 , w2 , y) = (w1 + w2 ) ln(y + 2) for w1 , w2, y ≥ 0. Check whether c∗
satisfies sufficient conditions for a cost function. If not, identify which of the standard properties the
underlying technology does not possess.

p2
5. (30) Suppose we have the function π ∗ (p, w) = w for p, w > 0 (both p and w are scalars).
a. (5) Verify that π ∗ is a profit function.
b. (10) Find the underlying production function, f(x).
c. (10) Verify that π ∗ (p, w) = max pf(x) − wx.
d. (5) Find the corresponding cost function, c∗ (w, y).
6. (15) Suppose we have the functions x∗1 (w1 , w2, y) = x∗2 (w1 , w2 , y) = ln(y + 1). Check whether x∗1 and x∗2 are
conditional factor demands.

1. (20) Given
1/2
p2
h∗1 (p1 , p2 , Ū) = Ū
p1
1/2
p1
h∗2 (p1 , p2 , Ū) = Ū .
p2
a. (5) Verify that h∗1 and h∗2 are Hicksian demands.
b. (15) Find corresponding Marshallian demands.
2. (5) Suppose the consumption set is the collection of all cars in the world. Alice has no opinion about car 1
and car 2 unless car 1 is a BMW, in which case she thinks car 1 is at least as good as car 2. Is there a
utility function that represents Alice’s preferences? Why/why not?
3. (20) Consider a consumer whose utility function is additively separable:
U (x1 , . . . , xn ) = f1 (x1 ) + f2 (x2 ) + · · · + fn (xn ),
where each fi is an increasing, concave function. Show that the Marshallian demands are downward-
sloping. (Hint: determine whether each good is normal).
4. (20) Consider a perfectly competitive industry in which all firms possess the technology summarized by the
average cost function  1


 y + y, 0<y<1
ac(y) = 2, 1≤y≤2


(y − 1) + 1
y−1 , 2 < y.
a. (5) Sketch this average cost curve.
b. (5) If there is a long-run equilibrium price pe , what is it?
c. (10) How large must market demand be at price pe in order to guarantee there is a long-run equilibrium?
5. (15) Now suppose there is a monopolist with average cost given in question 4 and market inverse demand
p = 4 − y. How much surplus is lost due to the monopoly behavior of this firm?
1
6. (15) Now suppose there are two firms with average cost ac(y) = y + y and market inverse demand given in
question 5. How much surplus is lost if these firms engage in Cournot behavior rather than perfectly
competitive behavior?
7. (5) Give a technology and input price for which the average cost function is that given in question 6.
1. (15) Decide whether each of the following technologies satisfy no free lunch, possibility of inaction, free disposal,
and convexity. Also characterize the returns to scale of each.
a) Z = {(x, y) ∈ R2 : x < 1 and y ≤ ln(−x + 1)}
b) Z = {(x, y) ∈ R2 : x2 + y2 ≤ 1}
c) V (y) = {x ∈ R2+ : x21 + x22 ≥ y}
2. (10) Suppose px = 1 and py = 0. Illustrate the profit maximizing point for a firm with technology b) in
question 1 above. Does this firm earn positive profit?
3. (20) Consider a firm with production function y = ln(x1 + 1) + x2 for x ≥ 0. Find the conditional factor
demands. How much will this firm supply if it maximizes profit with prices satisfying p = w1 = w2 ?
1 1
4. (20) Might c∗ (w, y) = ye 2 ln(w1 )+ 2 ln(w2 ) be a cost function? Why/why not? If so, find the conditional factor
demand functions.
5. (35) Consider a perfectly competitive cost-minimizing firm with a well-behaved technology that has to pay a
tax of t percent on its purchases of input 1. Thus the total cost to the firm of using 10 units of input 1 is
(1 + t)w1 10. Use the envelope theorem to show that the cost function is concave in the tax rate t.
282 TEST 1: OCTOBER 14, 1995
1. (15) Decide whether each of the following technologies satisfy no free lunch, possibility of inaction, free disposal,
and convexity. Also characterize the returns to scale of each.
a) Z = {(x, y) ∈ R2 : y ≤ (−x)3 }
b) V (y) = {x ∈ R2+ : x1 ≥ x2 }
y
c)
2. (10) Suppose px = py . Illustrate the profit maximizing point for a firm with technology c) in question 1 above.
Does this firm earn positive profit?
3. (20) Consider a firm with production function y = ex2 − 1 + x1 for x ≥ 0. Find the conditional factor demands.
How much will this firm supply if it maximizes profit with prices satisfying p = w1 = w2 ?
p2
4. (20) Might π ∗ (p, w) = 4w be a profit function? Why/why not? If so, find the supply and demand functions.
5. (35) Consider a firm with average cost function ac(y) = (ay − 1)2 + 1 for y > 0, where a > 0 is some parameter.
Suppose that, rather than maximizing profit, this firm chooses its output level y to minimize average cost.
1
Use the envelope theorem to show that this behavior yields total cost of a, no matter what the value of
a is.
SOLUTIONS TO PAST TESTS

284
Solutions to Test 3: December 11, 2007
1. The revenues are R1 = [100 − Q1 − Q2 ]Q1 and R2 = [100 − Q1 − Q2 ]Q2 , so the marginal revenues are
M R1 = 100 − 2Q1 − Q2 and M R2 = 100 − Q1 − 2Q2 . Setting these equal to the marginal costs gives the
two reaction curves:
Q2
Q∗1 (Q2 ) = 25 −
2
Q
Q∗2 (Q1 ) = 14 −
1
.
2
The simultaneous solution is Q1 = 24 and Q2 = 2. Here is the graph:
Note that the heavy dark lines are the reaction curves for firms 2 and 1 once Q1 exceeds 28 or Q2 exceeds
50, respectively. This will become important in question 8. Aggregate quantity is Q = Q1 + Q2 = 26 and
price is P = 100 − Q = 74. Profits are then
π1 = [P − c1 ]Q1 = [74 − 50]24 = 576
π2 = [P − c2 ]Q2 = [74 − 72]2 = 4.
2. Revenue is R = P Q = [100 − Q]Q, so marginal revenue is M R = 100 − 2Q. Set this equal to marginal
cost c1 = 50 and solve for Q to obtain Q = 25. Price is then P = 100 − Q = 75, and profit is
π1 = [P − c1 ]Q = [75 − 50]25 = 625.

286 SOLUTIONS TO TEST 3: DECEMBER 11, 2007
3.
4. The Hicksian and Marshallian demands coincide due to zero income effects. So the EV is the area left
of the Marshallian demand. The shaded area is 1 × 25 + 1

2
× 1 × 1 = 25.5. Profit in question 2 is 625.
Aggregate profit in question 1 is π1 + π2 = 576 + 4 = 580. So Cournot competition reduces profit by
625 − 580 = 45. Consumer surplus only goes up by 25.5, so society is worse off with the competition.
Even though aggregate quantity goes up and price goes down, thereby eliminating some deadweight loss,
production costs rise because some of the production shifts to a firm that is very inefficient. The new firm
has costs that are much higher than the old monopolist. These higher costs more than offset the gain due
to elimination of deadweight loss.
5. With Bertrand competition the firms undercut each other until price equals the marginal cost of the
high-cost firm. So P1 = P2 = c2 = 72 (note that this is below the monopoly price of firm 1, calculated
in question 2). This assumes that firm 1 sells all Q = 100 − 72 = 28 units of output at this price, so the
output of firm 2 is zero. If not, then firm 1 will undercut the price of 72 by an arbitrarily small amount
and firm 1’s output will be above 28 by an arbitrarily small amount.
6. Under Bertrand competition, price is lower and quantity is higher than under Cournot competition. So
there is an additional saving of deadweight loss beyond that saved under Cournot competition (see the
graph). Also, the low-cost firm produces all of the output under Bertrand competition, so there is no rise
in production costs (unlike the Cournot case). Hence society is unambiguously better off.
7. Firm 1 is globally more efficient than firm 2. Hence all production should occur in firm 1. The collusive
optimum is firm 1’s monopoly outcome, derived in question 2. However, firm 2 can obtain profit of $4 by
refusing to collude and thereby forcing the outcome to the Cournot solution. So at least $4 of firm 1’s
profit must be given to firm 2 to buy firm 2’s cooperation. Similarly, firm 1 can obtain profit of $576 by
refusing to collude. So no more than $625 - $576 = $49 of firm 1’s profit can be given to firm 2. Any
division of the $625 profit that gives firm 2 an amount between $4 and $49 is possible, depending on the
bargaining mechanism used to divide the profit.
8. Firm 2 (the follower) behaves as a Cournot competitor. So firm 2’s complete contingent plan is:

∗ 14 − Q21 when Q1 ≤ 28
Q2 (Q1 ) = .
0 when Q1 > 28
Firm 1 anticipates this reaction and therefore has objective function
π1 = [100 − Q1 − Q∗2 (Q1 )]Q1 − 50Q1 = [50 − Q1 − Q∗2 (Q1 )]Q1 .
Substituting Q∗2 (Q1 ) = 14 − Q1

2
, differentiating with respect to Q1 , and setting the derivative to zero
yields Q1 = 36. If we are careless, we might imagine this is the equilibrium strategy for firm 1. But
it exceeds 28, so 14 − Q1
2
is not the correct expression for Q∗2 (Q1 ) at this quantity. Indeed, Q1 = 36
imagines that firm 1 chooses the light colored tangency between an isoprofit and firm 2’s reaction curve
illustrated above in the graph for question 1. This corresponds to Q2 = −4, which is nonsensical. Instead,
the best isoprofit firm 1 can obtain touches firm 2’s reaction curve at the kink in Q∗2 (Q1 ) that occurs
when it hits the axis at Q1 = 28. This is the darker isoprofit in the graph above, which actually crosses
the line Q2 = 14 − Q1
2 but does not cross firm 2’s reaction curve because of the kink. So the subgame
perfect equilibrium is (28, Q∗2 (Q1 )) (note that firm 2’s strategy is the whole function; firm 2’s quantity in
the equilibrium is zero). The price is P = 72 and the profits are π1 = (72 − 50)28 = 616 and π2 = 0.
Note that firm 1 produces more than the monopoly output of 25 and the price is correspondingly lower.
This occurs even though firm 2 produces nothing in equilibrium because it is in firm 1’s interest to push
output up to 28 in order to drive firm 2 from the market. This eliminates more deadweight loss than
the Cournot competition above while still having all production done by the low-cost firm. Hence social
welfare is higher than under either the Cournot or monopoly situations.

9. Firm 1 acting as a price-taker is willing to supply any amount between 0 and ∞ at price P = c1 = 50.
Supply is zero below this price (firm 2 supplies nothing unless price is at least c2 = 72) and is infinite
above this price. So P = 50 and Q = 50, with firm 1 producing the entire amount and firm 2 producing
nothing.
10. Now the Hicksian and Marshallian demands do not coincide. A normal good has a Hicksian demand that
is steeper than the Marshallian demand:
Note that the relevant Hicksian demand for the EV of a price decrease from 75 to 74 is the one through
the point (26, 74) because we are measuring a change in income that is equivalent to the price decrease
so utility is held constant at the level obtained after the price decrease. The EV is now larger by the
amount of the shaded area in the graph. However, this area is less than 1 and is therefore far too small
to make up for the higher production costs that occur under Cournot competition; society is still better
off under the monopoly. Bertrand competition is still better than the monopoly because price is lower in
a Bertrand environment and all production is done by the low-cost firm. Similarly, Stackelberg is better
than monopoly or Cournot (Stackelberg is actually the same as Bertrand in this model).
Solutions to Test 2: November 6, 2007
1.
a.

y when y ≤ 1
Avoidable C = α +
2y2 − 1 when y > 1
1
y
+ 1 when y ≤ 1
AC =
2y when y > 1

1 when y < 1
MC =
4y when y > 1
α
y
+1 when y ≤ 1
AAC = α−1
y + 2y when y > 1
b. Set p = M C when p ≥ AAC. This gives p = 4y, or y = p

4 for p > 4. y = 1 is optimal for any p between
1 + α and 4. y = 1 and y = 0 are both optimal when p = 1 + α. y = 0 is optimal when p < 1 + α.
2.
a. The Lagrangian function is L = x1 + g(x2 ) − λ[p1 x1 + p2 x2 − m]. So the FOCs are 1 − λp1 = 0 and
g (x2 ) − λp2 = 0 (and also −[p1 x1 + p2 x2 − m] = 0).
b. The first equation gives λ = 1/p1 . Substituting this into the second gives g (x2 ) = p2
p1 . This is the
(implicit) solution for x2 since x2 is the only choice variable in this equation.
c. m does not enter the equation for x2 , so x2 does not change when m changes (assuming an interior
solution).
290 SOLUTIONS TO TEST 2: NOVEMBER 6, 2007
d. Since the income effect on x2 is zero, the Hicksian and Marshallian demands are the same. The
Hicksian demand coincides with the Marshallian demand no matter what level of Ū is used in the
Hicksian demand.
3.
a. w2 = 2w1 makes w1 x1 + w2 x2 smallest. So the defining condition for H(y) requires w1 x1 + 2w1 x2 ≥
3w1 y.
b. w1 = 2w2 makes w1 x1 + w2 x2 smallest. So the defining condition for H(y) requires 2w2 x1 + w2 x2 ≥
3w2 y.
c. H(y) = {(x1 , x2 ) ∈ R2+ : x1 + 2x2 ≥ 3y and 2x1 + x2 ≥ 3y}. The (x1 , x2 ) pairs that satisfy these two
inequalities are the shaded area:
d. If the isocost slope is steeper than 2 then the cost minimum subject to H(y) occurs at the corner
(0, 3y), which gives c∗ = 3w2 y as expected. If the isocost slope is flatter than 1/2 then the cost
minimum subject to H(y) occurs at the corner (3y, 0), which gives c∗ = 3w1 y also as expected. All
that remains is to identify the cost minimum when the isocost slope is between 1/2 and 2. Given H(y),
the minimum occurs at the vertex (y, y), which gives c∗ = (w1 + w2 )y.
4.
a. The indifference curve is the line with slope −1 from (0, Ū ) to (Ū , 0), except for the point where this
line crosses the x2 = x1 line, plus the point ((Ū − 1)/2, (Ū − 1)/2):
b. The preferences are complete and transitive because they are represented by a utility function. They
are not continuous because of the “hole” in the indifference curve at x2 = x1 . They are also not
monotonic or strongly monotonic because all points to the northeast of ((Ū − 1)/2, (Ū − 1)/2) and
below the line x2 = Ū − x1 are on a lower indifference curve (except the points on the x2 = x1 locus).
The preferences are, however, locally nonsatiable since we can increase any bundle by (, ) and thereby
strictly increase utility. The lack of continuity rules out all hope for any type of convexity.
c. The delicate part is to consider when it is optimal to choose the point on the x2 = x1 line. Consider the
−1
line through this point and the lower-right corner (Ū , 0). This line has slope − Ū
Ū +1
. If the isocost line
is flatter than this line then the minimum occurs at (Ū , 0), which gives expenditure of p1 Ū . Similarly,
the line through the point on the x2 = x1 line and the upper-left corner (0, Ū ) has slope − Ū +1
Ū −1
. If the
isocost line is steeper than this line then the minimum occurs at (0, Ū), which gives expenditure of p2 Ū.
The minimum occurs at ((Ū − 1)/2, (Ū − 1)/2) for any other isocost slope, which gives expenditure
(p1 + p2 ) Ū−1
2
. To summarize, the expenditure function is
 Ū −1

 p1 Ū when p1
≤
 p2 Ū +1
e∗ (p1 , p2 , Ū) = (p1 + p2 ) Ū−1 when Ū−1

< pp12 < Ū +1
.


2 Ū +1 Ū −1

p2 ≥ Ū −1
p1 Ū+1
p2 Ū when
292 SOLUTIONS TO TEST 1: OCTOBER 4, 2007
Solutions to Test 1: October 4, 2007
1.
a. The production set is only the 4 square points:
b. Yes because the point (0, 0) is in the set.
c. Yes because Z does not contain any points in the first quadrant except (0, 0).
d. No because none of the points below and left of the four illustrated points are elements of Z.
p1
e. The (absolute) slope of the isoprofit lines is p2
. When this slope is steeper than 2 the highest isoprofit is
attained at (0, 0), so profit is zero. When this slope is between 1 and 2 the highest isoprofit is attained
at (−1, 2), so profit is 2p2 − p1 . When this slope is flatter than 1 the highest isoprofit is attained at
(−4, 5), so profit is 5p2 − 4p1 . Note that the point (−3, 3) is never optimal because it is “inside” the
line between (−1, 2) and (−4, 5). To summarize:


 0, 2 ≤ pp12

π ∗ (p1 , p2 ) = 2p2 − p1 , 1 ≤ pp12 < 2 .


5p2 − 4p1 , pp12 < 1
f. The graph of Z is changed to include all points below and to the left of the 4 points illustrated above.
This changes d to “yes”. Nothing else, including π ∗ , changes because the interior points are irrelevant
for π ∗ .
2. λ∗ measures how much a change in q is worth in units of the objective K. If λ is too high then the choice
of K will be such that g(K, L) > q because this decreases L more than the change in K increases the
objective. If λ is too low then the choice of K will be such that g(K, L) < q because this increases L less
than the change in K decreases the objective.
3. Yes. For homogeneity, evaluating the objective at (αw1 , αw2) is still a monotonic transformation of the
objective evaluated at (w1 , w2 ), so the optimal choices of x1 and x2 are unaffected. That is, x∗i (αw) =
x∗i (w) (y is suppressed here because it is not changing). Hence
c∗ (αw) = αw1 ln x∗1 (αw) + αw2 ln x∗2 (αw) = αw1 ln x∗1 (w) + αw2 ln x∗2 (w) = αc∗ (w).
For concavity, fix wi0 and wi1 and note that the definition of a minimum requires, for every (x1 , x2) pair
satisfying f(x1 , x2 ) ≥ y,
c∗ (w 0 ) ≤ w10 ln x1 + w20 ln x2
c∗ (w 1 ) ≤ w11 ln x1 + w21 ln x2
multiplying the first inequality by α and the second by (1 − α) (for α ∈ [0, 1]), and adding, yields
" # " #
αc∗ (w 0 ) + (1 − α)c∗ (w 1 ) ≤ αw10 + (1 − α)w11 ln x1 + αw20 + (1 − α)w21 ln x2
for every (x1 , x2 ) pair satisfying f(x1 , x2 ) ≥ y (this is the same proof used for a “normal” cost function).
Now minimize the right side over (x1 , x2) subject to the constraint to get
αc∗(w 0 ) + (1 − α)c∗ (w 1 ) ≤ c∗ (αw 0 + (1 − α)w 1 ),
which is concavity.
1. If consumer 1 does not have locally nonsatiated preferences then indifference curves can be thick. Suppose
point E in the figure below is the endowment and the indifference curves are as shown, with consumer 1’s
indifference curve the entire shaded area, and both consumers having monotonic preferences. Then the
price line shown is an equilibrium, because each consumer is on his/her highest possible indifference curve
given his/her budget set, and both consumers are choosing the same point Q. However, the allocation Q
is not Pareto optimal because allocation R gives consumer 2 higher utility without changing the utility of
consumer 1.
2. The profit objective is
max π(y) = [p(y) − c]y = [α − c − βy]y.

{y}
The FOC is π (y) = α − c − 2βy = 0 and the SOC is satisfied since π (y) = −2β < 0. Solving the FOC
α−c
yields monopoly output of ym = 2β . Substituting ym into the inverse demand yields the monopoly
α+c 1
" α−c #2
price of pm = 2 . Substituting ym and pm into π yields the monopoly profit of π m = β 2 . The
deadweight loss is an area under the Marshallian demand because there are no income effects. It is the
area of the triangle with vertices at (ym , c), (ym , pm ), and (p−1 (c), c). Since p−1 (c) = α−c
β , this area is

2
1 α−c α−c α+c 1 α−c
DW L = − −c = .
2 β 2β 2 2β 2
3.
a. First, both sellers must charge the same price in equilibrium. If they charge different prices, the high-
price seller gets zero profit but can get half of the positive market profit generated at the low price by
switching to the low price (note that the low price exceeds marginal cost). Second, the strategy profile
(6, 6) is a Nash equilibrium since both sellers get positive profit and a unilateral switch to the high
price yields zero profit. So the only question is whether (10, 10) is a Nash equilibrium as well. The
market demand at p = 10 is y(10) = 10 and the market demand at p = 6 is y(6) = 14, so market profit
at each price is π(10) = [10 − 4]10 = 60 and π(6) = [6 − 4]14 = 28. If both sellers are charging p = 10
then they each get profit of 30, while a unilateral switch to p = 6 yields profit of only 28 for the seller
who switched. Hence (10, 10) is a second Nash equilibrium.
b. The observations that both firms must charge the same price and that a profile with both firms charging
the low price ((7, 7) in this case) is a Nash equilibrium do not depend on the particular prices (assuming
the low price is between the monopoly price and marginal cost). So (7, 7) is a Nash equilibrium. Market
output is y(7) = 13, so market profit is π(7) = [7 − 4]13 = 39. Hence (10, 10) is no longer a Nash
equilibrium, because a unilateral switch to p = 7 increases profit from 30 to 39.
c. If the leader chooses 10 then the follower will choose 10 as well, since doing so yields profit of 30 for
the follower while choosing 6 only yields profit of 28. The leader gets profit of 30 in this case. If the
leader chooses 6 then the follower will choose 6 as well, since doing so yields profit of 28/2 = 14 for
the follower while choosing 10 would yield zero profit since the follower would be the high-price seller.
The leader gets profit of 14 in this case. Hence the Nash equilibrium is for the leader to choose 10 and
the follower to choose the function p(10) = 10 and p(6) = 6. Both sellers will choose 10 in equilibrium.
Things change if the low price is 7. Then a choice of 10 by the leader will cause the follower to choose
7 since doing so give the follower profit of 39 rather than 30. The leader gets profit zero in this case. A
choice of 7 by the leader will cause the follower to choose 7, yielding profit of 39/2 for both the leader
and the follower. Hence the Nash equilibrium is for the leader to choose 7 and the follower to choose
the function p(10) = 7 and p(7) = 7. Both sellers will choose 7 in equilibrium.
4. The profit objective is
√
max π = px1 − x2 = 2p x2 − x2 .
{x2 }
−1/2 −3/2
The FOC is π (x2 ) = px2 − 1 = 0, yielding x∗2 = p2 and x∗1 = 2p. The SOC is π (x2 ) = − p2 x2 <0
so the FOC yields a maximum provided the quantities are positive. Substituting into the objective yields
π ∗ (p) = p2 .
The consumer’s monetary resources are x̄2 + π ∗ (p) = 3 + p2 . Hence the utility objective is
3/2
2/3 2/3
max x1 + x2 subject to px1 + x2 = 3 + p2 .
{x1 ,x2}
1/2 1/3
2/3 2/3 2 −1/3
The partials of utility are Ui = 3
2 x1 + x2 3 xi . Hence the MRS is − U
U2 = −
1 x2
x1 . Setting
this equal to the budget slope of −p yields x2 = x1 p3 (it is straightforward but tedious to check that the
indifference curve is strictly convex with infinite slope where it hits the vertical axis and zero slope where
3+p2
it hits the horizontal axis). Substituting for x2 in the budget line and simplifying yields x∗1 = p+p3 .
The equilibrium price can be found by setting supply equal to demand for either good. For example,
supply of good 1 from the firm’s problem is x∗1 = 2p and demand for good 1 from the consumer’s
3+p2
problem is x∗1 = p+p3 . Setting these equal and simplifying yields 2p4 + p2 − 3 = 0. This factors into
(2p2 + 3)(p2 − 1) = 0. So the equilibrium price is p = 1.

1.
a. The indifference curves are parabolas with minimum at x1 = 1. The parabola shifts vertically as the
utility level changes. The marginal rate of substitution is
∂x2 U1
=− = 2(x1 − 1).
∂x1 U2
Note that this slope is −2 at x1 = 0 irrespective of the utility level. So every indifference curve has
slope −2 where it hits the vertical axis. A rough graph is (the parts in the fourth quadrant are for
illustration purposes only, and are not actually part of the indifference curve):
b. Completeness: Yes, because the preferences are represented by a utility function.
Transitivity: Yes, because the preferences are represented by a utility function.
Continuity: Yes, because U is a continuous function, so the sets {(x1 , x2 ) : U (x1 , x2 ) ≥ Ū } and
{(x1 , x2 ) : U (x1 , x2 ) ≤ Ū } are closed for every Ū .
Local Nonsatiation: Yes, because an infinitesimal increase in x2 always increases utility.
Weak Monotonicity: No, because an increase in x1 starting at any x1 ≥ 1 always decreases utility.
Convexity: Yes, because the entire convex combination of any two points that are on or above a
given indifference curve lies entirely above that indifference curve.

c. The slope of 2 is critical to the analysis. Budget lines that have a slope steeper than 2 result in a corner
solution at x1 = 0 and x2 = m/p2 , since this point achieves the highest possible indifference curve.
Otherwise, the optimum occurs at a tangency between the indifference curve and the budget line, which
is described by M RS = −p1 /p2 or 2(x1 − 1) = −p1 /p2 . Solving for x1 yields x∗1 = 1 − p1 /2p2 . The
budget line then yields x∗2 = m/p2 − (p1 /p2 )x∗1 = m/p2 − (p1 /p2 ) [1 − p1 /2p2 ]. In summary,

0 if p1
≥2  m
p2 if p1
p2 ≥2
x∗1 =
p2
x∗2 =
1− p1
2p2 if p1
p2 <2  m
− p1
1− p1
if p1
<2
p2 p2 2p2 p2
2. First we have to find U ∗ . The MRS is
∂x2 U1 x2 + 1 U
=− =− = − 2.
∂x1 U2 x1 x1
Differentiating again while holding U constant confirms that the indifference curves are strictly convex, so
any tangency between an indifference curve and a budget line is a maximum. Setting the MRS equal to
− pp12 yields x1 = p2
p1 (x2 + 1). Substituting this into the budget line and using p1 = 1 yields the Marshallian
demands
m + p2 m − p2
x∗1 = and x∗2 = .
2 2p2
Note that these expressions are an interior solution only if m > p2 , which holds for the values given in
the problem (otherwise, the optimum is at the corner x2 = 0 and x1 = m). Substituting x∗1 and x∗2 into
U and simplifying yields (for m > p2 )

(m + p2 )2
U∗ = .
4p2
Therefore the initial utility level is U ∗ (1, 2, 50) = 338. The income level m̃ required to maintain this
utility level when p2 = 4 satisfies

(m̃ + 4)2
338 = .
16
√
Solving this quadratic yields m̃ = −4 + 4 338 = 69.54. Quantity demanded at the new price/income pair
is x∗2 = (69.54 − 4)/8 = 8.19. So we must spend 69.54 − 50 = 19.54 to keep the consumer indifferent and
we receive only (4 − 2)(8.19) = 16.38 in new revenue, yielding a deadweight loss of 19.54 − 16.38 = 3.16.
3. One implication of homogeneity of x∗1 (of degree zero) is
∂x∗1 ∂x∗ ∂x∗ ∂x∗

p1 + p2 1 + p3 1 + m 1 = 0
∂p1 ∂p2 ∂p3 ∂m
(this is Euler’s Theorem). Substituting in the given information yields
∂x∗1 ∂x∗
(1) + (2)(−5) + (6)(2) + (10) 1 = 0.
∂p1 ∂m
Since there are no income effects on commodities 2 and 3, but local nonsatiation holds (so we must stay
∂x∗
1 1
on the budget line), we know ∂m = p1 = 1. Therefore
∂x∗1
= −12.
∂p1
Now use the Slutsky equation:
∂x∗1 ∂h∗1 ∂x∗

= − x∗1 1
∂p1 ∂p1 ∂m
= −10 − (x∗1 )(1).
Substituting the two equations together yields x∗1 = 2.

1.
a. Since we are assuming there is an interior solution, that solution must satisfy the first order conditions
of the Lagrangian function L. Differentiating the first order conditions with respect to a yields a system
of equations of the following form:


 ∂x∗1  0
∂a  0 
 .   
 ..   −2a 
HL(x1,x2 ,x3 ,x4 ,x5 ,λ)  ∂x∗  =  ,
 5  0 
∂a∗  
∂λ 0
∂a 0
where λ∗ is the Lagrangian multiplier at the optimum and H is the Hessian of the Lagrangian function
with respect to the choice variables (x1 , x2 , x3 , x4 , x5, λ). Applying Cramer’s Rule to this system and
then using cofactor expansion on the numerator yields
∂x∗3 (−1)3+3 (−2a)|H33 |

= ,
∂a |H|
where H33 is the submatrix of H obtained by deleting the third row and third column. The second
order conditions require that |H| and |H33| have opposite signs, so
∂x∗3 s
= 2a > 0.
∂a
b. The envelope theorem gives

∗ ∂L
f (a) = = 2ax∗3 (a) > 0.
∂a xi =x∗ ,λ=λ∗
i
c. Here is an answer based on comparing the optimal value function to the objective function, as we did
several times in class. Fix a at a particular value, say a0 , and define the function
g(a) = x∗1 (a0 )x∗2 (a0 )x∗3 (a0 )x∗4 (a0 )x∗5 (a0 ) + x∗1 (a0 )1/3 x∗2 (a0 )1/9 x∗4 (a0 )5 x∗5 (a0 )
+ x∗3 (a0 )1/5 x∗4 (a0 )x∗5 (a0 )2/7 + a2 x∗3 (a0 ).
g is the objective function considered as a function of a with the values of the choice variables fixed at
the values that are optimal when a = a0 . By definition, g(a0 ) = f ∗ (a0 ) and the envelope theorem gives
g (a) = f ∗ (a) at a = a0 . Moreover, f ∗ cannot drop below g as a departs from a0 because f ∗ is the
maximum (note that changes in a do not affect the feasibility of the optimal choices x∗i (a0 ) because a
does not affect the constraint). This means f ∗ must be “more convex” than g at a = a0 . Note that
g (a) = 2x∗3 (a0 ). Hence f ∗ (a) ≥ 2x∗3 (a0 ) at a = a0 . This holds for any a0 .
Here is a second, equally acceptable, answer based on the answers to questions b and c above. Differ-
entiating b, we obtain
∂x∗3
f ∗ (a) = 2x∗3 (a) + 2a > 2x∗3 (a).
∂a
The inequality follows from question a above.
2.
a. At least 1 unit of x1 must be used in order to produce any output. This usage of x1 is avoidable, so
the fixed cost is not sunk. A typical isoquant for a positive level of output appears as follows:
The isoquant for output level zero is the horizontal axis and the entire area between the vertical axis
and the vertical line x1 = 1. The lowest isocost line for any positive output level is attained at the
√ √
vertex of the isoquant where x2 = x1 − 1. So we have y = x2 = x1 − 1 at the minimum, or
x∗1 = y2 + 1 and x∗2 = y2 . This gives a cost function of

0 if y = 0
c∗ (w1 , w2 , y) = .
(w1 + w2 )y2 + w1 if y > 0
w1
b. The average cost curve is AC = (w1 + w2 )y + y for y > 0 and the marginal cost curve is M C =
2(w1 + w2 )y. It is straightforward to set AC = M C and solve to find that the minimum of the AC

curve is at y = w1w+w 1
2
, and the common value of AC and M C at this intersection is 2 w1 (w1 + w2 ).
Setting p = M C gives a supply curve of y∗ = p

2(w1 +w2 )
. Since all of the fixed cost is avoidable, this

expression for y∗ is relevant for p ≥ 2 w1 (w1 + w2 ). y∗ = 0 when p ≤ 2 w1 (w1 + w2 ).
3. This is a matter of going through the proof of the properties of the profit function and checking on
which properties of π ∗ rely on particular properties of the technology. If we know that π ∗ exists then
the homogeneity, convexity, and monotonicity all follow merely from the definition of π ∗ as a maximum.
Nonnegativity, however, relies on the possibility of inaction (profit can be negative if there is a sunk cost).
4. The function g has all of the standard properties of a cost function except nonnegativity. Therefore we
need only consider what properties of H rely on nonnegativity and whether potential failures of these
properties affect the conclusion that g is the cost function for the technology H.
a. Going through the proof of the properties of H defined in terms of some function g, we see that no free
lunch and possibility of inaction both rely on nonnegativity. So H need not have the no free lunch and
possibility of inaction properties. All of the other properties of H (i.e., that Z = {(y, −x) : x ∈ H(y)}
is nonempty and closed, free disposal, convexity, and continuity) hold. The proofs that these properties
hold are the same as always, except for showing that Z is nonempty (Z nonempty is normally taken as
a consequence of possibility of inaction, so whether Z is nonempty has to be addressed in a different
way here – more on this below).
b. Let c∗ Be the cost function for H. The proof that g(w, y) = c∗ (w, y) proceeds as follows: First note
that c∗ (w, y) ≥ g(w, y) by definition of g as a lower bound of the cost objective on the feasible set
H(y); then establish existence of an input vector x0 with the properties (1) w · x0 = g(w, y), and (2)
x0 ∈ H(y). Existence of such an x0 establishes c∗ (w, y) ≤ g(w, y) by definition of c∗ as a minimum over
H(y). Item (1) is a pure consequence of homogeneity of g. Item (2) is a pure consequence of concavity
of g. Therefore the fact that g may not possess the nonnegativity property has no implications for the
basic result that g is a cost function. Note that existence of x0 ∈ H(y) establishes that Z is nonempty
(assuming there are y values in the domain of g).

1.
a. Marginal cost is c (q) = 2q, so single-firm supply is q = p2 . Therefore market supply is Q = 5p. This
intersects market demand at Q = 650 and p = 130.
- − q 2 , where Q
b. The profit objective of one firm is π(q) = (780 − q − Q)q - is the aggregate quantity of
- − 2q = 0. By symmetry, Q
all other sellers. The FOC is 780 − 2q − Q - = (n − 1)q in equilibrium.
Substituting this into the FOC with n = 10 and solving yields q = 60. Hence Q = 600. Substituting
this into demand gives p = 180.
c. Here is the graph:
1
The deadweight loss is the shaded area: 2 (50)(60) = 1, 500.
d. This technology has decreasing returns, so every price-taker makes positive profit. Entry will continue
until there are a large number of producers each producing a small amount and price virtually zero.
Technically, there is no free-entry equilibrium because, with any finite number of producers, a new
entrant can always earn a tiny positive profit.
780
e. Using the FOC from part b with n unspecified yields q = n+3
. The equilibrium price with n sellers is
p = 780 − nq, so equilibrium profit for one of n sellers is π = pq − q 2 = [p − q]q = [780 − (n + 1)q]q.
2
780 780
Now substituting in q = n+3 and simplifying yields π = 2 n+3 . This is strictly decreasing in n.
Each entrant must anticipate that this post-entry profit will exceed the entry cost of $1,000. Setting

π = 1, 000 and solving for n yields n = 780 2/1, 000− 3 ≈ 31.9. Thus all sellers make positive variable
profit above $1,000 when there are 31 sellers but the variable profit will not cover the entry cost if there
are 32 sellers. In equilibrium there will be n = 31 sellers.
2. Monopoly marginal revenue is M R = 780 − 2Q. Setting this equal to marginal cost of M C = 2Q and
solving for Q gives Q = 195. Substituting into demand gives P = 585. The elasticity at this point is
= |(−1) 585
195
| = 3. Based on this, the Lerner Index is 33%.
3.
a. Yes, a competitive equilibrium can be Pareto efficient even when a consumer’s preferences do not
have the local nonsatiation property. The proof of the First Theorem of Welfare Economics relies on
local nonsatiation only to ensure that every consumer’s optimum must be on the budget constraint in
equilibrium. This can happen even for a consumer whose preferences do not satisfy local nonsatiation.
For example, suppose the utility function has a local maximum inside the budget set but then increases
to higher utility levels at higher consumption levels, where a competitive equilibrium budget constraint
lies. Then the only maximum is on the budget line and the competitive equilibrium is Pareto efficient
because any reallocation to a point below the budget line of the consumer in question, even to the
interior local maximum, will harm that consumer. In short, the conditions of the First Theorem of
Welfare Economics are sufficient but not necessary for a competitive equilibrium to be Pareto efficient.
b. Yes. An important condition of the First Theorem of Welfare Economics is violated so the conclusion
of the theorem may not hold. In particular, suppose a consumer in a pure exchange economy has
a thick indifference curve and a competitive equilibrium budget constraint passes through that thick
indifference curve, as illustrated in the following Edgeworth box:

This shows an equilibrium because supply equals demand and each consumer is individually maximized
given the budget line. However, the equilibrium allocation is not Pareto efficient because there are other
allocations, like point C, that are strictly better for B and no worse for A.
1.
√
a. These preferences are represented by the utility function U (x1 , x2 , x3 ) = x1 + x2 − x3 . This function
is continuous. Therefore the preferences are complete, transitive, and continuous. The preferences are
also locally nonsatiable since a small increase in x1 or x2 always improves utility. The preferences
are also convex. Convexity can be shown by thinking about the shape of the indifference curves (see
below), or by noting that the utility function is concave since the Hessian is a matrix of zeros except
for the (2,2) element, which is negative. The preferences are not monotonic since increases in x3 cause
utility to decrease.
b. x3 decreases utility, so the demand for x3 is identically zero for all non-negative prices and income. A
typical indifference curve between x1 and x2 for utility level Ū is:
The slope of the indifference curve is zero at x2 = 0 but is −2Ū at x1 = 0, so a corner solution is
possible with x1 = 0. Solving the FOCs simultaneously for x1 and x2 yields

2
m p1 p1
x∗1 = − and x∗2 = .
p1 4p2 2p2
These are the demands provided the solution for x∗1 is positive. Otherwise, x∗1 = 0 and x∗2 = m
p2
. To
summarize:
 2

m
− p1
4p2 , if 4mp2 ≥ p21 p1
, if 4mp2 ≥ p21
x∗1 = p1
, x∗2 = 2p2 , x∗3 = 0.
0, otherwise  m
, otherwise
p2
Substituting these solutions into U gives indirect utility of

 m
 p1 + 4p p1
2
, if 4mp2 ≥ p21
∗
U = .
 pm , otherwise
2
2.
a. Check whether the demands have the properties of Marshallian demands. (1) The given demands are
homogeneous of degree zero in prices and income: multiplying both prices and income by some scalar
α does not change anything because the α’s cancel. (2) The Slutsky matrix is
*n
∂x∗i ∂x∗ − 9p
2m
2
2m
+ x∗j i 1 9p1p2
= .
∂pj ∂m i,j=1
2m
9p1 p2 − 9p
2m
2
2
This matrix is symmetric, and it is negative semidefinite because the (1, 1) element is negative and
the determinant of the whole matrix is zero. (3) The given x∗ function is nonnegative. (4) p · x∗ =
p1 m 2p2m
3p1 + 3p2 = m, so Walras’ Law holds. Therefore the given function can be a Marshallian demand
for a consumer with well-behaved preferences.
b. Check whether the demands have the properties of Hicksian demands. (1) The given demands are
homogeneous of degree zero in prices: multiplying both prices by some scalar α does not change
anything because the α’s cancel. (2) The matrix of price slopes is negative semidefinite, because the
∂h∗ −3/2 1/2
(1,1) element is 1
∂p1 = − Ū2 p1 p2 , which is negative, and the determinant of the whole matrix
∂h∗
1
must be zero due to the homogeneity. The matrix of price slopes is also symmetric because ∂p2 =
∂h∗ √
2
∂p1
= √Ū
2 p1 p2
. (3) The corresponding expenditure function is e∗ = p · h∗ = 2Ū p1 p2 . This function is
nondecreasing in (p1 , p2 ) provided Ū ≥ 0 (more on this condition below), and is strictly increasing in Ū
at positive prices. (4) The e∗ just derived is also continuous. (5) The given demands are nonnegative
provided Ū ≥ 0, are strictly positive at positive prices provided Ū > 0, and the expenditure function
is identically zero in prices at Ū = 0. So the nonnegativity property holds with U (0) = 0. Therefore
the given function can be a Hicksian demand for a consumer with well-behaved preferences, with the
utility representation Ū of those preferences that appears in h∗ benchmarked so that Ū ≥ U (0) = 0.
c. Invert e∗ from question b to get indirect utility U ∗ = 2√m

p1 p2 . Then use Roy’s Identity to get the

Marshallian demand x∗ = 2p m
, m . This is different from the Marshallian demand given in question
1 2p2
a, so the preferences are not the same (cannot be for the same consumer).
3.
a. Using the Marshallian demand from question 3.c, government revenue from Tax A is RA = tp1 x∗1 ((1 +
tm
t)p1 , p2 , m) = 2(1+t) .
b. T is calculated so that the consumer is indifferent between Tax A and Tax B. That is, T is the (negative
of the) equivalent variation of the price increase from p1 to (1 + t)p1 . Using the expenditure function
from question 2.b and the indirect utility function from question 2.c, government revenue from Tax B
√
is RB = T = −EV = −[e∗ (p1 , p2 , U ∗((1 + t)p1 , p2 , m)) − m] = −[2U ∗ ((1 + t)p1 , p2 , m) p1 p2 − m] =
" #
−m (1 + t)−1/2 − 1 .

c. RB − RA = m 1 − (1 + t)−1/2 − t
2(1+t) . Making a common denominator, this has the same sign as
√
g(t) = 2 + t − 2 1 + t. Note that g(0) = 0 (neither tax produces any revenue if the tax rate is zero)
and g (t) = 1 − (1 + t)−1/2 > 0 for t > 0. Hence RB > RA for every t > 0. Tax B always collects more
revenue for the government when the level of Tax B is set to make the consumer indifferent between
Tax A and Tax B. This is a general property: A lump-sum tax does not distort consumption, and is
therefore more efficient than a tax that changes the relative prices paid by consumers.
1.
a. The FOC is 8x3 − a3 = 0. This yields x∗ (a) = a/2. The second derivative is 24x2 , which is always
positive. So there is only one extremum, and it is a minimum.
b.
c. See the graph above. Note that a0 must be positive because x = x∗ (a0 ) = a0 /2 is positive. Also note
that, for a0 positive, 21/3 x < a0 when x = x∗ (a0 ) = a0 /2, so a0 is right of the point where g crosses the
a axis. The graph shows a lot of the g∗ function for completeness. Only the local part of g∗ near a0
can actually be graphed without explicitly deriving g∗ . The important thing is that optimality requires
that g∗ be tangent to g at a0 and below g everywhere else.
d. g∗ is locally concave because g is locally concave. This argument applies at all a0 (even when a0 < 0,
because then the shape of g is reflected across the vertical axis compared with the graph above), so g∗
is indeed globally concave.
2.
a. The technology is nonempty because there are points in the set. The technology is NOT closed, because
part of the boundary is missing. The technology satisfies no free lunch because the only point in the
first quadrant that is also in Z is the origin. The technology satisfies possibility of inaction because the
origin is included. The technology satisfies free disposal because there is no upward-sloping boundary.
The technology has no particular global returns to scale (the various rays involved in the definitions
will pass outside of the set). The technology is not convex because of the part of the boundary that
curves upward.
b. No. Draw some isoprofit lines that are tangent to the production set. No profit maximizing actor ever
chooses a point on the non-convex part of the boundary, so the fact that part of the boundary is not
included has no implications for maximization. This conclusion is not general. It holds only because
the missing boundary is on a nonconvex part of the boundary.
3.
a. Use Shephard’s Lemma to get
∂c∗
x∗1 = = ey − 1
∂w1
∂c∗ −1/2 1/2 y
x∗2 = = (1/2)w2 w3 (e − 1)
∂w2
∂c∗ 1/2 −1/2 y
x∗3 = = (1/2)w2 w3 (e − 1).
∂w3
b. Differentiate the factor demands from part a to get the matrix of demand slopes with respect to prices:
 
0 0 0
−3/2 −1/2 −1/2
(1/4)(ey − 1)  0 −w2 .
1/2
w3 w2 w3
−1/2 −1/2 1/2 −3/2
0 w2 w3 −w2 w3
Symmetry is verified by inspection. Negative semidefiniteness is verified by noting that the determinant
of the whole matrix is zero, the determinant of the 2 × 2 matrix in the lower-right corner is zero, and
the determinant of the 1 × 1 matrix in the lower right corner is negative.
The last part of the question involves derivatives with respect to y. From c∗ , marginal cost is (w1 +
√ −1/2 1/2
w2 w3 )ey . Differentiating marginal cost with respect to w1 , w2 , and w3 yields ey , (1/2)w2 w3 ey ,
1/2 −1/2 y
and (1/2)w2 w3 e , respectively. These are exactly the same as the expressions obtained by differ-
entiating x∗1 , x∗2 , and x∗3 above with respect to y, respectively.
4.
a. For y = 0, we can choose (x1 , x2) = (1/4, 0) to get cost w1 /4. For y > 0, we must choose x1 ≥ 1.
However, x1 is not productive beyond 1, so it is cost minimizing to choose x1 = 1. Then we choose

x2 = y2 , and get cost w1 + w2 y2 . To summarize:

∗ w1 /4, y=0
c (w1 , w2 , y) = 2
w1 + w2 y , y > 0
b. At the stated prices, cost is 12 + y2 for y > 0. At y = 0, cost is 3. So 3 is sunk (out of the total fixed
cost of 12). We ignore the sunk cost when determining shutdown. Hence the non-sunk cost is 9 + y2 ,
so the average non-sunk cost is 9/y + y. Marginal cost is 2y. Setting marginal cost equal to average
non-sunk cost yields y = 3. Substituting back into either function gives 6. The graph is (the heavily
shaded line is the supply curve):
The equation for the supply curve is

∗ 0, p≤6
y = .
p/2, p ≥ 6
1.
2. No. The technology has increasing returns (average cost is 6 − q for q ≤ 2 and 4/q + 2 for q ≥ 2, which
is strictly decreasing). A price-taking seller will supply an infinite amount at any price above 2, and will
supply zero at any price below 2. So the only hope for an equilibrium price is P = 2. However, profit is
negative at every positive quantity when P = 2 because the higher marginal cost of the first 2 units is
never recovered. So a price-taking seller will supply zero when P = 2. Hence there is no price at which
supply equals demand.
3. From the graph, the monopoly output is 2 and the monopoly price is 6.
4. Marginal cost equals marginal benefit at the social optimum. When Marshallian surplus measures con-
sumer welfare, marginal benefit is the inverse demand curve. From the graph, marginal cost crosses
demand at output 4.
5. The First Theorem of Welfare Economics states (under some conditions) that a price-taking equilibrium is
Pareto Efficient. The theorem does not guarantee existence of a price-taking equilibrium. So, when there
is no price-taking equilibrium, the theorem is vacuous. There is no conflict between non-existence of a
price-taking equilibrium and the theorem because the theorem merely establishes a property of equilibrium
when the equilibrium exists.

6. The monopoly deadweight loss area is shaded in the graph. The area is DW L = 12 (4 − 2)(6 − 2) = 4.
7. For firm 1, the Cournot objective is max{q1 ≥0} π1 (q1 |q2 ) = (10−2q1 −2q2 )q1 −(6q1 −q12 ) for q1 ∈ [0, 2]. It is
clear from the graph that we do not have to think about quantities larger than 2, since the marginal revenue
curve for a Cournot duopolist is left of the monopoly marginal revenue curve, so the duopoly marginal
revenue must cross marginal cost to the left of 2. The first order condition is 10 − 2q2 − 4q1 − 6 + 2q1 = 0.
Solving for q1 gives the reaction curve q1∗ (q2 ) = 2 − q2 for q2 ∈ [0, 2]. This reaction curve is unusual in
that its slope is -1. So if we find the reaction curve for the other firm it will be exactly the same line
(the reaction curves coincide). Hence any point on this line is a Nash equilibrium, but only the point
(q1 , q2 ) = (1, 1) is a symmetric Nash equilibrium. The equilibrium market output is 2 (same as monopoly),
so the equilibrium price is 6.
8. It is tempting to conclude that the duopoly deadweight loss is the same as the monopoly deadweight
loss, since aggregate output and price are the same. However, the symmetric Cournot duopoly incurs
higher cost than the monopoly in producing 2 units of output, because of increasing returns. So there is
additional deadweight loss, equal to the extra cost incurred by the duopoly. In the graph, this extra cost
is the difference between the area under MC between 0 and 1 and the area under MC between 1 and 2.
We can depict this area by moving the segment of MC between 1 and 2 to the interval between 0 and 1,
and then looking at the difference between this moved segment and the MC curve. This extra DWL area
is shaded in the graph. The extra area is (6 - 4)(1 - 0) = 2, so the total DWL for the duopoly is 6.
9. Normally we expect the duopoly to be more efficient than the monopoly. But with globally increasing
returns the socially efficient way to produce any given output is to have one firm do all production. So
there is a tradeoff. A duopoly usually produces more than a monopoly, thereby moving the market closer
to the social optimum. But the duopoly incurs inefficiently high costs in doing so, compared to what
could be obtained if the monopoly produced more. So the net effect on welfare of having a duopoly rather
than a monopoly is ambiguous when there is increasing returns. In the particular example under study
here the shape of the MC curve causes the symmetric duopoly output to be the same as the monopoly
output, thereby eliminating the benefit of duopoly. Hence it is unambiguously bad for welfare to have a
duopoly in this particular example.

10. We must set monopoly profit equal to zero and solve for price and quantity. Profit is positive at the
monopoly output of 2 in question 3. So we know the zero profit point will be at a quantity greater
than 2. This means we must use the second part of the cost function. So the zero-profit condition is
√
8q −2q 2 −4 = 0. The solutions to this equation from the quadratic formula are q = 2 ± 2. Since we know
√
we are looking for a quantity larger than 2, the relevant solution is q = 2 + 2. The price is therefore
√ √
P = 10 − 2(2 + 2) = 6 − 2 2.
√
11. Suppose we have two Bertrand competitors, each charging price P1 = P2 = 6−2 2. We must ask whether
either firm has a unilateral incentive to change price. This price gives zero profit for a single-seller. With
increasing returns, this means the two firms make negative profit at this price if they both produce positive
output. Since all costs are avoidable, the firms prefer shut down over negative profit. So the only way
√
the price pair P1 = P2 = 6 − 2 2 can be an equilibrium is if one firm produces all output (i.e., quantity
√
2+ 2) and the other firm produces zero output. With this arrangement of the quantities, consider now
the incentives of each firm to change price. The firm that is producing nothing can do no better by raising
price (output and profit will still be zero). This firm will steal the whole market from its rival if it lowers
price, and will make negative profit as the only seller at a lower price because the price we are looking at
is the zero-profit price. Hence this firm has no incentive to change price. The firm that is producing the
market output is making zero profit because we are looking at the zero-profit price. This firm will have
zero output and thus zero profit if it unilaterally raises price because then all consumers will buy from
the other firm. And it will earn negative profit at a lower price. Hence this firm also has no incentive
√
to change price. Therefore the price pair P1 = P2 = 6 − 2 2 is a Nash equilibrium, provided one firm
produces nothing and the other firm produces the entire market output.
12. From question 7, the reaction curve of the follower is q2∗ (q1 ) = 2 − q1 for q1 ∈ [0, 2], and this is the
only relevant range of q1 , for the same reason given in question 7. So the leader’s objective is π1 =
(10 − 2q1 − 2(2 − q1 ))q1 − (6q1 − q12 ) = q12 for q1 ∈ [0, 2]. This objective is strictly increasing in q1 on the
relevant interval. So the leader’s maximum is the corner q1∗ = 2. Therefore the Nash equilibrium strategy
profile is (2, 2 − q1). Note that the equilibrium strategy for firm 2 is a contingent plan, not just the output
level firm 2 produces in equilibrium (i.e., not 0).

1.
a. Consider any two points (x1 , x2 ) and (y1 , y2 ). If x1 + x2 ≥ 1 then (x1 , x2 ) (y1 , y2 ). Otherwise
∼
x1 + x2 < 1, which implies x1 < 1, so (y1 , y2 ) (x1 , x2). Hence the preferences are complete.
∼
b. Let x = (0, 0), y = (1/2, 1), and z = (1, 1). Then x y because y1 < 1, and y z because y1 + y2 ≥ 1.
∼ ∼
However, x z does not hold because neither x1 + x2 ≥ 1 nor z1 < 1 holds. Hence the preferences are
∼
not transitive.
c. Continuity requires that the sets {x ∈ R2+ : x y} and {x ∈ R2+ : y x} be closed for every y ∈ R2+ .
∼ ∼
Suppose y1 + y2 < 1. Then y1 < 1, and the only way y x can hold is if x1 < 1. So {x ∈ R2+ : y
∼ ∼
x} = {x ∈ R2+ : x1 < 1}:
This set does not include its right-side boundary, so it is not closed. Hence the preferences are not
continuous.
d. If x1 + x2 ≥ 1 and y1 + y2 ≥ 1 then (x1 , x2 ) (y1 , y2 ) and (y1 , y2 ) (x1 , x2 ). So all points whose
∼ ∼
coordinates sum to at least one are the same according to this preference relation. Therefore local
nonsatiation fails.
e. Suppose (x1 , x2) ≥ (y1 , y2 ). If x1 + x2 ≥ 1 then (x1 , x2 ) (y1 , y2 ). Otherwise y1 + y2 ≤ x1 + x2 < 1,

∼
which implies y1 < 1, so again (x1 , x2 ) (y1 , y2 ). Hence the preferences are monotonic.
∼
f. Convexity requires that the preferred-to set {x ∈ R2+ : x y} be a convex set for every y ∈ R2+ . If
∼
y1 ≥ 1 then the preferred-to set is all points x such that x1 + x2 ≥ 1:
Otherwise y1 < 1, in which case the preferred-to set is all of R2+ . Both of these preferred-to sets are
convex, so the preferences are convex.
g. No. Necessary conditions for a utility representation are that the preferences be complete and transitive.
Since transitivity fails, there is no utility function that represents these preferences.
2. This utility function is identical to the production function given in question 3 of the first test of this
year, so the indifference curves have exactly the same shape as the isoquants from that question.
a. The budget line when p1 = 9 is 9x1 +x2 = 5. The maximum occurs at x2 = x1 , at point A in the graph.
So 9x1 + x1 = 5, giving x1 = x2 = 1/2. Utility is U = x1 = x2 = 1/2. The budget line when p1 = 1 is
x1 + x2 = 5. The maximum occurs at x2 = 2x1 − 1, at point B in the graph. So x1 + 2x1 − 1 = 5, giving
x1 = 2 and x2 = 3. Utility is U = 2x1 − 1 = x2 = 3. A budget line with the new slope −1, tangent to
the original indifference curve, passes through the point A because of the L-shaped indifference curves.
So the substitution effect is zero. The income effect is the movement from point A to point B, which
is 1.5 units of x1 .
b. This is exactly the same as finding the conditional factor demands and cost function in question 3.b of
the first test of this year. So h∗1 = h∗2 = Ū when Ū ≤ 1. When Ū > 1, the coordinates of the vertex in
terms of Ū are h∗1 = Ū +1

2
and h∗2 = Ū. To summarize, the Hicksian demands are

Ū , when Ū ≤ 1 Ū, when Ū ≤ 1
h∗1 (p1 , p2 , Ū) = Ū+1
, h∗2 (p1 , p2 , Ū) = .
2 , when Ū > 1 Ū, when Ū > 1
Hence the expenditure function is
[p1 + p2 ]Ū when 0 ≤ Ū ≤ 1

e∗ (p1 , p2 , Ū) = .
Ū +1
p1 2 + p2 Ū when 1 < Ū
c. First is homogeneity of degree 1 in prices:

[λp1 + λp2 ]Ū when 0 ≤ Ū ≤ 1
e∗ (λp1 , λp2 , Ū) =
Ū +1
λp1 2 + λp2 Ū when 1 < Ū
[p1 + p2 ]Ū when 0 ≤ Ū ≤ 1
=λ
Ū +1
p1 2 + p2 Ū when 1 < Ū
= λe∗ (p1 , p2 , Ū).
Second is concavity in prices, which can be checked by verifying that the Hessian of e∗ with respect to
prices is negative semidefinite. The Hessian of e∗ with respect to prices is a matrix of zeros because
e∗ is linear in prices. So the Hessian is negative semidefinite trivially. Third is monotonicity. The e∗
function given above is obviously increasing in prices and utility level, since everything in the functions
is positive. And the monotonicity is strict in Ū when the prices are positive. Fourth is continuity. e∗
involves only sums and products, and both pieces are p1 + p2 when Ū = 1, so it is continuous. Last is
nonnegativity. U (0) = 0 in this case. Evaluating e∗ at Ū = 0 clearly gives e∗ = 0, whereas evaluating
at Ū > 0 clearly gives a positive number when the prices are positive.
3. No, because the Marshallian demands are not related to the indirect utility function in the required way.
Roy’s Identity dictates that the Marshallian demand for good 1, given the indirect utility function, be
3
∂U ∗ − pm
2 p2 m
x∗1
∂p1
=− ∂U ∗
=− 3m2
1 2
= .
∂m p1 p22
3p1
This is not the same as the given Marshallian demand x∗1 . The same problem arises with the demand for
good 2.
1.
a. Here is a graph of the production set. Only the black dots are included in the set. The gray lines in
the graph are not part of the set.
The technology is nonempty because there are elements in Z. It is closed because it includes all of its
boundaries (each of the 5 points is a boundary). It satisfies possibility of inaction because the point
(0, 0) is in the set. It satisfies no free lunch because Z contains no points in the first quadrant except
the origin. Free disposal is violated because, generally, if we move from any of the 5 points in Z to
the left or below we encounter points that are not in Z. Convexity is violated because the gray lines
between the points are not included in Z (neither are other combinations of the points that have not
been drawn on the graph).
b. For each (p1 , p2 ) pair, the optimal choice has to be one of the 5 points. Which point is determined
by the slope of the isoprofit. Notice that the point (−3, 2) is below the gray line between (−4, 3) and
(−1, 1). So (−3, 2) cannot be optimal (it is always possible to obtain a higher isoprofit line at either
(−4, 3) or (−1, 1)). If the slope is of the isoprofits is flatter than −2/3 then the highest isoprofit is
obtained at (−4, 3). If the slope of the isoprofits is between −2/3 and −1 then the highest isoprofit is
obtained at (−1, 1). If the slope of the isoprofits is between −1 and −2 then the highest isoprofit is
obtained at (0, 0). If the slope of the isoprofits is steeper than −2 then the highest isoprofit is obtained
at (1, −2). So the profit function is:


 −4p1 + 3p2 when p1
≤ 23

 p2

 −p1 + p2
3 ≤ p2 ≤1
2 p1
when
π ∗ (p1 , p2 ) =
0
 when 1 ≤ pp12 ≤2



p1 − 2p2 when 2 ≤ pp12
2. Necessary conditions for the function to be a cost function are that the Hessian be negative semidefinite
and symmetric. The given matrix is obviously symmetric. It is also negative semidefinite because the
(1, 1) naturally ordered principal minor is −1 (negative), the (2, 2) naturally ordered principal minor is
(−1)(−3) − (1)(1) = 2 (positive), and the (3, 3) naturally ordered principal minor is (−1)[(−1)(−3) −
(1)(1)] = −2 (negative). However, the function must also be homogeneous of degree 1, which implies that
the Hessian is singular. The given matrix is not singular since its determinant is nonzero. Therefore the
function cannot be a cost function.
3.
a. The gray lines in the graph below are index lines useful for locating the isoquants. The L-shaped dark
line closest to the origin is a typical isoquant for an output level y0 that is less than one. The other
L-shaped line is a typical isoquant for an output level y1 that is greater than one. The isoquant for
output level 1 is L-shaped with its vertex at the point where the two gray lines cross.
b. The cost minimum always occurs at the vertex of the relevant isoquant. So x∗1 = x∗2 = y when y ≤ 1.
When y > 1, the coordinates of the vertex in terms of y are x∗1 = y+1
2 and x∗2 = y. Hence the cost
function is

∗
[w1 + w2 ]y when 0 ≤ y ≤ 1
c (w1 , w2 , y) = " y+1 #
w1 2 + w2 y when 1 < y
c. From the cost function found in part b,

w1 + w2 when y ≤ 1
AC(y) = w1 w1
2
+ w2 + 2y
when 1 < y

w1 + w2 when y < 1
M C(y) = w1
2
+ w2 when 1 < y
(MC is not defined at y = 1 because the cost function has a kink there). So the graph is:
d. At the stated prices, the upper part of the MC curve is 5 and the lower part is 3. So the output price is
between these two parts. MC “crosses” this output price at y = 1, but the crossing is a local minimum,
not a local maximum. As y → ∞, AC approaches the lower part of MC, so for the stated prices AC
approaches 3. Hence, for y large AC is below the output price of 4, and remains below no matter how
large y is. Thus, a price-taker can make infinite profit by choosing y = ∞.
4. Consider π ∗ (αp) for some price vector p and scalar α > 0. The underlying objective function is π(z; αp) =

∗
(αp) · z. By the envelope theorem, ∂π ∂α ∗ . The right side here is p · z ∗ (αp), which is
(αp)
= ∂π(z;αp)
∂α
z=z
∗
α−1 π ∗ (αp). So we have π ∗ (αp) = α ∂π∂α(αp)
. That is, the function π ∗ (αp) considered as a function of α is
a linear function of its first derivative. This means π ∗ (αp) is linear in α. For example, using the product
∂π∗ (αp) ∂π∗ (αp) 2

π∗ (αp) ∂ 2π∗ (αp)
rule to differentiate again yields ∂α = ∂α +α∂ ∂α2 , which implies ∂α2 = 0. A zero second
derivative implies the original function is linear.

1.
a.
b. Yes, there is a competitive equilibrium at price equal to C. At this price, supply is horizontal and
demand is N . So supply equals demand with total output given by N .
c. Charge price equal to A and sell N units. Demand is horizontal at price A up to quantity N , so
marginal revenue equals A to the left of N . Marginal revenue is zero to the right of N . So marginal
revenue “crosses” marginal cost at quantity N with price A.
d. They are equally efficient. Both create all possible surplus from this market. The only difference is in
who gets the surplus. Under competition, the consumers get N (A − C) and the sellers get nothing.
Under monopoly, the consumers get nothing and the monopolist gets N (A − C). Monopoly does not
create deadweight loss because demand is perfectly inelastic at N (up to price A).
e. Assume seller 2 produces Q2 . Then seller 1’s optimal choice is N − Q2 (or zero, if Q2 exceeds N )
because seller 1 makes the same positive profit margin of A − C1 on every unit produced, provided
aggregate output is not higher than N . When aggregate output exceeds N , price is driven to zero (or,
equivalently from seller 1’s perspective, there are some units with positive production cost that cannot
be sold). So seller 1 does not want to produce more than N − Q2 . The same discussion applies to seller
2, taking Q1 as given. So any pair of nonnegative quantities that add to N is a Nash Equilibrium,
because at such a quantity pair neither seller has a unilateral incentive to change quantity (even though
their quantities might not be equal at such a quantity pair).
f. The sellers will undercut each other until the price is driven down to C2 . When P1 = C2 , seller 2 has
no further incentive to cut price and also has no incentive to raise price since seller 2’s profit is zero
in either case. If seller 2 actually (and arbitrarily, from seller 2’s perspective) chooses P2 = C2 , seller
1 also has no incentive to change price provided seller 1 sells all N units of output (which is OK with
seller 2 because seller 2’s profit margin is zero). This is the only equilibrium.
g. The leader chooses Q1 = N and the follower reacts by choosing Q2 = 0. The latter is the optimal
reaction by a Cournot competitor to a choice of N by the rival, from item e above. Given that the
follower will fully accommodate the leader’s quantity choice, the leader wants to sell all the units since
choosing this quantity does not reduce the price compared with choosing some smaller quantity. So
the pair (N, Q2 (Q1 ) = max{N − Q1 , 0}) is the only subgame perfect Nash Equilibrium (the follower’s
strategy is a complete contingent plan). If the roles of leader and follower are switched, the only
subgame perfect Nash Equilibrium is (Q1 (Q2 ) = max{N − Q2 , 0}, N ).
h. In all three cases, all N units are sold so gross consumer surplus of N A is created. In item e when
Q2 = 0, item f, and item g when firm 1 is the leader, all production is done by the low-cost firm so net
surplus plus profit is N (A − C1 ). This is fully efficient although the allocation of the surplus differs
across these cases. In the other cases at least some production is done by the high-cost firm, so net
surplus plus profit is lower.
2. Assume there are n taxis with licenses. Then the objective function for one of them is
  
1 n
max πi = α − yi + yj  yi − yi2 .
{yi ≥0} 10
j=i
The FOC is  
1 
n
α− yj + 2yi  = 2yi .
10
j=i
By symmetry, in equilibrium all n quantities will be the same, so the common equilibrium quantity yi
satisfies
1
α− (n + 1)yi = 2yi ,
10
10α
or yi = 21+n . The equilibrium profit of one taxi is therefore
2
∗ 1 10α 10α 10α
π = α− n −
10 21 + n 21 + n 21 + n
110α2
= .
(21 + n)2
The city can charge up to π ∗ for each license. So the aggregate revenue for the city is nπ ∗ . Differentiating
this with respect to n gives

∂nπ ∗ 110α2 (21 − n)
= .
∂n (21 + n)3
So n = 21 is the optimal number of licenses for the city.
3.
√
a. It is straightforward to set AC = M C and find they intersect at y = 2F . This intersection actually
√
does not depend on n. The value of both AC and M C at this quantity is n 2F .
b. With n sellers the figure is as shown below. The long run supply is the horizontal sum of the MC
curves of n sellers, above the AC curve, and zero below the AC curve.
c. The industry will experience entry and exit according to whether profit can be earned at the existing
price. The figures show supply for n = 1 and for arbitrary n. If we stack the supply for n = 1 on the
√
supply for n = 2 on the supply for n = 3 ..., we get a line through the origin with slope 1, above 2F ,
which is the lowest level that can occur (i.e., n = 1). This is the long-run industry supply. If cost did
√
not depend on n, the long-run industry supply would be discrete points at multiples of 2F along the
√
horizontal line at 2F .
d. We must guarantee that demand intersects long-run industry supply. Long-run industry supply has
√ √
only one discontinuity, from y = 0 to y = 2F , at price p = 2F . So we must guarantee that demand
√
does not cross in that discontinuity. If α ≤ 2F then supply and demand are equal at a quantity of
√ √
zero and a price of α. The more interesting case is when α ≥ 2 2F . Then demand exceeds 2F at
√ √
a price of p = 2F , so industry demand and long-run supply cross somewhere above p = 2F . If
√ √
2F < α < 2 2F then there is no equilibrium.
1.
a. Set Ū = 1 in the following graph of a typical indifference curve:
b. The slope of the line from (0, 3Ū/2) to (3Ū /2, 0) is −1. So when the slope of the budget line is steeper
than −1 the highest feasible indifference curve is attained at (0, m/p2 ) and when the slope of the budget
line is flatter than −1 the highest feasible indifference curve is attained at (m/p1 , 0). When the slope
of the budget line is exactly −1 the consumer is indifferent between these two endpoints of the budget
line. So the Marshallian demands are

 

 0, if p1 > p2 
 m/p2 , if p1 > p2
x∗1 = 0 or m/p1 , if p1 = p2 and x∗2 = m/p2 or 0, if p1 = p2 .

 

m/p1 , if p1 < p2 0, if p1 < p2
Substituting these into U gives indirect utility of
2m
3p2 , if p1 ≥ p2
U∗ = 2m
.
3p1
, if p1 < p2
c. The same geometric observations yield the Hicksian demands:

 

 0, if p1 > p2 
 3Ū/2, if p1 > p2
h∗1 = 0 or 3Ū /2, if p1 = p2 and h∗2 = 3Ū/2 or 0, if p1 = p2 .

 

3Ū/2, if p1 < p2 0, if p1 < p2
Substituting these into e gives expenditure of
3Ūp2
, if p1 ≥ p2
e∗ = 2
.
3Ūp1
2 , if p1 < p2
d. The original budget line has slope 1/2, like the line from point A to point C in the graph below. The
utility maximizing point is A. The new budget line has slope 2, like the line from point C to point D.
The utility maximizing point is C. When the budget line has slope 2 but utility is held at the original
level, the expenditure minimizing point is B. So the substitution effect is from A to B and the income
effect is from B to C.
2. First we must find the expenditure and indirect utility functions. By definition,
1/2
e∗ (p1 , p2 , Ū) = p1 h∗1 + p2 h∗2 = 2 p1 p2 eŪ .
Inverting then gives

m2
U ∗(p1 , p2 , m) = ln .
4p1 p2
Now, by definition the compensating variation is
e∗ (2, 1, U ∗(1, 1, 8)) − 8 = e∗ (2, 1, ln(16)) − 8 = 2(32)1/2 − 8 ≈ 3.31.
To find the change in Marshallian surplus, we need the Marshallian demand for good 1. By Roy’s Identity,
∂U ∗
m
x∗1 (p1 , p2 , m)
∂p1
=− ∂U ∗
= .
∂m
2p1
So the change in Marshallian surplus is

! 2 2
m m m ln(2)
− dp1 = − ln(p1 ) =− = −4 ln(2) ≈ −2.77.
1 2p1 2 p1 =1 2
Therefore the percent error is (sign is unimportant):
3.31 − 2.77
≈ 16%.
3.31
3.
a. Consider any 2 points x and y in the consumption set. If x ∈ C then y x by item 2. If x ∈

/ C then
∼
we must have x ∈ B, in which case if y ∈ C then x y by item 2 and if y ∈

/ C then still x y by
∼ ∼
item 1 (noting that y ∈

/ C ⇒ y ∈ B). We always get a comparison between x and y. Therefore the
preferences are complete.
b. Consider any 3 points x, y, and z in the consumption set, and assume x y and y z. One set of
∼ ∼
points that is consistent with this setup is y ∈ B ∩ C, x ∈ C but x ∈

/ B, and z ∈ B but z ∈
/ C. Here,
x y holds by item 2 (using item 2 on y, not on x) and y z holds by item 1. However, we do not
∼ ∼
have x z because x ∈ C but x ∈

/ B, while z ∈
/ C. Therefore the preferences are not transitive.
∼
c. Suppose y ∈
/ C. Then the set {x ∈ R2+ : x y} is B. On the graph, this is the entire first quadrant
∼
except the part labeled C, The part labeled C includes its boundaries, so the left, bottom, and right
boundaries of that part are not included in B. Hence the set {x ∈ R2+ : x y} is not closed. Therefore
∼
the preferences are not continuous.
d. Pick any point on the interior of B (or C). A circle can be draw around such a point small enough
so that the entire circle stays in B (or C). The consumer is indifferent among all points in B (and all
points in C). So local nonsatiation fails.
e. A point in the area labeled B is strictly preferred to a point in the area labeled C, but the latter can
be to the northeast of the former. So monotonicity fails.
f. The points in B are strictly preferred to the points in C but not in B. So, for y ∈ B but y ∈
/ C the
preferred set {x ∈ R2+ : x y} is B. B is not a convex set because a segment connecting two points on
∼
opposite sides of the area labeled C passes outside of B. Therefore the preferences are not convex.
g. There is no utility function because the preferences are not transitive (transitivity and completeness
are necessary for there to be a utility representation).

1.
a. Here is a graph of the isoquant for output level y:
From the graph, we conclude by inspection that the conditional factor demands are

 (0, (ey − 1)/5), if 2 < w1 /w2



 ([0, (e − 1)/30], (e − 1)/5 − 2x1 ),
 y y
if w1 /w2 = 2
(x∗1 , x∗2 ) = ((ey − 1)/30, 4(ey − 1)/30), if 1 < w1 /w2 < 2 .



 ([(ey − 1)/30, (ey − 1)/6], (ey − 1)/6 − x1 ), if w1 /w2 = 1


((ey − 1)/6, 0), if w1 /w2 < 1
b. 
 w2 (e − 1)/5,
 if 2 ≤ w1 /w2
y
∗ ∗ ∗
c (w1 , w2 , y) = w1 x1 + w2 x2 = [(e − 1)/30][w1 + 4w2 ], if 1 ≤ w1 /w2 ≤ 2 .
y


w1 (ey − 1)/6, if w1 /w2 ≤ 1
c. Marginal cost is 
 y
 w2 e /5,
∗
if 2 ≤ w1 /w2
∂c
mc = = [e /30][w1 + 4w2 ], if 1 ≤ w1 /w2 ≤ 2 .
y
∂y 

w1 ey /6, if w1 /w2 ≤ 1
Let p be the output price, set p = mc, and solve for y to obtain


 ln(5p/w2 ), if 2 ≤ w1 /w2
∗
y (p, w1, w2 ) = ln(30p/(w1 + 4w2 )), if 1 ≤ w1 /w2 ≤ 2 .


ln(6p/w1 ), if w1 /w2 ≤ 1
This is the supply function provided it is positive. Otherwise, we have a corner solution and therefore
y∗ = 0. The corner solution occurs when p is so low relative to w1 and w2 that positive profit cannot
be obtained. The threshold values of p are p = w2 /5 when 2 ≤ w1 /w2 , p = (w1 + 4w2 )/30 when
1 ≤ w1 /w2 ≤ 2, and p = w1 /6 when w1 /w2 ≤ 1.
d.
π ∗ (p, w1 , w2) = py∗ − c∗ (w1 , w2 , y∗ )


 p ln(5p/w2 ) − p + w2 /5),
 if 2 ≤ w1 /w2
= p ln(30p/(w1 + 4w2 )) − p + (w1 + 4w2 )/30, if 1 ≤ w1 /w2 ≤ 2 .


p ln(6p/w1 ) − p + w1 /6, if w1 /w2 ≤ 1
As above, this is the solution when we assume the y∗ values above are positive. Whenever the prices
are such that y∗ = 0 we also have π ∗ = 0.
e.
*
ln(6x1 + 6x2 + 1), if x2 ≤ 4x1
Z= (y, −x1 , −x2 ) : x1 ≥ 0, x2 ≥ 0, and y ≤ .
ln(10x1 + 5x2 + 1), if x2 ≥ 4x1
f. Yes. The properties are 1) Z nonempty, 2) Z closed, 3) (0, 0, 0) ∈ Z (possibility of inaction), 4)
/ Z when y > 0 (no free lunch), and 5) (y , x1, x2 ) ∈ Z when (y, x1 , x2 ) ∈ Z and (y , x1 , x2 ) ≤
(y, 0, 0) ∈
(y, x1 , x2 ) (free disposal). Z is closed because the natural log is a continuous function and all of the
inequalities used in the definition of Z are weak. The origin is in Z because ln(1) = 0. As usual, this
implies nonemptiness. This also shows that no free lunch holds because the left side of the defining
inequality for Z would be positive while the right side would be zero. Finally, free disposal holds
because the natural log is an increasing function and the arguments inside it are increasing in x1 and
x2 , while the left side of the defining inequality decreases with y.
2.
a. The five necessary and sufficient conditions are:
Homogeneous of degree 1 in (w1 , w2). c∗ (λw1 , λw2 , y) = 8y2 (λw1 λw2 )1/2 = λ8y2 (w1 w2 )1/2 .
Concave in (w1 , w2 ). Differentiate the conditional factor demands from part b below to obtain the
Hessian
−3/2 1/2 −1/2 −1/2
−2y2 w1 w2 2y2 w1 w2
−1/2 −1/2 1/2 −3/2 .
2y2 w1 w2 −2y2 w1 w2
The diagonal elements of this matrix are negative, and the determinant of the whole matrix is zero, so
the matrix is negative semidefinite.

Monotonic in (w1 , w2, y). By inspection, c∗ is nondecreasing in w1 , w2 , and y (strictly increasing when
all three are positive).
Continuity. c∗ involves only products and positive exponents, so it is continuous.
Nonnegativity. By inspection, c∗ is positive when w1 , w2 , and y are all positive; and c∗ is zero when y
is zero.
b.
∂c∗ −1/2 1/2 ∂c∗ 1/2 −1/2
x∗1 = = 4y2 w1 w2 and x∗2 = = 4y2 w1 w2 .
∂w1 ∂w2
c. c∗ (2, 8, y) = 32y2 . So mc = 64y and ac = 32y. The graph is:

d. From the conditional factor demands above, x̄1 = x∗ (2, 8, 1) = 8. So the fixed cost in the short-run is
w1 x̄1 = 16, and the short-run minimization problem is
1
min 16 + w2 x2 subject to y = (8x2 )1/4 .
{x2 ≥0} 2
As there is only one input to choose, we choose the smallest amount of that input consistent with
producing y: x∗2 (w1 , w2 , y|x1 = 8) = 2y4 . So the short-run cost function is c∗ (w1 , w2, y|x1 = 8) =
c∗ (2, 8, y|x1 = 8) = 16 + 16y4 . Therefore the short-run marginal cost is mc(y|x1 = 8) = 64y3 and the
16
short-run average cost is ac(y|x1 = 8) = y + 16y3 . The graph is:
At p = 8, the setting p = mc shows the firm will supply y∗ = 1/8 in the long-run and y∗ = (1/8)1/3 in
the short-run. The latter is larger because p = 8 is below the intersection of the two mc curves, where
the firm has an excess of input 1 in the short-run that it is better to use than let lay unused.

n
1. Firm i chooses yi to maximize πi (yi |y−i ) = 100 − j=1 yj yi − 20yi . The FOC with respect to yi is
n
80 − j=1 yj − yi = 0. As all firms are identical, the symmetric Nash Equilibrium involves yj all equal
in equilibrium. Call this common equilibrium output level yi . Then the FOC is 80 − (n + 1)yi = 0, so
80n
yi = 80/(n + 1) is the Nash Equilibrium output for each firm. Therefore aggregate output is n+1 and
price is P = 100 − 80n

n+1 = 100+20n
n+1 . This gives a price-cost margin of
P − mc
100+20n
n+1 − 20 80
= 100+20n = .
P n+1
100 + 20n
This margin is less than or equal to .05 if and only if n ≥ 75.
2.
a. With the addition of firm 0’s output, the FOC from question 1 becomes 80 − y0 − (n + 1)yi = 0,
so the symmetric Nash Equilibrium quantity of each follower, given that the leader has chosen y0 , is
80−y0
yi = n+1 . Therefore the leader’s objective is

(80 − y0 )n 80 − y0
π0 (y0 |yi∗ (y0 ); i = 1, . . . , n) = 100 − y0 − y0 − 20y0 = y0 .
n+1 n+1
By the envelope theorem,

∂π0∗ ∂π0 80 − y0
= =− 2
y0 = − (n + 1)−1 π0 y =y∗ = −(n + 1)−1 π0∗ .
∂n ∂n y0 =y∗ (n + 1) y0 =y ∗
0 0
0 0
b. From the expression for π0 above, the FOC for firm 0 is 80−2y0
n+1
= 0, so y0∗ = 40.
3. The firms will engage in Bertrand undercutting until it is unprofitable for one firm to undercut the
other. This happens when P1 = P2 = C2 = 40, because at this price firm 2 cannot benefit from further
undercutting. At these prices, firm 2 earns zero profit and firm 1 earns π1 = (40 − 30)Q1 ≥ 0. Neither
firm gains from raising price because that just leads to zero profit. Firm 2 clearly does not gain from
lowering price because then its profit margin is negative. Firm 1 will gain from lowering price unless Q1
is the entire market demand. So for this to be equilibrium we must have Q1 = 100 − 40 = 60 and Q2 = 0.
Firm 2 doesn’t care about Q2 because its profit margin is zero. Hence P1 = P2 = 40 with Q1 = 60
is equilibrium provided firm 1 doesn’t want to lower price even more. It is easy to check that firm 1’s
monopoly price is 65, so lowering price would just move firm 1 further from its monopoly price.
4. This question is exactly the same as the 1998 quiz for Lecture 17 (Perfect Competition). See the solution
there.
80 140
5. From question 1, with n = 2 we have y1 = y2 = 3 in equilibrium, and the equilibrium price is P = 3 .
140 80 80 2
Therefore each firm earns profit of π1 = π2 = 3
− 20 3
= 3
. As a monopolist, one of the firms will
produce the solution from question 1 for n = 1, giving ym = 40, P m = 60, and π m = (60 − 20)40 = 402 .
80 2 40 2
So the movement from duopoly to monopoly is worth 402 − 3 =5 3 to the firm that becomes the
monopoly. The graph is:
160
The deadweight loss from the acquisition is DW L = 1
2 60 − 140
3 3 − 40 = 800
9 .
1. A typical indifference curve is:
This indifference curve is strictly concave, so the minimum will be at one of the corners. The slope of the
√
line from one corner to the other is − Ū . Therefore the Hicksian demands are
 √
 0, Ū , if pp12 ≥ Ū
h = √
∗ √
 Ū , 0 , if pp12 ≤ Ū
This gives the following expenditure function:

√
p2 Ū , if p1
≥ Ū
∗ p2
e = √ √
p1 Ū, if p1
p2
≤ Ū
2.
a. No. The preference relation gives no ranking if both x and y are odd numbers.
b. Yes. Suppose x y and y z. The first ranking implies that x is even. Therefore x z.
∼ ∼ ∼
c. No. According to the relation, 2 3. A correct answer must note that an even number that is less
than an odd number is strictly preferred to the odd number.
3. Invert U ∗ to obtain the expenditure function e∗ = Ūp 1 p2 ∗

p1 +p2 . Differentiate e to find the Hicksian demands via
2 2
Shephard’s Lemma: h∗1 = Ū p1p+p 2
2
and h ∗
2 = Ū p 1
p1
+p2
. Let p = pp12 be the relative price. In terms
2 2
of the relative price, the Hicksian demands are h∗1 = Ū 1+p 1
and h∗2 = Ū 1+p p
. These equations
express the quantities x1 = h∗1 and x2 = h∗2 in terms of utility U = Ū and the relative price p. Solving
√ √ 2
simultaneously to eliminate p yields U = x1 + x2 . It is straightforward to check that the indirect
utility function obtained by maximizing U is indeed the given U ∗ .
4. CV is the extra expenditure required to keep utility constant when the price changes. Utility is constant
in e∗ . Expenditure increases from 1 to 10. So the CV is 9.
5. The MRS is − x1x+1

2
. It is straightforward to check that the indifference curve is strictly convex. So setting
the MRS equal to the negative price ratio and using the budget constraint yields the simultaneous solution
m−p1 m+p1
x1 = 2p1 and x2 = 2p2 . These are the Marshallian demands provided there is not a corner solution.
The MRS at x2 = 0 is zero, so no corner solution is possible with x2 = 0. But the MRS at x1 = 0 is
−x2 . So a corner solution with x1 = 0 is possible. The tangency gives x1 > 0 provided m > p1 . So the
Marshallian demands are 

 0, pm , if m ≤ p1
2
x∗ =
 m−p1 , m+p1 , if m > p
2p1 2p2 1
1. The Lagrangian function for cost minimization is L = w1 x1 + w2 x2 − λ(Ax1 x2 − y). By the envelope
theorem,

∂c∗ ∂L
= = −λx1 x2 |xi =x∗ &λ=λ∗ = −λ∗ x∗1 x∗2 .
∂A ∂A xi =x∗ &λ=λ∗ i
i
Now use the fact that λ∗ is marginal cost and y = Ax∗1 x∗2 to rewrite this derivative as −mc(y)y/A.
2.
a. The average variable cost function is AV C(y) = 1

y+1
+ y4 . So AV C (y) = − (y+1)
1 1
2 + 4 and AV C (y) =
2
(y+1)3 > 0. Hence setting AV C (y) = 0 will yield a minimum. The value of y at which AV C (y) = 0
is y = 1 and the value of AV C there is AV C(1) = 34 . Also, AV C(0) = 1.
The marginal cost function is M C(y) = 1

(y+1)2
+ y2 . So M C(0) = 1. Therefore the graph is
The supply curve is the M C curve above the AV C curve (because all fixed costs are sunk), and the
vertical axis at prices below 3/4.
b. The shutdown decision is made by examining average avoidable costs (AAC). When α < 1 some of the
fixed costs are avoidable (specifically, (1 −α)F ). So the average cost curve that is relevant for shutdown
(1−α)F
decisions is AAC(y) = y + AV C(y). This curve must be above AV C(y) and must cross M C(y)
at the minimum of AAC(y), so now the graph is:
The lowest price at which there is positive supply slides up the M C curve and the portion of the supply
curve on the vertical axis likewise slides up.
3. This technology is clearly not convex. More importantly, this technology does not satisfy the possibility of
inaction (because e0 = 1, so V (0) does not include the origin). All other standard properties are holding.
To find the profit function, first find the cost function. The lowest isocost line is always achieved at one
of the corners. So we have either x∗ = (0, ey ) or x∗ = (ey , 0). The former occurs when the isocost line
has slope steeper than −1 and the latter occurs when the isocost line has slope flatter than −1. So the
cost function is

w1 ey , w1
≤1
c∗ (w, y) = y
w2
w1
w2 e , w2
>1
Therefore the profit objective is
max π = py − wey ,
{y≥0}
p
where w = min{w1 , w2 }. The FOC for y yields y∗ = ln w
. This is indeed a local maximum because the
second derivative is −wey < 0. However, the value of y∗ given by the FOC can be negative. This will
p
happen when p < w. So we have y∗ = 0 when p ≤ w and y∗ = ln w when p > w. Substituting into the
objective yields the profit function:

−w, p≤w
π ∗ (p, w1 , w2 ) = " p #
p ln w − 1 , p > w
Note that the profit can be negative (even when p > w, because ln(p/w) < 1 when p/w < e). This is
because the possibility of inaction is not holding.
4.
a. The five sufficient properties for a cost function are
Homogeneity of degree 1 in w. Here we have c∗ (αw1 , αw2 , y) = y(αw1 ) = α(yw1 ) = αc∗(w1 , w2 , y).
Concavity in w. c∗ is linear in w, so it is trivially concave (Hessian is a matrix of zeros).
∂c∗ ∂c∗ ∂c∗

Monotonicity. ∂w1 = y ≥ 0; ∂w2 = 0; and ∂y = w1 > 0.
Continuity. c∗ = yw1 involves only products, so it is continuous.
Nonnegativity. c∗ = yw1 > 0 when y > 0 and w1 > 0. c∗ = 0 when y = 0.
As c∗ satisfies the sufficient conditions for a cost function, we know it is indeed a cost function for some
well-behaved technology.
b. From Shephard’s Lemma, x∗1 = y and x∗2 = 0. So the optimal choice in R2+ is x∗ = (y, 0) no matter
what the input prices are. Therefore the input requirement set cannot contain any points left of (y, 0)
(otherwise, such points would be chosen as cost minimizing points for some isocost slope). Using free
disposal then yields the input requirement set
c. Intersecting areas above isocost lines over all positive relative prices cannot reveal information about
possible positive slopes to the boundaries of input requirement sets. Yet another input requirement set
that yields the same cost function is
This set does not satisfy free disposal, but this does not affect cost because no points off of the horizontal
axis are ever chosen as cost-minimizing points.

1.
a. M R = 100 − 2Q. Set equal to M C to obtain Q = 100−c1

2 . Then P = 100 − 100−c1
2 = 100+c1
2 . This
assumes c1 < 100 (otherwise, Q = 0). Profit is

2
100 + c1 100 − c1 100 − c1
π1 = [P − c1 ]Q = − c1 = .
2 2 2
b. The Cournot objectives are
π1 = [100 − Q1 − Q2 − c1 ]Q1
π2 = [100 − Q1 − Q2 − c2 ]Q2 .
So the FOCs are
100 − 2Q1 − Q2 = c1
100 − Q1 − 2Q2 = c2 .
Solving simultaneously for the quantities yields the Nash Equilibrium:
1
Q1 = [100 + c2 − 2c1 ]
3
1
Q2 = [100 + c1 − 2c2 ].
3
Adding these gives aggregate quantity of Q = 13 [200 −c1 −c2 ], and substituting into the inverse demand
gives the equilibrium price P = 13 [100 + c1 + c2 ]. Then equilibrium profits are

2
100 + c2 − 2c1
π1 =
3

2
100 + c1 − 2c2
π2 = .
3
100+c1
c. If c2 = then Q2 = 0. Aggregate welfare based on Marshallian surplus is
2
! ! Q
Q
W = CS + π1 + π2 = [100 − t]dt − P Q + [P − c1 ]Q1 + [P − c2 ]Q2 = [100 − t]dt − c1Q1 − c2 Q2 .
0 0
Differentiating with respect to c2 yields
∂W ∂Q ∂Q1 ∂Q2
= P (Q) − c1 − c2 − Q2
∂c2 ∂c2 ∂c2 ∂c2
∂Q1 ∂Q2
= [P − c1 ] + [P − c2 ] − Q2 .
∂c2 ∂c2
100+c1
Evaluating at c2 = 2 (so P = c2 and Q2 = 0) yields

∂W ∂Q1
= [P − c1 ] .
∂c2 c2 =(100+c1 )/2 ∂c2
From the Nash equilibrium quantities, ∂Q 1 1

∂c2 = 3 , so

∂W 1 100 − c1
= [P − c1 ] = >0
∂c2 c2 =(100+c1)/2 3 6
100+c1
(again assuming c1 < 100). Therefore a small decrease in c2 from 2
results in a decrease in welfare,
100+c1
and society therefore does not benefit from Cournot competition when c2 is near 2 . Competition
is harmful in this case because the new competitor is much less efficient than the monopolist (c2 > c1 ).
So even though aggregate output increases, price decreases, and consumers are better off; production
costs rise enough to more than offset the gains to consumers. On the other hand, if the new firm has
cost c2 = c1 then the introduction of competition increases aggregate quantity and decreases price with
no offsetting rise in production costs. This is a pure saving of deadweight loss, and therefore improves
welfare.
d. Suppose c1 ≤ c2 . Then Bertrand competitors undercut each other until P1 = P2 = c2 . At this
price, firm 2 has no further incentive to undercut. Firm 1 will undercut slightly if necessary to obtain
the whole market (unless c1 = c2 , in which case they probably split the market), but since firm 2 is
indifferent between selling and not selling it is simplest to just assume firm 1 sells the entire demand
at price P1 = P2 = c2 . These prices are a Nash equilibrium provided firm 1 sells the entire demand
(unless c1 = c2 , in which case any division of demand is a Nash equilibrium). The aggregate quantity
is Q = 100 − P = 100 − c2 . If c1 > c2 then the roles of c1 and c2 reverse, and P1 = P2 = c1 is a
Nash equilibrium (provided firm 2 sells the entire demand) and Q = 100 − c1 . All of this assumes the
high-cost firm has marginal cost below the low-cost firm’s monopoly price. Otherwise, the low-cost
firm just charges its monopoly price and sells its monopoly quantity, as in part a above.
e. When a high-cost competitor competes in prices, it forces the price down to its own cost provided only
that its cost is below the monopoly price of the low-cost firm. This eliminates deadweight loss. In
equilibrium, the low-cost firm still produces all of the output, so there is no increase in production
costs of the type encountered in the Cournot model. Hence welfare improves provided only that the
high-cost firm is efficient enough to alter the monopoly behavior of the low-cost firm.
2.
a. Yes. We could check the sufficient condition, but since we have actual numbers in this case it is easiest
11
to just construct an equilibrium. For example, three firms each producing 3 units of output is an
equilibrium.
b. If all firms produce the smallest possible amount (i.e., 2) then six firms produce too much (i.e., 12).
11
So five firms is the maximum number. Five is an equilibrium if each produces 5 units of output, for
example. If all firms produce the largest possible amount (i.e., 4) then two firms produce too little
(i.e., 8). So three firms is the minimum number.
3.
a. The marginal cost of a typical fringe firm is cf = 10 + 20qf . So when the dominant firm charges price
P the typical fringe firm chooses qf to satisfy 10 + 20qf = P , or qf = P

20 − 12 . This is the supply
curve of a typical fringe firm for P > 10. When P ≤ 10 the fringe supplies zero (more on this below).
"P #
So aggregate fringe supply is Qf = nqf = n 20 − 1
2 for P > 10. Then the residual demand of the
dominant firm is

P 1 n n
Qd = Q − Qf = 100 − P − n − = 100 + − 1+ P.
20 2 2 20
Invert this to obtain the dominant firm’s inverse residual demand:
( n ) 20
P = 100 + − Qd .
2 n + 20
Multiplying this by Qd gives revenue for the dominant firm, and differentiating then gives marginal
revenue M Rd = 1
n+20
[2000 + 10n − 40Qd ]. Setting this equal to marginal cost cd = 1 and solving for
1980+9n
Qd gives the dominant firm’s quantity Qd = 40 . Substitute this into the dominant firm’s inverse
2020+11n
residual demand to get price P = 2[n+20]
. This is all contingent on P > 10. The dominant firm’s
price satisfies P > 10 if and only if n < 180.
∂Qd 9
b. ∂n = 40 > 0, so the dominant firm increases output as the number of fringe firms increases. This
is because the fringe supply becomes more elastic as n increases, which makes the dominant firm’s
residual demand more elastic. The arrows show what happens as n increases:
The marginal revenue curve that accompanies the dominant firm’s residual demand has smaller inter-
cept and flatter slope as n increases. The slope flattens enough to make the point of intersection with
the horizontal line cd = 1 move to the right as n increases.
c. If n > 180 then the marginal revenue curve that accompanies the dominant firm’s residual demand
crosses the horizontal line cd = 1 to the right of Q = 90. Of course, the dominant firm’s residual
demand and residual marginal revenue curves are not relevant for quantities above 90, since fringe
supply is zero at such low prices. Hence the dominant firm supplies Qd = 90 and charges P = 10. At
the kink, marginal revenue is below marginal cost for price decreases but above marginal cost for price
increases.
1. Check the five properties of an expenditure function:
Homogeneity of degree one in prices:
(λp1 )(λp2 )Ū p1 p2 Ū

e∗ (λp1 , λp2 , Ū ) = =λ = λe∗ (p1 , p2 , Ū).
λp1 + λp2 p1 + p2
Increasing in pi ; Strictly increasing in Ū :
∂e∗ p2j Ū ∂e∗ p1 p2

= ≥ 0; = > 0.
∂pi (p1 + p2 )2 ∂ Ū p 1 + p2
Concavity in (p1 , p2 ): The Hessian of e∗ with respect to prices is

p2

− (p1 +p
2
2)
3
p1 p2
(p1 +p2 )3
2Ū p21
.
p1 p2
(p1 +p2 )3
− (p1 +p 2)
3
The diagonal elements are nonpositive, and the determinant is zero, so this matrix is negative semidef-
inite.
Continuity: e∗ involves only sums, products, and division, so it is continuous except at p1 = p2 = 0,
where it is undefined.
Nonnegativity: By inspection, e∗ (p1 , p2 , 0) = 0 and e∗ (p1 , p2 , Ū > 0) > 0.
So e∗ is indeed an expenditure function for some complete, transitive, continuous, and locally nonsatiated
preference relation on R2+ .

∼
2. This can be answered by checking whether the given functions possess the properties of Marshallian
demands, but since question 4 asks for a comparison between these Marshallian demands and the expen-
diture function from question 1, we can answer both question 2 and question 4 at once by showing that
these Marshallian demands arise from the expenditure function in question 1. From the derivatives above,
the Hicksian demands via Shephard’s Lemma are
p22 Ū p21 Ū
h∗1 = ; h∗2 = .
(p1 + p2 )2 (p1 + p2 )2
Inverting the expenditure function yields the indirect utility function U ∗ = m(p1 +p2 )
p1 p2 . Substitute U ∗ into
the Hicksian demands to get the Marshallian demands (or, use Roy’s Identity):
p22 m(p1 + p2 ) p2 m p21 m(p1 + p2 ) p1 m

x∗1 = = ; x∗2 = = .
(p1 + p2 )2 p1 p2 p1 (p1 + p2 ) (p1 + p2 )2 p1 p2 p2 (p1 + p2 )
We know these are Marshallian demands for some complete, transitive, continuous, and locally nonsatiated
preference relation on R2+ , because we showed that the function in question 1 from which these are
∼
derived is indeed an expenditure function.
3. CV = e∗ (p11 , p2 , U ∗ (p01 , p2 , m)) − m. Substitute U ∗ from above into e∗ to obtain
1 0
p11 p2 m(p01 + p2 ) p1 (p1 + p2 ) p2 (p11 − p01 )

CV = 1 − m = m − 1 = m .
p1 + p2 p01 p2 p01 (p11 + p2 ) p01 (p11 + p2 )
4. Yes. They have the same Marshallian demands, so their (economically relevant) preferences are the same.
5. Let p = p1 /p2 be the relative price. In terms of p, the Hicksian demands are
Ū p2 Ū
h∗1 = ; h∗2 = .
(p + 1)2 (p + 1)2
These two equations relate quantities (h∗1 and h∗2 ) to the utility level those quantities deliver (Ū ), for any
given relative price p. We can substitute them together to eliminate p and thereby obtain the relationship
2
between quantities and utility. From h∗1 , p = hŪ∗ − 1. From h∗2 , Ū = h∗2 p+1
p . Substitute the former
1
into the latter to obtain

 2 √ 2
Ū
h∗ Ū
Ū = h∗2  1
 = h∗2 √ .
Ū
−1 Ū − h∗1
h∗
1
This is
2 2
Ū − h∗1 = h∗2 ⇔ Ū − h∗1 = h∗2 ⇔ Ū = h∗1 + h∗2 .
"√ √ #2
So the utility function is U (x1 , x2 ) = x1 + x2 .
6.
a. No. As long as either a or b is a plant, the relation gives a (weak) preference between a and b. But
if a and b are both “Iron,” the relation gives no information about whether a b or b a. How
∼ ∼
do we know Iron Iron? The given relation says nothing about this. Completeness requires that all
∼
pairs be comparable, even if the two elements in the pair are the same (Varian lists this separately as
“Reflexivity,” but it’s really just a special case of the Completeness property).
b. Yes. Given that a b and b c, the relation tells us that a and b are plants. Thus a c even if c is
∼ ∼ ∼
not a plant (i.e., even if c =“Iron”).

1. First check to see if the functions satisfy the five sufficient conditions for factor demands:
a. Homogeneity of degree zero in prices. Changing all input prices by a factor λ obviously does nothing
when y < 1. When y ≥ 1,
' '
λwj wj
x∗i (λw1 , λw2 , y) = (y − 1) = (y − 1) = x∗i (w1 , w2 , y),
λwi wi
so homogeneity of degree zero holds.
b. Symmetry and semidefiniteness of the matrix of price derivatives. For y < 1 the matrix is zero, which
is symmetric and negative semidefinite. For y ≥ 1 the matrix is

∂x∗ ∂x∗

−3/2 −1/2 −1/2

1
∂w1
1
∂w2 −w1 w2
1/2
w1 w2 y−1
∂x∗ ∂x∗ = −1/2 −1/2 1/2 −3/2 .
2
∂w1
2
∂w2
w1 w2 −w1 w2 2
This is clearly symmetric and the (1, 1) naturally ordered principal minor is clearly nonpositive. The
second order principal minor is the determinant
(y − 1)2 " −1 −1 #
|·| = w1 w2 − w1−1 w2−1 = 0.
4
So the matrix is symmetric and negative semidefinite.
c. w · x∗ is nondecreasing in (w, y). For y < 1, w · x∗ = 0, which is nondecreasing. For y ≥ 1, w · x∗ =

√
w1 x∗1 + w2 x∗2 = 2 w1 w2 (y − 1), which is also nondecreasing in all its arguments. Note that this
expression is zero at y = 1, so the nondecreasing property holds across the kink as well.
d. w · x∗ is continuous. The two parts are each individually continuous, and both parts are 0 at y = 1.
e. Nonnegativity. x∗i ≥ 0 for all (w, y) by inspection. As noted above, w · x∗ = 0 when y = 0. These two
parts of the nonnegativity property hold. However, w · x∗ is not strictly positive when 0 < y ≤ 1, so
the last part of the nonnegativity property fails. The given system is not a system of factor demands
for a technology that satisfies the five basic assumptions. Since x∗ = 0 when y > 0, the underlying
technology permits a free lunch. Positive output can be produced with zero inputs.
2.
a.
b. Yes. Z is clearly nonempty. Since the defining inequalities are weak, the boundaries are included and
therefore Z is closed. The possibility of inaction is present because (0, 0) is an element of Z. Free
disposal is present because none of the boundaries of Z have a positive slope. No free lunch is satisfied
because no part of Z except the origin is in the first quadrant.
c. Pick any point in Z. A segment from that point to the origin lies entirely in Z. Therefore Z has
nonincreasing returns. There are points in Z (for example, the point (−1, 2)) that cannot be expanded
while staying in Z. Therefore Z does not have nondecreasing returns.
d. Yes, Z is convex. The segment joining any two points in Z remains entirely in Z.
e. V (y) is the (negative of the) set of x values that, together with the given y, form elements in Z. So
V (y) = [0, ∞) for y ≤ 0; V (y) = [y/2, ∞) for 0 < y ≤ 2; V (y) = [y − 1, ∞) for 2 < y.
f. Superimpose the isoprofit line for a given slope −w/p on the graph of Z. If the slope is steeper (in
absolute value) than −2 then the highest isoprofit is achieved at the point (0, 0). If the slope equals
−2 then any point on the segment between (0, 0) and (−1, 2) is on the highest possible isoprofit. If
the slope is between −2 and −1 then the highest isoprofit is achieved at the point (−1, 2). If the slope
equals −1 then any point on the line y = 1 − x to the left of (−1, 2) is on the highest possible isoprofit.
If the slope is flatter (in absolute value) than −1 then we can achieve successively higher isoprofit lines
by moving to the northwest along the upper boundary of the set. Hence the highest isoprofit is achieved
at (−∞, ∞). These observations lead to the following supply/demand function:


 (0, 0) if w/p > 2



 ∗
 (−2x , [−1, 0]) if w/p = 2
∗ ∗
(y , −x ) = (2, −1) if 1 < w/p < 2



 (1 − x∗ , (−∞, −1]) if w/p = 1


(∞, −∞) if w/p < 1
Multiplying these optimal choices by the prices gives the profit function:


0 if w/p ≥ 2
∗
π = 2p − w if 1 ≤ w/p < 2


∞ if w/p < 1
g. At a positive input price, cost is minimized by using the smallest possible x for any given y. From the
input requirement sets found in part e, the smallest possible x values are

∗
y
2 if 0 ≤ y ≤ 2
x =
y − 1 if y > 2
Multiply this by the input price w to obtain the cost function:

∗
wy
2 if 0 ≤ y ≤ 2
c =
w(y − 1) if y > 2
h. Check the five sufficient conditions for cost functions:
Homogeneity of degree one in prices.

∗
λwy
if 0 ≤ y ≤ 2 wy
if 0 ≤ y ≤ 2
c (λw, y) = 2
=λ 2
= λc∗ (w, y),
λw(y − 1) if y > 2 w(y − 1) if y > 2
so homogeneity of degree one holds.
Concavity in prices. For a given y, c∗ is linear in w with slope either y/2 or y − 1. A straight line is
always concave (second derivative is zero).
Nondecreasing in (w, y). From above, the slope of c∗ with respect to w is positive (y − 1 is the slope
only when y > 2). The slope with respect to y is either w/2 or w, which are both positive. Note that
c∗ is continuous at y = 2 (both parts of c∗ are w), so there is no downward jump between the two
segments of c∗ .
Continuous. Each individual part of c∗ is continuous, and both parts are w at y = 2.

Nonnegative; and zero when y = 0. This is clear by inspection (again, the y − 1 segment only applies
when y > 2).
i.
w
if 0 < y ≤ 2
∗
ac(y) = c /y =
2

w 1 − 1y if y > 2

∂c∗ w
2 if 0 < y < 2
mc(y) = =
∂y w if y > 2
j. Supply is marginal cost above average non-sunk cost. Since there are no fixed costs here, supply is just
marginal cost. If p is below w/2 then supply is the vertical axis (y∗ = 0). If p equals w/2 then supply
is any output level between 0 and 2. If p is between w/2 and w then supply is y∗ = 2. If p equals w
then supply is any output level greater than or equal to 2. If p exceeds w then supply is infinite (price
exceeds marginal cost for all output levels, so profit is always increased by an increase in output). Note
that this is exactly the same as the y∗ function obtained in part f. The break points occur at p = w/2
and p = w, as in part f. At these critical prices, there are ranges of optimal supply levels that coincide
with the ranges identified in part f.

1.
a. Let Qi denote the quantity for firm i. Then revenue for firm i is Ri = [150 − Qi − Qj ]Qi , so marginal
revenue is M Ri = 150 − 2Qi − Qj . Setting this equal to M Ci and solving for Qi yields Qi = [150 −
M Ci − Qj ]/2. Substituting in the marginal costs yields
1 1
Q∗1 = 70 − Q2 , Q∗2 = 65 − Q1 .
2 2
These are the reaction curves, ignoring the possibility of shutdown at a positive output level. However,
since there are non-sunk fixed costs, the firms will shut down at positive output levels. To determine
the shutdown points, we must find each firm’s optimal profit as a function of the other firm’s output.
The equilibrium price from firm i’s perspective is
150 − M Ci − Qj 150 + M Ci − Qj
Pi = 150 − Qi − Qj = 150 − − Qj = .
2 2
So firm i’s profit is
150 + M Ci − Qj 150 − M Ci − Qj
πi = [Pi − M Ci ]Qi − Fi = − M Ci − Fi
2 2

2
150 − M Ci − Qj
= − Fi . (1)
2
Setting this equal to zero and solving for Qj gives the level of the rival’s output above which firm i will
shut down:

150 − M Ci − Qj = 2 Fi ⇒ Qj = 150 − M Ci − 2 Fi
(the other root is not relevant because it makes the intercept of residual demand, 150 − Qj , below
marginal cost). Substituting in marginal and fixed costs yields Q2 = 60 and Q1 = 70. So the reaction
curves are

70 − 12 Q2 , Q2 ≤ 60 65 − 12 Q1 , Q1 ≤ 70
Q∗1 (Q2 ) = , Q∗2 (Q1 ) =
0, Q2 ≥ 60 0, Q1 ≥ 70
Solving the positive parts simultaneously gives an intersection of (Q1 , Q2 ) = (50, 40). Also, on the
positive parts, Q∗1 (60) = 40 and Q∗2 (70) = 30. The graph is:
b. It is immediate from the graph that there are three (Q1 , Q2 ) pairs that are Nash Equilibria:
I = (0, 65), II = (50, 40), III = (70, 0).
c.
i. We must calculate the sum of consumer’s surplus and profit in each of the Nash Equilibria (it is
not immediate that the equilibrium with price closest to marginal cost is best, because there are extra
fixed costs incurred when more than one firm operates). The prices in the three equilibria are
P I = 150 − 65 = 85, P II = 150 − 50 − 40 = 60, P III = 150 − 70 = 80.
So the consumer’s surpluses in the three equilibria are
1 652 1 902 1 702

CS I = (65)(150 − 85) = , CS II = (90)(150 − 60) = , CS III = (70)(150 − 80) = .
2 2 2 2 2 2
From (1) above, the profits in the three equilibria are

2
2
150 − 10 − 40 150 − 10 − 0
π1I = 0, π1II = − 1, 600 = 502 − 1, 600, π1III = − 1, 600 = 702 − 1, 600
2 2

2
2
150 − 20 − 0 150 − 20 − 50
π2I = − 900 = 65 − 900,
2
π2II = − 900 = 402 − 900, π2III = 0
2 2
So aggregate welfare in each of the three equilibria is:
3 2 10, 875
π1I + π2I + CS I = 65 − 900 =
2 2
1 11, 300
π1II + π2II + CS II = 502 + 402 + 902 − 2, 500 =
2 2
3 2 11, 500
π1III + π2III + CS III = 70 − 1, 600 =
2 2
Thus equilibrium III = (70, 0) is best for aggregate welfare. This is better than II, despite the extra
deadweight loss created by the higher price, because the extra deadweight loss is less than the fixed
cost of 900 that is saved when firm 2 does not operate.
ii. There is no way to tell which equilibrium will actually emerge unless we make more assumptions.
However, a law that prohibits firm 2 from operating will produce the best welfare outcome among the
three equilibria because firm 1 will behave as a monopolist under such a law, which is exactly what firm
1 does anyway in equilibrium III. Of course, it would be even better to regulate firm 1 as a monopolist
and thereby force firm 1 to price closer to marginal cost, assuming the regulator has reasonably good
demand and cost information.
iii. No, it is not Pareto Efficient, because there is deadweight loss relative to having price equal M C1 .
The best outcome would be to set P = M C1 and then compensate firm 1 for its fixed cost through
some type of lump-sum transfer.
d. Both firms have strictly increasing returns, because a positive fixed cost and a constant marginal cost
result in a strictly downward-sloping ac curve. So, there is no perfectly competitive equilibrium price.
If the firms behave as price-takers, they will supply infinite output at prices above marginal cost and
zero output at prices no greater than marginal cost. But demand is positive and finite at marginal cost
c > 0, so there is no price at which demand equals competitive supply.
2.
a. This is Cobb-Douglas utility. It is straightforward to find the Marshallian demands x∗ (p, m) = m

2p and
y∗ (p, m) = m
2. For future reference, the indirect utility function is therefore
m
m
U ∗ (p, m) = U (x∗ , y∗ ) = ln + ln .
2p 2
Since there are k identical consumers, aggregate demand for x is D(p) = kx∗ (p, m) = km
2p .
km
b. Revenue for a monopolist is R = pD(p) = 2 for D(p) > 0. This revenue expression depends on
neither price nor quantity. In other words, the monopolist’s revenue is constant no matter how much
the monopolist chooses to produce. This is because Cobb-Douglas demands have the property that
elasticity is one everywhere on the demand curve. Hence marginal revenue is zero at every positive
output level. However, revenue is positive when D(p) > 0 (there is a discontinuity at D(p) = 0). Since
marginal cost is positive, the monopolist wants to produce the smallest possible positive output.
c. p = c.
d. Let Q denote aggregate quantity and Qi the quantity of firm i. Invert aggregate demand from part
km km
a to obtain inverse demand p(Q) = 2Q . Then the revenue of firm i is Ri = p(Q)Qi = 2Q Qi , so
marginal revenue is M Ri = km
2Q
− km
Q.
2Q2 i
Setting this equal to marginal cost yields the optimality
condition km
2Q − km
2Q2 Qi = c. Noting that the E firms are identical, the symmetric equilibrium outputs
are identical. Call this common output level q, so Qi = q and Q = Eq in equilibrium. Putting these
km(−1)
into the optimality condition yields km
2q − km
22q2 q = c, or q = 22c . Aggregate equilibrium output
km(−1)
is thus Q = Eq = 2c . Putting this into the aggregate inverse demand yields an equilibrium price
km 2c c
of p = 2 km(−1)
= −1
. Since the perfectly competitive price is c, the Cournot equilibrium price is
within 10% of the competitive price when

−1 ≤ 1.1, or E ≥ 11.

e. Inverting indirect utility from part a yields the expenditure function e∗ (p, Ū) = 2 p · exp(Ū ). We are
c
seeking a compensating variation measure of deadweight loss of the price increase from p = c to p = −1
(the government is going to “compensate” consumers for the higher price). So the compensation will
restore utility after the price increase to the level consumers would get if p = c. This utility level is
m m
U ∗ (c, m) = ln + ln .
2c 2

Putting this level of utility into the expenditure function yields e∗ (p, U ∗(c, m)) = m pc . This is the
expenditure required to maintain utility at the level obtained when price is at the competitive level,

as a function of p. Since there are k consumers, aggregate expenditure is ke∗ (p, U ∗ (c, m)) = km pc .
Thus the aggregate expenditure required to keep utility at the perfectly competitive level, when the
firms behave as Cournot oligopolists, is
'
∗ cE ∗ E
ke , U (c, m) = km .
E−1 E−1
The compensating variation is the difference between this expenditure and the original aggregate ex-
penditure km:
' '
E E
CV = km − km = km −1 .
E−1 E−1
To obtain the deadweight loss, we must subtract the extra revenue from CV. The price difference is
c
−1 −c = c
−1 . The quantity at the higher price, after the compensation, is most easily found from the
Hicksian demand, which is
'
∗ ∗ ∂e∗ (p, U ∗(c, m)) m 1
h (p, U (c, m)) = = .
∂p 2 pc

Evaluating this demand at the oligopoly price yields quantity h∗ c
−1
, U ∗(c, m) = m
2c
−1

. Multi-
plying this by k to get aggregate quantity yields extra revenue of

' 2
c km E−1 km 1
= .
E − 1 2c E 2 E(E − 1)
Thus the deadweight loss is

' 2 ' 2
E km 1 E 1 1
CV - extra revenue = km −1 − = km −1− .
E−1 2 E(E − 1) E−1 2 E(E − 1)
With k = 1, 000, 000, m = $30, 000, and E = 11, the deadweight loss is $34,071,561.
1.
a. The indifference curves are semicircles with radii Ū centered at the point (0, 10). Larger semicircles
correspond to higher utility levels:
b. The utility function is defined on all of R2+ . This implies completeness and transitivity of the preference
relation. The utility function is also continuous, which implies continuity of the preference relation.
c. For local nonsatiation, select any point in R2+ . Utility is strictly increasing if the x coordinate is
increased while the y coordinate is held fixed, because such a change always moves the consumer to a
larger semicircle (even at (0, 10) and along the x-axis, including the origin). Thus, local nonsatiation
holds. However, no version of monotonicity holds. For example, (0, 10) is worse than (0, 0). Also,
convexity does not hold, as can be seen by joining points A and B in the figure above.
d. From the shape of the indifference curves, the optimal choice must be at one of the corners (m/p1 , 0)

or (0, m/p2 ). The utility at these two corners is U (m/p1 , 0) = (m/p1 )2 + 100 and U (0, m/p2 ) =
|m/p2 − 10|, respectively. So,

 m
 p1 , if (m/p1 )2 + 100 > |m/p2 − 10|

( )
x∗1 = m
p1 , 0 , if (m/p1 )2 + 100 = |m/p2 − 10|



0, if (m/p1 )2 + 100 < |m/p2 − 10|


 0, if (m/p1 )2 + 100 > |m/p2 − 10|
 ( )
x∗2 = m
p2 , 0 , if (m/p1 )2 + 100 = |m/p2 − 10|


 m
p2
, if (m/p1 )2 + 100 < |m/p2 − 10|
2. It is straightforward to establish that these equations are homogeneous of degree zero, nonnegative, and
satisfy Walras’ Law. The key is checking symmetry and semidefiniteness of the matrix whose elements
∂x∗ ∂x∗
are i
∂pj
+ x∗j ∂mi . The first diagonal element when m < p2 is:
∂x∗1 ∂x∗ m2 m2 2m m2 2m
+ x∗1 1 = − 2 + = 2 −1 .
∂p1 ∂m p1 p2 p1 p2 p1 p2 p1 p2 p2
This is positive for 12 p2 < m < p2 , so negative semidefiniteness fails. The equations are not Marshallian
demands.
3.
√
a. Invert U ∗ to get e∗ (p1 , p2 , Ū) = Ū 2 p1 p2 .
∗

Ū 2 ∂e∗ Ū 2
b. Differentiate e∗ to get h∗1 = ∂e ∂p1 = 2
p2 ∗
p1 and h2 = ∂p2 = 2
p1
p2 .
c. Differentiate U ∗ to get
∂U ∗ /∂p1 −m2 p−2

1 p2
−1
m
x∗1 = − ∗
= − −1 −1 =
∂U /∂m 2mp1 p2 2p1
∂U ∗ /∂p2 −m2 p−1
1 p2
−2
m
x∗2 = − ∗
=− −1 −1 =
∂U /∂m 2mp1 p2 2p2
4. e∗ (p1 , p2 , Ū) = p1 h∗1 + p2 h∗2 = Ū [p1 + p2 ]. Invert to get U ∗ (p1 , p2 , m) = m

p1 +p2
. So, utility at the initial
price is U ∗ (1, 1, 160) = 80 and utility at the new price is U ∗ (31, 1, 160) = 5. Expenditure at the initial
price and the new utility level is e∗ (1, 1, 5) = 10, so the change in income that is equivalent, in utility
terms, to the price change is 10 − 160 = −150.

1.
a. This set is just the negative half of the real line, including the origin. Since the origin is included,
the possibility of inaction is satisfied and the set is closed (the only “boundary” is zero). It is also
clearly nonempty. All numbers smaller than any number in the set are also in the set, so free disposal
is satisfied. No positive numbers are included, so no free lunch is satisfied.
b. Z is convex. Take any two nonpositive real numbers z1 and z2 , and form the weighted average λz1 +
(1 − λ)z2 . The result is a nonpositive real number.
c. Constant returns. Shrink or expand any nonpositive real number z and you still get a nonpositive real
number αz, for α > 0.
d. Profit is pz, where p and z are both real numbers and p ≥ 0 and z ≤ 0. pz is maximized by choosing
z ∗ = 0 unless p = 0. When p = 0, z ∗ = (−∞, 0]. In both cases, π ∗ = 0 ∀p ≥ 0.
2. The profit objective is π = p[α ln(x1 + 1) + (1 − α) ln(x2 + 1)] − w1 x1 − w2 x2 . By the envelope theorem,

∂π ∗ ∂π
=
∂α x12 =x1∗
x =x∗
∂α
2
= p [ln(x1 + 1) − ln(x2 + 1)]|x1 =x∗1

x2 =x∗

2
pα p(1 − α)
= p ln − ln .
w1 w2
pα p(1−α) w2 1−α
Since ln is a strictly increasing function, this expression is positive if and only if w1 > w2 , or w1 > α .
3.
a. Homogeneity holds since π ∗ (λp, λw) = λp = λπ ∗ (p, w). Convexity holds because π ∗ is linear. Mono-
tonicity holds since π ∗ is strictly increasing in p and does not vary with w. Nonnegativity holds because
π ∗ ≥ 0 ∀p ≥ 0, and π ∗ = 0 when p = 0.
b. Let H = {(y, −x) ∈ R2 : py − wx ≤ p ∀p ≥ 0 and w >> 0}. By setting p = 0 and considering
any w >> 0 we see that x ≥ 0 for any (y, −x) ∈ H. The defining inequality for H can be written
p(y − 1) ≤ wx. Since the right side of this inequality is nonnegative, we see that the inequality will
hold for any p ≥ 0 provided y ≤ 1. Thus, H is:

With this production set, the highest isoprofit line is achieved at (x, y) = (0, 1) no matter what the
slope of the isoprofit is. If p = 0 then the isoprofits are vertical, in which case any point on the right
boundary of H is optimal. So, (x∗ , y∗ ) = (0, 1) ∀(p, w) >> 0, and (x∗ , y∗ ) = (0, (−∞, 1]) if p = 0. In
either case, π ∗ = p.
4.
a. V (y) = [0, ∞) for y ≤ 0. V (y) = [1, ∞) for y ∈ (0, 1]. V (y) = ∅ for y > 1.
b. If the slope of the isoprofit is less than or equal to −1 then the highest isoprofit is achieved at (x, y) =
(0, 0). If the slope of the isoprofit is greater than or equal to −1 then the highest isoprofit is achieved
at (x, y) = (−1, 1). So the supply/demand function for strictly positive prices is
(0, 0), w
≥1
(x∗ , y∗ ) =
p
(−1, 1), w
p
≤1
If p = 0 then x∗ = 0 and y∗ = (−∞, 0]. Thus, profit is
0, w
≥ 1 or p = 0
π∗ =
p
p − w, w
p
≤1
c. For a given y ≤ 1, the cost minimizing choice of x is to choose the smallest possible value. If y ≤ 0 this
means x∗ = 0, and if y ∈ (0, 1] this means x∗ = 1. So the conditional factor demand is

0, y ≤ 0
x∗ =
1, y ∈ (0, 1]
This means the cost function is

∗ 0, y ≤ 0
c =
w, y ∈ (0, 1]
w w
d. ac = y, avc = 0, afc = y (all costs are fixed):
Marginal cost is clearly zero for y ∈ (0, 1). It is impossible to produce more than y = 1 with this
technology, so in cost terms it is as if marginal cost has a vertical jump and becomes infinite at y = 1.
This conception of marginal cost is consistent with the supply behavior identified above. If price is at
or above the low point on the ac curve (i.e., w) then the firm chooses the only output where p = mc,
which is y = 1 where the vertical jump occurs. If price is below the minimum of the ac curve then the
firm shuts down since none of the fixed costs are sunk.
1.
1
a. AC = yi + yi and M C = 2yi . Setting these equal gives the minimum average cost at yi = 1. The value
here is M C(1) = 2. So, p = 2 is the only potential long-run competitive equilibrium price.
b. At p = 2, each firm must produce yi = 1. Demand is y = 100 − 2 = 98. So, there is an equilibrium
with 98 firms.
2.
a. Yes. We have consumption of good 1 = x̂1 and production of good 1 = x̂1 . Thus, consumption ≤
production. For good 2, we have m − AC(x̂1 ) + AC(x̂1 ) ≤ m.
b. No. x̄1 avoids the deadweight loss. The consumer would gladly pay M C[x̄1 − x̂1 ] for the extra units,
and the firm would be indifferent.
c. No. The price that makes demand = x̂1 makes supply infinite.
d. Yes. x̄1 ≤ x̄1 and m + 0 ≤ m.
e. Yes. Any deviation involves deadweight loss, from which somebody is made worse off.
f. No. The price that makes demand = x̄1 makes supply zero.
g. The theorem gives sufficient but not necessary conditions for an equilibrium to be Pareto Efficient. Here,
x̄1 is Pareto Efficient, but is not an equilibrium. This shows that the conditions are not necessary. x̂1
is neither an equilibrium nor Pareto Efficient, so it is unrelated to the theorem.
3. M C = 2y and M R = 100 − 2y, so the interior solution is y∗ = 25. But π(25) = −250, so the firm chooses
y∗ = 0 and p∗ ≥ 100 to get π ∗ = 0 (since the fixed cost is not sunk).
4.
a. The FOC for firm i is 100 − 2yi − yj = 1, so yi∗ =

99−yj
2
. This is the interior solution, which is only
relevant when πi∗ (yj ) ≡ π(yi∗ (yj ); yj ) ≥ 0 (we know that shutdown is a concern here because of the
non-sunk fixed cost). Substitution and simplification gives the optimal value function for firm i as
2 √
π ∗ (yj ) =
99−yj
2
− 1200. Setting this to zero and solving for yj yields yj = 99 − 40 3 $ 29.72. Thus,
the reaction curve for firm i is

99−yj
, yj ≤ 29.72
yi∗ (yj ) = 2
0, yj ≥ 29.72
b. Because of the discontinuity, yi∗ does not cross y2 = y1 , so there is no (pure strategy) symmetric Nash
Equilibrium. However, there are two non-symmetric equilibria, indicated by the dark squares on the
above graph.
1. The indifference curves are squares:
a. Complete: Yes. Everything is on some indifference curve.
b. Transitive: Yes. Utility increases as we move away from (10, 10).
c. Continuous: Yes. The sets outside each square, including the square, are closed. Same for the sets
inside each square.
d. Monotonic: No.
e. Locally nonsatiated. This is tricky. As the squares intersect the axes we get points that have superior
neighbors if we move out along the axis (when xi > 10) or in along the axis (when xi < 10). But, at
(0, 0) there is no point that is locally superior. So, this preference relation is NOT locally nonsatiated.
f. Convex: No. The segment from A to B in the graph passes inside the square.
2.
a. Homogeneity:
 Ū λp1  Ū p1

 2, if λp2 <2 
 2, if p2 <2
h∗1 (λp, Ū ) = Ū
or 0, if λp1
=2 = Ū
or 0, if p1
=2 = h∗1 (p, Ū).

 2 λp2 
 2 p2
0, otherwise 0, otherwise
The proof is the same for h∗2 .

∂h∗
Symmetry/semidefiniteness: i
∂pj
= 0 provided p1 = 2p2 . So the substitution matrix is

0 0
for p1 = 2p2 ,
0 0
which is symmetric and negative semidefinite. When p1 = 2p2 , the situation is
+ p1 ,
Monotonicity and Continuity: p · h∗ = min 2 , p2 Ū , which is strictly increasing in Ū and continuous.
Nonnegativity: The origin is Ū = U (0) = 0. Then h∗ > 0 ∀Ū > U (0) and h∗ (p, U (0)) = 0 ∀p (so
p · h∗ (p, U (0)) = 0).
b. The expenditure function is
p1 Ū2 , if p1
≤2 (p )
e∗ = p · h∗ =
p2 1
p1
= Ū min , p2 .
p2 Ū , if >2 2
p2
Invert to obtain indirect utility:

m
U∗ = + p1 ,.
min 2
, p2
Then use the identity

 m p1 

 2 min{ 21 ,p2 }
, if <2 
m p1
p1 , if <2
p
 p2
 p2
x∗1 (p, m) = h∗1 (p, U ∗ (p, m)) = m
or 0, if p1
=2 = m
p1 or 0, if p1
=2 .
 2 min{ ,p2 } 
p1 p2 p2


2 
0, otherwise 0, otherwise
Likewise,  p1


0, if p2 <2
x∗2 (p, m) = h∗2 (p, U ∗(p, m)) = m p1
0 or p2 , if =2

 m
p2
p1
p2 , if p2 >2
c.
?
∂x∗1 ∂h∗1 ∂x∗
= − x∗1 1 .
∂p1 ∂p1 ∂m
p1
For p2 < 2:
?
m m 1
− 2 = 0− . Clearly yes.
p1 p1 p1
p1
For p2 > 2:
?
0 = 0 − 00. Clearly yes.
3.
a. max x1 x2 subject to p1 x1 + p2 x2 = m. This is standard Cobb-Douglas. The Marshallian demands are
m m
x∗1 = , x∗2 = .
2p1 2p2
b. U is a monotonic transformation of x1 x2 and adding x3 > 0 does not affect the constraint, so the
Marshallian demands for x1 and x2 are unchanged.
m2
c. U ∗ = x∗1 x∗2 + x3 = 4p1 p2 + x3 .

d. By inversion, e∗ = (Ū − x3 )4p1 p2 .
e. The target level of utility is U ∗ (1, 1, 10|x3 = 11) = 100

4
+ 11 = 36. We need e∗ when Ū = 36 and x3 = 0.

So e∗ = (36 − 0)4 · 1 · 1 = 12. Existing income is m = 10, so the transfer is 12 − 10 = 2.
1. f(x) = 100 + 48x − x2 . This function has a positive intercept, is increasing for small x, and then is
decreasing for large x. The production set is Z = {(y, −x) : y ≤ 100 + 48x − x2 and x ≥ 0}:
a. Z is nonempty, closed (since the boundary is included), convex (since f is concave), and satisfies lower
semicontinuity in output (since f is continuous). Also, (0, 0) ∈ Z so Z satisfies the possibility of
inaction. But, f(0) > 0 so no free lunch is violated, and f is non-monotonic so free disposal is violated.
b. π ∗ is homogeneous of degree 1, monotonic, and convex because these properties come from the definition
of π ∗ as a maximum. The only property we might suspect is violated is nonnegativity, since it relies on
additional properties of the technology. However, in this case we still get π ∗ (p, w) ≥ 0 and π ∗ (0, w) = 0
because Z satisfies the possibility of inaction.
2. The firm’s profit objective is π(y; r) = R(y; r) − c∗ (y) = p(y; r)y − c∗ (y).
a. By the envelope theorem,

∂π ∗ (r) ∂π
= = p2 (y∗ ; r)y∗ > 0.
∂r ∂r y=y∗
The sign follows because substitutes means p2 > 0.
b. The first order condition is π1 (y∗ (r); r) ≡ 0. Assuming a proper maximum, this equation defines y∗ (r).
Differentiate with respect to r to obtain
∂y∗
π11 + π12 = 0,
∂r
which implies
∂y∗ π12
=− .
∂r π11
∂y ∗
By the second order condition, π11 < 0, so ∂r
has the same sign as π12 :
∂ ∂
π12 = π21 = (π2 ) = (p2 y) = p2 + p21 y = p2 + p12 y.
∂y ∂y
We know p2 > 0, but p12 is the change in the slope of the inverse demand when the rival’s price changes.
∂y ∗
We cannot determine the sign of ∂r without information on this.
3. This is Varian #5.16b (Lecture 8, Exercise 1) except for y +y2 rather than y. Since we still have c∗ ≥ 0, c∗
strictly increasing in y, and c∗ (w, 0) = 0; this function satisfies all sufficient conditions for a cost function.
4.
a.
b. As we vary x̄1 , for short-run cost minimization we must stay on the isoquant labeled y. So the short-
run minimum always occurs where x̄1 intersects the y isoquant. This occurs on different isocosts as x̄1
varies. The lowest isocost that this occurs on is when x̄1 is such that it crosses the y isoquant at the
point where the isocost is tangent to the isoquant. Of course, this point is also the long-run minimum,
so the value of x̄1 that minimizes short-run cost (i.e., that places us on the lowest isocost while staying
on the y isoquant) is exactly x∗1 (w, y).
c.
w2 y
min w1 x̄1 + .
{x̄1 } x̄1
The first order condition is

∂c∗ (w, y|x̄1 ) w2 y
= w1 − 2 = 0.
∂ x̄1 x̄1

This implies x̄∗1 = w2 y
w1 . The second order condition is satisfied:
∂ 2 c∗ 2w2 y
= > 0.
∂ x̄21 x̄31
Substitute x̄∗1 into c∗ (w, y|x̄1 ) to obtain long-run cost:
' '
w2 y w2 y w1 √
c∗ (w, y) = w1 x̄∗1 + = w1 + w2 y = 2 w1 w2 y.
x̄∗1 w1 w2 y
1.
a.
π1 = (12 − y1 − y2 )y1 − 4y1 and π2 = (12 − y1 − y2 )y2 − 10y2 .
Differentiate to get
12 − 2y1 − y2 = 4 and 12 − 2y2 − y1 = 10,
and then solve for y1 and y2 , respectively, to get the reaction functions:
8 − y2 2 − y1
y1∗ (y2 ) = and y2∗ (y1 ) = .
2 2
Setting y2∗ (y1 ) to zero yields the y1 intercept of 2. Setting y2 to zero in y1∗ (y2 ) yields the y1 intercept
of 4. Hence these reactions curves do not cross in the positive quadrant. They appear as:
For values of y1 greater than 2, firm 2 reacts by choosing y2 = 0 because firm 2’s costs are too high to
make any profit when y1 ≥ 2. Therefore the Nash equilibrium is (y1 , y2 ) = (4, 0). Substituting 4+0 into the
demand curve yields a price of 8.
b. The monopoly profit function for firm 1 is the same as the duopoly profit function when y2 = 0. So
firm 1 chooses the same quantity of 4 and sets the same price of 8.
c. They are the same, because firm 2’s high cost causes it to drop out, effectively making firm 1 a
monopolist (firm 2’s marginal cost is above firm 1’s monopoly price).
2.
a. Differentiating yields marginal cost of c = 2y, and dividing yields average cost of ac = 1
y
+ y. Setting
these equal shows that they cross at y = 1. The cost curves look like:
So individual firm supply is y = p/2 for p ≥ 2. With 100 firms, market supply is y = 50p. Solving this
simultaneously with market demand yields an equilibrium price of p = 10. Hence individual supply is 5 in
equilibrium and individual profit is
π = (10)(5) − 52 − 1 = 24.
Thus, an arbitrarily large number of bidders will bid the price of the license up to 24, because this is how
much the license is worth in terms of profit potential. The city gets revenue of R = (100)(24) = 2400.
b. Now profit will be bid to zero, so we must have p = 2 in any long-run equilibrium and we must have
each firm producing at the minimum average cost quantity of y = 1. Market demand at this price is
y = 510 − 2 = 508, so we will have 508 firms each producing one unit.
c. The lost consumer’s surplus is the shaded area:
So, the area is (8)(500) + (1/2)(8)(8) = 4032.
d. No. The net loss is 4032 - 2400 = 1632. This is the deadweight consumer’s surplus plus profit lost,
since the city can only rebate the profit that is actually transferred from consumers to firms, and then
to the city.
e. R(n) = nπ ∗ (n). To maximize R, find R = π ∗ (n) + nπ ∗ (n). But π ∗ (n) = π(y∗ (n), n) = p(n)y∗ (n) −
c(y∗ (n)). So, by the envelope theorem, π ∗ = p (n)y∗ (n).
3. Symmetry gives b = 2. Homogeneity of h2 yields
∂h2 ∂h2
p1 + p2 =0
∂p1 ∂p2

1
(8)(2) + p2 − = 0,
2
so p2 = 32. Homogeneity of h1 then yields
p1 a + 2p2 = 0
8a + 64 = 0,
so a = −8.
4. Yes. At high prices, the good is normal (or at least non-Giffen). Demand does not remain bounded away
from 0 for high prices, so there is no implied violation of the budget constraint. At low prices, the good
turns Giffen, so the extra income is simply being devoted to some other good.
5.
a. Homogeneity is obvious. The substitution matrix is

 1/2
p2

−Ū b12 3/2 Ū b12 1
1/2 1/2
 2p1 2p1 p2
1/2
.
p1
Ū b21 1
1/2 1/2 −Ū b 21 3/2
2p1 p2 2p2
Hence symmetry requires b12 = b21 and negative semidefiniteness requires Ūb12 , Ū b21 ≥ 0. Monotonic-
" #
ity requires that p · h∗ = Ū p1 b11 + p2 b22 + (b12 + b21 )(p1 p2 )1/2 be strictly increasing in Ū . Since
p can be arbitrarily large, this requires bij ≥ 0 for i, j = 1, 2, with at least one of these inequalities
strict. Returning to negative semidefiniteness, we then see that Ū ≥ 0 unless b12 = b21 = 0. With
the bij ’s nonnegative, hi ≥ 0 for Ū ≥ 0 automatically. Moreover, from the expression just derived,
p · h∗ (p, Ū) = 0 ∀p >> 0 if and only if Ū = 0 (unless all bij ’s are zero, which cannot happen since
at least one of the bij ’s must be strictly positive, by monotonicity). Hence U (0) = 0 and so Ū ≥ 0
is required. With this restriction, we have h∗i (p, Ū) > 0 ∀p >> 0 and ∀Ū > 0, provided at least one
bij > 0 for each i. To summarize, h1 and h2 are Hicksian demands provided either b12 = b21 = 0 and
b11 , b22 > 0; or b12 = b21 > 0 and b11 , b22 ≥ 0.
b. By definition, expenditure is
1/2 1/2
∗ p2 p1
e = Ū p1 b11 + b12 + p2 b22 + b21 .
p1 p2
Invert to get indirect utility

1/2 1/2 −1
∗ p2 p1
U = m p1 b11 + b12 + p2 b22 + b21 .
p1 p2
Differentiate to get
∂U ∗
= [·]−1
∂m
1/2
∂U ∗ 1 p 1 p
= −m[·]−2 b11 + b12
2 2
+ b21
∂p1 2 p1 2 (p1 p2 )1/2
1/2
p2
= −m[·]−2 b11 + b12
p1
1/2
∂U ∗ −2 p1
= −m[·] b22 + b21 .
∂p2 p2
So, by Roy’s Identity,

1/2
p2
x∗1 = m[·] −1
b11 + b12
p1
1/2
p1
x∗2 = m[·]−1 b22 + b12 .
p2
6. This is question 2 from the November 19, 1998 test. See those solutions for the answer.
1.
a.
b. The indifference curve for Ū ≥ 0 is strictly convex and never touches the axes, so the optimal choice is
described by the first order conditions
λ
p1 = and p2 = λ.
x21

These yield h∗1 = p2
p1 . Substituting into the constraint then yields h∗2 = p1
p2 + Ū . These equations
are valid for any Ū ≥ 0.

√
c. For Ū ≥ 0, from above e∗ = p1 h∗1 + p2 h∗2 = 2 p1 p2 + p2 Ū . Invert e∗ to get U ∗ = m
p2
−2 p1
p2
. This
√
expression is valid for U ∗ ≥ 0 (i.e. Ū ≥ 0). That is, the expression is valid for m ≥ 2 p1 p2 .
√
√
d. Use Roy’s Identity to get x∗1 = pp21 and x∗2 =
m− p1 p2
p2
, once again for m ≥ 2 p1 p2 .
2. Fix y ∈ X and > 0. By nonsatiation, there exists x ∈ X such that x y. By completeness, y y. So,
∼
by semi-strict convexity, λx + (1 − λ)y y. Now choose λ close to 0 so that the convex combination is
close to y. By choosing λ “small enough,” we get the convex combination within of y, and it is strictly

preferred to y as noted above. In particular, choosing λ = 2y−x yields

(λx + (1 − λ)y) − y = λx − y = <
2
(Note that y − x > 0 because y = x since x y).
3. Homogeneity is satisfied for any nonzero a and b (neither a nor b can be zero because this would make
demand infinite, thereby violating Walras’ Law). Nonnegativity requires a > 0 and b > 0. Since we are
looking for a consumer whose preferences are locally nonsatiated, we know Walras’ Law must hold. This
1 1
implies a + b = 1. Since a and b are positive, we then conclude that a > 1 and b > 1. Taking the price
and income derivatives, we find the Slutsky substitution matrix to be

(1−a)m m

a2 p21 abp1 p2
m (1−b)m .
abp1 p2 b2 p22
This is symmetric for any nonzero a and b. For negative semidefiniteness, the diagonal elements must be
nonpositive, so a ≥ 1 and b ≥ 1. Also, the determinant must be nonnegative, so ab ≥ a + b. Dividing by
ab, we see that we already have this condition holding with equality from Walras’ Law. Hence, symmetry
and semidefiniteness add no new restrictions on a and b. To summarize, any positive values of a and b
1 1
satisfying 1 = a + b yield valid Marshallian demands.
4. Mr. Giffen is correct. To see why, suppose otherwise. Then x∗i is upward-sloping in pi at (p0 , m) for every
m > 0. Since the substitution effect is nonpositive, this means that the income effect is strictly negative
at every m > 0. Since we know that x∗i (p0 , 0) = 0, the strict negative slope of x∗i with respect to m at
every m > 0 implies that x∗i (p0 , m) is strictly negative for m > 0, which violates nonnegativity of the
demand, a contradiction.
1.
a.
√
b. From the linear isoquant, an optimal choice occurs at the corners, and is (0, y) if w1
w2 ≥ 1 and is
√ w1
( y, 0) if w2
< 1. So,
√
w2 y, w1
≥1
c∗ (w1 , w2 , y) = √
w2
w1
w1 y, w2
< 1.
√
c. If y ≤ 10 (y ≤ 100) then there is more than enough of input 1 at x̄1 = 10 to produce the required
√
output, without using any of input 2. If y > 10 then the amount of input 2 needed is determined
√ √
from the isoquant, x2 = y − x̄1 = y − 10. Hence:
√
∗ 10w1 , y ≤ 10
c (w1 , w2, y|x̄1 = 10) = √ √
10w1 + w2 ( y − 10), y > 10.
2.
a. The only way homogeneity of degree one can hold is if α = 1.

y
−1
b. Average cost is ac(y) = (2w1 + w2 ) e y . So,
1
ac (y) = (2w1 + w2 ) (1 + ey (y − 1)).
y2
When y = 0 we have 1 + ey (y − 1) = 0, and this expression is clearly increasing in y. That is, ac (y) > 0
for all y > 0, so we at least suspect there is decreasing returns to scale.

c. By Shephard’s Lemma,
∂c∗ ∂c∗
x∗1 = = 2(ey − 1) and x∗2 = = (ey − 1).
∂w1 ∂w2
3. A careful graphing reveals the following production set:
This set is closed since the defining inequality is weak (so the boundary is included in Z), and is obviously
nonempty. Also, the boundary goes through the origin (check that (0, 0) satisfies the equation z2 = 1 − (1 +
z1 )2 ), so possibility of inaction is satisfied. No points in the strictly positive quadrant are included, so no
free lunch is also satisfied. Free disposal is violated, however, because the boundary on the left side of Z is
downward-sloping. Finally, since the boundary curves downward everywhere, Z is convex.
4.
a. We must check that the three sufficient conditions are holding.
1. (Homogeneity)

λp 1 1 p 1 1
y∗ (λp, λw1 , λw2 ) = + = + = y∗ (p, w1, w2 )
2 λw1 λw2 2 w1 w2
2 2
∗ λp p
x1 (λp, λw1 , λw2 ) = = = x∗1 (p, w1 , w2 )
2λw1 2w1
2 2
λp p
x∗2 (λp, λw1 , λw2 ) = = = x∗2 (p, w1 , w2 ).
2λw2 2w2
2. (Symmetry and Semidefiniteness) The matrix of derivatives of these supply and demand functions is
 ∂y∗ 1 1 
∂y ∗ ∂y ∗  + 1
− p
− p
2 w w 2w 2 2w 2
∂p
 ∂x∗1
∂w1
∂x∗
∂w2
∂x∗   1 2 1 2

 − ∂p − ∂w11 − ∂w12  =   − p
2w12
p2
2w13 0 

∗ ∗ ∗
∂x ∂x ∂x
− ∂p2 − ∂w21 − ∂w22 p2
− 2wp
2 0 2w 3 2 2
This is symmetric by inspection. To check positive semidefiniteness, check that all the naturally ordered
principal minors are nonnegative. The order 1 naturally ordered principal minor is just the (1, 1)

p2 p2
element, which is positive. The order 2 naturally ordered principal minor is 4w 3
1
w1
+ 1
w2
− 4w 4 > 0.
1 1
4
4 4
The order 3 naturally ordered principal minor is 8wp3w3 w11 + w12 − 8wp3 w4 − 8wp3 w4 = 0 (alternatively,
1 2 1 2 2 1
we can simply note that the matrix is singular, by homogeneity, so its determinant must be zero).
3. (Nonnegativity) First, the profit function defined from these supply and demand functions must be
nonnegative. It is derived below, and is clearly nonnegative. Second, the demands and supplies
themselves must be nonnegative. This is also clear by inspection (This and the semidefiniteness relies
on p ≥ 0 and w >> 0). Third, the demand and supply must be zero when p = 0, for every w >> 0.
This is also clear by inspection.
b.
2 2
p2 1 1 p p p2 1 1
π ∗ (p, w1, w2 ) = py∗ − w · x∗ = + − w1 − w2 = + .
2 w1 w2 2w1 2w2 4 w1 w2
1. Indifference curves are linear with a slope of −1. So,

 √
 0, if pp12 > 1  U, if p1
>1

 √ 
√ p2
∗ p1 ∗
h1 = [0, U ], if p2 = 1 ; h2 = U − h∗1 , if p1
=1.
 
√
  p2
 p1
U, if pp12 < 1 0, if p2 <1
2.
1 1
∗ 1 p2 2 p1 2 1 1

e = p1 h∗1+ p2 h∗2 =− p1 + 1 + p2 +1 =− 2(p1 p2 ) 2 + p1 + p2 .
U p1 p2 U
1

So, U ∗ = − m
1
2(p1 p2 ) 2 + p1 + p2 .
1
∂U ∗ 1 − 12
1 p2 2
=− (p1 p2 ) p2 + 1 = − +1
∂p1 m m p1
1
∂U ∗ 1 p1 2
=− +1
∂p2 m p2
∂U ∗ 1 1

= 2 2(p1 p2 ) 2 + p1 + p2 .
∂m m
By Roy’s Identity,
12
∂U ∗ p2
+1
p1
x∗1 = −
∂p1
∂U ∗
=m 1
∂m 2(p1 p2 ) + p1 + p2
2
12
∂U ∗ p1
+1
p2
x∗2
∂p2
=− ∂U ∗
=m 1 .
∂m 2(p1 p2 ) 2 + p1 + p2
3. The condition on the number of firms n is (n−1)y ≥ ny, where y = 10 and y = 11 here. So (n−1)11 ≥ 10n,
or n ≥ 11. Then we must have D(min ac) ≥ (n − 1)y. Since min ac = 1, we need D(1) ≥ 10 · 10 = 100.
4. M C = 10 − 2y, M R = 7 − y. MC is steeper than MR (more negatively sloped). So M C = M R is a local
minimum. Hence we must consider the corners y = 0 and y = 5. Now π = 0 at y = 0 obviously. At
y = 5, p = 7 − 5
2 = 9
2 and c = 50 − 25 = 25, so π = 9
2 · 5 − 25 = 45
2 − 50
2 = − 52 < 0. So y∗ = 0 is the max
and p∗ ≥ 7.
5. Complete: Yes, because with three voters every pairwise comparison has a majority, provided the voters
can make every pairwise comparison (which they can).
Transitive: Not necessarily. Suppose the voters’ preferences were
Ann: G B M ; Beth: M GB Carol: B M G

Then Pop has G B and B M, but M G.
6.
i. Homogeneous of degree 0:
2λm 2m
x∗1 (λp, λm) = = = x∗1 (p, m)
3λp1 3p1
λm m
x∗2 (λp, λm) = = = x∗2 (p, m)
3λp2 3p2
ii. Nonnegativity: Obviously x∗ ≥ 0.
iii. Walras’ Law:
p · x∗ = p1 3p
2m
1
m
+ p2 3p2
= 2m
3 + m
3 = m, so Walras’ Law is satisfied.
iv. The substitution matrix must be symmetric and negative semidefinite:
∂x∗1 2m ∂x∗2 m ∂x∗1 2 ∂x∗2 1

= − 2; = − 2; = ; = .
∂p1 3p1 ∂p2 3p2 ∂m 3p1 ∂m 3p2
So the matrix is
∂x∗  
∂x∗ ∂x∗ ∂x∗ − 3p
1
+ x∗1 ∂m1 1
+ x∗2 ∂m1
2m
2 +
2m 2 m 2
− 9p
2m
2
2m
= 3p1 3p1  =
∂p1 ∂p2 1 3p2 3p1 1
9p1 p2
∂x∗ ∂x∗ ∂x∗ ∂x∗ ,
2
+ x∗1 ∂m2 2
+ x∗2 ∂m2 2m 1
− 3p
m
2 +
m 1 2m
9p1 p2 − 9p
2m
2
∂p1 ∂p2 3p1 3p2 3p2 3p2 2
2
which is obviously symmetric. The diagonal elements are less than 0. The determinant is
4m2 4m2
− ≥ 0.
81p21 p22 81p21 p22
7.
 
−1 1 b
 a −2 c 
d e f
3 ∂h∗
a = 1 by symmetry. By homogeneity, j
i=1 ∂pi pi = 0. So, (−1)(1) + (1)(2) + (b)(4) = 0. So, b = − 14 .
Then d = − 14 by symmetry. This leaves

 
−1 1 − 14
 1 −2 c .
− 14 e f
So, (1)(1) + (−2)(2) + (c)(4) = 0, so c = 34 . Then e = 34 by symmetry. This leaves
 
−1 1 − 14
 1 −2 3 
.
4
−41 3
4
f

So, − 14 (1) + 34 (2) + (f)(4) = 0, so f = − 16 5
. Finally,
 
−1 1 − 14
 1 −2 3 
.
4
−41 3
4 − 5
16
1.

min w1 x1 + w2 x2 − λ (xρ1 + xρ2 ) ρ − y
{(x1 ,x2)}
Take the first derivative to find the FOCs:

−1
w1 − λ (xρ1 + xρ2 ) ρ ρxρ−1
1 =0
ρ

−1
w2 − λ (xρ1 + xρ2 ) ρ ρxρ−1
2 = 0.
ρ
ρ−1
1
xρ−1
Divide: w1
w2 = 1
xρ−1
⇒ x1 = w1
w2 x2 . Now use the constraint:
2
ρ−1
1 ρ ρ
w1
x2 + xρ2 = y,
w2
so
ρ−1
ρ ρ ρ−1
ρ − ρ1 ρ−1
ρ − ρ1
w1 1 w1 1 w2
x2 +1 = y ⇒ x∗2 = y +1 and x∗1 = y +1 .
w2 w2 w1

− ρ1
− 1ρ
ρ−1
ρ ρ−1
ρ
w1−ρ + w1−ρ w2−ρ + w2−ρ

1
∗
So c = w1 x∗1 + w2 x∗2 =y
w2
w1 + w1
w2 .
2.
3.
4.
i. HOD 1:
c∗ (λw1 , λw2 , y) = (λw1 + λw2 ) ln(y + 2) = λ(w1 + w2 ) ln(y + 2) = λc∗ (w1 , w2, y)
ii. Monotonicity in w and y:
∂c∗
= ln(y + 2) > 0 for y ≥ 0 for i = 1, 2,
∂wi
∂c∗ w1 + w2
= > 0 for w >> 0 and y ≥ 0
∂y y+2
iii. Concavity:
∂ 2 c∗
∂wi ∂wj = 0 ∀ i, j since c∗ is linear in w1 and w2 .
iv. Continuity: c∗ involves only sums, products, and the log function. So it is continuous provided the
argument of the log function is positive (which it is for y ≥ 0).
v. Nonnegativity:
c∗ (w, y) > 0 for w, y >> 0 .
c∗ (w, 0) = 0? NO: ln(2) > 0, so c∗ (w, 0) > 0.
Defining H(y) = {x ∈ Rn+ : w · x ≥ c∗ (w, y) ∀ w >> 0}, we see that this is regular, has free
disposal, no free lunch, convexity, and lower semicontinuity in output. But possibility of inaction fails
since c∗ (w, 0) > 0.

5.
a. HOD 1:
(λp)2 p2
π ∗ (λp, λw) = = λ = λπ ∗ (p, w)
λw w
Monotonicity:
∂π ∗ 2p
= > 0 for (p, w) >> 0
∂p w
∂π ∗ p2
= − 2 < 0 for (p, w) >> 0
∂w w
Convexity:
∂ 2 π∗ 2 ∂ 2 π∗ 2p ∂ 2 π∗ 2p2
2
= ; = − 2; = .
∂p w ∂p∂w w ∂w 2 w3
So,

2
w − w2p2
Hπ∗ = 2 .
−w
2p
2
2p
w3
4p2 4p2
The diagonal elements are positive and |Hπ∗ | = w4
− w4
= 0. Hence Hπ∗ is positive semidefinite,
implying that π ∗ is convex.
Nonnegativity: π ∗ ≥ 0 and π ∗ (0, w) = 0 are clear by inspection.

p2
b. H = {(y, x) ∈ R2+ : py − wx ≤ π ∗ (p, w) ∀(p, w) >> 0}. So, max{p,w} py − wx − w
to get y − 2p
w
=0⇒
p p2
p 2 1
y=2 w and −x + w2 =0⇒x= w . Substitute to get y = 2x 2 .
1 1 p 2 p p 2 2p2 p2
c. max{x} p2x 2 − wx ⇒ px− 2 − w = 0, or x = w . So max py − wx = 2p w −w w = w − w =
p2
w = π∗ .
1 2
d. Since y = 2x 2 (only one input), c∗ = w y4 .
6.
HOD 0:
x∗i (λw1 , λw2 , y) = ln(y + 1) = x∗i (w1 , w2, y)
Monotonicity: w · x∗ = (w1 + w2 ) ln(y + 1), so
∂w · x∗ w1 + w2
= >0
∂y y+1
Symmetry and Semidefiniteness: The substitution matrix is 0, so it is symmetric and negative semi-
definite.
Continuity: The expression for w · x∗ above is continuous at y ≥ 0.
Nonnegativity: x∗i ≥ 0 ∀ w, y ≥ 0 ; w · x∗(w, 0) = 0 ; x∗(w, y) = ln(y + 1) > 0 for y > 0

1.
a. Homogeneity is obvious.
∂p·h∗
Monotonicity: p · h∗ = 2Ū(p1 p2 )1/2 , so ∂ Ū
= 2(p1 p2 )1/2 > 0.
Nonnegativity: h∗ ≥ 0 clearly requires Ū ≥ 0. Then p · h∗ (p, 0) = 0 from above, and h∗ (p, Ū ) > 0 for
Ū > 0 is obvious.
Continuity: The expression for p · h∗ given above involves only products and nonnegative exponents,
so it is continuous.
Symmetry and Semidefiniteness:

 1 −1 
p2 1 p2
2
−1 2 U U
 2 p 32 2 12 
 1 p1 .
 −1
p1 2
1
p12

1
2 1 U − 12 3 U
p22 p22
This is symmetric and negative semidefinite since the diagonal elements are ≤ 0 and the determinant
2 2
is U
4p1 p2 − U
4p1 p2 = 0.
1
12
b. e∗ = p · h∗ = 2Ū (p1 p2 ) 2 . So U ∗ = m ∗ ∗ ∗
1 . So x1 = h1 (p, U ) =
p2
p1
m
1 = m
2p1 and x∗2 =
2(p1p2 ) 2 2(p1 p2 ) 2
12
h∗2 (p, U ∗) = pp12 m m
1 = 2p .
2
2(p1 p2 ) 2
2. No, the ranking is not complete since comparisons that don’t involve a BMW are not made.
∂x∗ ∂h∗ ∂x∗ ∂x∗

3. Slutsky: i
∂pi = i
∂pi − x∗i ∂mi , which is necessarily negative if ∂m
i
> 0.
FOC’s are:
∂fi (x∗i )
− λ∗ pi = 0 for i = 1, · · · , n
∂xi
−p · x + m = 0
So, differentiate with respect to m:
  ∗ 
∂ 2f1
−p1 ∂x1 
∂x21 0
   ∂m   .. 
 .. ..   ..   . 
 .  .
 .
∂ 2 fn
 ∂x∗
=
 0 
.
 −pn  n
∂x2n ∂m∗
−p1 ··· −pn 0 ∂λ −1
∂m
By Cramer’s Rule,
∂2f
21 0 −p1
∂x1

.. .. ..
. . .
∗
∂xi 1 ..
= 0 .
∂m |H| .. .. ..
. . .

0 ∂ 2 fn
−pn
∂x2n
−p ··· −1 · · ·
−pn 0
1
1 2
∂ 2 fi−1 ∂ 2 fi+1 ∂ 2 fn
= (−1)(−1)n+1+i (−pi )(−1)n+i ∂∂xf21 ··· ∂x2i−1
· ∂x2i+1
··· ∂x2n
|H| 1
1
= (−pi )[·].
|H|
|H| has the sign (−1)n and [·] has sign (−1)n−1 , so the whole thing is positive.
4.
a.
Average cost curve
b. pe = 2
c. We need (n − 1)y ≥ ny, or (n − 1)2 ≥ n, yielding n ≥ 2. So all output levels beyond 1 · y can be
produced at minimum ac. So, D(2) ≥ 1 is sufficient.
5. mr = 4 − 2y. So, y∗ = 1 for the monopolist, and p∗ = 3. This is where mr = mc. The area of the
deadweight loss triangle is 12 .

6. πi = (4 − y1 − y2 )yi − (1 + yi2 ) since AC(y) = y + 1

y
⇒ c(y) = 1 + y2 . ∂πi
∂yi
= 4 − 2yi − yj − 2yi = 0. So,
we need to solve two equations:
4 − 4y1 − y2 = 0
4 − 4y2 − y1 = 0.
Multiplying the second equation by -4, we get
4 − 4y1 − y2 = 0
−16 + 4y1 + 16y2 = 0.
Add the two together to get 12 − 15y2 = 0, so y2 = 12

15 = 4
5 = y1 ⇒ y1 + y2 = 85 . Perfect competition has
individual supplies p = 2yi , so aggregate supply is y1 + y2 = p. Setting this equal to demand, y = 4 − y,
or y = 2. So the comparison is:

Here, consumer’s surplus lost is 2

5
· 2
5
· 1
2
= 2
25
and producer’s surplus lost is 2
25
also. Thus, the total lost
4
surplus is 25 .
7. c(y) = 1 + y2 , where 1 represents the fixed (sunk) cost. So, assume px = 1.
√
The production function for x ≥ 1 is y = x − 1. This gives c(y) = px x = 1 · (y2 + 1) = y2 + 1.
1.
no free lunch possibility of inaction free disposal convexity
(a) y y y y
(b) n y n y
(c) y y y n
a.
This has decreasing returns to scale.

b.
This has decreasing returns to scale.

c.
This has increasing returns to scale.
2. The isoprofit lines are vertical. So, letting x be the output and y be the input, the firm chooses x∗ = 1
and y∗ = 0, and receives π ∗ = 1.
3. y = ln(x1 + 1) + x2 . Taking the derivative with respect to x1 , we get 0 = 1

x1 +1
+ dx2
dx1
⇒ dx2
dx1
= − x11+1 =
∗
−w
w2 ⇒ x1 =
1 w2
w1 − 1. Substituting x∗1 into the production function, we get x∗2 = y − ln( w2
w1 ). Taking the
d2 x2 1
second derivative, we get dx21
= (x1 +1)2 > 0. So the isoquant appears as:
Thus, the conditional factor demands are:

 
 0, if w1
≥1  y, if w1
≥1
 w2  w2
∗ ∗
x1 = e − 1, if w2 ≤ e−y ;
y w1
x2 = 0, if w1
≤ e−y .

 w2 

w2
w1
− 1, otherwise y − ln( w2
w1 ), otherwise
When p = w1 = w2 , we have x∗1 = 0 and x∗2 = y, so π = p[ln 1 + y] − w2y = 0 ∀y. Thus the firm is indifferent
to the choice of y.
4. Note first that c∗ (w, y) = yw1 w2 . Now check the properties of a cost function:
1/2 1/2
Homogeneity:
c∗ (λw, y) = y(λw1 )1/2 (λw2 )1/2 = yλw1 w2 = λc∗ (w, y) .

1/2 1/2
Monotonicity:
∂c∗ 1 −1/2 1/2 ∂c∗ 1/2 1/2
= ywi wj > 0; = w1 w2 > 0 .
∂wi 2 ∂y
Concavity:

y −w
w1
2
1
H= .
1/2
4w1 w2
1/2 1 −w
w2
1
To check for negative semidefiniteness, note that the diagonal elements are ≤ 0 and the determinant is
y2
|H| = 16w1w2 (1 − 1) = 0. So, the function is concave.
Nonnegativity: c∗ (w, 0) = 0 and c∗ (w, y) > 0 for y > 0 are obvious.
Continuity: c∗ involves only products and nonnegative exponents, so it is continuous.
Since c∗ is a cost function, we can find the conditional factor demands from Shephard’s Lemma:
∂c∗ 1 −1/2 1/2

x∗i = = ywi wj .
∂wi 2
5. We are given a tax t on x1 . So, our cost function is c∗ ((1 + t)w1 , w2 , y). Using the envelope theorem,
∂c∗ ∂ 2 c∗ ∂x∗ ∂x∗
∂t
= |
∂L ∗
∂t x
= w1 x∗1 . Taking the second derivative, we get ∂t2
= w1 ∂t
1
= w1 1 ((1+t)w1 ,w2 ,y)
∂w1
· w1 =
∂x∗
w12 · 1
∂w1 ≤ 0, so the cost function is concave in t.
1.
no free lunch possibility of inaction free disposal convexity returns to scale
a) y y y n no particular RTS
b) y y∗ y n IRTS
c) y y y n non-IRTS
0
*This answer presumes that 0 = 0. Otherwise, technology b does not satisfy possibility of inaction.
a.
b.
2.
d2 x2
3. The isoquant is y = ex2 − 1 + x1 . So MRTS is 0 = ex2 dx
dx1
2
+ 1 or dx2
dx1
= −e−x2 . Thus dx21
= e−x2 dx
dx1
2
=
−e−2x2 < 0. That is, the isoquant is concave. So, cost minimizing choices are at the corners. Graph is:
The slope of the line through the two intercepts is − ln(y+1)

y . So,
w1 ln(y+1) w1 ln(y+1)
0, if > ln(y + 1), if >
x∗1 x∗2
w2 y w2 y
= ln(y+1)
; = ln(y+1)
w1 w1
y, if w2 < y 0, if w2 < y
w1 ln(y+1)
If w2 = y , then both corners are cost-minimizing. Note that for any y > 0, ln(y + 1) < y :
So for y > 0 we have x∗1 = 0 and x∗2 = ln(y + 1) when w1

w2 = 1. Thus π = py − c∗ (y) = py − w2 ln(y + 1) =
p[y − ln(y + 1)] for y > 0 and p = w1 = w2 . Since the difference y − ln(y + 1) → ∞ as y → ∞, we get
y∗ = ∞.
4. First, check the properties of a profit function:
Homogeneity:
(λp)2 p2
π ∗ (λp, λw) = =λ = λπ ∗ (p, w)
4λw 4w
Monotonicity:
∂π ∗ 2p ∂π ∗ p2
= ≥ 0 ; =− 2 ≤0
∂p 4w ∂w 4w
Convexity:

1
2w
− 2wp 2
H= 2
− 2w
p
2
p
2w 3
p2 p2
The naturally-ordered principal minors are 1
2w > 0 and |H| = 4w 4 − 4w 4 = 0 ≥ 0, so H is positive
semidefinite, implying that π ∗ is convex.
Nonnegativity: π ∗ (0, w) = 0 and π ∗ (p, w) ≥ 0 are obvious.

∂π∗ ∗ p2
Since π ∗ is a profit function, from Hotelling’s Lemma we get y∗ = ∂p = p
2w and x∗ = − ∂π
∂w = 4w 2 .
5. To find y∗ , miny (ay − 1)2 + 1. Taking the derivative with respect to y, we get y∗ = 1
a
. The Envelope
Theorem says that

∂ac(y∗ (a), a) ∂ac(y, a)
= .
∂a ∂a y=y∗
∂ac(y ∗(a),a)
So ∂a
= 2(ay − 1)y|y=y∗ = 0. This shows that ac is constant in a when y is chosen to minimize
ac. So, c(y∗ , a) = y∗ ac(y∗ , a) = 1

a k, where k is the constant level of ac(y∗ , a). To find k, evaluate
ac(y∗ , a) = (a a1 − 1)2 + 1 = 1. So, k = 1 and c(y∗ , a) = 1a .

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LECTURES AND EXERCISES

Recall the circular ﬂow of income:

Figure 1.1: The Circular Flow of Income

2. Generates refutable hypotheses–i.e., has predictive power

3. NOT about “truth” in some metaphysical sense

Our basic behavioral postulate is:

“Rational actors make choices that maximize their objective.”

• These actors are usually either consumers or producers

• They may or may not be perfectly informed

• They may or may not be perfect competitors (price-takers)

This leads immediately into the mathematical theory of maximization:

• objective is f(x, p) (e.g., utility, proﬁt)

• x is a vector of choice variables (e.g., quantities to consume, factor inputs to production)

• p is a vector of parameters (e.g., prices, income)

There are two results from this maximization:

• The optimal choices x∗ (p) (e.g., demands, supplies)

We ﬁnd x∗ (p) by setting up a Lagrangian function

L(x, λ; p) = f(x, p) − λg(x, p)

and solving the ﬁrst order conditions (assuming an interior optimum):

• With explicit functions: solve these equations for x∗ and λ∗ .

• More generally: these equations implicitly deﬁne x∗ and λ∗ .

Lxi (x∗ (p), λ∗ (p); p) ≡ 0, i = 1, . . . , n

Lλ (x∗ (p), λ∗ (p); p) ≡ 0

At the maximum, g(x∗ (p), p) ≡ 0. So

L(x∗ (p), λ∗ (p); p) ≡ f(x∗ (p), p) ≡ f ∗ (p)

= Lpj (x∗ (p), λ∗ (p); p)

We can diﬀerentiate again to obtain refutable hypotheses about x∗ :

facts usually help us extract this information from this equation:

of supply and demand.

results become the “reciprocity” or “symmetry” results.

Exercises for Lecture 1 (Introduction)

1. Give a verbal statement of the envelope theorem.

Readings: Chapter 1 of Varian; Sections 5.A and 5.B of MWG.

Some examples of production sets are illustrated in Figure 2.1.

The minimal properties we frequently place on a production set Z are:

2. Z is closed–this assures existence of optima in some cases.

• Together, items 1 and 2 are what Varian calls “regularity.”

3. There is no free lunch: Z ∩ Rn+ ⊂ {0}.

5. There is free disposal: z ∈ Z ⇒ z ∈ Z ∀z ≤ z. This implies Varian’s “monotonicity,” and is an

“partially” sunk as well. A variant of this is a “ﬁxed” input.

Two other properties we sometimes place on a production set Z are:

6. Global returns to scale:

a. nonincreasing: z ∈ Z ⇒ αz ∈ Z ∀α ∈ [0, 1].

7. Convexity: Z is a convex set.

for output level y.

bounded (assured by convexity of Z–see the exercises following this lecture).

of both input requirement sets and production functions.

Occasionally we make use of an additional assumption for the single-output case:

(yi , −xi ) ∈ Z. This rules out production sets like this:

Figure 2.2: A production set that violates lower hemicontinuity in inputs

(yi , −xi ) ∈ Z. This rules out production sets like this:

Figure 2.3: A production set that violates lower hemicontinuity in output

implies that the boundaries of an isoquant cannot slope upward.

Isoquants can be conveniently illustrated on a graph of input requirement sets.

function with respect to some other component is

∂xi (x−i ) fj (x)

Convexity implies that the MRTS is nondecreasing in x−i .

Exercises for Lecture 2 (Technologies)

disposal, iv) convexity (Assume V (0) = R2+ in (e)):

values. Prove that convexity solves this problem.

of inaction. Prove the following properties of the corresponding production function f:

v. For any x, f(αx) = αf(x) ∀α ≥ 0 when Z has constant returns to scale.

f(λx + (1 − λ)x ) ≥ min{f(x), f(x )} ∀λ ∈ (0, 1).

{x : f(x) ≤ y} being a closed set for every y.

for every conformable vector a = 0.