CONSUMERS 3

Harry’s preferences are given by the following utility function:

U ( x, y ) = x + y

px 2
a. What is the demand for x and y, assuming that I ³ .
4py

px 2
b. What is the demand for x and y, assuming that I < .
4py

c. Draw the Engel curves for x and y for px = 4 and py = 1

d. Give the expenditure function and the compensated demand (in the order of your choice)
px
if U ³ .
2py

px 2 p2
e. Is y a gross substitute for x if I ³ ? Is x a gross substitute for y if I ³ x ?
4py 4py

px 2 p2
f. Is y a net substitute for x if I ³ ? Is x a net substitute for y if I ³ x ?
4py 4py

g. Give the expenditure function and the comensated demand (in the order of your choice) if
px
0£U < .
2py

CONSUMERS 4
People all over the world, rich and poor, have the same utility function:

U (x, y ) = ln(x - 10) + y ,

Here, x is the amount of food, y is the amount of luxury goods.

a. Give the demand for x and y if I > p y + 10 p x

b. Explain what is going on for I < p y + 10 p x and why demand for luxury goods is 0 there.
Do also give the demand for x.
c. Explain what is going on for I < 10 px and explain what the number 10 in the utility
function U (x, y ) = ln(x - 10) + y signifies.

There are two kinds of people: rich and poor. The rich ones live in rich countries, the poor
ones in poor countries. Because of free trade, prices are uniform all over the world: the price
of food is 0.2, the price of luxury goods is 10. The rich have an income of 100, the poor an
income of 3.

d. What applies to the rich, I > p y + 10 p x or I < p y + 10 p x ? Draw the maximization

problem for the rich.

e. What applies to the poor, I > p y + 10 p x or I < p y + 10 p x ? Draw the maximization

problem for the poor.

f. Draw the Engel curve for food

g. What is the income elasticity of the demand for food of the rich people?

h. What is the income elasticity of the demand for food of the poor people?

Now food prices double.

i. What happens to the consumption of the poor? Draw the situation. What would that
mean?

The World Bank suggests to transfer money from the rich to the poor countries. Assume that
there are as many rich as there are poor, which implies that after the transfer the poor
people’s income equals

I P new = I P old + T ,

while the rich people’s income is:

I R new = I R old - T ,

where T is the income transfer

j. What should T be to get the poor back to the utility from before the price hike?
.
A World Bank representative wants to explain that to a rich people audience in simple terms.
Therefore she summarized the message as follows “In order to feed the poor, we have to cut
back on the luxury”. With “we” she means the rich countries.

k. Does that explain the situation? Use your answers at f. en g..

l. Give the price elasticity of x if I > p y + 10 p x

m. Give the price elasticity of x if I < p y + 10 p x