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Subject: Mathematics for Economist, M.Sc. Economics, 1 Semester, 2019-20.

Course Instructor: Purbash Nayak +91 75074 86136

Gokhale Institute of Politics and Economics, Pune

Assignment 1
a b
1. Find the indirect utility function for the Cobb Douglas utility function, u(x 1,x2) = x1 .x2 with the
budget constraint p1x1 + p2x2 = m.

Given the price vector p and income m, what is the maximum utility that could be achieved? This is
done through a two-step process. Given the COP of the consumer, we can derive the demand
functions. The second step is to find the maximum possible utility level given the backdrop. Instead of
finding demand functions (read ‘quantities’) that gives the consumer the maximum utility; we have in
front of us the problem of finding the maximum reachable utility level given the utility function, the
1
budget set, the price vector p and the income level m of the consumer. Thus we are capturing utility
indirectly. This is indirect utility function.
a b
Gn: u(x1,x2) = x1 .x2

Subject to: p1x1 + p2x2 = m.

a b
Setting up the Lagrange: £ = x1 .x2 – ‫( ג‬p1x1 + p2x2 – m); the FOC’s are:
a-1 b
ꝺ£ / ꝺx1 = ax1 x2 – ‫ג‬p1 = 0
a b-1
ꝺ£ / ꝺx2 = bx1 x2 – ‫ג‬p2 = 0

ꝺ£ / ꝺ‫ = ג‬p1x1 + p2x2 – m = 0

On solving we get,

x1* = am / p1,

x2* = bm / p2
a b a+b
Substituting x1* and x2* back into the u(.) function, indirect utility function v(p,m) = (a/p1) (b/p2) (m)

The curious mind can also try solving the question by taking log transformation of the u(.). (Why?)

2. The objective of the activity is to solve the consumer’s utility maximization problem with a
linear utility function 2x1 + x2 subject to the constraints p1x1 + p2x2 <= m, x1 >= 0, x2 >= 0.
Assume p1 > 0, p2 > 0 and m > 0.

a. Draw the indifference curve for the utility function u(x1,x2) = 2x1 + x2. What is the marginal rate
of substitution?

The indifference map is the level set given the utility function, u(x 1,x2) = ax1 + bx2. We draw the locus
of all points given the equation ax1 + bx2 = r (say). Note that the given utility function, u(.) is that of
perfect substitutes utility function.

Insert fig 1.

1. All vectors are written in bold letters.

MRS between two goods 1 and 2, denoted by MRS12 (read as the marginal rate of substitution of
good 1 for good 2) is the rate at which the good 2 is given up in order to get an extra unit of good 1 to
leave the customer at the same indifference curve or the same utility level.

U = ax1 + bx2

We have to have dU = 0.

(ꝺU / ꝺx1) * dx1 + (ꝺU / ꝺx2) * dx2 = 0

dx2 / dx1 = -(ꝺU / ꝺx1) / (ꝺU / ꝺx2)

dx2 / dx1 = mod(MUx1 / MUx2)= a/b = 2/1 = 2.

This means that the consumer will give up two units of x 2 to get 1 unit of x1 irrespective of the amount
of x2 he has.

b. Assume that p1 / p2 < 2. Use your graph to guess the values x1 and x2 that solve the
maximizing problem. Which constraints bind, that is have hi(x1,x2) = ki where hi is the
constraint function i. Which are the constraints that do not bind, that is have h i(x1,x2) < ki ?
Does the problem have more than one solution?

Insert fig 2.

p1 / p2 < a/b

From graph, we can see that when the price ratio is lesser than the MRS, we have a budget
constraint which is flatter than the indifference curves and we have a corner solution. Assume (a>b)
and price ratio = 1; this means that commodity x1 and x2 can be traded for equal prices whereas the
MRS says that the consumer is willing to give up ‘a’ units of commodity x 2 to attain just ‘b’ units of x1
(remember a>b). Hence he is better off giving up infinite amounts of x2 in order to attain x1, however
constrained by x2 >= 0. Hence he gives up all the units and consumes 0 units of x2 and (m/p1) units of
x1 thus exhausting the budget constraint. Hence the binding constraints are:
 i. p1x1 + p2x2 = m
ii. x2 = 0

and the non-binding constraints are

iii. x1 > 0 (since m > 0).

Note that the constraints p1 > 0, p2 > 0 and m > 0 are given for expository reasons and are not to be
used as COP constraints ie., we can only put constraints as a function of variables and not that of
constants. Also, since we have a corner solution, the solution is unique and hence the tangency
condition would be violated.

c. Assume that p1 / p2 > 2. Use your graph to guess the values x1 and x2 that solve the
maximizing problem. Which constraints bind and which do not? Is there more than one
solution?

Insert fig 3.

A similar argument hold for p1 / p2 > a/b, except for the corner solution is for commodity 2. (try to give
the reasoning for yourself). Here the binding constraints are:

i. p1x1 + p2x2 = m
ii. x1 = 0

and the non-binding constraints are

iii. x2 > 0 (since m > 0).

d. Assume that p1 / p2 = 2. Use your graph to guess the values x1 and x2 that solve the
maximizing problem. Which constraints bind and which do not? Is there more than one
solution?

Insert fig 4.
When p1 / p2 = a/b, the budget constraint coincides with the indifference curve implying that the rate at
which the consumer is willing to trade off between the goods in monetary terms and in the utility terms
are the same and so we have infinite solutions lying along the budget constraint as shown in the fig 4.

Here the binding constraints are:

i. p1x1 + p2x2 = m

and the non-binding constraints are

ii. x1 > 0 (since m > 0)

iii. x2 > 0 (since m > 0).

e. Explain why Kuhn-Tucker conditions are the necessary and sufficient conditions for a solution
to this problem.

The FOC’s to any optimization problem as we know, are just the necessary condition since maxima or
minima can be ascertained only upon the SOC’s, these are considered in 2 cases when the COP
have a global maxima within the constraints and when they have a local maxima in the premises of
the constraints – the combination of which is generalized in the complementary slackness conditions
(CS) in the KT analysis and hence, the KT conditions provide the necessary and sufficient conditions
for the COP. Also, note that when we have multiple constraints, some of them might turn out to be
contradictory in which case it is the KT conditions that ensure the existence of not just the multipliers,
but also the solution(s) to our COP.

f. Write down the Lagrangian for the problem. Confirm that your guesses are correct by finding
the Lagrangian multipliers associated with the constraints for the theorem. Does the problem
have more than one solution?

£ = ax1 + bx2 – ‫( ג‬p1x1 + p2x2 – m) – α.x1 – β.x2

Equations 1: FOC

ꝺ£ / ꝺx1 = a – ‫ג‬p1 – α = 0

ꝺ£ / ꝺx2 = b – ‫ג‬p2 – β = 0

CS conditions:

‫( ג‬p1x1 + p2x2 – m) = 0

α.x1 = 0

β.x2 = 0

Equations 2: Kuhn Tucker conditions:

‫ג‬αβ >= 0

p1x1 + p2x2 <= m

x1 >= 0

x2 >= 0
Discussing by CS conditions, we have 8 cases:

i. ‫ = ג‬α = β = 0, which in equation 1 says a = b = 0, which is not true. Hence this is not a
solution.
ii. ‫ =! ג‬0; α = β = 0.
From 1, we have a / p1 = b / p2
From CS, p1x1 + p2x2 = m
Implying, x2 = (m/p2 – ax1/b)
Hence the solution is (x*, y*, ‫ ג‬, α, β) = (x1, m/p2 – ax1/b, a/p1, 0, 0) where x1 and x2 lies
along p1x1 + p2x2 = m.
iii. ‫ = ג‬α = 0, β != 0 implies a = 0 in equation 1 (contradiction)
iv. ‫ = ג‬β = 0, α != 0 implies b = 0 in equation 1 (contradiction)
v. ‫ = ג‬0, β != 0, α != 0
By CS, x2 = 0, x1 = 0 but m > 0 (hence this is a contradiction).
vi. ‫ =!ג‬0, β = 0, α !=0
From 1, ‫ = ג‬b/p2; α = a – (b/p2)*p1
X1 = 0, p1x1 + p2x2 = m implying x2 = m/p2
Hence the solution is (x*, y*, ‫ ג‬, α, β) = (0, m/p2, b/p2, 0, a – bp1/p2)
vii. ‫ =!ג‬0, β != 0, α = 0
From 1, ‫ = ג‬a/p1; p1x1 + p2x2 = m, α = b – lamda*p2
From CS x2 = 0, p1x1 + p2x2 = m implying x1 = m/p1
Hence the solution is (x*, y*, ‫ ג‬, α, β) = (m/p1, 0, a/p1, b – ap2/p1, 0)
viii. ‫ =!ג‬0, β != 0, α != 0
By CS, x2 = 0, x1 = 0 but p1x1 + p2x2 = 0 = m > 0 (hence this is a contradiction).

Hence the solutions are (x*, y*, ‫ ג‬, α, β) = (0, m/p2, b/p2, 0, a – bp1/p2); (m/p1, 0, a/p1, b – ap2/p1, 0);
(x1, m/p2 – ax1/b, a/p1, 0, 0) as expected from the previous answers.

Note that we have only found out the solutions to the COP. Do it as an exercise to find the
corresponding utility levels. Also, have the practice of solving specific numeric questions as
generalized cases before inserting the numbers back into them to interpret it.

3. Find the indirect utility function for the Cobb Douglas utility function, u(x1,x2) = ax1 + bx2 with
the budget constraint p1x1 + p2x2 = m.

As we saw in question number 2, the different cases of perfect substitutes utility function; the
maximum utility that could be reached for a particular p and m is,

v(p,m) = m / min {px1, px2}

4. Uncompensated demand functions:

a. What’s uncompensated demand function?

When the prices of a few commodities fall, the budget line changes in slope and so do the demanded
bundle. The locus of all such points is the uncompensated demand curve and the quantities
demanded are calculated from the utility function and the budget constraint as uncompensated
demand or Marshallian Demand Function. Note than in the case Marshallian Demand function, the
consumer is not compensated for the decrease or increase in prices in the name of income effect
unlike the Hicksian Demand Function in which the quantities are compensated to make the consumer
remain in the same indifference curve.

b. Derive the uncompensated demand curve for the CES utility function.
Refer to Example 1.1 of Advanced Microeconomic Theory by Geoffrey A. Jehle and Philip J. Reny.
Having gone through this, try to find uncompensated demand for the u(.) given in the assignment too.

c. Derive the indirect utility function for the CES utility function.

Refer to Example 1.2 of Advanced Microeconomic Theory by Geoffrey A. Jehle and Philip J. Reny.

5. Explain the meaning of non-satiation and transitivity assumptions in consumer theory.

There are two concepts, local non-satiation and non-satiation or monotonicity which in literal terms
means greed. How much ever we consume, there always is a bundle with slightly more of one, a few
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or all of the commodities in the R + space which is more preferred. However local non-satiation is
slightly different in the sense that even if all the commodities are lesser than the original bundle, the
former bundle might be preferred over the latter. We assume non-satiation for this reason:

One, the problems in the utility maximization in literature is obsessed with getting binding solutions
which means that whenever a consumer is inside the budget set, non-satiation forces him to find a
commodity containing more of goods, which is still better (giving him more utility) until he reaches the
boundary of the budget set. On the other hand, local non-satioation is assumed, if consuming gulab
jamuns is giving more utility to a consumer unequivocally; it might as well happen that consuming
more of it makes him puke the experience of which he dislikes. In which case, consumption of lesser
amount of it makes him better off. This need not be the case only for greater values of xi (where xi’s
are gulab jamuns in our case). Thus, local non-satiation assumption ensures that such sort of
preference is taken care of. We now turn again to monotonicity.

If a consumer who is consuming more that gives him higher utilities, then it means that the goods are
in fact ‘good’ goods rather than ‘bad’ goods (eg., air pollution). In order to mathematize that the goods
are ‘good’ goods, we use the assumption of non-satiation; non-satiation ensures that not all goods are
‘bads’ in which case 0 is the satiation point violating that there exists some bundle nearby which is
preferred. Do not worry at this stage on whether or not ‘bad’ goods could be included in the COP
analysis, we indeed can, as we will look at a later stage.

Transitivity of preferences is one of the consistency axioms that the consumer’s preferences need to
have for a very weak requirement. If a person prefers NaMo to AK and AK to RG, then at the same
moment he should not show reversal of preferences between NaMo and RG. Why do we call it a
weak requirement? Suppose you go to a painting shop to select the color of the paint for your
daughter’s room. When the pamphlet shows the pink color in slight increases of intensity from light
pink to dark, you may be indifferent between any two consecutive colors but still have a strict
1
preference ‘P’ between the very first and the very last color. What we are doing is a violation of
transitivity assumption when n is large, to be specific, when n>3. This can be modelled as an
‘acyclicity’ axiom which is considered in literature as a stronger assumption.

6. Suppose that preferences can be represented by a utility function u(x 1,x2). Do these
preferences satisfy the transitivity assumption?
2
If preferences are represented by a utility function, then for if xRy => u(x) >= u(y). --------- equation 1

Similarly if yRz => u(y) >= u(z). ------------ equation 2

From the RHS of equations 1 and 2, u(x) >= u(z) from the properties of number system;

Which implies that xRz. Q.E.D.

1. Where R is the weak preference relation, P is the strict relation and I the indifferent relation. This is also a style of
writing in literature.
2. This analysis could be carried to P and I too, without loss of generality.
 7. Assume the derivatives of the utility function u(x1,x2) are strictly positive. Do the preferences
represented by the utility function satisfy the non-satiation assumption?

No, derivative of utility function being strictly positive means that additional consumption makes a
person always better off and reduction in consumption of goods makes him always worse off whereas
we saw in the definition of non-satiation that there could also be cases where reduction of
commodities could make a person better off. Hence, the answer is a qualified ‘No’.

8. Continue to assume that the derivatives of the utility function u(x1,x2) are strictly positive, is it
possible that the solution to the consumer’s utility maximization problem does not satisfy the
budget constraint as an equality?

When the derivatives of utilities are strictly positive, and if the consumer in inside the budget set, then
she is always better off consuming more leading her to reach her binding constraint (budget set).
However, note that she will always be in the binding solution in two cases. When she has non-
satiated preferences and when the budget set is non-concave. The former is the celebrated Walras’
Law.

Proof: Suppose there exists such an optimal bundle x with p.x < w, then there exists a ɛ > 0 such that
there’s a bundle y within the circle at centre x and radius ɛ which he prefers to x with p.y < w in which
case y is the optimal bundle violating our assumption. This is a proof by contradiction.

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9. Assume the preferences are rational. Show the set {x: x ∈ R +, xIy}. What is this set called?

Insert figure 5. This is the indifference curve.

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10. Show in a diagram the set of weakly preferred points to y, namely {x: x ∈ R +, xRy}. Make
sure it is convex. What does this imply for the marginal rate of substitution?

Insert figure 6.
The given set in the question is the upper contour set. With convex upper contour set, the indifference
curves takes the sliding down shape with implications for the marginal rate of substitution which is that
when the quantity of good 1 is low, the consumer gives up a lot of good 2 in order to get this unit of
good 1 compared to when he has a lot of good 1. And with convex upper contour set, any linear
combination of goods between x and y is also preferred as is seen from the figure 6.

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11. Show the set of points {x: x ∈ R +, xRy}, where x>=y means xi >= yi for i =1,2,3,…,n.
Explain why non-satiation implies that this set is a subset of points weakly preferred to y. ie.,
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{x: x ∈ R +, xPy}?

Insert figure 7.

By the definition of non-satiation (monotonicity), the consumer because of greediness prefer more to
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less and by that the set {X: xi >= yi Ɐ i} is the set {X: x: x ∈ R +, xPy}

12. Explain why the non-satiation assumption implies that the indifference curve cannot slope
upwards?

Since non-satiation says that there’s a bundle that is preferred in excess quantity, if we have upwards
sloping indifference curves, two bundles will not have the same utility level and hence the level sets
have to be negatively sloped.

13. Show that the following constrained maximization problems have no solution. For each
example write what you think is the problem for the existence of a solution.
a. Maximize ln x s.t. x > 1

The function y = ln x when x > 1 is open at the otherwise maximization point and hence we do not
reach the maximum point, implying the maxima doesn’t exist.

b. Maximize ln x s.t. x < 1

By similar reasoning, we can say that the set is open and hence the maximum doesn’t exist.

With practice you will be able to understand which all questions to give mathematical reasoning and which all to give verbal
reasoning. Just make sure you are able to write mathematical reasoning questions comfortably, in order to score :P
 c. Maximize ln x s.t. x <1 and x > 2

The given function is not continuous, and hence the maximum doesn’t exist.

14. For each of the following sets of constraints either say, without proof, what’s the maximum of
2
x subject to the constraints, or explain why there’s no maximum.

a. x <= 0, x >= 1

The function at x <= 0, x >= 1 is not continuous and hence maximum doesn’t exists.

b. x <= 2

When x <= 2, it is tempting to say that we reach the maximum point, but the maximum occurs at the
negative x axis and since the set is open, maximum doesn’t exists.

c. 0 <= x <= 1

Maximum occurs at x=1 and the maximum value is 1. Try to draw the graph for yourself.

d. x >= 2

Function is open and so no maximum.

e. -1 <= x <= 1

Maximum occurs at x=1 and the maximum value is 1.

f. 1 <= x < 2

Function is open and so no maximum.

g. 1 <= x <= 1

Maximum occurs at x=1 and the maximum value is 1.

h. 1 < x <= 2

Maximum occurs at x=2 and the maximum value is 4.

15. XYZ is a profit- maximizing firm selling a good in a perfectly competitive market at price 4. It
2
can produce any non-negative quantity of such good y ay cost c(y) = y . However there’s a
transport bottleneck which makes it impossible for the firm to sell more than ‘k’ units of y,
where k >= 0. Write down XYZ’s profit maximization problem. Show on graph the set B for
this position. Using the graph write down the solution to the problem for all non-negative
values of k.

2
Gn: py = 4; c(y) = y . k >= 0, y >=0

Profit = Revenue – Cost

 2
Hence our objective function = ∏ = 4y - y .

Subject to : y <= k

Insert figure 8, 9.

2
Plot the graph profit ∏ = 4y - y in the ∏-y space as shown in the figure.

Similarly plot the k-v space as shown in the figure taking various values of non-negative k.

Solution to the problem is the set of all points in the v-axis of k-v space that is the highest attainable
set called the supremum set s(k).

Note that when k=1, v=3 and when k=2, v=4 and v=4 thereafter, which can be generalised as
2
solution s(k) = { 4k - k ; when k < 2 and is equal to 4; when k >= 2. }

16. ABC is a perfectly competitive, profit-maximizing firm, producing y from input x according to
0.5
the production function y= x . The price of the output is 2, input is 1. Negative levels of x are
impossible. Also, the firm cannot buy more than ‘k’ units of input. The firm is interested in
knowing what’s the amount of output to be produced or equivalently what’s the input required
for that in the short run.

Gn: py = 2; px = 1; x >= 0, y >=0

0.5
y = x ; x <= k

Profit = Revenue – Cost

0.5
Hence our objective function = ∏ = 2(x ) – 1.x

Subject to : x <= k

Setting up the Lagrangian function:

0.5
£ = 2(x ) – 1.x – ‫( ג‬x – k); the FOC’s are:
-0.5
ꝺ£ / ꝺx = x –1–‫=ג‬0

ꝺ£ / ꝺ‫ = ג‬x – k = 0
Solving for ‫ג‬

and x.

x=k
0.5 0.5
Max y = x =k

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17. A and B are two convex sets of R . Which of the following sets are always convex, sometimes
convex, or never convex? Provide proofs for the sets which are always convex, draw
examples to show why the others are sometimes or never convex?

a. A U B
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b. A + B = {x such that x belongs to R , x=a+b, a belongs to A, b belongs to B}

Refer class notes for the problem.

18. For a general 3X3 matrix, how many third order principal minors are there? How many
second order and first order principal minors are there? What are they?

Principal minor of order ‘k’ is obtained by deleting combinations of (n-k) rows and (n-k) columns. For
eg: third order principal minor is obtained by deleting (3-3) numbers of rows and columns, which the
matrix itself. If the last rows and columns are deleted, we get what is known as the leading principal
minor which is shown below.

th 2
The p order of principal minors deletes (n-p) rows and columns and gives in total (p+1) numbers of
principal minors.

19. Prove the definiteness of the matrix given propositions discussed in class, particularly in its
quadratic form.

Try to do this problem yourself.

20. The budget line is the set of points with p1x1 + p2x2 + …. + pnxn = m and xi >= 0 for i=1,2,..
+
The budget set is the subset of points in Rn satisfying the budget constraint. In formal
 +
notation, it is {x: x belongs to Rn , p1x1 + p2x2 + …. + pnxn <= m}. Assume n=2, and draw the
following:
a. The budget line and the gradient : Figure 10
b. The points where the budget line meets the axis, what are its economic properties? Figure 11.
c. The budget set: Figure 12.

21. Draw diagrams showing the effects of the following on the budget constraint:
a. An increase in p1.
b. A decrease in p2.
c. An increase in income m.

All the best for the exams.

For queries and clarifications, contact:

Deepika, +91 87788 03776