TA Session 1

Microeconomics 2 - LMEC - a.y. 2021/2022

Professor: Paolo Vanin
Teaching Assistant: Nektaria Glynia

19 December 2021

1 Cobb-Douglas Utility Function

Let the consumer’s preferences be described by the following Cobb-Douglas utility function:
n
Y
u(x1 , ..., xn ) = A xα
i
i

i=1
Pn
where A > 0 is a scale factor, and i=1 αi = 1. Prices are p = (p1 , p2 , ..., pn ) and the income is w.
1.1 Solve the Utility Maximization Problem (UMP) to derive the Walrasian demand function. Find
the indirect utility function.

1.2 Solve the Expenditure Maximization Problem (EMP) and derive the Hicksian demand function.
Find the expenditure function.
ANSWER

We solve the utility maximisation problem (UMP) and we derive the Walrasian demand Function:
n
Y
max A xα
i ,
i
x1 ;x2 ;...;xn
i=1
subject to
X
pi xi ≤ w, (budget constraint)
xi ≥ 0∀i, (non negativity constraint)

In general there are 2 way of writing the Lagrangian

1. Considering non-negativity constraints explicitly and derive the FOCs.

2. Embedding non-negativity constraints in the FOCs
The Lagrangian reads as:
n
Y X n
X
L(x1 ; x2 ; ...; xn ; λ; µ1 ; µ2 ; ...; µn ) = A xα
i + λ[w −
i
pi xi ] + µi [xi − 0]
i=1 i=1

∂L(.)
∂xi = 0 for i = 1, ..., n

λ ∂L(.)
P
∂λ = λ(w − pi xi ), with complementary slackness

∂L(.)
• λ = 0; ∂λ ≥ 0 (unconstrained maximization)
∂L(.)
• λ > 0; ∂λ = 0 (constrained maximization)

1
µi ∂L(.)
∂µi = µi xi = 0, with complementary slackness

• µi = 0; ∂L(.)
∂µi ≥ 0 (interior solution, non negativity constraints do not bind)

• µi > 0; ∂L(.)
∂µi = 0 (corner solution, non negativity constraints bind)

Notice that if λ = 0 the Budget constraint does not enter in the Lagrangean, if λ > 0 we have constrained
optimization, that is

• ∂L(.)
P P
∂λ = 0 ⇒ w − p i xi = 0 ⇒ w = pi xi i.e. Walras Law

∂L(.)
• ∂w = λ i.e. marginal rate of income equals λ (i.e shadow value of constraint or marginal benefit
of relaxing the constraint)

Assume a Cobb Douglas function

Y α
Aαi xiαi −1−αi xα
i
i
xj j (∗)
| {z }
Aα
j6=i
= x i | {z }
0 Qn α
i=1 xi i

• xi = 0 ⇒ U (.) = 0, it is always possible to get U > 0 if xi > 0 (i.e the non-negativity constraint
never binds, there is always an interior solution µi = 0; xi > 0∀i)
∂U (.)
• ∂xi > 0, which implies monotonicity, i.e. the agent always spends the entire income and the
budget constraint binds, λ > 0

Consider again the FOCs:

αj
• A : ∂L(.) αi −1 Q
∂xi = Aαi xi j6=i xj − λpi + µi = 0, ∀i

∂L(.) P P
• B: ∂λ =0⇒w− pi xi = 0 ⇒ w = pi xi
xα i
αi −1
Y α Qn
From A it holds that i
αi Aαi xi xj j = λpi ⇒ Aαi
xi i=1 xα
i = λpi
i

xi
|{z} j6=i
=1
| {z }
(∗)
Then for every i and j we have
n n
1 Aαi Y αi 1 Aαj Y αj
( xi ) = λ = ( x )
Pi xi i=1 Pj xj j=1 j

αi xi Pi
⇒ = ≡C
α j xj Pj
| {z }
M RSij

From (A) it holds that: X

P i xi + Pj xj = w
j6=i

From (C) it holds that:

αi
P j xj = P i xi
αj
,

plug this in (B) to get

X αi
Pi x i + Pi xi = w
αj
j6=i

Then multiply the last condition by αi to get

2
 X
αi Pi xi + Pi xi αj = αi w
j6=i

and group for the Pi xi in the LHS to get

X αi w
Pi x i αi = αi w → xi (P ; w) =
i=1
Pi
So Walrasian demand is given by:
αi w αn w
x(P ; w) = ( ; ...; )
Pi Pn
xi Pi ∂Pi
where αi = w and ∂xi = 0 i.e no cross price effect

Expenditure Maximization Problem: Hicksian Demand

n
X
max − x i Pi ,
x1 ;x2 ;...;xn
i=1
subject to
n
Y
A xα
i ≥ v̄,
i
(budget constraint)
i=1
xi ≥ 0∀i = 1, ..., n, (non negativity constraint)
The Lagrangean reads as
n
X n
Y n
X
L(.) = − xi Pi + λ[A xα
i
i
− v̄] + µi [xi − 0]
i=1 i=1 i=1
The FOCs ∀i are given by:
n n
∂L(.) Y Y
A: =A xα
i − v̄ = 0 ⇒ v̄ = A
i
xα
i
i

∂λ i=1 i=1

n =0 n
∂L(.) Y α αi Y αi
= Pi = λAαi xiαi −1 xj j + µi = 0 ⇒ Pi = λA
z}|{
B:− x
∂xi xi i=1 i
j6=i

Plug A in B so that ⇒ Pi = λA αxii v̄. Next, we want to remove λ. Solve the last condition for xi = λαi v̄
Pi ≡C
and plug in it back in condition (A) to get.

n n
Y i i α i αi 1 1 Y αi i 1
v̄ = A [λα v̄ α ( ) ] ⇒ v̄ = Aλ αi v̄ αi [( )α ] ⇒ λ = Qn αi i
P P

i=1
Pi i=1
Pi A i=1 ( Pi )α

Plugging the last condition in (C) to get

n  α
αi v̄ 1 ¯ i Y Pi i
vα
xi = hi (Pi ; v̄) = =
Pi A ni=1 αi αi APi i=1 αi
Q
Pi )
(Hicksian demand for i)

n  α n  α !
v̄ αi Y Pi i v̄ α Y Pi i
h(P ; v̄) = ; ...;
A Pi αi A Pn αi

3
 Indirect Utility
N  α αi
αi w i

Y αi
v(p; w) = v(x1 (p; w); ...; xN (p; w)) = A = AwP iN
i
i=1
Pi Pi

Expenditure Function
N N  N 
Y αi ! N  αi
X X v̄ αi Pi v̄ Y Pi
e(P ; u) = pi hi (p; v̄) = Pi =
i=1 i=1
A Pi i=1
αi A i=1 αi

Notice that:
v (P ; e(P ; u)) = v̄
e (P ; v(P ; w)) = w
∂e(P ; u)
= hi (P ; v̄)
∂Pi

4
2 Quasi-Linear Utility Function
Let the consumer’s preferences be described by the following quasi-linear utility function:

u(x1 , x2 ) = xα
1 + x2

where α ∈ (0, 1). Prices are p = (p1 , p2 ) and the income is w.

Solve the UMP to derive the Walrasian demand function, considering both interior and corner solutions.

ANSWER
Assume preferences are given by:

U (x1 ; x2 ; ...; xn ) = φ(x1 ; x2 ; ...; xn−1 ) + xn

max xα
1 + x2
x1 ;x2

P1 x1 − P2 x2 ≤ w ; x1 ≥ 0, x2 ≥ 0

L(.) = xα
1 + x2 + λ[w − P1 x1 − P2 x2 ] + µ1 x1 + µ2 x2

The FOCS are given by:

∂L(.)
∂x1 = αx1α−1 − λP1 + µ1 = 0
∂L(.)
∂x2 = 1 − λP2 + µ2 = 0

λ (w − P1 x1 − P2 x2 ) = 0

µ1 x1 = 0; µ2 x2 = 0; µ1 ≥ 0; µ2 ≥ 0; λ ≥ 0

CASE 1
x2 = 0; x2 = 0 ⇒ w = 0 (uninteresting case)

CASE 2
x1 > 0; x2 > 0 ⇒ µ1 = 0; µ2 = 0; λ = 0
From the FOCs we have that
1
αxα−1
1 − λP1 = 0 ⇒ λ = αxα−1
P1 1

5
 1
1 − λP2 = 0 ⇒ λ =
P2
Dividing by parts the two conditions above we get:
P1
= αx1α−1
P2
  1
P2 1−α
x1 = α
P1
 1
 1−α
w − αP 2
P1
x2 =
P2

CASE 3
x1 > 0; x2 = 0 ⇒ µ1 = 0; µ2 ≥ 0; λ > 0
1
αxα−1
1 − λP1 = 0 ⇒ λ = αxα−1
P1 1
1
1 − λP2 ≤ 0 ⇒ λ ≥
P2
Dividing by parts
P1
≤ αx1α−1
P2
x2 = 0
w
w − P1 x 1 − P2 x 2 = 0 ⇒ x 1 =
P1

CASE 4
x1 = 0; x2 > 0 ⇒ µ1 ≥ 0; µ2 = 0; λ > 0

6
 1
αxα−1
1 − λP1 ≤ 0 ⇒ λ ≥ αxα−1
P1 1
1
1 − λP2 = 0 ⇒ =λ
P2

Dividing by parts

P2 x1−α
≤ 1
P1 α

if x1 → 0 we have a corner solution

For PP1 ≤ 0; P2 = 0, P1 → ∞ super flat budget set
2

Walrasian Demand
w P1
x1 (P, w) = if < αx1α−1
P1 P2
 1
 1−α
P2 P1
x1 (P, w) = α if = αx1α−1
P1 P2
P1
x2 (P, w) = 0 if < αxα−1
1
P2
 1
 1−α
w − αP
P1
2
P1
x2 (P, w) = if = αxα−1
1
P2 P2

7
3 Kinked Preferences
Consider a consumer whose preferences are kinked and are described by the following utility function:

u(x1 , x2 ) = max{αx1 , αx2 } + min{x1 , x2 }

where α ∈ (0, 1).

3.1 Draw a set of indifference curves in the (x1 , x2 ) space.

3.2 Derive the Walrasian demand function. Is it really necessary to solve a maximization problem?
3.3 Find the indirect utility function.

U (x1 ; x2 ) = max (αx1 + αx2 ) + min (x1 ; x2 )

s.t P1 x1 + P2 x2 ≤ w

αx1 + x2
 if x1 > x2
U (x1 ; x2 ) = whatever combination if x1 = x2

αx2 + x1 if x1 < x2


Utiliy Maximation Problem:

Consider x1

P1 1
• if P2 > α ⇒ x1 = 0
 
P1 1 w w
• if P2 = α ⇒ P2 = αP1 ⇒ x1 = P1 (1+α) ⇒ x1 ∈ 0;
P1 (1 + α)
 
P1 P1 w w αw w αw
• if P2 = α ⇒ P2 = α ⇒ x1 = P1 +P2 ⇒ x1 = 1
P1 (1+ α )
= P1 (1+α) ⇒ x1 ∈ ;
P1 P1 (1 + α)

P1 w
• if P2 < α ⇒ x1 =
P1

P1 1 w
• if α < P2 < α ⇒ x1 =
P1 + P2

8
 
P1 1
0 

 → P2 α >

w P1
= α1

∈ 0; P (1+α)
 → P2
1


w P1 1
x1 (P ; w) = →α <P <
 P1
+P2  2 α
αw w P1
∈ →

P1 (1+α) ; P1 =α

P2



w P1

P1 → P2 <α


w P1 1

 P2  → P2 α >

αw w P1
= α1




 ∈ ;
P2 (1+α) P2 → P2
w P1 1
x2 (P ; w) = →α <P <
 P1
+P2  2 α
w P1
∈ 0; P1 (1+α) →



 P2 =α

P1

0 → <α

P2

——
V (p; w) = U (x1 (P ; w); x2 (P ; w))

P1 1
• if P2 > α ⇒ V (.) = max{0; αw αw
P2 } + min{0; P2 } =
αw
P2

P1 1 w(1+α)
• if α < P2 < α ⇒ V (.) = max{ P1αw αw αw αw
+P2 ; P1 +P2 } + min{ P1 +P2 ; P1 +P2 } = P1 +P2

P1
• if P2 < α ⇒ V (.) = max{ αw w
P1 ; 0} + min{ P1 ; 0} =
αw
P1

P1 1 w
• if P2 = α ⇒ V (.) = max{αx1 ; αx2 } + min{x1 ; x2 } = αx2 +x1 = α
| {z } | {z } P2
always x2 always x1
|{z}
plugging in the Walrasian demands at the two extremes

P1 w
• if P2 = α ⇒ V (.) = max{αx1 ; αx2 } + min{x1 ; x2 } = αx1 +x2 = α
| {z } | {z } P1
always x1 always x2
|{z}
plugging in the Walrasian demands at the two extremes

αw
 P2
 →P 1
P2 ≥ α
1

(1+α)w
V (P ; w) = P +P →α< P P2 ≥
1 1
α
 αw1 2
 P1
P1 → P2 ≤ α

9
4 Slutsky Decomposition (Based on MWG 3.G.15)

Consider a consumer with preferences represented by the following utility function:

1 1
U (x1 , x2 ) = 2x12 + 2x22

Prices of the two goods are p1 and p2 and income is w.

4.1 Derive Walrasian and Hicksian demand functions. Find indirect utility and expenditure functions.

4.2 Compute the Slutsky equation when all prices change simultaneously.
The utility function is given by:
1 1
U = 2x12 + 2x22
and !2
1
U − 2x12
x2 =
2
is the indifference curve
The utility maximization problem then is:

max U s.t p1 x1 + p2 x2 = w

The Lagrangean reads as:

L = U − λ(p1 x1 + p2 x2 − w)
Considering only interior solutions the FOCs are:
∂L −1
= x1 2 − λp1 ≤ 0
∂x1
∂L −1
= x2 2 − λp2 ≤ 0
∂x2
which gives:
M U1 p1
M RS12 = = =
M U2 p2
− 21   12
x1 x2 p1
− 21
· · ⇒
x2 x1 p2
 2
p1
x2 = x1
p2
Plug in the budget constraint:
 2
p1
p1 x1 + p2 x1 = w ⇒
p2
p21
p1 x1 + x1 = w ⇒
p2
p2 p1 x1 + p21 x1 = wp2 (plug in the expression for x2 )
wp2 p21
x2 = ⇒
p1 (p2 + p1 ) p22
wp1
x2 =
p2 (p2 + p1 )
The Walrasian Demand Function are:
 
wp2 wp1
= wp2 [p21 + p1 p2 ]−1 , wp1 [p1 p2 + p22 ]−1


x(p, w) = ,
p2 (p1 + p2 ) p2 (p1 + p2 )

10
Expenditure Minimization Problem
The problem is to:
1 1
min p1 x1 + p2 x2 s.t U = 2x12 + 2x22 ⇒ (no excess utility)

The MRS is then given by:

 
p1 p1
M RS = ⇒ x2 = x1 plug it into the constraint
p2 p2
 
1 p1 1
U = 2x1 + 2 2
x12 ⇒
p2
1 1
2p2 x12 + 2p1 x12 = U p2 ⇒

1 U p2
x12 = ⇒
2p2 + 2p1
 2
U p2
h1 (p, U ) =
2(p1 + p2 )

1 p21 U 2 p22
x22 = ⇒
p22 2p2 + 2p1
2
U 2 p21

h2 (p, U ) =
2(p1 + p2 )
So the Hicksian demands are:
 2  2 !
U p2 U p1
= (U p2 )2 · (p1 + p2 )−2 /4, (U p1 )2 · (p1 + p2 )−2 /4


h(p, U ) = ,
2(p1 + p2 ) 2(p1 + p2 )

2 2
p1 u2 p22 + p2 u2 p21
 
U p2 U p1
e(p, U ) = p1 + p2 =
2(p1 + p2 ) 2(p1 + p2 ) 4(p1 + p2 )2
So the expenditure function is given by

U 2 p1 p2
e(p, U ) =
4(p1 + p2 )

Finally, the indirect utility function is given by:

e(p, v(p, w)) = w ⇒ 4(p1 + p2 )w = U 2 p1 p2 ⇒

  12
4(p1 + p2 )w
v(p, w) = ⇒
p1 p2

Slutsky Equation
 

he (p, U ) = xe p, e(p, u)

| {z }
w

∂he ∂xe ∂xe ∂e(p, U ) ∂xe ∂he ∂xe

= + · ⇒ = − xk (p, w)
∂pk ∂pk ∂w ∂p ∂pk ∂pk |∂w {z
| {zk } |{z} }
hk (p,U )=xk (p,w) S.E I.E

It holds that ∂x
∂w > 0 (NORMAL GOOD),
e ∂xe
∂w < 0 (INFERIOR GOOD), ∂xe
∂pe > 0 (GIFFEN GOOD)
where I.E stronger than S.E. In matrix form :

11
 Dp h(p, U ) = Dp x(p, w) + Dw x(p, e) x(p, e)
| {z } | {z } | {z } | {z }
(N ×N ) (N ×N ) (N ×1) (1×N )

where Dp h(p, U ) is the Slutsky Substitution Matrix whose elements are:

∂h1 −2(U p2 )2 (p1 + p2 )−3 (U p2 )2

= =−
∂p1 4 2(p1 + p2 )3
∂h2 −2(U p1 )2 (p1 + p2 )−3 (U p1 )2
= =−
∂p2 4 2(p1 + p2 )3
∂h1 1 1 1
= 2p2 U 2 (p1 + p2 )−2 − (up2 )2 (−2)(p1 + p2 )−3 = .... = U 2 p2 (p1 + p2 )−3 p1
∂p2 4 4 2
∂h2 1 1 1
= 2p1 U 2 (p1 + p2 )−2 − (U p1 )2 (−2)(p1 + p2 )−3 = .... = U 2 p2 (p1 + p2 )−3 p1
∂p1 4 4 2
(U p2 )2
" #
1 2 −3
− 3 2 U p2 (p1 + p2 ) p1
S(w, p) = Dp h(p, U ) = 1 2 2(p1 +p2 ) −3 (U p1 )2
2 U p2 (p1 + p2 ) p1 − 2(p1 +p2 )3 ] =

= SLUTSKY SUB MATRIX where U = v(p, m)

  12
4(p1 + p2 )w
u = v(p, m) =
p1 p2
∂x1 wp2 [2p1 + p2 ]
= wp2 (−1) · [p21 + p1 p2 ]−2 [2p1 + p2 ] = − 2
∂p1 [p1 + p1 p2 ]2
∂x2 wp1 [p1 + 2p2 ]
= wp1 (−1) · [p22 + p1 p2 ]−2 [p1 + 2p2 ] = − 2
∂p2 [p2 + p1 p2 ]2

∂x1 w wp1 p2 w
= w · [p21 + p1 p2 ]−1 + wp2 (−1)[p21 + p1 p2 ]−2 p1 = 2 − 2 =
∂p2 p1 + p1 p2 [p1 + p1 p2 ]2 (p1 + p2 )2

∂x2 wp1 p2 + wp22 − wp1 p2 w

= w · [p1 p2 + p22 ]−1 + wp1 (−1)[p1 p2 + p22 ]−2 p2 = 2 2
=
∂p1 [p2 + p1 p2 ] (p1 + p2 )2
" wp2 [2p2 +p1 ] w
#
− [p2 +p1 p2 ]2 (p 1 +p 2 ) 2
Dp x(p, w) = 2
w
(p1 +p2 )2 − wp 1 [p1 +2p2 ]
[p2 +p1 p2 ]2
2

∂x1 p2
=
∂w p1 (p1 + p2 )
∂x2 p1
=
∂w p2 (p1 + p2 )

Properties:
S(p, w) is SYMMETRIC
S(p, w) Is NEGATIVE SEMIDEFINITE ⇒ function e(p, U ) is concave S(p, w) = ∇p h(p, U )
if S(p, w) Is NEGATIVE DEFINITE function e(p, U ) is strictly concave
determinant test: (−1)k ∆k > 0, det = 0
S · p = 0 (price vector)
" wp2 [2p2 +p1 ] w
# " p2
#
− [p2 +p1 p2 ]2 (p1 +p2 )2 p1 (p1 +p2 )
h
wp2 wp1
i
Dp x(p, w) = 2
w wp1 [p1 +2p2 ] + p1 · (p1 +p2 )p1 (p1 +p2 )p2
(p1 +p2 )2 − [p2 +p1 p2 ]2 p2 (p1 +p2 )
2

12
5 Slutsky substitution matrix (Based on MWG 3.G.14)

The matrix below records the demand substitution effects for a consumer endowed with rational prefer-
ences and consuming three goods at the prices p1 = 1, p2 = 2 and p3 = 6:
 
−10 ? ?
S= ? −4 ?
3 ? ?

Supply the missing numbers using the properties of the Slutsky matrix. Check whether it is negative
semidefinite.
 
−10 ? ?
S= ? −4 ? where p1 = 1, p2 = 2, p2 = 6, with S:symmetric, S:NSD, S · p = 0:
3 ? ?
 
−10 α 3
S= α −4 b
3 b c
     
−10 α 3 1 0
S·p=  α −4 b · 2 = 0
3 b c 6 0

−10 + 2α + 18 = 0
2α = −8
α = −4

α − 8 + 6b = 0
−4 − 8 + 6b = 0
b=2

3 + 2b + 6c = 0
3 + 4 + 6c = 0
c = −7/6
 
−10 −4 3
S =  −4 −4 2 
3 2 − 67
(−1)k ∆k > 0

(−1) · (−10) = 10 > 0;

 
3
−10 −4
(−1) det 
  = 40 − 16 = 24 > 0
−4 −4
det S = 0

(-1)3 10 · + 28
    28  
6 − 4 − 4 · + 6 − 6 − 3[−8 − 12] = ...... = 0

13