Solution Manual for Microeconomic Theory Basic

Principles and Extensions 12th Edition Nicholson

Snyder 1305505794 9781305505797
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CHAPTER 6:
Demand Relationships among Goods

Two types of demand relationships are stressed in the problems to Chapter 6: cross-price effects
and composite commodity results. The general goal of these problems is to illustrate how the
demand for one particular good is affected by economic changes that directly affect some other
portion of the budget constraint. Several examples are introduced to show situations in which the
analysis of such cross-effects is manageable.

Comments on Problems

6.1 Another use of the Cobb–Douglas utility function that shows that cross-price effects are
zero. Explaining why they are zero helps to illustrate the substitution and income effects
that arise in such situations.

6.2 Shows how some information about cross-price effects can be derived from studying
budget constraints alone. In this case, Giffen’s paradox implies that spending on all other
goods must decline when the price of a Giffen good rises.

45
46 Chapter 6: Demand Relationships among Goods

6.3 A simple case of how goods consumed in fixed proportion can be treated as a single
commodity (buttered toast).

6.4 An illustration of the composite commodity theorem. Use of the Cobb–Douglas utility
produces quite simple results.

6.5 An examination of how the composite commodity theorem can be used to study the
effects of transportation or other transactions charges. The analysis here is fairly
intuitive—for more detail consult the Borcherding–Silverberg reference or Problem 6.12.

6.6 Illustrations of some of the applications of the results of Problem 6.5. More extensive
answers are provided in the solutions to Problem 6.12.

6.7 This problem demonstrates a special case in which uncompensated cross-price effects are
symmetric.

6.8 This problem looks at cross-substitution effects in a three-good CES function.

Analytical Problems

6.9 Consumer surplus with many goods. This illustrates how expenditure functions can
help to clarify consumer surplus ideas when several prices change.

6.10 Separable utility. This problem shows that many of the complications in a many good
utility function can be greatly simplified if utility is assumed to be separable.

6.11 Graphing complements. The problem draws on Samuelson’s famous paper on

complementarity. It shows that there is a graphical representation of complements in the
three-good case that accurately reflects the Hicks definition.

6.12 Shipping the good apples out. This repeats the analysis in the Borcherding–Silberberg
paper in a simplified form. It is mainly intended to show how the various properties of
utility and demand function can be used to sign derivatives in special cases.

6.13 Proof of the composite commodity theorem. This problem outlines two general
approaches to proving the composite commodity theorem. The first, using duality, is
probably the most preferred such method.

6.14 Spurious product differentiation. This behavioral problem shows how firms may be
able to receive higher prices for their products if they can convince (spuriously)
consumers that they are better.
 Chapter 6: Demand Relationships among Goods 47

Solutions

6.1 a. As for all Cobb–Douglas applications, first-order conditions show

that pm m = ps s = 0.5I . Hence, s = 0.5 I ps and s pm = 0.

b. Because indifference curves are rectangular hyperboles (ms = constant)

own substitution and cross-substitution effects are of the same proportional
size, but in opposite directions. Because indifference curves are homothetic,
income elasticities are 1.0 for both goods, so income effects are also of same
proportionate size. Hence, substitution and income effects of changes in pm on s
are precisely balanced.

c. We have the two conditions

s s s
0= = −m
pm pm U I
m m m
0= = −s .
ps ps U I
But
s m
= .
pm U
ps U
So
s m
m =s .
I I

d. From part (a),

s  0.5   0.5   0.5  m
m = m  = m  = s =s .
I  ps   pm m s   pm  I

6.2 Since r / pr > 0 , a rise in pr implies that pr r definitely rises. Since p j j = I − pr r ,
must fall, j will fall. Hence, j pr  0.

6.3 a. Yes, pbt = 2 pb + pt .

b. Since p cc = 0.5I , c pbt = 0.

48 Chapter 6: Demand Relationships among Goods

c. Since changes in pb or pt affect only pbt , these derivatives are also zero.

6.4 a. The amount spent on ground transportation is

 p 
pbb + pt t = pb  b + t  t  = pb g ,
 pb 
where
p
g = b + t  t.
pb

b. Maximize U ( b, t , p ) subject to p p p + pbb + pt t = I . This is equivalent to

maximizing U ( g , p ) = g 2 p subject to p p p + pb g = I .

I 2I
c. p= , g= .
3 pp 3 pb

d. Given pb g , choose pbb = pb g 2 and pt t = pb g 2.

6.5 a. Composite commodity = p2 x2 + p3 x3 = p3 (kx2 + x3 ).

b. The relative price equals

p + t kp + t
= 2 = 3 .
p3 + t p3 + t
The relative price is less than 1 for t = 0. The relative price → 1 as t → .
Hence, increases in t raise the relative price of x2 .

c. Although it might seem like increases in t would reduce expenditures on the

composite commodity, the theorem does not apply to this directly. As part (b)
shows, changes in t also change relative prices.

d. Rise in t should reduce relative spending on x2 more than on x3 since this raises
its relative price. However, see the Borcherding and Silberberg analysis.

6.6 a. Transport charges make low-quality produce relatively more expensive at distant
locations. Hence, buyers will have a preference for high quality.

b. Increase in baby-sitting expenses raise the price cheap meals relative to expensive
ones.
 Chapter 6: Demand Relationships among Goods 49

c. High-wage individuals have higher value of time and hence a lower relative price
of Concorde flights.

d. Increasing search costs lower the relative price of expensive items.

6.7 Assume xi = ai I and x j = a j I . Hence,

xi x j
xj = ai a j I = xi .
I I
So income effects (in addition to substitution effects) are symmetric.

6.8 a. Example 6.3 gives

I
x= .
px + px p y + px pz
Clearly,
x x
,  0.
p y pz
So these are gross complements.

b. The Slutsky equation shows

x x x
= −y .
p y p y I
U =U

So x p y U =U could be positive or negative. Because of the symmetry of y and

z here, Hick’s third law suggests that both x p y  0 and x pz U =U  0.
U =U

Analytical Problems

6.9 Consumer surplus with many goods

a. CV = E ( p1, p2 , p3 ,K pn ,U ) − E ( p1 , p2 , p3 ,K pn ,U ).

b.
50 Chapter 6: Demand Relationships among Goods

Notice that the rise in p1 shifts the compensated demand curve for x2 .

c. Symmetry of compensated cross-price effects implies that order of calculation is

irrelevant.

d. The figure in part (a) suggests that compensation should be smaller for net
complements than for net substitutes.

6.10 Separable utility

a. This functional form assumes U xy = 0. That is, the marginal utility of x does not
depend on the amount of y consumed. Though unlikely in a strict sense, this
independence might hold for large consumption aggregates such as “food” and
“housing.”

b. Because utility maximization requires MU x px = MU y py , an increase in

income with no change in p x or p y must cause both x and y to increase to
maintain this equality (assuming U i  0 and U ii  0 ).

c. Again, using MU x px = MU y py , a rise in p x will cause x to fall and MU x to

rise. So the direction of change in MU x px is indeterminate. Hence, the change
in y is also indeterminate.

d. If U = x y  , then MU x =  x −1 y  .
But, ln U =  ln x +  ln y; and so MU x =  x . Hence, the first case is not
separable; the second is.

6.11 Graphing complements

a,b. The figure shows that the loss in x1 can be compensated for by an additional j of
 Chapter 6: Demand Relationships among Goods 51

x3 or k of x2 .

x3

k
U( x10 - h)
U( x10 )

x2

c. The new indifference curve is given by U 2 .

x3

U2
k

U0

x2
52 Chapter 6: Demand Relationships among Goods

d. The three cases are shown in the next three graphs:

x3

U2= U( x10 - 2h)

k

U0

x2
(i) independent

x3

U2
k
U= U(x1 - 2h)
U0

x2
(ii) complements

x3

k U( x10 - 2h)

U2
U0

x2
(iii) substitutes
 Chapter 6: Demand Relationships among Goods 53

Symmetry is shown by the fact that it does not matter in which order the j and k
compensations are made.

e. Samuelson suggests the following proof. Consider the implicit equation:

x1 = f ( x2 , x3 , U ).
Holding U constant we can examine the sign of
2 f
.
x2x3
It is clear (from the graphical argument) that this second-order partial should be
negative for complements and positive for substitutes. Now, consider how the
derivative relates to the Hicks definition. The first partial is
x1
.
x2 U
This is the negative of the MRS. The MRS will remain constant since p1 and p2
remain constant. We wish to know how a change in x3 will change the levels of
the other goods that yield this MRS. It is also clear that

x3
 0.
p3 U

Consider a fall in p3 . x3 will rise and if the second-order partial is positive, the
MRS will rise for given levels of x1 and x2 . To restore utility maximization, x2
will fall (and x1 will rise), and x2 and x3 would be declared substitutes by the
Hicks definition. Hence, the graphical and mathematical definitions agree.

f. The mathematical ideas will always be relevant since they are in principle
measurable. However, it seems unlikely that these derivatives could fully capture
complicated relationships between actual goods, especially in models with many
narrowly defined goods.

6.12 Shipping the good apples out

x2c x c
(x x
c
2
c
3 )= x3c
t
− x2c 3
t .
a.
t ( x3 )
c 2

x2c x c
(x x
c
2
c
3 )= x3c
t
− x2c 3
t
b.
t ( x3 )
c 2
54 Chapter 6: Demand Relationships among Goods

 x c x c   x c x c 
x3c  2 + 2  − x2c  3 − 3 
p p3   p2 p3 
=  2
( x3c )
2

x2c  1 x2c 1 x2c 1 x3c 1 x3c 

=   +  −  −  
x3c  x2c p2 x2c p3 x3c p2 x3c p3 
x2c  s22 s23 s32 s33 
=  + − − .
x3c  x2c x2c x3c x3c 

c. Given
sij p j
eijc = .
xic
Then
 ( x2c x3c ) x2c  s22 s23 s32 s33 
=  + − − 
t x3c  x2c x2c x3c x3c 
x2c  e22
c c
e23 c
e32 c
e33 
= c 
+ − − .
x3  p2 p3 p2 p3 

 e = 0 , for i = 1, 2,3. If we substitute for e23 and e33 in

3
d. Hicks’ third law is j =1 ij

the above equation, we get e23 = −e21 − e22 and e33 = −e31 − e32 . Thus,

e22 e23 e32 e33 e22 (−e21 − e22 ) e32 (−e31 − e32 )
+ − − = + − −
p2 p3 p2 p3 p2 p3 p2 p3
 1 1   1 1  e −e
= e22  −  + e32  − +  + 31 21
 p2 p3   p2 p3  p3
 1 1  e −e
= (e22 − e32 )  −  + 31 21 .
 p2 p3  p3

e. The own-price elasticity of x2 , e22 , is negative. If goods 2 and 3 are substitutes,

then e32 should be positive. Therefore, e22 − e32 should be negative. Since good 2
is more expensive, 1 p2  1 p3 . Thus, the following product should be positive:
 1 1 
(e22 − e32 )  −   0.
 p2 p3 
We are almost done finding the sign of the last equation in part (d); we only need
to deal with the last term:
 Chapter 6: Demand Relationships among Goods 55

e31 − e21
.
p3
This term is likely to be small if we assume that goods 2 and 3 have similar
relationships with 1: that is, e31 and e21 should have close values. Since goods 2
and 3 are close substitutes, such an assumption seems reasonable. Therefore,
overall, we can expect the expression to be positive.

f. a) In this example, high-quality apples and fresh oranges can

be represented as good 2 (using the above notation) and the low-quality
apples or oranges, respectively, as good 3. Clearly, high-quality apples (or
oranges) and low-quality apples (or oranges) are close substitutes, so the
term e22 − e32 should be negative (as explained above) and
 1 1 
(e22 − e32 )  −   0.
 p2 p3 
Moreover, we can assume that apples, whether of high or low quality,
have a similar relationship with the other commodities, thus e31 and e21
should have close values. Hence, transaction costs such as the
transportation costs are expected to increase the relative demand for the
more expensive fruits, making it harder to find such products.

b) In this example, expensive restaurant meals and cheap restaurant

meals are close substitutes. The expensive meals can be represented as
good 2 (using the above notation) and the cheap meals as good 3. Since
goods 2 and 3 come from the same category, namely restaurant meals, we
can expect them to have similar relationships with the other categories of
goods, represented by x1 . Therefore, e31 − e21 is likely to be small. And
since goods 2 and 3 are close substitutes, e22 − e32 should be negative,
implying
 1 1 
(e22 − e32 )  −   0.
 p2 p3 
Hence, a higher transaction cost (here, the higher baby-sitting expenses)
will increase the relative demand for the more expensive meals.

c) We can assume that flying the Concorde falls in the category of expensive
flights, and these are close substitutes to cheaper flights. Thus, the
Concorde flights can be represented as good 2 (using the above notation)
and the cheaper flights as good 3. Since goods 2 and 3 come from the
same category, namely flights, we can expect them to have similar
relationships with the other categories of goods, represented by x1 .
Therefore, e31 − e21 is likely to be small. And since goods 2 and 3 are close
substitutes, e22 − e32 should be negative, implying
56 Chapter 6: Demand Relationships among Goods

 1 1 
(e22 − e32 )  −   0.
 p2 p3 
Hence, a higher transaction cost (here, the value of the time lost flying
with a slower airplane) will increase the relative demand for the more
expensive Concorde flights.

d) In this example, the value of the time spent searching is a transaction cost
that changes the relative price of the items. As above, we can represent the
expensive items by good 2 and the cheap ones as good 3. Since goods 2
and 3 come from the same category, we can expect them to have similar
relationships with the other categories of goods, represented by x1 .
Therefore, e31 − e21 is likely to be small). And since goods 2 and 3 are
close substitutes, e22 − e32 should be negative, implying
 1 1 
(e22 − e32 )  −   0.
 p2 p3 
Hence, a higher transaction cost (here, the value of the time spent
searching) will decrease the relative price of expensive items.

6.13 Proof of the composite commodity theorem

a. Proof using duality

i. Applying the envelope theorem to both minimization problems yields:

dE dE dp1 dE dp2 dE dp3 dE *

=  +  +  = 0 + x2 p2 + x3 p3 = y =
c 0 c 0

dt dp1 dt dp2 dt dp3 dt dt

ii. Again applying the envelope theorem to both problems yields:

dE dE *
= x1c =
dp1 dp1
b. Proof using two-stage maximization

i. Because neither the price of x2 or x3 changes, the maximum value for the function
V depends only on m. That is, there is a unique correspondence between m and the
utility it provides.
ii. This equality is derived by repeated application of the envelope theorem to the
various optimization subproblems. The first-order conditions of Stage 2 require
V m =  . But, because V is the value function from Stage 1, the envelope
theorem also implies V m =  . Hence,  =  . But the first-order conditions
for the original optimization problem require U x1 =  p1 and the first-order
conditions for the Stage 2 problem require V x1 = U x1 =  p1 . So,  =  .
 Chapter 6: Demand Relationships among Goods 57

So, provided there is a unique solution to the original optimization problem, this
solution will be identical to the solution from the two-stage statement of the
problem.

6.14 Spurious product differentiation

a. The first-order condition for utility maximization for brand 1 is p1y = 500 (1 + y1 ) .
Hence, the maximum price this person will pay for this brand ( y1 = 1) is 250. For
brand 2, the maximum price this person is willing to pay is 300.

b. For brand 1, utility is 750 + 500ln 2 = 1097. For brand 2, utility is

700 + 600ln 2 = 1116 . Hence, this person will purchase brand 2.

c. Assuming the utility from brand 2 is really that from brand 1, utility would be
700 + 500ln 2 = 1047 , a loss of 50 from what could have been received if he/she
had purchased brand 1.

d.Spending funds to ascertain the quality of brand 2 (say by reading Consumer Reports)
would be equivalent to taking a gamble whose outcome depends on whether the
information reports that brand 2 is really better. Let p be the probability that
research determines that brand 2 really is better. Then this person will spend x on
gathering information provided the expected value of doing so exceeds what
he/she can receive from buying brand 1. Hence, we have
(1 − p)(750 − x + 500ln 2) + p(700 − x + 600ln 2)  1097 . Algebraic manipulation
of this condition yields: p(100ln 2 − 50)  19 p  x . This makes sense intuitively.
If p = 1 , this person would pay up to the 19 utility difference between the two
brands to know that brand 2 is better with certainty. On the other hand, if p = 0.5,
he or she would only pay half this amount because the expected value of the
information is less.