Econ 202 Microeconomics Theory I

First Semester, AY 2023-24

Assignment 4: Demand I

1. Consider a utility function with constant elasticity of substitution (CES):

1
U(x1, x2 ) = ⎡⎣α1x1ρ+ α 2 x 2ρ ⎤⎦ ρ , ρ ≠ 0, and ρ ≤ 1.
Show the following:
(i) When 𝜌 = 1, indifference curves are linear, and thus goods 1 and 2 are perfect
substitutes.
(ii) When 𝜌 → 0, the utility function represents a Cobb-Douglas utility function,
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𝑈 𝑥! , 𝑥! = 𝑥! ! 𝑥! ! , where 𝛼! + 𝛼! = 1.
(iii) When 𝜌 → −∞, the utility function becomes a Leontief utility function given by
𝑈 𝑥! , 𝑥! = 𝑚𝑖𝑛 𝑥! , 𝑥! , and thus goods 1 and 2 are perfect complements.

2. In a world with two commodities, consider a consumer’s preferences that are

represented by the utility function

U(x1, x2 ) = α1 log x1 + α 2 log x2

a) Is the function additively separable?

b) Calculate the consumer’s demand function.
c) Verify that the preferences satisfy convexity.
d) Show that diminishing marginal utility in at least one good is implied.
e) Suppose x1 exhibits increasing marginal utility. Show that (i) x1 is a normal good
(
while x2 is an inferior good; and (ii) x1 is a net substitute ∂x1H ∂p2 > 0 . )
f) Show that if there is diminishing marginal utility in each good, then both goods are
normal.
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g) Show that = = 0 for this specification of utility function.
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h) Show that for a different specification of an additively separable utility function, it is
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not always true that = 0, 𝑖 ≠ 𝑗.
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i) Assume now that 𝑥! is a Giffen good, i.e., > 0. Prove that > 0. Prove also
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that 𝑎𝑛𝑑 have opposite signs.
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3. Consider a Stone-Geary utility function

α β γ
U(x1, x2 , x3 ) = ( x1 − b1 ) ( x2 − b2 ) ( x3 − b3 )
where 𝑏! , 𝑏! , 𝑏! > 0 represent the minimal amounts of goods 1, 2 and 3 that this individual
must continue at any given period in order to remain alive.
(i) Find the Marshallian demand for each of the goods and indirect utility function.
(ii) Verify that the Marshallian demand functions obtained in part (i) satisfy homogeneity of
degree zero in prices and Walras’ law.
Econ 202 Microeconomics Theory I
First Semester, AY 2023-24

(iii) Let us now restrict to a utility function with only two goods
α β
U(x1, x2 , x3 ) = ( x1 − b1 ) ( x2 − b2 )
where 𝛼 + 𝛽 = 1. Are the preferences represented by this utility function homothetic?

4. Describe the effects of a monotonic transformation of the utility function on:

a) The rate of change of the marginal utility of one good with respect to a change in
another good;
b) The law of diminishing marginal utility;
c) The slopes of demand curves;
d) The values of income elasticities;
e) The homogeneity of the demand functions;
f) The size and sign of the marginal utility of income.