2 November

3 hours
Full points: 30
Fall 2018
ECN 201E Midterm Examination Solutions
Answer all 3 questions below. If you are stuck on a question, I recommend moving on to the
next question and returning to the problem after you have finished answering all the other
questions.
Make sure to show all your working and calculations for significant partial credit. You must
show all the steps that you did to get to your answer. If you just give me the answer, you
will get 0 even if it is correct. I will also give you 0 if all you give me is a formula without
any working.
Good luck!
Please write your name and ITU ID number on your answer sheet.
Question 1
A consumer has Cobb-Douglas preferences over two goods: good 1 and good 2. The
consumer’s preference can be represented by the utility function 𝑢(𝑥1 , 𝑥2 ) = 𝑥13 𝑥2 where 𝑥1
is the amount of good 1 and 𝑥2 is the amount of good 2 that the consumer consumes
respectively. The price of good 1 is 𝑝1 and the price of good 2 is 𝑝2 . The consumer has a
money income of 𝑚 that she intends on spending on both goods.
a) State the consumer’s constrained maximization problem. [2 points]

b) Find the demand functions for good 1 and good 2. [6 points]

c) Is good 1 a normal good or an inferior good? Prove your answer. [2 points]

Question 2
A consumer’s preference over two goods (good 1 and good 2) can be represented by the
utility function 𝑢(𝑥1 , 𝑥2 ) = √𝑥1 +𝑥2 where 𝑥1 is the amount of good 1 and 𝑥2 is the amount
of good 2 that the consumer consumes respectively. The price of good 1 is 𝑝1 and the price of
good 2 is 𝑝2 . The consumer has a money income of 𝑚 that she intends on spending on both
goods.
a) What type of preference does the consumer have over goods 1 and 2? [1 point]

b) Find the demand functions for good 1 and good 2. [7 points]

c) What property in good 1’s demand function do you find may not be true in the real
world? Why may not this property hold in the real world? [2 points]
Question 3
A consumer has a quasilinear utility function 𝑢(𝑥1 , 𝑥2 ) = 𝑣(𝑥1 ) + 𝑥2 where 𝑥2 is the
consumer’s expenditure on all other goods except good 1. Therefore, the demand for good 1
will depend only on its price 𝑝1 (because 𝑝2 = 1). We thus write the demand for good 1 as
𝑥1 (𝑝1 ). Suppose the price of good 1 𝑝1 changes from 𝑝1∗ to 𝑝̂1. Let the amounts of good 1 that
the consumer chooses to buy at prices 𝑝1∗ and 𝑝̂1 be 𝑥1∗ and 𝑥̂1 respectively (i.e. 𝑥1∗ = 𝑥1 (𝑝1∗ )
and 𝑥̂1 = 𝑥1 (𝑝̂1 ) ) and denote 𝑚 as the consumer’s money income as usual. Prove that in
such a case the compensating variation 𝑪 is equal to the equivalent variation 𝑬. [10 points]
Answer 1
1a) The consumer’s constrained maximization problem is:
𝑀𝑎𝑥𝑥1 ,𝑥2 𝑥13 𝑥2
𝑠. 𝑡. 𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝑚
1b) There are two methods to derive the demand functions for goods 1 and 2. One method is
solving by substitution and the other is by forming a Lagrangian. I will just show the
Lagrangian method here but I will accept both methods.
We can monotonically transform 𝑢(𝑥1 , 𝑥2 ) by taking its natural logarithm: 𝑣(𝑥1 , 𝑥2 ) =
3 ln 𝑥1 + ln 𝑥2 .
Because we know that a monotonic transformation of 𝑢(𝑥1 , 𝑥2 ) represents the same
underlying preferences as 𝑢(𝑥1 , 𝑥2 ), we can rewrite the consumer’s constrained maximization
problem as:
𝑀𝑎𝑥𝑥1 ,𝑥2 3 ln 𝑥1 + ln 𝑥2
𝑠. 𝑡. 𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝑚
We can then form a Lagrangian:
𝐿 = 3 ln 𝑥1 + ln 𝑥2 − 𝜆(𝑝1 𝑥1 + 𝑝2 𝑥2 − 𝑚) , (1)
where 𝜆 is the Lagrange multiplier.
The 3 first-order conditions are:
𝜕𝐿 3
= 𝑥 − 𝜆𝑝1 =0, (2a)
𝜕𝑥1 1

𝜕𝐿 1
= 𝑥 − 𝜆𝑝2 =0, (2b)
𝜕𝑥2 2

𝜕𝐿
= 𝑝1 𝑥1 + 𝑝2 𝑥2 − 𝑚 = 0. (2c)
𝜕𝜆

From first-order conditions (2a) and (2b), we get respectively:

3 = 𝜆𝑝1 𝑥1 , (3a)
1 = 𝜆𝑝2 𝑥2 . (3b)
Adding equations (3a) and (3b):
4 = 𝜆(𝑝1 𝑥1 + 𝑝2 𝑥2 ),
⇒ 4 = 𝜆𝑚
4
∴ 𝜆 = 𝑚. (4)

Substituting the value of 𝜆 from equation (4) into equation (3a) to get the demand function
for good 1:
3 = 𝜆𝑝1 𝑥1 ,
4
⇒ 3 = 𝑚 𝑝1 𝑥1
3𝑚
∴ 𝑥1 = 4𝑝 . (5)
1

Similarly, we can substitute the value of 𝜆 from equation (4) into equation (3b) to get the
demand function for good 2:
1 = 𝜆𝑝2 𝑥2 ,
4
⇒ 1 = 𝑚 𝑝2 𝑥2
𝑚
∴ 𝑥2 = 4𝑝 . (6)
2

Equations (5) and (6) show the demand functions for goods 1 and 2 respectively i.e.:
𝟑𝒎
𝒙𝟏 (𝒑𝟏 , 𝒎) = 𝟒𝒑 , (5)
𝟏

𝒎
𝒙𝟐 (𝒑𝟐 , 𝒎) = 𝟒𝒑 . (6)
𝟐

1c) Good 1 is a normal good. This can be shown by partially differentiating 𝑥1 (𝑝1 , 𝑚) with
respect to 𝑚:
𝜕𝑥1 3
= 4𝑝 > 0, because 𝑝1 > 0.
𝜕𝑚 1

Answer 2
a) Quasilinear preferences.
Again, there are two ways to solve this constrained maximization. Below I have worked out
the problem using a Lagrangian.
We can form a Lagrangian:
1
2
𝐿 = 𝑥1 + 𝑥2 − 𝜆(𝑝1 𝑥1 + 𝑝2 𝑥2 − 𝑚) , (7)

where 𝜆 is the Lagrange multiplier.

The 3 first-order conditions are:
𝜕𝐿 1
=2 − 𝜆𝑝1=0, (8a)
𝜕𝑥1 √ 𝑥1

𝜕𝐿
= 1 − 𝜆𝑝2 =0, (8b)
𝜕𝑥2

𝜕𝐿
= 𝑝1 𝑥1 + 𝑝2 𝑥2 − 𝑚 = 0. (8c)
𝜕𝜆

From equation (8a), we get:

2√𝑥1 𝜆𝑝1 = 1. (9)
From equation (8b), we get:
𝜆𝑝2 = 1. (10)
Substituting the value of 1 from equation (10) into equation (9):
2√𝑥1 𝜆𝑝1 = 𝜆𝑝2 ,
2 𝑝
√𝑥1 = 2𝑝1, (11)

𝒑𝟐
𝒙𝟏 = 𝟒𝒑𝟐𝟐 . (12)
𝟏

Equation (12) is the demand function of good 1. We can find the demand function of good 2
by substituting the value of 𝑥1 from equation (12) into the budget constraint (8c):
𝑝1 𝑥1 + 𝑝2 𝑥2 − 𝑚 = 0,
𝑝2
⇒ 𝑝1 . 4𝑝22 + 𝑝2 𝑥2 − 𝑚 = 0,
1

𝑝2
⇒ 4𝑝2 + 𝑝2 𝑥2 − 𝑚 = 0 ,
1

𝑝2
⇒ 𝑝2 𝑥2 = 𝑚 − 4𝑝2 ,
1

𝒎 𝒑
∴ 𝒙𝟐 = 𝒑 − 𝟒𝒑𝟐 . (13)
𝟐 𝟏

Equation (13) is the demand function for good 2. Therefore, the demand functions for good 1
and good 2 are:
𝒑𝟐
𝒙𝟏 (𝒑𝟏 , 𝒑𝟐 ) = 𝟒𝒑𝟐𝟐 , (12)
𝟏

𝒎 𝒑
𝒙𝟐 (𝒑𝟏 , 𝒑𝟐 , 𝐦) = 𝒑 − 𝟒𝒑𝟐 . (13)
𝟐 𝟏

2c) The demand function for good 1 is:

𝑝2
𝑥1 (𝑝1 , 𝑝2 ) = 4𝑝22, (11)
1

Note, that the consumer’s consumption of good 1 is independent of his income. This cannot
hold in the real world. If income is zero then demand has to be zero for good 1.
Answer 3
Let 𝐶 be the compensating variation. It is the extra money needed after the price change to
make her as well off as before the price change. This means 𝐶 is such that:
𝑈(𝑥̂1 , 𝑥̂2 = 𝑚 + 𝐶 − 𝑝̂1 𝑥̂1 ) = 𝑈(𝑥1∗ , 𝑥2∗ = 𝑚 − 𝑝1∗ 𝑥1∗ ),
⟹ 𝑣(𝑥̂1 ) + 𝑚 + 𝐶 − 𝑝̂1 𝑥̂1 = 𝑣(𝑥1∗ ) + 𝑚 − 𝑝1∗ 𝑥1∗ ,
∴ 𝐶 = 𝑣(𝑥1∗ ) − 𝑣(𝑥̂1 ) + 𝑝̂1 𝑥̂1 − 𝑝1∗ 𝑥1∗ . (1)
Let 𝐸 be the equivalent variation. It is the extra money to take away before the price change
to make her as well off as after the price change. This means 𝐸 is such that:
𝑈(𝑥1∗ , 𝑥2∗ = 𝑚 − 𝐸 − 𝑝1∗ 𝑥1∗ ) = 𝑈(𝑥̂1 , 𝑥̂2 = 𝑚 − 𝑝̂1 𝑥̂1 ),
⟹ 𝑣(𝑥1∗ ) + 𝑚 − 𝐸 − 𝑝1∗ 𝑥1∗ = 𝑣(𝑥̂1 ) + 𝑚 − 𝑝̂1 𝑥̂1 ,
∴ 𝐸 = 𝑣(𝑥1∗ ) − 𝑣(𝑥̂1 ) + 𝑝̂1 𝑥̂1 − 𝑝1∗ 𝑥1∗ . (2)
Comparing 𝐶 and 𝐸 from Equations (1) and (2), we see that they are equal. ∎