18 November

3 hour
Full points: 30
Fall 2016
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 ) = 𝑥12 𝑥23 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) Draw the Engel curve for good 1. What is the slope of the Engel curve for good 1? [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 ) = ln 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 consumes good 1 and good 2. The consumer is willing to substitute one good for
the other at a constant rate. Specifically, the consumer is willing to substitute 1 unit of good
1 for 3 units of good 2. 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) Draw indifference curves of the consumer for goods 1 and 2. Make sure to label the
slope of the indifference curves. Write down a utility function that represents the
consumer’s preference over goods 1 and 2. [5 points]

b) Find the demand function for good 1. Make sure to either show your working or make
clear or reasoning for your answer. [3 points]

c) Assume the price of good 2 is fixed at some value 𝑝2∗ . Plotting the amount of good 1, 𝑥1 ,
on the horizontal axis and the price of good 1, 𝑝1 , on the vertical axis, draw the demand
curve for good 1. Make sure to label 3𝑝2∗ on the vertical 𝑝1 −axis , and show what
happens to the demand of good 1 , 𝑥1 , when 𝑝1 is greater than 3𝑝2∗ , equal to 3𝑝2∗ and
less than 3𝑝2∗ .[2 points]
Answer 1
a) The consumer’s constrained maximization problem is:
𝑀𝑎𝑥𝑥1 ,𝑥2 𝑥12 𝑥23
𝑠. 𝑡. 𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝑚

b) There are two methods to derive the demand functions for goods 1 and 2. You can full
points if you use any of the 2 methods correctly.
Method 1: Use the Langrangian to solve.
We can monotonically transform 𝑢(𝑥1 , 𝑥2 ) by taking its natural logarithm: 𝑣(𝑥1 , 𝑥2 ) =
2 ln 𝑥1 + 3 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 2 ln 𝑥1 + 3 ln 𝑥2
𝑠. 𝑡. 𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝑚
We can then form a Lagrangian:
𝐿 = 2 ln 𝑥1 + 3 ln 𝑥2 − 𝜆(𝑝1 𝑥1 + 𝑝2 𝑥2 − 𝑚) , (1)
where 𝜆 is the Lagrange multiplier.
The 3 first-order conditions are:
𝜕𝐿 2
= 𝑥 − 𝜆𝑝1 =0, (2a)
𝜕𝑥1 1
𝜕𝐿 3
= 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:

2 = 𝜆𝑝1 𝑥1 , (3a)
3 = 𝜆𝑝2 𝑥2 . (3b)
Adding equations (3a) and (3b):
2 + 3 = 𝜆(𝑝1 𝑥1 + 𝑝2 𝑥2 ),
⇒ 5 = 𝜆𝑚
5
∴ 𝜆 = 𝑚. (4)

Substituting the value of 𝜆 from equation (4) into equation (3a) to get the demand function
for good 1:
2 = 𝜆𝑝1 𝑥1 ,
5
⇒ 2 = 𝑚 𝑝1 𝑥1
2𝑚
∴ 𝑥1 = 5𝑝 . (5)
1

Similarly, we can substitute the value of 𝜆 from equation (4) into equation (3b) to get the
demand function for good 2:
3 = 𝜆𝑝2 𝑥2 ,
5
⇒ 3 = 𝑚 𝑝2 𝑥2
3𝑚
∴ 𝑥2 = 5𝑝 . (6)
2

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

𝟑𝒎
𝒙𝟐 (𝒑𝟐 , 𝒎) = 𝟓𝒑 . (6)
𝟐

Note: Generally, the demand function of good 1will also be a function of 𝑝2 but for the
special case of these Cobb-Douglas preferences it does not ultimately enter into equation (5).
That is why we have written the demand function of good 1 as 𝑥1 (𝑝1 , 𝑚) leaving out 𝑝2 as
one of the input variables in this special case of preferences. The case is the same for the
demand function of good 2 and 𝑝1.
Method 2: Substitution of one of the control variables to convert the constrained
maximization problem into an unconstrained maximization in one control variable.
As we saw the consumer’s constrained maximization problem can be written as:
𝑀𝑎𝑥𝑥1 ,𝑥2 2 ln 𝑥1 + 3 ln 𝑥2
𝑠. 𝑡. 𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝑚
From the budget constraint, we can solve for 𝑥2 :
𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝑚
𝑚 𝑝
⇒ 𝑥2 = 𝑝 − 𝑝1 𝑥1 , (7)
2 2

Substituting the value of 𝑥2 from equation (7) into the constrained maximization problem, we
convert it into an unconstrained maximization in one control variable:
𝑚 𝑝1
𝑀𝑎𝑥𝑥1 2 𝑙𝑛 𝑥1 + 3 ln( − 𝑥 )
𝑝2 𝑝2 1
Differentiating the objective function with respect to 𝑥1 and setting equal to 0, we get the
first-order condition:
2 𝑝2 𝑝1
− 3. . = 0. (8)
𝑥1 𝑚−𝑝1 𝑥1 𝑝2

From the first-order condition (8), we can solve for 𝑥1 :

2 𝑝 𝑝
− 3. 𝑚−𝑝2 𝑥 . 𝑝1 = 0
𝑥1 1 1 2

2 3𝑝
⇒ 𝑥 = 𝑚−𝑝1𝑥
1 1 1

2 3𝑝
⇒ 𝑥 = 𝑚−𝑝1𝑥
1 1 1

⇒ 2(𝑚 − 𝑝1 𝑥1 ) = 3𝑝1 𝑥1
⇒ 2𝑚 − 2𝑝1 𝑥1 = 3𝑝1 𝑥1
⇒ 5𝑝1 𝑥1 = 2𝑚
2𝑚
∴ 𝑥1 = 5𝑝 . (5)
1

We can now substitute the value of 𝑥1 into the budget constraint (7) to solve for 𝑥2 :
𝑚 𝑝
𝑥2 = 𝑝 − 𝑝1 𝑥1
2 2

𝑚 𝑝 2𝑚
⟹ 𝑥2 = 𝑝 − 𝑝1 . 5𝑝
2 2 1

𝑚 2𝑚
⟹ 𝑥2 = 𝑝 − 5𝑝
2 2

3𝑚
∴ 𝑥2 = 5𝑝 . (6)
2

Equations (5) and (6) show the demand functions for goods 1 and 2 respectively i.e.:
𝟐𝒎
𝒙𝟏 (𝒑𝟏 , 𝒎) = 𝟓𝒑 , (5)
𝟏
 𝟑𝒎
𝒙𝟐 (𝒑𝟐 , 𝒎) = 𝟓𝒑 . (6)
𝟐

c) We can draw the Engel curve for good 1 by holding prices fixed and plotting how the
optimal consumption of good 1, 𝑥1 , varies with the consumer’s money income 𝑚. We
plot 𝑚 on the vertical axis and 𝑥1 on the horizontal axis.

The optimal consumption of good 1 is given by good 1’s demand function:

2𝑚
𝑥1 = 5𝑝 . We see from the demand function that the optimal consumption of good 1 is a
1
linear function of money income 𝑚. Specifically, if we re-arrange good 1’s demand
5
function we get 𝑚 = 2 𝑝1 𝑥1 . This means the Engel curve for good 1 is a straight line
𝟓
through the origin with a slope of 𝒑𝟏 .
𝟐

Answer 2
Refer to the solution of Homework 1 Question 2.
Answer 3
a) The indifference curves will look like below:
A utility function that represents this preference is:
𝑢(𝑥1 , 𝑥2 ) = 3𝑥1 + 𝑥2 .
b) The demand for good 1 can be derived by the following argument. As long as the price of
good 1 is less than 3 times the price of good 2, the consumer will spend all her income on
good 1. When the price of good 1 is equal to 3 times the price of good 2, she will is
indifferent among any bundle of the goods that satisfy the budget constraint. And finally,
when the price of good 1 is more than 3 times the price of good 2, she will spend her entire
income on good 2 and not on good 1. Therefore, the demand function for good 1 is the
following:
𝑚
𝑥1 (𝑝1 , 𝑝2 , 𝑚) = 𝑝 𝑖𝑓 𝑝1 < 3𝑝2
1

𝑚
= [0, 𝑝 ] 𝑖𝑓 𝑝1 = 3𝑝2
1

= 0 𝑖𝑓 𝑝1 > 3𝑝2
c) The demand curve for good 1 looks like below.