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PS1 Solutions PDF

The document provides an example of a utility function called the CES (constant elasticity of substitution) function. It then poses several problems related to this utility function, asking the reader to: 1) Show that the CES function exhibits strictly quasiconcave utility and derive the Walrasian demand functions. 2) Formulate the expenditure minimization problem and derive the Hicksian demand functions and expenditure function. 3) Verify various properties of indirect utility, expenditure, and demand functions including homogeneity, monotonicity, Roy's identity, and Shephard's lemma. 4) Write out the Slutsky equation for this utility function.

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328 views3 pages

PS1 Solutions PDF

The document provides an example of a utility function called the CES (constant elasticity of substitution) function. It then poses several problems related to this utility function, asking the reader to: 1) Show that the CES function exhibits strictly quasiconcave utility and derive the Walrasian demand functions. 2) Formulate the expenditure minimization problem and derive the Hicksian demand functions and expenditure function. 3) Verify various properties of indirect utility, expenditure, and demand functions including homogeneity, monotonicity, Roy's identity, and Shephard's lemma. 4) Write out the Slutsky equation for this utility function.

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pcr123
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Advanced Microeconomics - Problem set 1

Due date: classes on Novemeber 6


Consider the following utility function, called CES (constant elasticity of substitution func-
tion):
u(x1 , x2 ) = (xρ1 + xρ2 )1/ρ , where 0 6= ρ < 1.
This function is obviously strictly increasing.
Problem 1 (5p). For the above CES function:
1. Show that u is strictly quasiconcave.
Solution. Take two bundles x, x0 ∈ R2+ , such that u(x) = u(x0 ) = u. Define x00 =
tx + (1 − t)x0 for t ∈ (0, 1). We must show that u(x00 ) > u. We have:
u(x00 )ρ = (tx1 + (1 − t)x01 )ρ + (tx2 + (1 − t)x02 )ρ
> txρ1 + (1 − t)x0ρ ρ 0ρ
1 + tx2 + (1 − t)x2
= tu(x)ρ + (1 − t)u(x0 )ρ = uρ
where the inequality follows from the fact that function y ρ is strictly concave for 0 6= ρ < 1.
So by strict monotonicity of the power function we obtain: u(x00 ) > u as claimed.

2. Formulate the Utility Maximization Problem and solve it to derive Walrasian demand
functions x1 (p, w) and x2 (p, w) [You may assume interior solution and Walras law which
follows from strict monotonicity of u(·)].
Solution. The UMP is as follows:
maxx1 ,x2 ≥0 (xρ1 + xρ2 )1/ρ
s.t. p1 x1 + p2 x2 ≤ w
The Lagrangian for this problem is L(x1 , x2 , λ) ≡ (xρ1 + xρ2 )1/ρ + λ(w − p1 x1 − p2 x2 ). The
FOCs assuming interior solution and Walras law are:
∂L(x1 , x2 , λ)
= (xρ1 + xρ2 )1/ρ−1 xρ−1
i − λpi = 0, for i = 1, 2
∂xi
∂L(x1 , x2 , λ)
= w − p1 x1 − p2 x2 = 0
∂λ
Solving for x = (x1 , x2 ) gives:
1
pi1−ρ w
xi = xi (p, w) = ρ ρ , for i = 1, 2.
p11−ρ + p21−ρ
ρ
Or after defining r = ρ−1 :

pr−1
i w
xi (p, w) = , for i = 1, 2.
p1 + pr2
r

3. Form the indirect utility function v(p, w).


Solution.
ρ  r−1 ρ #1/ρ
"
pr−1
1 w p2 w
v(p, w) = u(x(p, w)) = r r +
p1 + p2 pr1 + pr2
p1 + pr2 1/ρ
 r 
= w
(pr1 + pr2 )ρ
= w (pr1 + pr2 )−1/r
4. Show that the indirect utility function is:

(a) homogeneous of degree zero in (p, w),


Solution. For any λ > 0:

v(λp, λw) = λw ((λp1 )r + (λp2 )r )−1/r


= λλ−1 w (pr1 + pr2 )−1/r
= w (pr1 + pr2 )−1/r
= v(p, w)

(b) increasing in w and decreasing in p.


Solution.
∂v(p, w)
= (pr1 + pr2 )−1/r > 0
∂w
∂v(p, w)
= −w (pr1 + pr2 )−1/r−1 pr−1
i < 0, for i = 1, 2.
∂pi

5. Verify the Roy’s identity.

Solution.

∂v(p, w)/∂pi −w (pr1 + pr2 )−1/r−1 pr−1


i
− = −
∂v(p, w)/∂w (pr1 + pr2 )−1/r
pr−1
i w
=
p1 + pr2
r

= xi (p, w), for i = 1, 2.

Problem 2 (5p). For the above CES function:

1. Formulate the Expenditure Minimization Problem and solve it to derive Hicksian demand
functions h1 (p, u) amd h2 (p, u) [You may assume interior solution and no excess utility
which follows from continuity of u(·)]

Solution. The EMP is as follows:

minx1 ,x2 ≥0 p1 x1 + p2 x2
s.t. (xρ1 + xρ2 )1/ρ ≥ u

The Lagrangian for this problem is L(x1 , x2 , λ) ≡ p1 x1 + p2 x2 + λ u − (xρ1 + xρ2 )1/ρ . The


FOCs assuming interior solution and no excess utility are:

∂L(x1 , x2 , λ)
= pi − λ(xρ1 + xρ2 )1/ρ−1 xρ−1
1 for i = 1, 2
∂xi
∂L(x1 , x2 , λ)
= u − (xρ1 + xρ2 )1/ρ = 0
∂λ
Solving for x = (x1 , x2 ) gives:
1
xi = hi (p, u) = u(pr1 + pr2 ) r −1 pr−1
i , for i = 1, 2.

2. Form the expenditure function e(p, u).

2
Solution.

e(p, u) = p1 h1 (p, u) + p2 h2 (p, u)


1 1
= u(pr1 + pr2 ) r −1 pr1 + u(pr1 + pr2 ) r −1 pri
1
= u(pr1 + pr2 )(pr1 + pr2 ) r −1
= u(pr1 + pr2 )1/r

3. Show that the expenditure function is concave in p.

Solution. Let’s take p00 = tp + (1 − t)p0 , where p, p0 >> 0. We must show that e(p00 , u) ≥
te(p, u) + (1 − t)e(p0 , u)

e(p00 , u)r = u[(tp1 + (1 − t)p01 )r + (tp2 + (1 − t)p02 )r ]


≥ u[tpr1 + (1 − t)p0r r 0r
1 + tp2 + (1 − t)p2 ]
= tu(pr1 + pr2 ) + (1 − t)u(p0r 0r
1 + p2 )
= te(p, u) + (1 − t)e(p0 , u)

where the inequality follows from the concavity of xr , where r < 1 (note that when 0 6= ρ <
ρ
1, then 0 6= r = ρ−1 <1)

4. Verify the Shephard’s lemma.

Solution.
∂e(p, u)
= r/ru(pr1 + pr2 )1/r−1 pr−1
i = hi (p, u)
∂pi

5. Show that the following relationships are true:

(a) v(p, e(p, u)) = u


(b) e(p, v(p, w)) = w
(c) h(p, v(p, w)) = x(p, w)
(d) x(p, e(p, u)) = h(p, u)
Solution. This is rather straightforward, plugging into obtained definitions.

6. Write Slutsky equation for the above functions.

Solution. We have the following:

∂hi (p, u)
= (pi pj )r−1 (1 − r) (pr1 + pr2 )1/r−2 u (1)
∂pj

∂xi (p, w) ∂xi (p, w)


+ = (pi pj )r−1 (1 − r) (pr1 + pr2 )−2 w (2)
∂pj ∂wxj (p, w)
Since we know that w = e(p, u) = (pr1 + pr2 )1/r u. Hence the above two formulas are the
same.

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