ECON 5113 Advanced Microeconomics

Winter 2015
Answers to Selected Exercises Instructor: Kam Yu

The following questions are taken from Geoffrey A. Jehle above in u, that is, for some p  0, there exists M > 0
and Philip J. Reny (2011) Advanced Microeconomic The- such that M ≥ E(p, u) for all u in the domain of E.
ory, Third Edition, Harlow: Pearson Education Limited. Let u∗ = V (p, M ). Then
The updated version is available at the course web page:
E(p, u∗ ) = E(p, V (p, M )) = M = pT x∗ ,
http://flash.lakeheadu.ca/∼kyu/E5113/Main.html
where x∗ is the optimal bundle. Since U is continuous,
there exists a bundle x0 in the neighbourhood of x∗ such
Ex. 1.14 Let U be a continuous utility function that that U (x0 ) = u0 > u∗ . Since U strictly increasing, E is
represents %. Then for all x, y ∈ Rn+ , x % y if and only strictly increasing in u, so that E(p, u0 ) > E(p, u∗ ) =
if U (x) ≥ U (y). M . This contradicts the assumption that M is an upper
First, suppose x, y ∈ Rn+ . Then U (x) ≥ U (y) or bound.
U (y) ≥ U (x), which means that x % y or y % x. There-
fore % is complete. Ex. 1.37 (a) Since x0 is the solution of the expenditure
Second, suppose x % y and y % z. Then U (x) ≥ U (y) minimization problem when the price is p0 and utility
and U (y) ≥ U (z). This implies that U (x) ≥ U (z) and level u0 , it must satisfy the constraint U (x0 ) ≥ u0 . Now
so x % z, which shows that % is transitive. by definition E(p, u0 ) is the minimized expenditure when
Finally, let x ∈ Rn+ and U (x) = u. Then price is p, it must be less than or equal to pT x0 since
U −1 ([u, ∞)) = {z ∈ Rn+ : U (z) ≥ u} x0 is in the feasible set, and by definition equal when
p = p0 .
= {z ∈ Rn+ : z % x}
(b) Since f (p) ≤ 0 for all p  0 and f (p0 ) = 0, it
= % (x). must attain its maximum value at p = p0 .
(c) ∇f (p0 ) = 0.
Since [u, ∞) is closed and U is continuous, % (x) is closed.
(d) We have
Similarly (I suggest you to try this), - (x) is also closed.
This shows that % is continuous. ∇f (p0 ) = ∇p E(p0 , u0 ) − x0 = 0,

Ex. 1.17 Suppose that a and b are two distinct bundle which gives Shephard’s lemma.
such that a ∼ b. Let
Ex. 1.46 Since di is homogeneous of degree zero in p
A = {x ∈ Rn+ : αa + (1 − α)b, 0 ≤ α ≤ 1}. and y, for any α > 0 and for i = 1, . . . , n,
and suppose that for all x ∈ A, x ∼ a. Then % is convex di (αp, αy) = di (p, y).
but not strictly convex. Theorem 1.1 does not require
% to be convex or strictly convex, therefore the utility Differentiate both sides with respect to α, we have
function exists. Moreover, since % (a) = % (b) is convex,
there exists a supporting hyperplane H = {x ∈ Rn+ : ∂di (αp, αy)
∇p di (αp, αy)T p + y = 0.
T
p x = y} such that a, b ∈ H. Since H is an affine set, ∂y
A ⊂ H. This means that every bundle in A is a solution Put α = 1 and rewrite the dot product in summation
to the utility maximization problem. form, the above equation becomes
n
Ex. 1.341 Suppose on the contrary that E is bounded X ∂di (p, y) ∂di (p, y)
pj + y = 0. (1)
1 It may be helpful to review the proof of Theorem 1.8. j=1
∂pj ∂y
Dividing each term by di (p, y) yields the result. (b) It is clear from part (a) that I depends on u0 .
(c) Using the technique similar to Exercise 1.47, it can
Ex. 1.47 Suppose that U (x) is a linearly homogeneous be shown that if U is homothetic, E(p, u) = e(p)g(u),
utility function. where g is an increasing function. Then
(a) Then
e(p1 )g(u0 ) e(p1 )
T I= = ,
E(p, u) = min{p x : U (x) ≥ u} e(p0 )g(u0 ) e(p0 )
x
= min{upT x/u : U (x/u) ≥ 1} which means that I is independent of the reference utility
x
level.
= u min{pT x/u : U (x/u) ≥ 1}
x
= u min{pT x/u : U (x/u) ≥ 1} (2) Ex. 2.2 For i = 1, . . . , n, the i-th row of the matrix
x/u multiplication S(p, y)p is
= u min{pT z : U (z) ≥ 1} (3) n  
z X ∂di (p, y) ∂di (p, y)
= uE(p, 1) pj + pj dj (p, y)
j=i
∂pj ∂y
= ue(p) n n
X ∂di (p, y) ∂di (p, y) X
In (2) above it does not matter if we choose x or x/u = pj + pj dj (p, y)
j=i
∂pj ∂y j=i
directly as long as the objective function and the con-
n
straint remain the same. We can do this because of the X ∂di (p, y) ∂di (p, y)
= pj + y (5)
objective function is linear in x. In (3) we simply rewrite ∂pj ∂y
j=i
x/u as z.
(b) Using the duality relation between V and E and =0 (6)
the result from Part (a) we have
where in (5) we have used the budget balancedness and
y = E(p, V (p, y)) = V (p, y)e(p) (6) holds because of homogeneity and (1) in Ex. 1.46.

so that Ex. 2.3 By (T.1’) on p. 82,

y
V (p, y) = = v(p)y,
e(p) U (x) = min {V (p, 1) : p · x = 1} .
n
p∈R++
where we have let v(p) = 1/e(p). The marginal utility
of income is The Lagrangian is
∂V (p, y)
= v(p), β
∂y L = −pα
1 p2 − λ(1 − p1 x1 − p2 x2 ),
which depends on p but not on y.
with the first-order conditions
0 0 0
Ex. 1.66 (b) By definition y = E(p , u ), Therefore −αpα−1 pβ2 + λx1 = 0
1
y1 E(p1 , u0 )
> and
y0 E(p0 , u0 ) −βpα β−1
1 p2 + λx2 = 0.
means that y 1 > E(p1 , u0 ). Since the indirect utility Eliminating λ from the first-order conditions gives
function V is increasing in income y, it follows that
β x1
p2 = p1 .
u1 = V (p1 , y 1 ) > V (p1 , E(p1 , u0 )) = u0 . α x2
Substitute this p2 into the constraint equation, we get
Ex. 1.67 It is straight forward to derive the expenditure
α 1
function, which is p1 = ,
α + β x1
p22
E(p, u) = p2 u − . (4) and
4p1 β 1
p2 = .
α + β x2
(a) For p0 = (1, 2) and y 0 = 10, we can use (4) to
obtain u0 = 11/2. Therefore, with p1 = (2, 1), The utility function is therefore

αα β β
 
u0 − 1/8 43 U (x) = x−α −β
I= = . 1 x2 ,
2u0 − 1 80 (α + β)α+β

2
which is a Cobb-Douglas function. which is the CES function with ρ = 1/2. You should
verify with Example 1.3 on p. 39–41 that the expenditure
Ex. 2.6 We want to maximize utility u subject to the function is indeed as given.
constraint pT x ≥ E(p, u) for all p ∈ Rn++ . That is,
Ex. 3.2 Constant returns-to-scale means that f is lin-
up1 p2
p1 x1 + p2 x2 ≥ . early homogeneous. So by Euler’s theorem
p1 + p2
x1 ∂y/∂x1 + x2 ∂y/∂x2 = y. (9)
Rearranging gives
Since average product y/x1 is rising, its derivative respect
p1 + p2 p1 + p2
u≤ x1 + x2 to x1 is positive, that is,
p2 p1
(x1 ∂y/∂x1 − y)/x21 > 0.
for all p ∈ Rn++ . This implies that
  From (9) we have
p1 + p2 p1 + p2
u ≤ min x1 + x2 . (7) x2 ∂y/∂x2 = −(x1 ∂y/∂x1 − y) < 0,
p1 ,p2 p2 p1

Therefore u attains its maximum value when equality which means that the marginal product ∂y/∂x2 is nega-
holds in (7). To find the minimum value on the right- tive.
hand side of (7), write α = p2 /(p1 + p2 ) so that 1 − α =
p1 /(p1 + p2 ) and 0 < α < 1. The minimization problem Ex. 4.5 Let w be the vector of factor prices and p
becomes be the output price. Then the cost function of a typ-
  ical firm with constant returns-to-scale technology is
x1 x2 C(w, y) = c(w)y where c is the unit cost function. The
min + :0<α<1 . (8)
α α 1−α profit maximization problem can be written as
Notice that for any x1 > 0 and x2 > 0, max py − c(w)y = max y[p − c(w)].
y y
 
x1 x2 For a competitive firm, as long as p > c(w), the firm will
lim + =∞
α→0 α 1−α increase output level y indefinitely. If p < c(w), profit
is negative at any level of output except when y = 0.
and
If p = c(w), profit is zero at any level of output. In
 
x1 x2
lim + =∞ fact, market price, average cost, and marginal cost are
α→1 α 1−α
all equal so that the inverse supply function is a constant
so that the minimum value exists when 0 < α < 1. The function of y. Therefore the supply function of the firm
first-order condition for minimization is does not exist and the number of firm is indeterminate.
x1 x2
− + = 0,
α2 (1 − α)2 Ex. 4.14 The profit maximization problem for a typical
firm is
which can be written as
max [10 − 15q − (J − 1)q̄]q − (q 2 + 1),
q
α2 x2 = (1 − α)2 x1 .
with necessary condition
Taking the square root on both sides gives
10 − 15q − (J − 1)q̄ − 15q − 2q = 0.
1/2 1/2
αx2 = (1 − α)x1 .
(a) Since all firms are identical, by symmetry q = q̄.
Rearranging gives This gives the Cournot equilibrium of each firm q ∗ =
10/(J + 31), with market price p∗ = 170/(J + 31).
1/2 1/2
x1 x2 (b) Short-run profit of each firm is π = [40/(J +31)]2 −
α= and 1−α= .
1/2
x1 + x2
1/2
x1
1/2
+ x2
1/2 1. In the long-run π = 0 so that J = 9.

It is clear that α is indeed between 0 and 1. Putting α Ex. 5.11 (a) The necessary condition for a Pareto-
and 1−α into the objective function in (8) give the direct efficient allocation is that the consumers’ MRS are equal.
utility function Therefore

1/2 1/2
2 ∂U 1 (x11 , x12 )/∂x11 ∂U 2 (x21 , x22 )/∂x21
U (x1 , x2 ) = x1 + x2 , = ,
∂U 1 (x11 , x12 )/∂x12 ∂U 2 (x21 , x22 )/∂x22

3
 Solving the quadratic equation gives one positive value
of 14.16. Consumer 2’s utility function can be written
as x21 (x22 )2 . This can be expressed in terms of x11 and
x12 using (11) and (12). The indifference curve passing
through endowment becomes

(21 − x11 )(10 − x12 )2 = (21 − 18)(10 − 4)2 = 108.

Putting x12 in (13) into the above equation and solving

for x11 give x11 = 15.21. Therefore the core of the economy
is given by

10x11

C(e) = (x11 , x12 , x21 , x22 ) : x12 = ,
42 − x11
14.16 ≤ x11 ≤ 15.21, x11 + x21 = 21,
x12 + x22 = 10.

Figure 1: Contract Curve and the Core

(c) Normalize the price of good 2 to p2 = 1. The

or demand functions of the two consumers are:
x12 x2
= 22 . (10)
x11 2x1 y1 p1 e11 + p2 e12 18p1 + 4
x11 = = =
The feasibility conditions for the two goods are 2p1 2p1 2p1
y1 1
p1 e1 + p2 e2 1
18p1 + 4
x12 = = =
x11 + x21 = e11 + e21 = 18 + 3 = 21, (11) 2p2 2p2 2
x12 + x22 = e12 + e22 = 4 + 6 = 10. (12) y2 2
p1 e1 + p2 e2 2
3p1 + 6
x21 = = =
3p1 3p1 3p1
Express x21 in (11) and x22 in (12) in terms of x11 and x12
2y 2 2 2
2(p1 e1 + p2 e2 ) 2(3p1 + 6)
respectively, (10) becomes x22 = = =
3p2 3p2 3
x12 10 − x12
1 = , In equilibrium, excess demand z1 (p) for good 1 is zero.
x1 2(21 − x11 ) Therefore
or 18p1 + 4 3p1 + 6
10x11 + − 18 − 3 = 0,
x12 = . (13) 2p1 3p1
42 − x11
Eq. (13) with domain 0 ≤ x11 ≤ 21, (11), and (12) com- which gives p1 = 4/11 (check that market 2 also clears).
pletely characterize the set of Pareto-efficient allocations The Walrasian equilibrium is p = (p1 , p2 ) = (4/11, 1).
A (contract curve). That is, From the demand functions above, the WEA is

10x11 x = (x11 , x12 , x21 , x22 ) = (14.5, 5.27, 5.6, 4.73).
A = (x11 , x12 , x21 , x22 ) : x12 = , 0 ≤ x 1
1 ≤ 21,
42 − x11 (d) It is easy to verify that x ∈ C(e).
x11 + x21 = 21, x12 + x22 = 10.

Ex. 5.23 Let Y ⊆ Rn be a strongly convex production

(b) The core is the section of the curve in (13) be- set. For any p ∈ Rn , let y1 ∈ Y and y2 ∈ Y be two
++
tween the points of intersections with the consumers’ in- distinct profit-maximizing production plans. Therefore
difference curves passing through the endowment point. p · y1 = p · y2 ≥ p · y for all y ∈ Y . Since Y is strongly
For example, in Figure 1, if G is the endowment point, convex, there exists a ȳ ∈ Y such that for all t ∈ (0, 1),
the core is the portion of the contract curve between
points W and Z. Consumer 1’s indifference curve passing ȳ > ty1 + (1 − t)y2 .
through the endowment is
Thus
(x11 x12 )2 = (18 · 4)2 ,
p · ȳ > tp · y1 + (1 − t)p · y2
1 1
or x2 = 72/x1 . Substituting this into (13) and rearrang- = tp · y1 + (1 − t)p · y1
ing give
5(x11 )2 + 36x11 − 1512 = 0. = p · y1 ,

4
which contradicts the assumption that y1 is profit-
maximizing. Therefore y1 = y2 .

Ex. 5.31 Let E = {(U i , ei , θij , Y j )|i ∈ I, j ∈ J } be

the production economy and p ∈ Rn++ be the Walrasian
equilibrium.
(a) For any consumer i ∈ I, the utility maximization
problem is
X
max U i (x) s. t. p · x = p · ei + θij π j (p),
x
j∈J

with necessary condition

∇U i (x) = λp.

The MRS between two goods l and m is therefore

∂U i (x)/∂xl pl
= .
∂U i (x)/∂xm pm

Since all consumers observe the same prices, the MRS is

the same for each consumer.
(b) Similar to part (a) by considering the profit maxi-
mization problem of any firm.
(c) This shows that the Walrasian equilibrium prices
play the key role in the functioning of a production econ-
omy. Exchanges are impersonal. Each consumer only
need to know her preferences and each firm its produc-
tion set. All agents in the economy observe the common
price signal and make their own decisions. This mini-
mal information requirement leads to the lowest possible
transaction costs of the economy.

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