Problem Set 1

Microeconomic Theory:
sumers Problem1 )

where bs is the number of burgers she consumes each

month, and ms is her phone usage measured in units of
hundred minutes.
With similar notation, Abhisheks utility function is
ua (ba , ma ) = ba ma .
Find the optimal choice the choice of phone plan, the
number of minutes spent on the phone, and the number
of burgers eaten for each.

A Mathematical Approach (Con-

1. You have just emerged from medical school with a debt

service burden of $25,000 per year, and have set up practice. You have to decide how hard to work. For each hour
of work, you expect to earn $50 (after subtracting expenses
of maintaining your office, taxes, etc.). Your utility function for a full year is U (I, H) = ln(I) + 2 ln(5000 H),
where H is the number of hours you work during the year,
and I is what is left of your annual income after expenses,
taxes, and debt service.

5. Consider the utility function u(x, y) = min{2x + y, x + 2y}

(a) Draw the indifference curve for u(x, y) = 20. Shade
the area where u(x, y) 20.
px
will the unique optimum be
(b) For what values of
py
x = 0.
px
(c) For what values of
will the unique optimum be
py
y = 0.

(a) What is your budget constraint linking I and H?

(b) Find your optimal number of hours of work.

(c) If taxes go up so you are left with only $40 per hour
of work, will you work more or fewer hours? Explain
the economic intuition for the result.

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(d) If neither x and y is equal to zero, and the optimum

x
is unique, what must be the value of in optimum?
y

2. There are two goods, whose quantities are denoted by X

and Y , each being a real number. An individuals consumption set consists of all (X, Y ) such that X 0 and
Y > 1. His utility function is: U (X, Y ) = 4 ln(X + 2) +
ln(Y 1). The price of X is p and that of Y is q; total
income is I. Assume q < I. Solve the consumers problem.

6. Consider an individual who consumes three goods. His

utility function is given by: u(x, y, z) = min{x + y, x + z}.
Solve the consumers problem.

7. A mathematician named Donic consumes either gin or

tonic. His preferences are rare because he thinks in the
square in a way that is almost sardonic. Specifically, Donic
prefers larger drinks to smaller drinks but requires that the
square of the amount of lime in a drink equal the sum of
the squares of the amounts of gin and tonic. Find a utility
function that represents Donics preferences. Find Donics
demand functions for lime, gin and tonic.

3. Denote a consumers daily hours of work by h, and hours

of non-work by n = 24 h. Consider a consumer who has
no other source of income than wages for hours worked,
and no debt or other obligations. He consumes what
he earns each day. Writing c for the rupees amount of
his consumption, suppose his utility function is u (c, n) =
ln (c) + 3 ln (n). All these quantities are to be treated as
continuous variables.

8. Give a utility function to represent Tommys preferences.

(Ref. 3.12(a), pg. 29 Workouts in Intermediate Micro Economics by Hal Varian.) Also plot an indifference curve representing Tommys mothers preferences,
Utility= (D) = (|7 M | + |2 C|). (Ref. 3.12(b),
pg. 30 Workouts in Intermediate Micro Economics by Hal
Varian.)

(a) Suppose the wage rate is Rs. 10 per hour. Write

down the consumers utility function and budget constraint with c and h as the choice variables. How
many hours will he choose to work, and what will be
the resulting utility?
(b) Suppose the wage rate is Rs. 10 per hour for the
first 8 hours of work each day, and Rs. 30 per hour
for each daily hour of work beyond the first 8. Write
down the consumers utility function and budget constraint with c and h as the choice variables. How
many hours will he choose to work, and what will be
the resulting utility?

9. Consider a consumer with utility function u(x1 , x2 ) =

1/2 1/2
x1 x2 and income of Rs. 15,000 per month. Suppose
that prices are p1 = 1 and p2 = 1 and that the consumer
spends his entire paycheck each month. The consumers
boss asks him to move to a new city that is identical to
his current city except that p1 = 1 and p2 = 2. The boss
offers no raise in pay. The consumer tells his boss: Asking me to move is just like if I stayed here and you cut my
pay by Rs. A. I would be willing to move to the new city,
but you would have to pay me Rs. B more for me to be
willing to do it. Find values for A and B.

4. Consider two graduate students, Sonali and Abhishek.

Each has a monthly allowance of Rs. 100, which can be
spent on two things: burger, and talking to friends back
home on the phone. Each burger costs Rs. 10. The phone
company offers two plans. The first has no fixed fee, and
charges 10 paise per minute of use. The second has a fixed 10. Sam enjoys both tea and coffee equally. However, he
fee of Rs. 40 per month, plus 3 13 paise per minute of use.
prefers to have only one at a time (i.e. he likes to have
4
Sonali has the utility function us (bs , ms ) = (bs ) ms ,
either tea or coffee and not both at a time). He likes to
have a cup of tea with exactly two spoonful of sugar and
1 Also solve the past year exam problems from this topic.
Rea cup of coffee with exactly one spoonful of sugar. One
fer: http://economicsentrance.weebly.com/lessons.html. Contact: econschool@gmail.com
evening, he goes to a coffee shop with Rs. M in his pocket
1

and makes his order. The coffee shop is owned by a stingy 16. Tiger consumes two goods, x and y and his utility function

business man, who charges price ps for each teaspoonful

is u(x, y) = min{ xy, x}. Draw a graph, showing a few of
of sugar bought, and pt and pc per cup for tea and coffee,
Tigers indifference curves. What is Tigers Marshallian
respectively. Give a utility function that represents Sams
demand function for each of the two goods?
preferences and also the demand function for sugar, tea
17. Consider the following functions f1 (x) = max{x, 1} and
and coffee in each of the following cases:
f2 (x) = min{x2 , 4}. Show the following sets on a plane:
(a) If Sam prefers more cups of tea/coffee to less.
(a) {(x, y)|y f1 (x)}
(b) If Sam only enjoys upto one cup at a time, any addi(b) {(x, y)|y f2 (x)}

tional consumption does not add to his satisfaction.

(c) {(x, y)|y = max{f1 (x), f2 (x)}}

11. Suppose u(x, y, z, w) = xy + wz. Find the demand function for x.

Additional Problems (Inter-temporal Choice)

12. A consumer of three goods has utility function u(x, y, z) =

(min{x, y})a z a , with 0 < a < 1. Derive the demand functions for x, y and z.

1. An infinitely lived agent must choose his lifetime consumption plan. Let xt denote consumption spending in period
t, yt denote expected income in period t, and r > 0, the
market rate of interest at which the agent can freely borrow or lend. The agents intertemporal utility function
takes the additively separable form

(a) u(x, y) = y + x

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13. Solve the consumers problem and find the demand function for x for each of the following utility functions. Also
consider a price change from p = (2, 1) to p0 = (1, 1) and
let income be 100, decompose the total price effect into income effect and substitution effect using Hicksian Method
and Slutsky Method for all the cases below.

u (x0 , x1 , x2 , . . .) =

(d) u(x, y) = [x+y], where [.] denotes the greatest integer

function.
(e) u(x, y) = max{x, 2y}

14. Consumer has a utility function U (x, y, z)

median{x, y, z}. Find the demand function for x.

t=0

(a) What interpretation can you give to parameter ?

(b) Write down the first-order conditions for optimal

choice of consumption in period t.

15. Consider a consumers problem:

maxx

t u(xt )

where u(x) is increasing and strictly concave, and 0 < <

1. The inter temporal budget constraint requires that the
present value of expenditures not exceed the present value
of income:
t
t


X
X
1
1
xt
yt
1+r
1+r
t=0
t=0

(b) u(x, y) = max{min{3x, 3y}, x + y}

(c) u(x, y) = x2 + 4y 2 + 4xy

(c) Assume that consumption in all other periods remain

constant, sketch an indifference curve showing the
inter temporal trade-off between xt and xt+1 alone.
Carefully justify the slope and curvature you have
depicted.

u(x1 , x2 )
p1 x1 + p2 x2 M
x = (x1 , x2 ) 0.

One way to rule out the potential that the non negativity
constraints arent binding is to look at the marginal rate
of substitution (MRS) when one of the factors gets arbitrarily close to zero. For the utility function u(x1 , x2 ), the
MRS12 (x1 , x2 ) is the change in the amount of x2 required
to keep the function u the same when x1 changes by a
small amount. MRS12 (x1 , x2 ) is read the marginal rate
of substitution of good 1 for good 2 at (x1 , x2 )

(d) How does consumption in period t vary with the market interest rate?
(e) Show that the lifetime utility will always increase
with an income increase in any period.
(f) If = 1/(1 + r), what is the consumption plan of the
agent?
(g) Describe the agents consumption plan if > 1/(1 +
r) and if < 1/(1 + r).

(a) Consider the function u(x1 , x2 ) = x1 x2 . Starting from a point where x1 , x2 > 0, what happens
to the MRS12 as x1 grows smaller and approaches
zero i.e., limx1 0 MRS12 (x1 , x2 )? What happens to
limx2 0 MRS21 (x1 , x2 )?

2. Consider a two-period version of the preceding exercise

where
u(xt ) = (1/2)(xt 2)2 ,

(b) Consider the function u(x1 , x2 ) = x1 + x2 . What is

limx1 0 MRS12 (x1 , x2 )?

t = 0, 1

(a) If y0 = 1, y1 = 1, and = 1/(1+r), solve for optimal

consumption in each period and calculate the lifetime
utility the agent achieves.

(c) Consider u(x1 , x2 ) = ln(x1 ) + x2 .

What is
limx1 0 MRS12 (x1 , x2 ) and limx2 0 MRS21 (x1 , x2 )?
2

Suppose, now that the agent knows that income in the

initial period will be y0 = 1. However, there is uncertainty about what next periods income will be. It could
be high, y1H = 3/2; or it could be low, y1L = 1/2. He
knows it will be high with probability 1/2. His problem
know is to choose the initial period consumption, x0 ; the
future consumption if income is high, xH
1 ; and the future
consumption if income is low, xL
,
to
maximise
(intertem1
poral) expected utility.

(a) Solve the consumers dynamic consumption-savings

problem, as a function of prices pa0 , pb0 , pa1 , and pb1 ,
the gross return r on loans to/from the bank, and
the consumers income Y0 and Y1 . We assume that
the consumer can borrow or lend at gross return r.
(b) Suppose we assumed that the consumer could only
lend money at rate r but cannot borrow at all. What
is the collusion in this case?
(c) Suppose now that the consumer is able to store vegetables from today to tomorrow. Assume there is
no spoilage or anything like that - vegetable put in
the refrigerator today and taken out for consumption
tomorrow is just as good as vegetable bought fresh
tomorrow. What is the solution to the consumers
dynamic consumption-savings problem?

(b) Again, assuming that = 1/(1 + r), formulate the

agents optimisation problem and solve for the optimal consumption plan and level of lifetime utility.
(c) How do you account for any difference or similarity
in your answers to part (a) and (b)?
3. Saving and Borrowing in an Exchange Economy with a
Continuum of Consumers. Consumers have Cobb-Douglas
preferences u(x1 , x2 , ) = ln x1 + (1 ) ln x2 , where xt
is consumption in period t. Consumers vary in their preference parameter . We will refer to a consumer with
parameter as a type consumer. There is a single commodity. Types are distributed continuously over the interval [0, 1]. Type has density f () = 1 over this interval
so that the total mass of types is 1. Each type has the
same income in each of two periods.

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6. A consumer lives for three periods, denoted by t = 0, 1, 2,

and consumes artichoke and broccoli on each day. We
let at be the amount of artichoke on day t and bt be
the amount of broccoli. This consumer has preferences
over lotteries on consumption bundles (where a consumption bundle is a six-tuple (a0 , b0 , a1 , b1 , a2 , b2 )), which satisfy the von Neumann-Morgenstern axioms and are represented by the von Neumann-Morgenstern utility function
u(a0 , b0 , a1 , b1 , a2 , b2 ) = (a0 b0 ).25 + .9(a1 b1 ).25 + .8(a2 b2 ).25

(a) If the interest rate is r, which types will be savers

and which will be borrowers.
(b) Show that type has a net saving of s() = (1
2+r
1+r ).
(c) Solve for the total saving S(r) by all types who save
and the total borrowing B(r) of all types who borrow.
Depict S(r) and B(r) in a graph.

This consumer can buy artichoke and broccoli in the market place each day. Because both vegetables spoil rapidly,
what he buys on any given day is his consumption for that
day. (He is constrained to consume nonnegative amounts
of each vegetable.) The price of artichoke is $1 per unit
on each and every day. The price of broccoli is more complex: It begins at $1 per unit of broccoli at t = 0. But at
t = 1, it is either $1.10 or $.90, each of these being equally
likely. And at t = 2, the price of broccoli is again random and depends on the price the day before: If its price
was $1.10 at t = 1, then it is either $1.20 or $1.00, with
each equally likely. If its price was $.90 at t = 1, then at
t = 2 it is either $.98 or $.80, each equally likely. At date
t = 0, the consumer has no information (beyond what is
given above) about subsequent prices of broccoli. At date
t = 1, he knows the current price of broccoli and no more.
At date t = 2, he knows the current price. This consumer
has $300 to spend on artichoke and broccoli over the three
days, which he can divide any way he wishes. Any money
he doesnt spend on a given day sits in his pocket where
it earns zero interest.

4. Futures and Future Spot prices. A consumer has the twoperiod utility function defined over current and future consumption levels of two commodities:
u(x1 , x2 ) = ln x11 + 2 ln x21 + (ln x12 + 2 ln x22 )

The period 1 (spot) market price vector is p1 = (p11 , p21 )

and the futures market price vector is p2 = (p12 , p22 ). Endowment vector is = (1 , 2 ) = ((11 , 21 ), (12 , 22 ))
where it denotes endowment of commodity i in period
t and t denotes the endowment vector of the two commodities in period t.
(a) Show that expenditure on each of the first- and
second-period commodities is as follows:
p
(p11 x11 , p21 x21 , p12 x12 , p22 x22 ) =
(1, 2, , 2)
3(1 + )

7. Imagine a decision maker who must decide how much asparagus and how much broccoli to eat in each of two time
periods, t = 1 and t = 2. Let at be the amount of asparagus consumed in period t, and bt the amount of broccoli
consumed in period t. Suppose the price of broccoli and
asparagus are both a constant $1 (in both periods), and
the decision maker has a total of $100 to spend on these
four commodities.

(b) Obtain an expression for total spending in period 1.

(c) Hence show that consumer will save if and only if
p2 2
p1 1 <
5. Consider a consumer who decide how much of artichoke
and broccoli to consume today and tomorrow and how
much to save (or borrow) today. Suppose the consumers
preferences are given by the utility function

(a) At time t = 1, the decision makers preferences are

given by the utility function

u(a0 , b0 , a1 , b1 ) = ln(a0 ) + 0.9 ln(b0 ) + 0.8 ln(a1 ) + 0.7 ln(b1 )

3

u(a1 , a2 , b1 , b2 ) = ln(a1 ) + ln(a2 ) + ln(b1 ) + ln(b2 ).

If the decision maker is able to choose at time t = 1

(according to these preferences) how much of each
vegetable to consume, what will she choose?

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(b) Suppose instead that the decision maker chooses, at

t = 1, the amounts of a1 and b1 to consume, and
also the amount s1 of savings to set aside for period
2 vegetable purchases. Then at time t = 2, she decides how to spend the s1 she saved on a2 and how
much to spend on b2 . To be very clear, at time t = 1
she is choosing a1 , b1 , and s1 subject to the budget
constraint a1 + b1 + s1 100, and at time t = 2
she is choosing a2 and b2 subject to the budget constraint a2 + b2 s1 . (Her savings earn no interest.
To keep matters simple, assume that all variables including s1 are constrained to be nonnegative.) Assuming that her preferences are unchanging and the
standard methods for dealing with dynamic choice
problems are employed, what does she choose to do?