Problem Set #3: Revealed Preferences, and Income and Substitution Effects
Microeconomics I
The problems marked with an asterisk (∗ ) will be given higher priority in the seminars.
Revealed Preferences.
1. (∗ ) In four consecutive days, Vanessa was given a level of income and faced different
possible choices of bundles of goods 1 (packages of crackers) and 2 (portions of
manchego cheese). The bundles that she actually chose to consume are indicated
below (by a symbol “X”), as are the prices at which the two goods were available.
(p1 , p2 ) A = (1, 3) B = (2, 2) C = (3, 1) D = (4, 1) E = (1, 2) F = (3, 3)
(1, 1) X
(1, 2) X
(2, 2) X
(8, 2) X
(a) State the Weak Axiom of Revealed Preference (WARP).
(b) State the Strong Axiom of Revealed Preference (SARP).
(c) Generally speaking, what are the three basic assumptions that need to hold
to evaluate whether Vanessa’s choices satisfy WARP or SARP? Explain your
answer.
(d) Do her choices satisfy WARP? Explain.
(e) Do her choices satisfy SARP? Explain.
(f) What do you conclude about whether there could be a utility function that
represents her preferences?
2. (∗ ) Juan chooses the bundle (6,6) when the prices are (6,5) and chooses (10,0)
when the prices are (5,5).
(a) Can we conclude that any of the bundles is revealed as directly preferred to
the other? Which one?
(b) Do his decisions violate the Weak Axiom of Revealed Preference?
3. Roberto, Carla and Oriol all have constant, monotonic and convex preferences (and
they all have an income of m = 10).
When prices are (p1 , p2 ) = (1, 2):
Roberto chooses xR = (xR R
1 , x2 ) = (2, 4)
Carla chooses xC = (xC C
1 , x2 ) = (6, 2)
and Oriol chooses xO = (xO O
1 , x2 ) = (2, 4).
1
When prices are (p̂1 , p̂2 ) = (2, 1):
Roberto chooses x̂R = (x̂R R
1 , x̂2 ) = (4, 2)
Carla chooses x̂C = (x̂C C
1 , x̂2 ) = (4, 2)
10 10
and Oriol chooses x̂O = (x̂O O
1 , x̂2 ) = ( 3 , 3 ).
Which of the three individuals violates the Weak Axiom of Revealed Preference?
Explain your answer. (Hint: It might be useful to draw a separate graph for each
individual.)
Income and Substitution Effects.
4. Assume that the preferences of Maria can be represented using the following utility
1/4 3/4
function U (x1 , x2 ) = x1 x2 . Her demand functions for goods x1 and x2 are:
m 3m
x1 (p1 , p2 , m) = and x2 (p1 , p2 , m) = .
4p1 4p2
Suppose the price of good 2 decreases from p2 = 2 to p′2 = 1 and the price of good
1 and income remain constant at p1 = 2, m = 24.
(a) Compute the total effect of the price change on the demand for both goods.
(b) Compute the Slutsky decomposition (income and substitution effects) for both
goods.
(c) Draw the Slutsky decomposition for both goods.
(d) (For Seminar 4) For the change in prices described, compute the compensatory
variation (CV), the equivalent variation (EV) and the change in consumer
surplus (∆CS).
5. (∗ ) A consumer has preferences for bread (good 1) and wine (good 2) represented
by the utility function u(x1 , x2 ) = x1 x2 . Income is m = 100 and the prices for the
two goods are unitary (i.e., p1 = p2 = 1).
(a) Compute optimal consumption.
(b) The government decides to reduce wine consumption (good 2) and to this
effect decides to tax consumption with 25% VAT.
i. Compute the total effect on demand for the two goods.
ii. Compute the additional nominal income necessary to compensate the real
income loss in the sense of Slutsky.
iii. Compute the Slutsky decomposition for both goods.
iv. Draw the Slutsky decomposition for both goods.
(c) (For Seminar 4) For the consumption tax described in (b), compute the com-
pensatory variation (CV), the equivalent variation (EV) and the change in
consumer surplus (∆CS).
6. Consider following utility function u(x1 , x2 ) = min{3x1 , x2 }.
(a) Compute the demand functions for good 1.
2
(b) If prices are p1 = p2 = 2, draw the Engel curve for good 1.
(c) Suppose income is m = 400 and prices are p1 = p2 = 2. Compute the change
in demand if the price of good 1 drops to p1 = 1.
(d) Obtain the income and substitution effects for good 1 according to the Slutsky
decomposition analytically and graphically.
7. (∗ ) Consider following utility function: u(x1 , x2 ) = 20 ln x1 + x2 .
(a) Compute the demand functions for goods 1 and 2.
(b) If prices are p1 = 4 and p2 = 1, compute the income-offer curve.
(c) Suppose income is m = 60 and prices are still p1 = 4 and p2 = 1. Compute
the change in her demand if the price of good 1 drops to p′1 = 1.
(d) Obtain the income and substitution effects for good 1 according to the Slutsky
decomposition analytically.
(e) (For Seminar 4) For the price decrease described in (c), compute the com-
pensatory variation (CV), the equivalent variation (EV) and the change in
consumer surplus (∆CS).