Problem Set 5
1. A consumer’s preference between two goods can be represented by the following
utility function: 𝑈(𝑥1 , 𝑥2 ) = 𝑥1 𝑥2 . The prices of good 1 and good 2 are Rs.3 per unit
and Rs. 1 per unit respectively. The consumer’s total income is Rs. 120.
a) Derive the optimal quantity demanded for these two commodities given the prices
and income.
b) Suppose price of commodity 1 becomes Rs. 2.5 per unit. What happens to the optimal
quantity demanded for these two commodities now? (price of commodity 2 and
income remain unchanged)
c) Compute the substitution effect and income effect of the change in total demand for
commodity 1 in part (b) i.e. how much of the total change in demand can be
explained by substitution effect and how much can be explained by income effect?
(Here substitution effect implies the Slutsky substitution effect and not the Hicksian
substitution effect. You can draw a diagram to understand the problem graphically).
2. A consumer’s preference between two goods can be represented by the following
utility function: 𝑈(𝑥1 , 𝑥2 ) = 𝑥1 + 𝑥2 . The prices of good 1 and good 2 are Rs.2 per
unit and Rs. 3 per unit respectively. The consumer’s total income is Rs. 120.
a) Derive the optimal quantity demanded for these two commodities given the prices
and income.
b) Suppose price of commodity 1 declines and it becomes Re. 1 per unit. What
happens to the optimal quantity demanded for these two commodities now? (price
of commodity 2 and income remain unchanged)
c) Compute the substitution effect and income effect of the change in total demand
for commodity 1 in part (b) i.e. how much of the total change in demand can be
explained by substitution effect and how much can be explained by income
effect?
d) Think of an alternative scenario when instead of decline, price of commodity 1
increases to Rs. 4 per unit. What is the substitution effect and income effect of the
change in total demand for commodity 1 in that case (i.e. decompose the total
change into substitution effect and income effect).
e) How does the demand for good 2 changes if price of good 1 remains 2 per unit
but price of good 2 becomes Re. 1 per unit (Decompose the total change in
demand for good 2 into substitution effect and income effect).
(Here substitution effect implies the Slutsky substitution effect and not the
Hicksian substitution effect. You can draw a diagram to understand the problem
graphically)
3. “In a two commodity world, both the goods can’t be luxury goods” Is this statement
true or false? Show mathematically. (This question has nothing to do with income
effect and substitution effect. You need to use the definition of necessary good and
luxury good as well as the budget line equation).
4. Consider the following utility function:
𝑢(𝑥1 , 𝑥2 ) = 𝑥1𝑎 𝑥21−𝑎 ; 0 < 𝑎 < 1
𝑥1 and 𝑥2 are the amount consumed of the two commodities. 𝑃1 and 𝑃2 are the prices of these two
commodities.
a) Derive the Hicksian demand function for the two commodities from the consumer’s expenditure
minimization exercise (you need to assume that a consumer minimizes expenditure subject to
achieve at least a utility level 𝑢− )
b) Derive the expenditure function
c) Show that the expenditure function is a linearly homogeneous function in prices (i.e. if you
multiply all the prices by some constant t, total expenditure will increase by the constant t; t>0).
d) Show that differentiating the expenditure function (partial differentiation) with respect to price of
good 1 generates the Hicksian demand function for good 1 (This property is known as Shephard’s
Lemma).
5. A consumer’s preference between two goods is represented by the following utility
function: 𝑈(𝑥1 , 𝑥2 ) = min(𝑥1 , 𝑥2 ). The prices of good 1 and good 2 are Rs.2 per unit
and Re. 1 per unit respectively. The consumer’s total income is Rs. 120.
(a) Derive the optimal quantity demanded for these two commodities given the prices
and income.
(b) Suppose price of commodity 1 declines and it becomes Re. 1 per unit. What happens
to the optimal quantity demanded for these two commodities now? (price of
commodity 2 and income remain unchanged)
(c) Compute the substitution effect and income effect of the change in total demand for
commodity 1 in part (b) i.e. how much of the total change in demand can be
explained by substitution effect and how much can be explained by income effect?
6. Consider a consumer with preference defined over bikes and all other goods. Bikes is
consumed only in discrete units. From his monthly salary M, the consumer can
consume upto 2 bikes. Given the price of a bike (say 𝑃1 ), consuming 3 bikes is
beyond the affordability of the consumer. We can assume the composite price of all
other goods as 𝑃2 .Provided the utility function of the consumer is 𝑈(𝑥1 , 𝑥2 ) =
1 1
( ) ( )
2 2
𝑥1 𝑥2 where 𝑥1 and 𝑥2 are the quantity consumed of the bike and all other goods
(𝑥1 is measured in discrete units and 𝑥2 is the composite amount of all other goods).
(a) What are the affordable bundles for the consumer (provided fractional unit of bike is
not feasible)?
(b) Under what condition, buying 1 bike is utility maximizing? (mathematical condition)