PROBLEM SET #1: BUDGET CONSTRAINTS, PREFERENCES, UTILITY FUNCTIONS
Microeconomics I
Budget Constraints.
1. (∗) Elena has the following budget constraint p1x1 + p2x2 ≤ m where p1 = 2 and
p2 = 3.
(a) Suppose income is m = 30. Write down and draw Elena’s budget line.
Budget Constraint: 2x1+3x2≤30
Budget Line: 2x1+3x2=30
Intercepts:
x1x1-intercept: x1=15 (set x2=0)
x2x2-intercept: x2=10 (set x1=0)
Graph: A straight line connecting (15, 0) and (0, 10).
(b) What is the slope of the budget line? How do you interpret it?
−p 1 −2
Slope: =
p2 3
Interpretation: The slope represents the opportunity cost of good 1 in terms of
good 2. For every unit of x1 consumed, Elena must give up 2/3 units of x2.
(c) Suppose income increases by 20%. Write down and draw Elena’s budget line
now. How does this affect the slope of the budget line?
New income: m=30 · 1 ,2=36
New budget line: 2 x1 +3 x 2=36
Intercepts:
x 1 intercept: x 1=18
x 2 intercept: x 2=12
Slope: Remains –2/3 (unchanged because prices are unchanged)
Effect: the Budget line shifts outwards parallelly, increasing Elena’s purchasing
power.
(d) Suppose that on top of the 20% income increase, the price of good 1 increases
by 50%. Write down and draw Elena’s budget line. What is the slope of the
budget line in this case?
New price of good 1: p1=2 · 1, 5=3
New budget line: 3 x 1+3 x 2=36 x 1+ x2 =12
Intercepts
1
x 1 intercept: x 1=12
x 2 intercept: x 2=12
Slope: -3/3 = -1
Effect: The Budget line rotates inward, becoming steeper due to the higher price
of good 1.
(e) How does the Elena’s well-being change between (a) and (c) and between (a)
and (d)? Explain.
From (a) to (c) Elena’s well-being improves because her income increases,
allowing her to afford more of both goods.
From (a) to (d) The effect is ambiguous. The income increase improves her
well-being, but the price increase for good 1 reduces her purchasing power for
that good. The net effect depends on her preferences.
2. (∗) Anna lives in a country near the Baltic Sea. There are three main food com-
modities there: bread, milk, and potatoes. Suppose the price of bread is 1.80
crowns per kilo, the price of milk 1.20 crowns per liter and the price of potatoes
0.60 crowns per kilo.
(a) Suppose Anna has a yearly food budget of 900 crowns. Write down Anna’s
yearly budget set for food. Can you draw it?
Prices: Bread = 1,8 crowns /kg , Milk = 1,2 crowns / liter, Potatoes = 0,6 crowns /
kg
Budget constraint: 1 , 8 x bread +1 ,2 x milk +0 , 6 x potatoes ≤ 900
Graph ( x bread , x milk , x potatoes )
(b) Suppose now that the country decides to adopt the euro as its currency and
that 1 euro is worth 1.50 crowns. Write down Anna’s yearly budget set for
food in euros. Is it different from the one in crowns? Explain.
Exchange rate: 1euro = 1,5 crowns
Converted prices: Bread = 1,2 euros / kg, Milk 0,8 euros / liter, Potatoes 0,2 euros
/ kg.
900
Budget constraint: 1 , 2 x bread + 0 , 8 x milk + 0 , 4 x potatoes ≤ =600 euros
1, 5
Difference: the budget set is the same in real terms, only the currency unit
changes.
(c) Consider instead the proposal of dropping both the crown and the euro and
using one kilo of potatoes as the num´eraire. What would the prices of bread,
2
milk and potatoes be? What would Anna’s budget set be in this new
currency?
Prices in potatoes: Bread 3kg potatoes/ kg bread, Milk 2kg potatoes/liter milk
900
Budget constraint: 3 x bread +2 x milk + x potatoes ≤ =1500 kg potatoes
0,6
(d) As it turns out, Anna does not like potatoes at all and she never consumes
them, so that her food budget is spent entirely on bread and milk. Suppose
also that, as in (c), a kilo of potatoes is the num´eraire. Plot Anna’s
budget constraint for bread and milk.
Budget constraint: 3 x bread +2 x milk ≤1500
Intercepts:
x bread intercept: 500 kg
x milk intercept: 750 liters
Graph: a straight line connecting (500,0) and (0,750)
3
Preferences.
3. (∗) Three friends (Alice, Bob, and Carol) want to go together to the cinema. They
are considering three different movies: X, Y, and Z. Our final aim in this problem
is to try to characterize a preference relation that represents this group’s collective
preference relation for these movies. The individual preferences are as follows:
Alice : X ≻ Y ≻
Z Bob : Y ≻ Z ≻
X Carol : Z ≻ X
≻Y
The group has come up with the following idea: when they have to compare a pair
of movies they are going to say that one movie is better if a majority prefers this
movie. Given this rule, try to write down the group’s preference relation over any
two alternatives.
Group preferences
X vs Y: Alice (x), Carol (x) vs Bob (y) X ≻ Y
Y vs Z: Alice (y), Bob (y) vs Carol (z) Y ≻Z
X vs Z: Alice (x), Carol (z), Bob (z) Z≻X
(a) Is it complete?
The relation is complete because all pairs are compared.
(b) Is it transitive?
X≻ Y, Y≻Z, but Z≻X, This violates transitivity.
(c) Can you construct a utility function that represents the group’s preferences?
Suppose now that Bob talks to both Alice and Carol and changes his mind about
the movies. His preferences are now:
Bob : Z ≻ X ≻ Y
while Alice’s and Carol’s preferences are unchanged. Using the same rule as
above, write down the group’s preference relation with this new set of preferences
and answer the questions (a)–(c) above.
Cannot be constructed due to instransitivity.
After Bob’s Change:
Bob’s new preferences Z≻X≻Y
Group preferences:
X≻Y (Alice, Carol)
4
X ~ Z (Alice, Bob vs Carol)
Y~Z (Alice, Bob vs Carol)
Completeness: still complete
Transitivity: violated if X≻ Y ~Z ~X
Utility function: still cannot be constructed.
Utility Functions.
√
4. Consider the following utility function U (x1, x2) = x1x2 where x1 > 0 and x2 > 0.
What type of preferences does it represent? Which of the following utility
functions represents the same preferences? Explain your answer.
(a) U (x1, x2) = x1 + x2 Non-equivalent function
√ √
(b) U (x1, x2) = x1 + x2 Non-equivalent function
1 1
(c) U (x1, x2) = 1 ln x1 + 1 ln x2 ln x 1+ ln x 2 (Monotonic transformation of the original)
2 2 2 2
(d) U (x1, x2) = ln x1 + ln x2 ln x 1 +ln x 2 (also monotinc transformation, but
scales differently)
(e) U (x1, x2) = 32 + x1x2. Non-equivaltent function
√ √
(f) U (x1, x2) = 32 + 2 x1 x2. 32+2 √ x 1 x2 (affine transformation of the
original)
5. (∗) Draw in each case some indifference curves for the preference relations repre-
sented by the following utility functions (the last two are, maybe, more difficult) in
(x1, x2)-space for x1 > 0 and x2 > 0:
1
a) u ( x 1 , x 2 )=x 2 +3
Indifference curves: vertical lines (independent of x2)
Properties: not monotone in x2 convex.
b) u ( x 1 , x 2 )=−x 1 +4 x2
Indifference curve: Straight lines with slope (1/4)
Properties: monotone, convex
2
c) u ( x 1 , x 2 )=x 1 + x 2
Indifference curve: Parabolas opening upwards
Properties: monotone, concave
5
2 2
d) u ( x 1 , x 2 )=x 1 + x 2
Indifference curves: circles centered at origin.
Properties: monotone, strictly concave.
2
e) u ( x 1 , x 2 )=( x 1 +4 x2 )
Indifference curves: Parallel straight lines.
Properties: monotone, convex
2 2
f) u ( x 1 , x 2 )=−( x 1−2 ) −( x 2−3 )
Indifference curves: circles centered at (2,3).
Properties: not monotone (decreasing utility away from center, strictly convex.)
g) u ( x 1 , x 2 )=mi n { x1 +2 x 2 , 2 x1 + x 2 }
Indifferences curves: kinked lines along x1 = x2
Properties: not monotone, convex
h) u ( x 1 , x 2 )=ma x { x 1 +2 x2 , 2 x 1 + x 2 }
Indifference curves: V shaped kinked lines.
Properties: monotone, not convex
6
6. (∗) For the utility functions (a)-(f) of the previous question compute:
i. The marginal utility of the first good (MU1(x1, x2)).
ii. The marginal utility of the second good (MU2(x1, x2)).
iii. The marginal rate of substitution (MRS(x1, x2)).
iv. Use your formula in iii. to compute the MRS at the point (4, 2). Interpret
the number you obtain.
1
a) u ( x 1 , x 2 )=x 2 +3
M U 1=2 x1
M U 2=0
MRS=−∞ (undefined, as M U 2=0)
b) u ( x 1 , x 2 )=−x 1 +4 x2
M U 1=−1
M U 2=4
1
At (4,2) MRS=
4
2
c) u ( x 1 , x 2 )=x 1 + x 2
M U 1=2 x1
M U 2=1
MRS=−2 x 1
At ( 4 ,2 ) : MRS=−8
2 2
d) u ( x 1 , x 2 )=x 1 + x 2
M U 1=2 x1
M U 2=2 x2
−x1
MRS=
x2
At ( 4 ,2 ) : MRS=−2
2
e) u ( x 1 , x 2 )=( x 1 +4 x2 )
M U 1=2 ( x 1+ 4 x 2 )
M U 2=8 ( x 1+ 4 x 2 )
7
−1
MRS=
4
−1
At ( 4 ,2 ) : MRS=
4
2 2
f) u ( x 1 , x 2 )=−( x 1−2 ) −( x 2−3 )
M U 1=−2 ( x 1−2 )
M U 2=−2 ( x 2−3 )
−X 1−2
MRS=
X 2−3
−2
At ( 4 ,2 ) : MRS= =2
−1