LUBS5103M Microeconomics Semester 1, 2025/2026
Problem Set 2
Model solutions and comparative statics
1. Cobb-Douglas Preferences
Oftentimes micro models use Cobb-Douglas preferences if the model solution needs
to be localised. This is because they are well-behaved, i.e. they fulfil important axioms
of consumer choice.
In this exercise, we apply the notion of Cobb-Douglas preferences to our traditional
model of consumption choice. The Cobb-Douglas utility function in the two-goods
example takes the form:
U x1 x21
where 0 1. There are two goods, x1 and x 2 . M is the consumer's budget.
(a) Solve the model using the technique presented in the lecture. Show that the
demand functions derived are
M
x1 for good x1 with price p1
p1
M
x2 (1 ) for good x 2 with price p2
p2
(b) Why must the solution be a global maximum (without proving sufficiency)?
(c) Show that there are no corner solutions.
(d) Taking prices and money income as strictly positive (>0), sketch exemplary
Marshallian demand curves for one of the two goods and two levels of income, M0
and 2M0. What are the interesting features of these demand functions?
LUBS5103M Microeconomics Semester 1, 2025/2026
2. Corner solutions and quasi-linear utility function
For the two-good case a ‘quasi-linear’ utility function takes the following form:
df ( x1 ) d 2f ( x1 )
U f ( x1 ) x2 where: 0 0
dx1 dx12
(a) Sketch two indifference curves. What is an important feature? Can the consumer
choice problem have a corner solution?
(b) Suppose the utility function takes the form: U x1 x2 . What is the marginal rate
of substitution at any value for x1 x10 , and how many units of good x 2 are
purchased when p1 =1, p2 = 4, and M = 20? Is this a corner?
(c) If the income of the consumer doubles, what happens to the demand for both
goods? Could there be a corner solution now? Give an educated guess, explain it,
and check using calculus.
Additional self-study exercises
3. Income changes
In this exercise, you will perform comparative statics in the standard consumer choice
model with regard to money income. Sketch two examples of solutions to the
consumer’s problem in the two-good case: for a normal good and an inferior good.
(a) If income reduces, what is your prediction for the demand for goods 1 and 2 in both
examples?
(b) Is it possible to (i) identify a substitution effect and (ii) check if the inferior good is
a Giffen good? Explain.
4. General solution
Consider the utility function Ui i 1i ln( xi ) with
n n
i 1 i
1, and i 0 . An agent
seeks to maximise their utility by consuming optimal quantities of all goods i, …, n. A
fixed sum of income M is spent on all goods at given prices pi .
(a) Set up the utility maximisation problem. Which condition does the Lagrangian
multiplier need to meet for a Corner solution xi = 0 to exist?
(b) How do pi and βi influence the probability of a Corner solution xi = 0 (all else equal)?
Explain. Also, explain what role βi plays in the utility function.
(c) What is the Marshallian demand for any good i ?
(d) Now consider your exercise (4c) solutions for the Marshallian demand for any good
i. Compare these with the Cobb-Douglas preferences in exercise 1(d). Which
attributes do the two types of preferences considered in exercises 1 and 4 have in
common?