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Answers to some old prelim questions:

1. Ms Blue and Mr. Green

A Ms Blue has same preferences as Mr. Green, since her utility function is
a monotone increasing function of his UB = eUG
B Preferences are homothetic if (x, y)I(x0 , y 0 ) implies (tx, ty)I(tx0 , ty 0 ) for
all t > 0. His preferences are not homothetic. To see this, we note for
example that U (0, 1) = 3/2 = U (3/2, 0). But U (0, 2) = 2 6= U (3, 0) = 3.

C y(p, w) = 2 − p if p ≤ 2: y(p, w) = 0 if p > 2.


x(p, w) = w − py(p, w).
D If p ≤ 2, v(p, w) = ln (w − p(2 − p) + 2(2 − p) − (2 − p)2 /2) = ln (w + (2 − p)2 /2).
If p > 2, v(p, w) = w.

E Roy’s law requires that

− ∂v(p,w)
∂p
y(p, w) = ∂v(p,w)
.
∂w

In this instance if p < 2,

− ∂v(p,w)
∂p −(2 − p)(w + (2 − p)2 /2)
= = −y(p, w).
∂v(p,w) w + (2 − p)2 /2
∂w

If p > 0
− ∂v(p,w)
∂p
∂v(p,w)
= 0 = −y(p, w).
∂w

F Mr. Green’s expenditure function satisfies the equation

(2 − p)2
u = v(p, e(p, u)) = ln (e(p, u) + )
2
and hence
(2 − p)2
e(p, u) = eu − .
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G If p < 2, h(p, u) = 2 − p. If p > 2, h(p, u) = 0.

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2. Utility Question
A) The same preferences are represented by the utility function V where
1
V (x) = U (x) α+β+γ

This is true since V = f (U ) where f is a strictly increasing function. But


0 0 0
V (x) = (x1 + b1 )α (x2 + b2 )β (x3 + b3 )γ

where α0 + β 0 + γ 0 = 1.
B) These preferences are not in general homothetic. Preferences are homothetic
only if U (x) = U (y) implies that U (kx) = U (ky) for all k > 0. To show that
U is not homothetic, all we need is an example that violates this necessary
condition. Here is one such example. Let α = β = γ = 1. Let b1 = 1, b2 = 0,
and b3 = 1. Now let x = (1, 1, 0) and y = (0, 2, 0). Then U (x) = U (y) = 2. But
U (2x) = 6 and U (2y) = 4 6= U (2x).
C) The same preferences are represented by the function V where

V (x) = ln U (x) = α ln(x1 + b1 ) + β ln(x2 + b2 ) + γ ln(x3 + b3 )

which is of the additively separable form.


D) At an interior solution we would have

m + p1 b1 + p2 b2 + p3 b3
x1 = α − b1 .
p1
m + p1 b1 + p2 b2 + p3 b3
x2 = β − b2 .
p1
m + p1 b1 + p2 b2 + p3 b3
x3 = γ − b3 .
p1
The only equilibrium will be an interior solution if all three of the above
expressions are positive. If this is not the case, we need to find a corner solution.
A corner solution in which x3 = 0 and the other two quantities are positive would
have
α m + p2 b1 + p2 b2
x1 = − b1
α+β p1
β m + p2 b1 + p2 b2
x2 = − b2 .
α+β p1
and it would also have to be true that when x3 = 0, the ratio of marginal utility
of good 3 to its price is less than the ratio of marginal utility to price for the
other two goods. That is
γ α+β

p3 b3 m + p3 αb1 + p2 βb2

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Similar conditions would apply to the cases where x2 = 0 and x3 = 0.
There could also be corner equilibria in which only one good was purchased,
If only good 1 is purchased, then it would have to be that x1 = m/p1 and that
the ratio of marginal utility of good 1 to its price was greater than the ratio of
the marginal utilities of either of the other goods to their prices when 0 units
of the other two goods are consumed. This means that
α β

m + p1 b1 p2 b2
and
α γ
≥ .
m + p1 b1 p 3 b3

E) At prices and income for which there is an interior solution, the indirect
utility function is
−β −γ
V (p1 , p2 , p3 , m) = αα β β γ γ (m + b1 p1 + b2 p2 + b3 p3 )p−α
1 p2 p3 .

To verify Roy’s identity, we need to show that

∂V (p1 , p2 , p3 , m) ∂V (p1 , p2 , p3 , m)
− ÷ = xi (p1 , p2 , p3 , m).
∂pi ∂m
Calculations show that
∂V (p1 , p2 , p3 , m) −β −γ
= αα β β γ γ p−α
1 p2 p3
∂m
and that
 
∂V (p1 , p2 , p3 , m) α −β −γ
=− (m + b1 p1 + b2 p2 + b3 p3 ) − b1 αα β β γ γ p−α
1 p2 p3 .
∂p1 p1

Then it must be that

∂V (p1 , p2 , p3 , m) ∂V (p1 , p2 , p3 , m) α
− ÷ = (m + p3 αb1 + p2 βb2 + p3 γb3 )−b1 = x1 (p1 , p2 , p3 , m).
∂pi ∂m p1
An exactly parallel argument verifies Roy’s identity for goods 2 and 3.
F) The Hicksian demands are the corresponding partial derivatives of the expen-
diture function. We can find the expenditure function from the indirect utility
function, making use of the identity

V (p1 , p2 , p3 , E) = u.

In this case we have the equation.


−β −γ
V (p1 , p2 , p3 , E) = αα β β γ γ (E + b1 p1 + b2 p2 + b3 p3 )p−α
1 p2 p3 = u.

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Solving for E, we have
β γ
E(p1 , p2 , p3 , u) = uα−α β −β γ −γ pα
1 p2 p3 − (b1 p1 + b2 p2 + b3 p3 ) .

Then the hicksian demand for good 1 is

∂E(p1 , p2 , p2 , u) α β γ
= − uα−α β −β γ −γ pα
1 p2 p3 − b1 .
∂p1 p1
Parallel expressions are found for demands for the other two goods. The Hick-
sian substitution matrix is the matrix of second order partials of the function
E(p1 , p2 , p3 , u) with respect to the pi ’s.
G) Demand of a person of type 1 for good 1 is
α
(m1 + 10(p1 + p2 + p3 ) − 10
p1
if this expression is positive and is 0 otherwise. Demand of a person of type 2
for good 1 is
α
(m2 + 10p1 ) − 10
p1
if this expression is positive and is 0 otherwise. If both types buy positive
quantities, aggregate demand is
α
(100(m1 + m2 ) + 2000p1 + 1000(p2 + p3 )) − 2000.
p1

H) Demand will not change. We see from the expression for aggregate demand
that it depends only on total income and thus does not change when income is
redistributed.
I) For an income transfer to change aggregate demand, it must be that one of
the two types is at a corner solution either before or after the transfer (or both).
At these prices, if income of type i is mi , then demand for good 1 by type 1
persons is
α(m1 + 30) − 10
10
where m1 > α − 30 and 0 otherwise. Demand by type 2 persons is

α(m2 + 10) − 10

if m2 > 10 10 10
α −10 and zero otherwise. Suppose that m1 > α −30 and m2 < α −10,
then for every dollar that a type 2 gives up, he will buy reduce his demand for
good 1 by α units. On the other hand a small increase in income for a type 1
will not change his demand for good 1.

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3.Background to Harry Question
Harry consumes just one commmodity and he will live for T periods. His current
preferences over consumption streams are represented by a utility function of the form
T
X
U (x1 , . . . , xT ) = βt u(xt )
t=1

where xt is the amount of the commodity that he will consume in year t and where the
function u(·) is strictly concave and twice continuously differentiable. Harry knows that
his income stream will be (w1 , . . . , wT ) where wt is the income that he will receive in
period t. Harry is able to borrow or lend at the constant interest r. At time 1, Harry
is able to commit himself to any time path of consumption that satisfies his budget
constraint. His budget constraint is that the present value of his lifetime consumption
must not exceed the present value of his lifetime income stream.
Part 1

Part 1) Suppose that for some α where 0 < α < 1, and for all t = 1, . . . T , βt = αt−1 .
At what interest rate will Harry will choose to consume the same amount of goods in
every period of his life? Explain why your answer is correct. Does this interest rate
depend on the time path of his income stream? At this interest rate, what can you say
about the way in which his borrowing and saving behavior depend on the time path of
his income stream.

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Answer to Part 1:
Harry will commit himself to the consumption stream (x1 , . . . , xT ) that max-
imizes
T
X
U (x1 , . . . , xT ) = αt−1 u(xt )
t=1

subject to the constraint that


T
X T
X
p t xt = pt wt
i=1 i=1

where
1
pt = .
(1 + r)t
This requires that his marginal rate of substitution between consumption in
period t and consumption in period t + 1 is equal to the ratio pt /pt+1 = 1 + r.
His marginal rate of substitution between consumption in periods t and t + 1 is

αt u0 (xt ) 1 u0 (xt+1 )
= .
αt+1 u0 (xt+1 α u0 (xt )
This means that if he chooses the same amount of consumption x̄ in every
period, his marginal rate of substitution between consumption in periods t and
t + 1 must be
1 u0 (x̄) 1
= .
α u0 (x̄) α
Setting this marginal rate of substitution equal to the price ratio pt /pt+1 = 1+r,
we see that it must be that 1 + r = 1/α and hence
1
r= − 1.
α
This interest rate does not depend in any way on the time path of his income
or even on the present value of his income stream so long as it is positive.
If P V is the present value of his income stream, the Harry will consume a
constant amount x̄ in every period such that

x̄(1 + α + α2 + . . . αT ) = P V.

This implies that

PV P V (1 − αT +1 )
x̄ = = .
(1 + α + α2 + . . . αT ) 1−α
Where wt is income in period t, he will save wt − x̄ if wt − x̄ > 0 and dissave
wt − x̄ if wt − x̄ < 0.
Part 2)

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Suppose that β2 = β1 = 1 and that for t = 3, . . . T , βt = αt−2 . Suppose that at
time 1, Harry can commit himself to a time path of future consumption. Qualitatively,
how does his time path of consumption depend on the interest rate? For example, at
what if any interest rates r > 0 is his consumption first increasing, then constant, at
what interest rates is his consumption always increasing, at what interest rates is his
consumption first increasing, then decreasing, etc, etc.
Answer to Part 2:
Setting Harry’s marginal rate of substitution between consumption in period
1 and period 2 equal to the p1 /p2 , we have

u0 (x1 )
= 1 + r.
u0 (x2 )

Since we have assumed that u is strictly concave and twice continuously differ-
entiable, it must be that u0 (x1 ) > u0 (x2 ) if and x1 < x2 and u0 (x1 ) < u0 (x2 ) if
and x1 > x2 . Therefore if r > 0, Harry will consume more in period 2 than in
period 1. If r < 0, he will consume more in period 1 than in period 2, and if
r = 0, he will consume the same amount in each period.
It must also be true that Harry chooses consumptions such that

αt u0 (xt ) u0 (xt )
= =1+r
αt+1 u0 (xt+1 ) αu0 (xt+1 )

for all t ≥ 2. This is equivalent to

u0 (xt )
= α(1 + r).
u0 (xt+1 )

If α(1 + r) = 1, he will choose xt = x2 for all t such that 2 ≤ t ≤ T . If


α(1 + r) < 1, then it must be that for all t ≥ 2,

u0 (xt )
>1
u0 (xt+1 )

which implies that xt+1 < xt for all t such that 2 < t. Similar reasoning show
that if α(1+r) > 1 , he will choose xt+1 < xt for all t such that 2 < t < T . From
these statements it follows that if r = α1 − 1, he will increase his consumption
from period 1 to period 2 and then hold his consumption constant at the period
2 level for the rest of his life. If r < α1 − 1, he increases his consumption from
period 1 to period 2 and in every period thereafter he decreases his consumption.
If r > α1 − 1, his consumption in every period of his life exceeds his consumption
in the previous period.
Part 3)
Suppose that T = 3 and Harry’s utility function is
√ √ √
U (x1 , x2 , x3 ) = x1 + x2 + α x3 .

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Harry earns income W > 0 in period 1, while wt = 0 for t > 1. Suppose also that
1
= α.
1+r
If Harry can commit himself to a time path of future consumption at time 1, solve for
his choice of x1 , x2 , and x3 as a function of the parameters W and r.
Answer to Part 3:
Harry’s budget constraint is
1 1
x1 + x2 + x3 = W.
1+r (1 + r)2

Setting his marginal rate of substitution between x1 and x2 equal to 1 + r, we


find that x2 = (1 + r)2 x1 . Setting his marginal rate of substitution between x2
1
and x3 equal to 1 + r and using the fact that α = (1+r) , we find that x2 = x3 .
Substituting into the budget constraint, we have

(1 + r)2 x1 (1 + r)2 x1
x1 + + = W.
1+r (1 + r)2

Simplifying and solving for x1 , we find that

W (1 + r)W
x1 = 1 = .
2 + 1+r 3 + 2r

Then
(1 + r)3 W
x2 = x3 = (1 + r)2 x1 = .
3 + 2r

Part 4:
Suppose that Harry can save money in period 1 but he must leave the choice of
allocation between periods 2 and 3 to his future self. Harry is aware of this and knows
that in Period 2 his utility function for consumptions periods 2 and 3 will be
√ √
U (x2 , x3 ) = x2 + x3 .

He also knows that the interest rate will continue to satisfy the equation
1
= α.
1+r
If Harry consumes x1 in period 1, what consumptions will his period 2 self choose for
periods 2 and 3? Write down an expression for Harry’s utility as a function of x1 ,
taking into account the fact that he knows that his period 2 self will determine the
division of income between his period 2 self and his period 3 self. Find the optimal
choice of x1 for Harry. Is this the same as the amount of x1 that he would choose in
Part 3 above?

Answer to Part 4:

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If Harry consumes x1 in period 1, his budget for periods 2 and 3 will be
x3
x2 + = (1 + r)(W − x1 ).
1+r
Setting his marginal rate of substitution between x2 and x3 equal to 1 + r, we
find that x3 = (1 + r)2 x2 and substituting into the budget constraint we find
that
(1 + r)(W − x1 )
x2 =
2+r
and
(1 + r)3 (W − x1 )
x3 = .
2+r
Harry’s utility if he chooses x1 in the first period will be
r r
√ (1 + r)(W − x1 ) (1 + r)3 (W − x1 )
x1 + +α .
2+r 2+r
Since we have assumed that α = 1/(1+r), this expression simplifies to simplifies
to r
√ (1 + r)(W − x1 )
x1 + 2 .
2+r
Harry will choose the x1 that maximizes this expression. Taking derivatives, we
will find that this is maximized when
2 + 3r + r2
x1 = W.
6 + 3r + r2
Recall that in Part 3, we found the solution
1
x1 = W.
3+r
To compare these solutions, we note that
1 1
W < W
3+r 3
for all r > 0 and
2 + 3r + r2 1
x1 = W > W
6 + 3r + r2 3
for all r > 0. Thus for all r > 0, Harry would consume more and save less if he
cannot commit than if he can commit to a future consumption path.

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4. Answers to Oskar Question
√ √ √ √
A If M > p, Dy (p, M ) = 1/ p and Dx (p, M ) = M − p. If 0 < M ≤ p,
Dy (p, M ) = M/p and Dx (p, M ) = 0.
√ √ √ √
B If M > p, V (p, M ) = M − 2 p. If M < p, V (p, M ) = − p

C p p
π M1 − 4 + (1 − π) M2 − 4.

D  p 2
p
M = 4 + π M1 − 4 + (1 − π) M2 − 4 .

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