National University of Singapore ECA5101 Microeconomic Analysis I

Department of Economics Semester 1 AY 2021/2022

Homework 1 — Solution
Consumer Theory

Question 1 (Perfect Substitutes) A consumer has utility function U(x, y) = 3x + 4y . The

consumer’s income is $60, the price of x is $2, the price of y is $4.

a) What is the optimal basket? If the consumer receives a voucher of $12 that can only be
spent on x, what is the new optimal basket?

MUx 3 MUy
Since = > = 1 , the consumer only buys x and the optimal basket is x=30,
Px 2 Py
y=0. With the voucher, the consumer still only buys x. The $12 voucher can be used to buy 6
units of x, thus the new optimal basket is x=36, y=0.

b) Suppose instead of the voucher on x, the consumer receives a $d per unit discount on every
unit of y purchased (that is, the price of y decreases by $d). To make the consumer as well off
as with the voucher in part a), how much should the discount be? What is the optimal basket
given the discount?

Since the price of x and the consumer’s income have not changed, if the discount is such that
the consumer still buys x, the consumer will not be able to get the same utility as with the
voucher. Thus it must be that the consumer only buys y. See graph below. The red line should
be the new budget line. With the voucher in part a), the consumer gets a utility of 36*3=108.
To get the same utility with y, the consumer needs 108/4=27 units of y. Thus the new optimal
basket is x=0, y=27. To afford 27 units of y, the price of y must be 20/9=2.22. Thus the
discount should be 4-20/9=16/9=1.78.

c) Suppose no voucher or discount is available. Calculate the income and substitution effects
(with respect to y) when the price of y decreases to $3. Show your steps clearly. In particular,
find the intermediate basket and the new optimal basket.

MUx 3 MUy 4
When the price of y is 3, = > = , thus the consumer only buys x and the
Px 2 Py 3
new optimal basket is the same as the initial optimal basket, x=30, y=0. The intermediate
basket is when the price of y is $3 and the consumer gets the same utility as with the initial
optimal basket. Given this price, the consumer still only buys x and to get the same utility as

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National University of Singapore ECA5101 Microeconomic Analysis I
Department of Economics Semester 1 AY 2021/2022

before, the consumer buys 30 units of x. Thus the intermediate basket is still x=30, y=0. Thus
the income effect is 0-0=0 and the substitution effect is also 0-0=0.

d) Suppose no voucher or discount is available. Let the price of x be Px, the price of y be Py,
and the income be I. Derive the demand functions for x and y and the indirect utility function.
For simplicity, assume that 4Px ≠ 3Py.

I
When 4Px < 3Py , the consumer only buys x and x = . When 4Px > 3Py , the consumer
Px
I
only buys y and y = . Thus the demand function of x is
Py
I
Px
, 4Px < 3Py
x=
0, 4Px > 3Py
and the demand function of y is
0, 4Px < 3Py
y= I
P
, 4Px > 3Py
y

Using the demand functions derived above, the indirect utility function is
3I
Px
, 4Px < 3Py
V(Px, Py, I ) = 4I
Py
, 4Px > 3Py

Question 2 (Quasi-Linear Utility Function) A consumer’s utility function is

U(x, y) = ln x + y.

a) Show that the demand for x does not depend on income at interior solutions. At interior
solutions, what is the shape of the Engel curve for x?

1 P
The tangency condition is = x , the budget line is Px x + Py y = I. Note that there is no y
x Py
in the tangency condition, so the tangency condition alone can give us the demand for x,
Py
x = . Thus the demand for x does not depend on income. This means no matter how
Px
income changes, demand for x will stay the same. Thus the Engel curve for x is a vertical line
with x on the horizontal axis and I on the vertical axis. Substituting the demand for x into the
I − Py
budget line, we have the demand for y as y = .
Py

b) Is it possible to have corner solutions? If yes, under what condition? Taking corner
solutions into account, derive the equations of the indirect utility function.

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National University of Singapore ECA5101 Microeconomic Analysis I
Department of Economics Semester 1 AY 2021/2022

Py I − Py
Based on part a), the demand for x is x = and the demand for y is y =
. However,
Px Py
this is true only when the constraints x ≥ 0 and y ≥ 0 are satisfied. It is possible that
I − Py
y= < 0, and this happens when I < Py . In this case, the constraint y ≥ 0 binds and
Py
we have a corner solution. Hence the demand for x is
Py
Px
, I ≥ Py
x=
I
Px
, I < Py
And the demand for y is
I − Py
Py
, I ≥ Py
y=
0, I < Py

Therefore, the indirect utility function is

Py I − Py
ln Px
+ Py
, I ≥ Py
V(Px, Py, I ) =
I
ln Px
, I < Py

c) Suppose the price of x is $2 and the price of y is $4, the consumer has an income of $36.
Calculate the income and substitution effects (with respect to x) when the price of x decreases
from $2 to $1.

The initial optimal basket

1 2
The tangency condition is = , the budget line is 2x+4y=36. Solving the two equations
x 4
together, we have x=2 and y=8.

The new optimal basket

1 1
The tangency condition is = , which gives us x=4.
x 4

The intermediate basket

The intermediate basket is tangent to a budget line with the same slope as the new budget
1 1
line. Thus the tangency condition is = , which gives us x=4.
x 4

The substitution effect is 4-2=2. The income effect is 4-4=0.

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National University of Singapore ECA5101 Microeconomic Analysis I
Department of Economics Semester 1 AY 2021/2022

The utility function in this question is called quasi-linear. Any utility function in the form of
U(x, y) = v(x) + a y where v(x) is a non-linear function of x, is quasi-linear. It is called quasi-
linear because it is only linear in one variable, in this case, y.

As we can see from part a), at any interior solution, the demand for x does not depend on
income I. Therefore, when the price of x changes, there is no income effect (with respect to
x).

Question 3 (Roy’s Identity) Consider a general utility maximization problem with utility
function U(x, y) and budget line Px x + Py y = I. Let x*(Px, Py, I ) denote the demand function
for x and V(Px, Py, I ) denote the indirect utility function.

a) Differentiate the indirect utility function with respect to Px using the Envelope theorem.

The Lagrangian function is Λ(x, y, λ) = U(x, y) + λ(I − Px x − Py y) . By the Envelope

∂V(Px, Py, I ) ∂Λ
theorem, = |x=x*,y=y*,λ=λ* = − λ* x*(Px, Py, I ).
∂Px ∂Px

∂V(Px, Py, I )/∂Px

b) Show that x*(Px, Py, I ) = − . (Hint: use the relationship between the
∂V(Px, Py, I )/∂I
indirect utility function and the Lagrange multiplier we derived in class.)

∂V(Px, Py, I ) ∂V(Px, Py, I )/∂Px ∂V(Px, Py, I )/∂Px

Since λ* = , x*(Px, Py, I ) = − =− . This
∂I λ* ∂V(Px, Py, I )/∂I
equation is called the Roy’s Identity.

∂V(Px, Py, I ) ∂V(Px, Py, I )

It can be rearranged as − = x*(Px, Py, I ) . The marginal utility of
∂Px ∂I
a price change is equal to the marginal utility of income multiplied by the quantity demanded.

Question 4 (Subsistence Constraint) A consumer consumes two goods, a basic good (b) and a
fancy good (f). For instance, the basic good could be rice and the fancy good could be meat.
The consumer’s utility function U(b, f ) satisfies the four assumptions and diminishing
marginal rate of substitution. In addition to the usual budget constraint, suppose the consumer
is subject to an additional subsistence constraint — the total calories consumed must be at
least c̄ for the consumer to survive. Let cb denote the calories provided by a unit of the basic
good and cf denote the calories provided by a unit of the fancy good. Suppose the basic good
cb cf
provides higher calories per dollar, that is, > , where Pb is the price of the basic good
Pb Pf
and Pf is the price of the fancy good.

a) Write down the utility maximization problem.

The utility maximization problem is

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National University of Singapore ECA5101 Microeconomic Analysis I
Department of Economics Semester 1 AY 2021/2022

max U(b, f )
b, f
s.t. Pb b + Pf f ≤ I
cb b + cf f ≥ c̄

b) Which one is steeper, the budget line or the subsistence line?

cb cf c P
The subsistence line is cb b + cf f = c̄ . Since > , we have b > b , the subsistence
Pb Pf cf Pf
line is steeper.

c) Show in graph that holding prices constant, the subsistence constraint binds when income
is low enough and does not bind when income is high enough. (Hint: draw the subsistence
line and two parallel budget lines given two income levels I1 and I2, where I1 < I2. Draw the
indifference curves and indicate the optimal baskets under I1 and I2 respectively.)

Given the two constraints, the set of feasible baskets is the area under the budget line and
above the subsistence line. See graph below. The red line is the subsistence line. When the
income is I1 , the tangency point A does not satisfy the subsistence constraint, hence the
optimal basket is point B where the subsistence constraint binds. When the income is I2 , the
optimal basket is point C and the subsistence constraint does not bind.