ECON 612: Microeconomics I Midterm 1

Charles L. Baum II Fall 2005

Instructions: Answer all five questions, which are equally weighted. You may write on the backs of these pages when necessary. 1. Janets utility function is U(X,Y) = (X+1)Y where X and Y denote her consumption of the goods X and Y. Janet purchases the goods at market prices pX and pY and she has income I. a) Derive Janets Hicksian demand functions and her expenditure function (assuming an interior optimum). b) Use the expenditure function to derive her indirect utility function. c) Use her indirect utility function to derive the Marshallian demand function for good X.

2. Consider the simple labor supply model in which the individual consumes two goods: leisure (L) and consumption (X). The individual has a total allocation of T hours, which can be allocated for leisure or work. The individual receives a wage w for each hour worked, pays the market price p for each unit of consumption X, has unearned income I, and pays a tax of t on all earned income. a) State the individuals constrained optimization problem. Derive the first order conditions for an internal optimum. b) Use comparative statics to determine the effect of a change in unearned income (I) on the optimal amount of consumption (X). Assume consumption is a normal good. c) Use comparative statics to determine the effect of a change in the earned income tax (t) on the optimal amount of consumption (X). d) Assume the individual is at an interior optimum. Using your comparative static result in part c, identify the substitution effect and its sign and the income effect and its sign. e) Explain the intuition behind the substitution and income effects prompted by an increase in t.

3. Suppose Walt consumes two items: good X and good Y. The price of good X is $25, the price of good Y is $6.25, and Walt has income I=100. Walts utility function is U = (XY)1/2. a) Find the utility maximizing amount of good X and good Y for Walt to consume. b) What is Walts utility at this optimum? c) Now suppose Walt seeks to identify the lowest-cost way of attaining utility of U = 2. How much of good X and good Y should Walt consume? d) Now suppose Walt seeks the lowest-cost way of attaining utility of U = 4. How much of good X and good Y should Walt consume? e) If you havent already done so, prove your answer to part d mathematically using the cost minimization setup. f) Explain under what circumstances the utility maximization setup is equivalent to the cost minimization setup. Also, explain when, if ever, theyre different.

4. Alans preferences satisfy the von Neumann-Morgenstern axioms, and he is strictly risk averse. His von Neumann-Morgenstern utility is a function of income spent on consumption, U(Y), where Y denotes income (let the price of consumption be normalized to 1). With probability p, Alan develops no health problems and gets U = U(Y); however, with probability (1-p), he gets develops health problems and dies (and gets utility of U(0) = 0). However, Alan is considering whether to start smoking cigarettes. Let the probability of dying be an increasing function of smoking (use S to represent the number of cigarettes smoked), p(S)<0. a) Set up Alans expected utility function. Given this setup, how much will Alan smoke? Explain why intuitively. b) Now, suppose that smoking affects utility such that U = U(Y, S), where S is the number of cigarettes smoked with US > 0 and where the first argument in the utility function is redefined to be income spent on non-cigarette consumption. Calculate Alans first order condition. What is the marginal benefit of smoking? What is the marginal cost of smoking? Identify these from your first order condition. c) Now, revise your model to incorporate cigarette prices, pS. Show your new expected utility function. d) Let T be the tax on cigarettes. If T is increased, will Alan be more or less likely to smoke? Show mathematically. Explain your results intuitively. What does each term in your comparative static result mean?

5. Now suppose Liz has the option of taking a job as an executive assistant that pays $62,000 with certainty or choosing a career in law. If Liz chooses the career in law, there is a 50% chance she will not make partner and will only earn $45,000. On the other hand, if Liz chooses a career in law, there is a 50% chance she will make partner and will earn $80,000 annually. Liz's utility function is U(I) = I, where I represents annual income in dollars. a) Given that Liz is risk-averse, should she become an executive assistant or choose a career in law? b) Now assume the job as an executive assistant is no longer an option. How much is Liz willing to pay for insurance to protect herself from the variable income associated with a career in law? c) Graph Liz's utility function with respect to income.

Answer to question 1: a) Min pXX + pYY + {U* - (X+1)Y}. First order conditions: LX (X,Y, = pX - Y = 0 LY (X,Y, = py - (X+1) = 0 L (X,Y, = U* - (X+1)Y = 0 Thus, (X+1)/Y = pY/pX or Y = (X+1)pX/pY. By the constraint, U* = (X+1)2 pX/pY or X+1 = [U*(pY/pX)]1/2 or X = [U*(pY/pX)]1/2 -1. Thus, Y = [U*(pX/pY)]1/2. E(pX,pY,U*) = 2 [pXpYU*]1/2 pX. b) Since the expenditure and indirect utility functions are inverses, V = [(I + pX)/2]2 (1/pXpY) = (I+pX)2/4pXpY c) You can use Roys identity: X(p,I) = -V(p,I)/ pX / V(p,I)/ I. X(p,I) = { (I+pX)/2 (1/pXpY) [(I+pX)/2]2 (1/pX2pY) } / (I+pX)/2 (1/pXpY) = (I+pX)/2pX 1 = (I+pX-2pX)/2pX = (I-pX)/2pX

Answer to question 2:

Answer to question 3: a) From L(p,I) = U(X,Y) + (I pxX pyY) or L(p,I) = (X,Y)1/2 + (I 25X 6.25Y), we find that X* = 2 and Y* = 8. b) U* = (2*8)1/2 = 4. c) X* = 1 and Y* = 4. d) X* = 2 and Y* = 8. e) From L(p,I) = pxX + pyY + ( U - U(X,Y)) or L(p,I) = 25X + 6.25Y + (4(X,Y)1/2), we get the following first order conditions: LX : 25 - (0.5)(XY)-1/2Y = 0 LY: 6.26 - (0.5)(XY)-1/2X = 0

L: U - U(X,Y) = 0. Dividing the first first order condition by the second yields Y = (px/py)X. Plugging this into the third and solving for X yields X = (py/px)1/2- U . So, X* = 2 and Y* = 8. f) Assuming the same prices (px and py), the same income (I), and the same utility functions (U(X,Y)) in both setups, utility maximization [L(p,I) = U(X,Y) + (I pxX pyY)] yields the same answers (X*,Y*) as cost minimization [L(p,I) = pxX + pyY + ( U - U(X,Y))] when U (from the cost minimization setup) is the same as U* (maximized utility from the utility

maximization problem). They yield different answers (X*,Y*) when U is not equal to U*. And, of course, they would yield different answers if the prices, incomes, and/or utility functions were different between the two setups. Answer to question 4:

Answer to question 5: a) b) She should become an executive assistant because (62,000)1/2 = 248.99 > 247.48 = 0.5(80,000)1/2 + 0.5(45,000)1/2. (62,500 X)1/2 = 247.48. So, X = $1253.64.

c)

Liz's Preferences
12 10

Utility

8 6 4 2 0 1 11 21 31 41 51 61 71 81 91 Income Risk-Averse