ECO 206Y1Y: Microeconomic Theory Prof.

Freitas, University of Toronto

Eco 206 HW4: Sketch Solutions

These are sketch solutions only. If you still have questions, please stop by office hours.

Q1) For each of the utility functions below derive the demand functions for x1 and x2 . The price of x1 and x2 are p1 = 1 and
p2 = 1 respectively. The consumer has income I = 100

(a) u(x1 , x2 ) = min{7x1 , 5x2 }

(b) u(x1 , x2 ) = 4x21 + x22
(c) u(x1 , x2 ) = αln(x1 ) + βln(x2 )
(d) u(x1 , x2 ) = 5x1 + 2x2
(e) u(x1 , x2 ) = αln(x1 ) + x2
Solution: Since we’re solving for the demands for both x1 and x2 we leave both prices as variables for the derivations and then
sub in for the prices not needed at the end. I’m subbing in for income right from the start.
(a) At the optimum 5x2 = 7x1 . Substituting into the BC produces x1 p1 + 75 x1 p2 = 100 which implies

100
x1 = (1)
p1 + 75 p2

subbing in for p2 = 1 gives us the demand curve for x1

100
x1 =
p1 + 75

Since x2 = 75 x1 , we get
100
x2 = 5 (2)
7 p1 + p2
subbing in for p1 = 1 gives us the demand curve for x2
100
x2 = 5
7 + p2

(b) These are non-convex preferences. The optimal solution will be at one of the corners. Which corner depends on which one
gives the highest utility based on prices given income. The corners are
   2
0, 100
p2 ⇒ U = 100
p
   2 2
100 100
p1 , 0 ⇒ U = 4 p1

Buy only x1 if
 2  2
100 100
4 > ⇒ 2p2 > p1
p1 p2
Buy only x2 if the opposite is true. If they give exactly the same utility, the consumer can choose either corner. Plugging
in p2 = 1 gives us the demand for x1 as 
0
 p1 > 2
x1 = 0 or 50 p1 = 2
 100

p1 p1 < 2
Similarly for x2 after plugging in p1 = 1 gives us

1
0
 p2 > 2
1
x2 = 0 or 200 p2 = 2
 100
 1
p2 p2 < 2

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ECO 206Y1Y: Microeconomic Theory Prof. Freitas, University of Toronto

(c) The utility maximization problem is

max αln(x1 ) + βln(x2 ) (3)
x1 ,x2

subject to
p1 x1 + p2 x2 = 100 (4)

L = αln(x1 ) + βln(x2 ) + λ [100 − p1 x1 − p2 x2 ]

F OC
α
x1 = λp1
β
x2 = λp2
100 = p1 x1 + p2 x2
Ratio of the first two FOC gives us
p1
α x2
β x1 = p2 ⇒ x2 = x1 pp21 α
β

 
100 = p1 x1 + p2 x1 pp12 α
β
h i
100 = p1 x1 α+βα

α(100)
x∗1 = (α+β)p1 .

β(100)
x∗2 = (α+β)p2 .

(d) If M U1 /p1 > M U2 /p2 , an additional dollar spent on good 1 generates more satisfaction compared to an additional dollar
spent on good 2. In this case, the consumer only buys good 1. We have that M U1 = 5 and M U2 = 2.
Thus, demand for x1 when p2 = 1 is: 
100 5

 p1
 p1 < 2
5
x∗1 = 0h i p1 > 2
5

 0, 40 p1 =

2

The demand for x2 given p1 = 1 is: 

100 2

 p2
 p2 < 5
2
x∗2 = 0h i p2 > 5
2

 0, 250 p2 = 5.


(e) These are quasilinear preferences so we must be careful about corner solutions.
The utility maximization problem is
max αln(x1 ) + x2 (5)
x1 ,x2

subject to
p1 x1 + p2 x2 = 100 (6)

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ECO 206Y1Y: Microeconomic Theory Prof. Freitas, University of Toronto

L = αln(x1 ) + x2 + λ [100 − p1 x1 − p2 x2 ]
F OC
α
x1 = λp1
1 = λp2
100 = p1 x1 + p2 x2
Ratio of the first two FOC gives us
α p1 αp2
x1 = p2 ⇒ x1 = p1

100 = p1 ( αp
p1 ) + p2 x2
2

100
x2 = p2 −α
However, we must be careful since we need to make sure x2 ≥ 0.
100 100
−α≥0⇒ ≥ p2
p2 α
Thus, the demand function for x1 when p2 = 1 is
(
α
α ≤ 100
x∗1 = p1
100
p1 α > 100

and the demand function for x2 when p1 = 1 is

(
100 100
−α p2 ≤
x∗2 = p2 α
100
0 p2 > α

Q2) We’re going to do a similar exercise as last week’s Q2 but with quasilinear preferences. We’ll keep income simple with just
exogenous income so you can focus on the relationship between MRS and OC. You should go back to last week’s Q2 and
try the same exercise to see similarities and differences with different preference classes.
Scenario: You have preferences over “benefits” (b) and the composite good (c) captured by U (b, c) = αln (b) + c. Your
income is $I and suppose the price of benefits is $pb . As with last week, qualitatively think about how and why your choices
change. No equations or number calculations. Again, use Desmos to help you visualize the changes.
Explain how and why your choice of b changes when
(1) α changes, pb , I held fixed and
(2) pb changes, α, I held fixed.

Solution: These are quasilinear preferences as the MRS − αb just depends on the quantity of b. n both these cases, the

consumer makes choices based on MRS vs OC. However, unlike last week’s exercise, we need to worry about corners. Let’s
think through it without worrying about corners first so we can focus on MRS vs OC and then bring in the possibility of
corners.

(1) Notice that for these preferences if we hold pb fixed, as α increases, at the same bundle, the consumer becomes more willing
to give up the composite good for additional benefits. Increasing α is effecively increasing the relative weight of benefits in
the consumer’s preferences. As the consumer is now more willing to give up c, for the same OC (because pb ) is unchanged,
they move along the budget line to a bundle with the same total expenditure (i.e. lies on the same budget line as I,pb
fixed), but has relatively more b in the final choice.

(2) Since we’re not changing α at the same bundle, the consumer’s willingness to give up c for additional b stays the same.
However, when pb increases, the OC of b increases. This gives the consumer an incentive to readjust their bundle so that

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ECO 206Y1Y: Microeconomic Theory Prof. Freitas, University of Toronto

MRS=OC. You know that these preferences are monotonic and have diminishing MRS. If the OC increases, the way to
increase MRS to match is to decrease b in the bundle. From the first two FOC (i.e. MRS vs OC) we can predict how just
a change in OC affects a consumer’s bundle composition. The question remains, what final bundle will they choose. With
monotonic preferences, they choose a bundle on the budget line. However unlike before the budget line also changes with
changing prices. Even if I stays the same the set of affordable bundles changes. How do we know how to figure out which
effect works in which way? Short answer–we use income and substitution effects to decompose the total change.

Corners: Notice that both movements need to keep track of not heading into negative good territory. As soon as the direction
of movement above reaches a corner, we stop there and no further adjustment to choice is possible.

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