ps2 Sol

Prof.
Ignacio Monzon
Collegio Carlo Alberto
Fall 2011
M ICROECONOMIC T HEORY - PS #2 - A NSWER K EY

Due date: 17 Oct 2011
1. Let (B, C ()) be a choice structure. Moreover, let C () be a function (that is, for all B B,
C ( B) = x for some x B). In such a case, is the following property an equivalent expression
for the weak axiom of revealed preference?
x, y B and x, y B0

C ( B) = x C B0 6= y
Answer:
Let us denote this new property by (WA*) and the usual weak axiom by WA.
(a) We deal first with the following statement: WA WA*.
We are told that x, y B, x, y B0 and x C ( B). Can we show that C ( B0 ) 6= y? If the
weak axiom holds, and y C ( B0 ), then also y C ( B). But we know that y 6 C ( B),
since C is a function. As a result, y 6 C ( B0 ). This implies of course that C ( B0 ) 6= y.
(b) We deal now with the following statement: WA* WA.
The weak axiom applies when x, y B, x, y B0 and x C ( B). It requires, under those
conditions, that y C ( B0 ) x C ( B0 ). This is equivalent to x 6 C ( B0 ) y 6 C ( B0 ).
Since C is a function, this is equivalent to x 6= C ( B0 ) y 6= C ( B0 ). Finally, again since
C is a function, of course if C ( B0 ) = x, then C ( B0 ) 6= y. To sum up, if C is a function,
the weak axiom requires:

x, y B and x, y B0 C ( B) = x C B0 6= y
which is exactly what we were trying to show.
2. MWG 1.D.3B Let X = { x, y, z} and consider the choice structure (B, C ()) with
B = {{ x, y} , {y, z} , { x, z} , { x, y, z}}
and C ({ x, y}) = { x }, C ({y, z}) = {y} and C ({ x, z}) = {z}, as in example 1.D.1. Show that
(B, C ()) must violate the weak axiom.
Answer: Let us do it in steps.
(a) Assume that x C ({ x, y, z}). Recall that z C ({ x, z}) and of course, x, z { x, y, z}
and x, z { x, z}. Then, by the weak axiom, x C ({ x, z}), which is false.
(b) Assume that y C ({ x, y, z}). Recall that x C ({ x, y}) and of course, x, y { x, y, z}
and x, y { x, y}. Then, by the weak axiom, y C ({ x, z}), which is false.
(c) Assume that z C ({ x, y, z}). Recall that y C ({y, z}) and of course, y, z { x, y, z}
and x, z {y, z}. Then, by the weak axiom, z C ({ x, z}), which is false.
Now, we know C ({ x, y, z}) is non-empty, so (B, C ()) must violate the weak axiom.
3. MWG 2.E.1A Suppose L = 3, and consider the demand function x ( p, w) defined by:
p2
p1 + p2 + p3
p3
x2 ( p, w) =
p1 + p2 + p3
p1
x3 ( p, w) =
p1 + p2 + p3
x1 ( p, w) =
w
p1
w
p2
w
p3
Does this demand function satisfy homogeneity of degree zero and Walras law when = 1?
What about when (0, 1)?
Answer:
Let us start with homogeneity of degree zero. We should verify wether x (p, w) = x ( p, w)
for all ( p, w). In this case,
p2
w
p2
=
p1 + p2 + p3 p1
p1 + p2 + p3
p3
w
p3
x2 (p, w) =
=
p1 + p2 + p3 p2
p1 + p2 + p3
p1
w
p1
x3 (p, w) =
=
p1 + p2 + p3 p3
p1 + p2 + p3
x1 (p, w) =
w
= x1 ( p, w)
p1
w
= x2 ( p, w)
p2
w
= x3 ( p, w)
p3
So in fact, homogeneity of degree zero hols for all .

Next, regarding Walras law, we should verify that px ( p, w) = w for all ( p, w). In this case,
p2
p1
w
p3
w
w
+ p3
+ p2
p1 + p2 + p3 p1
p1 + p2 + p3 p2
p1 + p2 + p3 p3
p3
p1
p2
w+
w+
w
=
p1 + p2 + p3
p1 + p2 + p3
p1 + p2 + p3
w
=
( p2 + p3 + p1 )
p1 + p2 + p3
px ( p, w) = p1
So Walras law only holds if = 1.

4. MWG 2.E.4B Show that if x ( p, w) is homogeneous of degree one with respect to w [i.e.,
x ( p, w) = x ( p, w) for all > 0] and satisfies Walras law, then lw ( p, w) = 1 for every l.
Interpret. Can you say something about Dw x ( p, w) and the form of the Engel functions and
curves in this case?
Also, draw the Engel curve for the case L = 2.
Answer:

Note that for all l, xl ( p, w) = xl ( p, w). Let = w1 . Then, xl p, w1 w = w1 xl ( p, w),
or more nicely, xl ( p, w) = xl ( p, 1) w. Then, saying that demand is homogeneous of degree
one is equivalent to saying demand is linear in income. Then, the elasticity of demand will
be one:
wl =
w
w
w
xl ( p, w)
= xl ( p, 1)
= xl ( p, 1)
=1
w
xl ( p, w)
xl ( p, w)
xl ( p, 1) w
x2
w)
x ( p,
x1
Figure 1: Engel curve for L = 2
Next, note Dw x ( p, w) = ( x1 ( p, 1) , x2 ( p, 1) , . . . , x L ( p, 1)). That is, given a fixed vector of
prices, Dw x ( p, w) is constant for all w.
So Engel curves will be linear. Figure 1 shows the case for L = 2.
5. (Loosely based on Rubinstein) Consider the following example taken from Kahneman and
Tversky (1984). Members of one group of subjects were presented with the following question:
(a) Imagine that you have decided to see a play and paid the admission price of $10 per
ticket. As you enter the theater, you discover that you have lost the ticket. The seat was
not marked and the ticket cannot be recovered. Would you pay $10 for another ticket?
Members of another group were asked to answer the following question:
(b) Imagine that you have decided to see a play where the admission is $10 per ticket. As
you arrive at the theater, you discover that you have lost a $10 bill. Would you still pay
$10 for a ticket to the play?
Consider the decision that an individual in the first group faces. Analyze the possible outcomes. Define the set X of alternatives and denote it by Xa . Consider the decision that an
individual in the second group faces. Analyze the possible outcomes. Define the set X of
alternatives and denote it by Xb . Compare Xa and Xb . What is your prediction about the
behavior of people in each group. Is that behavior consistent with rationality? Why?
Answer: Let us start with people in the first group. They have no ticket. They have some
money. Let M denote the amount of money they have. They can either buy a ticket and
spend $10 or not buy the ticket. The outcomes are (one ticket and M 10 dollars) or (no
ticket and M dollars) respectively. Then,
Xa = {( one ticket and M 10 dollars ) , ( no ticket and M dollars )}
Let us continue with the second group. They have no ticket. They have some money. Let M
denote the amount of money they have. They can either buy a ticket and spend $10 or not
buy the ticket. The outcomes are (one ticket and M 10 dollars) or (no ticket and M dollars)
3
respectively. Then,
Xb = {( one ticket and M 10 dollars ) , ( no ticket and M dollars )}
Consequently, Xa = Xb .
Regarding how people actually behaved, you might want to take a look at the original paper.
If you dont, have in mind that in the experiment, only 46% bought another ticket, but 88%
bought a ticket after being told they had lost a $10 bill.
http://www.bm.ust.hk/mark551/readings/T4cR4_kahneman1984.pdf

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Prof.

M ICROECONOMIC T HEORY - PS #2 - A NSWER K EY

So in fact, homogeneity of degree zero hols for all .

So Walras law only holds if = 1.

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