Problem Set 1

1 Growth Accounting
1.1. Labor and capital share of national income
labor income
national income
capital income

Labor share of national income :

Capital share of national income :

national income

wN d
Y

rK
Y

Y = zF IK, Nd M = zK1- INd M

Production function :

Profit-maximizing and price-taking behaviour of firms:

MaxNd HL = MaxNd HY - VCL = MaxNd IzK1- INd M - wNd - r KM

HL = zK1- INd M

-1

N d

-wU0

zK1- INd M
1-

zK

-1

IN M

=w

d -H1-L

z J

K 1-

Nd

=w
=w
wN d
Y

Labor share of national income :

zK

1-

zK

IN d M

1-

-1

IN M

N d

IN d M N d

IN M N d
d

MaxK HL = MaxK HY - VCL = MaxK IzK1- INd M - wNd - r KM

HL = H1 - L zK- INd M - r U 0

H 1 - L zK- INd M = r

H 1 - L z J

Nd
N
K

=r

Capital share of national income :

H1 -L zK IN d M K

rK
Y

zK

1-

IN M

H1-L K - K K
K

1.2 Firms demand for labour

MaxNd HL = MaxNd HY - VCL = MaxNd IzK1- INd M - wNd - r KM

N d

HL = zK1- INd M

1.3 Labor Tax

-1

zK1- INd M

-1

INd M

=w

-1

INd M = J

U(c,l) = log c + log l,

FINd M = zNd

-wU0

zK

-1

1-

N -1
1-
1

w
zK

where (0,1)

l + Ns = 100 | Ns = h - l = 100 - l
Constraint:

-1

=1-

zK

1-

1.3 Labor Tax

2

| Problem Set 1.nb

U(c,l) = log c + log l,

where (0,1)

FINd M = zNd

l + Ns = 100 | Ns = h - l = 100 - l
Constraint:
C w Ns + H - TL
C w Ns
C w(100-l)
Optimization:
m a x{ log c + log l }

s.t. c = w (100-l)

c,l

0 = c-w(100-l)
L(c,l,) = log c + log l + [c-w(100-l)]
FOC:

1
LHc, l, L = + = 0
c
c

II. LHc, l, L = + w = 0
l
l

III. LHc, l, L = c - 100 w

I.

1
c

-1
+I Mw
l
c

+l =0

I. = II.

c=w I100 l=

100
1+

=0

c
M
w

w
c

l=

c
w

in c = w (100-l)

100 w
1-

2. Sales Tax
2.1 Consumers nominal budget constraint
(a) ad valoram tax on consumption of c1 :
Y = c1 p1 H1 - t1 L + c2 p2

(b) per-unit tax on consumption of c1 :

Y = c1 Hp1 - t1 L + c2 p2
2.2 Change in the optimal choice of goods c1 , c2 through imposition of sales tax on c1
A per-unit sales tax on c1 has a similar effect as a price increase on good 1 for a consumer who has
a budget constraint that is subject to goods 1 and 2.
As a consequence, the price of c1 has risen by which the budget constraint line rotates inwards
along the c1 axis. This means a lowering of real income for the consumer where he or she has less
of c1 .
We extract the pure substitution effect from an increase in price of c1 by hypothetically imagining,
how the consumers optimal choice of goods would change, if the opportunity costs between c1 and

2.2 Change in the optimal choice of goods c1 , c2 through imposition of sales tax on c1
3|Problem Set 1.nb

3 | Problem Set 1.nb

A per-unit sales tax on c1 has a similar effect as a price increase on good 1 for a consumer
who has
a budget constraint that is subject to goods 1 and 2.

As a consequence, the price of c1 has risen by which the budget constraint line rotates inwards
along the c1 axis. This means a lowering of real income for the consumer where he or she has less
of c1 .
We extract the pure substitution effect from an increase in price of c1 by hypothetically imagining,
how the consumers optimal choice of goods would change, if the opportunity costs between c1 and
c2 would change for him or her (without a change in real income).
Thus we hypothetically compensate the initial real income loss by shifting the inwardly rotated
budget constraint line to the right until it tangentially intersects the consumers initial indifference
curve.
The distance on the c1 axis from the consumers initial optimal choice of goods to his or her new
optimal bundle of goods on his initial indifference curve constitutes the substitution effect.
The distance on the c1 from the consumers optimal choice of goods on his inwardly rotated budget
constraint line to the new optimal bundle of goods on his initial indifference curve would be the
income effect.
(Hicks Substitution)
2.3 Optimization
u Hc1 , c2 L = log c1 + log c2

s.t. Y = c1 p1 + c2 p2

m a x{ log c1 + log c2 }
c1 ,c2

0 =Y - Hc1 p1 + c2 p2 L

LHc1 , c2 , ) = log c1 + log c2 + [Y - Hc1 p1 + c2 p2 L]

= log c1 + log c2 + Y - c1 p1 - c2 p2
FOC:

LHc1 , c2 , L =
c1

II.
LHc1 , c2 , L =
c2

III. LHc1 , c2 , L =

I.

1
c1

I. p1 =
II.

1
c2

1
c1 p1

c1 =
c2 =

= p2
=

1
c2 p2

c2 p2
p1
c1 p1
p2

1
- p1 = 0
c1
1
- p2 = 0
c
2

Y - c1 p1 - c2 p2 = 0

1
;
c1 p1

c1 =

1
p1

1
;
c2 p2

c2 =

1
p2