Problem Set 1 Solution

ECON201 – Element of Economic Analysis II (Honors)

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Siying Cao

October 8, 2017

Question 1

(a) Anna solves the constrained maximization problem given by the following

max + xα1 x21−α

x1 ,x2 ∈Rn

s.t. p1 x1 + p2 x2 ≤ m

(b) The associated Lagrangian is

L(x; p, m) = xα1 x1−α

2 + λ(m − p1 x1 − p2 x2 )

The Kuhn-Tucker Theorem yields the FOCs for maximization:

• ∂L
∂x1
= αxα−11 x1−α
2 − λp1 ≤ 0, x1 ≥ 0, and ∂L
x
∂x1 1
= 0 [Complementary slackness
condition]
• ∂L
∂x2
= (1 − α)xα1 x−α
2 − λp2 ≤ 0, x2 ≥ 0, and
∂L
x
∂x2 2
= 0 [Complementary slackness
condition]
∂L ∂L
• ∂λ
= m − p1 x1 − p2 x2 ≥ 0, λ ≥ 0, and ∂λ
λ = 0 [Complementary slackness condition]
(c) To derive the demand function, we have to analyze the inequalities given in part (b).
Notice that the marginal utility of consuming good 1 M U1 = αxα−1
1 x21−α → ∞ as x1 → 0.
Thus, at the optimum, x1 > 0. Complementary slackness suggests that the derivative
w.r.t x1 holds with equality. The same goes for good 2. In addition, since utility is
strictly increasing in both goods so long as they are positive, budget constraint has to
bind. Otherwise, Anna could increase her utility by consuming a little more of one good.
∗
Please send any corrections to siyingc -at- uchicago -dot- edu

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 Hence we nail down to three equations in three unknowns given price vector p and income
m:

αxα−1
1 x1−α
2 = λp1
(1 − α)xα1 x−α
2 = λp2

p 1 x1 + p 2 x2 = m

Doing some simple algebra, we obtain

αm
x1 (p, m) = (1)
p1
(1 − α)m
x2 (p, m) = (2)
p2

(d) Anna’s expenditure on goods 1 and 2 are p1 x1 (p, m) = αm, and p2 x2 (p, m) = (1 − α)m,
respectively. These values do not change with p1 (or p2 ). In other words, no matter what
the prices of the two goods are, Anna always devotes α fraction of her income to good 1,
and the remaining (1 − α) to good 2. This is a property of Cobb-Douglas utility function.
 α  1−α
αm (1−α)m
(e) V (p, m) = u(x1 (p, m), x2 (p, m)) = p1 p2

(f) Mathematically, using the demand function derived in part (c), we have

αkm
x1 (kp1 , kp2 , km) =
kp1
αm
=
p1
= x1 (p1 , p2 , m)

for all k > 0. This shows that x1 (p1 , p2 , m) is homogeneous of degree 0. It is straightfor-
ward to prove the case for x2 (p, m).
(g) Applying the same trick, we have
 αkm α  (1 − α)km 1−α
V (kp1 , kp2 , km) =
kp1 kp2
 αm α  (1 − α)m 1−α
=
p1 p2
= V (p1 , p2 , m)

suggesting that the value function is also homogeneous of degree 0.

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(h) If the price of consumption goods and income are blown up by the same factor, the
purchasing power of the consumer is unchanged loosely speaking. Since Anna’s preference
stays the same, she will make the same choice before and after the nominal changes.
Subsequently the optimal level of utility she could obtain does not change either.
(i) Marginal utility of income at the optimal consumption bundle is

∂V 
M Um =
∂m x∗

=λ (3)

where the second equality uses the Envelope Theorem and the objects with stars denote
the optimal quantities.
Solving for λ from the system of three equations in part (c) and evaluating x1 and x2 at
the optimum, we obtain
 α α  1 − α 1−α
M Um =
p1 p2

(j) Using the expression for the value function derived in part (e), we can easily calculate

∂V  α 1+α  1 − α 1−α
= −m
∂p1 p1 p2
∂V  α α  1 − α 2−α
= −m
∂p2 p1 p2
where the partial derivatives are evaluated at the optimal consumption bundle.
Alternatively, we may resort to Envelope Theorem:
∂V 
 = −λ∗ x∗i , for i = 1, 2 (4)
∂pi x∗

Plugging in the optimal λ and xi gives us exactly the same answer as what direct com-
putation yields.
(k) Combining the result from (i) and (j), we have

∂V . ∂V mα
− = = x∗1
∂p1 ∂m p1
This should look familiar as it is exactly a representation of Roy’s identity. As we’ll see
in Question 2, this equality holds for a very general class of utility function.

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Question 2

(a) None of the results from Question 1 will change. Notice the utility function u(x1 , x2 ) =
α ln x1 + (1 − α) ln x2 = ln(xα1 x1−α
2 ), which is a monotone transformation of the utility we
have in Question 1 since the natural log function is strictly increasing. As a result, these
two utility functions represent the same preference – the objective of the maximization
problem facing Anna does not change at all.
(b) If the utility function is u(x1 , x2 ) = xα1 xβ2 , which is a slight generalization of the util-
α β
ity function in Question 1, the expenditure share of good 1 and 2 are α+β , and α+β ,
respectively. Homogeneity, Roy’s identity, and other useful properties all carry through.
(c) For an arbitrary utility function that is strictly concave and increasing, we formulate the
consumer’s problem as

max u(x1 , x2 )
x1 ,x2 ∈R+
n

s.t. p1 x1 + p2 x2 ≤ m

Strict quasi-concavity ensures that utility function is differentiable, and the strictly in-
creasing property guarantees the budget constraint holds with equality.
To see why the answers to (f)-(h) do not change, we know that multiplying price and
income by a positive number simply scales up the budget constraint to kp1 x1 + kp2 x2 ≤
km, which reduces to the same thing as before. Since the optimization problem facing
Anna doesn’t change, nor will the demand function and value function.
For (i)-(k), Roy’s identity which says the marshallian demand function

∂V . ∂V
xm
i = −
∂pi ∂m

The proof for this can be shown most easily if the utility function is differentiable in
both arguments. Combining the insights from equation (3) and (4) gives us the Roy’s
identity. This is just a special application of the Envelop theorem.

Question 3

(a) Recall the elasticity of substitution is defined as the percentage change in the relative
consumptions of two goods for a given percentage change in the relative prices.

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 Since at the optimal choice, the marginal rate of substitution M RS12 equals to the
relative price pp21 , we can rewrite the elasticity of substitution as

d ln( xx21 )
σ12 = −
d ln( pp21 )
d ln( xx12 )
=−
d ln M RS12

For the utility function given in this question, we have

M U1
M RS12 =
M U2
σ−1 σ−1 1
−1/σ
αx1 (αx1 σ + (1 − α)x2 σ ) σ−1
= σ−1 σ−1 1
−1/σ
(1 − α)x2 (αx1 σ + (1 − α)x2 σ ) σ−1
α  x1 −1/σ
=
1 − α x2

x1
Let x denote x2
, then

α 1
ln M RS12 = ln − ln x
1−α σ
1
d ln M RS12 = − d ln x
σ
d ln x
σ12 =− 1 =σ
− σ d ln x

Thus we’ve shown that the utility exhibits constant elasticity of substitution (CES)
characterized by parameter σ.
(b) If we could show ln u(x1 , x2 ) → α ln x1 + (1 − α) ln x2 as σ → 1, then we are done.
Note
σ σ−1 σ−1
ln u(x1 , x2 ) = ln(αx1 σ + (1 − α)x2 σ )
σ−1
Since both the denominator and nominator goes to 0 as σ goes to 1, we could apply
L’Hopital’s rule to get
σ−1 σ−1
σ−1 σ−1 αx1 σ ln x1 σ12 + (1 − α)x2 σ ln x2 σ12
lim ln u(x1 , x2 ) = lim ln(αx1 σ
+ (1 − α)x2 σ
)+σ σ−1 σ−1
σ→1 σ→1
(αx1 σ + (1 − α)x2 σ )
= ln(α + 1 − α) + 1 × [α ln x1 + (1 − α) ln x2 ]
= α ln x1 + (1 − α) ln x2

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 which is exactly what we want to show. The limit case of σ → 1 implies that a one
percentage increase in the relative price of the two goods can be perfectly offset by
substituting towards the relatively cheaper good, leaving the (optimal) expenditure on
good 1 and 2 unchanged.

Question 4

(a) The marginal product labor for a fixed level of capital is given by

∂f (k̄, l)
M Pl ≡ = (1 − α)Ak̄ α l−α
∂l
This quantity is positive for any α ∈ (0, 1) as long as the fixed level of capital input and
labor are positive.
(b) To see what happens to M Pl when labor input changes, we look at the quantity

∂M Pl
= −α(1 − α)Ak̄ α l−α−1
∂l
which is negative for any α ∈ (0, 1). Therefore, the production function exhibits dimin-
ishing returns to labor for all values of α in the range of 0 and 1.
(c) The lower curve in Figure 1 plots the firm’s M Pl schedule when capital is fixed at k̄

Figure 1: M Pl before and after the capital increase

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(d) Before the capital increase, we have M Pl (k̄) = (1 − α)Ak̄ α l−α . After we increase the
fixed capital level to k ∗ , M Pl (k ∗ ) = (1 − α)Ak ∗α l−α . At any point of labor input l, the
∗
marginal product of labor is increased by a multiple of ( kk̄ )α .
(e) Labor and capital are Edgeworth complements if the cross derivative of production func-
tion is positive, i.e. flk > 0. In our example,
∂f (k, l) ∂M Pl
flk ≡ = = α(1 − α)Ak α−1 l−α
∂k∂l ∂k
which is strictly positive for any α ∈ (0, 1) and k, l > 0. Hence, labor and capital are
Edgeworth complements in this case. Adding one more capital to the production plan
increases the conversion rate of labor to output.
(f) See Figure 1 for illustration. Graphically, the M Pl schedule shifts upward when the fixed
capital level increase from k̄ to k ∗ . More specifically, the distance between the two curves
as we move along the labor axis is proportional to the old M Pl at the corresponding level
of labor.

Question 5

(a) The lower curve in Figure 2 is the isoquant when output is equal to 1.

Figure 2: Isoquant when output y = 1, 2

1 1
Setting f (k, l) = Ak 2 l 2 = 1 reveals how k and l are inversely related in producing 1 unit
of output.

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(b) The upper curve in Figure 2 corresponds to the isoquant when output is equal to 2.
(c) Using k1 unit of capital and l1 unit of labor yields 1 unit of output, as is represented by
point A in the graph. Once we double both inputs so that we are at point A0 , we double
the output as well. The movement from point B to B 0 tells the same story.
(d) A production function exhibits constant returns to scale if f (tk, tl) = tf (k, l) for all t > 0
and all k, l ∈ R+ . In our example, we have
1 1 1 1
f (tk, tl) = A(tk) 2 (tl) 2 = tAk 2 l 2 = tf (k, l)

Thus, we’ve shown that the Cobb-Douglas function exhibits CRS.

(e) For any point on the isoquant y = ȳ, scaling all factor inputs by t > 0 would produce a
new isoquant y = tȳ.