Price Theory Problems

Matthew E. Kahn

Johns Hopkins University and NBER and IZA

July 2019

1
Preface

In fall 1988, I enrolled as a Ph.D. student in the economics department at the University of
Chicago. Having attended Hamilton College (and the London School of Economics for my
junior year), I had limited preparation for the logical rigor of the Price Theory Sequence. I
would attend lectures by ​Gary Becker,​ ​Sherwin Rosen​, ​Jose Scheinkman​, ​Lester Telser​ and
Robert Townsend​ and I would walk out scratching my head and having ever more questions.
Thirty years have now passed and I still have many questions.

This book uses little mathematics. A basic understanding of calculus and high school algebra
and statistics is sufficient to follow the arguments.

Throughout this document, I list several references. Please use Google to learn more about
economists named and economic concepts that I discuss. These references inspired the actual
problems.

2
The Problems

1. Trade vs. Autarky

1’. Supply and Demand
2. The Roy Model of Comparative Advantage
3. Household Economics
4. Standard Consumption Theory with a "Becker Twist"
5. The Cost of Climate Change
6. The Diet Problem
7. Hyperbolic Discounting
8. Rational Addiction
9. Risk Smoothing through the Family versus the Market
10. Risk Smoothing through the Village
11. The Family and the Quantity vs. Quality Tradeoff
12. Fertility in the Developing World
13. The Permanent Income Hypothesis
14. The Benefits of Regulation?
15. Revealed Preference and Patriotism
16. Compensating Differentials
17. Identification of Preferences using Revealed Preference Methods
18. Lotteries
19. Lotteries and Social Preferences
20. Option Value and Discrete Choice Over Human Capital Investment
21. Robust Decision Making
22. Robust Decision Making II
23. Urban Housing and Labor Markets
24. The Microeconomics of Regression Discontinuity Research Designs
24’ Instrumental Variables and Willingness to Pay
25. Hedonic Estimation and Infra-Marginal Households
26. Pollution Exposure and Offsetting Using Market Products
27. Model Mis-specification and Inference
28. Labor Supply
29. Adapting to Spatial Risk
30. Rebound Effects
31. Sea Level Rise
32. Urban Transportation Mode Choice
33. The Coase Theorem
34. Crime and Punishment
35. Car Insurance

3
36. Revealed Preference and Self Selection
37. Disneyland
38. Air Conditioning and Firm Productivity
39. Durables Demand and Expectations
40. Becker's Discrimination Model
41. Differentiated Product Supply
42. Moral Hazard and Firm Contracts
43. Matching and Heterogeneous Workers Matched to Heterogeneous Firms
44. Misallocation and Productivity Wedges
45. Farmer Adaptation to Climate Change

4
Lecture #1 The Gains to Trade

Why do we trade with each other? How do we measure the gains from trade?

You are stranded on an island and you are all alone. You are unable to store food. Each day
you have 300 minutes to allocate to two tasks. Either you can look for wood to make a fire or
you can catch fish.

Your utility function = minimum(wood collected, fish caught). So, if you find 6 units of wood
and catch 5 fish. Your utility = 5. This is the “Leontief Utility Function”.

You know that you can find one unit of wood if you spend 10 minutes looking and you can catch
a fish if you spend 5 minutes in this activity. These are your production technologies.

Your time budget constraint can be written as: 300 = 10*wood + 5*fish

Given the nature of the utility function, you will choose to consume an equal amount of wood
and fish. Substitute this into the time budget constraint so; 300 = 15*fish = 15*wood so fish =
20 and wood = 20. Your utility = 20.

In this economy, there is no market and there is no trade.

You now receive a message in a bottle that says that Jane is stranded on another nearby island.
In her note, she writes; “I can find one unit of wood if I spend 5 minutes looking and I can catch
a fish if I spend 10 minutes in this activity.” These are Jane’s production technologies.

Will I trade with Jane?

We have different production capabilities. I can catch 2 fish in 10 minutes or I can find one unit
of wood in 10 minutes. The opportunity cost of my looking for 1 unit of wood is that I give up 2
fish. I have a comparative advantage in fishing. Jane can find 2 units of wood in 10 minutes or
catch 1 fish. Her opportunity cost of finding 1 unit of wood is she gives up ½ of a fish. She has
a comparative advantage in looking for wood.

5
Economics predicts if you can trade with others that you should specialize in your comparative
advantage. If I specialize in fishing, I will catch 300/5 = 60 fish. If she specializes in finding
wood , she will find 300/5 = 60 units of wood.

Note that “world” production just increased. Before Jane and I interacted, we produced 40 fish
and 40 units of wood. Now together, we have produced 60 fish and 60 wood.
Trade breaks the link between consumption and production. Each of us will now consume 30
fish and 30 wood and both of our utility will increase by 10.

Now, note that I assumed that trade between the islands was costless.

Question: ​What is the most that Jane and I would be willing to pay to build a transport canal
between us?

Note that the market structure plays a key role in this economy. Matt made different time
allocation choices when he could not trade with Jane. When he knows that he can trade with
Jane, he chooses to specialize.

Question: ​There is a 4% chance each day that a typhoon will destroy the canal connecting Matt
and Jane. If the maximum life of the canal is 6 days, what is the most that Matt will be willing to
pay on the first day to build the canal? Assume that Matt is risk neutral and the interest rate is
0%.

Question: ​Given that Matt and Jane are the only people on this ocean, the canal can only be
built if they build it. They are both equally good at producing a canal and it will take 80 minutes
of time to build the canal. Fill in the matrix below and discuss what is the Nash Equilibrium to
this simultaneous move game if this game is played once: To simplify the strategy space, we
assume that each player can devote 0 minutes, 40 minutes or 80 minutes to building the canal.
Assume the canal lasts for just 1 day. Use the opportunity cost information presented above.
Note that if the canal isn’t built then the economy returns to autarky.

6
Fill in the 9 entries using the notation : (jane’s total utility, Matt’s total utility)

Matt Spends Matt spends 40 Matt spends 80

0 minutes minutes minutes

Jane spends 0
minutes

Jane spends 40
minutes

Jane spends 80
minutes

Question: ​If they play this game every day forever, could cooperation emerge? (Assume that
the transport device only exists for 1 period and must be rebuilt each period).

7
Supply and Demand

1. People who live in the United States can live in Miami or Atlanta. For a cost, one can
move from one city to the other. Draw 4 supply and demand graphs with 2 for each city.
In each city, there is a local labor market and there is a local housing market.

A. A large number of immigrants unexpectedly arrive in Miami. Who bears the economic
incidence of this shock in the short run?
B. Use your 4 supply and demand graphs to show the long run equilibrium.

Borjas GJ, Freeman RB, Katz LF, DiNardo J, Abowd JM. How much do immigration and trade affect labor
market outcomes?. Brookings papers on economic activity. 1997 Jan 1;1997(1):1-90.

2. Consider the markets for apples and potato chips. Poor people spend a larger share of their
income on food. Environmentalists now convince the U.S Congress to ban pesticides used in the
apple growing industry. These pesticides kill bugs that destroy apples. How does the ban on
pesticides affect the equilibrium price and consumption of apples and potato chips? Show using
your supply and demand diagram. What is the unintended consequence of this regulation for
poor children’s diets? How does economic analysis inform public policy design?

3. Housing is highly durable and often lasts for 100 years. Assume that Detroit features
300,000 homes built before the year 2000. Assume that homes never depreciate and assume that
no new homes have been built in Detroit over the last 18 years. Assume the marginal cost of
building a new home in Detroit is $160,000 and the construction industry has constant returns to
scale.

Graph Detroit’s aggregate housing supply curve in the year 2018.

Do increases in Detroit housing demand and decreases in Detroit housing demand have
symmetric effects on local house prices and equilibrium quantities of housing? Use your
diagram to show your answer and explain.

Glaeser EL, Gyourko J. Urban decline and durable housing. Journal of political economy. 2005
Apr;113(2):345-75.

David H, Dorn D, Hanson GH. The China syndrome: Local labor market effects of import competition in
the United States. American Economic Review. 2013 Oct;103(6):2121-68.

8
4. In the 1950s and 1960s, women faced significant limits (due to labor market discrimination)
on their career opportunities in the U.S labor market. A vast majority of working women were
either social workers, or teachers. In recent decades, women’s labor market opportunities (i.e
becoming a computer programmer or a physicist or an investment banker) began to increase.
Women have responded to these opportunities by investing more in their human capital.

Assumptions;

1. Women differ among each other with respect to their ability.

2. Women have the same ability distribution as men.
3. Teachers all work at public schools and teaching pays less than investment banking.
4. Investment banking requires more skill than teaching.
5. Women were not allowed to be bankers in 1950.
6. The demand for investment bankers and teachers does not change over time.
7. School teachers work fewer hours per week than investment bankers

Suppose that there are only two labor markets; school teachers and Investment Bankers.

1. Draw the market equilibrium in the two markets in 1950 when women did not have the
opportunity to be an investment banker.
2. Over time, women can now enter investment banking. Use a new pair of supply and
demand graphs to show the new equilibrium.
3. What happens to the average quality of teachers over time? What is the weighted
average algebra that determines teacher quality at each point in time?
4. Given that teaching pays less, why would some talented women choose this sector?
(hint: what are workers maximizing when they choose which sector to work in?)

Lakdawalla D. The economics of teacher quality. The Journal of Law and Economics. 2006
Apr;49(1):285-329.

Flyer F, Rosen S. The new economics of teachers and education. Journal of Labor Economics. 1997 Jan
1;15(1, Part 2):S104-39.

Goldin C. The quiet revolution that transformed women's employment, education, and family. American
economic review. 2006 May;96(2):1-21.

9
10
Lecture #2 ​The Roy Model of Comparative Advantage

The previous exercise on women’s occupational choice implicitly assumed that ability is “1
dimensional” and fixed for each person. This means that if I know your IQ that this is a
sufficient statistic for your ability. Economists reject this view. Read Heckman’s review of the
Murray’s The Bell Curve.

Heckman JJ. Lessons from the bell curve. Journal of Political Economy. 1995 Oct 1;103(5):1091-120.

We view people as embodying a vector of skills that can be augmented by investments. We now
explore comparative advantage in a large economy featuring many, many people. In this lecture,
we will explore how different types of people self select to enter a specific occupation. This
approach can be used to study many different assignment problems ranging from the choice of
marriage partner, to choosing a home, to choosing a city to live in.

Here are some famous references that explore in more technical detail some of the issues we
explore below;

Roy AD. The distribution of earnings and of individual output. The Economic Journal. 1950 Sep
1;60(239):489-505.

Heckman JJ, Honore BE. The empirical content of the Roy model. Econometrica: Journal of the
Econometric Society. 1990 Sep 1:1121-49.

Heckman J, Scheinkman J. The importance of bundling in a Gorman-Lancaster model of earnings. The

Review of Economic Studies. 1987 Apr 1;54(2):243-55.

An Economy

People differ with respect to their skills. For now, we will assume that this variation is “God
Given” or exogenously determined. In a later problem, we will endogenize this variation by
allowing individuals to invest in building up their skills (human capital). While skill can be
multidimensional, to keep this simple, everyone has embodied in them two skills called “brains”
and “muscle”. Each of these can be measured in units that take on the values 0 to 100. A
person with 100 units of muscle and 100 units of brains is “the best”.

11
The economy features two sectors; one is called construction and the other one is called Silicon
Valley. Each of these sectors has a different production function for producing its output and
thus it has a different demand for worker skills.

Each person knows her own skill endowment. For example, Alice may have 87 units of brains
and 38 unit of muscle. She rents them to a labor market sector and is paid a given amount of
income. A key point is that a person must rent her brains and muscle to the same sector. This is
called ​bundling.

Each person in the economy must decide whether she will work in construction or in Silicon
Valley.

Some notation

Sector Market price for each unit of Market price for each unit of
worker Brains worker muscle

Silicon Valley p brains,s p muscle,,s

Construction p brains,c p muscle,c

Questions

1. Assume that worker i has S1i units of brains and S2i units of muscle. Use the algebra
to write down her income if she chooses to enter sector Silicon Valley. Write down her
income if she chooses to enter Construction.
2. Assuming she chooses the sector with the highest income, write down an algebra
equation that determines whether person i enters construction.
3. Use the matrix below as the economy’s factor prices in the year 2018. Make a graph
with brains on the x-axis and muscle on the y-axis.

Sector Market price for each unit of Market price for each unit of
worker Brains worker muscle

Silicon Valley 23 2

12
 Construction 8 18

Shade the area such that this subset of people chooses to work in construction. Discuss the
economic intuition of the slope that separates the two sets. For some technical details see page
3, Definition​ 2 here.

4. Holding one’s salary at the same level in both sectors, why would most people choose to
work in Silicon Valley? What are “compensating differentials”?
5. Suppose that each worker who works in Construction suffer pain equal to $-40 each
year. This is the sector disamenity effect. Does this change your answer to question #3?
Sketch out the set of “marginal people” who would work in construction if there was no
disamenity effect from the job but now choose to work in Silicon Valley because of the
disamenity effect caused by this sector.
6. Building on #5, for workers who choose to work in construction, suppose that they can
buy a $20 spacesuit that protects them from all of the construction disamenities. How
does this affect the labor market equilibrium?
7. Return to question #3, suppose that due to technological advances in construction, the
market price for brains in this sector increases from 8 to 9. Assuming no other changes to
the economy, how is the equilibrium assignment of workers to sectors affected?
8. Define the word “being at the margin” in the context of your answer to #7.
9. Suppose that a space Alien visits earth and observes the incomes of people who choose to
enter construction and the incomes of people who go to Silicon Valley. This alien
observes each person’s brains but not their muscle. This alien runs two separate OLS
regression of the form: income = a + b*brains + u with one estimated for each sector.
If the economy’s data is generated using the information reported in question #3, will the
alien estimate a “b” = 23 for the Silicon Valley sector and equal to 8 for the construction
sector? Why? Does your answer depend on what is the correlation between a worker’s
brains and muscle? Use a random number generator to test this by taking draws of
workers with correlations of -.5, 0 and .5 between their brains and muscle. In each of the
3 cases, draw 1000 draws of brains and muscle for each worker. Use the information in
question #3 to assign each worker to a sector. Run 6 regressions (2 for each sector under

13
 each of the 3 skill correlation structures) and discuss whether you recover the “true” b on
skills. Explain. Hint, what is “u” in the above regression? Does it have a mean of zero?
10. Suppose that a progressive President places a tax on Silicon Valley so that all workers in
this sector now pay 25% of their income in taxes to the government while construction
workers are not taxed. Under what conditions on the joint distribution of brains and
muscle in the population will very little tax revenue be collected by the government?
How can you use a version of the graph in question #3 to calculate the deadweight loss
from this tax?
11. Building on #10, redo question #3 in the presence of this tax and identify the subset of
workers who now substitute from working in Silicon Valley and now work in
construction.
12. A new baby is born with 12 units of brains and 12 units of muscle. Given the factor
prices in #3 are in steady state; she can invest $X dollars each year for 6 years and then
enter the labor force with 64 units of brains and 12 units of muscle. Solve for the
constant annual interest rate such that she is indifferent between making this investment
or not. To keep this simple, assume that the worker works for just 1 year.
13. In this economy, there were 2 sectors and each worker has 2 skills. Suppose that the
number of sectors that the worker can work grows large so there are now 32 sectors to
choose from. If every other one of these 30 other sectors attracts workers, do the factor
prices in the construction and Silicon Valley sectors place any restrictions on the factor
prices in these other sectors?

Now let’s add additional realism to this model. In an Overlapping generations (OLG) model,
there are three generations alive at any point in time. There are the young, the middle aged, and
the old. The young must make a choice whether to work or study. If they work, they must
choose a sector (construction or Silicon Valley). The middle aged work and must only choose a
sector. The old must choose whether to retire or to work. If they work, they choose a sector.

14. Draw supply and demand graphs for the labor market for construction and Silicon Valley.
Draw the the separate graphs under the assumption that equilibrium earnings are higher in
Silicon Valley than in construction.

Under the assumption that Silicon Valley is brains intensive, under what conditions will young
people choose not to go to work and instead will invest in education to increase their “brains”
that they can sell to the market when they are middle aged and old?

14
Under the assumption that the young is a large cohort, if the young invest in human capital this
period, how does this affect the current generation of middle aged people’s decision to retire the
next period when they are old?

A final point: ​Rename the sector called Silicon Valley “the labor force” and relabel the sector
called Construction “household production”. With this relabeling and the assumption that we do
not observe the “earnings” for those who choose to work in the household production sector, we
now have Jim Heckman’s famous selection bias model. We only observe the earnings for the
select sample of people who choose to work in the labor force sector. Since this is not a random
subset of the population, key “selection issues” arise.

https://economics.mit.edu/files/4092

https://www.bauer.uh.edu/rsusmel/phd/ec1-24.pdf​ (see start on slide 29)

15. Use algebra to show the formula for calculating the average brain power and muscle for
those who choose not to work. How would you calculate the 90th percentile of the muscle
distribution for the subset of the population who chooses not to work in the labor force? (hint:
this is easy to calculate given the data for each person’s brains and muscle and given an indicator
on whether each person works). What algebra condition must hold in order for this person to be
observed choosing to be in the home sector?

15
Lecture #3: Household Economics

This lecture focuses on household production. I use this to discuss women’s labor force
participation, optimal fertility and the famous fertility decision and the “quantity/quality”
tradeoff.

Gary Becker argued that households are a special type of firm. While you can make coffee at
home or you can go to Starbucks. There are other examples of “make versus buy” decisions
where you have to make “the good” yourself. If you want a quality child, you cannot buy one.
You must produce one. This lecture focuses on this household production.

Some optional reading.

Michael RT, Becker GS. On the new theory of consumer behavior. The Swedish Journal of Economics.
1973 Dec 1:378-96.

Greenwood J, Seshadri A, Yorukoglu M. Engines of liberation. The Review of Economic Studies. 2005
Jan 1;72(1):109-33.

Question: ​Consider the economics of producing a pizza. The local pizza place is selling a pizza
for $15. You can produce an identical pizza if you buy $3 worth of ingredients and use $.2
worth of electricity and 26 minutes of your time to buy the ingredients and to cook it. Your
goal is to minimize the full cost you incur by eating a pizza. Your full cost reflects both your
time and your expenditure. An observer notes that you choose to buy the pizza rather than make
the pizza.

1. If you value your time at $W per hour, what has the observer just learned about your
value of time?
2. If the price of pizza goes up to $45 and you now choose to make your own pizza, can the
observer make a stronger statement about your hourly wage?

This is an example of “partial identification” based on revealed preference logic. From

observing your choice and from posting your objective criteria (in this case to minimize your
costs) the researcher learns about you from the choices you make. You reveal your type based
on the choices you make).

I present many of these types of problem​s in this Amazon Book.

16
Becker GS. A Theory of the Allocation of Time. The economic journal. 1965 Sep 1:493-517.

Dating back to Becker (1965), household consumption theory has noted that both a person’s
time and market goods are used to produce goods. If making dinner at home costs you $11.42 in
ingredients and 45 minutes in time, then the “full price” of this cooking is 3*W/4 + 11.42.
W = the hourly wage.

Question: ​Standard Consumption Theory with a “Becker Twist”

You gain pleasure from consuming beer and eating pizza. The price of beer = $1 per unit and the
price of pizza is $2 per unit. You earn $20 an hour and there are 24 hours in a day.

Your utility function equals = 100 * beer.5 + 100 * pizza.5

1. What is your utility maximizing consumption bundle?

2. Now suppose that it takes you 5 minutes to drink a beer and it takes you 12 minutes to eat
a slice of pizza. If you are eating or drinking, you cannot work. Resolve for your utility
maximizing bundle. Why has your answer changed? (hint: what is the full price of
consuming each good now?).
3. Return to question #1 and assume that you have $480 in total and you do not work. From
your training in intermediate micro, you know that you solve this problem by using the
budget constraint and the first order conditions from the maximization problem (i.e
equating the marginal utility per dollar spent on each good). Once you have solved for
the optimal beer and pizza consumption as a function of market prices and your income,
you can substitute these demand functions into the utility function to yield the indirect
utility function. This function tells you the maximum utility you can achieve given
market prices for goods and your income. Convince yourself that this function is a
decreasing function of market prices and an increasing function of income.

17
New Question: ​The Cost of Climate Change

You gain utility from eating pizza and you lose utility when the temperature is too hot. Here is
your utility function:

utility = 50 * √pizza − 5 * (temperature − 65)2

You are endowed with 10000 pieces of pizza.

Climate Scientists have estimated the following regression:

Temperature = 65 + .001*tons of CO2

1. Due to increased car driving in China, global tons of CO2 have increased by 1000 so the
temperature outside has increased from 65 degrees to 66 degrees. How much are you
willing to pay (measured in slices of pizza) for one less ton of CO2 to be released? This
is the social cost of carbon (SCC) imposed on you as an externality. See
https://epic.uchicago.edu/news-events/news/michael-greenstone-testifies-social-cost-carb
on
2. Now suppose that you can buy an air conditioner for a fixed cost of 15 slices of pizza and
an operating cost of 4 slices of pizza per degree of outdoor heat that must be offset. If
the outdoor temperature is 70 degrees, will you buy the air conditioner? What
temperature will you be exposed to? Does the social cost of carbon in this economy still
equal the SCC you solved for in question #1? Why? Explain.
3. This problem makes an assumption that would make most environmentalists angry.
What assumption is being made? Challenge this assumption by naming cases where this
assumption is false.

Barreca A, Clay K, Deschenes O, Greenstone M, Shapiro JS. Adapting to climate change: The
remarkable decline in the US temperature-mortality relationship over the twentieth century.
Journal of Political Economy. 2016 Feb 1;124(1):105-59.

18
Question: ​The Diet Problem

The pizza and beer consumption problem focused on utility maximization. We can also explore
expenditure minimization. Consider the famous Stigler Diet Problem.

Stigler GJ. The cost of subsistence. Journal of farm economics. 1945 May 1;27(2):303-14.

Silberberg E. Nutrition and the Demand for Tastes. Journal of Political Economy. 1985 Oct
1;93(5):881-900.

The store sells 3 foods called banana, burger and berries. Your goal is to minimize your
expenditure on food such that you achieve your daily basic nutrients. The following matrix
provides the key information. Note that each food is a bundle of vitamins. You cannot buy these
vitamins individually. You instead purchase a food that embodies these attributes you need to
survive. You must achieve the minimal nutrition goal or you die.

Food Vitamin A in 1 Vitamin B in 1 Vitamin D in 1 Price to

unit unit unit purchase 1 unit

Banana 40 20 0 4

Burger 100 0 20 8

Berries 0 10 100 11

Your Minimum 400 400 400

Nutritional
needs

What is the minimum amount of money you need to spend each day to meet your nutrition
goals?

Here is some Stata code for solving this.

log using diet, t replace

input z
1
end

19
expand=200
gen burger=_n
sort burger
expand=200
drop z
sort burger
quietly by burger: gen berry=_n
expand=200
sort burger berry
quietly by burger berry: gen banana=_n
replace burger=burger/10 -.1
replace berry=berry/10 -.1
replace banana=banana/10 -.1
summ
gen totalcost=4*banana+ 8*burger+ 11*berry
gen VA=40*banana+100*burger
gen VB=20*banana+10*berry
gen VD=20*burger+100*berry
keep if VA>=400 & VB>=400 & VD>=400
sort totalcost
list if _n==1
gen totalcost2=4*banana+8*burger+6*berry
sort totalcost2
list if _n==1

If due to a reduction in trade costs with Mexico, the price of Berries declines from $11 to 6, does
your answer change? How much money do you save thanks to being able to purchase cheaper
imports from Mexico?

A philosophical question​: Do poor people solve this cost minimization problem? Or, do they
solve a utility maximization problem? Why do poor people eat fast food? Why are Type 2
diabetes rates high among poor people?

20
New Question: Hyperbolic Discounting

You live for three periods called 1, 2 and 3. You have $2000 and the price of pizza always
equals one. The interest rate is 0%. Your utility function each period = √pizza . Your budget
constraint = 2000 = pizza1 + pizza2 + pizza3

You seek to maximize the following criteria;

lif etime utility = √pizza1 + B * δ * √pizza2 + B 2 δ * √pizza3

Where B is the discount factor and δ is a parameter representing your “now bias”. Both B and δ
lie between 0 and 1.

1. At time period 1 solve for your optimal pizza consumption each period.

Now suppose you are given the opportunity at time 2, to resolve your life consumption plan.

2. At time period 2, your objective function now equals

remaining lif etime utility = √pizza2 + B δ * √pizza3

Your budget constraint at this point = 2000 - pizza1 = pizza2 + pizza3 where pizza1 equals
your solution in question #1. Does your solution to #1 represent the solution to #2? What is
time inconsistency? Why does it arise in this problem? (hint: If δ = 1 , would your answer to
#1 and #2 have been the same?)

Laibson D. Golden eggs and hyperbolic discounting. The Quarterly Journal of Economics. 1997 May
1;112(2):443-78.

21
New Question: Rational Addiction

A person lives for 3 periods. She gains utility from pizza and from smoking. Her utility in any
period equals:

utility in period t = √pizzat + 10 * ( S t )

S t = Cigarst − Cigarst−1

Assume that the price of pizza always equals 1. Assume there is no discount factor. There is a
period by period budget constraint such that the person has $2000 each period to spend. Assume
that Cigars0 = 0. Note that this utility function features habit persistence.

1. If the price of a cigar is expected to always equal 1, what is this person’s optimal
consumption?
2. If the price of a cigar is expected to equal 1 in period 1, 10 in period 2 and 1000 in period 3,
what is the optimal consumption?

Becker GS, Murphy KM. A theory of rational addiction. Journal of political Economy. 1988 Aug
1;96(4):675-700.

Constantinides GM. Habit formation: A resolution of the equity premium puzzle. Journal of political
Economy. 1990 Jun 1;98(3):519-43.

Becker GS, Grossman M, Murphy KM. Rational addiction and the effect of price on consumption. The
American Economic Review. 1991 May 1;81(2):237-41.

22
New Question: Risk Smoothing Through the Family versus The Market

You consume only pizza and you live for at most T years. If your consumption of pizza each
year ever falls below 4, then you die because of starvation. You have no access to financial
markets or savings. You receive an endowment of pizza each year that is drawn from a normal
distribution N(6,1). If your pizza endowment is ever less than 4 you die and you collect no utility
from that point until date T.

Your annual utility function = pizza

Assume that your annual discount factor = .95

1. Calculate your lifetime expected utility. Show your algebra.

2. Now you can marry another person. Each year, this person draws from a normal
distribution pizza endowment with independent draws over time distributed N(6,1). The
correlation of your endowment and this person’s endowment = -1. You have agreed to
the following risk sharing contract, each year your consumption = (person a’s endowment
+ person b’s endowment)/2 . Measured in slices of pizza at time 0, how much would
you be willing to pay to marry this person?
3. Repeat #2 under the assumption that the correlation of your endowments = 0. Why does
your willingness to pay to marry this person decline?
4. How does your answer to #2 change if at age 0 you are given for free a bond that pays
you 1 slice of pizza each year until you die? Explain why this reduces your willingness
to pay to marry.

Government transfers (and such social insurance) are a substitute for transfers from family members.

Edlund L, Pande R. Why have women become left-wing? The political gender gap and the decline in
marriage. The Quarterly Journal of Economics. 2002 Aug 1;117(3):917-61.

Costa DL. A house of her own: old age assistance and the living arrangements of older unmarried
women. Journal of Public Economics. 1999 Apr 1;72(1):39-59.

Costa DL. Displacing the family: Union army pensions and elderly living arrangements. Journal of Political
Economy. 1997 Dec;105(6):1269-92.

23
Question: Risk Smoothing Through the Village

This problem is based on :

Townsend RM. Risk and insurance in village India. Econometrica: Journal of the Econometric Society.
1994 May 1:539-91.

You consume only pizza and you live for 1 year. You have no access to financial markets or
savings. You receive an endowment of pizza that is iid distributed from a normal distribution
N(6,1). Assume endowments cannot be negative.

Your utility function = √pizza

1. Calculate your expected utility. (feel free to approximate this using the properties of a
Normal distribution).
2. You live in a village with 4 other people. You agree to a risk sharing contract that pools
all of your endowments and then gives you 20% of the total endowment. Calculate your
expected utility under this arrangement. Why has your expected utility increased?
3. You live in a village with 19 other people. You agree to a risk sharing contract that pools
all of your endowments and then gives you 5% of the total endowment. Calculate your
expected utility under this arrangement. Why has your expected utility increased? (hint:
what distribution is the mean consumption of this village converging to as the number of
people in the village goes to infinity?)
4. A development economist visits your village and measures each person’s consumption
and observes each person’s endowment. She runs a person level OLS regression of the
form:

Consumption for person i = a + b*endowment for person i + U

Assume that the data are generated based on the contract discussed in question #3 above. You
can generate these data and run the regression based on the model and the data generating
process (so there are 20 data points in the regression). Does a=0 and b=1 or is a>0 and b=0?
5. Suppose that each of the 20 people now each live in their own village and cannot sign a risk
sharing contract, if you re-run the same regression (see #4 above) using these data, do your
estimates of a and b change? explain.

24
25
New Economy: the Family and the Quantity vs. Quality tradeoff

An adult values his own consumption and he also wants to have many children and he wants his
children to be high quality.

His utility function can be expressed as U(c,N,quality) where c is his private consumption, N is
his number of children and quality is each child’s average quality.

The adult knows the production function of producing a quality child.

Quality = f(time with child, nanny time with child, market inputs)

Time with child = the number of hours the adult spends with the child
Nanny time with child = the number of hours a paid nanny spends with the child
Market inputs = a vector of other inputs such as piano lessons and tutors that can be purchased.

Question: What assumptions do you make about the child production function? For example
what is the relationship between the marginal product of adult time with the child versus the
marginal product of nanny time with the child? Are they complements or substitutes?

Assume that there are 24 hours in a day and the adult’s time is valued at $W per hour. The
budget constraint for the adult is:

(24 - time with child*N)*W = c + P_market*market inputs + P_nanny*nanny hours

Why is this the budget constraint? What assumptions does this algebra make about the adult as a
household “public good”?

Write out the first order conditions for this problem in choosing, c, N and child quality.

Conduct the following comparative statics:

If the wage goes up, what happens to the adult’s optimal quantity/quality tradeoff?

If market inputs become more productive (new computers), what does this do the family?

26
China has had a one child policy. Use this model to identify households for whom this is a
binding constraint.

Why does Hillary Clinton have 1 child? Note that the problem above featured a 1 person
household.

Readings

Becker GS. Nobel lecture: The economic way of looking at behavior. Journal of political economy. 1993
Jun 1;101(3):385-409.

Becker GS, Lewis HG. On the Interaction between the Quantity and Quality of Children. Journal of
political Economy. 1973 Mar 1;81(2, Part 2):S279-88.

Becker GS, Tomes N. Child endowments and the quantity and quality of children. Journal of political
Economy. 1976 Aug 1;84(4, Part 2):S143-62.

Heckman JJ. The economics, technology, and neuroscience of human capability formation. Proceedings
of the national Academy of Sciences. 2007 Aug 14;104(33):13250-5.

27
New Problem: Taxation over the Lifecycle and Home Production

A government must raise 100,000 dollars a day in revenue. It can tax labor and this is its only
source of revenue. All workers in the economy have the same ability and all workers of the
same age have the same preferences defined over pizza and leisure.

A worker of age X has a utility function of the form:

U tility = √pizza + 500/X * √leisure

The after tax budget constraint for this worker is:

W*(1-tax)*(24-leisure) = pizza and 0<=leisure<=24 , 0<tax<=1

Assume that workers are between the integer ages of 40 and 44 and age is uniformly distributed
integers so 20% of the population is 40, 20% is 41, 20% is 42, 20% is 43 and 20% is 44.
Assume that W = 50.

1. If there are 10,000 workers in this economy, solve for the optimal tax rate if all workers
must be taxed the same tax.
2. Graph the indifference curves of a person of age 30 versus a person of age 60. What do
learn about their respective marginal rates of substitution? Resolve #1 if the tax can vary
as a function of age. Discuss this tax function’s properties. Why is this society better off
from moving away from uniform taxation?
3. Now suppose that there is the opportunity to engage in home production of pizza. A
person who makes pizza at home can produce 40 slices per hour. The new budget
constraint can be written as; W*(1-tax)*(24-leisure-home production) = pizza purchased
and pizza = pizza purchased + 50*hours engage in home production. Will this
opportunity to engage in home production change your answer to #2? If “yes”, then solve
for the new optimal tax function. Provide intuition.

See:

http://www.people.hbs.edu/mweinzierl/paper/SurprisingPowerOfAge-DependentTaxes_REStud_
2011.pdf

28
Question: The Benefits of Regulation?

An Uber driver seeks to maximize his expected income. Expected income = probability of
survival*earnings. If he drives at a higher speed he can make more income because he can make
more trips but he raises his death risk. Define p(s,M) as his probability of surviving driving M
miles at an average speed of “s” miles per hour. This function is decreasing with respect to its
first element and decreasing with respect to its 2nd argument. If a driver drives M miles for uber
he earns θ * M in revenue. The Uber drives for 20 hours a day. Recall that average speed = s
= M/20.

Given these assumptions, the risk neutral Uber driver chooses M and s to maximize:
p(s,M)* θ * M subject to the time constraint that 20 = M/s

1. Write down the first order conditions to this problem.

2. Now the government mandates new vehicle safety regulation that reduces the Uber
driver’s probability of death to 0. Re-solve for the new equilibrium and explain.
3. Does this new regulation impose any risks for anyone in the economy?

Peltzman S. The effects of automobile safety regulation. Journal of political Economy. 1975 Aug
1;83(4):677-725.

Viscusi WK. The lulling effect: the impact of child-resistant packaging on aspirin and analgesic ingestions.
The American Economic Review. 1984 May 1;74(2):324-7.

29
New Problem: Revealed Preference and Patriotism

After the terrorist attacks of 9/11/2001, many young American men volunteered for the U.S
Army. Such men were aware that they were placing themselves at risk. A famous example is
the NFL star ​Pat Tillman.

Consider the set of all men aged 23 in the United States in the year 2000. Suppose we observe
each of these men’s earnings that year. Some will have high earnings and some will have low
earnings. Suppose that the opportunity cost of working in their year 2000 job is that they can
join the Army and be paid $20,000 per year. Now suppose the 9/11/2001 attack occurs.
Who volunteers to fight for the U.S Army?

We will study a very special case in order to simplify the math. We will assume that nobody
dies by fighting in the army. The only thing you sacrifice by joining the army is that you lose
your civilian sector pay for one year. If you join the army, you gain the pleasure of volunteering
and serving your country.

For every 23 year old man, let us assume that his utility function is an increasing function of his
earnings and whether he volunteers for the Army. Earnings is measured in $ and volunteer takes
on the values 0 and 1. Volunteer equals 1 if the man volunteers and it equals zero if he stays in
the civilian sector.

Our goal here is to learn about each person’s ​ . This measure of patriotism can differ for every
person in the economy. For example, if a person has a equal to 17 then she would be willing
to sacrifice $17 in earnings for the honor of volunteering to fight for our country. We learn
different information based on who does and does not volunteer to fight for the Army.

For each 23 year old, we observe the following data. His civilian earnings, his earnings as a
soldier ($20,000) and whether he volunteers or not. A patriot is somebody who has a large
value of . We seek to learn about this parameter.

Before I write out some math, let me provide you with some intuition. If a person chooses to
volunteer for the army when he could earn $10 million dollars a year as a civilian, then he must
be a patriot because he just sacrificed 10 million - 20,000 to join the Army! Conversely, if
another worker’s civilian earnings are just $4,000 a year then he actually gains a pay raise of
$16,000 by joining the army. This person will join the army even if his equals zero!

30
So, suppose that Matt Kahn makes $122,000 and joins the Army and now earns $20,000. If Matt
chooses to join the Army based on Utility maximization then his utility from being in the Army
must be greater than his utility from not being in the Army.

Matt’s Utility in the Army can be written as:

Matt’s Utility in civilian life equals;

Given that Matt chose to be in the Army, his utility from being in the Army must be greater than
utility from not being in the Army, so the following condition holds for matt;

Each man reveals information about his by whether he volunteers or not. For men who do
volunteer, we recover a lower bound on their patriotism by comparing their earnings in the
civilian and soldier sectors. For men who do not volunteer we recover an upper bound on their
patriotism by comparing their earnings in the civilian and soldier sectors. To appreciate this
point, consider Jerome. He chooses not to volunteer and he earns $33,000 a year. From these
data we learn that an upper bound on Jerome’s is $13,000.

Note that anyone with a Δ equals zero will join the military if his civilian salary is less than
$20,000 (recall that the military pays $20,000) and anyone with a Δ equal to zero will not join
the military if their opportunity cost (their civilian salary) is greater than $20,000. Every man
whose earnings and Δ are such that his earnings-20000 + Δ > 0 will volunteer for the army
because they raise their utility by doing. Every man knows his own earnings in the civilian
sector and his own patriotism parameter (his Δ ). He “reveals his type” to the economist by
making his volunteer choice.

31
New Problem: Compensating Differentials

Compensating differentials ​is a key concept that dates back to Adam Smith.
See ​http://www.massey.ac.nz/~hengelbr/08BorjasCh6.pdf​. Sherwin Rosen (my thesis advisor)
made major advances in pushing this subject to the front of labor economics.

Rosen S. Markets and diversity. American Economic Review. 2002 Mar;92(1):1-5.

A job can be described along two dimensions. Each job has an annual earnings and each job has
a probability of death. Assume that all workers have identical tastes and talents. Assume that
workers can costless switch from one job to another.

Assume that if the worker dies that he receives 0 utiles.

If each worker’s utility is of the form;

utility = cα where c is consumption priced at $1 per unit and 0 < α < 1 , what do you learn
about α based on the following data? Assume that workers choose a job to maximize their
expected utility.

Job Death risk Earnings in 2018

Dog walker 0 $25000

Construction .02 $62000

Define the Value of a Statistical life = the extra earnings paid to compensate a worker for taking
a 1 percentage point increase in the chance of death * 100.

Now assume that ½ of the population has been randomly assigned to take a course on how to
walk on construction sites. This education has reduced their death risk from 2% to 1%.

Using a supply and demand diagram for dog walking and another diagram for construction, how
does this treatment affect the earnings in the two occupations? In equilibrium, would the
education treatment change the estimated Value of a statistical life?

32
New Problem: Semi-Parametric Identification of Preferences Using Revealed Preference

A researcher knows that he does not know Matt’s preferences over pizza and beer. He is sure
that Matt’s preferences feature diminishing returns and that Matt’s Preferences are separable
such that U(pizza,beer) = g(pizza) + f(beer).

The researcher watches as Matt makes 3 choices. Here is what the researcher now knows;

Observation (price of pizza, price Matt’s Income Matt’s choice

of beer) (pizza, beer)

1 (4,1) 200 (16,136)

2 (2,2) 304 (92,60)

3 (3,6) 636 ( 160, 26)

1. In a consumption graph, with pizza on one axis and beer on the other, graph the three
budget constraints and the 3 optimal choices.
2. What restrictions can you place on Matt’s Marginal rate of substitution (MRS) based on
these data?
3. If you the researcher have complete control over experimenting here (rather than waiting
for market forces to nudge prices and income to change), what experiment would you run
to more tightly pin down Matt’s MRS?

Samuelson PA. Consumption theory in terms of revealed preference. Economica. 1948 Nov
1;15(60):243-53.

Varian, Hal
http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.115.9983&rep=rep1&type=pdf

33
New Problem: Lotteries 1

An economy consists of 15 people. Each of them is risk averse and each maximizes her
expected utility. If a person dies, she receives 0 utiles.

Each person’s utility can be expressed as: utility = √(pizza − 4)

Each person needs to consume at least 4 pieces of pizza to survive.

1. Graph the person’s utility as a function of pizza.

2. Each person has an endowment of 4 pieces of pizza. What is the gain to each person
from participating in a lottery where 1 person wins the lottery and receives all 60 slices of
pizza? Use your graph to show the geometry of your algebra. Assume your probability
of winning the lottery = 1/15 (hint: look at the chord connecting the origin to the utility
level associated with 60 units of pizza).

Rosen S. Manufactured inequality. Journal of Labor Economics. 1997 Apr 1;15(2):189-96.

New Problem: Lotteries and Social Preferences

Consumption in society is normally distributed N(20000,4000) (so 4,000 is the standard

deviation). Matt has a consumption level of 16000. Matt has “keeping up with the Jones”
preferences such that he loses utility as a function of what percentage of the population is richer
than him. So, if Matt is in the 40th percentile of the income distribution then F( cmatt ) = .4 and
60% of the population is richer than him.

utility = 100 * √cmatt − 50 * (1 − F (cmatt ))

1. Holding matt’s consumption constant, how does his utility change if the rest of society
becomes richer? What is your explanation for this?
2. Now matt is offered the opportunity to participate in the following lottery. If gives up
2000 units of consumption, he has a 50% chance of receiving 0 and a 50% chance of
receiving 3500 units of consumption. Does Matt participate in this lottery? Given his
concave utility function, is his interest in playing the lottery surprising?
3. If matt’s initial consumption level had been 24000 would your answer have been
different?

https://dornsife.usc.edu/assets/sites/350/docs/Prof._Fernando_Zapatero_slides.pdf

34
New Problem: Option Value and Discrete Choice over Human Capital Investment

You are risk neutral. You have $5,000 in the bank and you cannot borrow. You are 15 years old
and you will work until you are 30 years old. The annual interest rate is 5%. You do not have a
high school diploma. You know the data reported below:

Education Level Years of study Tuition per year Age when can Earnings per
work year with this
level of
education ($)

No High School 0 0 15 8000

High School 3 0 18 8100

College 3 12000 21 18000

Your goal is to maximize your expected PDV of lifetime earnings net of tuition costs. You can
only go to college if you have completed high school. So, college requires 6 years of investment.

1. If you can borrow and lend at a 5% interest rate, what is your optimal human capital
investment level?
2. Given the constraint that you only have $5,000 in the bank and you cannot borrow, what
is your optimal choice of educational attainment that you can afford?
3. Now assume that a new government policy offers a full college tuition scholarship to
33% of all high school graduates. So, the tuition cost of college goes to $0 for these
scholarship winners. These lucky 33% will be chosen at random from the high school
graduate pool. Does your answer to #2 change? Why?
4. A new disease arises that kills everyone at age 23, does your answer to #3 change?
5. How is this simple discrete choice problem related to dynamic programming and choice
under uncertainty? What role do expectations play in this economy? In reality, how do
people form these expectations of what their earnings will be in the future if they achieve
a given level of education?

Buchinsky M, Leslie P. Educational attainment and the changing US wage structure: dynamic implications
on young individuals’ choices. Journal of Labor Economics. 2010 Jul;28(3):541-94.

Manski CF. Measuring expectations. Econometrica. 2004 Sep 1;72(5):1329-76.

35
New Problem: ​Robust Decision Making

You must drink a cup of coffee each morning or you die. If you die, you receive 0 utiles. You
have 1 hour each day. You live for at most 1 day. Your job pays you $35 for this hour and the
price of pizza equals 1. You can either make your own cup of coffee or you can buy a cup of
coffee. It takes you 30 minutes to make a cup of coffee and the ingredients cost $0. If the
coffee shop is open, you can buy a cup of coffee for $5. Your utility function = 4*pizza.

1. There is only one coffee seller and whether this coffee shop is open is a random variable.
Define the probability that it is open as; ϕ . If you are risk neutral, write down an
equation such that you choose to buy your coffee. Assume you must make your decision
to go to the coffee shop or make your own coffee before you know whether the coffee
shop is open. How do you choose to allocate your time?
2. Building on #1, now suppose you know that you do not know the probability ϕ. Now
assume that your goal is maximize your utility in the worst state of the world. What is
your new optimal time allocation strategy? Explain.
3. Extra credit: Building on #2; what is the relevance of the ideas embodied in this problem
for thinking about the economics of adapting to climate change?

Lars Hansen and Thomas Sargent, Robustness https://press.princeton.edu/titles/8535.html

36
New Problem: ​Robustness II

This is a simplified version of a problem worked out in the Hansen and Sargent Robustness
book.

A consumer lives for two time periods called 1 and 2. Her utility function is:

√c1 + B * √C 2 B is the discount factor and 0<B<1

Consumption always has the price = 1. In time period 1, she receives an endowment of $200.
She can save at a 10% interest rate. She cannot borrow.

She knows that at time period 2, there will be a lottery. There is a 50% chance she receives
$300 then and a 50% chance she loses the lottery and receives $50 .

1. A researcher observes that she consumes 160 at time period 1 and 344 at time period 2.
Did she win the lottery at time period 2? Using her first order conditions, solve for her B.
2. Using the B you estimated in equation (1), now consider the following. The consumer
seeks to follow robust decision rules and she is worried that she does not know δ . This is
the probability of winning the lottery. She believes that a lower bound for δ = .2 .
What is her optimal consumption in periods 1 and 2?
3. Building on #2, the researcher does not know that the consumer seeks to follow robust
decision rules. The researcher assumes that the consumer is maximizing expected utility.
What mistake will the researcher make about this consumer’s B if the researcher assumes
that consumption was chosen based on expected utility maximization while the consumer
actually tried to maximize utility subject to robust decision rules? Provide intuition.

37
Lecture #5 Urban Housing Markets and Labor Markets

This lecture allows me to explore the famous “hedonic pricing gradient”. This pricing gradient
prices out different differentiated products. For example, a Mercedes is a better car than a
Toyota Camry but given the higher price for the Mercedes relative to the price of a Camry the
products become much closer substitutes once you take into account the price differential.

The Urban Economy

Everyone in a city works in the city center and lives in an identical housing unit. Housing units
differ with respect to their distance to the city center. Distance is measured in miles. There is
one transportation technology that moves at 20 miles per hour. Everyone has the same hourly
wage of $10.

Question #1: ​If commutes are round trip each day and if the daily rent for a housing unit
downtown with a commute time of 0 is $300 what is the rental price of a house 15 miles from the
city center? In this economy, what is a “spatial equilibrium”?

Question #2: ​If farmers can generate $200 of daily profit using the land that a house would sit
on, does this place any restrictions on the shape of the city? Where will farmers operate in this
geographic area? Explain.

Question #3: ​Suppose that 10% of the population have a wage of $100 an hour and 90% have a
wage of $10 an hour, who will live where in this city? Why? Would your answer change if the
people who make $100 an hour can buy cars that move at 80 miles an hour? Why?

Question #4: ​Do your answers to questions #1 and #2 change if the train can now move at 40
miles per hour due to importing Japanese technology?

Readings

LeRoy SF, Sonstelie J. Paradise lost and regained: Transportation innovation, income, and residential
location. Journal of Urban Economics. 1983 Jan 1;13(1):67-89.

38
Urban Economy #2​ The Microeconomics of Regression Discontinuities (RD)

Over the last 20 years, more applied micro scholars have used regression discontinuity research
designs. Such research studies changes at borders to achieve a sharp jump in a “cause variable”
to study how an effect changes. This research implicitly assumes that the unobservables do not
also “jump” at such boundaries. The goal of such RD research designs is to “cleanly estimate” a
causal effect such as the effect of school quality on home prices.

Black SE. Do better schools matter? Parental valuation of elementary education. The Quarterly Journal of
Economics. 1999 May 1;114(2):577-99.

Bayer P, Ferreira F, McMillan R. A unified framework for measuring preferences for schools and
neighborhoods. Journal of political economy. 2007 Aug;115(4):588-638.

Lee DS, Lemieux T. Regression discontinuity designs in economics. Journal of economic literature. 2010
Jun;48(2):281-355.

A house has four attributes. One is the square footage of the house, one is whether it is in a good
school district or not and one is whether the home has a jacuzzi in the bathroom and one is
outdoor climate

All people have the same utility function but they differ with respect to their income. The typical
person’s utility function is of the form;

utility = 40 * √square f ootage + 20 * test score + 30 * √climate + 1000 * j acuzzi +

40*pizza + 12*test score*jacuzzi

The budget constraint equals;

Income = price(square footage, school test score, jacuzzi, climate) + pizza

Note that there is a complementarity between the home’s quality (as measured by whether it has
a jacuzzi) and local neighborhood quality (as proxied by local elementary school test scores).

1. Write down the first order conditions for how much square footage a person with a given
income will buy.
2. If a person j chooses to buy a home with a Jacuzzi, what algebra condition must hold
true?

39
 3. Suppose that whether a home has a jacuzzi or not is not observed by the econometrician.
The econometrician examines average home prices for homes of the same square footage
that are close to each other (so they have the same climate) but the homes are located in
different school districts with one district featuring high test scores and the other district
featuring low test scores.

The researcher calculates N

Where N = E(average home price | high test score) - E(average home price|low test score)

Does this consistently estimate the average household’s willingness to pay for good schools?

Suppose that a homeowner can install a jacuzzi for a $500 payment. If the researcher is unaware
of this technology for upgrading the quality of the home (and still does not observe which homes
have jacuzzis), does this affect the estimate of N and the interpretation of N as the marginal
willingness to pay for good schools?

Provide your intuition for why the RD approach breaks down in this economy. Is “all else equal”
as you cross the school district border?

40
New Problem

An economy features people who all have the same preferences defined over Clean Air and pizza
and opera music. Migration costs across cities equal zero. All people earn the same amount of
money that can be spent on rent or pizza. Opera music and Clean Air vary across cities but not
within cities. These are local public goods.

Assume that the correlation of Clean Air and Opera Music =1 so cities with really clean air have
great opera music.

The representative agent’s utility function is:

utility = β 1 * clean air + B 2 * Opera M usic − rent

1. What is the equilibrium relationship between rents in city l and city m? Does cross-city
variation in clean air and opera music and rent allow you to recover estimates of β 1 and
β2 ?
2. Suppose a cross-sectional econometrician had data on each city’s rent and clean air level
and runs a regression of the form; Rent = a1 + a2*clean air + U. Will a2 be related to
β 1 ? Explain. (hint: the econometrician does not observe the “opera quality” in each
city).
3. Now suppose that the government introduces clean air regulation by randomly assigning
50% of the cities to this treatment. Clean air doubles in these treated cities. Assuming
the spatial distribution of Opera Music does not change, does the introduction of this
government policy allow you to recover estimates of β 1 and β 2 ?
4. Returning to question #2, If you estimate that same rental hedonic regression but this
time first difference and use the data only for the subset of cities assigned to the
randomized treatment; so you run the regression; Delta rent = c1 + c2*Delta Clean Air +
delta U ; Will c2 be related to β 1 ? Explain.

Chay KY, Greenstone M. Does air quality matter? Evidence from the housing market. Journal of political
Economy. 2005 Apr;113(2):376-424.

41
New Problem: Hedonic Estimation and Infra-Marginal Households

A society features two types of people. One type have asthma and suffer greatly from being
exposed to air pollution. The other type have a mild distaste for being exposed to air pollution.

Here are their respective utility functions defined over pizza and pollution.

utility asthmatic = 50 * √pizza − .4 * pollution

utility non−asthmatic = 50 * √pizza − .1 * pollution

Every person has an income of $1,000 and the price of pizza equals 1. There are two geographic
locations. One is called San Francisco and it has a pollution level of 100 and the other is called
Houston and it has a pollution level of 1000.

Assume that asthmatics are 70% of the population and ½ of the population must live in San
Francisco and ½ must live in Houston due to housing supply constraints.

1. Describe the spatial equilibrium. Who lives in which city? Make a graph with pizza and
pollution on the axis. Graph the indifference curves for both types of people and label
San Francisco and Houston as points in this attribute space.
2. Solve for the equilibrium rent to live in each city. This rent is paid to a landlord who is
outside of the model.
3. Use your answer to #2 to estimate the price of purchasing clean air. Does the OLS
coefficient recovered by estimating price = a +b*pollution + U, recover any interesting
information about either type’s utility function?
4. Solve for the consumer surplus that asthmatics receive in this economy versus the
consumer surplus that the non-asthmatics receive.
5. Government offers to reduce pollution by 20% in Houston in return for taxing everyone
who lives there by 10% of their income. Assuming that Houston’s rent does not change,
would a majority of the people who choose to live in Houston vote in favor of this
government policy? Explain.

42
New Problem: Pollution Exposure and Offsetting Using Market Products

Each person has the same health production function but differs with respect to how they are
willing to trade off health for pizza. Science research has estimated the following offsetting
production function for health. Health = 40 - .5*pollution + .1*medicine.

Pollution is determined by outdoor air pollution and this varies exogenously. Everyone has the
same income level of 200. The price of pizza = 1 = price of medicine in 2018 and 2019. In the
year 2020 and 2021 the price of pizza =1 and the price of medicine = .5

Each person has their own Marginal Rate of Substitution between Health and pizza. Assume that
the utility function is additively separable in health and pizza. From collecting credit card
information on person #1, you observe the following data about her consumption and her
pollution exposure;

Person pollution date pizza medicine

1 44 2018 100 100

1 66 2019 80 120

1 62 2020 140 120

1 80 2021 110 180

1. Based on these data, what have you learned about person 1’s willingness to pay for health
(measured in slices of pizza)? (hint: graph each consumption bundle in pizza, health
space and present the two budget constraints and 4 consumpt

2. Consider a specific utility function of the form; utility = α1 * √pizza + √health . Given
the data reported above, you will have 4 equations as a function of one unknown parameter α1 .
Use numerical methods to estimate this parameter such that these 4 equations all hold true.

3. Econometricians often discuss the topic of partial identification. Discuss the relevance of this
concept for this problem. (hint: is the utility function in #2 the only relevant utility function?)

4. Continuing with problem #2 and given your estimate of α1 what would be person 1’s pizza
and health level if his income increased to 300 and the pollution level equaled 94 and the price of
pizza=1.5 and the price of medicine=1.5? Why is recovering an estimate of a utility function
useful? http://nber.org/papers/w24688

43
New Problem: Model Misspecification and Inference

THIS problem is identical to the previous problem with 1 twist. The researcher studying the
decision maker is using the wrong model of health production.

Each person has the same health production function but differs with respect to how they are
willing to trade off health for pizza.

The researcher believes t​hat the following function is the production function for health.
Health = 40 - .5*pollution + .1*medicine.

The decision maker knows t​hat the following function is the production function for health.
Health = 40 - .5*pollution + .2*medicine.

Pollution is determined by outdoor air pollution and this varies exogenously. Everyone has the
same income level of 200. The price of pizza = 1 = price of medicine in 2018 and 2019. In the
year 2020 and 2021 the price of pizza =1 and the price of medicine = .5

Each person has their own Marginal Rate of Substitution between Health and pizza. Assume that
the utility function is additively separable in health and pizza. From collecting credit card
information on person #1, you observe the following data about her consumption and her
pollution exposure;

Person pollution date pizza medicine

1 44 2018 100 100

1 66 2019 80 120

1 62 2020 140 120

1 80 2021 110 180

1. Consider a specific utility function of the form; utility = α1 * √pizza + √health . Given
the data reported above, and GIVEN the researcher’s misspecified model of health production,
you will have 4 equations as a function of one unknown parameter α1 . Use numerical methods
to estimate this parameter such that these 4 equations all hold true.

2. Resolve #1 using the correct health production function. Why do the answers differ? Provide
intuition.

44
Labor Supply

There are 24 hours in a day. A low skilled person can make $10 per hour. The price of pizza
equals $1 per unit.

Each person i in the economy has a different utility function of the form:

utility i = αi * √pizza + leisure (1)

The constraints are;

24 = leisure + hours worked

Pizza = hours worked*10

Each person knows his own α . The econometrician knows that (1) is the general utility
function but knows nothing else about the distribution of α across the population.

1. If αi = .5 , solve for this person’s optimal labor supply.

2. A progressive is elected President and she enacts a new policy that gives 50 units of pizza
to people who do not work but gives 0 to people who do work, solve for the αi of a
person who is indifferent between not working and working given this incentive.
3. The researcher observes the percentage of low skilled people who now choose not to
work. If the welfare payment rises to 75 units, why does this “exogenous variation” help
accelerate academic research? What do you now know about the population that you
would not have known had the welfare payment never changed?
4. Now suppose that the government learns from Europe (see
https://www.nytimes.com/2018/04/24/business/finland-universal-basic-income.html​) and
introduces a “Universal Basic Income” that guarantees all low skilled workers 50 slices
of pizza regardless of whether they work or not. If αi = .75 , solve for this person’s
optimal labor supply.
5. From the standpoint of the econometrician who seeks to learn the empirical CDF of αi
is the welfare program or the UBI a more useful source of exogenous variation? Why?
explain.

More Reading; ​Moffitt R. Incentive effects of the US welfare system: A review. Journal of Economic
Literature. 1992 Mar 1;30(1):1-61.

45
New Problem: Adapting to Spatial Risk

An economy consists of 99 people. Each person must choose to live in one of 3 locations. Each
location has 33 identical homes. The 99 people differ with respect to their income. Incomes are
uniformly distributed from $1,000 to $100,000 with 1 person having an income of $1,000, 1
person having an income of $2,000 etc. Everyone has the same preferences and seeks to
maximize expected utility.

There are three locations called A, B and C. Location A has a 40% chance of having a disaster.
Location B has a 20% chance of having a disaster and location C has a 10% chance of having a
disaster. If a disaster occurs, the person receives a utility = 0. These probabilities of disaster
decline if people invest in public protection and/or private protection (see below).

Assume that the utility function = √consumption . Each person’s budget constraint =
income = consumption + tax + protection - location rent

Within each of the 3 locations, the 33 people who live there choose a common tax that each
person pays. The revenue collected is 33*tax. This is spent on a ​local public good ​that reduces
the location specific disaster risk. Assume this production function takes the form:
public protection = .004 * √33 * tax .Once an individual chooses a location and knows the tax
and public protection level, each individual can choose to spend $ on private protection. Such
expenditure reduces an individual’s disaster risk and this production function is written as:
private protection = .05 * √protection

Assume that the median voter determines each of the 3 community’s tax and service packages.
(hint: there will be 3 different tax and public protection levels across A, B and C).

probability of disaster = exogenous disaster risk - public protection - private protection,

1. If community A charges a rent = 0, solve for equilibrium rents in B and C such that the
poorest 33% of people live in A and the richest 33% of people live in C
2. What is the expected utility for the person whose income is $45,000? Explain.
3. How does this additive separability simplify this problem?
4. Discuss the following comparative statics; if private self protection productivity
increased, would public protection go up or down? If climate change increases the risk
of death by 5 percentage points in communities A, B and C, would the richest people
fully offset this risk using public and private self protection? Would the poorest offset
this risk? What do you learn about the inequality effects induced by climate change?
New Question: Rebound Effects
46
There is only one type of car and it achieves 30 miles per gallon (MPG). People gain utility from
driving and from eating pizza. People differ with respect to their marginal utility from driving.
The price of gasoline =2 and the price of pizza = 1. The price of this car is $4,000. Each
person has an income of $10,000. Person i’s utility function can be expressed as;

utility i = αi * √mileage + √pizza (1)

1. How much will person i drive?

2. She now chooses between buying 2 different vehicles; either purchase the 30 MPG
vehicle for $4,000 or the 40 MPG vehicle for $5,000. Calculate the α of the consumer
who is just indifferent between purchasing these vehicles. For this consumer, calculate
her gallons of gasoline consumed if she drove the 30 MPG vehicle versus if she drove the
40 MPG vehicle. Does her consumption of gasoline (miles/MPG = gallons) decrease by
33%? Explain. If αi is larger, why is the “energy savings” from the fuel economy
improvement smaller?
3. Given that it takes time to drive and the opportunity cost of driving is working to earn the
income, how does this affect the likelihood of observing a rebound effect?
4. An empirical researcher believes that equation (2) is the general form of each person’s
utility function but does not know the empirical CDF of α .

utility i = αi * √mileage + √pizza + B*1(MPG = 30 Vehicle) (2)

The researcher observes the following percentages that add up to 100%

Mileage 30 MPG Vehicle 40 MPG Vehicle

Less than 10000 20% 14%

>=10000 15% 51%

1(MPG=30 Vehicle) is a dummy that equals one if the person purchases the 30 MPG vehicle and
it equals 0 otherwise. Everyone has the same valuation of the two vehicles types. So, 14% of all
people buy a 40 MPG vehicle and then drive it less than 10,000 miles. Based on this aggregate
information and equation (2), what restrictions can you place on the CDF of α and B?

West J, Hoekstra M, Meer J, Puller SL. Vehicle Miles (Not) Traveled: Why Fuel Economy Requirements
Don't Increase Household Driving. National Bureau of Economic Research; 2015 May 21.
New Problem: Sea Level Rise

47
Everyone has the same utility defined over survival and eating pizza. The utility function is
defined as: utility = prob(survival) * √pizza . Each person has $10,000 and the price of
pizza=1. Each person must live in location A or B. The budget constraint can be written as
10000 = pizza + rent

Here are the relevant data describing these places

Place probability(survive) Rent

A .75 4000

B .25 X

1. Solve for X.
2. Now sea level rise lowers the probability of survival in location B to .2 while it does not
affect A. Solve for the new X such that the spatial equilibrium exists. Interpret what the
change in X means.
3. Now suppose that 50% of the population must live in A and 50% of the population must
live in B due to exogenous housing supply. Suppose that 60% of the population are
climate deniers who believe that their probability of survival =1 in both locations.
Assume that the probabilities in the table are the true probabilities. Where do the climate
“believers” live? Do they gain from living in an economy where there are a large number
of climate deniers? Why?

https://www.sciencedirect.com/science/article/pii/S0094119018300354

48
New Problem​: Urban Transportation Mode Choice

Every person must choose a commute mode. People differ with respect to their value of time.
Everyone has the same goal of minimizing their total cost of commuting. Total cost of
commuting differs by mode. Here are the data;

Mode Speed (MPH) Fixed Cost in $ Fixed cost in Cost per mile in
minutes $

Uber 30 5 5 .5

bus 15 1.75 10 0

car 30 50 0 .25

1. For a person who makes a M mile trip, define this person’s wage per hour as W (the
opportunity cost of time). If this person chooses to commute by Uber, what restrictions
can you place on M and W?
2. Building on #1, if Uber is unavailable for the week and the person is now observed to
commute by car, what restrictions can you now place on M and W?
3. Assume that everyone on the bus makes ten mile trips, solve for the highest wage
earner’s wage who rides the bus.
4. The bus has a capacity to hold 40 people while Uber and cars transport a single
passenger. The city seeks to reduce traffic congestion by encouraging commuters to
substitute to commuting by bus. Will introducing free bus trips be more effective at
encouraging modal substitution to buses than a gas tax that raises the price per mile by
25%?

49
New Problem​: The Coase Theorem

Bruce has the property rights to smoke a cigar. He gains $400 in pleasure from smoking the
cigar. The cigar costs him $40 and it causes him $30 in health damages.

1. If nobody makes him an offer to not smoke, will he smoke?

2. 10 children are playing close to Bruce. Each would suffer $X dollars in health damage if
Bruce smokes. Solve for $X such that it is efficient for Bruce to smoke.
3. Suppose that X equals $42. What challenges will this group face to make Bruce a pareto
optimal offer? Would this problem be less likely to arise if there was only 1 child who
suffered 10*X in damage from Bruce’s smoke? Why?
4. Now suppose there are 1000 victims from his smoker who all suffer X/100 in damage
and X=42. Can this externality problem now be solved without government?

50
New Problem​: Tiebout and the Size and Types of Communities

There are 2000 people who gain utility from eating pizza, c, and enjoying a local public good,
G. Each person i’s utility function if she locates in community j can be written as:

utility ij = B i * Gj + 10 * √ci

B is uniformly distributed from [0,1]

Each person’s budget constraint can be written as: 1000 = C + tax

Assume that the population is equally divided across communities and that everyone who lives in
a given community pays the same tax and enjoys the same level of the local public good.

The cost function of producing G units of the public Good = F + .2*G*G.

The tax = cost of public goods/count of people who live in the community. Note that this tax
varies by community. So, taxes and local public goods vary across communities but not within
communities.

1. Assume there are two communities called 1 and 2. People with a B greater than .5 live
in 1 and people with a B <=.5 live in 2. Assume the median voter determines the tax and
G for each of the communities. Solve for the equilibrium tax and G in each community
and double check that B=.501 does not want to move from community 1 to 2.
2. Now suppose there can be 4 equally sized communities and in each of these
communities, the median voter will determine the tax and G. Does everyone in this
economy gain consumer surplus from having more choice? Explain. What role does
“F” play in determining your answer?
3. Write out the optimization problem to calculate the optimal number of communities in
this economy. How could you solve this problem?

51
Lecture #6: Firms

Crime and Punishment

A risk neutral firm must choose whether to pollute a nearby river or legally dispose of the toxics.
The firm must pay $10,000 to dispose of the toxics. If the firm illegally dumps the chemicals,
there is a probability ϕ it will be caught. If it is caught it will be fined $F.

What is the key equation for determining whether this firm will legally dispose of the toxics?

Suppose the firm can pay a one time fixed cost of $36,000 to reduce its emissions to zero. If the
firm’s factory will last for 5 years and if the annual interest rate is 4%, write down the key
algebra equation if this risk neutral firm chooses to make this anti-pollution investment.

If a Republican leader is expected to be elected in year 3 and if Republicans do not enforce

regulations, does this affect the firm’s ex-ante decision to invest in pollution control?

Becker, Crime and Punishment, JPE

https://www.journals.uchicago.edu/doi/pdfplus/10.1086/259394

52
New question ​Car insurance

A libertarian state drops the law that car drivers must have car insurance. Car insurance costs
$F per year. If you cause an accident, you will be sued for $1 million dollars. Everyone drives
the same number of miles each year but people differ with respect to their driving ability.
Assume that people seek to minimize their expected cost of driving. Define θ as the
probability of having an accident.

If Jane chooses to buy insurance, what has the researcher just learned about Jane’s belief about
her θ ? If the price of insurance rises to 1.3*F and she continues to buy insurance, what do we
now know about her θ ?

53
​Revealed Preference Again: Self Selection

A cell phone company makes money by selling phones and minutes used to make calls using the
phones.

The cell phone company recognizes that people differ with respect to their preferences. It
believes that person i has the following utility function:

utility i = αi * √minutes − price of phone − p * minutes

Where p is the price per minute. Note that in this expression every person has his own αi . The
firm does not know this parameter but it is positive.

The phone company knows that there are 1000 possible customers considering buying its phone.

The phone company offers plan A where the price of a phone is $200 and p = .05. Solve for
person i’s optimal number of minutes spent on the phone. Solve for the cutoff person who does
not buy a phone.

The phone company offers plan A where the price of a phone is $200 and p = .05 and it offers
plan B where the price of the phone is $100 and p=.1. Solve for the new set of cutoffs for αi
for those who choose neither plan, those who choose plan A an those who choose plan B. Solve
for the optimal minutes that the phone is used for , for people who choose plan A and a separate
function for those who choose plan B.

A researcher observes which plan each person picks and their number of minutes they use the
phone. From these data, how could the researcher place restrictions on the empirical CDF of αi
?

Provide intuition for why when the phone company introduces more plans to choose from that
this allows the researcher to provide tighter bounds on the empirical CDF of αi .

54
Disneyland

Disneyland welcomes 1000 people to have fun going on rides. Disneyland knows that there are
two types of people; high wage people who are willing to pay to not wait on line and lower wage
people who hate high prices for tickets but do not mind waiting on line. Disneyland knows that
½ of the people are one type and ½ of are the other type but Disneyland doesn’t know who is
who.

Assume that each ride takes 20 minutes and there is a 40 minute wait if you do not have an
express pass. High wage people earn $99 an hour and low wage people earn $21 an hour.

The demand for rides for each person = 400 - 2*(full price of a ride)

The full price of the ride is a function of the market price of the ride + the value of time lost
during the ride and waiting for the ride.

1. If Disneyland must treat everyone the same, what is its best pricing strategy and how
much revenue does it collect?
2. Disneyland introduces the VIP Pass. For a fixed entry fee of $1000, those who buy the
VIP pass are promised to have a 0 minute wait for each ride. What percentage of visitors
buy this VIP pass? How much does Disneyland’s revenue rise by? How much extra
consumer surplus do those who buy the VIP pass gain? Assume that everyone is charged
the same price per ride.

Oi WY. A Disneyland dilemma: Two-part tariffs for a Mickey Mouse monopoly. The Quarterly Journal of
Economics. 1971 Feb 1;85(1):77-96.

55
New Question

This question is based on:

Zivin JG, Kahn ME. Industrial Productivity in a Hotter World: The Aggregate Implications of
Heterogeneous Firm Investment in Air Conditioning. National Bureau of Economic Research; 2016 Dec
22.

Consider a perfectly competitive industry featuring three types of firms. Each firm has a
production function of the form; y = θ * L.5 . For exogenous reasons, 33% of the firms have
a θ = 100, 33% of the firms have a θ = 25 and 33% of the firms have a θ = 5.

1. If the price of output is 24 and the wage is 8 and the fixed cost of production = 100, solve
for the short run equilibrium output, profit and labor demand for each type of firm.
2. Climate change is making the world warmer. The hotter it is outside, the less productive
are a firm’s workers. Define H as the heat index such that each type of firm’s output is
now: y = θ * (1 − H ) * L.5 . Assume H is between 0 and 1. There is a device
called the air conditioner. For a fixed cost of $F , this device completely offsets the heat.
Solve for $F such that the only the highly productive firms adopt this technology.
3. Using the $F you found in question #2, what share of industry output is now produced by
the most productive firms? Why has this share increased? As H increases further,
holding F constant, what happens to the % of production by the less productive firms?
4. Given your answer to #3, how will aggregate industry output in an competitive industry
featuring heterogeneous firms adapt to climate change?
5. If F declines over time, perhaps due to trade with China and China exporting cheaper
cooling systems, how does this affect the industry’s equilibrium?

56
New Problem

Many people own long lived durables such as cars or homes. These products use energy. Some
cars are energy efficient (think of the Prius) while others are energy inefficient. This has two
implications. First, the people who purchase these products face a tradeoff between paying more
upfront versus bearing higher operating expenses (i.e paying for energy and gasoline to operate
these products). Second, both the consumption of gasoline and electricity has environmental
consequences. More fuel efficient vehicles such as the Toyota Prius use less gasoline per mile of
driving.

Consider the demand for a new car. The owner will drive this car for three years and then sell it
for $500. To keep this problem simple, we will assume the market interest rate is 0% each year.
Suppose that Matthew drives 10,000 miles each year. He is choosing between a Prius and a
Honda Civic. He views these cars as perfect substitutes (meaning they have the same attributes)
but the Prius achieves 50 miles per gallon while the Honda Civic achieves 35 miles per gallon.

Here are the data on Matt’s annual operating expenditure for each car

Car Price of Gasoline Expected Price of Expected Price of

In 2017 is $3 gasoline in 2018 is $3 gasoline in 2019 is
$4

Operating Expense Operating Expense Operating Expense

In 2017 In 2018 In 2019

Prius (10000/50)*3 (10000/50)*3 (10000/50)*4

Civic (10000/35)*3 (10000/35)*3 (10000/35)*4

In this matrix, I calculate the annual operating expense by calculating Matthew’s total gasoline
consumption (miles/MPG) and multiplying this by the price of gasoline.

1. If the Prius is priced at $26500 and the Civic is priced at $23,000 , which car will he buy?
2. If in 2017, the expected price of gasoline in 2018 and 2019 is a random variable called X
that has a mean of M. Write down an equation for M that must hold if the person
purchases the Prius.

57
New Problem: Becker’s Discrimination Model

All workers have the same ability. In a perfectly competitive industry, every firm has the same
production function of the form; Y = 100 * √labor

The price of output = 12. Each firm has a fixed cost of 100. All of the managers of these firms
refuse to hire female workers. The male wage is 20.

1. Solve for each firm’s short run profit.

2. Solve for each firm’s minimum average cost.
3. A new CEO of a firm is willing to hire women and he can hire women for a wage of 14.
What is this firm’s minimum average cost?
4. This CEO gives a TED talk and becomes famous and other CEOs who are willing to hire
women enter the industry. Use a supply and demand graph to show what this dynamic
means for the output price in this industry and the share of output produced by sexist
CEOs.
5. What happens to the male/female wage gap?

Becker GS. The economics of discrimination. University of Chicago press; 2010 Aug 15.

58
New Problem​: The Firm’s Supply of Varieties of a Product

Since ice cream melts, it must be produced and sold locally. People live in communities of 100
people and there is one ice cream seller in each community. There are two types of people
called Matt and Jane. The matrix below reports the relevant data:

Person Type Count of the type in Willingness to pay Willingness to pay

community j for strawberry ice for vanilla ice cream
cream ($)

Matt 1 11 0

Jane 99 0 4.5

The local ice cream monopolist must choose what flavors to offer and a pricing strategy. The
fixed cost of offering an ice cream variety is $12 and the marginal cost per unit produced is $1.
To be clear, if the ice cream maker in community j offers both ice creams she incurs a total fixed
cost of $24.

Assume that there is a law that the price of ice cream cannot be higher than $4. (I recognize
that this exogenous constraint is unusual but it makes question #2 more interesting).

1. In community j, what varieties of ice cream will be produced by the ice cream maker?
What will be the price of each ice cream? What will be the ice cream maker’s profits?
Will Matt eat any ice cream?
2. Now suppose that the 99 Janes leave community j and 99 Matts replace them. Does your
answer to #1 change? How does the consumer surplus for the original Matt change as
his neighborhood composition changes?
3. How do you explain the intuition behind your answer to #2?

Waldfogel J. The median voter and the median consumer: Local private goods and population
composition. Journal of Urban Economics. 2008 Mar 1;63(2):567-82.

59
New Problem : Moral Hazard and Firm Contracts

All workers are identical. Workers lose utility from exerting effort. A firm’s production is an
increasing function of a worker’s effort. Assume each firm hires one worker. The price of
output equals 10 per unit. The worker’s earnings is the only cost the firm incurs.

The firm’s production function equals;

output = 40 * ef f ort

The worker’s utility function equals

utility = 100 * pizza − ef f ort2

1. Given that a worker’s effort is not observed, what share of revenue will this firm offer the
worker if the firm knows the worker’s utility function and knows its own production
function? Assume the worker spends all of his earnings on pizza and pizza has a price of
$1.
2. Suppose the firm does not know the worker’s utility function but knows that it is
additively separable in pizza and effort. Using the firm’s production function listed
above and the price of output=10, devise a field experiment for non-parametrically
recovering the agent’s utility function (up to scale based on the marginal rate of
substitution between effort and pizza). Explain the intuition for how you would conduct
this field experiment and what data you would collect. (hint: from the worker’s
perspective graph her budget constraint with pizza on the Y axis and effort on the x-axis,
is the “budget constraint” linear?)

This problem is a “cousin” of this paper.

Bajari P, Benkard CL. Demand estimation with heterogeneous consumers and unobserved product
characteristics: A hedonic approach. Journal of political economy. 2005 Dec;113(6):1239-76.

60
New Problem: Heterogeneous Workers Matched to Heterogeneous Firms​: ​The
Assignment Problem

Workers and Managers differ with respect to their productivity. Worker productivity is defined
by θ . θ is uniformly distributed with 10% of workers have a productivity level 1, 10% have a
productivity level = 2 etc and 10% of workers have a productivity level = 10 . Workers are
matched with managers. Every firm has 100 workers and 1 manager. There are 10 managers
and 1000 workers. One managers has an ability = 1, one manager has an ability =2 … one
manager has an ability = 9 and one manager has an ability = 10. So, manager quality is also
uniformly distributed. So, both worker and manager quality are independently and uniformly
distributed taking on the discrete values [1,10].

Each firm has the same production function such that output = 50*E( θ )*Manager Quality
Where E( θ ) = mean productivity for workers who work at that firm

1. If there are 10 firms (each feature 1 manager and 100 workers) and if workers are
randomly assigned to managers, what is total output in this economy?
2. What is the pareto optimal allocation of workers to managers? What is the total output in
this economy? Explain why your answer to #1 isn’t the same as your answer to #2.
3. Make a graph with expected firm output on the y-axis and average worker quality on the
x-axis. Graph expected firm output in case #1 and case #2 on the same graph. Why does
the slope differ? (hint: what is the correlation of worker quality and manager quality in
each case?)
4. Can the pareto optimum solved for in #2 be decentralized using a wage contract? (hint: if
the firm knows the production function and the manager quality, how can it design a
contract to attract “the right workers”?)
5. Assume workers are paid 10% of their firm’s output. Building on #2, now suppose that
each manager must choose to produce output or to sell his firm and the rights to his
current workers to another firm (so we are allowing mergers to take place). What will be
the new equilibrium in this economy? Will aggregate output increase? Why? (hint:
assume that for a merged firm that the Manager Quality is a local public good so a
Manager of quality 7 would offer 7 units of manager quality to each factory she now
controls) .

http://faculty.arts.ubc.ca/lhao/research/Durlauf.pdf

Gabaix X, Landier A. Why has CEO pay increased so much?. The Quarterly Journal of Economics. 2008
Feb 1;123(1):49-100.

61
Rosen S. The economics of superstars. The American economic review. 1981 Dec 1;71(5):845-58.

New Problem: Misallocation and “Wedges” at the City Level

In a perfectly competitive industry, the world price of output = 25. Each firm has the same
production function that can be written as: outputt = 120 * √labori .

The price of labor =2. A factory that locates in San Francisco must pay a fixed cost of 100 to
open the factory and land costs $20 per acre. Assume that 10 workers require 1 acre of space.

San Francisco passes a law stating that no factory can be larger than 2 acres.

1. Is this a binding constraint for each firm? Why? How costly is this constraint? Who
bears the economic incidence of this constraint? If this regulation imposes costs, why
would a city impose such a law?
2. Now suppose there is another city that firms can move to. This city is called Houston. It
has no zoning constraints limiting the size of factories.

For exogenous reasons, firms in this industry are less productive if they locate in Houston rather
than in San Francisco. Firm i’s output if it locates in Houston equals:

outputt = 30 * √labori

In Houston the price of labor =1 and the fixed cost of opening a factory is $100 and land costs
$10 per acre.

3. In equilibrium, where will this industry concentrate? Why would Houston choose to have no
land regulation? Why would firms be more productive in San Francisco than in Houston?
4. Calculate the marginal increase in profit if firm i increases its land consumption by .1 acres
in San Francisco and its marginal increase in profits if firm i could increase its land consumption
by .2 acres in Houston. Do these two numbers equal? What is a “wedge”? (recall that land is
twice as expensive in San Francisco than in Houston so we are calculating marginal profit per
dollar spent on inputs).

See page 7 of
https://cepr.org/sites/default/files/events/papers/995_Productivity%20Puzzle%20and%20Misallo
cation.pdf

62
New Question: Farmer Adaptation to Climate Change

A farmer’s output by growing corn at time t equals:

cornt = 40 * temperaturet − .45 * temperature2t

Temperature is drawn from a normal distribution at time t distributed N(60,10). The price of corn
is 12 and cost of producing a unit of corn = 0.
1. What is your expected profit? Calculate this by taking 1000 draws from the temperature
distribution and calculating your corn production for each draw.
2. Now due to climate change, the temperature distribution shifts and is now distributed as
iid N(70,20). Recalculate your expected profit. Assume corn production cannot be
negative.
3. For a cost of $X, you can switch to Genetically modified (GMO) corn that is less
sensitive to outdoor temperature. Its production function is:

GM O cornt = 40 * temperaturet − .04 * temperature2t

If you can sell this GMO corn for $12 a unit, solve for X such that you are indifferent between
adopting and not adopting this technology given that you face the new climate distribution.

4. There are N farmers and all farmers are identical. It costs $F dollars for a corporation to
create the GMO corn. Given this fixed cost, this firm faces a zero variable cost. Write down an
equation such that the corporation chooses to enter the GMO corn industry and create this variety
based on your answer to #3.

5. If the firm has a 50% chance of success developing the GMO corn and only learns if it
succeeds after it pays the cost of $F to develop the GMO corn, how does your answer to #4
change?

Acemoglu D, Linn J. Market size in innovation: theory and evidence from the pharmaceutical industry.
The Quarterly Journal of Economics. 2004 Aug 1;119(3):1049-90.

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