Economics 326 Midterm 2

1 November 2018 Instructor: Heejeong Kim

Instructions: You have seventy five minutes to complete this exam. Please number each
question, underline your final answers, and present your work clearly.

1. (20 points) True or False. Answer true or false for each of the following statements.
If it is false, explain why or give an example to show that it is false.

(a) If f (x) is a convex function, then −f (x) is also a convex function.

Answer: False By the definion of convex function, for any θ ∈ (0, 1),

θf (x0 ) + (1 − θ)f (x1 ) ≥ f (θx0 + (1 − θ)x1 ) (1)

for any x0 and x1 . Multiplying (−1) to (1) implies that

θ(−f (x0 )) + (1 − θ)(−f (x1 )) ≤ −f (θx0 + (1 − θ)x1 )

for any x0 and x1 . Thus, −f (x) is a concave function.

(b) A twice continuously differentiable utility function

(1−σ) (1−σ)
X X
U (X1 , X2 ) = 1 + 2
1−σ 1−σ
is globally concave for all X1 > 0 and X2 > 0 when σ > 0.

Answer: True Let’s construct the Hessian matrix to show the sign of d2 U
[ ]
U11 U12
H=
U21 U22

U1 = X1−σ

U2 = X2−σ

U11 = −σX1−σ−1
 U12 = U21 = 0

U22 = −σX2−σ−1

Thus, Hessian matrix is

[ ]
−σX1−σ−1 0
H=
0 −σX2−σ−1

For any X1 > 0 and X2 > 0,

|M1 | = U11 = −σX1−σ−1 < 0

|M2 | = U11 U22 − U12

2
= σ 2 X1−σ−1 X2−σ−1 > 0

Thus, this utility function is globally concave.

2. (20 points) For the following function

√
f (x) = x

Find the second-order Taylor series at x0 = 16 and use this Taylor series to calculate
√
the approximate value of f (18) = 18.

√
Answer: Second order taylor seris for f (x) = x at x0 = 16 is

f ′′ (x0 )
f (x) ≈ f (x0 ) + f ′ (x0 )(x − x0 ) + (x − x0 )2 (2)
2!

Note that f ′ (x) = and f ′′ (x) = − 14 x− 2 . Substituting this into the equation (2),
1 3
√
2 x

√ √ 1 1 1 −3 1 1
f (x) = x≈ x0 + √ (x − x0 ) − x0 2 (x − x0 )2 = 4 + (x − 16) − 2−6 (x − 16)2
2 x0 2! 4 8 8

Then,
√ 1 1
f (18) = 18 = 4 + − 2−6 22 = 4 + 0.5 − 0.0078 = 4.2422
2 8

2
3. (40 points) A perfectly competitive firm has a globally concave production function
1 2
Q = F (L, K) = L 3 K 3

where L is the labour and K is the capital. We assume that r is the unit cost of capital
and w is the wage per unit of labor. The price of output is P = 1.

(a) Show whether the production function exhibits decreasing, constant, or increasing
returns to scale.

Answer: Increase the factors of production proportional to λ.

1 2 1 2 1 2
F (λL, λK) = (λL) 3 (λK) 3 = λ 3 + 3 L 3 K 3 = λF (L, K)

Thus, this production function exhibits constant returns to scale.

(b) Prove that the maximized profit is zero.

Answer: Profit function for this firm is

1 2
π(L, K) = P F (L, K) − wL − rK = L 3 K 3 − wL − rK

First order conditions are

∂π 1 2 2
= L− 3 K 3 − w = 0
∂L 3
∂π 2 1
= L 3 K− 3 − r = 0
1

∂K 3
Using these first-order conditions,
1 2 2 2 1 1 1 2 2 1 2
π ∗ = Q−wL∗ −rK ∗ = Q− L− 3 K 3 L− L 3 K − 3 K = Q− L 3 K 3 − L 3 K 3 = 0
1

3 3 3 3
For a firm with CRS technology, the long-run maximized profit is always zero.

4. (20 points) Suppose that a monopoly movie theater sells tickets to two different groups.
The first group is a student group with a demand function x1 = 100−p1 and the second
group is a non-student group with a demand function x2 = 120 − 0.5p2 . The cost of
playing a movie is C(x) = 2000 + 20x, where x is the total production of movie tickets
for both groups.

3
(a) Suppose that this monopoly movie theater employs a third-degree price discrimi-
nation strategy, charging different prices to two different groups. Find the profit-
maximizing prices and quantities for each group.

Answer: When the firm is charging different prices to two groups, the total
revenue of a firm becomes p1 x1 + p2 x2 and the total cost of a firm becomes
C(x1 + x2 ) = 2000 + 20(x1 + x2 ). Thus, the profit function for a firm becomes

π(x1 , x2 ) = p1 x1 +p2 x2 −C(x1 +x2 ) = (100−x1 )x1 +(240−2x2 )x2 −2000−20(x1 +x2 )

= −x21 + 80x1 − 2x22 + 220x2 − 2000

First order conditions are

∂π
= −2x1 + 80 = 0 → x∗1 = 40
∂x1
∂π
= −4x2 + 220 = 0 → x∗2 = 55
∂x2
To check the second-order condition, let’s construct the Hessian matrix
[ ]
−2 0
H=
0 −4

|M 1| = −2 < 0

|M 2| = 8 > 0

Thus, profit is maximized at (x∗1 , x∗2 ) = (40, 55) and the corresponding prices are
(p∗1 , p∗2 ) = (60, 130).

(b) Explain your result above using the price elasticity of demand for each group.

Answer: Given the demand function for each group, we can derive the price
elasticity of demand for a movie ticket. For a student group,
∂x1 p1 p1
|ε1 | = | |=|−1 |
∂p1 x1 100 − p1
For a non-student group,
∂x2 p2 p2
|ε2 | = | | = | − 0.5 |
∂p2 x2 100 − p2

4
This implies that if the firm charges the same price to both groups, p1 = p2 = p,
then |ε1 | > |ε2 |. Thus, student group has more elastic demand in a response to
a price change compared to non-student group. So, the theater can maximize
its profits by charging a lower price to a group of customers with more elastic
demand.