IE54500 – Exam 2

Dr. David Johnson

Fall 2020
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appropriate. Be complete in your reasoning and state your assumptions.

1. Island Castaway
Suppose an individual is stranded alone on an island. They must consumer whatever they produce. In
other words, there is no possibility for trade with other individuals, and they are the only producer and
only consumer in their market. The individual lives for two time periods and is endowed with a certain
level of resources from the island in period 1, 𝑅1 , and in period 2, 𝑅2 . Resources can be consumed to
produce utility, but in the first period, the castaway can choose to convert some resources to goods that
would then be consumed in the second period, according to the production function 𝑓(𝑅1 − 𝑐1 ).

Assume that 𝑓(0) = 0, 𝑓 ′ (𝑥) > 0, and 𝑓 ′′ (𝑥) < 0, and that the castaway has an additively separable
utility function with a personal discount rate of 𝛿.

a) Set up the castaway’s utility maximization problem (5 points).

We are told the castaway has an additively separable utility function with discount rate 𝛿, so
𝑢(𝑐2 )
assume that 𝑈(𝑐1 , 𝑐2 ; 𝛿) = 𝑢(𝑐1 ) + 1+𝛿
where 𝑢(𝑐) conforms with the usual properties of a
utility function. In period 2, the individual consumes resources 𝑅2 plus anything that was produced
using leftover resources from period 1, so our budget constraint is 𝑐2 = 𝑅2 + 𝑓(𝑅1 − 𝑐1 ).

𝑢(𝑐2 )
∴ max ℒ = 𝑢(𝑐1 ) + + 𝜆(𝑓(𝑅1 − 𝑐1 ) + 𝑅2 − 𝑐2 )
𝑐1 ,𝑐2 1+𝛿
b) Derive the first-order conditions that characterize this individual’s optimal choice of consumption
in periods 1 and 2 (5 points).
 ℒ𝑐1 = 𝑢𝑐1 − 𝜆𝑓 ′ = 0
𝑢𝑐2
ℒ𝑐2 = −𝜆 = 0
1+𝛿
ℒ𝜆 = 𝑓(𝑅1 − 𝑐1 ) + 𝑅2 − 𝑐2 = 0
c) Draw a graph showing the castaway’s optimal choice of consumption in periods 1 and 2 that is
consistent with the first-order conditions derived in part b). Depict 𝑐2 on the vertical axis and 𝑐1
on the horizontal axis. Show mathematically that at the tangency between the castaway’s
𝑢
indifference curve and budget constraint, 1 (1 + 𝛿) = 𝑓 ′ (𝑅1 − 𝑐1 ), where 𝑢𝑖 is the partial
𝑢2
derivative of the utility function with respect to 𝑐𝑖 . (5 points)

The slope of the budget constraint can be found by differentiating the budget constraint with
respect to 𝑐1 and 𝑐2 :

𝑑𝑐2 = −𝑓 ′ 𝑑𝑐1

So the slope of the budget constraint is:

𝑑𝑐2
= −𝑓 ′ < 0
𝑑𝑐1

Further, the slope changes according to

𝑑2 𝑐2
= 𝑓 ′′ < 0
𝑑𝑐12

This implies that the individual faces diminishing returns to investing period 1 resources into
producing consumption for period 2. Moving the second term of the first two FOCs to the right-
𝑢
hand side, we can then divide the first FOC by the second FOC to obtain 𝑢1 (1 + 𝛿) = 𝑓 ′ (𝑅1 − 𝑐1 ).
2
d) Suppose that after exploring, the individual discovers a group of indigenous people living on the
other side of the island. This means that the castaway is suddenly now back in a market economy
with a well-functioning capital market. They can still produce goods in period 2 according to the
same production function, but they can now also borrow and lend resources across time periods
at the market interest rate, 𝑟. Set up the new optimization problems governing i) how much the
individual consumes in periods 1 and 2, and ii) how much the individual produces in period 2.
(Hint: these are two separate problems.) You do not need to take first-order conditions or solve
the problem. (5 points)

𝑢(𝑐2 )
max ℒ = 𝑢(𝑐1 ) + + 𝜆((1 + 𝑟)(𝑅1 − 𝑐1 ) + 𝑅2 − 𝑐2 )
𝑐1 ,𝑐2 1+𝛿
𝑐2
min ℒ = 𝑐1 + + 𝛾(𝑓(𝑅1 − 𝑐1 ) + 𝑅2 − 𝑐2 )
𝑐1 ,𝑐2 1+𝑟
e) Show graphically and explain intuitively why the introduction of the market economy means that
the individual’s production and consumption choices may no longer be the same as when the
individual was alone, and why, if they change their production and consumption choices, this
means their utility will increase. (10 points)

The individual now produces where the marginal return to investing the endowment, in terms of
period 2 consumption, equals the interest rate, 𝑓 ′ = (1 + 𝑟) (point A), and consumes where the
𝑢
marginal rate of substitution equals the interest rate, 𝑢1 (1 + 𝛿) = (1 + 𝑟) (point B). These
2
consumption and production bundles will not necessarily coincide since there is no guarantee that
a given bundle of 𝑐1 and 𝑐2 will yield the same rates of return in the production and utility
functions. However, the original choices of consumption and production are still feasible for the
individual, who could choose not to trade in the market. Because the original choices are still part
of the feasible action space, they will only choose to engage in trade if it increases their utility. The
potential for trade is illustrated below, where the individual produces 𝑝1∗ , which would allow them
to consume 𝑝2 in period 2. However, they will then choose to trade some of the production and
period 2 resources at the market rate, allowing them to instead consume at (𝑐1∗ , 𝑐2∗ ).
2. Monopoly Production Quantity and Quality
Consider a firm that produces a widget that is protected by a patent and for which there are no other
close substitutes. Because of the patent protection, no other firm can duplicate the widget, giving this
firm monopoly power. The inverse demand curve for this widget is given by 𝑃 = 100 − 𝑄 + 𝐴, where 𝑃
is price, 𝑄 is quantity, and 𝐴 is a measure of the widget’s quality. From this equation, we can see that
higher quality allows the firm to sell the same quantity of widgets at a higher price.

The firm gets to choose the level of quality, such that the cost of developing a design with quality 𝐴 is
𝐶(𝐴) = 𝐴2 . Once the design has been developed, a widget can be produced for a constant marginal cost
of 10 (regardless of 𝐴). The producer incurs other fixed costs, 𝐹, for research and development (R&D).

a) Write down the equation that defines the producer’s profits. (5 points)
The firm’s profit function is
𝜋 = 𝑃(𝑄, 𝐴) ∙ 𝑄 − 𝐶(𝑄, 𝐴) = (100 − 𝑄 + 𝐴)𝑄 − 10𝑄 − 𝐴2 − 𝐹

b) Given this profit function, what level of quantity and quality should the producer choose? What
price can the producer charge for this combination of quantity and quality? What are the
producer’s profits if the fixed costs are 𝐹 = 500? (Answer every question!) (10 points)
First-order conditions are
𝜋𝑄 = 100 − 2𝑄 + 𝐴 − 10 = 0
𝜋𝐴 = 𝑄 − 2𝐴 = 0
Solving these two equations yields quantity and quality of 𝐴 = 30 and 𝑄 = 60. Plugging this
back into the inverse demand curve gives an optimal price of 𝑃 = 70. The firm’s profits are thus
𝜋 = 2700 − 𝐹 = 2200.

c) A consumer group accuses the firm of selling the widget at an inflated price. The producer
responds by claiming that it must charge this price to cover its R&D costs. Is the producer’s
argument valid? Why or why not? In what sense is the producer’s price “inflated?” (5 points)
No. the firm’s price equates marginal revenue with marginal cost, which is independent of the
fixed costs (see the fact that F does not appear in the first-order conditions). The price is inflated
in the sense that it exceeds the marginal cost because the firm can exploit its market power as a
monopolist. The marginal cost is the price that would obtain in a perfectly competitive market.

d) What is the difference between the quantity and quality produced under the monopoly and the
socially optimal levels? To answer this question, note that socially optimal levels of quantity and
quality maximize the total surplus in the economy: (10 points)

𝑄
𝑄2
𝑇𝑆(𝑄, 𝐴) = ∫ 𝑃(𝑄, 𝐴)𝑑𝑄 − 𝐶(𝑄, 𝐴) = 100𝑄 − + 𝐴𝑄 − 10𝑄 − 𝐴2 − 𝐹
0 2

A benevolent social planner would therefore seek to maximize total surplus by choosing quantity
and quality. Taking first-order conditions for the total surplus expression:

𝑇𝑆𝑄 = 100 − 𝑄 + 𝐴 − 10 = 0
 𝑇𝑆𝐴 = 𝑄 − 2𝐴 = 0

Solving these two equations simultaneously yields solutions 𝐴 = 90 and 𝑄 = 180. So, the
monopolist therefore chooses to produce less quantity and less quality than is socially optimal.
This happens because the monopolist chooses quantity and quality to equate marginal costs
with their private marginal revenue, whereas the social planner equates marginal costs with the
marginal benefits (i.e., marginal total surplus to society).

3. (EXTRA CREDIT) Investment in a Risky Asset

Suppose an individual’s utility function is given by

𝑢(𝑤) = −𝑒 −𝛼𝑤 + 1
for some constant 𝛼 > 0. Suppose their initial wealth is 𝑊, and they invest some quantity 𝑥 in a risky
asset with a rate of return 𝑅 that has expected value 𝑅 > 0 and variance 𝜎𝑅2 .

a) Show mathematically that the individual’s absolute risk aversion is constant. (2 points)
𝑢′ (𝑤) = 𝛼𝑒 −𝛼𝑤
𝑢′′ (𝑤) = −𝛼 2 𝑒 −𝛼𝑤
Therefore, absolute risk aversion is
𝑢′′
− ′ =𝛼
𝑢

b) Prove that the amount they choose to invest in the risky asset is independent of their initial
wealth. (3 points)
The individual wants to choose 𝑥 to maximize expected utility, where their outcome after
realizing the asset’s return is to have wealth (𝑊 − 𝑥) + 𝑥(1 + 𝑅) = 𝑊 + 𝑥𝑅:

max 𝔼[−𝑒 −𝛼(𝑊+𝑥𝑅) ]

𝑥

This has first-order condition

𝔼[𝛼𝑅𝑒 −𝛼(𝑊+𝑥𝑅) ] = 0

In other words, we have

𝛼𝑒 −𝛼𝑊 𝔼[𝑅𝑒 −𝛼𝑥𝑅 ] = 0 ⇒ 𝔼[𝑅𝑒 −𝛼𝑥𝑅 ] = 0

This first-order condition is independent of wealth 𝑊, so the amount of investment in a risky

asset is not a function of initial wealth for an individual with this utility function.