TA Session 2

Microeconomics 2 - LMEC - a.y. 2021/2022

Professor: Paolo Vanin
Teaching Assistant: Nektaria Glynia

3 December 2021

1 Duality in Production Theory

Consider a firm whose technology can be described by the following production function:
√
f (z) = z

Let w be the price of one unit of input and p the price of one unit of output.
1.1 Solve the Profit Maximization Problem (PMP) of the firm to derive the (unconditional) factor
demand function z(w, p). Find the supply function q(p, w) and the profit function π(w, p).

1.2 Solve the Cost Minimization Problem (CMP) of the firm to derive the conditional factor demand
function z(w, q). Derive the cost function c(w, q).
1.3 Evaluate the conditional factor demand z(w, q) at the optimal output level q = q(p, w) to ob-
tain z(w, q(p, w)), show that it coincides with the unconditional factor demand z(w, p), that is
z(w, q(p, w)) = z(w, p).

1.4 Prove that the Shepard’s Lemma holds.

5.5 Compute the substitution matrix.

Answer
1.1
Assume a production function given by :
√
q = f (z) = z

√
max pq − wz s.t q= z, z ≥ 0
z

The Lagrangian reads as: √

L(.) = p z − wz + µ(z − 0)

The FOCs are given by:

∂L(.) 1
= pz −1/2 − w + N = 0
∂z 2

∂L(.)
µ = µz = 0
∂µ

Considering an interior solution the FOC becomes:

r
1 −1/2 p2 p p2 p
pz − w = 0 ⇒ z(p; w) = and q(w) = z(w; p) = =
2 4w2 4w 2 2w

1
The profit function is given by:
p p2 p
π(p; w) = p −w 2 =
2w 4w 4w
1.2 √
min wz if q= z, z ≥ 0
z
or √
max −wz if q= z, z ≥ 0
z

The Lagrangian reads as: √

L(.) = −wz + λ( z − q)

The FOCs are given by:

∂L(.) 1
= −w + λ z −1/2 = 0
∂z 2

∂L(.) √
λ = λ( z − q) = 0
∂λ

From the FOCs, solving for z:

 2
λ
z=
zw
√
The constraint is binding → z = q → z = q 2 , that is:
 2
2 λ
q = ⇒ λ = zqw
zw

Plug λ in the first FOC to get:

 zqw 2
z(w; q) = = q2
zw

The cost function is given by:

C(w; q) = wz(w; q) = wq 2
1.3
 p 2  p 2 
z(w; q(w)) = z(w; p) → =
| {z } | {z } 2w 4w
conditional f actor demand unconditional f arctor demand

1.4 Shephard’s Lemma

∂C(w; q)
= q 2 = z(w; q)
∂w

1.5
Substitution matrix
Define p̃ = (p; w); Y (p̃) = (q(p; w); −z(p; w))
" #
∂q ∂q 1
− 2wp 2
 
; 2w ;
Dp Y (p̃) = ∂p∂z
∂w
∂z = p2
∂p ; ∂w − 2wp 2 ; 2w3

2
2 Profit maximisation
Consider a firm with technology described by the production function: y = min{z1 , z2 }γ . Find the
output supply function y(p, w), the demand function of the two inputs z(p, w) and the profit function
π(p, w). Which restriction do you need to impose on the values of γ for such functions to be well defined?

Answer

This is an example of a Leontief production function: factors must be used in fixed proportions. The
firm operates where y = z1γ = z2γ , since a greater amount of any factor would only mean a waste of money
as long as its price is positive. Let p the market price of output y; w = (w1 , w2 ) the market price of factor
1 and factor 2 respectively; and π(z) = πz γ − (w1 + w2 )z firm’s profits, where z is either z1 or z2 . The
profit maximisation problem is:

max pz γ − (w1 + w2 )z
z≥0

The first-order condition is:

∂π(z)
= 0 ⇒ γpz γ−1 − (w1 + w2 ) = 0.
∂z
Therefore, the demand function of the two inputs is:
w1 + w2 γ−1
1
z1 (p1 , w) = z2 (p, w) = ( )
γp
and the output supply function is:
w1 + w2 γ−1
γ
y(p, w) = ( )
γp
The profit function can be found by replacing y(p, w) and z(p, w) in the previous formula:
w1 + w2 γ−1
γ w1 + w2 γ−1
1
π(p, w) = p( ) − (w1 + w2 )( )
γp γp
The most intuitive way to find the restrictions on is to look at the profit function and its derivatives:

π(z) = pz γ + (w1 + w2 )z

∂π(z)
= γpz γ−1 − (w1 + w2 )
∂z
∂ 2 π(z)
= γ(γ − 1)pz γ−2
∂z 2

The function is well-defined when the second derivative of the profit function is negative; this is true
when 0 < γ < 1, hence the function is concave in z, and the solution of the maximisation problem is
unique. In this interval, the production function exhibits decreasing returns to scale. If, instead, γ = 1,
the profit function is linear in z ; i.e. π(z) = (p−w1 −w2 )z; and the production function exhibits constant
returns to scale. In order to have a well-behaved function, it is necessary to put restrictions on prices as
well. If p − w1 − w2 = 0 the profit function is just zero, so it is not possible to determine a solution of
the problem. If, instead, p − w1 − w2 < 0, the firm obtains the highest attainable profits by not using
any input, so the optimal plan would be z = 0; because of the no free lunch property, no input means no
output, so in this case profits are zero. Finally, when p − w1 − w2 > 0, there is no global maximum, but
only local maxima when factors have to lie within a certain interval; theoretically, in this case profits are
infinite.

3
3 Supply and Profit Functions
Consider a firm whose technology can be represented by the following production function:

f (z) = z α

where α ∈ (0, 1). Output and input prices are respectively p and w, with p = (p, w).

3.1 Solve the PMP of the firm to derive the net supply function y(p) and the profit function π(p).
3.2 Prove that:
- y(p) is homogeneous of degree 0;
- π(p) is homogeneous of degree 1;
- Dp2 π(p) is a symmetric and positive semi-definite matrix (i.e. π(p) is convex).

Answer

3.1

Let the production function to be given by

q = f (z) = z α α ∈ (0; 1)

max pz α − wz
z≥0

We derive the demand functions from the FOC:

 1
 α−1
∂π w
= αpz α−1 − w = 0 ⇒ z(w; p) =
∂z αp

 α
 α−1
w
Supply function: q(p; w) = (z(w; p))α =
ap

 α
 α−1  1
 α−1
w w
Profit function: π(p; w) = pq(p; w) − wz(w; p) = p −w
ap ap

Net supply function: p̃ = (p; w); Y (p̃) = {q(p; w); −z(p; w) }

3.2

• Y (p̃) : Homogeneous of Degree 0

 α
 α−1 α
  α−1 α
  α−1
γw γ w
q(γp; γw) = = = q(p; w)
aγp γ ap

4
  1
 α−1 1
  α−1 1
  α−1
γw γ w
z(γp; γw) = = = z(w; p)
aγp γ ap

• π(p̃) : Homogeneous of Degree 1

 α
 α−1  1
 α−1  α
 α−1  1 !
 α−1
γw γw w w
π(γp; γw) = γp − γw =γ p −w = γπ(p; w)
aγp aγp ap ap

• Dp2 π(p̃) is symmetric and positive semidefinite (π(p̃) is convex). Rewrite the profit function as:
α
  α−1 α
  α−1 1
  α−1 1
  α−1
1 α 1 1 1 1
π= w α−1 p − w α−1 w
α p α p

1 α α 1
π(p; w) = Ap 1−α w α−1 with A = α 1−α − α 1−α

∂π 1 α α
=A p 1−α w α−1 > 0
∂p 1−α

∂π α 1 1
=A p 1−α w α−1 < 0
∂w α−1
The Hessian matrix is:
" 2α−1 α α 1 #
α α
(1−α)2 p
1−α w α−1 ; − (1−α)2p
1−α w α−1
H= Dp2 π(p̃) =A α α 1
α 1 2−α
− (1−α)2p
1−α w α−1 ;
(1−α)2 p
1−α w α−1

where
α 2α−1 α
D1 = A 2
p 1−α w α−1 > 0
(1 − α)

α2 2α−1+1 α+2−α α2 2α 2
D2 = A 4
p 1−α w α−1 − A p 1−α w α−1 = 0
(1 − α) (1 − α)4
H is symmetric and positive semidefinite → π(p̃) is convex

5
4 Uncertainty and risk aversion
Consider a consumer with preferences described by the following Von-Neumann Morgenstern utility
1
function: U (w) = w 2
6.1 What is the attitude towards risk of the consumer?
2
6.2 Consider an initial wealth at w0 = 10 and a lottery with prize 6 with probability 3 and loss -6 with
probability 13 . Is the consumer accepting the lottery?
6.3 Compute the certainty equivalent of the lottery.

Answer
1.
1
U (w) = w 2
∂U (w) 1 1
= w− 2 > 0
∂w 2
∂ 2 U (w) 1 3
= − w− 2 < 0 → Adverse to risk
∂w2 4

2.

w0 = 10
n 2 1 o
L = {6, −6}, { , }
3 3
2 1 2 1
U (16) + U (4) = ∗ 4 + ∗ 2 ' 3.33
E(U (L)) =
3 3 3 3
2 1 32 4
EL = ∗ 16 + ∗ 4 = + = 12 → Expected value of the lottery
3 3 3 3
U (EL) = 3.46
U (EL) > E(U (L)) → Risk Averse

3.
Certainty Equivalent C(U, L) : amount of money that makes the consumer indifferent between accepting
the lottery or not.
√
E(U (L)) = U (C(U, L)) ⇒ 3.33 = c ⇒ c = 3.332 = 11.09 < EL

6
5 Relative and absolute risk aversion
7.1 Consider the exponential utiliy function U (w) = 1 − exp{−ρw}. Show that it is increasing and
concave for all w as long as ρ > 0, that is, as long as the agent is risk-averse. Show that this
function has constant absolute risk aversion coefficient given by ρ.
1−ρ
7.2 Consider the power utiliy function U (w) = w1−ρ for ρ 6= 1. Show that it is increasing and 1 − ρ
concave for all c > 0. Show that this function has constant relative risk aversion coefficient given
by ρ.
7.3 Consider the log utility function U (w) = logw. Show that it is increasing and concave for all w > 0.
Show that this function has constant relative risk aversion coefficient equal to 1.

Answer

1.
U (w) = 1 − exp(−ρc)

U 0 (w) = ρexp(−ρc) > 0

U 00 (w) = −ρ2 exp(−ρc) < 0

−ρ2 exp(−ρc)
A(w) = − =ρ
ρexp(−ρc)

R(w) = wρ
2.

w1−ρ
U (w) =
1−ρ

U 0 (w) = w−ρ > 0

U 00 (w) = −ρw−ρ−1 < 0

−ρw−ρ−1
A(w) = − = ρw−1
w−ρ

R(w) = ρ

3.

U (w) = logw

1
U 0 (w) = >0
w
1
U 00 (w) = − <0
w2

w ∗ (−w−2 )
R(w) = − =1
w−1

7
6 Demand of Insurance
Consider a farmer living in an environment characterized by two states of the world: Ω1 (good weather)
that occurs with probability P r(Ω1 ) = (1 − π), and Ω2 (bad weather) with probability P r(Ω2 ) = π. In
the good weather state her wealth is w1 = w0 . In the bad weather state her wealth is reduced by an
amount L ∈ (0, w0 ), that is w2 = w0 − L.
Assume that the farmer is risk-averse and that her preferences are characterized by a Bernoullian utility
function
u(w) = ln w
Moreover, the farmer can buy insurance against bad weather for a total cover of C from a risk-neutral
insurance company, at a premium rate (per unit of cover) p.
4.1 Derive the state-contingent budget constraint and set up the farmer’s (Expected) Utility Maximiza-
tion Problem (with C as his choice variable).
4.2 Derive the First Order Conditions (FOCs) and the optimal cover C(w0 , π, p, L)

4.3 Assume that p ≥ π. Show that the optimal cover is non-increasing in wealth w0 and in the premium
rate p, and it is non-decreasing in loss L and in loss probability π.
4.4 Consider a perfectly competitive insurance supply side (the insurance company makes 0 profit),
show that the farmer buy full cover, that is C(w0 , π, p, L) = L.

Answer

1. State contingent budget set

W1 = W0 − pC
W2 = W0 − pC − L + C = W0 − L + (1 − p)C

If you want to graph the budget constraint solve the first equation for C, substitute in the second
to get:

W0 − pC (1 − p)
W2 = − W1
p p

max (1 − π)ln(W1 ) + πln(w2 )

C

s.t W1 = W0 − pC
W2 = W0 − L + (1 − p)C
same as

max (1 − π)ln(W0 − pC) + πln(W0 − L + (1 − p)C)

C

2. First Order Conditions

1 1
−p(1 − π) + (1 − p)π =0
W0 − pC W0 − L + (1 − p)C
Move the first term to the RHS, and cross-multiply

(1 − p)π(W0 − pC) = p(1 − π)(W0 − L + (1 − p)C) ⇒

(1 − p)π(W0 ) − (1 − p)π(pC) = p(1 − π)(W0 − L) + (1 − p)(1 − π)(pC) ⇒

(pC(1 − p)[(1 − π) + π]) = (1 − p)W0 − p(1 − π)(W0 − L) ⇒

8
 (1 − p)π (1 − π)p
C(W0 ; π; p; L) = W0 − (W0 − L) =
(1 − p)p (1 − p)p
π (1 − π)
= W0 − (W0 − L)
p (1 − p)
3. Partial Derivatives
Wealth:
∂C π 1−π π(1 − p) − p(1 − π) π−p
= − = = ≤0 sinceπ ≤ p; inferior good
∂W0 p 1−p p(1 − p) p(1 − p)

Loss:
∂C (1 − π) (1 − π)
=− (−1) = > 0; since(π, p) ≤ 1 → higher the loss higher the desire to cover it
∂L (1 − p) (1 − p)

Loss prob:
∂C 1 1
= W0 − (−1)(W0 − L) > 0 → Makes sense but in genera π is not exogenous
∂π p (1 − p)

Premium:
∂C π (1 − π)
= − 2 W0 − (−1) (W0 − L)(−1) > 0 → Normal good
∂p p (1 − p)2
4. Supply Side
Insurance company expected profits reads as:

(1 − π)(pC) + π(pC − C) ⇒ p = π

since profits equals 0 in perfect competition and there are no entry barriers

C(W0 ; π; p; L) = L