Macroeconomics I

Analytical Problem Set # 1

Marti Mestieri Ferrer, UPF, BSE

This is due Thursday January 21st

Exercise # 1: Neoclassical production functions

(a) Show that the Cobb-Douglas production function:

F (K, L) = K α L1−α (1)

is a Neoclassical production function.

(b) Euler’s Theorem: A version of the Euler’s Theorem is represented by the following
statement. Suppose that the function f (x, y) is continuously differentiable. Then,
f is positive homogeneous of degree 1 if and only if

fx (x, y)x + fy (x, y)y = f (x, y)

where fi (x, y) = ∂f (x,y)

∂i . Show that the theorem applies to the case of a Cobb-Douglas
production function.

(c) Consider a more general class of production functions known as “Constant Elasticity
of Substitution (CES)” production functions:

σ
σ−1 σ−1 σ−1
Y = F (K, L) = [αK σ + (1 − α)L σ ] (2)

Prove that this general type of functions satisfy the first two properties of Neo-
classical production functions: (i) constant returns to scale and (ii) Positive and
diminishing marginal returns. Ignore the Inada conditions.

1
 HINTS:

• The proof for -(i) constant returns to scale- is easy

• To make calculations simpler when proving (ii) Positive and diminishing marginal
returns (FKK (K, L) < 0), keep the expressions as compact as possible. In par-
Y
ticular, try to get final expression for FKK (K, L) that depends on α, σ, K ,
FK (K, L), and F (K, L). You can then make use of Euler’s theorem.

(d) Show that the CES production function converges to the Cobb-Douglas function
when σ → 1
HINT: follow the following steps

• Take natural logs on the CES production function

• Take the constant that multiplies what it’s inside the log and invert it so you
can write an expression like:

ln of something that depends on α, σ, K, and L

lnY =
something that depends on σ
• Your goal is to compute the limit of that expression when σ → 1. In order to
do so, apply the l’Hopital’s rule, which says the following:

f (x) f ′ (x) f (x)

if lim exists ⇒ lim ′ = lim
x→c g(x) x→c g (x) x→c g(x)

• Define your numerator as f (x) and your denominator as g(x), where x = σ

• Take the derivatives of these two functions with respect to σ. You will have to
make use of the following properties of derivatives:

∂lnh(x) h′ (x)
= (3)
∂x h(x)
∂a h(x)
= ah(x) ln(a)h′ (x) (4)
∂x

• You are almost done. Just take the limit:

f ′ (σ)
lim (5)
σ→1 g ′ (σ)

2
 • Most of the terms should equal one and cancel out. You should get a final
expression like this:

f ′ (σ)
lim = lim lnY = αlnK + (1 − α)lnL (6)
σ→1 g ′ (σ) σ→1

• Taking the exponential on both sides will conclude the proof.

Excersise # 2: Elasticity of substitution between labor and capital

Let’s define the elasticity of substitution between capital and labor as:

∂ln ( K
L
)
ϵ≡ (7)
∂ln ( wr )
where w and r are the prices of labor and capital respectively.

(a) Assume that a representative firm producing in perfect competition has access to
the following CES production function:

σ
σ−1 σ−1 σ−1
Y = F (K, L) = [αK σ + (1 − α)L σ ] (8)

(i) Define the profit maximization problem of the firm

HINT: In perfect competition firms take all prices as given (P , w, and r).
Normalize P to be equal to 1.
(ii) Compute the FOC conditions with respect to labor and capital
(iii) Combine the two FOC and calculate ϵ
(iv) Use the FOC of capital to compute the share of capital in total income defined
as:

rK
(9)
Y
How does this change when r increases? What parametrization would make
the evolution of PrKY consistent with the Kaldor fact that states that the income
share of capital should be constant over time?
HINT: This relationship depends on the value of σ. Remember that σ can take
any value as long as σ > 0