Macroeconomics I

Problem Set 8
Marti Mestieri, Universitat Pompeu Fabra

March, 2023

1. Exercise 2: Consider the standard model by Lucas (1978) that we saw in class: there is a represen-
tative household with a continuum of members who are heterogeneous in their managerial talent,
which is distributed according to a generic distribution with pdf f(z) and cdf F(z). The represen-
tative HH consumes, saves and decides the occupational choice of its members. HH’s preferences
are given by:

∞
X
β t log(Ct ) with β < 1
t=0

where Ct is total household consumption at t.

Conditional on being entrepreneurs, individuals have access to the following production function:

γ
y = z 1−γ k ν n1−ν with 0 < γ < 1, 0<ν<1

The labor, capital, and final good market are perfectly competitive. Assume that the final good is
the numeraire. The price of labor is denoted by w. The price of capital is denoted by r.

(a) Define the problem of an entrepreneur. Derive the FOC. Compute the functions n(z, w, r),
k(z, w, r), y(z, w, r), and π(z, w, r).
(b) Compute entrepreneur’s optimal capital-labor ratio (k/n). Is it constant or different across
entrepreneurs? Provide the intuition for your answer.
(c) Is there any kind of misallocation of resources across production units (entrepreneurs) in this
economy? Justify your answer.
(d) Define the competitive equilibrium of this economy.
(e) Now imagine that the government implements a policy that consist on imposing a tax on the
cost of capital of τk > 0 (the actual cost of capital becomes r(1 + τk )) to all entrepreneurs
who operate in the economy.
i. Compute again the functions k(z, w, r), n(z, w, r), y(z, w, r), and π(z, w, r).
ii. Compute again the optimal capital-labor ratio (k/n). Is it constant or different across
entrepreneurs? Provide the intuition for your answer.

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iii. Is there any kind of misallocation of resources across production units (entrepreneurs)
in this economy? Is there any kind of misallocation in the choice between becoming an
entrepreneur or a worker? Justify your answer.