Macroeconomics I

Analytical Problem Set # 1

Marti Mestieri Ferrer, UPF, BSE

This is due Thursday January 19th

Exercise # 1: Neoclassical production functions

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

F (K, L) = K α L1−α

is a Neoclassical production function.

(i) Linear Homogeneity: we know that a production function is homogenous of

degree one if:

F (λK, λL) = λF (K, L)

Then, we have to prove that:

F (λK, λL) = (λK)α (λL)1−α = K α L1−α

Proof.
(λK)α (λL)1−α = λα λ1−α K α L1−α = K α L1−α

(ii) Positive and diminishing marginal returns: we have to prove that:

1
 FK (K, L) > 0 and FKK (K, L) < 0 ∀K > 0, ∀L > 0
FL (K, L) > 0 and FLL (K, L) < 0 ∀K > 0, ∀L > 0

We’ll focus on the case of K, but a similar proof applies for L.

Proof.

∂F (K, L) α−1 1−α L 1−α

FK (K, L) = = αK L = α( ) >0 ∀K, L > 0, α ∈ (0, 1)
∂K K

K α−1
∂ 2 F (K, L) ∂ [α ( L ) ] L 1−α 1
FKK (K, L) = = = (α−1)α ( ) ( ) < 0 ∀K, L > 0, α ∈ (0, 1)
∂ 2K ∂K K K

(iii) Inada conditions: We have to prove that:

lim FK (K, L) → ∞ and lim FK (K, L) → 0 ∀L > 0

K→0 K→∞

lim FL (K, L) → ∞ and lim FL (K, L) → 0 ∀K > 0

L→0 L→∞

Again, we’ll focus on the case of K, but a similar proof applies for L.
Proof.
L 1−α
lim FK (K, L) = lim α ( ) = α∞1−α = ∞
K→0 K→0 K
L 1−α
lim FK (K, L) = lim α ( ) = α01−α = 0
K→∞ K→∞ K

(b) Euler’s Theorem: A version of 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.

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 We have to prove that:

FK (K, L)K + FL (K, L)L = F (K, L)

Proof.

αK α−1 L1−α K + (1 − α)K α L−α L = αK α L1−α + (1 − α)K α L1−α = F (K, L)

(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 ]

Prove that this general type of functions satisfies 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.
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.

(i) Linear Homogeneity: we know that a production function is homogeneous of

degree one if:

F (λK, λL) = λF (K, L)

Then, we have to prove that:

σ
σ−1 σ−1 σ−1
F (λK, λL) = [α(λK) σ + (1 − α)(λL) σ ]

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 Proof.
σ σ
σ−1 σ−1 σ−1 σ−1 σ−1 σ−1 σ−1 σ−1
[α(λK) σ + (1 − α)(λL) σ ] = [λ σ αK σ +λ σ (1 − α)L σ ]
σ
σ−1 σ−1 σ−1 σ−1
[λ σ (αK σ + (1 − α)L σ )] = λF (K, L)

(ii) Positive and diminishing marginal returns:

Proof.

σ−1 σ−1 −1
σ
σ σ−1
αK σ −1
σ−1 σ−1
FK (K, L) = [αK σ + (1 − α)L σ ]
σ−1 σ
σ
−1
σ−1 σ−1 σ−1 σ−1
−1
= [αK σ + (1 − α)L σ ] αK σ

1
1
σ−1 σ−1 σ−1 − σ1 1
− σ1 Y σ
= [αK σ + (1 − α)L σ ] αK =Y K σ α = α( ) > 0
K
∀ K, L > 0, α ∈ (0, 1), σ > 0

Proof.

Y σ −1 1
1
1 Y
FKK (K, L) = ( ) α ( ) [( ) FK (K, L) − 2 ]
σ K K K
1−σ
1 Y σ KFK (K, L) − F (K, L)
= ( )α( ) [ ]
σ K K2

We know what, by the positive marginal returns + Euler Theorem, [ KFK (K,L)−F
K2
(K,L)
]<
0 ⇒ FKK (K, L) < 0

(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

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 • 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)
=
∂x h(x)
∂a h(x)
= ah(x) ln(a)h′ (x)
∂x

• You are almost done. Just take the limit:

f ′ (σ)
lim
σ→1 g ′ (σ)

• 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
σ→1 g ′ (σ) σ→1

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

Proof.

(i) We first take logs in the production function:

σ−1 σ−1
σ σ−1 σ−1
ln ([αK σ + (1 − α)L σ ])
lnY = ln ([αK σ + (1 − α)L σ ]) = σ−1
σ−1 σ

(ii) We define:

σ−1 σ−1
f (σ) = ln ([αK σ + (1 − α)L σ ])
σ−1
g(σ) =
σ

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 (iii) We take derivatives of these two functions:

σ−1 σ−1
α [K σ lnK ( σ12 )] + (1 − α) [L σ lnL ( σ12 )]
′
f (σ) = σ−1 σ−1
[αK σ + (1 − α)L σ ]
1
g ′ (σ) =
σ2

f ′ (σ)
(iv) Taking the limit of g ′ (σ) when σ → 1 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≡
∂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 ]

(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.

max{P Y − wL − rK}
K,L

(ii) Compute the FOC conditions with respect to labor and capital

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 σ−1
−1
σ σ−1 σ−1 σ σ−1 σ−1
−1
L∶ σ−1 [αK σ (1 − α)L σ ] σ (1 − α)L
σ −w =0
σ−1
−1
σ σ−1 σ−1 σ σ−1 σ−1
−1
K∶ σ−1 [αK σ αK σ ] σ (1 − α)L
σ −r =0

(iii) Combine the two FOC and calculate ϵ

1 − α L −σ w
1
K α σ w σ K α w
( ) = ⇒ =( ) ( ) ⇒ ln = σln ( ) + σln ( )
α K r L 1−α r L 1−α r

Then,

∂ln ( K
L
)
ϵ≡ =σ
∂ln ( wr )

(iv) Use the FOC of capital to compute the share of capital in total income defined
as:

rK
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
Manipulating the FOC of capital we get:
1
Y σ
( ) α=r
K

Manipulating this expression we get:

rK
= ασ r1−σ
Y
rK
Which implies that the sign of the relationship between Y and r depends on
the value of σ.
• σ ∈ (0, 1): ↑ r ⇒ rK
Y ↑

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• σ > 1: ↑ r ⇒ rK
Y ↓
• σ = 1: ↑ r ⇒ rK
Y =α