EC 502: Midterm Exam for Fall 2017

SOLUTIONS

Exam Instructions

• There are 75 points in total on this exam. You have exactly 75 minutes to complete the
exam. Budget your time accordingly, i.e. allocate 1 minute per point.

• You may not use any outside written material (e.g. notes) or any electronic device during
this exam.

• You must show your work, i.e. you will not receive full credit for simply writing the correct
answer without any justification.

• Before writing anything, record your name and BU ID number below!

NAME:
BU ID:
1. True/False/Uncertain (20 points total)
Please indicate whether the statement in each part is true, false, or uncertain given the
information provided. You must briefly justify your answer, i.e. you will not receive full credit
for simply stating the answer without an explanation.

(a) (5 points) Ideas are partially excludable.

TRUE. Institutions such as patents, copyrights, and secrecy can be used to exclude
others from using an idea.

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(b) (7 points) The Solow model covered in class can explain the high capital accumulation
rates of East Asian economies such as China and South Korea in recent decades.
TRUE. The Solow model predicts that nations with low initial living standards will ac-
cumulate capital rapidly, and grow quickly, over a transition path as they approach a
“steady state.” In the long run, at the steady state, the growth of living standards is
eventually constrained by the growth rate of technology.

(c) (8 points) The Bernoulli utility function U (C) = eαC , where α > 0, exhibits diminishing
marginal utility.
FALSE. Note that the first and second derivatives of this Bernoulli or period utility
function are given by

U 0 (C) = αeαC > 0, U 00 (C) = α2 eαC > 0.

Since U 00 (C) > 0, we have by definition that this utility function does not exhibit dimin-
ishing marginal utility.

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2. Solow Model (15 points total)
Time is continuous, and output Y (t) is given by the neoclassical production function Y (t) =
F (K(t), A(t)L(t)), where K(t) is capital, A(t) is technology, and L(t) is labor. F exhibits
constant returns to scale. The exogenous laws of motion for technology and labor are
Ȧ(t) L̇(t)
A(t) = g and L(t) = n. Investment is a constant fraction of output with I(t) = sY (t), and
the law of motion for capital is given by K̇(t) = I(t) − δK(t). To fix terminology, g > 0 is
the technology growth rate, n > 0 is the population growth rate, 0 < s < 1 is the savings
K(t) Y (t)
rate, and 0 < δ < 1 is the capital depreciation rate. Let k(t) = A(t)L(t) and y(t) = A(t)L(t)
be capital and output per efficiency unit of labor, respectively. Let y(t) = f (k(t)) be the
intensive form of the production function. Note that the law of motion for k(t) is given by

k̇(t) = sf (k(t)) − (n + g + δ)k(t),

a result which you may take as given.

(a) (5 points) The term sf (k(t)) in the law of motion for k(t) is realized investment per
efficiency unit of labor. The term (n + g + δ)k(t) is known as break even investment.
Draw a figure which plots both realized investment per efficiency unit of labor and break
even investment as a function of k(t). On the horizontal axis, mark the steady state
level k ∗ such that k̇(t) = 0 whenever k(t) = k ∗ .
The figure will look something like

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(b) In the long run, the level of capital per efficiency unit of labor approaches the steady
state level, i.e. k(t) → k ∗ . Similarly, if y ∗ = f (k ∗ ), then output per efficiency unit of
labor approaches y ∗ , i.e. y(t) → y ∗ . You make take these results as given. For each
of the sub-questions (i)-(ii) in this part, justify your answer using expressions involving
only parameters from the following list: A(0), L(0), g, n, k ∗ , s, and y ∗ .
i. (4 points) Let S(t) be total savings in this economy. Derive the long run growth
rate of S(t).
Note that S(t) = sY (t) = sy(t)A(t)L(t) → sy ∗ A(0)L(0)e(g+n)t , implying that S(t)
grows at the rate g + n in the long run.

K(t)
ii. (3 points) Derive the long run growth rate of capital per capita L(t) .
Note that K(t) ∗ gt
L(t) = k(t)A(t) → k A(0)e , implying that
K(t)
L(t) grows at the rate g in
the long run.

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(c) (3 points) Assume the economy begins at steady state with k(t) = k ∗ . Then, there is
a horrible natural disaster causing a sudden decline in the capital stock K(t) to 50%
of it’s previous level. The natural disaster leaves technology A(t) and the population
L(t) unchanged. Determine whether the level of capital per efficiency unit of labor k(t)
increases, decreases, or stays the same at the moment of the natural disaster.
At the moment of the natural disaster, capital per efficiency unit of labor changes to the
level
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Knodisaster (t) Knodisaster (t)
kdisaster (t) = 2 < = k ∗ = knodisaster (t).
A(t)L(t) A(t)L(t)
Because kdisaster (t) < k ∗ = knodisaster (t), we conclude that capital per efficiency unit
has declined.

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3. An Island’s GDP (15 points total)
An isolated island economy is made up of two companies: MoreInc and ProduceCo. Mor-
eInc and ProduceCo both produce output using a Cobb-Douglas production function

Yi = Kiα (Ai Li )1−α ,

where α ∈ (0, 1) is the capital elasticity, Yi is output, Ki is capital, and Li is labor used by
each of the firms. Note that i = m refers to MoreInc and i = p refers to ProduceCo. Each
firm’s capital stock is permanently fixed at an identical level, with

Kp = Km = K̄

for some number K̄ > 0. ProduceCo’s productivity is equal to the productivity of MoreInc,
so that
Ap = Am = Ā
for some number Ā > 0. The population size on the island is fixed, so that

Lp + Lm = L̄

for some number L̄ > 0. Therefore, any increase in labor Lp used at ProduceCo implies a
decrease in the amount of labor Lm used at MoreInc, and vice-versa. The total GDP Y of
the economy is the sum of the output of both firms

Y = Yp + Ym .

Assume that the amount of labor Lp allocated to the firm ProduceCo is determined by a
dictator with absolute power.

(a) (7 points) Derive the following formula for the rate of change of total GDP Y in the
island with respect to the amount of labor Lp allocated to ProduceCo:

dY
= M P Lp − M P Lm .
dLp

The terms M P Lm and M P Lp refer to the marginal products of labor at MoreInc and
ProduceCo, respectively.
Note that we have by the multivariate Chain Rule that

dY ∂Yp ∂Ym ∂Lm

= + = M P Lp + M P Lm (−1) = M P Lp − M P Lm .
dLp ∂Lp ∂Lm ∂Lp
∂Lm
We can substitute the terms M P Lp and M P Lm by definition, and ∂Lp = −1 follows
from Lm = L̄ − Lp .

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(b) (8 points) Determine the choice of Lp which would maximize total GDP Y on the island.
Explain your answer intuitively. Note that you may use the formula from part (a).
The maximizing choice of labor Lp at ProduceCo must satisfy the first-order condition
dY
dLp = 0, which in turn implies that

M P Lp = M P Lm

at the maximizing level of Lp . But then, note that the information given in the problem
implies that the functions M P Lp (Lp ) and M P Lm (Lm ) are the same. Since these are
strictly decreasing functions, the only way in which M P Lp = M P Lm can be satisfied is
if Lp = Lm . But then we have that Lp = L̄ − Lm = L̄ − Lp → Lp = L̄2 = Lm . Intuitively,
if the dictator chooses anything other than exactly equal labor allocations across the
identical firms, then one of the two firms will have a higher marginal product of labor
than the other. In that case, the dictator could increase output by shifting labor back
towards the high M P L firm. In other words, choosing anything other than an exactly
equal split of labor across the two firms will not be maximizing.

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4. Endogenous Growth and Consumption (20 points total)
Let time t be continuous. GDP or output Y (t) is given by Y (t) = A(t)L(t). In this production
function, A(t) is the level of knowledge in the economy. L(t) is the size of the population
at time t, which is fixed at a constant level L(t) = L̄ > 0. Output may be used either for
consumption C(t) or for R&D investments R(t), which implies that

C(t) + R(t) = Y (t).

At any point in time, the change in knowledge Ȧ(t) is a function of the existing stock of
knowledge A(t) as well as the level of R&D investments, with

Ȧ(t) = R(t)ρ A(t)1−ρ ,

for some innovation elasticity ρ ∈ (0, 1). There is an exogenously given share sc ∈ (0, 1) of
output consumed in this economy, so C(t) = sc Y (t) at all times.

(a) (7 points) Show that the growth rate of knowledge A(t) in this economy is given by the
formula  ρ
gA = (1 − sc )L̄ .
We have that according to the resource constraint

R(t) = Y (t) − C(t) = (1 − sc )Y (t) = (1 − sc )L̄A(t),

which implies that according to the innovation production function

Ȧ(t)
Ȧ(t) = [(1 − sc )L̄A(t)]ρ A(t)1−ρ → = [(1 − sc )L̄]ρ .
A(t)

We conclude from this final equation that the growth rate of knowledge A(t) is gA =
[(1 − sc )L̄]ρ as desired, so that A(t) = A(t)egA t where gA satisfies the given formula.

(b) (6 points) Show that the growth rate gC of consumption C(t) is equal to the growth rate
of knowledge gA given in part (a).
ρ
We have that C(t) = sc Y (t) = sc L̄A(t) = sc L̄A(0)egA t = sc L̄A(0)e[(1−sc )L̄] t . We con-
clude that the growth rate of consumption C(t) is equal to the growth rate of knowledge,
i.e. gC = [(1 − sc )L̄]ρ .

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(c) (7 points) Assume that a government policymaker suddenly and exogenously de-
creases the share of output sc devoted to consumption. Draw a figure plotting the
natural logarithm log(C(t)) of consumption as a function of time before and after the
policy change. Label your axes, and indicate the moment of the policy change on the
horizontal axis. In the long run, does consumption increase or decrease as a result of
the decrease (typo pointed out during exam, said “increase” in test sheet) in sc ? In the
short run, immediately after the policy change, does consumption increase, decrease,
or stay the same due to the decrease (typo pointed out during exam, said “increase” in
test sheet) in sc ? Explain the intuition behind your
 answers. 
ρ
We have from the parts above that log C(t) = log sc L̄A(0)e[(1−sc )L̄] t = log sc L̄A(0) +

[(1 − sc )L̄]ρ t. In other words, as a function of time, log consumption is a line with an
intercept that varies positively in sc and a slope which varies negatively in sc . We con-
clude that the figure will look something like the one below. At the moment of the policy
change, consumption will decline, but in the long run consumption will be higher on the
new path. Intuitively, lowering the share of output devoted to consumption leads to a
direct drop in consumption in the short-run, but in the long run the higher resulting level
of R&D leads to more knowledge and hence greater levels of output and consumption
than would otherwise have resulted. Just as in the case of the Solow model, invest-
ment – which in this case takes the form of R&D – has both indirect and direct effects
on consumption.

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5. Utility Maximization (5 points total)
A household which lives for two periods faces income levels Y1 and Y2 in periods 1 and 2
respectively. These income levels are known with certainty. The household can save the
amount S in period 1 and receive the return 1 + r on its savings, also known with certainty,
in period 2. The household derives utility U (C) from consumption in each period, and the
household discounts period 2 at rate β. The household solves the utility maximization prob-
lem
max U (C1 ) + βU (C2 )
C1 ,C2

s.t. C1 + S = Y1 , C2 = Y2 + (1 + r)S

Derive the Euler equation governing the optimal savings choice S. Explain, in words, the
intuition behind the Euler equation.
By substituting the budget constraints into the household utility functions we can obtain the
equivalent utility maximization problem

max U (Y1 − S) + βU (Y2 + (1 + r)S).

S

The first-order condition of this problem with respect to S is given by

0 = −U 0 (Y1 − S) + β(1 + r)U 0 (Y2 + (1 + r)S)

which can be simplified to the Euler equation

U 0 (C1 ) = β(1 + r)U 0 (C2 ).

The Euler equation for optimal savings behavior implies that the household sets the marginal
cost of savings, equal to the marginal utility of lost consumption in period 1 on the left hand
side, equal to the marginal benefit of savings. The marginal benefit of savings is given by
the discounted marginal utility of consumption tomorrow, adjusted by the return on savings.
This marginal benefit is exactly the right hand side of the Euler equation.

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