EVALUATION GUIDELINES - Course paper

Component of continuous assessment

GRA 65161
Economics for Finance

Department of Economics

Start date: 09.11.2018 Time 09:00

Finish date: 16.11.2018 Time 12:00

For more information about formalities, see examination paper.

All problems should be solved, and they are given equal weights.

Question 1: Demand

Erik Tytgat is a passive nature lover, and his preferences for buying penguin documentary DVDs (
x𝑝𝑑) and turtle sanctuary lottery tickets (x𝑡𝑠) are represented by the utility function U(x𝑝𝑑,xts) = 6x1/2
pd
x2/3
ts . The prices of penguin documentary DVDs and turtle sanctuary lottery tickets are p𝑝𝑑 and pts,
respectively, per unit. Erik has an income of w to spend.

a. Find the Walrasian demand functions for both goods, and show that these functions are
homogenous of degree 0 in prices (p) and income (w).

b. What is Erik’s marginal rate of substitution when he is consuming four lottery tickets and three
DVDs? Explain your result.

c. When Erik is consuming the best bundle he can afford, what fraction of his income does he spend
on penguin documentary DVDs?

d. Are turtle sanctuary lottery tickets a normal good?

e. What is the marginal utility of wealth at the equilibrium point? (Note: As a point of reference, also
indicate the utility level at the equilibrium point.)

f. Derive the indirect utility function, and verify that it is increasing in wealth as well as non-
increasing in the price of penguin documentary DVDs.

g. Imagine that the prices of penguin documentary DVDs and turtle sanctuary lottery tickets are equal
to p𝑝𝑑 = 50 and pts = 30. Draw that part of the Engel curve for penguin documentary DVDs where
income lies between w = 200 and w = 500. Can we infer from this Engel curve whether or not
these DVDs are a normal good?

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Question 2: Production

a. Spiralhefte Ltd is in the college notebook business. With q representing the amount of output (i.e.
notebooks) and 𝑥𝑐 and 𝑥𝑙 the amounts of capital and labour used in the production process, its
production function f(.) takes the following form: q = f(𝑥𝑐,𝑥𝑙) = 4𝑥𝑎𝑙.𝑥𝑏𝑐, where parameters a and b
are both positive numbers (a>0, b>0). What is the marginal product of inputs 𝑥𝑐 and 𝑥𝑙? Under
what condition is the marginal product of capital decreasing as the amount of that factor alone is
varied?

b. Consider a representative firm that produces output q in a perfectly competitive market using inputs
L and K according to the following production function: q = f(K,L)= √L+√K. The output price is
p, and prices of inputs are w (for input L) and r (for input K) respectively. Illustrate that the
conditional input demand functions for inputs L and K are downward sloping. [You may assume
that second-order conditions are met, and that an internal solution exists.]

c. Consider a representative firm that produces output q in a perfectly competitive market using inputs
L and K according to the following production function: q = f(K,L)= L2 . √K (where ‘.’ signifies
a multiplication). The output price is p, and prices of inputs are w (for input L) and r (for input K)
respectively. Is this production function characterised by increasing, decreasing or constant returns
to scale? Would your answer change if the production function was instead given by: q = L2 + √K?
Explain your answer.

Question 3: Equilibrium

Consider a 2-consumer (i=1,2), 2-good (k=1,2) Pure Exchange economy. Each consumer has well-
behaved preferences over the consumption vectors (x1i, x2i) in ℝ2+, represented by his/her utility
function. Specifically, the utility function of consumer 1 is given by U1(x11, x21) = x11x21, while that
of consumer 2 is U2(x12, x22) = x12x22. Each consumer’s initial endowments are given by ωki ≥0 (with
total endowment of each good k strictly positive). [Note that the first subscript represents the good,
while the second one represents the consumer.] Given a price vector p=(p1, p2), the Walrasian
demands in this economy will look as follows:
(p1 ω11 + p2 ω21) (p1 ω11 + p2 ω21)
x11 = x21 =
2p1 2p2
(p1 ω12 + p2 ω22) (p1 ω12 + p2 ω22)
x12 = x22 =
2p1 2p2

a. Calculate the (general equilibrium) price ratio p1*/p2* that clears the market for good 2.

b. Show that this price ratio also clears the market for good 1.

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c. Would equilibrium quantities and prices differ if the consumers’ utility functions instead took the
following form: U1(x11, x21) =  ln x11 +  ln x21; U2(x12, x22) =  ln x12 +  ln x22? Explain your
answer!

As discussed in class, the competitive market equilibrium allocates resources (Pareto) efficiently
according to the First Theorem of Welfare Economics.

d. Discuss – and graphically illustrate – why this must imply that a competitive market equilibrium
maximizes total surplus (defined as the sum of consumer and producer surplus) in the economy.

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Answer 1: Demand

a. The Lagrangian of this Utility Maximization Problem is given by:

𝐿(.) = 6x1/2 2/3
pd x ts ‒ λ(p𝑝𝑑x𝑝𝑑 + p𝑡𝑠x𝑡𝑠 ‒ 𝑤)

The three first-order conditions for the equilibrium consumption choices are:
1 2 1 2
∂𝐿(.) 1 ‒ ‒
= 0:6 x 𝑝𝑑2xts3 ‒ λp𝑝𝑑 = 0→3x 𝑝𝑑2xts3 = λp𝑝𝑑
∂x𝑝𝑑 2
1 1 1 1
∂𝐿(.) 2 2 ‒3 2
‒
= 0:6 x𝑝𝑑 x ts ‒ λp𝑡𝑠 = 0→4x𝑝𝑑 x ts3 = λp𝑡𝑠
∂x𝑡𝑠 3
∂𝐿(.)
= 0:p𝑝𝑑x𝑝𝑑 + p𝑡𝑠x𝑡𝑠 = 𝑤
∂λ

Dividing the first two FOCs allows us to derive the equilibrium relation between the optimal
demands for both goods:
1 2
‒
3x 𝑝𝑑2xts3 λp𝑝𝑑 3x𝑡𝑠 p𝑝𝑑 4p𝑝𝑑
= → = →x𝑡𝑠 = x
1
‒
1 λp𝑡𝑠 4x𝑝𝑑 p𝑡𝑠 3p𝑡𝑠 𝑝𝑑
2
4x𝑝𝑑 x ts3

Filling this equilibrium relation into the third FOC (i.e. the budget constraint), we can determine the
Walrasian demand functions for both goods:
4p𝑝𝑑
p𝑝𝑑x𝑝𝑑 + p𝑡𝑠 ( x =𝑤
3p𝑡𝑠 𝑝𝑑 )
4
→p𝑝𝑑x𝑝𝑑 + p𝑝𝑑x𝑝𝑑 = 𝑤
3
7
→ p𝑝𝑑x𝑝𝑑 = 𝑤
3
3𝑤
→x𝑝𝑑 =
7p𝑝𝑑
4𝑤
→x𝑡𝑠 =
7p𝑡𝑠

Verifying that these functions are homogenous of degree 0 in prices (p) and income (w) requires two
steps. First, multiply each p and w in each function with a factor t>0. Second, check whether you can
rewrite the resulting function to retrieve the original demand functions.
3 (𝑡𝑤) 4 (𝑡𝑤)
x𝑝𝑑 = x𝑡𝑠 =
7 (tp𝑝𝑑) 7 (tp𝑡𝑠)

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 𝑡 3(𝑤) ! 𝑡 4(𝑤) !
→ x → x
t7(p𝑝𝑑) = 𝑝𝑑 t7(p𝑡𝑠) = 𝑡𝑠

3x𝑡𝑠
b. Erik’s marginal rate of substitution is 4x𝑝𝑑. Hence, evaluated at the consumption of four lottery
tickets and three DVDs, this equals 1. The interpretation is that Erik is at this consumption point
just willing to substitute both goods on a one-for-one basis in order to remain equally well off
(i.e. on the same indifference curve).

c. We can rewrite the Walrasian demand function for DVDs to show that Erik would spend 3/7 of his
income on DVDs (and the remaining share on lottery tickets):
3
x𝑝𝑑.p𝑝𝑑 = 𝑤
7

d. Turtle sanctuary lottery tickets are a normal good if Erik consumes more of them whenever his
income goes up. This implies a positive derivative of the Walrasian demand function with respect
to w:
∂x𝑡𝑠 4
= >0
∂w 7p𝑡𝑠
This derivative is clearly positive (since all prices are assumed to be positive), so the lottery tickets
are a normal good for Erik.

e. The marginal utility of wealth at the equilibrium point is reflected in the value of the Lagrangian
multiplier. From the FOCs, we know that this multiplier equals:
1 2
‒
3x 𝑝𝑑2xts3
λ=
p𝑝𝑑

Filling in the equilibrium choices for both goods derived under question 1.a above, we obtain:
1 2 1 2 1
3
3𝑤
( ) ( ) () ()
7p𝑝𝑑
‒
2 4𝑤
7p𝑡𝑠
3
3
3
7
‒
2 43 6
7
w
λ= =
p𝑝𝑑 1 2
2 3
p𝑝𝑑 p𝑡𝑠

(Meaning: Imagine an income of 700 and prices of penguin documentary DVDs and turtle
sanctuary lottery tickets that are equal to p𝑝𝑑 = 30 and pts = 40. Then Jeremy will consume 10
DVDs and 10 lottery tickets, and his utility will equal 88.068. The marginal utility of wealth at

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 the equilibrium point will then equal 0.1468. That is, marginally adding to Jeremy’s income at
the equilibrium will increase his utility with 0.1468.)

(Note that you can obtain the same result when using the other FOC!)

f. The indirect utility function is obtained by inserting the optimal choices of both good (i.e. the
Walrasian demand functions) into the original utility function:
1 2

v(.) = 6 ( )( )
3𝑤
7p𝑝𝑑
2 4𝑤
7p𝑡𝑠
3

1 2 7
3 43 6
6 ( )( )
7
2
7
w
→v(.) = 1 2
2 3
p𝑝𝑑 p𝑡𝑠

This function is increasing in w, since the derivative w.r.t. w is clearly a positive number. It is non-
increasing in prices since the derivative w.r.t. each price will clearly be negative number.

g. The Engel curve gives the relation between Erik’s level of income w and the optimal consumption
level of a good. In this case, this will be a linear upward-sloping curve. An upward-sloping Engel
curve implies that the change in consumption from a change in income is positive, which reflects
that this concerns a normal good (at least over this range of income)

Answer 2: Production

a. The marginal product of inputs 𝑥𝑐 and 𝑥𝑙 is obtained by taking the derivative of the production
function with respect to the input under consideration.

∂𝑓(.)
MP𝑙 = = 4𝑎𝑥𝑎 ‒𝑙 1𝑥𝑏𝑐
∂𝑥𝑙
∂𝑓(.)
MP𝑐 = = 4𝑏𝑥𝑎𝑙𝑥𝑏 ‒𝑐 1
∂𝑥𝑐

Given that parameters a and b are positive by assumption and only non-negative amounts of inputs
are feasible, both marginal products will generally be positive. The marginal product of capital is
decreasing as the amount of that factor alone is varied whenever its derivative with respect to 𝑥𝑐 is
negative.

∂MP𝑐
= (𝑏 ‒ 1)4𝑏𝑥𝑎𝑙𝑥𝑏 ‒𝑐 2
∂𝑥𝑐

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 This is a negative number whenever the parameter b is smaller than 1. Hence, the marginal product
of capital is decreasing as the amount of that factor alone is varied whenever b<1.

b. The idea is to set up the Cost Minimization Problem to derive the conditional input demand
functions. Then take the derivative of these functions to show that this is a non-positive number.

The CMP associated with this problem is:

min 𝑟𝐾 + 𝑤𝐿 𝑠.𝑡. ( 𝐿 + 𝐾) = q
𝐾.𝐿

To solve for the conditional factor demand functions (i.e., K(q,w,r) and L(q,w,r) – i.e. factor
demands conditional on the output level), we set up the Lagrangian and set its first derivatives with
respect to L, K and λ equal to zero.

𝐿(𝐾,𝐿,𝜆):𝑤𝐿 + 𝑟𝐾 ‒ 𝜆( 𝐿 + 𝐾 ‒ 𝑞)

∂𝐿(.) 1
=𝑤‒𝜆 =0 (1)
∂𝐿 2 𝐿
∂𝐿(.) 1
=𝑟‒𝜆 =0 (2)
∂𝐾 2 𝐾
∂𝐿(.)
= 𝐿+ 𝐾‒𝑞=0 (3)
∂𝜆

Bringing w and r to the right-hand side, and then dividing (1) by (2), we obtain:

𝐾 𝑤
=
𝐿 𝑟

Note that the left-hand side of this equation is the derivative of the production function w.r.t. L
divided by the derivative of the production function w.r.t. K – which is the Marginal Rate of
Technical Substitution (MRTS). The right-hand side is the input price ratio. Importantly, we can use
this to express K as a function of L (or, of course, L as a function of K).

𝑤 𝑟
𝐾=𝐿 ()
𝑟
2
𝑜𝑟 𝐿 = 𝐾 ()
𝑤
2

This can now be inserted into FOC (3) (which gives our ‘production’ constraint)

𝑟 2
𝐾 ()
𝑤 +
𝐾=q

Some re-writing to keep only K on the left-hand side will give K as a function of input prices and
the production level, which is what we’re looking for.

𝑟
𝐾+ 𝐾=𝑞
𝑤

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 (𝑤𝑟 + 1) 𝐾 = 𝑞
(𝑤 𝑤+ 𝑟) 𝐾 = 𝑞
𝑞𝑤
𝐾(𝑞, 𝑤,𝑟) = (
𝑤 + 𝑟)
2

This is the conditional factor demand function for good K. Repeating the same steps – i.e., inserting
K as a function of L into equation (3) – leads to the demand function for good L.

𝐿(𝑞, 𝑤, 𝑟) = (𝑤𝑞𝑟+ 𝑟) 2

It is easy to see that K(.) and L(.) are downward sloping in input prices w and r, respectively,
because an increase in r will decrease the value of K(.) whereas an increase in w decreases the value
of L(.). More formally, this can be illustrated by taking the derivative of each conditional factor
demand function w.r.t. its input price.

∂𝐿(𝑞, 𝑤, 𝑟) 𝑞𝑟 𝑞𝑟
∂𝑤
=2 ( )
𝑤+𝑟
.( ‒ 1 )
(𝑤 + 𝑟 )2
.1

(𝑞𝑟)2
=‒ 2
(𝑤 + 𝑟 )3
≤0

Reason: All input prices are assumed to be strictly positive and q≥0 since you cannot
produce negative amounts.

∂𝐾(𝑞, 𝑤, 𝑟) 𝑞𝑤 𝑞𝑤
∂𝑟
=2 ( )
𝑤+𝑟
.( ‒ 1 )
(𝑤 + 𝑟 )2
.1

(𝑞𝑤)2
=‒ 2
(𝑤 + 𝑟 )3
≤0

Reason: All input prices are assumed to be strictly positive and q≥0 since you cannot
produce negative amounts.

c. Returns to scale tell us what happens to output (y) if we scale all inputs (x) by factor t>1.
Constant returns to scale (CRS): f(tx) = t.f(x) for all t>1
Increasing returns to scale (IRS): f(tx) > t.f(x) for all t>1
Decreasing returns to scale (DRS): f(tx) < t.f(x) for all t>1

Important: Returns to scale are a local property and may change over the range of production. It
only becomes a global property if the production function f(.) is homogenous of degree r>0 [[Such
functions are defined by f(γx)= γr f(x)]]. This is important here because this homogeneity property

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holds for the production function: q = f(K,L)= L2 . √K, but not for the production function q = L2 +
√K.

To see this, multiplying production function L2 . √K with a factor t>1 gives:

(tL)2 . (tK)½
= t2L2 t½K½
= t2+1/2 . L2K½
= t2.5. f(K,L)

Hence, returns to scale are 2.5, and we have increasing returns to scale.

Multiplying production function L2 + √K with a factor t>1 gives:

(tL)2 + (tK)½
= t2L2 + t½K½

This cannot be rewritten as a function of the original production function, such that returns to scale
are a local property for this production function. Hence, returns to scale depend on the exact level of
L and K in this case.

Answer 3: Equilibrium

a. The price ratio p1*/p2* that clears the market for good 2 should equate x21+x22= 21+22. That is:
𝑝1𝜔11 + 𝑝2𝜔21 𝑝1𝜔12 + 𝑝2𝜔22
+ = 𝜔21 + 𝜔22
2𝑝2 2𝑝2

From this, it’s just a matter of re-writing to get at p1*/p2*:

1 1 𝑝1
[ 2 2 ] 𝑝2
1
2
1
𝜔11 + 𝜔12 = 𝜔21 ‒ 𝜔21 + 𝜔22 ‒ 𝜔22
2
1 1 𝑝1 1
[ 2 2 ] 𝑝2 2
1
𝜔11 + 𝜔12 = 𝜔21 + 𝜔22
2
1 1
𝑝1 2𝜔21 + 2𝜔22
=
𝑝2 1 1
𝜔11 + 𝜔12
2 2
𝑝1 𝜔21 + 𝜔22
=
𝑝2 𝜔11 + 𝜔12

b. To show that this price ration also clears market 1, we insert it into x11 and x12 and evaluate
whether the resulting sum of both equals the sum of endowments of good 1 across both consumers
(i.e., x11+x12= 11+12).

First, let us calculate x11:

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 1 1𝑝2
x11 = 𝜔11 + 𝜔
2 2𝑝1 21
𝜔11 + 𝜔12
1 1
x11 = 𝜔11 + 𝜔21
2 2 [
𝜔21 + 𝜔22 ]
In the same way we can get to x12:
𝜔11 + 𝜔12
1 1
x12 = 𝜔12 + 𝜔22
2 2 [
𝜔21 + 𝜔22 ]
Finally, summing both x11and x12, we obtain:
𝜔11 + 𝜔12
1 1 1 1
x11 + x12 = 𝜔11 + 𝜔12 + 𝜔21 + 𝜔22 .
2 2 2 2 [𝜔21 + 𝜔22 ][ ]
𝜔11 + 𝜔12
1 1 1
x11 + x12 = 𝜔11 + 𝜔12 + [𝜔21 + 𝜔22].
2 2 2 𝜔21 + 𝜔22[ ]
1 1 1
x11 + x12 = 𝜔11 + 𝜔12 + [𝜔11 + 𝜔12]
2 2 2

→x11 + x12 = 𝜔11 + 𝜔12

Clear, market one thus also clear at the price ratio p1*/p2*.

c. For two different utility functions to represent the same preferences, they must have identical
marginal rates of substitution (MRS). For the original utility functions U1(x11, x21) = x11x21 and
U2(x12, x22) = x12x22, we have that their MRS equals:

𝑥21 𝑥22
𝑈1(𝑥11,𝑥21)→ MRS equals ; 𝑈2(𝑥12,𝑥22)→ MRS equals
𝑥11 𝑥12

For the logarithmic utility functions U1(x11, x21) =  ln x11 +  ln x21 and U2(x12, x22) =  ln x12 + 
ln x22, we have instead that their MRS equals:

𝛼𝑥21 𝛿𝑥22
𝑈1(𝑥11,𝑥21)→ MRS equals ; 𝑈2(𝑥12,𝑥22)→ MRS equals
𝛽𝑥11 𝜀𝑥12

As long as 𝛼 = 𝛽 and 𝛿 = 𝜀, these MRS are equivalent. Hence, under that condition, the results
would not change.

d. We can derive aggregate demand for good l from the equilibrium of the UMP: xi*(p*,wi) ≥ 0
-> For any price p, we can then define aggregate demand as follows: x(p,wi)= ⅀i xi (p,wi)
-> Graphically, it’s horizontal sum of individual demands

Similarly, we can derive aggregate supply of good l from equilibrium of the UMP: qj*(p*) ≥ 0

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-> For any price p, we can then define aggregate supply as follows: q(p)= ⅀j qj(p)
-> Graphically, it’s horizontal sum of individual supplies

The market clearing condition (⅀i xi* = ⅀j qj*) now shows the way to equilibrium. In effect, the
equilibrium price of good l is p* where aggregate demand equals aggregate supply. Graphically, we
get:

Competitive market equilibrium maximizes total surplus in the economy, because the sum of
Consumer Surplus (CS; Area under demand curve and above price) and Producer Surplus (PS; Area
above supply curve and under price) is maximised in the market equilibrium.

[to see this, imagine CS and PS at ANY other level of (x,q) and note that mutually beneficial trades
remain possible left of (x*,q*). This is no longer true at (x*,q*)]

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