IE54500 – Exam 2

Dr. David Johnson

Fall 2023
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searching for them on the internet.

Requests to “show mathematically,” “derive” or “prove” information are asking you to use calculus,
algebra, etc. to formally prove something. “Show graphically” means a logical argument based on a
graph is requested. Words like “explain” mean either is fine, with the appropriate approach likely based
on what you’ve done so far in the problem; you may still support your reasoning with math or figures, as
appropriate. Be complete in your reasoning and state your assumptions. The points associated with
each question are listed, including the extra credit; spend your time and energy accordingly.

1. Cast Away
In the 2000 movie Cast Away, Tom Hanks’s character, Chuck, is stranded alone on an island in the Pacific
after a plane crash. Without any other survivors, he must produce himself everything that he consumes.
In other words, he has no possibility for trade with other individuals, and he is the only producer and
only consumer in the island’s market. The movie focuses on two time periods, around the time of the
crash and several years later once Chuck has adapted to life on the island. You can model Chuck’s
experience as living for two time periods and being endowed with a certain level of resources from the
island in period 1, 𝑅1 , and in period 2, 𝑅2 . Resources can be consumed to produce utility, but in the first
period, Chuck can choose to convert some resources to goods that would then be consumed in the
second period, according to the production function 𝑓(𝑅1 − 𝑐1 ), where 𝑐𝑖 represents Chuck’s
consumption in time period 𝑖.

Assume that 𝑓(0) = 0, 𝑓 ′ (𝑥) > 0, and 𝑓 ′′ (𝑥) < 0, and that Chuck has an additively separable utility
function with a personal discount rate of 𝛿 per time period.

a) Set up the castaway’s utility maximization problem (5 points).

We are told the castaway has an additively separable utility function with discount rate 𝛿, so
𝑢(𝑐2 )
assume that 𝑈(𝑐1 , 𝑐2 ; 𝛿) = 𝑢(𝑐1 ) + where 𝑢(𝑐) conforms with the usual properties of a
1+𝛿
utility function. In period 2, the individual consumes resources 𝑅2 plus anything that was produced
 using leftover resources from period 1, so our budget constraint is 𝑐2 = 𝑅2 + 𝑓(𝑅1 − 𝑐1 ).

𝑢(𝑐2 )
∴ max ℒ = 𝑢(𝑐1 ) + + 𝜆(𝑓(𝑅1 − 𝑐1 ) + 𝑅2 − 𝑐2 )
𝑐1 ,𝑐2 1+𝛿
b) Derive the first-order conditions that characterize Chuck’s optimal choice of consumption in
periods 1 and 2 (5 points).

ℒ𝑐1 = 𝑢𝑐1 − 𝜆𝑓 ′ = 0
𝑢𝑐2
ℒ𝑐2 = −𝜆 = 0
1+𝛿
ℒ𝜆 = 𝑓(𝑅1 − 𝑐1 ) + 𝑅2 − 𝑐2 = 0
c) Draw a graph showing Tom Hanks’s character’s optimal choice of consumption in periods 1 and 2
that is consistent with the first-order conditions derived in part b). Depict 𝑐2 on the vertical axis
and 𝑐1 on the horizontal axis. Show mathematically that, at the tangency between his indifference
curve and budget constraint,
𝑈𝑐1
(1 + 𝛿) = 𝑓 ′ (𝑅1 − 𝑐1 )
𝑈𝑐2

where 𝑈𝑐𝑖 is the partial derivative of the utility function with respect to 𝑐𝑖 (5 points).

The slope of the budget constraint can be found by differentiating the budget constraint with
respect to 𝑐1 and 𝑐2 :

𝑑𝑐2 = −𝑓 ′ 𝑑𝑐1
So the slope of the budget constraint is:

𝑑𝑐2
= −𝑓 ′ < 0
𝑑𝑐1

𝐹urther, the slope changes according to

𝑑2 𝑐2
= 𝑓 ′′ < 0
𝑑𝑐12
This implies that the individual faces diminishing returns to investing period 1 resources into
producing consumption for period 2. Moving the second term of the first two FOCs to the right-
 𝑢1
hand side, we can then divide the first FOC by the second FOC to obtain (1 + 𝛿) = 𝑓 ′ (𝑅1 − 𝑐1 ).
𝑢2

d) Imagine an alternative draft of the movie’s script in which Chuck discovers a group of other
people living on the other side of the island. This means that he is suddenly now back in a market
economy with a well-functioning capital market. He can still produce goods in period 2 according
to the same production function, but he can now also borrow and lend resources across time
periods at the market interest rate, 𝑟. Set up new optimization problems governing i) how much
Chuck consumes in periods 1 and 2, and ii) how much he produces in period 2. (Hint: these are
two separate problems.) Do not take first-order conditions or solve the problem; this is not
required for full credit (5 points).

𝑢(𝑐2 )
max ℒ = 𝑢(𝑐1 ) + + 𝜆((1 + 𝑟)(𝑅1 − 𝑐1 ) + 𝑅2 − 𝑐2 )
𝑐1 ,𝑐2 1+𝛿
𝑐2
min ℒ = 𝑐1 + + 𝛾(𝑓(𝑅1 − 𝑐1 ) + 𝑅2 − 𝑐2 )
𝑐1 ,𝑐2 1+𝑟
e) Show graphically and explain intuitively why the introduction of the market economy means that
the individual’s production and consumption choices may no longer be the same as when the
individual was alone, and why, if they change their production and consumption choices, this
means their utility will increase (10 points).

The individual now produces where the marginal return to investing the endowment, in terms of
period 2 consumption, equals the interest rate, 𝑓 ′ = (1 + 𝑟) (point A), and consumes where the
𝑢
marginal rate of substitution equals the interest rate, 𝑢1 (1 + 𝛿) = (1 + 𝑟) (point B). These
2
consumption and production bundles will not necessarily coincide since there is no guarantee that
a given bundle of 𝑐1 and 𝑐2 will yield the same rates of return in the production and utility
functions. However, the original choices of consumption and production are still feasible for the
individual, who could choose not to trade in the market. Because the original choices are still part
of the feasible action space, they will only choose to engage in trade if it increases their utility. The
 potential for trade is illustrated below, where the individual produces 𝑝1∗ , which would allow them
to consume 𝑝2 in period 2. However, they will then choose to trade some of the production and
period 2 resources at the market rate, allowing them to instead consume at (𝑐1∗ , 𝑐2∗ ).

2. Traveling First Class

To reduce carbon emissions, a growing number of European countries have proposed bans on regional
flights where an alternative train route exists. This means that a greater amount of business travel will
be done by train. Because of business travelers’ work demands and the wealth of corporations, demand
for business travel is less elastic (i.e., price-sensitive) than for other types of customers. Train companies
know that they can exploit that difference in elasticity by charging more for first class tickets; because of
the price difference, the train company knows that the more expensive tickets may be the only ones
available when business travelers need to book a ride on short notice.

Trains can model this by offering “first class” seats 𝑥1 at a price 𝑝1 and “economy class” seats 𝑥2 at a
price 𝑝2 , and their decision problem is to choose how many seats of each class to offer. Assume the train
company has a monopoly on a route, so that the price of each class of seats is a function of the number
of seats the airline chooses. Assume their total costs are a function of the total number of seats offered,
𝐶(𝑥1 + 𝑥2 ). In other words, you can ignore that first class seats may include free food and drink; assume
the cost of a seat to the company is the same, regardless of whether it is first class or economy class.

Therefore, the profit function for the train operator is

𝜋 = 𝑝1 (𝑥1 ) ∙ 𝑥1 + 𝑝2 (𝑥2 ) ∙ 𝑥2 − 𝐶(𝑥1 + 𝑥2 )

a) Show mathematically that the train’s profits are maximized when the marginal revenue from
first class seats equals the marginal revenue from economy class seats, and when these
marginal revenues each equal the marginal cost of offering an additional seat. (5 points)

The relevant first-order conditions are

𝜋𝑥1 = 𝑝1′ (𝑥1 )𝑥1 + 𝑝1 (𝑥1 ) − 𝐶 ′ (𝑥1 + 𝑥2 ) = 0
and
 𝜋𝑥2 = 𝑝2′ (𝑥2 )𝑥2 + 𝑝2 (𝑥2 ) − 𝐶 ′ (𝑥1 + 𝑥2 ) = 0

The marginal revenue is 𝑝𝑖′ (𝑥𝑖 )𝑥𝑖 + 𝑝𝑖 (𝑥𝑖 ), and it is clear that the marginal costs are equal,
𝐶1 = 𝐶2 = 𝐶′(𝑥) where 𝑥 = 𝑥1 + 𝑥2 . Therefore, the marginal revenue for each class of seats
must, at the profit-maximizing choices, be equal to the marginal cost and thus to each other.

b) Show mathematically that for each class of seats 𝑖, the marginal revenue for an additional unit
of 𝑥𝑖 is equal to (1 + 1/𝜖𝑖 ) ∙ 𝑝𝑖 , where 𝜖𝑖 is the elasticity of demand for class 𝑖 seats with respect
to a change in price. (7 points)

The price elasticity of demand is

𝜕𝑥𝑖 𝑝𝑖
𝜖𝑖 = ∙
𝜕𝑝𝑖 𝑥𝑖
so the specified expression is

1 1 𝑥𝑖 𝜕𝑝𝑖
(1 + ) ∙ 𝑝𝑖 = 𝑝𝑖 (𝑥𝑖 ) + 𝑝𝑖 (𝑥𝑖 ) ∙ = 𝑝𝑖 (𝑥𝑖 ) + 𝑝𝑖 (𝑥𝑖 ) ∙ ∙ = 𝑝𝑖 (𝑥𝑖 ) + 𝑥𝑖 𝑝𝑖′ (𝑥𝑖 ) = 𝑀𝑅𝑖
𝜖𝑖 𝜖𝑖 𝑝𝑖 (𝑥𝑖 ) 𝜕𝑥𝑖

c) Why must the demand for both types of seats be elastic, meaning that 𝜖𝑖 < −1? (3 points)

For the train to offer seats, the marginal revenue must be non-negative, so
1 1 1
(1 + ) ∙ 𝑝𝑖 > 0 ⇒ 1 + > 0 ⇒ > −1 ⇒ 𝜖𝑖 < −1
𝜖𝑖 𝜖𝑖 𝜖𝑖

d) The problem context argued that the demand for first class seats is less elastic than the demand
for economy class seats. The company has observed that, regardless of the initial prices,
increasing the price of first class seats 𝑝1 by 10% results in an 15% reduction in demand 𝑥1 ,
while a 10% increase in 𝑝2 results in a 50% reduction in economy class demand 𝑥2 . If the profit-
maximizing price of an economy class ticket is 𝑝2 = $100, what is the corresponding profit-
maximizing price of a first class ticket 𝑝1 ? (10 points)

The company’s observations indicate that the price elasticities of demand for each class of seats
are
𝜖1 = −1.5 𝜖2 = −5

Because the marginal revenues for each class of seats are equal when profit is maximized,
1 1 1 + 1/𝜖2 1 − 1/5 4 3
𝑝1 (1 + ) = 𝑝2 (1 + ) ⇒ 𝑝1 = 𝑝2 = ∙ 100 = ∙ ∙ 100 = $240
𝜖1 𝜖2 1 + 1/𝜖1 1 − 1/1.5 5 1

3. (EXTRA CREDIT) Patents and Generics

In the US, patents frequently give pharmaceutical companies a monopoly on drugs to treat a particular
condition. If the company develops a drug that is vastly superior to other options, they may effectively
sell it as a monopoly for twenty or more years before other companies can start producing “generic”
versions of the same drug. An example is the arthritis drug Enbrel, which the company Amgen produces
based on patented research into reducing inflammation in cells; the method was so revolutionary
compared to other approaches that the researcher, Bruce Beutler, later received a Nobel prize for it.

Pharmaceutical research and development (R&D) is notoriously expensive, however. As a simple model
of the decisions faced by firms like Amgen, imagine that a pharmaceutical company is working to
develop a new drug. They know that the drug will be a major success, such that they would essentially
achieve monopoly power in selling it, because they will patent the drug and there will be no substitutes
with comparable effectiveness. The company can, however, choose how effective they want their own
drug to be, but this has cost implications, such that the cost of developing a drug with effectiveness 𝐸 is
𝐸 2 . The producer also incurs other fixed costs, 𝐹, for their general R&D infrastructure and the costs of
getting a new drug tested and approved for sale. Once the drug has been developed, each dose can be
produced for a constant marginal cost of 10 (regardless of 𝐸).

The inverse demand curve for the medication is given by 𝑃 = 100 − 𝑄 + 𝐸, where 𝑃 is the market-
clearing price, 𝑄 is the quantity produced, and 𝐸 is a measure of the drug’s effectiveness. From this
equation, we can see that higher effectiveness allows the firm to sell the same quantity of the
medication at a higher unit price.

Imagine that the company believes that there is a 10% chance that the testing process will discover a
side effect of the drug that prevents it from being approved for sale. If this happens, the company would
incur all of the development costs of the drug, 𝐸 2 , and 75% of the fixed costs associated with testing and
approval, but they would never get to produce and sell the drug. Write down the profit maximization
problem faced by the company under this uncertainty (you do not have to solve it). Assume that the
problem is being solved in advance of the drug’s development. In other words, assume the company
must decide on plans for the quantity and effectiveness of the drug before the development starts; do
not model this as a sequential process where the company decides how much to produce after learning
whether the drug has been approved. (3 points)

max 𝔼[𝜋] = 0.1 ∙ [−𝐸 2 − 0.75𝐹] + 0.9 ∙ [(100 − 𝑄 + 𝐸)𝑄 − 10𝑄 − 𝐸 2 − 𝐹]

𝑄,𝐸