Econ 303: Intermediate Macroeconomic Theory I
V1 ®
Instructor: Axel Watanabe*, Ph.D.
Fall 2023
⟳ Last updated on November 29, 2023 at 21:08
Below is a list of questions that summarize the lecture and it
is meant to help you retain the topics you have just learned
and try them out by yourself.
Some questions are easy and some are a bit challenging.
I marked each question as follows for your reference:
This is the basic recipe that you can and should be able
to follow right out of the box.
I’ll ask you to switch proteins. In lecture, you learned
how to make lamb tajine. Now make beef tajine by
yourself.
Take a step farther and modify some seasoning, which
is much harder to do than switching proteins and you
can very easily mess things up. There is no need to
solve this unless you are aiming for an A. If you are
just trying to pass, by all means skip this. I’d rather like
you to spend time on and questions and secure
points in the exam than to try questions only to fail
in the end.
Regardless of the ratings above, most of the questions are
readily edible when it is still hot but not so much so if you
wait around to get down to it right before the exam. Be sure
to have a set time with your group members to compare notes
(work on the problems over the weekend and then check your
answers with your group members on Monday for example).
Questions marked with are vital. Not that you can
pass this course by solving only ones but nonetheless they
are important either in themselves or because other questions
depend on them and you cannot go far without mastering
ones first.
Questions marked with are by prescription only and
not meant for general consumption. If you’d like to deepen
your understanding, check in with me first. I will then look
into your class schedule and your current standing in this
course to see whether ’s benefit outweighs cost in your
case. questions are a bit beyond the scope of the material
covered, a repeat of prior questions that I wrote for your drill,
or too obvious. These questions are in the pool of candidate
questions for the exams but your priority should go to non-
questions.
Work in the following order of priority: → →
→ → . If you are prescribed take it only after
you finish over-the-counter’s above.
Some questions seem easy and they are. Some others
seem easy but only ostensibly so. I add after those ques-
tions to clarify my intention (or occasionally, ulterior motive)
behind them so you can raise your alert level accordingly.
Some questions come with (part of) the answer and/or
tips . I just add them to help you check your answer by
* Department of Economics, Concordia University B
1
yourself. Don’t count on them. You won’t find them on your
exam.
And occasionally, I toss in
Le maquereau foo bar
Some random facts about macroeconomics. It’s just
for fun and you won’t be tested on this.
This file is an intellectual property of myself and Concor-
dia University. Any unauthorized use for unintended pur-
poses, including distributing it outside the Concordia server,
is strictly prohibited.
is a registered trademark of Sesame Workshop.
September 6
P Production-Possibility Frontier
P.1 Definition of Economics Pick whatever you have
at hand right now or the service you just received and
discuss the economic trade-off associated with it from
1) consumer’s perspective and 2) producer’s perspec-
tive.
P.2 Definition of Economics Explain why the air
you’re breathing in right now does not make an eco-
nomic subject.
P.3 PPF Define PPF.
P.4 PPF In the economy we had today, are the following
part of PPF? Why or why not?
• 100 lectures and 100 concerts
• 10 lectures and 10 concerts
• 0 lectures and 0 concerts
P.5 PPF In the example we used today, suppose that
Zedd and I work 40 hours each rather than 20 hours.
Redraw the PPF.
P.6 PPF In the example we used today, suppose that
both Zedd and I got a steroid shot and now we can
produce (probably very moody but nonetheless) lec-
ture and concerts twice as fast. In particular, I can pro-
duce one lecture in an hour or one concert in an hour,
and Zedd can produce one lecture in an hour or one
concert in 30 minutes. Redraw the PPF.
P.7 PPF In the example we used today, what would
happen to the PPF if Zedd killed me?1
1 He doesn’t even know that I exist. I’m probably safe.
 Chapter C1

Manitoba Québec British Columbia P.15 PPF In the example we used in class today, what
is Zedd’s opportunity cost of a lecture? And what is
Salmon 1 salmon / 1 worker 1 salmon / 5 workers 1 salmon / 5 workers
Zedd’s opprotunity cost of a concert?
Orange 1 orange / 20 workers 1 orange/ 5 workers 1 orange/ 1 worker

P.16 PPF In the example we used in class today, while

Table 1.
P.8 PPF In class, starting from the top left end of the
PPF, we let me switch from concert to lecture produc-
tion first. Sketch a PPF when you switch Zedd first
instead. Is the resulting line a PPF? Why or why not?
P.9 PPF Consider the technology specified in table 1.
What are the outputs and factor of production in ta-
ble 1?
P.10 PPF In table 1, if each province has 100 workers,
what is the maximum number of oranges and salmon
that can be produced?
both Zedd and I can prepare one lecture in the same
two hours from an accounting point of view, I am a
better instructor than him from an economic point of
view. How so?
P.17 PPF Consider an economy with two producers, Olaf
and Baymax, who produce two commodities, snow-
balls and microbots. Olaf takes two minutes to make
one snowball and four minutes to make one microbot,
whereas Baymax takes one minute to make one snow-
ball and one minute to make one microbot. Their PPF
is represented in figure 1. Who is switching in the red
60

P.11 PPF Which province is the most cost-effective in the

production of oranges in table 1? 50

P.12 PPF In table 1, which province is the least cost-

effective in salmon fishing? 40
Microbots
P.13 PPF If all the provinces in table 1 are specialized in 30
salmon fishing and if they were to start producing or-
anges, which province should be the first one to switch
production from salmon to orange? On what ground? 20
And how many salmon do they have to give up to pro-
duce the first orange?
10
Le maquereau Hello Seattle
0
Delta is cutting Minneapolis-Tokyo non-stop flights. 0 20 40 60 80
Is this an economic subject too? Snowballs
It is. Wherever you have scarcity, there’s eco-
nomics. Delta (actually Northwest, before it merged
Figure 1.
with Delta) operates a hub-and-spoke network to
serve Asian cities. A dozen of flights leave major
US cities (including Minneapolis) and land in Tokyo
around three in the afternoon. Then a bunch of segment (0 to 40 snowballs) and why?
flights take off from Tokyo around five in the af-
ternoon to major destinations in Asia. P.18 PPF What is this economy’s MRT in figure 1? It
Delta is in the process of switching its hub from will take two distinct values depending on the ongoing
Tokyo to Seattle. Take an itinerary from Milwaukee
to Shanghai for example. You would have to con-
number of snowballs.
nect in Minneapolis and Tokyo (there is no non-stop
flight from Milwaukee to Tokyo). With the hub in P.19 Intertemporal Choice Consider the economy where
Seattle, you’ll have only one layover in Seattle (there farmers produce corn. Its PPF is sketched in figure 2.
are non-stop flights between Milwaukee to Seat- If the economy chooses point A, how much corn do
tle). they consume this year and how much do they leave
What’s the scarcity here? – The fleet size. If
for next year?
they spare an airplane to Minneapolis-Tokyo flight,
that same aircraft cannot be used to fly Seattle-
Shanghai. Delta (or any airliner) does not have an P.20 Intertemporal Choice How much can they con-
infinite number of airplanes. Canceling Minneapolis- sume next year in item P.19?
Tokyo will only leave Minnesotans grumpy (they will
now have to have two layovers rather than one). P.21 Intertemporal Choice What is the opportunity cost
In turn, repositioning aircraft to Seattle-Shanghai
will benefit not only Milwaukee but any midsized Mid- of corn this year at point A in figure 2? Don’t just
western cities in the same situation. There you go, give me a number but tell me in terms of what.
the trade-off. Good luck finding something that
falls outside economics realm. P.22 Intertemporal Choice Between A and B in figure 2,
which point will result in the larger PPF in the years to
follow?
P.14 PPF Define opportunity cost.

2
Chapter C1

70 Le maquereau Pumpkin-Spiced GDP

B It’s an annual thing. Each year, as the fall ap-

60
proaches, everything starts to get pumpkin spiced:
Corn Next Year (tons)

Pumpkin-spiced latte, pumpkin-spiced yogurt, pumpkin-

50 spiced beer, ... at this rate, I wouldn’t be surprised
if they start selling pumpkin-spiced two-bedroom
apartments. Now, a two-bedroom apartment is an
40 apartment as the name suggests. On the contrary,
pumpkin spice has a word pumpkin in it, but it doesn’t
30 have any actual pumpkin in it.
GDP falls into the latter category. Canadian GDP
is about $2.19 billion, but it does not have any money
A in it. In fact, Canadian currency in circulation is
20
about $937 trillion, just as the amount of pump-
kin and amount of pumpkin spice are different from
10 each other.
GDP is not money just as an orange is not $2 (it’s
a citrus fruit with succulent flesh, not two pieces
0 of banknotes). Likewise, instead of $, we opted to
0 5 10 15 20 25 30
measure everything in terms of a number of bas-
Corn This Year (tons)
kets. Real wage is 4 baskets per hour. But this does
not mean that labor is baskets. We just quote it
Figure 2. in terms of baskets. The choice of numéraire is ar-
bitrary, as we just use it as a unit of measure. We
can equally say that Canadian GDP is about 1.1 billion
oranges (but then we are more familiar with Cana-
C1 Budget Constraint dian dollars than oranges, and thus, GDP is quoted
in dollars).
C1.1 Budget Constraint Figure 3 sketches ’s budget
constraint. What is the opportunity cost of fish in terms September 13
of cheese?
C1.1 Budget Constraint Suppose that the (nominal)
10 lump-sum tax is $1,000 and the (nominal) price of the
composite good is $2 per basket. How much is the real
9 lump-sum tax T ?
8
C1.2 Budget Constraint We took the composite good
7 as a numéraire in class today. What if we take the
Cheese (oz)

6 leisure as a numéraire instead? What is the real price of

the composite good and leisure? See that the choice
5
of a numéraire is arbitrary. How many baskets of C
4 trade for one unit of l ?
3
C1.3 Budget Constraint For cheesecakes and tea, we can
2 observe how the budget constraint changes when the
price of tea changes. For the work-leisure choice, the
1
real price of C is always one. How, then, can we an-
0 alyze the change in the budget constraint when the
0 1 2 3 4 5
Fish (oz) (nominal) price of the basket changes? Recall that
we defined the real wage to be W /2 (h/ ) in class for
example. How do we reflect the change in the nominal
Figure 3. This is a culinary offense by the way.
price of C ?

C1.4 Budget Constraint Sketch the budget constraint when

real non-wage disposable income π − T = 0.
C1.2 Budget Constraint Fill in the budget constraint in
figure 3 when the price of cheese doubles.
C1.5 Budget Constraint Suppose π − T ∈ (−4h, 0).2
π−T
If l = h + , how much C does have under his
4
budget?

C1.6 Budget Constraint Sketch ’s budget constraint

in item C1.5. In this case, is (C, l) = (0, h) within his
budget?
PA from the cockpit: Suppose π − T ≥ 0 in what follows
unless otherwise specified.
2 Keep in mind, though, that we usually assume π − T ≥ 0.

3
Chapter C3

C1.7 Budget Constraint Suppose that has h = 12 C2 Utility

units of time. His real non-wage disposable income is
π − T = 4 baskets. Sketch his budget constraints when C2.1 Utility Suppose ’s utility function for punches
4 = 1 and 4 = 2 each in figure 4. in the face x P and cheesecake x C is given by3
u(x P , x C ) = −x P + x C . (1)
28
27 With the number of hits on the horizontal axis and the
26 number of slices on the vertical axis, sketch his indif-
98

25 ference curve at u(x P , x C ) = −1, 0 and 1.

81

24 C2.2 Utility Are his preferences monotone in item C2.1?

23 Why or why not?
64

22
21 C2.3 Utility In item C2.1, how much is his marginal
20 rate of substitution of a punch in the face in terms of
slices, and what does it represent? The situation is
19
a little different from cheesecake and tea. Deep down,
18 can you tell what MRS really represents?
17
16 C2.4 Utility Figure 5 represents ’s indifference curves
15 for left and right shoes. Are his preferences convex?
C

14
13 12
12
11 10 10
10
9 8 8
left shoes

8
7 6 6
6 98
5 81
64 4 4
4
3
2 2 2
1
0 0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 0 2 4 6 8 10 12
l right shoes
Figure 4. Figure 5.

C1.8 Budget Constraint The two budget lines in item C1.7 C2.5 Utility Suppose that ’s preferences are repre-
share one bundle. What is it and why do they share sented in figure 6. Are his preferences monotone? Ex-
this particular bundle? plain.

C1.9 Budget Constraint In item C1.7, sketch his budget C2.6 Utility In item C2.5, are his preferences convex?
constraint when π − T = 6 while 4 = 1. Explain.

C1.10 Budget Constraint Suppose that the real wage rate C2.7 Utility Suppose that ’s preferences are repre-
is 4 L for N s ≤ 34 h and rises to 4H (> 4 L ) past 43 h. Sketch sented by
the budget constraint. What is (are) the opportunity u(C, l) = C l. (2)
cost(s) of l in this case? Fill his utility levels in table 2.4

C1.11 Budget Constraint Sketch budget constraint but in- C2.8 MRS Fill his marginal rate of substitution for
stead of l , measure N s on the x -axis. You’ll have to (2) in table 3. See for yourself how M RSl, C (C, l)
get comfortable going back and forth between l and N s changes depending on the bundle. See figure 7.
when we derive labor supply.
C2.9 MRS Explain why MRS at (C, l) = (5, 1) is higher
C1.12 Budget Constraint What do the slopes of PPF and than the one at (1, 5) in item C2.8.
budget line have in common? 3 For exercise purposes only. Do not actually punch my sidekick.
4 The one for (C, l) = (4, 2) is already filled out for your reference.

4
Chapter C3

10 1 5
indifference curves MRSl, C (C, l)

composite goods C [baskets]

9 9
8 4
16
7 25
3
tea [cups]

6 36 1

5
4
3
2
5
49 2
4
3 64 0.5
1 33
0.303.235

1
2
81 0 .2
1 0

4
0 1 2 3 4 5
0
0 1 2 3 4 5 6 7 8 9 10 leisure l [hr]
cheesecake [slices]
Figure 7.
Figure 6.

32
31
5
30
4 8
29
3
28
2
27
1
26
C  25
l 1 2 3 4 5
 24
23
Table 2. 22
21
20
5 19
4 2 18
3 17
C

2 16
1 15
14
C 
l 1 2 3 4 5 13
 12
11
Table 3. 16
10 2
9
8 12
8
C3 Utility Maximization Problem 7
6
C3.1 UMP The curves in figure 4 on page 4 represent 5
4
’s indifference curves. Locate his optimal consump- 3
tion bundles for each of the three budget constraints 2
you sketched last time. 1
0
C3.2 UMP Suppose that real non-wage disposable in- 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
come doubled from 4 to 8 baskets in the example today.
Write down the utility maximization problem and up- l
date the optimal consumption bundle. Judging by your
Figure 8.
answer, are C and l normal? You can use figure 8
to check your answer if you like.

C3.3 UMP Suppose, for some unknown reasons, left we cannot use the tangency condition here because MRS
and right shoes are sold separately, and a right shoe is cannot be defined at the optimal bundle for this partic-
$2 and a left shoe is $1 each. Suppose has $12 to ular preference. That doesn’t stop from finding his
spend on his shoes. Fill in his budget line in figure 5 optimal consumption bundle. In essence, what does
and locate his optimal consumption bundle. Unfortunately,

5
Chapter C3

UMP try to do? Le maquereau A Mountain of ©

C3.4 UMP Suppose ’s utility function is given by Geographers use a contour map (cf. figure 9(a) on
page 7) to represent 3-dimensional objects (terrain)
u(C, l) = C + 4 log l on a 2-dimensional surface (a map). If you go on
treks often, you probably have seen their works be-
1
and 4 = or 1, h = 10, and π − T = 3. Write down his
2
fore. A bundle of weaving lines you see on fig-
utility maximization problem and find his optimal con- ure 9(a) is called a contour. A contour is a set of
sumption bundle for each wage rate. Part of (C ∗ , l ∗ ) = points that are at the same elevation. If two points
are on the same contour, then you can tell that
(4, 8) when 4 = 12 . these two points have the same height above the
sea level. If this sounds familiar to you, right on.
C3.5 UMP Explain in words why (C, l) = (6, 11) is A contour [indifference curve] is a set of all the
not a solution to utility maximization problem in C-4 combinations of latitude [cheesecake] and longitude
[tea] that have the same elevation [©].
in Graph Vault. Thus, indifference curves are actually a 2D pro-
jection (contour map) of a 3D © (terrain). For
instance, figure 5 on page 4 is a 2D projection of
figure 10(b) on page 7. Why didn’t I introduce these
3D surfaces in class then? Actually, economists
barely use these full-fledged 3D graphs to represent
© for two reasons. For one, 3D objects (terrain
or ©) presented on a 2D surface (a piece of paper)
is harder to read than 2D objects (contour or in-
difference curve) presented on a 2D surface (... duh).
The other reason is that we only need MRS (the
slope of the indifference curve) to find the solu-
tion to UMP, not the height of the indifference
curve (note that tangency condition doesn’t men-
tion anything about height). And if you just need
the slope,a you only need two axes (one for lati-
tude/cheesecake and the other for longitude/tea).
The third axis (for elevation/©) is redundant for our
purposes. For these reasons, we usually use contour
maps rather than 3D maps when solving UMP.
In this light, we can give another spin on MRS.
Let’s say is currently at an elevation of 100 m
(or 100 ©). If walks due east by u T (·) m (or have
u T (·) slices of cheesecake), he’ll climb by u T (·)uC (·) m.
Now if wants to get back to an elevation of
100 m (or 100 ©) by moving due north (or by having
more tea) this time, he will walk −uC (·) m (i.e., uC (·) m
to the south). Then he will climb up by −uC (·)u T (·) m
(i.e., going down by uC (·)u T (·) m). In total, climbed
up by u T (·)uC (·) m and then down by uC (·)u T (·) m, i.e., he
came back to 100 m. The ratio between the distance
he moved to the north and to the east, −uC (·)/u T (·)
is exactly what MRS is. That is, if has one more
cheesecake, he will come back to the original eleva-
tion level if he gives up −uC (·)/u T (·) slices. And of
course MRS changes depending on where he stands
and the shape of the mountain (or his preferences).
Just for curious, geographically minded people out
there, I’ve left two more graphs for the combina-
tions we learned in class in figure 10 on page 7.
Figure 10(a) is for perfect substitutes and at the
opposite extreme, we have figure 10(b) for perfect
complements.
If you find these 3D representation confusing, so
do I (and most economists). Sometimes, less (dimen-
sions) is more (legible). Let’s just stick to 2D and
leave the actual mountains for climbing.
a The slope here means the slope of the contour, not the mountain.

6
Chapter C3

60
54
48
42
36
30

(:
24
18
12
6
0
30

24

18

12
5
4
6 3
Bottles 2
0 1
0 6−Packs
(a) The one I used today.

(a) From Google Maps. 10

9
8
7
6
5
(:

100 4
90 10
80
70 3 9
60 8
50 2
40
(:

30 7
20 1 6
10 5
0 0 4
10 0 1 3
2 3 2
9 4 5 6 7 1
8 9 0 Right Shoe
8 10
7 Left Shoe
6
(b) This is what I drew figure 5 out of.
5
4
3 10 Figure 10.
9
8
2 7
6
5
Tea (cups) 1 4
3
2
0 1
0 Cheesecake (slices)
(b)

Figure 9.

7
Chapter C3

Le maquereau Can I Use a Lagrangian?

– But of course. What I explained in class is es-

sentially the first-order conditions of Lagrangian
method (but I didn’t explicitly say so because some of
you haven’t learned it yet).
Let’s see how. First, in the • ˜ interest of lighter
l
notations, let’s define x ··= , ’s consumption
C
• ˜
h
bundle; ω ··= , his endowment; z ··= x − ω, his
π−T
net demand, i.e., his consumption bundle net of his
endowment (He can self-supply h [hr] of time allot-
ted and π − T of • ˜ . The remainder needs to be
4
purchased); p ··= , the price vector.
1
The two conditions I introduced were
tangency condition: M RS(x) = −4. (3)
budget constraint: p · z = 0. (4)
How are (3) and (4) the first-order conditions of
Lagrangian method? Let’s define L(x, λ) ··= u(x)−λp·z .
The first-order conditions are
• ˜
0
Dx L = ∇u − λp = . (5)
0
Dλ L = p · z = 0. (6)
It is immediate that (4) and (6) are identical. They both
mean z ⊥ p when satisfies the budget constraint.
Notice that p (in purple) and z (in blue) form a right
angle in figure 11 (top).
What about (3) and (5)? – They represent the same
condition as well. Let’s start with (5). It simply means
∇u ∥ p. Let 3 and q be a vector orthogonal to ∇u and
p respectively. Since 3 ⊥ ∇u and ∇u ∥ p, 3 ∥ q. The slope
of 3 is M RS(x) and the slope of q is −4. Then 3 ∥ q
implies (3). And vice versa, if (3) holds, ∇u ∥ p so that
(5) holds as well. Therefore, (3) and (5) represent the
same condition.
How do (5) and (6) translate to the graph that
we used in class? – Again, the same concept, just
expressed differently. To see this, imagine that
meets (6) (or (4)) but not (5) (or (3)). Now recall
that gradient ∇u (in red) denotes the direction in
which u(·) makes its steepest ascent. can shift
3 in the direction of ∇u to find some other bundle
that meets (6) and gives him higher utility, meaning
his current selection is not a solution.
On the contrary, what if meets (5) but not
(6)? I left you figure 11 (middle). See if you can tell Figure 11. Top: (6) is met but (5) is not. Middle: (5) is met but (6) is
that this won’t fly either. not. Bottom: Both conditions are met.
Now if meets both (5) and (6), then he will no
longer find any affordable bundle in the direction of
∇u (figure 11 (bottom)). Recall that when 3 ⊥ ∇u, 3 ’s optimal bundle can appear after a decrease in
marks the direction where u(·) makes neither ascent
π − T.
nor descent: du ≈ ∇u · 3 = 0, (or 3 marks the slope
of the indifference curve, if you will). Thus, moving
along in the direction of 3 (or along the budget line C3.7 Comparative Statics on Income Suppose that C
in this case) won’t help either. Therefore, this x is a is normal but l is not necessarily so. Indicate the area
local extremum. where ’s optimal bundle can be after tax breaks.
I used such terms as indifference curves (instead
of 3) and tangency (instead of ∇u = λp) in class to C3.8 Comparative Statics on Real Wage Explain in
explain the same concept above. However you name words how income and substitution effects take place.
them and whichever method you take, the idea is still
the same and you’ll reach the same solution in the
end. Thus, you are more than welcome to use a C3.9 UMP Suppose that is endowed with h = 10
Lagrangian in the exam. units of time and his preferences are represented by

u(C, l) = (2l + 4)C.

September 20
Write down his utility maximization problem and find
C3.6 Comparative Statics on Income In class, we have his optimal consumption bundle for each case repre-
indicated the area where ’s optimal bundle can ap- sented in table 4, and compute the maximum utility
pear after an increase in π − T . Indicate the area where level he achieves for the first two cases.

8
Chapter F

π−T 4 50
49 Indifference Curves
8 1 48
-8 4 47
8 4 46
45
Table 4. 44
43

392
42
41
C3.10 Comparative Statics on Real Wage Compute ’s 40
income, substitution and overall effects in item C3.9 39
when the wage rate changes from 1 to 4. Part of Substitution 38
effect is +10 on C and −5 on l . 37
36
35

200
C3.11 Comparative Statics on Real Wage Sketch ’s
three budget constraints in item C3.9 and mark his in- 34
come and substitution effects when 4 goes from 1 to 4 33
in figure 12. 32
31
C3.12 Comparative Statics on Real Wage Sketch indif- 30
ference curves where the substitution effect falls be- 29
hind the income effect in magnitude. We assume 28
the opposite in class, but this question should help you 27
see how substitution and income effects appear on the 26
graph. C 25
24
23
C4 Labor Supply 22
21
C4.1 Labor Supply With N s on the horizontal axis and 20
19
4 on the vertical axis, sketch ’s labor supply when 18
π − T = 8 in item C3.9. We only have two points, 17
one for 4 = 1 and the other for 4 = 4. Locate them and 16
you can simply connect the dots. 15
14
C4.2 Labor Supply Sketch labor supply that corresponds 13
to item C3.12. It should be downward sloping if 12
you sketched it right in item C3.12. 11
10
C4.3 Labor Supply Consider the utility maximization 9
problem we worked on in class last time. With N s
8
7
on the horizontal axis and 4 on the horizontal axis,
6
sketch the labor supply. Judging by the graph you 5
drew, does ’s substitution effect exceed his income 4
effect in magnitude? It should be a hyperbola. For 3
this question, you’ll need to leave 4 as is rather than 2
setting it equal to 2 so that you can sketch the supply 1
curve rather than a point on the curve at 4 = 2. 0
0 1 2 3 4 5 6 7 8 9 10 11 12
F Firm l

F.1 Production Function We sketched a production func- Figure 12.

tion of concerts in class. Sketch one for lectures.

F.2 Production Function In item F.1, suppose that

F.4 Production Function Show that the line you plot-
hired two workers in a wrong order, namely, start-
ted in item F.2 is not a production function. For the
ing production with the worker whose opportunity cost
same reason item P.8 on page 2 is not a PPF.
of lecture is higher than the other. Plot the number of
lectures over the number of hours worked.
F.5 Marginal Product From items F.3 and F.4, what
F.3 Marginal Product Sketch marginal product that can you infer about production when has increas-
corresponds to item F.2 directly below it. ing marginal product? Again, he’s dumb for the
same reason item P.8 is dumb.

F.6 Production Function Write Zedd alone’s produc-

9
Chapter F

tion function of concert from the day #1. Ignore labor of the economy made of Zedd, Doja Cat and Sen-
Sensei. sei. Does marginal product of labor decline with hours
worked? If so, why? You’ll add Doja Cat some-
F.7 Marginal Product What is his marginal product where. Where would you place her? Before Zedd?
of labor in item F.6? After Sensei? Or between the two?
F.8 Marginal Product Between Zedd and Sensei in item F.6, F.17 Marginal Condition Define marginal profit using
who is more productive on the grounds of marginal M R N (K, N d ) and M CN .
How do they appear on a
product? graph?
F.9 R2S What is Zedd’s returns to scale in item F.6? F.18 Marginal Condition Whereas marginal revenue can
change with N d , marginal cost does not in our model.
F.10 R2S Between Zedd and Sensei in item F.6, who is
Why not?
more productive on the grounds of returns to scale?
F.19 Marginal Condition You should increase N d if
F.11 Production Function Both marginal product and
returns to scale are a measurement of productivity. Ex- M R N (K, N d ) > M CN to seize the positive marginal profit.
plain, in words, the exact difference between them. The Does this mean you should increase N d if revenue >
answer to item F.8 is different from the answer to item F.10. variable cost as well? Why or why not? Do not mix
We use both marginal product and returns to scale to up a function with its slope.
categorize different production technologies, but they
are distinct concepts. Be able to tell them apart and F.20 Marginal Condition ’s profit structure is tabu-
know when to use which. lated in table 5 (some cells are intentionally left blank).
Find his profit-maximizing level of N d ∗ .
F.12 Marginal Product Suppose that ’s production
function is given by
Nd 1 2 3 4 5 6 7 8
d 1/2 d 1/2
z F (K, N ) = K (N ) . (7) M R N (K, N d ) 10 8 6 4 2 0 -2 -4
M CN 6 6
Find his marginal product of labor when K = 4 and 9.
Table 5.
F.13 Marginal Product With N d on the horizontal axis
and Y on the vertical axis, sketch ’s production func-
tion in item F.12 when K = 4 and 9. Then right beneath
it, sketch his marginal product of labor ( M PN ) for each F.21 Production Function Does the production func-
K. tion we used today satisfy the four assumptions?

F.14 Production Function Does production function F.22 Marginal Condition Discuss the similarities and
(7) satisfy the fourth assumption? The fourth as- differences between tangency condition and marginal
sumption implies that marginal product of labor (or condition.
capital) increases with capital (or labor).
F.23 PMP Suppose that ’s production function is
F.15 R2S Examine the returns to scale of the following given by
1
3
zF K, N d ··= zK 4 N d 4 ,


production functions:5

(a) z F (K, N d ) = K + N d with z = 2 and K = 16. Write his profit maximization

p problem and find his profit maximizer N d ∗ (4).
(b) z F (K, N d ) = N d
(c) z F (K, N d ) = N d F.24 Labor Demand Compute N d ∗ (4) at 4 = 1 or 32 in
item F.23 and sketch his labor demand function with
(d) z F (K, N d ) = (N d )2 N d ∗ on the horizontal axis and 4 on the vertical axis.
(e) z F (K, N d ) = K 2 + (N d )2
F.25 PMP Suppose that ’s production function is given
(f) z F (K, N d ) = K α (N d )β , with α > 0 and β > 0. by

1
zF K, N d ··= z K + N d 2 ,


For the last one, you’ll have to make three cases
depending on what value α + β takes.
with z = 16 and K = 6.6 Write his profit maximization
F.16 Production Function Suppose that Doja Cat joined problem and find his profit maximizer N d ∗ (4).
the production of concerts. She has 20 hours as well but
she can produce one concert in half an hour. Sketch the F.26 PMP Compute N d ∗ (4) when 4 = 1 and 2 each in
concert production function and marginal product of item F.25.
5 K doesn’t appear on some of them for pedagogical purposes. Imagine that 6 This production function does not satisfy the first and fourth assumption by

these are a production function of cheesecake and K is the number of space shut- the way (why?)
tles. For those who have never baked a cheesecake (why not?), you do not need a
space shuttle to bake one.

10
Chapter 5A
F.27 PMP We assumed that the consumer’s substitution
effect exceeds income effect in magnitude to have an
upward-sloping labor supply curve. What assumption
about the firm makes the labor demand curve down-
ward sloping? What condition did we use to derive
N d (4)?
F.28 Labor Demand Consider the example from today.
Suppose that z = 3 instead of 2. Overlay the new labor
demand function with the one you have on your lecture
note. How does the total factor productivity change the
labor demand curve?
Le maquereau Well, That’s One Way to
Produce Bronze
You may have noticed in Econ 201 that production
functions are always defined over a positive domain.
Namely, be it raw materials or labor, inputs are al-
ways a positive amount. Can they be defined over a
negative domain? You can, but then the output has
to be negative in exchange. If a firm could produce
a positive output from a negative input, it means
they produce two outputs from nothing: a negative
input is in effect a positive output. Thus, scarcity is
gone and the firm is no longer a well-defined en-
tity and falls outside economics’ purview. However,
so long as output is negative, scarcity maintains its
presence. How can you use an output to produce an
input though? Wouldn’t that mean that we take an
airplane (an output) apart to “produce" scrap metal
(an input)?
Germany used to import industrial bronze ovens
(seemingly an output) from the Soviet Union, to
melt it and harvest bronze (seemingly an input).
Check out NPR Planet Money episode . In this case,
an output is negative (Germany produces a negative
amount of ovens) as is an input (Germany takes in
a negative amount of bronze).
As can be seen, we deal with production functions
that appear in the first quadrant (the familiar one)
or in the third quadrant (as above). Soviet’s produc-
tion function appears in the first quadrant (Poor
Soviet people. They had no idea they might as well
have simply sold bronze as is), and German produc-
tion function appears in the third quadrant. We
assume that production does not take place in the
second quadrant, in which case, you would be able to
produce two outputs from nothing. No scarcities,
no economics.
As the bronze oven example shows, the labelling of
input and output is rather arbitrary. For this rea-
son, in general equilibrium models (cf. Econ 302 and
401) we typically assume there are only outputs and
regard inputs as negative outputs. In our course,
however, we will retain inputs as they are not in-
terchangeable with outputs in our economy. Unlike
bronze, cannot conceivably produce leisure out
of consumption goods. Thus, our production func-
tion resides exclusively in the first quadrant.
5 One-Period Model
5A Competitive Equilibrium
5A.1 Intertemporal Allocation If there is only one pe-
riod in the economy, points like A or B in figure 2 on
page 3 will never be selected. Why? Which point will
be selected then?
11
September 27
5A.2 Intertemporal Allocation Why isn’t T greater or
smaller than G if there is only one period in the econ-
omy?
5A.3 Competitive Equilibrium Suppose that the firms
are owned by the government rather than by the share-
holders. In this case, π gets paid out to the government
rather than to the consumers. Redefine the competitive
equilibrium in this scenario.
5A.4 Competitive Equilibrium Does the income-expenditure
identity still hold in item 5A.3? Know exactly what
constitutes the total income and expenditure.
5A.5 Competitive Equilibrium Walras’ law doesn’t
specify which markets have to be in equilibrium to
show that the remaining one is also in equilibrium. I
just picked the composite goods market as the remain-
ing market in class. Suppose, instead, that the com-
posite goods market is in equilibrium. Show that the
labor market will be in equilibrium as well. Be sure
to show exactly which condition (other than N s = N d
of course) of the competitive equilibrium you used in
each step to establish that N s = N d .
5A.6 Competitive Equilibrium Suppose that there is ex-
cess supply in labor market, namely, N s > N d . In this
case, would the composite goods market be in equilib-
rium? If not, would there
be excess supply or demand?
Note that 4 N s − N d > 0 in this case. See that
the income-expenditure identity doesn’t hold unless
the economy is in equilibrium.
5A.7 Competitive Equilibrium In class, I employed con-
dition (2), labor market clearance, to find the equilib-
rium. Use condition (1), goods market clearance in-
stead and see if you can find the equilibrium without
condition (2). See that Walras’ law just says one mar-
ket is in equilibrium as long as the others are, but it
doesn’t specify which one, and hence the choice of the
said market is arbitrary. It will be the same proce-
dure up to the point where we employed condition (2):
N s = N d . Do not use this equality here but use condi-
tion (1) instead. After you derive the equilibrium, you
can check to see if that satisfies condition (2) (it does
thanks to Walras’ law but see it for yourself).
5A.8 Competitive Equilibrium Suppose that the pro-
duction function is given by the following:
1
 ‹
zF K, N d = z K + N d ,


(8)
2
with z = 4 and K = 0. In addition G = 5 and h = 10
in this economy. Draw yourself three sets of grids. On
the first one, sketch the production function with N d
on the horizontal axis and Y on the vertical axis. On
the second one, sketch the production function with l
on the horizontal axis and Y on the vertical axis. On
the third one, sketch the production function with l on
the horizontal axis and C on the vertical axis. From
the first to second, you’ll need to rewrite the produc-
tion function by swapping N d with some function of
Chapter 5A
l . From the second to the third, you’ll need to swap Y
with some function of C . I used a generic produc-
tion function in class. The production function (8) is
simple enough that you can get your hands dirty and
sketch the exact function to observe the transition from
the N d − Y plane to the l − C plane by yourself.
5A.9 Competitive Equilibrium On the third one in item 5A.8,
shade in the set of (C, l) that are feasible in this econ-
omy.
5A.10 Competitive Equilibrium Compare the area you
shaded in in item 5A.9 to Zedd and Sensei’s PPF from
the first week. Discuss similarities and differences be-
tween them. Are they upward sloping or down-
ward sloping? What can you say about their shape?
5A.11 Competitive Equilibrium The second graph I
sketched in class today is in fact Y s = z F (K, h − l). We

is then p 2 cos θ , or the area size of the rectangle
learned that the slope of this graph is −M PN K, N d (I
just flipped the graph about the vertical axis. “Rise over
run” simply becomes “fall the same amount over run”).

Show algebraically that the slope is indeed −M PN K, N d .
Use the chain rule.
5A.12 MRT Explain in words why the marginal rate of
transformation of leisure coincides with the marginal
product of labor.
5A.13 Competitive Equilibrium Suppose that ’s pro-
duction function is given by
p other hand 2∗ is the maximizer because you cannot
d make θ any smaller while keeping to the production


z F K, N =z KNd,
with z = 16 and K = 16 1
. Suppose also that 4 = 1.
Write his profit maximization problem, find N d ∗ and
compute the maximized profit.
5A.14 Competitive Equilibrium Write the PPF as a
function of l , i.e., write C = some function of l . You
can start with item 5A.8 and then generalize.
5A.15 Competitive Equilibrium Suppose that ’s utility
function is given by
p
u(C, l) = C + 4 l + 2.
∗ spin counterclockwise, and a vector like 2′ will now
7
Given 4 and π found in item 5A.13, h = 16 and
G = 2, write his utility maximization problem, find his
optimal consumption bundle, and compute the maxi-
mized utility level.
5A.16 Competitive Equilibrium Would the labor market
clear with the labor demand and supply found in items 5A.13
and 5A.15? If not, is labor overpriced or underpriced?
In which direction does the labor market push 4?
7 This type of utility function is called a quasi-linear utility function. If it is
linear, u(C, l) = C + l . In comparison, (9) is linear only in C (hence, quasi-linear).
This is a popular choice when you have composite goods. One of the notable
features of this function is that MRS does not increase with C for a given l . MRS
typically grows with C as C becomes relatively abundant in comparison to l . In
−1
contrast, MRS of (9) takes the same value M RSl, C (C, l) = 12 (l + 2) 2 whatever
C is. This implies that l does not increase with income. Therefore, quasi-linear
utility functions violate the assumption of normality. It is nevertheless an easy
function to work with, and I will often use this in what follows, except when we
conduct comparative statics in chapter 5 (this is the only time normality sinks in).
Le maquereau May the Force Be... GDP?
For those who have taken physics in high school (if
you didn’t, just disregard this maquereau), you’ll find
that profit maximization is analogous to maximizing
the work applied to a point. To see the connection,
set up output vector 2 = (21 , 22 ). The negative out-
put means an input. In this example, let’s say 21 ≤ 0
is labor input and 22 ≥ 0 is cookies. The price vec-
tor is p = (p1 , p2 ). In this example, p1 is a wage rate,
and p2 is the price of a cookie. The profit maximiza-
tion is then max2 p · 2 subject to 22 ≤ f (21 ), where f (·)
is a production function.a In more familiar terms,
p · 2 = p1 21 + p2 22 , with p1 21 (≤ 0) being the total cost
and p2 22 the total revenue.
*
Now imagine that you are applying force 2 to a
*
particle moving in the direction of p as in figure 13.
* * *
The length of 2 projected on p is 2 cos θ , where θ
* *
is an angle that 2 and p form. The resultant work
* *
that appears in figure 13.
Now recall that the law of cosines implies p · 2 =
* *
p 2 cos θ . Thus, profit p · 2 is the same as work
* * *
p 2 cos θ . You are effectively looking for 2 of the
*
form 22 ≤ f (21 ) that yields the largest work, given p .
*
To do so, you create a vector orthogonal to p (such
*
as a in the figure) and shift it so that it will barely
touch the production function. That will maximize
the work done, a.k.a. the profit generated. In fig-
*
ure 13, 2′ is not a profit-maximizer because we can
generate more work by tilting it clockwise. On the
*
function given. And you can check by yourself to see
* * *
that a being orthogonal to p at 2∗ is none other
than the marginal condition itself.
Is this analogy useful? – It is in the following two
senses: For one thing, your high school physics teach-
ers (perhaps unknowingly) laid the groundwork for
Econ 303. Tell them I said thank you next time you
meet them. In addition, it makes a great tool to
visualize comparative statics. For instance, if both
p1 and p2 increased in proportion (i.e., extending the
*
length of p without changing its direction), we can
immediately see that that only increases the work /
profit (the box gets bigger) but it won’t change the
*
optimizer 2∗ itself. On the other hand, if the output
*
(9) price goes up while the input price goes down, p will
*
become a new optimizer. You can also easily visualize
what happens if gets more productive, i.e., when
f (21 ) fluffs up towards the northeast.
Now you might be tempted to say “why don’t we
simply set θ = 0 to generate the maximum work?"
Yes in physics, but no in economics. (why?) This is
where we part our ways.
a The function will be a mirror image of the one we learned in class
because we flip the sign of 21 in this example. If works for 5
hours, then 21 = −5, i.e., 5 hours of negative output (= 5 hours of
positive input).
12
Chapter 5A

with K = 16. The government spending is G = 1 and

time allotted is h = 4. Find the
equilibrium in this econ-
omy. C, l, N s , N d , T, Y = (1, 3, 1, 1, 1, 2) and
4 = 32 .

*
Figure 13. The right force 2∗ yields the maximum work (or profit if
*
you will) possible done to a particle moving in the direction of p .

October 10

5A.17 Competitive Equilibrium Do the allocation and the

wage you found in items 5A.13, 5A.15 and 5A.16 con-
stitute an equilibrium? If not, which part of the defini-
tion of the competitive equilibrium do they violate?

5A.18 Competitive Equilibrium Repeat items 5A.13 and 5A.15

to 5A.17 with 4 = 32 and 4 = 12 . You should be
able to solve items 5A.13 and 5A.15 to 5A.18 without
a graph but feel free to fill in the budget constraint in
figures 14 and 15 to check your answer.
1
5A.19 Competitive Equilibrium Between 4 = 2 and 32 , the
former earns a higher profit. Why, then, does 4 = 23
constitute an equilibrium when it does not maximize
his profit?

5A.20 Competitive Equilibrium Among three wage rates

in items 5A.13 and 5A.15 to 5A.18, 4 = 32 gives the
lowest utility level. Why, then, does 4 = 32 constitute
an equilibrium when it does not maximize his utility
level?

5A.21 Competitive Equilibrium In items 5A.13 and 5A.15

on page 12, I gave you three random wage rates, which
may or may not be the equilibrium price. This time, do
not fix 4 in advance and find the equilibrium.

5A.22 Competitive Equilibrium Suppose that ’s pref-

erences are represented by
4
u(C, l) = log(C + 1) + l
3
and his production function is given by
1
3
z F K, N d = K 4 N d 4

13
Chapter 5A

18 24
34
17 Indifference Curves
16 Budget Constraint
C=zF(K, h-l)-G
22

15
14
20

13
12
11
10
9
C

8
7
6
5 14
4 13 Indifference Curves
3 28
C=zF(K, h-l)
12
2 16 18
12 14
10 11
1 26
8

0 10

16
-1 9

18
20 24
-2 8
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 23
l 7 22
C

(a) For 4 = 1. 6

14 5

13 Indifference Curves 4
24 C=zF(K, h-l)
12 3

11 2 14
12
22
1 18
10

10 16
8

0
16

9
18

20
8 -1

7 -2
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
C

6 l
5
Figure 15. For 4 = 21 .
4
3
2 14
12
1 18
10

16
8

0
-1
-2
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
l
(b) For 4 = 23 .

Figure 14.

14
Chapter 5A

Le maquereau Why Is the Leading Digit

of Canadian GDP Two?

It is hard to predict GDP. It takes us three chapters

just to see how much our output is going to be in
equilibrium.
0.35 GDP
That said, it is actually quite easy to predict what Benford's Law

Frequency of GDP Whose First Digit Is d

the leading digit of GDP is. I don’t know how useful
it is to know the leading digit, but well, we just do. 0.3
The probability that GDP starts with one is about
30.1%. Taking US for example, its GDP’s leading
digit is indeed one (about $1.8 trillion, cf. figures 16 0.25
and 17 on page 15).
This is due to an empirical observation called Ben-
ford’s law, which states that the probability that 0.2
the first digit of a naturally occurring collection of
numbers is d is proportionate to the ratio between 0.15
d +1 and d (cf. figure 17 on page 15). For instance, the
2
probability that d = 1 is proportionate to d+1 d = 1 = 2,
and d = 2 is 32 (Canadian GDP is here now) and d = 3 0.1
is 43 . As you can see, the probability declines with the
number and the probability that d = 9 is proportion- 0.05
ate to only 10 9 .
But why? Shouldn’t any of nine numbers appear as
frequently as any other with probability 19 across the 0
1 2 3 4 5 6 7 8 9
board? I’ll show the proof in the next installment.
Long story short, GDP grows in such a way that First Digit d of GDP
it takes more time to pass through leading digit of
one than of nine. That is, it trots in equal intervals Figure 17. First-digit distribution of US GDP
along the line in figure 18 (bottom) than in figure 18
(top) on page 15.
The law is applied to many areas. For instance,
attorneys check for deviation from Benford’s law if
embezzlement is suspected. If figures are artificially
altered, they won’t follow Benford’s law. Knowledge
is king. Even when you want to racketeer, you will
easily get caught if you are unaware of Benford’s
law (not that I’m condoning criminal acts, but be
knowledgeable at whatever you do, i.e., study hard,
people).
GDP (in log scale, base year 2009)

10 12

1 2 3 4 5 6 7 8 9 10
x (in linear scale)

10 11

1930 1940 1950 1960 1970 1980 1990 2000 2010

1 2 3 4 5 6 7 8 9 10
Year
x (in log scale)

Figure 16. US GDP. Red dots are the years whose GDP’s first digit
was one, orange when two, ... blue when nine. Figure 18. Top: The difference between any two adjacent numbers is
the same. Bottom: The quotient between any two adjacent numbers
is the same.

15
Chapter 5C

October 18 5B.6 Pareto Optimality Does 4 have to be equal to M RSl, C

at a Pareto optimal allocation? Why or why not? Checking
5B Optimality to see if you get the gist of Pareto optimality. Read
the definition of Pareto optimality very carefully. Also,
5B.1 Pareto Optimality Define a Pareto optimal allo- if you are tempted to quote the second fundamental
cation. theorem of welfare economics, that’s a good instinct
but resist your temptation. Read the second theorem
5B.2 Pareto Optimality Suppose that there are 6 cook- very carefully too. Short No.
ies to be split between and Sensei. One of the Pareto
optimal allocation is (x C , x S ) = (3, 3), where x C and 5B.7 Pareto Optimality State and prove the first and
x S are the number of slices given to each one of us. second fundamental theorem of welfare economics in
This allocation is Pareto improved upon by another al- one-period model.
location (3, 4). How, then, is (3, 3) a Pareto optimum?
Read the definition very carefully. 5B.8 Pareto Optimality Write UMP and social plan-
ner’s problem side by side, and discuss the similarities
5B.3 Pareto Optimality Suppose that there are 6 cook- and differences between them. For similarities, re-
ies to be split between and Cookie Angel. Unlike fer back to your lecture note from day 1. What is eco-
, Cookie Angel is gluten intolerant and his utility nomics all about?
function is decreasing in cookies. Find the Pareto op-
5B.9 Pareto Optimality What condition does a social
timal allocation(s). For instance (3, 3) is not Pareto
planner use to find the solution to her problem?
optimal because it will be Pareto improved upon by
(4, 2). 5B.10 Pareto Optimality Does a social planner need to
determine 4 to solve her problem? Why or why not?
5B.4 Competitive Equilibrium Suppose that M RSl, C (C, l) >
Short No.
M RTl, C (C, l) at some feasible allocation. Explain why
this allocation cannot be an equilibrium. 5B.11 Pareto Optimality Which one of the theorems we
learned today guarantees that the solution to item 5B.9
5B.5 Pareto Optimality In class today, we observed can be implemented as a competitive equilibrium?
why M RSl, C cannot be > M RTl, C at a Pareto optimal
allocation using figure 5-3 in Graph Vault® . Use fig- 5B.12 Pareto Optimality Solve item 5A.22 on page 13
ure 19 to show that M RSl, C cannot be < M RTl, C at a again but as a social planner this time. If done
Pareto optimal allocation either. After proving this, right, you’ll have a lot less calculations to do than in
in conjunction with what we excluded in class, the only item 5A.22. This is the beauty of having a fictional so-
possibility left is M RSl, C = M RTl, C at a Pareto opti- cial planner. Write the social planner’s problem first
mal allocation, establishing the first theorem we intro- and then use item 5B.9 to find a Pareto optimal alloca-
duced today. (C, l) = (3, 11) is probably an easy tion. After that, quote the appropriate theorem to show
bundle to work with. Show that M RSl, C (C = 3, l = that the Pareto optimal allocation that you’ve found is
11) < M RTl, C (C = 3, l = 11) on the graph to start with actually the competitive equilibrium too.
and then find another feasible allocation that Pareto im-
proves upon (3, 11). 5B.13 Pareto Optimality Solve item 5A.21 as a social
planner.
15
Indifference Curves
14 5B.14 Pareto Optimality If you were to implement the
64

C=zF(K, h-l)-G
13 Pareto optimal allocation in item 5B.12 as a compet-
12 itive equilibrium, how much should 4 be and why?
44

This is why the 2nd fundamental theorem does not

10

11
15 say that a Pareto optimal allocation is a competitive
10 0
equilibrium. There is no mention of price in Pareto op-
9
timality, whereas the price is a crucial component of
8
competitive equilibrium. Thus you have to supply the
C

7 right 4 to have it realized as a competitive equilibrium.

6
5
56.5 5C Comparative Statics
4 685
3 5C.1 Comparative Statics Suppose that ’s preferences
2 are given by
1 u(C, l) = C l,
10
0 with h = 15. Production function is given by
-1
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 p
zF K, N d = z K N d ,


l
1
Figure 19. with z = 2 and K = 16 . Suppose that G is currently 0
and the government will increase it to 1. Find equilib-
rium (C0 , l0 ) before G is increased. See figure 20.

16
Chapter 5C

11
.1
80
3
1.5

1.1180
C [basket]

3
0.5
1.180
34
0.1180
0 Indifference Curves
Budget Constraint (w=(4 5.5 )-1 )
Budget Constraint (w=1/12)
C=zF(K, h-l)-0
C=zF(K, h-l)-1
-1
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
l [hr]

Figure 20. 8

Feel free to solve this as a social planner. That’ll get

p
(C0 , l0 ) = 12 5, 10 much faster. 6


you to
9
5C.2 Comparative Statics In item 5C.1, suppose that simply
C [basket]
reduced his C by 1 to offset the tax increase. Would 8
(C0 − 1, l0 ) constitute an equilibrium? In this case, how 4
much are ∆Y and ∆C ? 7

5C.3 Comparative Statics Compute equilibrium (C1 , l1 ) 6

after the government spending increase in item 5C.1. 2
Compute ∆Y and ∆C in this case. See figure 20 to 5
check your answer.
3 4
5C.4 Comparative Statics Compare your answers to 0
items 5C.2 and 5C.3. Why doesn’t simply reduce C Indifference Curves
by ∆G to offset tax increase? C = zF(K, h-l) - varying G
5C.5 Comparative Statics In class, we have seen that
-2
an increase in G triggers an increase in Y . This observa- 0 5 10 15
tion actually hinges on one of the three assumptions we l [hr]
made about consumer preferences. Identify which one
it is and show why the violation of the said assumption
Figure 21.
may leave Y unchanged (or even have it reduced) after
government spending increase. Cf. figure 21 (this
is a case where Y d does not respond to a change in G )
and footnote 7.

5C.6 Comparative Statics In item 5C.5, would |∆C|

be larger than |∆G|? How would you interpret the re-
sult? Short It can be. Without the assumption in
item 5C.5, there is no guarantee that will reduce l
in response to an increase in G .

17
Chapter 9A

10 4
Le maquereau Geometric Progression
Geometric progression
and Benford’s Law 3.5
Arithmetic progression

GDP (in linear scale)

As I discussed in the previous installment, GDP is
known to follow Benford’s law. This is partly due
2.5
to multiplicative (instead of additive) nature of GDP
growth. Before I venture out to connect GDP 2
to Benford’s law, first, let me show a cheap proof
of Benford’s law.a Suppose that x ∈ [1, 10) and 1.5
log10 (x) follows the uniform distribution over its
domain (cf. figure 18 (bottom) on page 15). Then 1
the first digit of x is 1 when log10 x ∈ [log10 1, log10 2)
and 2 when log10 x ∈ [log10 2, log10 3) and so on. Then 0.5
P r(The first digit is d) = log10 (d + 1) − log10 d as the
probability is proportional to (and is in this case) 0
the length of each bin in figure 18 (bottom), lead- 0 50 100 150 200 250 300
ing to Benford’s law. Note that if x itself (rather Year
than the log thereof) is uniformly distributed, then
P r(The first digit is d) is just 19 for any d (Each bin
in figure 18 (top) has the same length).
Then the question becomes "Why does GDP be-
have as if its log is uniformly distributed (and thus
follows Benford’s law)?" To answer this, note that
10 4
GDP usually follows geometric progression rather

GDP (in log scale)

than arithmetic progression. An arithmetic pro-
gression is a sequence where any two adjacent num-
bers are apart from each other by the same dis-
tance, e.g., {1, 2, 3, . . .} (add 1 to reach the next) or 10 3
{103, 106, 109, . . .} (add 3 to reach the next). A ge- Geometric progression
ometric progression is a sequence where any two Arithmetic progression
adjacent numbers are apart from each other by the
same factor, e.g., {1, 2, 4, . . .} (multiply by 2 to reach
the next) or {10, 100, 1000, . . .} (multiply by 10 to reach 10 2
the next). GDP trots like the latter.
Now suppose that GDP starts off with $100 and
increases 2% annually as in figure 22 on page 18. This 0 50 100 150 200 250 300
creates a geometric progression where you multiply Year
the previous GDP by 1.02 to reach the next. In this
manner, GDP walks along the line in equal steps in
Figure 22. Arithmetic progression (pale) and geometric progression
logarithmic scale figure 18 (bottom) rather than in
(dark) plotted in linear and log scale. Any geometric progression
linear scale figure 18 (top). That is, GDP will spend
appears as a straight line in log scale, whereas any arithmetic pro-
a lot of time to get out of the first bin (the red
gression appears as a straight line in linear scale. Notice that US GDP
segment) but after a while, since GDP will grow
figure 16 on page 15 roughly lines up along a straight line.
exponentially (at the rate of 2%), it doesn’t take
much to pass through later bins (like green or blue
segments). In figure 22, notice that GDP will spend 100 Geometric progression
lots of time getting out of the red segment than Arithmetic progression
Frequency of GDP Whose First Digit Is d

the blue segment. Thus, GDP behaves as if it is uni- 90

formly distributed along figure 18 (bottom) rather
than figure 18 (top). Consequently, GDP follows 80
Benford’s law.
Canadian GDP is going through the orange bin in 70
figure 18 (bottom) right now. I expect it to move on
to the next bin quicker than we spent time getting 60
out of the red bin.
Still not convinced? Then consider the counter- 50
factual: Suppose instead that GDP increases by $2
40
rather than 2%, i.e., an arithmetic progression. Then
Benford’s law won’t apply to GDP because GDP will
30
spend an equal amount of time to move across each
bin in linear scale in figure 18 (top). Consequently, 20
any number will appear as the first digit asymptotically
with the probability of 19 (cf. pale bars in figure 23). 10
a Cheap because I will establish Benford’s law for one particular 0
class of numbers. 1 2 3 4 5 6 7 8 9
First Digit d of GDP

October 25
Figure 23. First-digit distribution for figure 22. Notice the close re-
semblance of geometric progression (dark) to figure 17 on page 15.
9 Two-Period Model
with Exogenous Output 9A Financial Instruments
9A.1 Financial Instruments Figure 24 represents ’s
income and desired consumption level over time. His

18
Chapter 9B

income level fluctuates due to booms and busts of the 9A.6 Financial Instruments Suppose that Zedd has
economy but he prefers to have a steady stream of ceviche that he does not want and can build him
cookies throughout. His preferences are represented a cookie-themed concert venue in three months. Zedd
wants the cookie-themed nightclub in three months and
6 needs to eat ceviche now. Who should write an IOU
income stream to whom? Who should be a creditor and who should
desired consumption stream be a debtor in this case?
5.5
y , c [baskets ]

9A.7 Financial instruments In item 9A.6, would the

economy with an IOU Pareto improve upon the one
without it? Explain. Short Yes.
5
9A.8 Financial Instruments How is a hot slice of pizza
not a financial instrument but banknotes are, when you
can’t even eat the latter?
4.5
9A.9 Financial Instruments That $1 bill you have in
your wallet is a financial instrument, and as such, an
IOU. Who is an “I” and a “U” in this case? How about
4
a check you write?
22 23 24 2 5 26 27 2 8 29 30
20 20 20 20 20 20 20 20 20
9B Utility Maximization Problem
Figure 24. 9B.1 Utility Suppose that ’s preferences are strongly
monotonic, but not convex. Sketch his indifference
in figure 25. Use this to explain why the green line in curves and show that in this case, would hate to
smooth out his consumption over time. Cf. figure 6
on page 5.
Indifference Curves
consumption in the following

9
9B.2 Utility Does levelling sτ (rather than cτ ) help
period c +1 [baskets +1 ]

improve the utility level over time? Namely, is it ben-

25

eficial to set aside the same amount of baskets every

period to better prepare for retirement?

9B.3 Intertemporal Budget Constraint A bundle (c1 , c2 ) =

5
(21 − t 1 , 22 − t 2 ) is always affordable for the same rea-
son (C, l) = (π−T, h) is always affordable (cf. item C1.8
9

on page 4). Discuss their similarities and explain why

25 they are always available for consumption.

1 9 9B.4 Intertemporal Budget Constraint Suppose (21 , 22 ) =

(5, 6) and (t 1 , t 1 ) = (1, 2). Why isn’t the lifetime in-
0 come 5 − 1 + 6 − 2 = 8 ? As always, check the unit
0 1 5 9
of measure. Some of them are quoted in in period 1
current consumption c [baskets ] and others are in period 2. Adding them as is wouldn’t
make any sense. Hence, the time machine.
Figure 25.
9B.5 Intertemporal Budget Constraint In item 9B.4
figure 24 gives him a higher utility level than the blue if the lifetime income were actually 8 (in period 1),
line. how much should r be?

9A.2 Financial Instruments Fill in his consumption 9B.6 Intertemporal Budget Constraint In item 9B.4
stream if there were no financial instruments in fig- if the lifetime income were actually 8 (in period 2),
ure 24. how much should r be?

9A.3 Financial Instruments Assume that interest and 9B.7 Intertemporal Budget Constraint In item 9B.4
inflation rates are both zero. Sketch his consumption if the lifetime income is 6 (in period 1), how much
stream when there are financial instruments in item 9A.1. should r be? r = 1.

9A.4 Financial Instruments In item 9A.3, is he a cred- 9B.8 Intertemporal Budget Constraint In item 9B.4
if the lifetime income is 10 (in period 2), how much
itor or debtor? Short a creditor.
should r be? r = 12 .
9A.5 Financial Instruments Sketch his income stream
where he will instead be a debtor in item 9A.3.

19
Chapter 9C

9B.9 Intertemporal Budget Constraint In class, we 9B.18
quoted period 1’s budget constraint in period 1’s ,
and period 2’s budget constraint in period 2’s . Write
period 1’s budget constraint in period 2’s , and write
period 2’s budget constraint in period 1’s . When
we write the budget constraint period by period, the
most obvious choice of the unit of measure is the con-
temporary , and that’s what we did in class. But
who’s stopping us from writing them in different units? 9B.19
There is probably not much practical value to this ques-
tion, but it should help you get the hang of time ma-
chine operations.
9B.10 Intertemporal Budget Constraint In item 9B.9,
does ’s lifetime purchasing power change depend-
ing on which unit it is quoted in? Short No.
9B.11 Intertemporal Budget Constraint While there
9B.20
are only two periods in this chapter, let us add a third
period in this question. Suppose that the interest rate
is r baskets in period 2 per a basket in period 1, and
then again r baskets in period 3 per a basket in period
2. How much is the opportunity cost of a basket in pe-
riod 1 in terms of baskets in period 3? Conversely, how
much is the opportunity cost of a basket in period 3 in
terms of baskets in period 1? There will be not one
but two legs of a journey on the time machine.
Intertemporal Budget Constraint In class, we
wrote the intertemporal budget constraint using s1 , the
amount of IOU buys. In fact, there is no need to
define the intertemporal budget constraint in this way.
Write the intertemporal budget constraint with b1 in-
stead of s1 , where b1 measures the amount of IOU
writes.
Intertemporal Budget Constraint Suppose that can:
(a) neither save or borrow.
(b) save but not borrow.
(c) borrow but not save.
Shade in the set of affordable bundles in each case
above. A rectangle, a trapezoid and another trape-
zoid.
Intertemporal Budget Constraint We assumed that
the interest rate is r whether is a debtor or creditor.
Suppose instead that the saving rate is rs and the bor-
rowing rate is r b (> rs ). Sketch the budget constraint.
(c1 , c2 ) = (21 − t 1 , 22 − t 2 ) should still be on the
budget line because doesn’t save or borrow at this
point, and thus the interest rates, whatever they are,
have no bearing on this bundle. Take this bundle as
your point of departure.

9B.12 Intertemporal Budget Constraint Suppose that
endowed with 21 baskets this year and 22 baskets next
year, whereas the government collects t 1 and t 2 baskets
in each period respectively. How much is his lifetime
endowment measured in terms of 1 , and in terms of
2?
9B.13 Intertemporal Budget Constraint In class, s1 is
defined to be a number of IOU’s that buys. Write
his budget constraint in period 1 and 2 respectively,
with a number of IOU’s that issues instead. You
can use whatever variable you prefer but let’s say a
number of IOU he issues is represented by b1 (b for
borrowing). Which side of the equation should b1 ap-
pear? Just for reference, s1 takes income away this year
and augments it next year.
9B.14 Intertemporal Budget Constraint What is the
relationship between s1 in class and b1 as in item 9B.13?
9B.15 Intertemporal Budget Constraint When construct-
ing the intertemporal budget constraint, does it mat-
ter whether we build it via s1 as in class or via b1 in
item 9B.13? Short It doesn’t.
9B.16 Intertemporal Budget Constraint Write consumer’s
intertemporal budget constraints in terms of baskets in
period 1, and in period 2. Sketch each on the graph
with c1 on the horizontal axis and c2 on the vertial axis.
9B.17 Intertemporal Budget Constraint The two bud-
get constraints in item 9B.16 should be identical on a
graph. Why? Suppose that cheesecake is 2 $/slice
and tea is 1 $/cup. Say you have $12. Does it make any
difference to say that your income is worth 6 slices or
12 cups?
is 9B.21 Intertemporal Budget Constraint Technically, the
budget constraint in period 2 should be c2 + s2 = 22 −
t 2 + (1 + r)s1 . However, s2 = 0. Why? For the same
reasons as item 5A.2 on page 11.
9B.22 UMP Suppose that earns (21 , 22 ) = (16, 50)
baskets, out of which the government collects (t 1 , t 2 ) =
(1, 10). The interest rate is r = 3. His preferences are
given by
1p
u(c1 , c2 ) = c1 +
p
c2 .
4
Find his optimal consumption bundle. To maximize
his utility level, does he issue an IOU (a debtor) or buy
one (a creditor), and for how many baskets? See
figure 26.
9B.23 UMP In item 9B.22, assume that there are no fi-
nancial instruments. Write his UMP, find his optimal
bundle and compare the realized utility level to that of
item 9B.22. Is your answer consistent with item 9A.7?
See figure 26.
9C Comparative Statics on Income
9C.1 Comparative Statics on 21 In class, I raised 21 from
21L to 21H . Reduce 21 from 21H to 21L instead and indicate
∆c = (∆c1 , ∆c2 ) on your graph.
9C.2 Comparative Statics on 21 In class, I sketched a case
where is a creditor. Reproduce a graph for when
he is a debtor instead to run comparative statics on 21 .
Indicate two s1 ’s on your graph before and after the
change in 21 . Is the effect on s1 the same to the case
of a creditor? Draw the indifference curve so that
the optimal bundle will appear to the southeast of the
endowment.

20
Chapter 9C

100 9C.9 Comparative Statics on 21 and 22 Fill in the three

Indifference Curves budget constraints for items 9C.7 and 9C.8, find the
90
Budget Constraint optimal bundle for each, and indicate two ∆c ’s in fig-
80 ure 27.
70 33

5.5.454
32

5
Indifference Curves
60 31

90 1
30
c2

2
50 29
28
40 27
26
30 25
24
20 23
22

4.9
21

4.7
10

74
20

9
43
4.2
19

4
0

426
18
0 5 10 15 20 25 17

c2
16
c1 15
14
13
Figure 26. 12
11
10
9
9C.3 Comparative Statics on 21 Explain why ∆s1 = 0 8
7
when c H is found due east of c L after replacing 21L with 6
21H (> 21L ). 5
4
3
9C.4 Comparative Statics on 21 and 22 Explain both in 2
words and with equations, why ∆s1 > 0 when ∆21 > 0, 1
0
and ∆s1 < 0 when ∆22 > 0. Convexity. 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
c1
9C.5 Comparative Statics on 21 In class, I went over
the case where c H appears to the southeast of c L , result- Figure 27.
ing in ∆s1 < 0, and showed you why this cannot hap-
pen (in violation of what again?) Sketch a case where
c H appears to the northwest of c L and explain why this
cannot happen either.

9C.6 Comparative Statics on 21 Suppose that you raised

’s income from 21L to 21H . Show on a graph a set of
bundles where

• he uses up his intertemporal budget,

• his savings increase, but
• consumption goods are not normal.

This question is effectively the same as item 9C.5.

9C.7 Comparative Statics on 21 Suppose that ’s

preferences are represented by

1p
u(c1 , c2 ) = c1 +
p
c2 .
2
His income is (21 , 22 ) = (6, 18) or (9, 18), out of which
the government collects (t 1 , t 2 ) = (2, 2). The interest
rate is r = 1 [ 2 / 1 ]. Write his UMP and find his op-
timal bundle for each case. Compute ∆c and ∆s1 when
21 increases by 3 [ 1 ]. Part of ∆c = (∆c1 , ∆c2 ) =
(+2, +2).

9C.8 Comparative Statics on 22 In item 9C.7, suppose

that the income changes further from (9, 18) to (9, 21).
Compute ∆c and ∆s1 when 22 increases by 3 [ 2 ]. Part
of ∆c = (+1, +1).

21
Chapter 9D

Le maquereau Compound Interest and e 9D.3 Comparative Statics on r Explain, in words, why
the income effect from increasing r on c1 has to be
negative if is a debtor. Quote the appropriate
In class, receives interest payments once because
there are only two periods. In reality, we receive
assumption on his preferences.
interest payments multiple times because we tend
to live longer than two periods. Let’s say that we 9D.4 Comparative Statics on r The overall effect of in-
save $100 with the annual interest rate of 1%. By creasing r on s1 is indeterminate when is a creditor.
the end of the first year, we receive $1. By the
I sketched a case where ∆s1 happens to be > 0 in class.
end of the second year, do we receive another $1
again? – No. We receive $1.01 rather. The interest Draw yourself a case where ∆s1 < 0. I made the
payment of $1 at the end of the first year itself will substitution effect stronger than the income effect in
earn the interest in the second year (cf. item 9B.11). class. Reverse that here so that c1 will decline, leaving
This is called compound interest. Interest will accrue ∆s1 > 0.
not only to the principal but also to the preceding
interest payments all combined. 9D.5 Comparative Statics on r The overall effect of in-
There is an unexpected connection between com-
pound interest and some mathematical constant creasing r on c2 is indeterminate when is a debtor.
that you are familiar with. To make the argument I sketched a case where ∆c2 happens to be > 0 in class.
simpler, let’s say that saves $1 and instead of Draw yourself a case where ∆c2 < 0. I made the
expanding the periods, divide the payment intervals substitution effect stronger than the income effect in
within one year. Namely, instead of receiving 1% class. Reverse that here so that the overall effect on c2
over a year, receive .5% twice every half year, re-
ceive .25% four times every quater, receive 1/12% will be positive.
every month, receive 1/365% every day, and so on.
In these cases, a dollar of investment will yield 9D.6 Comparative Statics on r We went over the cases
• (1 + .01)1 = 1.01 where s1 > 0 and < 0 in class. Sketch a case for s1 = 0.
• (1 + .01/2)2 = 1.010025 Does increasing r affect in the same way as when
• (1 + .01/4)4 ≈ 1.01003756 he is a debtor or creditor?
• (1 + .01/12)12 ≈ 1.01004596
. 9D.7 Comparative Statics on r In class, I sketched a
.
. case where a creditor remains to be a creditor and a
over a year. As we divide the interval finer and finer, debtor remains to be a debtor when r increases. Is it
’s return seems to grow larger and larger. Can possible for a creditor to turn into a debtor and vice
he be a billionaire at the limit then? versa when r changes? Explain.
Sadly no. There’s a cap: His compound interest is
at most e1% ≈ 1.010050167. PA from the cockpit: For items 9D.8, 9D.10 and 9D.12, it’ll probably
What is Euler’s number e doing
n here? Recall be quicker to solve item 9D.8 without substituting 21 , 22 , t 1 , t 2
that e is equal to limn→0 1 + 1n . Let r be the
annual interest rate and h be the number of in-
and r with given values first to find the solution c1∗ , c2∗ and s1∗ , and
tervals over the year. ’s compound interest then swap these in the solution with the given values. You don’t

h •€
1
Šh/r ˜ r have to but I’m just tossing in a time-saving idea.
is 1 + hr = 1 + h/r . Now let h → ∞, i.e.,
make the interval infinitesimally small. Then˜ his 9D.8 Comparative Statics on r Suppose that ’s pref-
•€ Šh/r r
compound interest becomes limh→∞ 1 + h/r 1
= erences are represented by
• Šh/r ˜ r
€
1
limh/r→∞ 1 + h/r
 1 n r
= limn→0 1 + n


= e . Thus,
r 1
u (c1 , c2 ) = log c1 + log c2 .
2
even when the interest rate is as high as a 100%
for example, no matter how thinly you slice the year, He earns (21 , 22 ) = (33, 13), out of which the govern-
a dollar of investment will yield at most e100% ≈ 2.718
ment collects (t 1 , t 2 ) = (3, 1). The interest rate is r = 1
dollars. That’s one handsome yield but still, not a
billion. basket next year per a basket this year. Write his util-
ity maximization problem and find his optimal bundle
and s1 . Compute his utility level at the optimal bundle.
November 1
9C.10 Comparative Statics on 21 and 22 Compare ∆c1 in 9D.9 Comparative Statics on r Fill in ’s budget con-
item 9C.7 to ∆c1 in items 9C.7 and 9C.8 combined. straint in item 9D.8 and locate his optimal consumption
Do your results support permanent income hypothe- bundle in figure 28 on page 23.
sis? Explain.
9D.10 Comparative Statics on r In item 9D.8, suppose that
5
9D Comparative Statics on Interest Rate his income becomes (21 , 22 ) = (9 · 2 3 + 3, 1), and r = 3.
Write his utility maximization problem and find his op-
9D.1 Comparative Statics on r Suppose r went down. timal bundle. Compute his utility level at the optimal
Explain in words why the substitution effect on s1 will 5 5
€ Š
bundle. (c1∗ , c2∗ ) = 6 · 2 3 , 12 · 2 3 , as represented
be negative. We covered the case where r went up
by the blue dot in figure 28. The utility level is the same
in class. Simply put the argument in reverse.
to the one you found in item 9D.8.
9D.2 Comparative Statics on r It is obvious that a
change in r alters the opportunity cost of c1 and thus 9D.11 Comparative Statics on r Compare your answers
creates a substitution effect. How does it cause an in- to items 9D.8 and 9D.10 and indicate ’s substitution
come effect as well? effect in figure 28.

22
Chapter 9F

132 both substitution and income effects are ab-

128 Indifference Curves
Budget Constraint
sent in this case.
124
120
116
It’ll probably be easier to sketch the budget con-
112 straint and indifference curves to see what will or will
108 not happen. In particular, pay close attention to the
104 tangency condition.

4.983
100
96
1 9D.17 Comparative Statics on r Suppose that r goes
92
4.7671

up. Do you yourself (not ) tend to save or borrow

88
84
more or less? Explain your behavior and determine
80 whether your income effect is larger or smaller than
76 your substitution effect. It’s okay if you do not reg-
72 ister one of the effects. You have your own preferences,
68 and has his own.
c1

64
60
56 9E Competitive Equilibrium
52
48 9E.1 Government’s Budget Constraint Suppose that the
44 government needs to raise (G1 , G2 ) = (1, 1).
40
36 (a) If T1 = 0, how much should B1 and T2 be?
32
28
(b) If T2 = 0, how much should B1 and T1 be?
24 4.9
83 You can use 1 or 2 for a unit of measure. Both
20 1
16 4.76
71
work so long as you pick one and stick with it through-
12 out.
8
4 9E.2 Government’s Budget Constraint Write the gov-
0 ernment’s intertemporal budget constraint.
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36
c0
9E.3 Government’s Budget Constraint Repeat items 9B.9
and 9B.10 but for the government.
Figure 28. I filled in the disposable endowment e (purple dot) for
your reference. Be sure to have both your budget lines pass through 9E.4 Consumer’s Budget Constraint Repeat item 9E.2
this bundle.
for consumers. Watch out for the sign: B1 > 0 is a
debt but s1 > 0 is saving, and vice versa. The rest is the
same though.
9D.12 Comparative Statics on r In item 9D.10, revert his
earnings to item 9D.8 while maintaining r = 3. Write 9E.5 Government’s Budget Constraint Explain why B2
his utility maximization problem and find his optimal
cannot be > 0 or < 0, while B1 can. For the same
consumption bundle and s1 .
reasons as items 5A.2 and 9B.21 on pages 11 and 20.
9D.13 Comparative Statics on r Fill in ’s budget con-
9E.6 Intertemporal Budget Constraint Does B1 or s1
straint in item 9D.12 and locate his optimal consump-
increase or decrease the lifetime tax revenue or income?
tion bundle in figure 28.
If it does, then what should happen to the govern-
ment or ?
9D.14 Comparative Statics on r Compare your answers to
items 9D.10 and 9D.12 and indicate ’s income effect 9E.7 Intertemporal Budget Constraint If item 9E.6
in figure 28. is true, then what’s the point of leaving B1 or s1 , 0?
Cf. items 9A.1, 9A.7 and 9B.23.
9D.15 Comparative Statics on r Using your answers to
items 9D.11 and 9D.14, indicate ’s overall effect in 9E.8 Competitive Equilibrium Define the competitive
figure 28. equilibrium.

9D.16 Comparative Statics on r Suppose that ’s ex-
isting optimal consumption bundle is (c1∗ , c2∗ ) = (21 −
t 1 , 22 − t 2 ), that is, he achieves the highest utility level
without a help of an IOU. Validate or discredit the fol-
lowing statement:
Since he does not save or borrow at his op-
timal bundle, r does not affect his consump-
tion choice. Accordingly, when r changes,
9E.9 Competitive Equilibrium In this chapter, we as-
sume that the labor supply is inelastic, i.e., Nτs (4) = N̄τs
for any 4 > 0 and τ = 1, 2. In this case, there is one Yτ
that leaves the labor market in equilibrium (from which
Y
I derived 2τ as mτ so that labor market will be in equi-
librium). What does Yτ have to be equal to? Recall
the production function from the previous chapter.

23
Chapter 9F

9F Comparative Statics on Tax 36

Budget Constraint with B2=-4
9F.1 Ricardian Equivalence State the Ricardian equiv- 32
alence theorem. Budget Constraint with B2=4

T2 (baskets in period 2)
28
9F.2 Ricardian Equivalence Suppose that the govern-
ment needs to meet (G1 , G2 ) = (10, 12). Suppose also 24
that r = 1. Write the government’s budget constraint in 20
period 1 and 2.
16
9F.3 Ricardian Equivalence In item 9F.2, write the
government’s intertemporal budget constraint, one mea- 12
sured in terms of baskets in period 1 and another in
terms of baskets in period 2. 8
4
9F.4 Ricardian Equivalence On a graph with T1 on
the horizontal axis and T2 on the vertical axis, sketch 0
the set of (T1 , T2 ) that satisfies item 9F.3. 0 2 4 6 8 10 12 14 16 18
9F.5 Ricardian Equivalence In item 9F.2, suppose that T1 (baskets in period 1)
currently (T1 , T2 ) = (8, 16). Indicate B1 and (1 + r)B1
on your graph in item 9F.4. Figure 29.

9F.6 Ricardian Equilibrium Read off from your graph

in item 9F.4 the amount ∆T2 required when you reduce
T1 to 7 [ 1 ] while staying on the budget in item 9F.5.
9F.7 Ricardian Equivalence What does the slope of
the line you found in item 9F.4 represent? Let’s go
back to the ’s budget constraint as a point of refer-
ence. What does its slope represent there?
9F.8 Ricardian Equivalence (T1 , T2 ) = (G1 , G2 ) is a
member of the set in item 9F.4. Why? Once again,
. His disposable endowment (21 − t 1 , 22 − t 2 ) is al-
ways on his intertemporal budget line. Why was that?
Also, a little note here: For , we measure his ex-
penditure c1 and c2 on each axis, and then his income
(21 − t 1 , 22 − t 2 ) appears as a fixed point along his bud-
get line. For the government, they are in reverse: We
measure its tax revenue T1 and T2 on each axis, and
then its expenditure (G1 , G2 ) appears as a fixed point
along its budget line. The reason for reversal between
income/revenue and expenditure is that takes his
income (21 , 22 ) as given and then picks his spending
(c1 , c2 ). On the contrary the government takes their
spending (G1 , G2 ) as given and then picks its revenue
(T1 , T2 ).
9F.9 Ricardian Equivalence Put an interpretation on
the x - and 2-intercept in item 9F.4.
9F.10 Ricardian Equivalence Suppose that in item 9F.2
the government (stupidly) left 4 baskets in period 2 for
the next period (that never comes), i.e., B2 = −4. Over-
lay this new (stupid) budget constraint in item 9F.4.
See figure 29.
9F.11 Ricardian Equivalence Repeat item 9F.10 with
B2 = 4 instead. Rest assured that neither item 9F.10
or item 9F.11 would not actually happen thanks to item 9E.5
on page 23. These two questions should, however, help
you relate the equation to the graph. See figure 29.
9F.12 Ricardian Equivalence Assume m = 1. Write ’s
budget constraint under items 9F.5 and 9F.6.
9F.13 Ricardian Equivalence Sketch the two budget
constraints on a graph in item 9F.12. Why are they
identical? What if not?
9F.14 Ricardian Equivalence In item 9F.12, do you expect
to have distinct optimal bundles under two situations?
Explain.
9F.15 Ricardian Equivalence Prove Ricardian equiva-
lence theorem assuming ∆r = 0.
Le maquereau Your Paycheck vs GDP per
Capita
Canadian GDP per capita was $59,181, coming in as
the 16th in the world in 2017. This is how much we
produced per capita, and according to the income-
expenditure identity, this is how much we earned as
well. Is this really what’s written on your pay check?
Probably not. Some of you earn more than $59,181
and some, less. Keep in mind that macroeconomics
studies economic aggregates (like GDP) but not in-
dividual variables (like your paycheck). Thus, your pay-
check does not necessarily match Canadian GDP per
capita. Note also that GDP is the sum of all in-
comes, which includes not only labor income 4N d (the
paycheck) but also capital income π.
November 8
9F.16 Ricardian Equivalence Prove Ricardian equiva-
lence theorem.
9F.17 Ricardian Equivalence We assumed that ’s
substitution effect exceeds income effect in magnitude
during the proof of Ricardian equivalence theorem. Does
the theorem not hold if these are in reverse?
PA from the cockpit: Assume that r1 and r p remain constant through-
out item 9F.18 to item 9F.23. Also, it is unlikely that I will include
any of item 9F.18 through item 9F.23 in the final, but if you have
extra time to spare, give them a shot nonetheless. These should
help you broaden your understanding of Ricardian equivalence by
way of going through the scenario where it does not apply.

24
Chapter 9F

9F.18 Ricardian Equivalence Suppose that the IOU 72

that government issues/buys trades at the rate of r1 , 68 Indifference Curves
whereas the one issues/buys trades at r p (> r1 ). 64
If t 1 goes down by ∆t 1 , how much should ∆t 2 be 60
to keep to the government budget constraint? How 56
many additional baskets does have to save in pe- 52

4.76
riod 1 to offset the said ∆t 2 in period 2? Recall 48
that if the rates were the same, he should increase his

71
44
savings by exactly −∆t 1 in period 1, which pays for 40
∆t 2 = −(1 + r)∆t 1 in period 2. Does need to save

c2
36

4.2
that many additional baskets here? 32

827
28
9F.19 Ricardian Equivalence Would Ricardian equiva-
lence theorem apply to item 9F.18? If not, how does his
24
lifetime income change and why? Recall the case 20
4.7
discussed in class for the credit constraint that faces 16 671
in reality. Tax cuts work as a substitute for private bor- 12
rowing for credit-constrained consumers. Tax cuts here 8 4.278
2
have a similar effect. If borrows on his own, he 4
will face r1 , but if his "borrowing" comes in the form 0

0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
32
34
36
of tax cuts, what rate will he face? (part) Up by
r1 − r p c1
∆t 1 baskets (in discounted present value).
1 + rp
Figure 30.
Ricardian Equivalence How would c1∗ , c2∗ , s1∗


9F.20
change in item 9F.19?

9F.21 Ricardian Equivalence Repeat items 9F.18 to 9F.20
assuming t 1 goes up by ∆t 1 .
9F.22 Ricardian Equivalence Between items 9F.18 to 9F.20
and item 9F.21, which one is more favorable to and
why?
9F.23 Ricardian Equivalence Redo item 9F.18 assum-
ing, unrealistically,8 that r p < r1 .
9F.24 Ricardian Equivalence Suppose that
ences are represented by
1 buyer, say a bank, will have terms specified. For in-
u (c1 , c2 ) = log c1 + log c2 ,
2
and his income is (21 , 22 ) = (28, 52) and (t 1 , t 2 ) =
(18, 0). In addition to his usual intertemporal bud-
get constraint, he also faces credit constraint s1 ≥ 0.
The interest rate is given by r = 1. Write his utility
maximization problem. You’ve already done this in
item 9B.19 on page 20.
9F.25 Ricardian Equivalence Fill in his two constraints in
item 9F.24 in figure 30 and find his optimal bundle.
9F.26 Ricardian Equivalence How much is the smallest
tax cut in period 1 that would make his credit con-
straint non-binding in item 9F.25? Remove the con-
straint s1 > 0 and find his (usual) optimal consumption
bundle first. Then find out how far you would have to
move his disposable endowment (21 − t 1 , 22 − t 2 ) (by
changing t 1 and t 2 ) to include his optimal bundle as
part of his budget constraint while s1 > 0 is in place.
∆t 1 = −14.
8 In reality, IOU’s issued by the government are usually considered to be risk-
free, as opposed to IOU’s issued by you and s and alike. Consequently, we
usually find ourselves in item 9F.18 than in this one.
9F.27 Ricardian Equivalence Compute and compare ’s
utility levels in items 9F.25 and 9F.26. Explain why the
tax cuts improve his utility level. Normally they
don’t, due to Ricardian equivalence theorem, which
doesn’t apply to here. Recall how Cookie and Sen-
sei die as discussed in section 9A. (part) See the
values on figure 30.
Le maquereau Canada v. , an IOU Edi-
tion
’s prefer- p
Private IOU’s (S1 ) have interest rate r explicitly writ-
ten on it. For instance, when issues an IOU, its
stance, his IOU might say “I, , will pay back $100 plus
5% interest on December 31st of next year”. If you
have an auto loan, mortgage etc., your promissory
note has r written on it.
In contrast, a T-Bill, the government’s IOU (B1 ),
doesn’t say what r applies to it. It simply says, ”I, the
Canadian Government, will pay back $100 on Decem-
ber 31st of next year”. Does this mean B1 has r = 0?
A T-Bill typically has a lower interest rate than ’s
IOU (cf. item 9F.18), but no, the lack of r does not
mean r = 0. A creditor will still earn the interest
from a T-Bill just as he would from ’s IOU. The
thing is, a T-Bill only says the payoff on the maturity
date, but it doesn’t say how much it sells for before
the maturity date. For instance, if a T-Bill that pays
$100 a year from today is traded for $95.24 today,
then the interest rate is r = 100−95.24
95.24 ≈ 5%. Con-
sequently, if the trading price of a T-Bill falls, its
interest rate rises.

25
 Chapter 11A

11 Two-Period Model 11A.6 Intertemporal Leisure-Consumption Choic Fill in

with Endogenous Output ’s budget constraint in figures 31 and 32 on page 27
to confirm your answer to item 11A.5. Plug the op-
11A Utility Maximization Problem timal values you found in item 11A.5 in the variables
other than the pair in question to derive the budget
11A.1 Intertemporal Leisure-Consumption Choice In class, constraint. For instance, for figure 31(a) replace l2 , C2
we calculated the opportunity cost of with the optimal value and leave l1 , C1 free. Then
sketch the budget constraint. Whatever you do, the line
(a) C1 in terms of C2
got to be tangent to the indifference curve at the opti-
(b) lτ in terms of Cτ (τ = 1, 2) mal bundle. If not, then you failed to meet one of the
(c) l1 in terms of l2 tangency conditions, or the budget constraint. So
that you can visualize tangency conditions in this chap-
as in table 6. Fill the variable in the blank cells and
ter. I can’t draw a four-dimensional object, but I (and
you) can still draw it by reducing the dimension to two,
opportunity cost of
the familiar11 one. Figures 31 and 32 are the slice of the
C1 C2 l1 l2 four dimensional object cast onto the two-dimensional
C1 NA 41 [ 1 / hr1 ]
coordinates.
in terms of

C2 1+r [ 2 / 1 ] NA 42 [ 2 /hr2 ]
l1 NA 11A.7 Intertemporal Leisure-Consumption Choice It
41 (1 + r) is understandable that r is related to ’s savings de-
l2 [hr2 /hr1 ] NA p
42 cision S1 , and consequently, to his choice of C1 . On
the other hand, r doesn’t seem to be related to his la-
Table 6. bor supply decision. It does alter his N1s nonetheless.
In class, we went over how increasing r causes income
give an interpretation of each.9 In particular, explain and substitution effects on l1 (and in turn N1s ). Out-
why the opportunity cost of l1 in terms of l2 increases line how decreasing r sets off income and substitution
with 41 and r but decreases with 42 . Just we did in effects on l1 and N1s .
class, write 2 in terms of x . The coefficient of x is then
the opportunity cost of x measured in terms of 2. This 11A.8 Intertemporal Leisure-Consumption Choice If ’s
alone would be worthy. An interpretation makes labor supply function turns out to be downward slop-
ing on the N1s − 41 coordinates, which one of the three
this question . assumptions is different from the one we made in class?

11A.2 Intertemporal Leisure-Consumption Choice Sup- 11A.9 Intertemporal Leisure-Consumption Choice When
pose that is allotted with h = 30 units of time in pe- I went over the third assumption in class, I assumed
riod 1 and 2 each. The wage rate is given by 41 = 42 = 4 that is a creditor. What if he is a debtor? Do we
baskets in each period per unit of time in each pe- still have to assume that the income effect is smaller
riod. His non-wage real disposable income is π1 − T1 = than the substitution effect in magnitude to have the
π2 − T2 = 8 baskets in each period. The interest rate is labor supply curve shift to the right with r ? Explain.
p
r = 1 [ 2 / 1 ]. Denoting his savings by S1 ,10 write Short No. Just checking to see if you remember
his budget constraint for what happened in chapter 9 when we ran comparative
statics on r .
(a) period 1
(b) period 2 PA from the cockpit: Items 11A.10 and 11A.11 do not re-
(c) the intertemporal one. quire anything special. Just solve them in the same way you
solved item 11A.3 through item 11A.6 (or any UMP in chap-
11A.3 Intertemporal Leisure-Consumption Choice In ter 11 for that matter), except that I’m leaving 41 variable
item 11A.2, ’s preferences are represented by in order to derive the labor supply function N1s (41 , 42 , r),
which is a function of 41 . If you fix 41 as in item 11A.3
1 1 through item 11A.6, you won’t be able to sketch the labor
u (C1 , l1 , C2 , l2 ) ··= log(l1 +2)+log C1 + log(l2 +2)+ log C2 . supply function in item 11A.12.
2 2
Write his utility maximization problem. 11A.10 Intertemporal Leisure-Consumption Choice Sup-
pose that has h = 60 in each period to spend on
11A.4 Intertemporal Leisure-Consumption Choice De- work and leisure. The real wage in period 2 is 42 = 2
rive ’s tangency conditions for item 11A.3 and inter- [ 2 / hr2 ]. The non-wage real disposable income is
pret them.
11 We can actually draw up to three dimensions reasonably well on the two-

11A.5 Intertemporal Leisure-Consumption Choice Find dimensional surface (V1 ® is only available in 2D. At least for now), in which case,
an indifference “curve” becomes an indifference “surface”. I can barely sketch
p∗
’s C1∗ , l1∗ , C2∗ , l2∗ and S1 for item 11A.3.


(part) the indifference curve, much less the surface... My software can though. See
∗ ∗ ∗ ∗

figure 33 on page 28. The flat plane is the budget “plane” rather than “line” and
C1 , l1 , C2 , l2 = (68, 15, 68, 15). the curvy one is the indifference “surface” rather than “curve”. This is what I
picture in mind when I solve UMP. Don’t worry. I won’t ask you to sketch this
9
τ is the number of baskets in period τ.
figure (because I can’t hand draw it either).
10 Once again, S p is neither > 0 or < 0. Why is it again? Cf. items 5A.2, 9E.5
2
and 9B.21 on pages 11, 20 and 23.

26
 Chapter 11B

128 204
119 Indifference Curves 187 Indifference Curves
102 170
153
85 136
119

10
68

C2
C1

11 102 11
51 10.5 85
791 68 10
.57
34 51 91
10 34
17
8 17 10
0 0
0 5 10 15 20 25 3032 0 17 34 51 68 85 102
l1 C1
(a) Indifference curves given (C2 , l2 ) = (C2∗ , l2∗ ). (a) Indifference curves given (l1 , l2 ) = (l1∗ , l2∗ ).

128 45
119 Indifference Curves Indifference Curves
40
102 35
85 30
10

25 11
l2

68

10
C1

11 20
51 10.5 15 10
791 .57
10 91
34
10 5
17 10
8 0
0 0 2.5 5 7.5 10 12.5 15 17.5 20 22.5
0 5 10 15 20 25 30 32
l1
l1
(b) Indifference curves given (C1 , C2 ) = (C1∗ , C2∗ ).
(b) Indifference curves given (C1 , l1 ) = (C1∗ , l1∗ ).

Figure 32.
Figure 31.

11A.13 Intertemporal Leisure-Consumption Choice Judg-

(π1 − T1 , π2 − T2 ) = (60, −120). His preferences are
represented by ing by item 11A.12, does satisfy the first assump-
tion we made in class? Explain. Short yes.
1 1
u(C1 , l1 , C2 , l2 ) = log C1 + log l1 + log C2 + log l2 .
2 2 11A.14 intertemporal Leisure-Consumption Choice In
class we wrote the budget constraint in terms of 1 (this
Write his utility maximization problem.
is called discounted present value). Write the bud-
get constraint in terms of 2 (this one doesn’t have a
11A.11 Intertemporal Leisure-Consumption Choice Find
p name but I personally call this inflated future value).
his optimal bundle, N1s , and S1 in item 11A.10. C1∗ = Does expressing the budget constraint in inflated fu-
A ∗ A (1 + r)A (1 + r)A ture value change the optimal bundle? Explain.
,l = , C∗ = , l2∗ = , where A ··=
3 1 341 2 6 12
20 p∗
60(41 + 1). N1s (41 ) = 40 − and S1 = 20(41 − 1). 11B Profit Maximization Problem
41
11B.1 Flow and Stock How can we tell flow and stock
11A.12 Intertemporal Leisure-Consumption Choice Sketch variables apart?
’s labor supply function in item 11A.11 on the N1s −
41 coordinates. See figure 34 on page 28. 11B.2 Flow and Stock Which ones are flow variables
and which ones are stock variables below?

27
Chapter 11B

• Rent
• Depreciation
• Mortgage payment
• GDP
• Tax
• Salary
• Wealth
• Capital stock12
• Gross investment
• Net investment
• Currency issued
• Currency in circulation

11B.3 Two-Period PMP Try item 9E.9 on page 23 if you

skipped it before. This should be clearer by now.

11B.4 Two-Period PMP Repeat item 11A.14 but for the

firms. If f (x) takes the highest value at x ∗ , so does
Figure 33. Indifference curve and budget constraint given l2 = l2∗ . The (1 + r) f (x).
tangency condition translates to the indifference curve (now surface)
being just back to back with the budget line (now plane) at the optimal 11B.5 Law of Motion Was K1 13 a choice variable in
bundle in this case. Figure 31(a) is this figure sliced along C2 = 68. As
you can see, the cut surface satisfies tangency condition. section 5? If not, why not? Where does K1 come
from, or whose decision is it to set K1 ?

11B.6 Law of Motion Suppose that K1 = 10 and I1 = 2.

2
Explain why K2 won’t simply be = 12.

11B.7 Law of Motion Can d be > 1? If not, why not?

11B.8 Law of Motion Can d be < 0? If not, why not?

1.5
11B.9 Law of Motion Can net investment be equal to gross
w1

investment? If so, under what condition? If not, why

not? Deep down, this is essentially the same as
item 11B.6.
1
12 Well,obviously...
13 It
was simply called K back then because there was only one period and there
was no need to specify the period.

0.5
0 5 10 15 20 25 30
Ns1

Figure 34.

• Account balance
• Deposit and withdrawal
• Debt
• Deficit
• Pumping the gas
• Reading on the fuel gage
• Asset
• Net worth
• Tip
• Tip jar
• Copper production
• Copper deposits
• Property value
• Appreciation

28
 Chapter 11B
Le maquereau Is GDP Gross?
Ever wondered why we have gross domestic product
rather than just domestic product? Well, there is
nothing disgusting about domestic product. We just
call it so as a reminder that GDP has a secret twin
called net domestic product (NDP). NDP is defined
as GDP minus capital depreciation. We hear a lot
about GDP but barely about NDP. What’s with our
overwhelming preference for GDP over NDP?
Take an airplane (part of I , investment) for exam-
ple. Unfortunately, your airplane does not last for-
ever. Since you’ll have to replenish your investment
at some point, GDP preempts additional investment
required in the future in the form of capital de-
preciation d . If you pay for the whole bill upfront, I
(and consequently K ) will go up by the ticket amount
(only) in 2023. However, planes usually last longer
than a year. You’ll keep operating your plane for
years to come. It’s a bit misleading to see K spiking
up only in 2023, when in fact you’ll be still flying the
same airplane, which generates revenue, not only in
2023 but beyond. Instead of dumping all the pay-
ment in 2023, we spread the cost over the period
of utilization to keep the one-time payment more
in tune with the multi-years of usage. This practice
is called capital depreciation, which GDP takes into
account but NDP doesn’t. Consequently, a ride on
NDP is bumpier than how our economy drives in ef-
fect. A passenger on an NDP ride would probably
barf for too much gyration (now that is gross).
This is why you almost exclusively hear about GDP
but barely about NDP.
If we barely use NDP, why can’t we just call GDP
DP and add ’net’ in front only for (rare) occasions
when we have to refer specifically to NDP? That’s
an approximately 2.2 trillion Canadian dollar question
that I can’t answer. Calling DP GDP is as if calling
a pomegranate a red pomegranate. ’Red’ here is
redundant because I’ve never seen a pomegranate
coming in any different colors.
November 15
11B.10 Law of Motion What is the point of making gross
investment if it takes away the equal amount of output
to make one? Explain the trade off associated with I1
and I2 each.
11B.11 Two-Period PMP We assumed (and will assume
for the remainder of the semester except in this ques-
tion) that one basket of output makes one basket of
gross investment in class. What if it takes two baskets
of output to make one basket of gross investment? Up-
date ’s profit in period 1.
11B.12 Law of Motion We saw that I2 < 0 in class (i.e.,
disinvestment). Can I1 be < 0 as well? If so, how would
you interpret it? It can, but be sure to understand
what that means.
11B.13 Law of Motion If sets I2 = 0 (the maximum
value possible) to maximize his profit, what must have
taken place? There are two possible scenarios. They
are theoretically possible but practically implausible (and
thus we assume I2 < 0 outside this question). Refer to
the law of motion and examine under what condition
I2 should be zero.
11B.14 Law of Motion We assume that K1 is exogenous
because it was left by the previous generation from pe-
riod 0, which is not the part of the periods covered.
29
While he was baking cookies in period 1, using the
oven that he inherited from Cookie Typhon, his late fa-
ther, started to wonder how this oven came about.
Write him the law of motion that his predecessor fol-
lowed to define K1 . You will need K0 somewhere in
your answer.14
11B.15 Dynamic PMP While we are free to select both
N1d and N2d to maximize our profit, we can only do so
with K2 but not with K1 . Why not?
11B.16 Dynamic PMP Suppose that the wage rate is 1
[ 2 /hr2 ] whereas an additional hour of work brings
in 4 more baskets at the ongoing level of N2d . This
∂ π2 (K2 , N2d )
gives the firm the profit margin of = 4−1
∂ N2d
[ 2 /hr2 ]. While the firm earns the positive profit mar-
gin, the ongoing N2d is not a profit maximizer. Why
not? This is nothing newly introduced in this chap-
ter. I just wanted to check in to see if you remember
how to find the profit maximizer from section F.
11B.17 Dynamic PMP In our model, can learn? That
is, would his work experience in period 1 make him a
more efficient worker in period 2? If not, what do you
think you would need to model his accumulation of
skill or knowledge over time?
On the contrary, can capital behave like labor? For
instance, can we remove intertemporal dependence by
setting d = 0 for example? The marginal conditions
for labor are chronologically separable whereas the one
for capital is intertemporal. Understand why by asking
yourself “what if not?”
11B.18 Dynamic PMP Derive the marginal conditions for


PMP. You might want to spell out V N1d , N2d , K2
first before taking the partial derivatives. Use the law
of motion to remove I1 out of V (·).
11B.19 Dynamic PMP Give an economic interpretation
of the marginal condition for K2 in item 11B.18.
11B.20 Dynamic PMP Examine how the profit maximizers
respond to changes in z1 , z2 and K1 using your answers
to item 11B.18.
11B.21 Dynamic PMP What if d = 0? Re-interpret your
answer to item 11B.18.
11B.22 Dynamic PMP What if d = 1? Re-interpret your
answer to item 11B.18.
11B.23 Dynamic PMP What if r = 0? Re-interpret your
answer to item 11B.18.
11B.24 Dynamic PMP Explain why I2 = −(1 − d)K2 .
11B.25 Dynamic PMP I picked K2 as a variable of choice


to maximize the objective function V N1d , N2d , K2 . My
choice was actually arbitrary: Since the law of motion
14 Strictly speaking, K should be zero just as K should be zero, i.e., Cookie
1 3
Typhon should have disinvested K1 and thrown an epic rave on December 31st to
leave nothing behind when he died. In this class, we assume that he was altruistic
and left some K1 (> 0) for .
 Chapter 11C

dictates the relationship between K1 and I1 , I could 11B.30 Dynamic PMP What would happen to your gross
have as well selected I1 as a choice variable instead of investment demand curve in item 11B.27 if you replace
K2 . If I1 is determined, K2 is uniquely determined as z1 = 1 with 2, and why? Short Nothing.
well, and vice versa. Rewrite your answer to item 11B.18
in terms of I1 rather than of K2 , and give an interpreta- 11B.31 Dynamic PMP Figure 36 plots the capital and in-
tion of your updated marginal condition. vestment demand curves in item 11B.27 with varying
values of d (while leaving K1 = 4). Explain how and
11B.26 Dynamic PMP How does I1∗ (or K2∗ if you prefer,
in the spirit of item 11B.25) respond to a change in d ? 1
Holding everything else constant, an increasing d K2(r; d=1/2)
needs to be compensated by a high M PK2 (·) (or else, 0.9
the marginal revenue from I1 will cut below the interest K2(r; d=1/4)
0.8
payment 1 + r ). To do so, what would you have to do I 1(r; d=1/2)
to I1 and what is the economic meaning of it? 0.7
I 1(r; d=1/4)
11B.27 Dynamic PMP Suppose production function is 0.6
given by 0.5

r
p Ç
z2 F (K2 , N2d ) = z2 K2 N2d . 0.4
1
Depreciation rate is d = TFP is z1 = z2 = 1, and the
2, 0.3
∗
firm has inherited either K1 = 2 or 4. N2d = 8 for this
firm. Derive K2 (r) and I1 (r) for each K1 and sketch 0.2
the functions. For the graph, you can compute the 0.1
values at r = 0 and .5 and connect them. (part) See
figure 35. 0
0 1 2 3 4 5 6 7 8
1 K2 , I 1
K2(r; K1=2)
0.9
K2(r; K1=4) Figure 36.
0.8
I 1(r; K1=2)
0.7
I 1(r; K1=4) why each K2 (r; d) and I1 (r; d) respond to d the way it
0.6 does in figure 36. Because I ran comparative statics
on K2 and z2 , but not on d in class (not because it is
0.5
r

banned or anything but because if you can run the one

0.4 on K2 , then the one on d should be straightforward).

0.3 11B.32 Dynamic PMP Labor demand curve is down-

0.2 ward sloping because we hire Zedd (with high M PN d (·))
τ
alone when 4τ is high, and hire Zedd and Sensei (with
0.1 low M PN d (·)) only when 4τ is low enough. How does
τ
0 this compare to investment demand curve? It should
-2 -1 0 1 2 3 4 5 6 7 8 be analogous to labor demand.
K2 , I 1
11B.33 Dynamic PMP Is the economic rate of return
always lower than the accounting rate of return? Why
Figure 35. The actual value of I1 doesn’t fall below 0 but I extended or why not?
the axis nonetheless to better show you that I1 (r) is a left-shifted ver-
sion of K2 (r). To actually turn I1 (·) negative in this case, the interest
rate has to be the unlikely rate of whopping 50% or above. 11C Competitive Equilibrium
11C.1 Competitive Equilibrium Define competitive equi-
librium.
11B.28 Dynamic PMP Explain in words why I1 (r; K1 = 4)
11C.2 Y1s Suppose that a firm’s production function in pe-
is located to the left of I1 (r; K1 = 2) in item 11B.27.
riod 1 is given by
November 22 p Ç 2
z1 F (K1 , N1d ) = z1 K1 + N1d , (10)
11B.29 Dynamic PMP An increase in z2 implies that an
additional K2 will bring in more output than before. with z1 = 1 and K1 = 1. Derive the firm’s labor demand
Put differently, to raise Y2s by the same amount, it only function N1d (41 ) and fill it in figure 37. You can pick
takes a smaller increase in K2 than before. Why then
41 = 1.5 and 2 to compute N d (41 ), and connect the
does a firm increase I1 in response to a rising z2 ? ‹2
z1

dots. (part) N1d (41 ) = K1 .
41 − z1

30
 Chapter 11C

11C.3 Y1s Define output supply curve. where z1 = 2 or 4. The firm inherited K1 = 4 from
the previous generation. See figure 39(b) on page 34
11C.4 Y1s Suppose that labor supply function is given (which one is which?) Derive N1d (41 ; z1 ) for each z1 .
as in figure 37(a). Trace out the output supply function Which one in figure 39(a) corresponds to which case?
−1
in item 11C.2 in figure 37(c). You should be able to (part) N1d (41 ; z1 = 2) satisfies 41 = 2(N1d ) 2 , namely,
find the value from (10) but you can use figure 37(b) to
N1 (41 ; z1 = 2) = 44−2
d
1 .
check your answer.
11C.11 Y1s Green and blue lines in figure 39(a) represents
11C.5 Y1s Consider the red point in figure 37(c). Is this
combination part of the equilibria? If not, why not? the labor supply when r = .1 or .2. Which one is which
and why?
11C.6 Y1s Suppose that income effect exceeds substitution
effect in figure 37(a) so that the location of the green 11C.12 Y1s Outline the output supply curve in figure 39(c)
and blue lines are flipped. Trace out the output supply for each z1 . If done right, the curve should shift to
curve in figure 37(c) in this case. the right.

11C.13 Y1s Interpret your result in item 11C.12.

Le maquereau Are Thunder Bayers
Lazier than Torontonians?
11C.14 Y1s How about a change in K1 rather than z1 in
Toronto’s GDP was $181 billion in 2013, making item 11C.10? Trace out the output supply curve and
about 18.6% of Canadian GDP, whereas the popu- interpret your result. You can just outline the re-
lation share was around 15.9%.a Thunder Bay’s GDP sult but if you want something numerical, leave z1 at 2
was $5.7 billion, .32% of Canadian GDP, whereas the and increase K1 from 4 to 16. You’ll get the same re-
population share was .31%. In general, per capita GDP sult as item 11C.12 (the interpretation will be different
grows with the size of the city. This does not nec-
essarily mean that Thunder Bayers are lazier than though).
Torontonians. Labor productivity grows with the
size of the city, and accordingly, the nominal wage 11C.15 Y1s How about a change in z2 instead in item 11C.10?
also grows with it, the empirical regularity called ’ur- Does your output supply curve register any difference?
ban wage premium’. There are several reasons be- Why or why not? Recall that labor is chronologi-
hind it (which you’ll learn in Econ 492. See me there
after you finish 302 and 304).
cally separable.
Then why would anyone live in Thunder Bay (or any
small city) on purpose? If a Thunder Bayer moves 11C.16 Y1d Define output demand curve.
to Toronto, she (yes, the same person) can pro-
duce and earn more merely because she lives in a big 11C.17 Y1d Y1d (r) declines with r . Why? For two
city. While you do earn urban wage premium in big
cities, they usually come with a steep cost of living
reasons.
(most notably, rent). In the end, a low cost of living
(among many other location-variant factors such as 11C.18 Y1d If the substitution effect is smaller than the in-
congestion) compensates for reduced productivity come effect, would Y1d (r) be upward-sloping? Explain.
in Thunder Bay.
It could but not necessarily. Specify the condition
a Source: Statistics Canada. where it will be upward-sloping.

11C.19 Y1d Suppose that optimal consumption and invest-

November 29 ment are given by
11C.7 Y1s Suppose that K1 or z1 changes in item 11C.2.
C1 (Y1 , r) = 12 Y1 − T1 − r
(
How would the output supply in item 11C.4 respond?
I1 (r) = 5 − r.
11C.8 Y1s Suppose that G1 went up from 1 to 2 baskets
(other than that, everything is the same as item 11C.2). Sketch Y1d (Y1 , r) for a given r on the Y1 − Y1d coordi-
Fill in the two output labor supply curves, one each nates.
for G1 ’s in figure 38(c) on page 33. Locate three
points in figure 38(c) corresponding to the labor market 11C.20 Y1d Sketch Y1d (Y1 , r) in item 11C.19 on the Y1d − r
equilibrium in figure 38(a). coordinates.

11C.9 Y1s Ricardian equivalence implies that the opti-
mal consumption bundle does not change whether the
tax is charged early on or not. Why then does labor
supply change in item 11C.8? Read the theorem
carefully and you’ll see that this ostensibly reasonable
question in fact does not make much sense.
11C.21 Y1d In class, we ran comparative statics on Y1d (Y1 , r)
over z2 . How does the output demand curve respond
if we change G1 instead? You can model after your
class note, or you can plug in two different G1 ’s in
item 11C.19 to compare the resulting output demand
curves.

11C.10 Y1s We ran a comparative statics on Y1s (·) over G1 in 11C.22 Equilibrium On a graph with output demand and
class. What if z1 changes instead of G1 ? In particular, supply curve today, shade in the following quadrants:
assume that the firm’s production function is given by There is
Ç
z1 F K1 , N1d = z1 K1 N1d ,

(a) excess supply of goods and excess supply of labor

31
 Chapter 11D

(b) excess supply of goods and excess demand for
labor
(c) excess demand for goods and excess supply of
labor
(d) excess demand for goods and excess demand for
labor.
11C.23 Equilibrium On a graph with output demand
and supply curve today, trace out the following line
segments: There is
(a) excess supply of goods but no excess in the labor
market
(b) excess demand for goods but no excess in the la-
bor market
(c) no excess in the goods market but excess supply
of labor
(d) no excess in the goods market but excess demand
for labor.
11C.24 Equilibrium On a graph with output demand and
supply curve today, trace out the following point: There
is
(a) no excess in either market.
11C.25 Equilibrium On the last we used today, r = r H
(green line) puts the labor market in equilibrium but
the goods market won’t be in equilibrium at this rate.
Explain why. Anywhere along the output supply
curve, the labor market is in equilibrium via the marginal
condition with respect to N1d . But that condition is in-
dependent of the marginal condition with respect to K2
or the tangency condition. Being on the output supply
curve is a necessary condition for an equilibrium, but
that is not sufficient.
11C.26 Equilibrium If your answer to item 11C.15 on page 31
is no, does that mean that a change in z2 has no bear-
ing on equilibrium? Explain. It does, but through a
different channel than Y1s .
11D Comparative Statics
11D.1 Comparative Statics on G1 I assumed that the
government would finance its spending increase ∆G1
contemporaneously in class, i.e., ∆T1 = ∆G1 . What
if they finance it in the next period? Namely, ∆T1 =
0 and ∆T2 = (1 + r)∆G2 instead. Does the effect on
equilibrium GDP change? Explain.
11D.3 Comparative Statics on G1 The government increased
their spending by 1 basket in item 11D.5. Draw in fig-
ure 40 the new Y1d (·) with T1 = 1 (in green) and T1 = 2
(in red) while leaving r = 1. Which one of them does
the economy settle with if r stays at 1?
11D.4 Comparative Statics on G1 In item 11D.3, given the
current r = 1, how much is the output demand?
11D.5 Comparative Statics on G1 What is the ratio be-
tween ∆G1 and ∆Y1d in item 11D.3?
11D.6 Comparative Statics on G1 If r = 1 does not consti-
tute an equilibrium in item 11D.4, in which direction
does the goods market move it? The market tries to
clear the excess demand in this case.
11D.7 Comparative Statics on G1 How does the equilib-
rium wage 41 respond to the change in r you predicted
in item 11D.6?
11D.8 Comparative Statics on G1 How does the output
supply function respond to the change in the labor
market in item 11D.7?
11D.9 Comparative Statics on G1 Combine items 11D.4
and 11D.8 to gauge the ultimate change in equilibrium
GDP, and examine how the new GDP feeds into the
labor market.
11D.10 Comparative Statics on G1 Is the ratio between ∆G1
and the change in the equilibrium GDP more than or
less than the ratio you found in item 11D.5? Explain.
Explain why ∆G1 crowds out consumption and in-
vestment demand.
11D.11 Comparative Statics on G1 Suppose that the gov-
ernment gave a tax cut instead to lift the economy out
of recession in item 11D.3. Would there be any differ-
ence in equilibrium GDP?
11D.12 Comparative Statics on z1 Suppose that z1 went up.
How does I1 respond to the change?
11D.13 Comparative Statics on z1 Suppose that ∂ C1 /∂ 41 >
0. How does increased z1 affect the equilibrium GDP,
41 and r ?

11D.2 Comparative Statics on G1 Suppose that ’s opti-

mal consumption is given by

1 1
C1 (Y1 , T1 , r) = (Y1 − T1 ) − r
2 4
and the gross investment demand is

1
I1 (r) = 2 − r.
4
Suppose that r = 1 is the current equilibrium rate. Plot
Y1d (Y1 , T1 , r) against Y1 when r = 1, G1 = 1 and T1 = 1.
How much is Y1d in equilibrium? See figure 40.

32
Chapter 11D

4 4
MPN (K1, N 1) MPN (K1, N 1)
3.5 1 3.5 1

Ns1(r=.1) Ns1(r=.1, G1=1)

3 3
w 1, MP N (K 1, N 1)

w 1, MP N (K 1, N 1)
Ns1(r=.2) Ns1(r=.2, G1=1)
2.5 2.5 Ns1(r=.1, G1=2)
1

1
2 2

1.5 1.5

1 1

0.5 0.5

0 0
0 1 2 3 4 5 0 1 2 3 4 5
Ns1, N d1 Ns1, N d1
(a) (a)

10 10
9 9
8 8
7 7
6 6
Ys1

Ys1

5 5
4 4
3 3
2 2
1 1
0 0
0 1 2 3 4 5 0 1 2 3 4 5
Nd1 Nd1
(b) (b)

0.3 0.3

0.2 0.2
r

0.1 0.1

0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Ys1 Ys1(r)
(c) (c)

Figure 37. Figure 38.

33
Chapter 11D

MPN (K1, N 1, z 1=?)

1
MPN (K1, N 1, z 1=?)
1
w 1, MP N (K 1, N 1)

Ns1(r=?)

Ns1(r=?)
1

2.8284

1.1547

0
0 1 2 3 4 5
Ns1, N d1
(a)

7
Y s1=(one of z1)(K1Nd1 ).5
Y d1(Y1, r=1, T1=1, G1=1)
Y s1=(the other z1)(K1Nd1 ).5 6
Y d1(Y1, r=1, T1=1, G1=2)
12 5 Y d1(Y1, r=1, T1=2, G1=2)
8*sqrt(2)
Y d1=Y1
Yd1(Y1, r)
Ys1

4
8
4*sqrt(3) 3

4 2

1
0
0 1 2 3 4 5 0
Nd1 0 1 2 3 4 5 6 7
Y1
(b)

0.3 Figure 40.

0.2
r

0.1

0
0 4 4* 8* 12
sq 8 sq
rt( rt(
3) 2)

Ys1(r)
(c)

Figure 39.

34
Chapter 11D

Le maquereau Diverging Diamond Inter-

change and TFP

As a former Missourian, I’m proud to say that Mis-

souri is the first state in North America to in-
troduce a diverging diamond interchange (DDI). See
figure 41.
DDI can process more traffic (there is no green
left turn arrow) with less traffic accidents. Accord-
ingly, the economy with DDI’s yields more than the
one with alternative crossings, holding everything
else constant. DDI is part of G that the MODOT
purchases from the general contractors, who pro-
duce and maintain it according to their production
function Y = zF (K, N d ). Where does this productiv-
ity increase fall into? K ? – No. They still use the
same amount of capital (or probably less because it is
usually more space-saving than alternatives). N d ? –
Still no. They still use the same amount of labor (or,
once again, probably less for the same reason). The
only option left is then z , the total factor produc-
tivity. The same capital, the same workers but DDI
can squeeze more G out of them.
We tend to focus on the welfare effect of z
through C but TFP improves the utility level through
G just as much. With a DDI, we do not need as much
capital and labor to produce the same G . We can
then spare labor thus saved for production of C or
increase l (or both), through which we can increase
our utility level. The effect would be even more
pronounced if we factor G directly into the utility
function (which we didn’t do for simplicity).
St. Louis has lots to offer (and I left my heart
there) but if you got a chance to visit (and if you
are an urban economics nerd as I am), rent a car
and drive along Dorsett Rd. It might feel a bit
weired because you’ll see your oncoming traffic to
your right while you cross I-270. Don’t freak out.
Everything is clearly marked. Simply follow the signs
and enjoy your ride. Also found along the I-270:
• You might as well travel a bit farther to the
west and continue onto MO 94, an unexpect-
edly idyllic highway that I think is the most scenic
in Missouri.
• Highway 67, which runs parallel to I-270, is one
of the few highways that drive underneath a
runway. It was here first and then Lambert St.
Louis International expanded on top of it. Do
not poke the tunnel’s ceiling. There’s an ac-
tive runway with planes taking off and landing
right above your head.
• The I-70, from which the I-270 spins off,
carries the highest exit suffix, the exit 2X
in Kansas City, MO. Exits are numbered by
the mile, and if there is a multiple of them
within the same mileage, an alphabetical suffix
is added for their distinction. In Kansas City, Figure 41. I-270 at Dorsett Rd (Image retrieved from Google Maps).
the exit number 2 is shared by 2A through 2X.
Spaghetti much?
You are welcome, Missouri, for the unsolicited plug.
Can I get my money now? This is all me haz. Work hard
and good luck with the final!

Sesame Street ®

35