John Riley

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ANSWERS TO EVEN NUMBERED EXERCISES FOR CHAPTER 1 Section 1.1

Exercise 1.1-2: Supporting hyperplane for CES preferences (a) For > 1 show that the CES utility function U ( x) = ( x1 concave. Hint: Show that the utility function u ( x) = f (U ( x)) is concave, where f (U ) = U (b) Show that this is true for < 1 . HINT: Consider the mapping f (U ) = U
1 1 1 1

+ x1

1 1

is strictly quasi-

(b) For any x > 0 obtain an expression for the supporting hyperplane of the upper contour set through x .

ANSWER (a) Suppose that both ( z 0 , q 0 ) and ( z 0 , q 0 ) Y . Then q 0 F ( z 0 ) and q1 F ( z1 ) . We need to show that every convex combination ( z , q ) Y . Since F ( z ) is concave,

F ( z ) (1 ) F ( z 0 ) + F ( z1 ) . Appealing to the previous inequalities it follows that F ( z ) (1 )q 0 + q1 = q . Hence the convex combination is indeed in the production set. (b) Since F (1,1) = 1 , the production plan (1, 1,1) is on the boundary of Y

(c) To support the production plan, it must be profit maximizing. That is, ( z * , q* ) = arg Max{ p3 q p1 z1 p2 z2 | q z11/3 z 2/3 } .
z ,q

Since profit is increasing in q the constraint must be binding at the maximum. Therefore
z * = arg Max{ ( z ) = p3 z11/3 z 2/3 p1 z1 p2 z2 } .
z

First Order Conditions

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2/3 2/3 1/3 1/3 = p3 1 z2 p1 = 0 and = p3 2 p2 = 0 . 3 z1 3 z1 z2 z1 z2 Substituting for z = (1,1) ,

1 2 = 3 p3 p1 = 0 and = p3 p2 = 0 z1 z2 3 Hence p = (1, 2,3) is a supporting price vector.

Exercise 1.1-4: Robinson Crusoe Economy

Robinson Crusoe lives alone on an island off the coast of New Zealand. He has a production set Y = {( z1 , y2 ) | y2 16 z11/3 , z1 0} and an endowment vector = (32, 0) .

His preferences are represented by the utility function U ( x) = ln x1 + ln x2 . (a) Solve for his optimal choice of input and hence his optimal production plan and consumption plan x* . (b) Depict the production set and the set Y + in a neat figure and indicate the optimal production and consumption plans. Explain what it means for the optimal production plan to be supported by a price vector p = ( p1 , p2 ) . (c) Solve for the price vector that supports the optimal production plan. (d) Depict this supporting price line, Crusoes budget set and indifference curve though

x* .
(e) Hence explain why the supporting price vector is a WE price vector if Robinson Crusoe is a price-taker.

ANSWER

(a) If Robinson chooses input level z1 , his consumption of commodity 1 is x1 = 1 z1 = 32 z1 . Output of commodity 2 is y2 = 16 z11/3 . Since his endowment of
commodity 2 is zero, his consumption of commodity 2 is x2 = y2 . His utility is therefore U = ln x1 + ln x2 = ln(32 z1 ) + ln16 z11/3 = ln(32 z1 ) + ln16 + 1 3 ln z1 . FOC

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1 1 dU = 3 = 0. dz1 32 z1 z1

21 September 2011

Solving, z1* = 8 . Then y2* = 32 and x* = (24,32)

(b) A price vector supports a production plan if, at those price, the plan is profit maximizing. The more heavily shaded region is the production set, bounded by the production function y2 = 16 z11/3 = 16( y1 )1/3 . Adding the endowment vector = (32, 0) shifts the set to the right by 32.

p y = p y*

x2 , y2

y = (8,32)
*

x* = (24,32)

Y +

x1 , y1

(c) FOC

1/3 = p y = p2 y2 p1 z1 = p216 z1 p1 z1 .

16 = p2 z12/3 p1 = 0 . z1 3 Since z1* = 8 , 4 = p2 p1 = 0 . z1 3

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Thus the price vector p = (4,3) is a supporting price vector. At these prices, maximized profit is 64. The iso-profit line though the profit-maximizing production plan is depicted in the figure. (d) In the next figure the budget line for Crusoe has been added. Since profit is 64, the budget set is B = {x | x 0, p x 64 + p = 192} . Note that the right-hand side is the dividend (the profit) plus the value of Crusoes endowment.

(e) If you solve for the optimal consumption vector in this budget set you will find that is it x* = (24,32) . Therefore the prices that support the optimal production plan are also market clearing prices.

p y = p y*

x2 , y2
p x = p y + p

y = (8,32)
*

x* = (24,32)

Y +

x1 , y1

Exercise 1.1-6: Robinson Crusoe Economy with 4 commodities

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Robinson Crusoe has a production set Y = {( z , y3 ) | y3 z11/ 3 z2 2 / 3 , z 0} and an endowment vector = (32,160, 0,16) . His preferences are represented by the utility function U ( x) = ln x j .
j =1 4

(a) Solve for the optimal production plan and hence the optimal consumption vector x* . (b) Obtain a price vector ( p1 , p2 , p3 ) , where p2 = 1 , that supports the optimal production plan. (c) What must be the price of commodity 4 if x* is Crusoes optimal consumption bundle in his budget set? HINT: There is only one consumer so Crusoe must consume his endowment.
ANSWER

(a) Utility is strictly increasing. Therefore x = (1 z1 , 2 z2 , z11/ 3 z2 2 / 3 , 4 ) . Hence U = ln(32 z1 ) + ln(160 z2 ) + ln( z11/ 3 z2 2 / 3 ) + ln 4
2 1 = ln(32 z1 ) + ln(160 z2 ) + 1 3 ln z1 + 3 ln z 2 + 3 ln 2 + ln 4 .

FOC
1 2 1 1 U U = 3 = 0 . Solving, z * = (8, 64) . = 3 =0, z2 160 z2 z2 z1 32 z1 z1

Then the optimal production plan is ( z * , q* ) = (8, 64,32) and so x* = (24,96,32,16) . (b) The supporting price vector must be profit maximizing. Therefore
z * = arg Max{ = p3 z11/3 z2 2/3 p1 z1 p2 z2 }
z

FOC 1 = 3 p3 z12/3 z2 2/3 p1 = 0 . z1 2 = 3 p3 z11/3 z2 1/3 p2 = 0 z2 Substituting for z * , ( p1 , p2 , p3 ) = (4,1,3) (c) The consumers optimization problem can written as follows. Max{U ( x) | p x p x*} .
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FOC
U * (x ) x j pj 1 = , j=1,,4. p j x* j

Substituting for x* . 1 1 1 1 = = = . p1 24 p2 96 p3 32 p416 Hence p = (4,1,3, 6) is a supporting price vector.

Section 1.2: CONSTRAINED OPTIMIZATION

Exercise 1.2-2: Consumer Choice A consumer with income I has utility function U ( x) = x11 ...xn n , > 0 and faces the price vector p. (a) Find an increasing function f such that u ( x) = f (U ( x)) is concave and hence quasiconcave. (b) By Proposition 1.2-4 the FOC for the modified problem are both necessary and sufficient. Hence solve for the consumers optimal choice.
ANSWER

(a) Facing a price vector p the cost of a bundle x is p x thus the consumer must satisfy the budget constraint p x I . The function u = ln U is increasing and ln U = i ln xi is the sum of concave functions and is therefore concave and so quasii =1 n

concave. Then we consider the concave maximization problem, Max{u = i ln xi | x 0, p x I } .

x i =1 n

For such a problem we need only check for a solution to the necessary conditions since they are also sufficient. (b) Writing the problem in standard form, the consumer seeks to solve
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Max{u ( x) | h( x) = I p x 0, x 0} .
x

Note that the gradient vector

n

h 0 thus the KT constraint qualifications are satisfied. x

n

L( x, ) = j ln x j + ( I p j x j )
j =1 j =1

First order conditions

L j = p j 0, with equality if x* j >0. x j x j

Since the first term increases without bound as x j goes to zero, this constraint cannot be satisfied if x j = 0 . It follows that x* j > 0, j = 1,..., n . Then, from the first order conditions,

j L j = p j = 0 and so x* . j = x j x j pj
Substituting into the budget constraint,

j p j x j = = I . Hence = j =1 j =1
n n

j
j =1

Then x* j =

j j I = n p pj i j
i =1

Exercise 1.2-4: Satisfying the constraint qualification with a single constraint

There is a single constraint g ( x) g ( x ) and x

g (x ) < 0 . x

(a) Show that the linearized set at x has a non-empty interior. (b) Hence show that the constraint qualifications hold at x .
ANSWER

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(a) Define h( x) = g ( x) g ( x ) so that the constraint can be written in the standard form

h( x) 0 . The gradient of h at x is
g (x ) (x x ) 0 . x By hypothesis x

g ( x ) so the linearized constraint is x

g ( x ) < 0 thus the constraint is satisfied strictly at x = 0 . Then it is x

also satisfied at interior points of the linearized feasible set in some neighborhood of
x = 0 . Hence the interior of the linearized feasible set is non-empty.

(b) Since x

g h g ( x ) < 0 , it follows that (x ) = ( x ) 0 . Thus the constraint x x x

qualifications are both satisfied at x .

1.3 THE ENVELOPE THEOREM

Exercise 1.3-2. Illustrating the Envelope Theorem

To produce q units of output, a profit-maximizing firm requires input. The price of the output is p and the price of the input is r. (a) Write down an expression for profit (q, p, r ) .

1 2

q 2 units of the single

(b) Solve for the profit maximizing output q* and hence show that maximized profit is ( p, r ) = (q* ( p, r ), p, r ) = (c) Confirm that
1 2

p2 . r

* * (q , p, r ) and = ( q , p, r ) . = p p r r

ANSWER To produce q units of output, a profit-maximizing firm requires

1 2

q 2 units of the single

input. The price of the output is p and the price of the input is r. (c) Write down an expression for profit (q, p, r ) .
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(d) Solve for the profit maximizing output q* and hence show that maximized profit is ( p, r ) = (q* ( p, r ), p, r ) = (c) Confirm that
1 2

p2 . r

* * (q , p, r ) and ( q , p, r ) . = = p p r r

2 (a) = pq 1 2 rq .

(b) This is a strictly concave function so the first order condition is both necessary and sufficient. = p rq = 0 at q (r , p ) = p / r . q Substituting into the expression for profit, maximized profit is
2 2 1 (r , p ) = pq (r , p ) 1 2 rq ( r , p ) = 2 p / r .

(c) Hence 2 = p / r and =1 2 ( p / r) . p r Since q(r , p) = p / r we can rewrite these expressions as follows. 2 = q(r , p) and =1 2 q ( r , p ) .. p r
2 Since = pq 1 2 rq ,

= q 2 = q and r p

1.3-4: Envelope Theorem with a corner solution

A consumer has a utility function U ( x) = ln( + x1 ) + ln x2 , income I and faces a price vector p = ( p1 , p2 ) >> 0 . (a) Show that if she consumes both commodities, her optimal consumption bundle is
I p1 I + p1 x ( p, I , ) = , . 2 p2 2 p1

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(b) Hence write down an expression for maximized utility F ( ) = U ( x( p, I , )) and show that 2 p1 dF = . d I + p1 (c) Explain why, for large , F ( ) = ln + ln( I / p2 ) and confirm that F is continuously differentiable for all 0 .

ANSWER

(a) If x* >> 0 the marginal utility per dollar is the same for both commodities, that is 1 U 1 1 2 2 = = = = . pi xi p1 ( + x1 ) p2 x2 p1 + p x p1 + I Note that we have appealed to the ratio rule for the third equality. Since utility is strictly monotonic, total expenditure is equal to income, hence the fourth equality. Solving, x* = ( I p1 I + p1 , ) 2 p1 2 p2 p1 + I p + I ) + ln( 1 ) 2 p1 2 p2

(b) Substituting into the utility function, F ( ) = U ( , x* ( )) = ln(

= ln 2 p1 ln 2 p2 + 2 ln( p1 + I ) Differentiating by , 2 p1 dF = d p1 + I
* (c) From the answer to (a) we note that x1 cannot be strictly positive if > I / p1 . For a
* corner solution with x1 = 0 , the marginal utility per dollar must be lower for commodity

1. That is 1 U 1 U (0, I / p2 ) < (0, I / p2 ) . p1 x1 p2 x2 Substituting,

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1 1 < . p1 I Then F ( ) = U (0, I / p2 ) = ln + ln I / p2 . It is then easy to check that the derivative is continuous at = I / p1 .
Remark: This exercise illustrates three general propositions. First, given the strict quasi-

concavity of the utility function and the convexity of the feasible set, the solution x ( p, I , ) is a continuous function in all its arguments. Second, given the continuity of the solution, F ( ) is continuously differentiable for all 0 . Finally, by the envelope theorem, dF U 1 = x ( p, I , )) = . ( x ( p, I , ) + d

Section 1.4 FOUNDATIONS OF CONSTRAINED OPTIMIZATION

Exercise 1.4-2: Generalization of the Kuhn-Tucker conditions

(a) Suppose that

x = arg Max{a0 x | Ax z , x j + , j I , x j , j J , x j , j K }
x

exists and that the interior of the feasible set is non-empty. Modify the proof or Proposition 1.1-5 to obtain new necessary conditions. (b) Suppose that
x = arg Max{ f ( x ) | hi ( x) 0, i = 1,..., m, x j + , j I , x j j J , x j , j K }
x

Explain how Proposition 1.4-3 must be restated.

ANSWER

(a) For the linear model, it follows from the supporting hyperplane theorem that

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q q ( z z ) 0 for all ( z , q) Y .

(1)

Consider the activity vector x = x + . The associated change in input requirements is

z z = A and the change in output is q q = a0 ( x x ) = a0 .

Substituting into (1), a0 A = (a0 A) 0 . Next set all the changes in x except the jth component equal to zero. This inequality then becomes (a0 j i aij ) j 0 .
i =1 m

(2)

For i I the argument is an in Chapter 1. For i J both x j + and x j are feasible as long as is sufficiently small. Therefore (a0 j i aij ) 0 and (a0 j i aij )( ) 0
i =1 i =1 m m

and so a0 j i aij = 0 .
i =1 m

For i K , there are two cases. If x j < 0 we can argue as above that a0 j i aij = 0 .
i =1

If x j = 0 , x j is feasible if > 0 . Therefore, appealing to (2), (a0 j i aij ) j = (a0 j i aij )( ) 0 and so
i =1 i =1 m m

a0 j i aij 0
i =1

(b) The FOC for the non-linear optimization problem are the FOC for the linearized optimization problem. Thus the FOC become L 0, i I , with equality if xi > 0 xi
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L = 0, j J x j

L 0, k K , with equality if xk > 0 xk

SECTION 1.5
Exercise 1.5-2:Multi-product firm with Joint Costs

A firm produces two products. The production function for product j is Fj ( K j , L j ) = K j L j . Capital equipment can be used in the production of either or both products. Thus if K 0 units of capital are rented, the capital use constraints are K j K 0 , j = 1, 2 . The unit cost of labor is 2 and the unit cost of capital is 10. (a) Explain why the Lagrangian for minimizing the total cost of producing (q1 , q2 ) can be written as follows
L(q, K ) =

2q12 2q2 2 10 K 0 + 1 ( K 0 K1 ) + 2 ( K 0 K 2 ) . K1 K2

(b) Hence, or otherwise show that all the capital equipment will be used for the production of both products. (c) Solve for the minimized total cost. (d) Fix q2 and depict the marginal cost of producing commodity 1. (a) From the production function qt2 = K t Lt . Thus, given that K t units of capital have
2 2q12 2q2 + + 10 K 0 . been rented, labor demand is Lt = q / K t . Hence total cost is K1 K2 2 t

(b) FOC L = 10 + 1 + 2 = 0 (since qt > 0 K t > 0 ) K 0

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L 2qt2 = t = 0 since K t > 0, t = 1, 2 . K t K t2

2qt2 Since 2 > 0 the second FOC cannot be satisfied unless t > 0, t = 1, 2 . Hence the Kt second constraint must hold with equality and so K t = K 0 , t = 1, 2

(a) From the FOC

2 1 2q12 2q2 1 2 2 2 K = ( q + q ) . Substituting, minimized + = 10 , hence 0 1 2 K 02 K 02 5

1

2 2 total cost is C (q ) = 4 5(q12 + q2 ) .

(b) Differentiating by q1 ,

C 4 5q1 4 5 = = 1 q2 1 q1 (q 2 + q 2 ) 2 1 2 (1 + 2 )2 q12

Thus, as q1 increases, marginal cost rises from zero to 4 5 .

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