ISI ME II, 2013

Amit Goyal

May 1, 2013

Amit Goyal

ISI ME II, 2013

Problem 1

An agent earns w units of wage while young, and earns nothing

while old. The agent lives for two periods and consumes in both
the periods. The utility function for the agent is given by
u = log c1 + log c2 , where ci is the consumption in period i = 1, 2.
The agent faces a constant rate of interest r (net interest rate) at
which it can freely lend or borrow,
(a) Find out the level of saving of the agent while young.
(b) What would be the consequence of a rise in the interest rate,
r , on the savings of the agent?

Amit Goyal

ISI ME II, 2013

Solution 1
Agents utility maximization problem is the following:
max
c1 ,c2

log c1 + log c2

s.t. c1 (1 + r ) + c2 = w (1 + r )
&

c1 0, c2 0

(a) Solving the above problem we get:



w w (1 + r )
(c1 , c2 ) =
,
2
2
w
2
(b) Clearly, Savings doesnt change with change in rate of interest
rate, r .
Hence, Savings = w c1 =

Amit Goyal

ISI ME II, 2013

Problem 2
Consider a city that has a number of fast food stalls selling Masala
Dosa (MD). All vendors have a marginal cost of Rs. 15 per MD,
and can sell at most 100 MD a day.
(a) If the price of a MD is Rs. 20, how much does each vendor
want to sell?
(b) If demand for MD be d(p) = 4400 120p, where p denotes
price per MD, and each vendor sells exactly 100 units of MD,
then how many vendors selling MD are there in the market?
(c) Suppose that the city authorities decide to restrict the number
of vendors to 20. What would be the market price of MD in
that case?
(d) If the city authorities decide to issue permits to the vendors
keeping the number unchanged at 20, what is the maximum
that a vendor will be willing to pay for obtaining such a
permit?
Amit Goyal

ISI ME II, 2013

Solution 2
(a) If the price of a MD is Rs. 20 and the marginal cost is Rs. 15
per MD, vendors profit maximization problem is the following:
max
m

20m 15m

s.t. 0 m 100
Thus, each vendor would want to sell 100 MD a day.
(b) Given competitive behavior, free entry-exit from the industry
and constant returns to scale technology, we have zero profit
condition, that is, price equals marginal cost. Thus, demand is
d(15) = 4400 120(15) = 2600
Since each vendor sells 100 units and demand is 2600 units,
there are 26 vendors selling MD in the market.
Amit Goyal

ISI ME II, 2013

Solution 2 contd...

(c) If number of vendors are 20 and each vendor produces 100

units, price is given by
p=

4400 2000
= 20
120

(d) The maximum price that a vendor is willing to pay for the
permit is equal to the profit that a vendor gets if he operates
i.e. 5 100 = 500.

Amit Goyal

ISI ME II, 2013

Problem 3

A firm is deciding whether to hire a worker for a day at a daily

wage of Rs. 20. If hired, the worker can work for a maximum of 10
hours during the day. The worker can be used to produce two
intermediate inputs, 1 and 2, which can then be combined to
produce a final good. If the worker produces only 1, then he can
produce 10 units of input 1 in an hour. However, if the worker
produces only 2, then he can produce 20 units of input 2 in an
hour. Denoting the levels of production of the amount produced of
the intermediate goods byk1 and k2 , the production function of
the final good is given by k1 k2 . Let the final product be sold at
the end of the day at a per unit price of Rs. 1. Solve for the firms
optimal hiring, production and sale decision.

Amit Goyal

ISI ME II, 2013

Solution 3
The production possibility frontier of the two inputs is given by
k2
k1
+
= 10
10 20
Since final product can be sold at the end of the day at a per unit
price of Rs. 1. the firms profit maximization problem is

max
k1 k2 20
k1 ,k2

k1
k2
+
= 10
10 20
& k1 0, k2 0,

s.t.

Thus, firm will hire the worker,

produces k1 = 50, k2 = 100 and
produces and sells output = 50 2.
Amit Goyal

ISI ME II, 2013

Problem 4

A monopolist has contracted with the government to sell as much

of its output as it likes to the government at Rs. 100 per unit. Its
sales to the government are positive, and it also sells its output to
buyers at Rs. 150 per unit. What is the price elasticity of demand
for the monopolists services in the private market?

Amit Goyal

ISI ME II, 2013

Solution 4
Since monopolists sale to the government is positive, his marginal
revenue at the point of sale in the private market must be Rs. 100.
Now price in the private market is Rs. 150. We can compute the
price elasticity of demand in the following way:
TR(x) = p(x) x
Differentiating TR(x) w.r.t. x, we get,
dp(x)
dx
x dp(x)
MR(x) = p(x) + p(x)
p(x) dx


1
MR(x) = p(x) 1 +

MR(x) = p(x) + x

Now substituting p(x) = 150 and MR(x) = 100 in above we get

elasticity, = 3
Amit Goyal

ISI ME II, 2013

Problem 5

Consider the following production function with usual notations.

Y = K L1 K + L with 0 < < 1, > 0, > 0
Examine the validity of the following statements.
(a) Production function satisfies constant returns to scale.
(b) The demand function for labour is defined for all non-negative
wage rates.
(c) The demand function for capital is undefined when price of
capital service is zero.

Amit Goyal

ISI ME II, 2013

Solution 5

(a) Let f (K , L) denotes the production function.

f (tK , tL) = (tK ) (tL)1 tK + tL
= t(K L1 K + L)
= tf (K , L)
Thus, production function satisfies constant returns to scale.
(b) Profit maximization problem of the competitive producer is
max K L1 K + L wL rK
K ,L

s.t.

L 0, K 0

Amit Goyal

ISI ME II, 2013

Solution 5 contd...

(b) The above problem is equivalent to

max K L1 (r + )K (w )L
K ,L

s.t.

L 0, K 0

Clearly, when 0 w , demand function for labor is not

defined.
(c) Also, the demand function for capital is defined when price of
capital service is zero provided w > .

Amit Goyal

ISI ME II, 2013