ECON 8010 FINAL EXAM PREP FALL 2016

1. TRUE or FALSE and EXPLAIN: Label each statement TRUE or FALSE, and
rigorously justify your answer.

a. FALSE__ “For a profit-maximizing firm with a two-input, linear

homogeneous production function, the demand for labor is less wage-elastic
the more easily labor is substituted for capital.”

The Marshall-Hicks Rules for derived demand state that

εLW = – (1 – SL)σKL + SLηxp. Therefore, ∆εLW/∆σKL = – (1 – SL) < 0.

b. TRUE__ “In the standard model of labor supply, a marginal increase in the
market wage rate, ceteris paribus, unambiguously increases hours of work for
an individual who, before the wage increase, uses all of his time to consume
leisure.

From the Slutsky equation for labor supply, ∂h*/∂w = ∂h*c/∂w + h*

(∂h*/∂I), when h* = 0, the income effect is zero and there is only a positive
substitution effect.

2. RESTRICTIONS: Briefly explain or justify your answer.

a. Suppose that a firm’s (maximum) profit function is

π*(p,w) = p ∙ ln(p/w) – p

where p denotes the price of output and w denotes the per-unit price of
labor. What restriction must be placed on the relationship between p and
w? Why?

p > w The profit function is increasing in p; ∂π*/∂p = loge(p/w) +

p(1/p) – 1 = loge(p/w) = x*(p,w) > 0

b. If the compensated demand for good Y is given by

Yc *(Px,Py,U) = U – (1/2) ∙ lnPy + b ∙ lnPx, what is the value of b? Why?

b = 1/2. The compensated demand function is homogeneous of

degree zero in Px and Py.
 3. Suppose that an individual’s preferences are given by the indirect utility
function

V ( Px , Py , M )  [( Px1 / 2  Py1 / 2 ) 2 ] / M

a. Derive the individual’s uncompensated demand functions X* (Px,Py,M)

and Y* (Px,Py,M).

∂V/∂Px = ( 2/M) ( Px  Py ) (1/2 Px ½)

1/2 1/2

∂V/∂Px = ( 2/M) ( Px  Py ) (1/2 Py ½)

1/2 1/2

∂V/∂M = (1/M 2) ( Px  Py ) 2
1/2 1/2

X*(Px , Py , M) = ̶ ∂V/∂Px / ∂V/∂M = M / [ ( Px  Py ) Px ] = M / [ Px + (Px Py) ½]

1/ 2 1/2 1/2

X*(Px , Py , M) = ̶ ∂V/∂Py / ∂V/∂M = M / [ ( Px  Py ) Py ]= M / [ Py + (Px Py) ½]

1/2 1/2 1/2

b. What is the individual’s direct utility function U(X,Y)?

U(X,Y) = ̶ X-1 ̶ Y-1

4. Suppose that a consumer’s preferences are represented by the expenditure

function M*(Px, Py, U) = 2Px1/2Py1/2 + PyU, where Px and Py are the per-unit
prices of X and Y, respectively, and U is utility.

a. Derive the compensated demand functions for X and Y.

Xc*(Px,Py,U) = ∂M*/∂Px = Px - ½ Py ½ = (Py / Px) ½

Yc*(Px,Py,U) = ∂M*/∂Py = U + Px ½ Px - ½ = U + (Px / Py) ½

b. What is the associated (direct) utility function U(X,Y)?

 U[Xc*(Px, Py, U), Yc*(Px, Py, U)] = Yc* – (Xc*) -1

U(X,Y) = Y – X -1

5. A consumer is observed to purchase the bundle (X0, Y0) = (2, 3) when per-unit
prices are (Px0, Py0) = (2, 1). She is subsequently observed to purchase the
bundle (X1, Y1) = (1, 2) when per-unit prices are (Px1, Py1) = (1, 2). Is her
behavior consistent with the weak axiom of revealed preference? Why or why
not?

WARP: If P0 X0 ≥ P0 X1, then P1 X0 > P1 X1.

Since P0 X0 = 7 > P0 X1 = 4 and P1 X0 = 8 > P1 X1 = 5, the observed behavior

is consistent with the weak axiom of revealed preference.