Economics 7010-001 Fall 2010

Problem Set 13 Solutions

1. Suppose there are two consumers indexed by i {1, 2} and 2 commodities indexed by l {1, 2}. Let p 2 + represent the vector of prices and w i + + represent the wealth of Consumer i . Suppose Consumer 1 s Walrasian demand function is given by

x 11 ( p , w1 ) =

w1 4 p1 w2 3 p1

x 12 ( p , w1 ) =

3w1 4 p2 2w 2 3 p2

and Consumer 2 s Walrasian demand function is given by

x 21 ( p , w 2 ) =

x 22 ( p , w 2 ) =

Suppose further that Consumer i s wealth is determined by the wealth 1 distribution rule w i = 2 w , where w represents aggregate wealth. a. Derive the aggregate demand function x ( p , w ) .

Summing the individual demand functions for goods 1 and 2 yields

x1( p, w ) = x 2 ( p, w ) =
1 w 2

4 p1

1 w 2

3 p1

7w 24 p1

1 1 3( 2 w ) 2( 2 w ) 17w + = 4 p2 3 p2 24 p2

Hence, the aggregate demand function is

7w 24 p 1 . x ( p, w ) = 17w 24 p2 b. Does x ( p , w ) satisfy the Weak Axiom of Revealed Preference (WARP)?

We will employ the following theorem (from our discussion of the Integrability Problem) to demonstrate that there exists a rational preference relation f that could have generated x ( p , w ) .

Economics 7010-001 Fall 2010

x ( p , w ) is homogeneous of degree 0 x ( p , w ) satisfies Walras law S ( p , w ) is negative semidefinite S ( p , w ) is symmetric

There exists a rational f that could have generated x ( p , w ) .

Once we have established the existence of such a f , we can assert that x ( p , w ) satisfies WARP since rationality implies WARP.
x ( p , w ) is homogeneous of degree zero since

x (p , w ) = (7w 24p1 , 17w 24p2 ) = (7w 24 p1 , 17w 24 p2 ) = x ( p, w )

x ( p , w ) satisfies Walras law since

p x ( p , w ) = p1 (7w 24 p1 ) + p2 (17w 24 p2 ) = (7w 24 ) + (17w 24 ) =w

To check the remaining two conditions, we must construct the Slutsky substitution matrix S ( p , w ) . A set of straightforward calculations yields 1 p 2 119 1 S ( p, w ) = w 576 1 p1 p2 1 p1 p2 1 2 p2

S ( p , w ) is clearly symmetric. It remains to show that S ( p , w ) is negative semidefinite. Since S ( p , w ) is a symmetric, 2 2 matrix, we can employ the shortcut outlined in the semidefiniteness handout. We observe that the diagonal elements are negative and that the determinant is zero. It follows that S ( p , w ) is negative semidefinite. Having verified the four conditions of the theorem, we can assert that there exists a rational f that could have generated x ( p , w ) . Since rationality is stronger than WARP, we conclude that x ( p , w ) satisfies WARP.

Economics 7010-001 Fall 2010

c. Does there exist a positive representative consumer?

L on + such that the aggregate demand function x ( p , w ) is the Walrasian demand function generated by f .

A positive representative consumer exists if there is a rational preference relation f

The existence of such a f was proven in part b. Hence, a positive representative consumer does exist.

Economics 7010-001 Fall 2010

2. Suppose f ( ) is the production function associated with a single-output technology, and let Y be the production set of this technology. Show that Y satisfies constant returns to scale if and only if f ( ) is homogeneous of degree one.

Part One: Y satisfies CRS f ( ) is HD1

L Let z + 1 . Then ( z , f (z )) Y . Let > 0 . Since Y satisfies constant returns to scale, ( z , f (z )) Y . Since f (z ) q holds for any ( z , q ) Y , we must have f ( z ) f (z ) . L Since ( z , f (z )) Y , it must be the case that z + 1 . Then ( z , f ( z )) Y . Since Y satisfies constant returns to scale,

1 1 z , f ( z ) Y , which simplifies to (z , (1 ) f ( z )) Y . Since f (z ) q holds for any ( z , q ) Y , we must have

f (z ) which simplifies to f (z ) f ( z ) .

f ( z ) ,

Since we have both f ( z ) f (z ) and f (z ) f ( z ) , we have f ( z ) = f (z ) . That is, f ( ) is homogeneous of degree one. Part Two: f ( ) is HD1 Y satisfies CRS Let ( z , q ) Y . Then f (z ) q . Let > 0 . Then f (z ) q . Since f ( ) is homogeneous of degree one, f ( z ) q . Then ( z , q ) Y . Since we went from ( z , q ) Y to ( z , q ) Y for arbitrary > 0 , we have shown that Y satisfies constant returns to scale.

Economics 7010-001 Fall 2010

3. Show that for a single-output technology, Y is convex if and only if the production function f (z ) is concave.

Part One: Y is convex f (z ) is concave

L Let z , z + 1 . Then ( z , f (z )) Y and ( z , f (z )) Y . Since Y is convex,

( z (1 )z , f (z ) + (1 ) f (z )) Y for any [0, 1] . Since f (z ) q holds for any ( z , q ) Y , we must have f ( z + (1 )z ) f (z ) + (1 ) f (z ) for any [0, 1] . That is, f ( ) is concave.
Part Two: f (z ) is concave Y is convex Let ( z , q ) Y and ( z , q ) Y . Then f (z ) q and f (z ) q . Hence,

f (z ) + (1 ) f (z ) q + (1 )q
for any [0, 1] . Since f ( ) is concave,
f ( z + (1 )z ) f (z ) + (1 ) f (z )

for any [0, 1] . Combining the two inequalities yields

f ( z + (1 )z ) q + (1 )q

for any [0, 1] . Since f (z ) q if and only if ( z , q ) Y , we have

( z (1 )z , q + (1 )q ) Y
for any [0, 1] , or equivalently

( z , q ) + (1 )( z , q ) Y
for any [0, 1] . That is, Y is convex.

Economics 7010-001 Fall 2010

4. There are three goods. Goods 1 and 2 are inputs. The third, with amounts denoted by q , is an output. Output can be produced by two techniques that can be operated simultaneously or separately. The techniques are not necessarily linear. The first technique uses only the first input. Thus, the first technique is completely specified by 1 (q1 ) , the minimal amount of input one sufficient to produce the amount of output q1 . 1 ( ) is an increasing function and 1 (0 ) = 0 . The second technique uses only the second input. Thus, the second technique is completely specified by 2 (q 2 ) , the minimal amount of input two sufficient to produce the amount of output q 2 . 2 ( ) is an increasing function and 2 (0 ) = 0 . a. Describe the three-dimensional production set associated with these two techniques. Assume free disposal.

The production set is

Y =
1

{( z , z

2,

q ) 3 : z 1 1 (q1 ), z 2 2 (q 2 ), q 1 0, q 2 0, and q 1 + q 2 q} .

The following diagram is consistent with the production set described.

q

z2

z1

z 2 = 2 (q )

z 2 = 2 (q )

Economics 7010-001 Fall 2010

b. Give sufficient conditions on 1 ( ) and 2 ( ) for the production set to display additivity.

Claim: The condition that l (q l + q l ) l (q l ) + l (q l ) for all q l 0 , q l 0 , and l {1, 2} is sufficient for the production set Y to satisfy additivity.
Proof: Let ( z 1 , z 2 , q ) Y and ( z 1 , z , q ) Y . Then by the definition of 2

Y offered in part a, there exist (q 1 , q 2 ) 2 such that

z 1 1 (q 1 ) , z 2 2 (q 2 ) , and q 1 + q 2 q
2 and there exist (q 1 , q ) 2 such that

z 1 1 (q 1 ) , z 2 (q ) , and q 1 + q q . 2 2 2
It follows that

(1) z 1 + z 1 1 (q 1 ) + 1 (q 1 ) ,
(2) z 2 + z 2 (q 2 ) + 2 (q ) , and 2 2

(3) (q 1 + q 1 ) + (q 2 + q ) q + q . 2
By applying the condition in the claim, we obtain

(1') z 1 + z 1 1 (q 1 + q 1 ) and
(2') z 2 + z 2 (q 2 + q ) . 2 2
The sum of our two production vectors is ( (z 1 + z 1 ), (z 2 + z ), (q + q )) , 2 so to establish additivity, we need to show that this vector is in Y . Since conditions (1), (2), and (3) satisfy the definition set forth in part a, ( (z 1 + z 1 ), (z 2 + z 2 ), (q + q )) Y .

Economics 7010-001 Fall 2010

c. Suppose that the input prices are w1 and w 2 . Write the first-order necessary conditions for profit maximization and interpret. Under which conditions on 1 ( ) and 2 ( ) will the necessary conditions be sufficient?

The profit maximization problem (PMP) is max pq 1 + pq 2 w 11 (q 1 ) w 2 2 (q 2 )

q1 , q 2

s.t.

q1 0 q2 0

The functions 1 (q 1 ) and 2 (q 2 ) were substituted for z 1 and z 2 respectively since profit maximization requires that the firm use the minimum z l necessary to produce ql . In order to validate our use of the Kuhn-Tucker theorem, we must verify that a solution exists and that the constraint qualification is satisfied. Existence: The objective function is continuous if 1 (q 1 ) and 2 (q 2 ) are continuous. Let us assume they are. The constraint set contains the point (0, 0 ) and is therefore non-empty. The constraint set is simply 2 , which is clearly closed but + not bounded. Whether or not the constraint set can be compactified depends on the form of the functions 1 (q 1 ) and 2 (q 2 ) . The properties given in the problem are not enough to make compactification possible. (For instance, if p > w l l (q l ) for all q l 0 and all l {1, 2}, no solution exists.) Let us assume that compactification is possible so that we can proceed with the problem. Constraint Qualification: If both constraints are effective, the relevant matrix is

1 Dh E (q 1 , q 2 ) = 0
Dh E (q 1 , q 2 ) = [1 Dh E (q 1 , q 2 ) = [0

0 1
0] 1]

which has rank 2. If only the first constraint is effective, the relevant matrix is which has rank 1. If only the second constraint is effective, the relevant matrix is which has rank 1. Hence, the constraint qualification is satisfied.

Economics 7010-001 Fall 2010

Kuhn-Tucker: We will now proceed with the Kuhn-Tucker cookbook procedure. The Lagrange function is
L = p1q 1 + p 2 q 2 w 11 (q 1 ) w 2 2 (q 2 ) + 1q 1 + 2 q 2 .

The Kuhn-Tucker first-order conditions are

(1) p w 11 (q 1 ) + 1 = 0 (2) p w 2 2 (q 2 ) + 2 = 0
(3) q 1 0 (4) q 2 0

(5) 1 0 (6) 2 0 (7) 1q 1 = 0 (8) 2 q 2 = 0

Conditions (1) and (2) are the ones worth interpreting. They can be collectively summarized as follows
p w l l (q l ) with equality if q l > 0

where l {1, 2}.

l (q l ) is the minimum z l necessary to produce q l . l (q l ) is the increase in z l necessary to produce an additional 1 unit of q l , and w l l (q l ) is the additional cost necessary to produce an additional 1 unit of q l . That is, w l l (q l ) is the marginal cost of the output produced using input l .
So the first-order condition says that at the profit-maximizing q l ,

price is less than or equal to marginal cost when q l = 0 price equals marginal cost when q l > 0

Sufficiency: We can now address the sufficiency issue. The KT FOC are both necessary and sufficient when the objective function is concave, the constraint functions are concave, and Slaters condition is satisfied. Slaters condition is satisfied since (1, 1) is in the interior of the constraint set. The constraint functions are linear and hence concave. It remains to identify conditions under which the objective function is concave. p1q 1 + p 2 q 2 is linear and hence concave. w l l (q l ) is concave if l (q l ) is convex. Therefore, if l (q l ) is convex for every l {1, 2}, the objective function p1q 1 + p 2 q 2 w 11 (q 1 ) w 2 2 (q 2 ) is concave, and the KT FOC are both necessary and sufficient.

Economics 7010-001 Fall 2010

d. Show that if 1 ( ) and 2 ( ) are strictly concave, then a cost-minimizing plan cannot involve the simultaneous use of the two techniques. Interpret the meaning of the concavity requirement and draw isoquants in the twodimensional space of input uses.

Let q 1 > 0 , q 2 > 0 , and q 1 + q 2 = q . Without loss of generality, suppose w 2 2 (q ) w 1 1 (q ) . Our objective is to show that
w 1 1 (q 1 ) + w 2 2 (q 2 ) > w l l (q )

for some l {1, 2}. (The left-hand side of the inequality is the cost of producing q units of output when both techniques are used. The right-hand side of the inequality is the cost of producing the same q units of output when only technique l is used.) We will make use of the following theorem: Let g : D be strictly concave, where D is open and convex. Let x 1 , x 2 , and x 3 be points in D satisfying x 1 < x 2 < x 3 . Then
g (x 2 ) g (x 1 ) g (x 3 ) g (x 1 ) g (x 3 ) g (x 2 ) > > . x 2 x1 x 3 x1 x3 x2

Let l : so that the domain of l will be open and convex. We choose the points 0 , q l , and q so that 0 < q l < q . Since l is strictly concave, we have

l (q l ) l (0 )
ql 0

>

l (q ) l (0 )
q 0

and since l (0 ) = 0 , we have

l (q l ) > (q l q )l (q )
for all l {1, 2}. It follows that
w 1 1 (q 1 ) + w 2 2 (q 2 ) > w 1 (q 1 q )1 (q ) + w 2 (q 2 q ) 2 (q ) = (q 1 q )w 1 1 (q ) + (q 2 q ) w 2 2 (q ) w 1 1 (q )

where the last inequality follows from w 2 2 (q ) w 1 1 (q ) and q 1 + q 2 = q . Since w 1 1 (q 1 ) + w 2 2 (q 2 ) > w 1 1 (q ) , the claim is proved.

Economics 7010-001 Fall 2010

We will now interpret the meaning of the concavity requirement. Recall that l (q l ) is the minimum z l necessary to produce q l units of output. Since l ( ) is increasing, the quantity of z l needed increases with q l . But because l ( ) is strictly concave, the required increases in z l get smaller as q l increases. In other words, the production technology exhibits increasing returns to scale. The claim proven can then be reworded as follows: When the production technology exhibits increasing returns to scale, a cost-minimizing firm will employ a single technique. which is a fairly intuitive statement. Finally, we present the following diagram depicting a couple of isoquants that are consistent with the technology as described.
z2

2 (2q )
2 (q )
1 2 ( 2 q )

1 2 2

(q )

q
1 2 1

2q
z1

(q )
1 1 ( 2 q )

1 (q ) 1 (2q )

1 1 The fact that l ( 2 q ) > 2 l (q ) follows from our earlier statement that 1 l (q l ) > (q l q )l (q ) -- just set q l = 2 q .

Economics 7010-001 Fall 2010

5. Prove that, in general, if the production set Y exhibits nondecreasing returns to scale, then either ( p ) 0 or ( p ) = .

Suppose there exists a y Y such that p y > 0 . Then ( p ) > 0 . Fix an arbitrary y Y that satisfies p y > 0 . Since Y exhibits nondecreasing returns to scale, y Y for all 1 . Since p y > 0 ,
p ( y ) = ( p y ) > p y

for all > 1 . Taking , we obtain ( p y ) . Since infinite profit is feasible, it must be the case that ( p ) = . Now suppose there is no y Y such that p y 0 . That is, suppose that p y 0 for all y Y . Then, it must be the case that ( p ) 0 . Hence, either ( p ) 0 or ( p ) = .

Economics 7010-001 Fall 2010

L 6. Suppose that there are L commodities and that p + + . Suppose further that the production set Y is nonempty and closed and satisfies free disposal.

a. Show that ( ) is homogeneous of degree one.

The original PMP is specified as follows: max p y

y

s.t. y Y Consider an adjusted PMP in which prices are given by p , where > 0 : max p y
y

s.t. y Y Since > 0 , the new objective function is simply a monotonic transformation of the original objective function. Since the constraint set has not changed, the set of solutions for the adjusted PMP is identical to the set of solutions for the original PMP. Let y be a solution to both PMPs. Then the profit function for the original PMP is given by ( p ) = p y , while the profit function for the adjusted PMP is given by

( p ) = p y . Hence, ( p ) = ( p ) ; that is, the profit function is

homogeneous of degree one.

b. Show that ( ) is a convex function.

Let p and p be two arbitrary price vectors. Let p p + (1 ) p , where [0, 1] . We want to show that ( p) ( p ) + (1 ) ( p) . Let y y ( p) . Then y Y . It follows that p y ( p ) and p y ( p) . Hence,

p y = p y + (1 ) p y
( p ) + (1 ) ( p) Since y y ( p) , p y = ( p) . Hence, ( p) ( p ) + (1 ) ( p) .

Economics 7010-001 Fall 2010

c. Show that if Y is convex, then Y = y L : p y ( p ) for all p >> 0 .

Let Y L be a closed and convex production set that satisfies free disposal. Let y ( ) be the associated supply correspondence and ( ) be the associated profit function. Let Z z L : p z ( p ) for all p >> 0 . The proof will proceed in two parts. We will first show that Y Z . We will then show that Z Y . With both parts verified, we can conclude that Y = Z . Part One: Y Z Suppose not. Suppose there exists a y Y such that y Z . Then p y > ( p ) for some p >> 0 . But since y Y and ( p ) = max{ p x : x Y }, p y ( p ) -- a contradiction. Part Two: Z Y We will prove the contrapositive. That is, we will show that if x Y , then x Z . We begin by employing the following version of the separating hyperplane theorem: Suppose that S n is convex and closed and that there exists a point y S C . Then there is a vector p n with p 0 and a value a such that p y > a and p x < a for every x S . By assumption, Y is convex and closed and x Y . By the separating hyperplane theorem, there exists a vector p L with p 0 and a value a such that p y < a < p x for every y Y . Note that pl 0 for all l . If this were not the case, there would exist an l such that pl < 0 . If we were then to take y l (which we can do because Y satisfies free disposal), we would have p y , which would violate the condition that p y < a for every y Y . Let K {1, K, L } be the set of indices such that k K pk = 0 . Let

pl l p pl +

if l K if l K

where > 0 . Then p >> 0 . Since p y < a < p x for every y Y , then if is sufficiently small, p y < a < p x for every y Y .

Economics 7010-001 Fall 2010

Recall that Z z L : p z ( p ) for all p >> 0 and note that we have established the existence of a p >> 0 and an a such that

p x > a and p y < a for every y Y .

Since p y < a for every y Y , a > ( p ) . Since p x > a , p x > ( p ) . Since there exists a p >> 0 such that p x > ( p ) , x Z .

Having shown that x Y implies x Z , we can assert that x Z implies x Y . That is, Z Y .

Economics 7010-001 Fall 2010

7. Suppose that c (w , q ) is the cost function of a single-output technology Y with production function f ( ) and that z (w , q ) is the associated conditional factor demand correspondence. Assume also that Y is closed and satisfies the free disposal property. Prove that
L a. if the sets z + 1 : f (z ) q are convex for every q , then Y = {( z , q ) : w z c (w , q ) for all w >> 0}.

b. if f ( ) is homogeneous of degree one, then c (w , q ) and z (w , q ) are homogeneous of degree one in q .

We will first show that z (w , q ) is homogeneous of degree one in q . The proof will proceed in two parts. We will first show that z (w , q ) z (w , q ) . We will then show that z (w , q ) z (w , q ) . Part One: z (w , q ) z (w , q ) Let z z (w , q ) and let > 0 . Since f ( ) is homogeneous of degree one,
f (z ) = f (z ) q .

Consider z 0 such that f (z ) q . By the homogeneity of f , we have

f (z ) q

(1 ) f (z ) q
f [(1 )z ] q

Since (1 )z 0 and f [(1 )z ] q , the input vector (1 )z is in the constraint set of the CMP. Since z z (w , q ) , w z w (1 )z . Hence,

w z w z
L for every z + 1 such that f (z ) q . Since z 0 and f (z ) q , the input vector z is in the constraint set of the CMP with parameters (w , q ) . Hence,

z z (w , q ) .
Since z was chosen arbitrarily from z (w , q ) , we have z (w , q ) z (w , q ) .

Economics 7010-001 Fall 2010

Part Two: z (w , q ) z (w , q ) From part one, we know that z (w , q ) z (w , q ) for arbitrary w >> 0 , q 0 , and > 0 . Let 1 and q (1 )q . Then z (w , q ) z (w , q ) becomes (1 )z (w , q ) z (w , (1 )q ) z (w , q ) z (w , q ) which is the inclusion we seek. It remains to show that c (w , q ) is homogeneous of degree one in q . Fix > 0 arbitrarily. By applying the definition of c (w , q ) and the property that z (w , q ) is homogeneous of degree one in q , we obtain
c (w , q ) = w z (w , q ) = w z (w , q ) = [w z (w , q )] = c (w , q )
c. if f (

) is concave, then c (w , q ) is a convex function of q .

Let q 0 and q 0 . Let z z (w , q ) and z z (w , q ) . Then f (z ) q , f (z ) q , c (w , q ) = w z , and c (w , q) = w z . Let [0, 1] . Then

c (w , q ) + (1 )c (w , q) = (w z ) + (1 )(w z )
= w [z + (1 )z ] Since f (

) is concave, f [z + (1 )z ] f (z ) + (1 ) f (z )
q + (1 )q

Let z z + (1 )z and q q + (1 )q . Then f (z ) q , or rather z is in the constraint set of the CMP with parameters (w , q) . It follows that w z c (w , q ) . Since c (w , q ) + (1 )c (w , q ) = w z , we have

c (w , q ) + (1 )c (w , q) c (w , q ) .
Since [0, 1] was chosen arbitrarily, we have established that c (w , q ) is convex.

Economics 7010-001 Fall 2010

8. Derive the profit function ( p ) and supply function (or correspondence) y ( p ) for the single-output technologies whose production functions f (z ) are given by a.
f (z ) = z 1 + z 2

Economics 7010-001 Fall 2010

b.

f (z ) = min{z 1 , z 2 }

c.

f (z ) = z 1 + z 2

for (0, 1]

Economics 7010-001 Fall 2010

Economics 7010-001 Fall 2010

9. Derive the cost function c (w , q ) and conditional factor demand functions (or correspondences) z (w , q ) for each of the following single-output constant-return technologies with production functions given by a.
f (z ) = z 1 + z 2

(perfectly substitutable inputs)

b.

f (z ) = min{z 1 , z 2 }

(Leontief technology)

c.

f (z ) = z 1 + z 2

for (0, 1]

(constant elasticity of substitution technology)