Written work for submission,week beginning 6th November 2006 Answer both questions.

Question 1 is worth 30 marks; question 2 is worth 70 marks.

1. A price-taking rm purchases m inputs where the price of input i is wi , i = 1; :::; m and the price of the rm single output is p. Let the s rm demand for input i be given as s Di (w1 ; w2 ; :::; wm ; p) (a) Is it possible to have @Di =@wi > 0? Explain. (b) Is it possible to have both @Di =@wj > 0 and @Dj =@wi < 0? Explain. (c) Is it possible to have @Di =@p < 0? Explain.

2. A person lives for three periods (1: youth, 2: middle age, 3: old age and has preferences represented by the utility function ) U (x) = [x1 a1 ] [x2 = 0 otherwise a2 ] [x3 a3 ] ; x t at

where xt is the amount consumed in period t and the at are parameters such that a2 > a3 > a1 > 0: The price of goods in period t is pt , measured in terms of period-1 currency. The person will receive a known amount of exogenous money income y1 ; y2 ; y3 in each of the three periods respectively where income is xed in terms of period-1 currency. The person can borrow or lend freely at the known, per-period interest rate r > 0. (a) Interpret the parameters a1 ; a2 ; a3 and write down the person s lifetime budget constraint. (b) Solve the consumer optimisation problem and interpret the sos lution. Under what conditions will the person want to save i. during youth? ii. during middle age? (c) Assume that the person does save in period 1 and that any price changes in future periods could be perfectly foreseen. i. Suppose there were a small rise in the price of period-2 goods. What eect would this have on period-1 savings? ii. What eect would there be on period-1 savings if the price of period-3 goods were to rise? Is this greater than the eect of period-2 prices? (d) What would be the eect on period-1 savings of a rise in the price of period-1 goods? Explain why this eect is dierent from those analysed in part 2c.

Outline Solutions 1. Demand for input i can be written Di (w; p) := H i (w; S(w; p)): (1)

where H i is the conditional demand for input i and S is the supply function. From this we nd that the eect of an output price change is @Di (w; p) @H i (w; q ) @S(w; p) = : @p @q @p the eect of an input price change is: @H i (w; q ) @Di (w; p) = @wj @wj Ciq (w; q )Cjq (w; q ) : Cqq (w; q ) (3) (2)

where C is the cost function and Ciq is short for , @ 2 C=@wi @q. (a) No. Given that @H i (w; q )=@wi must be negative or zero, equai 10 tion (3) implies that Di (w; p) 0. (b) No. Given that @H i (w; q )=@w = C = C = @H j (w; q )=@w marks
j ij ji i

equation (3) implies that @Di =@wj = @Dj =@wi . (c) Yes the case of an inferior input in (2). 2. (a) These are the minimum consumption requirement (needs in ) each of the three periods. Needs in middle age are higher than those in old age which, in turn are higher than those in youth. The lifetime budget constraint is p1 x1 + where y := y1 + p2 x2 p3 x3 + 1 + r [1 + r]2 y;

10 marks 10 marks

y2 y3 + : 1 + r [1 + r]2 18 marks

(b) Clearly, if y is su ciently high, we must have an interior solution with xt > at in all periods. It is slightly easier to work with log (U (x)) rather than U (x). The Lagrangean for the optimisation problem is: " # 3 3 X X log (xt at ) + y p0t xt (4)
t=1 t=1

where p01 := p1 ; p2 ; p02 := 1+r p3 : p03 := [1 + r]2 Dierentiating (4) with respect to xt and and setting the dierentials equal to zero we get the following FOCs 1 xt y at 3 X
t=1

p0t = 0, t = 1; 2; 3 p0t xt = 0

(5) (6)

where the asterisks denote values at the optimum. Substituting from (5) into (6) we nd = where y0 := Substituting riod t is 3 y
3 X t=1

y0

p0t at :

(7)

into (5) we nd that optimal consumption in pex t = at + y y0 3p0t : (8)

The sum y0 represents the present value in period 1 of the minimum consumption requirements. Call the amount consumed in 4

any period above minimum requirements discretionaryconsumption; then, in present-value terms, the expenditure on discretionary consumption in each period is exactly one third of discretionary income y y0 . i. The person will want to save in period 1 if p1 x1 < y 1 : ii. Denote net savings in period 1 by s1 := y1 p1 x1 (9)

(if s1 is negative then s1 is the amount of borrowing in period 1). Of course if the person saves in period 1 he will also have interest income in period 2 and if he borrows in period 1 he will have to pay interest on this in period 2. So the person will want to save in period 2 if p2 x2 < y2 + [1 + r] s1 ; i.e. if p2 x2 < y2 + [1 + r] [y1 (c) From (8) and (9) we have 3 Note that, if we dierentiate (7) we have @y0 at = @pt [1 + r]t
1;

p1 x1 ] : 18 marks

s1 = y 1

p 1 a1

y0

(10)

t = 1; 2; 3:

So, dierentiating (10) with respect to p2 and to p3 , we have, respectively @s1 a2 = ; @p2 3 [1 + r] a3 @s1 = : @p3 3 [1 + r]2 (11) (12)

Given that a2 > a3 and the interest rate is positive it must be the @s @s case that @p1 > @p1 . 17 2 3 marks 5

(d) Dierentiating (10) with respect to p1 @s1 = @p1 = a1 + 2 a1 : 3 a1 3 (13) (14)

If there is a rise in pt for any t this raises the cost of the minimum lifetime expenditure y0 and so there is an eect of lowering lifetime discretionary expenditure; by itself this eect raises period-1 savings by an amount 1 at [1 + r]1 t see equations (11), (12) and 3 the second term in (13). For price rises in middle age or old age there is no other eect. But if p1 rises one has to spend more to satisfy needs during youth this extra amount is exactly a1 ; so there is an additional eect of a1 on period-1 savings, the rst term in (13); this is larger than the second term in (13) and thus overall period-1 savings must decrease. 17 marks