Problem Set 3 Solution

ECON201 – Element of Economic Analysis II (Honors)

∗
Siying Cao

October 22, 2017

Question 1

(a) It doesn’t hurt to solve for the general case, then specialize to various parameter config-
urations. Let’s start from deriving the conditional input demand function by solving the
firm’s cost minimization problem.

min ω1 x1 + ω2 x2
x1 ,x2 ∈R+

s.t.xα1 xβ2 ≥ y

Recall in the previous problem we have solved exactly the same problem except for
allowing an arbitrary productivity parameter A > 0. Setting A = 1, we arrive at the
conditional input demand function
β
 ω α  α+β
1 2
x1 (ω1 , ω2 , y) = y α+β
ω1 β
α
1
 ω1 β  α+β
x2 (ω1 , ω2 , y) = y α+β
ω2 α
This implies the cost function

c(ω1 , ω2 , y) = ω1 x1 (ω1 , ω2 , y) + ω2 x2 (ω1 , ω2 , y)

α
 α − α+β
1
α β α+β 1 α
=y α+β (ω1 ω2 ) (1 + )
β β
At this point, we don’t know whether the profit function is well-defined for a general set
of α, β > 0, though the cost function always is.
∗
Please send any corrections to siyingc -at- uchicago -dot- edu

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 Now consider the special case with α = β = 13 . The cost function simplifies down to
3 1
c(ω1 , ω2 , y) = 2y 2 (ω1 ω2 ) 2
1 1
The marginal cost M C(ω1 , ω2 , y) = 3y 2 (ω1 ω2 ) 2 , which is increasing in output y, sug-
gesting that the cost function is convex. This ensures that the profit maximization
problem has a unique solution, and can be obtained by using the first order condition
p = M C(ω1 , ω2 , y). The output supply function is
1 p2
y(p, ω1 , ω2 ) =
9 ω1 ω2
The (unconditional) input demand function is
1 p3
x1 (p, ω1 , ω2 ) = x1 (ω1 , ω2 , y(p, ω1 , ω2 )) =
27 ω12 ω2
1 p3
x2 (p, ω1 , ω2 ) = x2 (ω1 , ω2 , y(p, ω1 , ω2 )) =
27 ω1 ω22
where the first equality follows from the fact that the unconditional input demand is the
conditional demand function evaluated at the optimal level of output y.
It immediately follows that the profit function
π(p, ω1 , ω2 ) = py(p, ω1 , ω2 ) − c(ω1 , ω2 , y(p, ω1 , ω2 ))
1 p3
=
27 ω1 ω2

(b) IDF for input i = 1, 2 is decreasing in ωi since ∂x1 (p,ω

∂ω1
1 ,ω2 )
< 0, ∀p, ω1 , ω2 > 0. The same
∂y(p,ω1 ,ω2 )
holds for x2 . The OSF is decreasing in p since ∂p
> 0, ∀p, ω1 , ω2 > 0. Finally,
∂π(p,ω1 ,ω2 ) ∂π(p,ω1 ,ω2 )
the PF is increasing in p and decreasing in ω since ∂p
> 0 and ∂ωi
< 0, for
i = 1, 2.
(c) IDF is HD 0 (in prices) as for any t > 0,
1 (tp)3 1 p3
x1 (tp, tω1 , tω2 ) = = = x1 (p, ω1 , ω2 )
27 (tω1 )2 tω2 27 ω12 ω2
The same goes for x2 (p, ω1 , ω2 ).
To show that OSF is HD 0, note that for any t > 0,
1 (tp)2 1 p2
y(tp, tω1 , tω2 ) = = = y(p, ω1 , ω2 )
9 (tω1 )(tω2 ) 9 ω1 ω2

Finally, PF is HD 1 since for any t > 0,

1 (tp)3 t p3
π(tp, tω1 , tω2 ) = = = tπ(p, ω1 , ω2 )
27 (tω1 )(tω2 ) 27 ω1 ω2

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(d) Hotelling’s Lemma states that ∂π(p,ω
∂p
1 ,ω2 )
= y ∗ (p, ω1 , ω2 ), and ∂π(p,ω
∂ωi
1 ,ω2 )
= −x∗i (p, ω1 , ω2 ).
We can easily verify the lemma by plugging in the expressions for π, y ∗ , and x∗i for i = 1, 2

∂π(p, ω1 , ω2 ) 3 p2
= = y ∗ (p, ω1 , ω2 )
∂p 27 ω1 ω2
∂π(p, ω1 , ω2 ) 1 p3
=− = −x∗1 (p, ω1 , ω2 )
∂ω1 27 ω12 ω2
∂π(p, ω1 , ω2 ) 1 p3
=− 2
= −x∗2 (p, ω1 , ω2 )
∂ω2 27 ω1 ω2

(e) Now let’s switch gear and consider the case with α = β = 21 and ω1 = ω2 = 1. The cost
function now becomes
1
c(ω1 , ω2 , y) = 2y(ω1 ω2 ) 2 = 2y
The firm’s profit maximization is as simple as

max py − 2y
y∈R+

Depending on the value p takes, the profit function may or may not be well-defined as
we show below.
• Case I. p > 2
Whenever a firm considers a finite quantity ȳ to supply, it can increase its profit
by producing a little more. Hence, the solution to the profit maximization problem
does not exist, meaning that the problem is ill-defined.
• Case II. p < 2
Whenever a firms is producing a strictly positive quantity of output, it incurs nega-
tive profit. Thus the best the firm could do is shutting down, i.e. y ∗ = 0. The IDF,
OSF, PF are degenerate as y ∗ = x∗i = 0 for any p > 2, ω1 , ω2 > 0
• Case III. p = 2
This is interesting as the firm would earn zero economic profit regardless of how
much it produces. In other words, the profit maximization problem is well-defined,
but the solution is not unique. Profit function π(p, ω1 , ω2 ) = 0 for all p = 2, ω1 , ω2 >
0. The optimal output is a set y ∗ (p, ω1 , ω2 ) = {t : t ≥ 0}. For any given y∗ in this
set, the optimal input mix is x∗1 = x∗2 = y ∗ .
(f) More generally, the relationship between output price p and marginal cost of production
M C(ω1 , ω2 , y) dictates whether the profit maximization problem is well-defined. In par-
ticular, the problem has a unique solution if and only if the marginal cost function is
increasing in y. In the case of Cobb Douglas production function, this requires α +β < 1,
i.e. DRS (easy to show).

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 If MC curve is downward sloping, the problem will be ill-defined since the firm can
always increase its profit by producing more. For Cobb Douglas production function,
this requires α + β > 1, i.e. IRS.
For a flat MC curve, which in the Cobb Douglas production function case corresponds to
α + β = 1 or CRS, the result depends on the specific values of p, ω1 , ω2 . The discussion
in part (e) provides a concrete example of this kind.

Question 2

From previous exercise, we know that the conditional input demand function is iven by
y
x1 (ω1 , ω2 , y) =
α
y
x2 (ω1 , ω2 , y) =
β
and the associated cost function is
ω1 ω2
c(ω1 , ω2 , y) = ( + )y
α β

Restricting ω1 = ω2 = 1, we have c(1, 1, y) = α+β

αβ
y, which is linear in y. Going back to
the firm’s profit maximization problem, the objective function becomes py − c(1, 1, y) =
(p − α+β
αβ
)y.
α+β
• Case I. p > αβ

The problem is ill-defined.

α+β
• Case II. p < αβ
α+β
The solution is degenerate with IDF, OSF, and PF being zero for all p < αβ
α+β
• Case III. p = αβ

Profit function π(p = α+β

αβ
, ω1 = 1, ω2 = 1) = 0, output supply is a set y ∗ (p, ω1 , ω2 ) =
∗ ∗
{t : t ≥ 0}. For any given y ∗ in the set, input demand x∗1 = yα , x∗2 = yβ

Question 3
α ω1
The slope of the isoquant is β
whereas the slope of the isocost is ω2
.

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 α ω1
• Case I. β
> ω2

The firm uses x1 as the sole input, meaning that the conditional input demand is
x1 (ω1 , ω2 , y) = αy , x2 (ω1 , ω2 , y) = 0. The cost function is c(ω1 , ω2 , y) = ωα1 y , and the
marginal cost is again a constant M C(ω1 , ω2 , y) = ωα1 . Repeating our previous argument
for a generic constant marginal cost function once again, we know that if p = 1 > ωα1 ,
the problem is ill-defined. If p = 1 < ωα1 , the solution is unique but degenerate, with
y ∗ = x∗1 = x∗2 = π ∗ = 0. If p = 1 = ωα1 , the problem has multiple solutions.
α ω1
• Case II. β
< ω2

The firm uses x2 as the sole input, meaning that the conditional input demand is
x2 (ω1 , ω2 , y) = βy , x1 (ω1 , ω2 , y) = 0. Marginal cost is ωβ2 . The same reasoning as in Case
I goes through.
α ω1
• Case III. β
= ω2

The firm is indifferent to any input mix as long as it yields output y. Thus, x1 (ω1 , ω2 , y) =
t, and x2 (ω1 , ω2 , y) = y−αt
β
, for t ∈ [0, αy ]. The cost function is c(ω1 , ω2 , y) = ω1 t +
ω2 y−αt
β
= ωβ2 y = ωα1 y. What follows is pretty standard.

Question 4

(a) In the short run, the firm solves the cost minimization problem

min w1 x1 + w2
x1

s.t. xα1 = y
1
The conditional input demand for factor 1 is x1 (w, y) = y α and the associated cost
1
function is c(w, y) = w1 y α + w2 . Following this, we have the marginal cost function
1 00 1
M C(w, y) = α1 w1 y α −1 , and the second order derivative c (w, y) = α1 ( α1 − 1)w1 y α −2 .
From our previous discussion, we know the existence and uniqueness of solution to the
profit maximization problem depends on the shape of the cost function. The problem
is well-defined and solution is unique if the cost function is convex. The problem is not
well defined when the cost function is concave. In the case it’s linear, our results depend
on the comparison between output price p and (constant) marginal cost.
• Case I. α < 1, i.e. cost function is convex
Profit maximization has a unique solution, and we can directly solve for the optimal
1
output by p = M C = α1 w1 y α −1 , which gives the short run output supply function
α
y(p, w) = ( wαp1 ) 1−α

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 • Case II. α > 1, i.e. cost function is concave
The problem is not well-defined.
• Case III. α = 1, i.e. marginal cost is constant
If p > w1 , problem not well defined. If p < w1 , solution is degenerate in that
y ∗ = x∗1 = 0. If p = w1 , optimal output is any non-negative number, and there is
no well-defined supply function in this case.
(b) Building on our answer in part (a), we conclude there is no competitive equilibrium when
α > 1 as the firm is willing to supply infinite amount of output. Market clearing fails
since demand is always finite as suggested by P (q) = 10 − q with P > 0. So let’s focus
on the other two cases.
• Case I. α < 1
Since there are two identical firms operating in the market, we have aggregate supply
α
equals Qs (p) = 2( wαp1 ) 1−α , which is increasing in price as what we expect. Price in the
competitive equilibrium is pinned down by the market clearing condition,
α
i.e. 2( wαp1 ) 1−α = 10 − p. We don’t have an explicit form for the competitive price
though. Once We solve the equilibrium price, the quantity can be immediately
obtained by Q∗ = 10 − p∗
• Case III. α = 1
If p > w1 , market clearing fails since the firm is willing to supply infinite amount of
the good.
If p < w1 , each firm supplies zero output so that the total supply is zero. When
w1 ≤ 10, Qd = 10 − p > 0, meaning market can’t clear. When w1 > 10, we end up
with a degenerate competitive equilibrium where p∗ = 10, and Q∗ = 0.
If p = w1 , equilibrium price if it exits is completely pinned down by w1 while output
supply is not binding. When w1 > 10, market demand is negative, which can
not arise in a competitive equilibrium. When w1 ≤ 10, we have a competitive
equilibrium with price p∗ = w1 , quantity Q∗ = 10 − w1 , and each firm
supplies q s∗ = Q∗ /2.
To summarize, we may have short run competitive equilibrium in the following three
cases.1
αp α
α < 1 : p∗ implicitly determined by 2( ) 1−α = 10 − p
w1
∗
α = 1, w1 > 10 : p = 10 (degenerate)
α = 1, w1 ≤ 10 : p∗ = w1
1
We only discuss equilibrium price, since the quantity is straightward to derive

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(c) In the long run when the firm could freely choose both factors in the production, we
leverage our prior experience with Cobb Douglas production function and write down
the cost function
α
1 α
α+β
β 
α+β α − α+β α
c(w, y) = y α+β w1 w2 (1 + )
β β
• Case I. α + β > 1, i.e. increasing returns to scale
The problem is not well defined.
• Case II. α + β < 1, i.e. decreasing returns to scale
Problem is well-defined and the solution is unique. In fact, the output supply
function is
α+β α+β
α α+β
α
 1−α−β h p(α + β) i 1−α−β
y(p, w1 = 1, w2 = 1) = pβ( ) ≡
β φ
β α
where φ = ( αβ ) α+β + ( αβ )− α+β .
Profit function π(p) = py(p, w1 = 1, w2 = 1) − c(w1 = 1, w2 = 1, y(p, w1 = 1, w2 =
1
1)) = p 1−α−β ψ where ψ is a strictly positive constant.2 . In the long run equilibrium,
profit has to be zero, which suggests p∗ = 0. However, at this price, each individual
firm would supply zero output whereas demand is strictly positive. Hence long run
equilibrium does not exist.
• Case III. α + β = 1, i.e. constant returns to scale
1
Marginal cost simplifies down to M C(w, y) = 1−α ( 1−α
α
)α ≡ θ, where θ is a con-
stant. Applying the argument in part (b), we have two possible competitive
equilibrium.

θ > 10 : p∗ = 10 (degenerate)
θ ≤ 10 : p∗ = θ (number of firms undetermined)

Question 5

(a) In the short run with x̄2 = 1, Type 1 firm solves the minimization problem

min x1 + 1
x1

s.t. α min{x1 , 1} = y
α+β α+β
2
Some computation shows ψ = φ− 1−α−β (1 − α − β)(α + β) 1−α−β

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 Note the firm cannot produce output more than α in the short run, and the conditional
input function x1 (w1 = 1, w2 = 1, y) = αy . Cost function is c(w1 = 1, w2 = 1, y) =
y
α
+ 1, ∀y ≤ α. Again, we have constant marginal cost M C(w1 = 1, w2 = 1, y) = α1 . The
firm solves profit maximization problem
y
max py − ( + 1)
0≤y≤α α
Note we have a capacity constraint on the firm now. The short run supply function for
Type 1 firm is3
• p> 1
α
: y∗ = α
• p< 1
α
: y ∗ = x∗1 = 0
• p= 1
α
: y ∗ ∈ [0, α]
Replace the α with β gives the parallel result for Type 2 firm. Since we restrict α > β > 0,
we discuss existence of competitive equilibrium by comparing possible equilibrium price
p with the parameters.
• p > β1 : both firms would supply their maximum capacity, i.e. q s1 = α, q s2 = β, and
the aggregate supply is Qs = α + β. If A > α + β + β1 , we have a competitive
equilibrium with p∗ = A − α − β, q d∗ = α + β = Qs∗ , q s1∗ = α, q s2∗ = β. Any
other A would fail market clearing condition when p > β1 .
• p = β1 : q s1 = α, q s2 ∈ [0, β]. If α + β1 ≤ A ≤ α + β + β1 , we would have an
equilibrium with p∗ = β1 , q d∗ = A − β1 = Qs∗ , and q s1∗ = α, q s2∗ = A − α − β1
• p ∈ ( α1 , β1 ) : Type 1 firm would supply α while Type 2 firm would supply zero
amount. If α + α1 < A < α + β1 , we have a competitive equilibrium with
p∗ = A − α, q d∗ = α = Qs∗ , q s1∗ = α, q s2∗ = 0
• p = α1 : q s1 ∈ [0, α], and q s2 = 0. If A ∈ [ α1 , α + α1 ], we have a competitive
equilibrium where p∗ = α1 , q d∗ = A − α1 = q s1∗ , q s2∗ = 0. For any other value of
A, no competitive equilibrium.
• p ∈ (0, α1 ) : both firms would supply zero amount. If 0 < A < α1 , we have a
degenerate competitive equilibrium with p∗ = A, q d∗ = 0 = Qs∗ . For other
values of A, no competitive equilibrium.
In summary, for any value of A > 0, we can find an equilibrium in the short run.
Depending on the relation between A, α, β, we end up with different equilibrium solution.
(b) In the long run with free entry and exit, all firms must earn zero profit. Type 1 firm
solves the cost minimization problem, resulting in conditional input demand function
3
If we plot the output supply on p, we have a stepwise function.

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 y
x1 (w1 = 1, w2 = 1, y) = x2 (w1 = 1, w2 = 1, y) = α
, and cost function c(w1 = 1, w2 =
1, y) = 2y
α
2
• p> α
: problem not well defined.
• p< 2
α
: y ∗ = x∗1 = x∗2 = 0, profit function π 1 (p) = 0
• p= 2
α
: y ∗ ∈ [0, +∞], profit π 1 (p = α2 ) = 0
Analogously we can derive the results for Type 2 firm by replacing α with β. Now we
discuss the long run equilibrium depending on the parameter values.
• p > β2 : both types of firms would want to supply infinite amount, no competitive
equilibrium.
• p ∈ ( α2 , β2 ] : Type 1 firm would supply infinite amount, no competitive equilibrium.
• p ∈ (0, α2 ) : both types would supply zero amount, achieving zero profit. If 0 <
A < α2 , we have a degenerate competitive equilibrium with p∗ = A, q d∗ = 0 =
Qs∗ = q s1∗ = q s2∗ .
• p = α2 : q s1 ∈ [0, +∞], and q s2 = 0. Both types accrue zero profits. If A ≥ α2 , we
have a competitive equilibrium where p∗ = α2 , q d∗ = A − α2 = Qs1∗ , q s2∗ = 0.
In this case, only Type 1 firm is effectively serving the market demand, and the
number of them is undetermined.

Question 6

Whenever the profit maximization solution exists, define the profit function as

π(p, ω) ≡ max py − ω · x
y,x

s.t.y = f (x)

We are asked to show that π(p, ω) is convex in its arguments. To make our notation more
compact, we let P = (p, ω1 , · · · ωm )0 , and Y = (y, −x1 , · · · , −xm )0 , so that

π(P ) ≡ max P · Y
Y

s.t.g(Y ) = 0

We want to show that π(tP1 + (1 − t)P2 ) ≤ tπ(P1 ) + (1 − t)π(P2 ), for any t ∈ [0, 1] where
π(·) denotes any well-defined profit function. In particular, since π(P1 ) is well defined ,we
must have a maximizing bundle Y1 (under this notation a feasible production plan) that
obtains the maximum given price vector P1 . Hence we can write π(P1 ) = P1 · Y1 . Similarly,

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π(P2 ) = P2 · Y2 for some feasible production plan Y2 . Denote P3 = tP1 + (1 − t)P2 , we must
have π(P3 ) = P3 · Y3 for some feasible Y3 . Then

π(P3 ) = (tP1 + (1 − t)P2 ) · Y3

= tP1 · Y3 + (1 − t)P2 · Y3
≤ tP1 · Y1 + (1 − t)P2 · Y2
= tπ(P1 ) + (1 − t)π(P2 )

The inequality holds because under price vector P1 , the firm chooses Y1 over Y3 when both
are feasible, implying that the profit generated must be greater using Y1 . Hence, we’ve shown
that the profit function, whenever well-defined, is convex in (p, ω1 , · · · , ωm )

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