Problem Set 2 Solution

ECON201 – Element of Economic Analysis II (Honors)

∗
Siying Cao

October 16, 2017

Question 1

(a) The cost-minimization problem is

min ω1 x1 + ω2 x2
x1 ,x2 ≥0

s.t.Axα1 xβ2 ≥ y

We can easily verify that the solution is interior in the Cobb-Douglas case, i.e. x1 , x2 > 0,
and that the MRTS has to equal relative price of the two inputs at the optimum, i.e.
ω1 M P1
=
ω2 M P2
When the exponents do not add up to one, what matters would be the relative magni-
α β
tude. In fact, the minimized expenditure shares are constant, given by α+β and α+β ,
respectively. In the special case with β = 1 − α, we are back to the results derived in the
lecture slides.
The exact form of the conditional demand function and the resulting cost function would
certainly be different, but the main properties remain valid. If we work through the
algebra for the general Cobb-Douglas production function, we end up having
1 
 y  α+β β
ω2 α  α+β
x1 (ω1 , ω2 , y) =
A ω1 β
1 
 y  α+β α
ω1 β  α+β
x2 (ω1 , ω2 , y) =
A ω2 α
∗
Please send any corrections to siyingc -at- uchicago -dot- edu

1
(b) For any t > 0, and x1 , x2 ≥ 0, we have

f (tx1 , tx2 ) = A(tx1 )α (tx2 )β

= tα+β Axα1 xβ2
= tα+β f (x1 , x2 )

Therefore, α + β >, <, = 1 corresponds to the production function being IRS, DRS, and
CRS.
(c) M P1 (x̄2 , x1 ) = Aαxα−1
1 x̄β2 , M P2 (x̄1 , x2 ) = Aβ x̄α1 xβ−1
2 . The marginal rate of technical
M P1 αx2
substitution M RT S12 = M P2 = βx1 Focusing on M P1 , if x̄2 > 1, then M P1 (x̄2 , x1 )
increases with β. It increases with α for x1 ∈ (1, +∞). In other intervals, the chane in
shape depends on specific values of α and x1 . Multiplying α and β by the same factor
will leave the MRTS unchanged.
(d) In Question 3 from Problem Set 1, we show that the Cobb-Douglas production function
is the limit case of the CES production function class as σ goes to 1. Thus, the elasticity
of substitution at (x1 , x2 ) is constant (equals to 1). In other words, it does not depend
on α or β. Here is a simple and quick derivation in case you are not convinced.
d ln xx21 d ln xx21
σ12 = − =−
d ln ωω12 d ln M RT S12

Since M RT S12 = M P1
M P2
= αβ xx21 , we may let x denote xx21 to simplify the notation. Then
ln M RT S12 = ln αβ + ln x, and d ln M RT S12 = d ln x. This implies σ12 = − −d ln x
d ln x
=1

Question 2

(a) For any t > 0, x1 , x2 ≥ 0, we have

f (tx1 , tx2 ) = min{tαx1 , tβx2 }

= t min{αx1 , βx2 }
= tf (x1 , x2 )

Thus, the Leontief production function exhibits CRS.

(b) Since the production function is not differentiable at some points, we use graphical rep-
resentation to help analyze the cost minimization problem.
As long as factor prices ω1 , ω2 , y are strictly positive, given the isoquant (level set at a
fixed y), the cost minimizing bundle of inputs always occur at the point where αx1 = βx2 .

2
 To achieve the desired output, it must be
y
x1 (ω1 , ω2 , y) =
α
y
x2 (ω1 , ω2 , y) =
β
Note that the conditional demand function does not depend on factor prices. The prop-
erty of Leontief production technology is that the factors will be used in fixed proportions
( xx21 = αβ ), as they are perfect complements.
(c) c(ω1 , ω2 , y) = ω1 x∗1 + ω2 x∗2 = ( ωα1 + ω2
β
)y
∂c(ω1 ,ω2 ,y) ω1 ω2
(d) M C(ω1 , ω2 , y) = ∂y
= α
+ β
, which is invariant to output level y.
∂c(ω1 ,ω2 ,y) y y
(e) By Shephard’s Lemma, we have ∂ωi
= x∗i , which equals α
for i = 1, and β
otherwise.
∂ 2 c(ω1 ,ω2 ,y)
(f) (∂ωi )2
= 0. In the Leontief case, cost is linear in factor prices.

Question 3

(a) Firm A solves the cost minimization problem

min ωl + rk
l,k∈R+

s.t.k α l1−α ≥ y

where y is a parameter that enters the conditional demand function, and ω and r are
constants. Firm B, on the other hand, solves the following problem

min φωl + φrk

l,k∈R+

s.t.k α l1−α ≥ y

Notice that as long as φ > 0, the two minimization problems look exactly the same.
Hence the conditional demand will be the same as well, i.e. lA (ω, r, y) = lB (φω, φr, y)
and kA (ω, r, y) = kB (φω, φr, y), ∀y > 0 for a given set of strictly positive constants
(ω, r, φ).
(b) The cost of producing one unit for firm A and B equals ωlA (ω, r, 1) + rkA (ω, r, 1) and
φωlB (φω, φr, 1) + φrkB (φω, φr, 1). Since we’ve shown in part (a) that the conditional
factor demand is the same for the two firms, we conclude cB (φω, φr, 1) = φcA (ω, r, 1)
(c) See Figure 1 for illustration. Point A is where the optimal bundle occurs for both firms.

3
 Figure 1: Isoquant, isocost, and optimality condition

(d) Since the relative factor price facing the two firms are identical, their isocost curves are
all parallel to each other.
(e) The optimal input mix for both firms is represented by point A on the graph.
(f) Solving the cost minimization problem explicitly for firm A, we have
∗ r 1
lA = ( )2
ω
∗ ω 1
kA = ( ) 2
r
1
∗
cA = ωlA + rkA∗ = 2(ωr) 2
1
For firm B, its cost cB = φcA = 2φ(ωr) 2
(g) Cost function is homogeneous of degree 1, conditional factor demand function is homo-
geneous of degree 0. Therefore, viewing firm B as doubling the factor prices facing firm
A, we must have the cost of production for Firm B being twice as large while the same
input choice is maintained.

Question 4

(a) Let’s solve for the general case with α and 1 − α. From lecture notes, we know the long
run cost-minimization problem has the following conditional input demand
 w α 1−α
2
x1 (w, y) = y
w1 1 − α
w 1 − α
1
x2 (w, y) = y )α
w2 α
The associated long run cost function is
w1α w21−α
c(w, y) = w1 x1 (w, y) + w2 x2 (w, y) = y
αα (1 − α)1−α

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(b) The firm’s cost minimization problem in the short run is

min w1 x̄1 + w2 x2
x2 ≥0

s.t. x̄α1 x21−α ≥ y

where x̄1 is the fixed level of input in the short run. It’s straightforward to derive
α
1 −
xSR
2 (w, y; x̄1 ) = y
1−α x̄ 1−α
1

The short-run cost function for an arbitrary x̄1 is then

α
1 −
sc(w, y; x̄1 ) = w1 x̄1 + w2 xSR
2 (w, y; x̄1 ) = w1 x̄1 + w2 y
1−α x̄ 1−α
1

In the case of x̄1 = 1, the short-run cost function becomes

1
sc(w, y; x̄1 = 1) = w1 + w2 y 1−α

(c) There are at least two ways to go about this question. We know from lecture that the
short-run cost cannot be smaller than the long-run cost because the firm in the long-run
can at least choose the short-run optimal bundle. We also know that the cost functions
will coincide only if the fixed level of input in the short run equals to the conditional
demand of the same factor in the long run. Hence verifying x1 (w, y) 6= 1 for all y ∈ [0, 1)
2
would be sufficient. For α = 31 and w1 = w2 , we have x1 (w, y) = y · ( 12 ) 3 which is always
less than 1 for any 0 ≤ y < 1. This implies that sc(w, y; x̄1 = 1) > c(w, y) for all
0≤y<1
The other way to very the inequality is by brutal force calculation. Substitute the
expressions for the cost functions derived in part (a) and (b), we need to show

1 w1α w21−α
w1 + w2 y 1−α > y
αα (1 − α)1−α

for all 0 ≤ y < 1. Imposing w1 = w2 and α = 13 , the condition boils down to

√3
4 3
(1 + y 2 ) − y > 0
3
It’s easy to show that the function on the left hand side is monotonically decreasing on
[0, 1) and the value at y = 1 is strictly positive. This concludes our proof.
(d) Following the same argument as in part (c), sc(w, y; x̄1 = 1) = c(w, y) if and only if
 w α 1−α
2
1 = x1 (w, y) = y
w1 1 − α
 1−α
This implies y = w 1 1−α
w2 α

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(e) At the value of y found in part (d), the cost function in the short run is the same as in
the long run. Using the tangency condition, we immediately have

dsc(w, y; x̄1 = 1) dc(w, y) w1α w21−α

= = α
dy dy α (1 − α)1−α

and
∂sc(w, y; x1 )
=0
∂x1

 1−α
w2 α
(f) To have short run an long run cost equal, we must have x̄1 = x1 (w, y = 1) = w1 1−α