Macroeconomics I

Problem Set #6
Due: February 24, before the seminar
Marti Mestieri, Universitat Pompeu Fabra

1. Consider a market in which M firms indexed by i produce different varieties and compete under
monopolistic competition. They take as given the following demand function:

 ϵ
P
y(i) = Y with ϵ > 1
p(i)
P  1
M 1−ϵ 1−ϵ
where ϵ is the elasticity of substitution across varieties and P = i=1 p(i) is the price
index. Labor is the only factor of production and firms have access to the following technology:

y(i) = A(i)l(i)

where A(i) is firms’ physical TFP. Firms take as given the price of labor, w, which is the same for
all firms.

(a) Write down firms’ profit maximization problem

(b) Derive the FOC of this problem
(c) Solve for the optimal price charged by firms. Provide an intuition for the expression that you
find
(d) Assume M = 2. Is this a good assumption? Justify your answer.
(e) Write down the price index P as a function of ϵ, A(1), A(2) and w.
(f) Assume that A(1) > A(2). Compute the size of firm 1 relative to firm 2: l(1)/l(2)
(g) Provide the intuition for why, even though firm 1’s productivity is higher, the two firms can
co-exist in equilibrium. In other words, what prevents firm 1 to takeover the entire market?
(h) Is labor efficiently allocated across the two firms? Justify your answer.

Imagine now that there are two final goods in the economy: X and Y . These two goods are
produced by perfectly competitive firms using the following production functions:
h ϵ
i ϵ−1
ϵ−1 ϵ−1
Y = y(1) ϵ + y(2) ϵ and X = Kα

where y(1) and y(2) are the goods produced by firm 1 and 2 respectively. K is a generic factor
of production. A few things to keep in mind:

1
 • Assume PX = 1.
• Since the final producer of Y is producing in perfect competition:

PY = M gCostY = P

where P is the price index that you derived in part (e). NOTE: this information is needed
just for part (k)
(i) Assume that the government artificially increases the labor cost of firm 1 by τ % ((1 + τ )w
instead of w). Write down the profit maximization problem of firm 1 and compute the new
optimal price that it charges.
(j) Is labor efficiently allocated across the two firms? Justify your answer.
(k) Will the introduction of this tax change the sectoral composition of the economy? In other
words: do you think that the introduction of this tax will affect PX Px+P
YY
YY
? Justify your answer
(NOTE: here you just have to provide an “educated” conjecture).