Microeconomics, Homework 5

Carlos Cass
November 14, 2011
Problem 1
A competitive equilibrium is a set of consumption allocations, such that,
given a set of prices:
The consumers maximizes their utility.
The rms maximizes their prots.
Aggregate demand equals aggregate supply in all markets.
Therefore, in order to obtain the competitive equilibrium in this problem we
should use the optimality conditions in both consumers and rms problem and
solve for the consumption allocations subject to the market clearing condition.
First, letts solve the rms problem:
Firm Problem
In the problem it is not specied if there is one rm or many rms. But,
as we only have one production technology we can solve the problem for a
representative rm without any loss of generality:
max
f,:g
(j, .) = jj n.
:.t.
j = )(.) = .
. _ 0
j _ 0
1
We can use the restriction to transform the problem to simpler one:
max
f:g
(.) = j. n.
:.t.
. _ 0
The optimality condition of this problem is:
1 = j. n. + `.
FOC
Jt(:)
J:
= 0 j + ` = n
Slackness conditions
`. = 0
Non-negativity constraints
. _ 0
` _ 0
If ` 0 n j and . = 0 (.) = 0. Now, if ` = 0 . = j (.) =
0 . 0
Therefore, we have two solutions for the rm problems:
Case 1 Case 2
j
1
< j
2
j
1
= j
2
. = 0 . 0
(.) = 0 (.) = 0
In case 1 there is no demand for labor and no supply of r
1
. Therefore, there
is no r
1
in the economy. This, and the fact that we have zero prot, force the
consumer to maximizes its utility when r
1
= 0 and r
2
= 1. This is so because
the utility function is monotonically increasing in the linear good r
2
, therefore
r
2
< 1 gives a smaller utility level than r
2
= 1. The market clearing condition
is:
Aggregate Demand Aggregate Supply
r
1
= 0 n
1
+ )(.) = 0
r
2
= 1 n
2
. = 1
r
1
+ r
2
= 1 n
1
+ n
2
= 1
Therefore in case 1 we have the following market equilibrium
2
Price ratio Allocations of goods
j
1
< j
2
r
1
, r
2
= 0, 1
In the second case, normalizing the prices of all the goods in the economy
to one simplies the problem. Lets solve the consumer problem.
Consumer Problem
'ar
fr1,r2g
n(r
1
, r
2
) = ar
1

b
2
(r
1
)
2
+ r
2
:n/,cct to,
r
1
+ r
2
_ 1
r
1
_ 0
r
2
_ 0
With 1 a/ and a 1. As the consumer does not have any endowment of
r
1
and one endowment of labor, the available resources for the market value of
the consumer wealth 1. As n(r
1
, r
2
) is monotone in r
2
, whenever r
1
+ r
2
< 1,
the consumer can increase the amount of r
2
and obtain a higher utility level,
therefore any consumption bundle such that r
1
+r
2
< 1 is not optimal, therefore
we should have r
1
+r
2
= 1. Before aplying Kuhn-Tucker conditions we should
verify if the function is quasi-concave and dierentiable in all the arguments:
0n(r
1
, r
2
)
0r
1
= a /r
1
0
2
n(r
1
, r
2
)
0r
2
1
= /
0n(r
1
, r
2
)
0r
2
= 1
0
2
n(r
1
, r
2
)
0r
2
2
= 0
As the rst derivative exist in both arguments the function is dierentiable.
As the second derivative is n
00
(r
1
, r
2
) _ 0 in both arguments, the function is
quasi-concave. Now we can compute the rst order conditions:
1 = ar
1

b
2
(r
1
)
2
+ r
2
`[r
1
+ r
2
1] + j
1
r
1
+ j
2
r
2
FOC
[1]
JJ
Jr1
= 0 a /r
1
+ j
1
= `
3
[2]
JJ
Jr2
= 0 1 + j
2
= `
Slackness conditions
`[r
1
+ r
2
1] = 0
r
1
j
1
= 0
r
2
j
2
= 0
Non-negativity constraints
r
1
_ 0
r
2
_ 0
` _ 0
j
1
_ 0
j
2
_ 0
Before, we have argued that, by monotonicity we should have r
1
+ r
2
= 1,
thefore ` 0. As 1 0 we should always have at least one of r
1
and r
2
greater
than 0. If r
1
0 and r
2
= 0 then j
1
= 0. Using [1] and [2] we obtain:
a /r
1
= 1 + j
2
r
1
=
a 1 j
2
/
r
2
= 1
a 1 j
2
/
/ + 1 a = j
2
Using the condition 1 a / we know that j
2
0 j
2
< 0, wich
contradict the inequality constraint j
2
_ 0. Therefore we can discard the corner
solution r
1
0 and r
2
= 0. Now, if r
1
= 0 and r
2
0 the j
2
= 0. Using [1]
and [2] we obtain:
a + j
1
= 1
But, as a 1 this imply that j
1
< 0, this contradicts the inequality con-
straint j
1
_ 0. Therefore we can discard the corner solution r
1
= 0 and r
2
0.
Finally, if we have an interior solution with r
1
0 and r
2
0 j
1
= 0 and
j
2
= 0. We have:
r

1
=
a 1
/
r

2
= 1
a 1
/
4
We should verify that this allocations satises the market clearing conditions:
Aggregate Demand Aggregate Supply
r
1
=
o1
b
n
1
+ )(.) = .
r
2
= 1
o1
b
n
2
. = 1 .
r
1
+ r
2
= 1 n
1
+ n
2
= 1
Therefore in case 2 we have the following market equilibrium
Price ratio Allocations of goods
j
1
= j
2
r
1
, r
2
=
o1
b
, 1
o1
b

Problem 3
Part a)
As the rms share the same technology and the same cost function we can
consider then identical. Therefore, solving the cost minimization problem for
one rm will gives us the cost function of a representative rm. We know that
the price of the two inputs is one and the xed cost is 16, therefore we can
formulate the problem as follows:
min
f|,lg
/ + | + 16
:.t
j
2
= min
/
c
,
|
1 c

j _ 0
with c (0, 1). For a given value j

, we know that if
|

o
<
l

1o
j
2
=
|

o
and viceversa. In this case, in order to minimize the cost the rm can reduce the
value of |

to a new |

such that
|

o
<
l

1o
and still obtain j
2
=
|

o
. Actually
it can keep doing this until
|

o
=
l

1o
, at this point we still have .
2
=
|

o
and it is not possible to reduce the cost and obtain the same production level.
Therefore we should have
|

o
=
l

1o
at the minimum. We can use this to obtain
the cost function:
c(j) = cj
2
+ (1 c)j
2
+ 16 = j
2
+ 16
Part b)
5
If a rm exit the market it does not face any xed cost, therefore its prots
will be zero. This means that whenever we have negative prots a rm will
decide to exit the market. In opposition if a rm can obtain positive prot will
stay in the market.
Using the cost function c(j) = j
2
+16 we can solve the prot maximization
problem of the individual rm as follows:
max

(j) = jj j
2
16
:.t. j _ 0
For j 0 we have the following optimality condition:
0(j)
0j
= 0 j =
j
2
The aggregate supply (as all the rms are identical) is Q =

2
. Therefore,
using the inverse demand function:
j = 100
j
2
j =
200
+ 2
Q =
100
+ 2
Therefore , for = 6 we have:
Prices Long Run Production
j =
200
6+2
= 25 Q = 6
100
6+2
= 75
Now we can compute the equilibrium number of rms i.e. the number of
rms that makes (j) = 0. This will gives us the long-run equilibrium with free
entry:
(j) = 0
jj j
2
= 16
200
+ 2
100
+ 2
(
100
+ 2
)
2
= 16

= 23
6
Therefore, the market equilibrium with free entry is charactherized by the
following:
Prices Long Run Production
j =
200
23+2
= 8 Q = 23
100
23+2
= 92
Problem 4
Part a)
Lets take a look at the geometry of the cost, average cost and marginal
cost:
C = c(
I
) = a
I
+ /
2
I
C =
c(
I
)

I
= a + /
I
'C =
0c(
I
)
0
I
= a + 2/
I
Note that the cost function is concave. Therefore, using the Kunh-Tucker
techniques for solving the cost minimization problem will result in maximizing
the cost (as the minimization problem is equivalent to the prot maximization,
7
we can use the same argument for not using KT to obtain the maximum prot).
But, the graphic suggest two possible solutions to the cost minimization prob-
lem. Consider that there is a has an upper bound . If c(0) < c()

= 0,
also if c(0) c()

= , and, nally, if c(0) = c() the rm is indierent

between producing 0 or . Therefore, in the short run we have the following
equilibria that depends on .
Q()

c(0) c()
c(0) < c()
J
0
j()

c(0) c()
c(0) < c()
c ,J
c
In order for this conditions to make sense we need to impose the following
restriction on the parameters: c ,J, , _ 0, J _ 0 and 0.
Part b)
Here we need to show that in the long run rms can decide to enter and
leave the market according to the level of prot in the market. For this we need
to put an special attention to the behaviour of prots and the number of rms:
= j a /
2

I
=
I
(j a /)

I
= 0 j = a + / = min(C)
c ,J = a + /
J =
oo
j
/
,
Therefore, we should have:
Q()

c(0) c()
c(0) < c()
oobj
o
0
j()

c(0) c()
c(0) < c()
a + /
c
8
Therefore, in orther to this equilibrium to exist we should have c a /
and a + / 0.
Part c)
In this case the cost function is convex, so we can use Kunh-Tucker to solve
the prot maximization problem.
max
ji
(
I
) = j
I
(a
I
+ /
2
I
)
:.t.
I
_ 0
If
I
= 0 (
I
) = 0. If
I
0
Jt(ji)
Jji
= 0 j = a+2/
I
= 'C

I
=
o
2b
. The rm will decide to produce whenever (
I
) 0 j a + /
I
= C.
Therefore, the equilibrium is characterize by the following:
Q()

j C
j _ C
J
2b+Ja
2b+J
o
2b
0
j()

j C
j _ C
2bo+oo
2b+o
c
9