Economics 2020a / API 111 / HBS 4010 / Gov 2005

Final Examination
Fall 2004

Instructions: You have 180 minutes to complete the following examination. The exam has five
questions, each with multiple parts. Answer all parts of all questions in the exam books provided. Partial
credit will be awarded on the basis of (partially correct) work shown, so write legibly and show your
work. If you believe a question is ambiguous, clearly state any assumptions you are making.

You may use a calculator on this exam.

This exam has 5 pages, including this one. The exam has 150 points. Each question has 30 points, total.
Point values follow each part of each question.

Please write your name on each blue book. Questions 1 and 2 should be answered in separate blue books
from questions 3 5.


1. Suppose a typical consumer currently consumes 10 pounds of bananas per month and that the price
of bananas is $1 per pound. At this price, the consumers elasticity of (Walrasian) demand for bananas is
2. The government is considering a tax that will increase the price of bananas by 5%.

For the purposes of parts (a) through (c) of this question, you may use linear approximations for the
consumers demand curves.

(1a) Suppose you know nothing else about the consumers preferences. Provide an estimate of the
largest and smallest possible values for this consumers compensating variation of the banana tax.
Explain your answer. [8 points]

(1b) Suppose that, in addition to the above information, you also know that the bananas are a normal
good for this consumer. How does this additional information change the answer to part (a)?
Explain your answer. [8 points]

(1c) Suppose that the consumer in question is a randomly selected Harvard undergraduate. What would
be a reasonable estimate for the compensating variation of the banana tax? Your answer should be
a single number. Explain any assumptions you make. [7 points]

(1d) How sensitive are the answers to parts (a) and (b) to the assumption that demand is linear? How
would the answers change if this assumption were dropped? Explain your answer. [7 points]






2. A firm produces output y using inputs x
1
, x
2
, and x
3
according to production function:

f(x
1
,x
2
,x
3
) = (x
1
+ x
2
)
1/2
x
3
1/2
.

The (strictly positive) prices of the three inputs are w
1
, w
2
, and w
3
. Assume that w
1
is not equal to w
2
.

(2a) Does this production function exhibit increasing, decreasing, or constant returns to scale? Explain
your answer. [3 points]

(2b) State the firms cost minimization problem. [3 points]

(2c) Suppose the firm must produce q > 0 units of output. Without solving the firms cost-minimization
problem, for each input describe the conditions under which the firms optimal production plan will
use zero units of that input. [6 points]

(2d) Derive the firms first-order conditions and find the firms conditional factor demand and cost
functions. You do not need to explicitly consider non-negativity constraints, but your response
should address the cases identified in part (c). [12 points]

(2e) Suppose that w
1
= 2, w
2
= 1, and w
3
= 1. The firm is a monopolist. Demand for its output is given
by D(p) = A B p, where A and B are strictly positive. Find the firms profit-maximizing price
and quantity. [6 points]


API 111 / Econ 2020a / HBS 4010
Solution to Final Exam, Fall 2004
Question 1:
Currently, the consumer consumes 10 units at a price of 1. If the 5% increase in price goes through,
assuming linear demand the new price will be 1 + 0:05 (1) = 1:05, and the consumer will consume 10
2 (0:05) 10 = 9 pounds of bananas.
Compensating variation is computed as the area between the two prices left of the Hicksian demand
curve for the original utility level. Assuming the Hicksian demand curve is linear, we could determine what
it must be using the Slutsky equation if we had information on wealth elasticity. But, we dont have this
information.
1a) Without any additional information, the Hicksian demand curve must go through the point p = 1,
q = 10, and can be anywhere between at (for a very inferior good) and vertical (for a normal good with
high wealth elasticity). This puts bounds on CV between 0 (at Hicksian) and 0:05 10 = 0:5 (vertical
Hicksian).
1b) If we know the good is normal, then we know that the Hicksian demand curve must be steeper than
the Walrasian demand curve. This means that the CV must lie between the CS and the value for a vertical
Hicksian demand curve, 0:5. For a linear Walrasian demand curve, CS = (0:05)
(9+10)
2
= 0:475.
1c) It is reasonable to think that the wealth elasticity of bananas for a Harvard undergraduate is very
small, i.e., zero. Other assumptions are reasonable, but you should explain why you assume what you do.
If you assume this, then the CV is the same as CS; which is 0:475, from the previous part.
1d) If you dont assume that demand is linear, then anything can happen. The elasticity of 2 is only
valid at the current prices and quantity, and can chane in any way for other price-quantity pairs. Regardless
of whether the good is normal or inferior, the Hicksian demand curve can fall anywhere between at and
vertical (it cannot be upward sloping, though, by negative semi-deniteness of the Slutsky equation). This
means that, CV can always range between 0 and 0:05.
1
Question 2:
Look at the production function. It is basically Cobb-Douglas, except goods x
1
and x
2
are perfect
substitutes for each other. So, given input prices, the rm will use x
1
and not x
2
if w
1
< w
2
and x
2
but not
x
1
if w
2
< w
1
.
2a) Scaling all inputs by t we see that
f (tx
1
; tx
2
; tx
3
) = (tx
1
+tx
2
)
1=2
(tx
3
)
1=2
= t (x
1
+x
2
)
1=2
x
1=2
3
= tf (x
1
; x
2
; x
3
) .
Hence the production function exhibits constant returns to scale.
2b) The rms CMP is:
min
x1;x2;x3
w x
s:t: : (x
1
+x
2
)
1=2
x
1=2
3
q, and
x
i
0 for i = 1; 2; 3.
2c) Clearly, if q > 0 then x
3
must be strictly positive. Similarly, x
1
+x
2
must also be strictly positive.
Note that x
1
and x
2
are perfect substitues. Since w
1
6= w
2
, the rm will use either one or the other input,
but not both. If w
1
> w
2
, the rm will use only x
2
, and x
1
= 0. If w
2
> w
1
, then the rm will use only
x
1
, and x
2
= 0. [For an argument, suppose the rm uses x

1
> 0 and w
1
> w
2
. The rm could produce the
same output as lower cost by increasing x
2
by x

1
units and using zero units of x
1
.]
2d) Suppose w
1
< w
2
. Then the rm uses x
1
and x

2
= 0. The CMP is:
min
x1;x3
w x
s:t: : x
1=2
1
x
1=2
3
q.
The Lagrangian is:
L = w x

x
1=2
1
x
1=2
3
q

.
We already argued that the solution will be interior. So, the FOC are [asterisks omitted from variables for
2
notational simplicity]:
w
1

1
2
x
1=2
1
x
1=2
3
= 0
w
3

1
2
x
1=2
1
x
1=2
3
= 0
x
1=2
1
x
1=2
3
= q
Substituting the third into the rst two yields:
w
1

1
2
q
x
1
= 0, and
w
3

1
2
q
x
3
= 0,
which becomes:
2w
1
q
x
1
= =
2w
3
q
x
3
w
1
x
1
= w
3
x
3
x
1
=
w
3
x
3
w
1
and using the constraint:
x
1=2
1
x
1=2
3
= q

w
3
x
3
w
1

1=2
x
1=2
3
= q
x
3
=

w
1
w
3

1=2
q
x
1
=

w
3
w
1

1=2
q,
and so the cost function is
c (w; q) = w
1

w
3
w
1

1=2
q +w
3

w
1
w
3

1=2
q = 2 (w
1
w
3
)
1=2
q.
If, on the other hand w
2
< w
1
, you get the same thing with subscript 2 replacing subscript 1 everywhere.
x
2
=

w
3
w
2

1=2
q
x
3
=

w
2
w
3

1=2
q
c (w; q) = (w
2
w
3
)
1=2
q.
3
2e) The rms cost function is c (w; q) = q. Inverse demand is:
q = ABp
p =
Aq
B
.
The prot maximization problem is
max
q

Aq
B

q 2q

A2q

2 = 0
q

=
A2B
2
=
A
2
B.
p

=
A+ 2B
2B
=
A
2B
+ 1
4



3. Suppose that there are two consumers in an exchange economy with two goods. Let the consumption
bundles for consumer 1 be denoted by x = (x
1
, x
2
) and let the consumption bundles for consumer 2 be
denoted by y = (y
1
, y
2
). There are total of 10 units of good 1 and 14 units of good 2.

For parts (a) through (c), assume that consumer 1 has utility function u(x
1
, x
2
) = x
1
* x
2
2
, while consumer
2 has utility function v(y
1
, y
2
) = y
1
* y
2
.

(3a) What are the conditions for the consumption bundles (x
1
, x
2
) and (y
1
, y
2
) to be a Pareto optimal
allocation? (Assume that x
1
+ y
1
= 10 and x
2
+ y
2
= 14.) [6 points]

The main condition for Pareto optimality (given that first-order conditions are sufficient for
an interior optimum, as shown by (b)) is that the marginal utility ratio is equalized for the two
consumers. This means that the two people cannot both improve their utility levels with a
small trade of goods. In this case, the condition for Pareto optimality is
2 x
1
x
2
/ x
2
2
= y
1
/ y
2

OR 2 x
1
/ x
2
= y
1
/ y
2



(3b) Suppose that the consumers are allowed to trade at market prices p
1
= 1 for good 1 and p
2
= p for
good 2. That is, good 1 is the numeraire. Will the first-order conditions for maximization identify
the optimal bundles for each consumer at these prices? Explain your answer. [4 points]

If either player chooses a corner solution, that player consumes 0 of one good and receives utility of 0.
With any nonzero endowment, it would be preferable to choose a bundle that is not on the boundary of
the budget line. So each player will choose an interior point on the budget line, which means that the
first-order conditions will be sufficient for an optimal bundle for each consumer. (This answer does
not consider the possibility of multiple solutions to the first-order conditions. Another way to reach the
same conclusion is to observe that each utility function is Cobb-Douglas and that Cobb-Douglas
functions have a unique interior optimum.)

(3c) Suppose that the initial endowment is (5, 7) for consumer 1 and (5, 7) for consumer 2. If the
consumers are allowed to trade goods at market prices, which of the following will occur?

1. There is an exchange equilibrium where consumer 1 will trade good 1 for good 2.
2. There is an exchange equilibrium where consumer 1 will trade good 2 for good 1.
3. There is an exchange equilibrium, but the consumers will retain their endowments.
4. There will be no exchange equilibrium.

Explain your answer, using either a mathematical or a verbal argument. Note: it is possible
to answer this question by solving analytically for the equilibrium prices and bundles, but it
is not necessary to use such a time-consuming method. [8 points]

The initial endowment point does not satisfy the Pareto optimality condition from (a) because
consumer 1 has greater marginal utility for good 2 relative to good 1 than does consumer 2.
(The ratio of marginal utilities is 10 / 7 for consumer 1 as opposed to 5 / 7 for consumer 2).
Since the First Welfare Theorem states that an exchange equilibrium achieves a Pareto
optimum, it is natural to conclude that consumer 1 will trade good 1 for good 2 in an
exchange equilibrium.


(A complete proof of this result would go on to observe that if consumer 1 traded good 2 for
good 1, it would be impossible to satisfy the condition for Pareto optimality in part (a), but that
is beyond the scope of an exam answer.)

For parts (d) and (e), assume that consumer 1 has utility function u(x
1
, x
2
) = x
1
+ x
2
2
, while consumer 2
has utility function v(y
1
, y
2
) = y
1
+ y
2
.

(3d) As in part (b), suppose that the consumers are allowed to trade at market prices p
1
= 1 for good 1
and p
2
= p for good 2. Will the first-order conditions for maximization identify the optimal bundles
for each consumer at these prices? Explain your answer. [4 points]

The first-order conditions for maximization will not identify the optimal bundles for either consumer
because each has nonconvex preferences. In particular, consumer 1 has increasing marginal utility
for good 2 as x
2
increases. Since there is no interaction between x
1
and x
2
, consumer 1 will
always choose a boundary solution (and will usually only consume good 2).

Similarly, consumer 2 should spend all money on the less expensive good, since each good has
constant marginal utility equal to 1.

(3e) Suppose that the initial endowment is (5, 7) for consumer 1 and (5, 7) for consumer 2. If the
consumers are allowed to trade goods at market prices, which of the following will occur?

1. There is an exchange equilibrium where consumer 1 will trade good 1 for good 2.
2. There is an exchange equilibrium where consumer 1 will trade good 2 for good 1.
3. There is an exchange equilibrium, but the consumers will retain their endowments.
4. There will be no exchange equilibrium.

Explain your answer, using either a mathematical or a verbal argument. Note: it is possible to
answer this question by solving analytically for the equilibrium prices and bundles, but it is not
necessary to use such a time-consuming method. [8 points]

The main point here is that both consumers will choose boundary solutions except in the case where p
= 1, which leaves consumer 1 indifferent between all choices of consumption. In fact, there is an
equilibrium with p = 1 and consumption bundles (10, 2) for consumer 1 and (0, 12) for consumer 2.
So answer 2 is correct, but it is also possible to make a cogent argument (though it is ultimately
incorrect) for answer 4.

A formal answer would proceed as follows (NOT EXPECTED IN AN EXAM ANSWER!).

If p does not equal 1, then both players will choose boundary solutions. So for an equilibrium with p
not equal 1, one would have to consume (10, 0) and the other would have to consume (0, 14). In
addition, each would have to increase utility from the endowment point. Consumer 1 prefers (5, 7) to
(10, 0), so the only possibility is for consumer 1 to choose (0, 14) and consumer 2 to choose (10, 0). By
Walras Law, if consumer 2 chooses (10, 0), the initial endowment must have value equal to 10 * 1 + 0
* p = 10 implying 5 + 7p = 10 or p = 5/ 7. But if p < 1, consumer 2 will spend all of her money on
good 2, NOT on good 1. This rules out the possibility of any equilibrium with p not equal to 1.

If p equals 1, then consumer 1 will spend all money on good 2, consuming (0, 12), while consumer 2 is
indifferent between all choices along the budget line y
1
+ y
2
= 12.

Market clearing requires
consumer 2 to select (10, 2), which produces an exchange equilibrium.

4. Suppose that consumers 1, 2 and 3 have the following VNM utility functions:
u
1
(w
1
) = ln w
1
, u
2
(w
2
) = w
2

1/2
, u
3
(w
3
) = - exp(-w
3
).

(4a) Is it possible to say that consumer 1 is more risk averse (or less risk averse) than consumer 2
without knowing more about their wealth levels and the risky investments that are available to
them? Explain your answer. [5 points]

The Arrow-Pratt coefficient for person 1 is u(w
1
) / u(w
1
) = w
1
. Similarly, the Arrow-Pratt
coefficient for person 2 is w
2
/ 2. This indicates that consumer 1 is more risk averse than consumer 2
since the Arrow-Pratt coefficient is larger for consumer 1 than for consumer 2 at any wealth level.

(4b) Is it possible to say that consumer 1 is more risk averse (or less risk averse) than consumer 3
without knowing more about their wealth levels and the risky investments that are available to
them? Explain your answer. [5 points]

The Arrow-Pratt coefficient for person 3 is equal to 1. So the Arrow-Pratt coefficient is lower for
person 1 than for person 3 at low wealth levels and higher for person 1 than for person 3 at high
wealth levels. It is impossible to say which consumer is more risk averse without knowing initial
their wealth levels. (Also, even if the initial wealth level is high, person 1 might still be more risk
averse in response to investments that involve substantial probability of bankruptcy.)

(4c) Suppose that consumer 1 has the option to purchase shares of a company at price p = 1. With
probability 0.5 the company will go bankrupt and the shares will be worthless. With probability 0.5
the shares will increase in value from 1 to 3. Solve consumer 1s maximization problem to find the
optimal number of shares for consumer 1 as a function of w
1
. [5 points]

If consumer 1 purchase x shares, his final wealth is w
1
x with probability 0.5 and w
1
+ 2x with
probability 0.5. Consumer 1s optimization problem is
max
x
0.5 ln (w
1
x) + 0.5 ln (w
1
+ 2x).

Note that the second derivative of the objective function is negative so the second-order conditions for
an interior optimum holds. The first-order condition for this problem is 3 / (w
1
+ 2x) = 1 / (w
1
x),
which has solution x = w
1
/ 4.

(4d) Suppose that consumer 2 is offered the same option that was given to consumer 1 in part (c) and
that both start with the same initial wealth. Will consumer 2 buy more shares, buy the same
number of shares, buy fewer shares than consumer 1, or is it impossible to tell without knowing
more about that wealth level? Explain your answer. [5 points]

Since consumer 2 is strictly more risk averse than consumer 1, consumer 2 will purchase fewer shares
of any risky asset than consumer 1. (It is also possible to solve directly for consumer 2s optimal
number of shares, which is equal to w
1
/ 2. This is less than the optimal number of shares for
consumer 1.)








(4e) Suppose that consumer 3 is offered the same option that was given to consumer 1 in part (c). How
does the (optimal) number of shares in the company purchased by consumer 3 vary with consumer
3s wealth? Explain your answer. [5 points]

Since consumer 3s Arrow-Pratt coefficient of absolute risk aversion is constant, consumer 3s attitude
towards absolute levels of risk does not change with initial wealth. So consumer 3s optimal number of
shares is independent of wealth. (Further calculations show that consumer 3s optimal number of
shares is x = (ln 2) / 4 at any wealth level.)

(4f) Compare the comparative static results from parts (c) and (e) for the change in number of shares
purchased by consumers 1 and 3 as their individual wealth levels change. Are these results
consistent with our intuition about how investment patterns change with wealth? [5 points]

Consumer 1 purchases more of the risky asset as wealth increases, while consumer 3 purchases the
same amount of the risky asset as risk increases. Since we think that people have more tolerance for
risk as wealth increases, consumer 1s behavior and utility function seems more reasonable than does
consumer 3s behavior and utility function.



5. Tom and George are neighbors who share a common yard. Tom agrees to take care of the lawn and
George agrees to take care of the garden. Each of them chooses the number of hours to spend on this
work. If Tom chooses to spend t hours trimming the lawn and George chooses to spend g hours caring
for the garden, then their utilities are as follows:

Tom: u(t, g) = t 2t
2
+ 3gt + w
T

George: v(t, g) = 2g 3g
2
+ 4gt + w
G


Here, w
T
is Toms wealth and w
G
is Georges wealth. Both start with $1,000 in wealth.

(5a) What will be the equilibrium outcome (t, g) if Tom and George make separate and simultaneous
choices of the number of hours to work, but do not make monetary exchanges of any sort? [6
points]

For fixed g, Toms first-order condition for an interior optimum is 1 4t + 3g = 0, or t*(g) = (1+3g)/4.
Similarly, for fixed t, Georges first-order condition is 2 6g + 4t = 0, or g*(t) = (1 + 2t) / 3.

Substituting the second equation into the first gives
t* = [1 + 3(1+2t*)/3 ] / 4
OR 4t* = (6 + 6t*) / 3
OR 12t* = 6 + 6t*
OR t* = 1.

Solving for g*, we then have g* = (1 + 2t*) / 3 = 1.

The equilibrium outcome if Tom and George choose t and g independently and simultaneously is
t = g = 1.

(5b) Explain why any Pareto optimal outcome (t, g, w
T
, w
G
) must include choices of t and g that
maximize the sum u(t, g) + v(t, g). [6 points]

Any outcome that does not maximize u(t, g) + v(t, g) does not maximize the sum of utilities for the two
consumers. It is possible to make a Pareto improvement by switching to values (t, g) that maximize the
sum of utilities and then transferring wealth between the consumers, since their utility functions are
linear in wealth with the same coefficient for each player.

(5c) Compare the first-order conditions from (a) and for maximizing the sum
u(t, g) + v(t, g). Use this comparison to demonstrate that the outcome in (a) is not Pareto optimal.
[6 points]

The sum of the two utility functions is t 2t
2
+ 7gt + w
T
+ 2g 3g
2
+ w
G
. Differentiating by t and g
separately yields two first-order conditions: 1 4t + 7g = 0 and 2 6g + 7t = 0. These resemble the
first-order conditions from (a) but with greater coefficients on the other persons choice variable,
reflecting the gains to Tom from increases in g and the gains to George from increases to t gains that
were not incorporated in the first-order conditions in part (a). Since the first-order conditions for
Pareto optimality do not match the first-order conditions for simultaneous individual optimization, the
result from (a) will not be Pareto optimal.


Note that we expect the Pareto optimal choices for g and t to be larger than the values that result when
George and Tom choose their actions simultaneously. The problem also contains one wrinkle that was
not intended to be included. In fact, the two first-order conditions for Pareto optimality give rise to
negative solutions for t and for g. This means that for any positive values of t and g, there is a gain to
increasing at least one of the two values. Mathematically, we should expect a corner solution to the
problem: at least one of the two values should be set to its maximum possible value.


(5d) Explain in words why the incentives in (a) do not lead Tom and George to a Pareto optimal
outcome. [6 points]

Acting on his own, each person neglects the positive externality that his choice has on the other
persons utility. As a result, each will stop working at a point where the sum of marginal utilities for
the two players is positive. That is, Tom and George will not work enough hours in (a) to achieve a
Pareto optimal outcome.

(5e) Describe a reform involving property rights that would enable Tom and George to achieve a Pareto
optimal outcome. Explain in words how this reform alters incentives to overcome the inefficiency
of the outcome from (a). [6 points]

Tom and George will achieve a Pareto optimum if either is granted the property right to set the level of
activity of the other person. That is, if Tom can make a take it or leave it offer to George where the two
would go ahead with the solution in (a) if George refuses the offer, then Tom will select values of (t, g)
to maximize the sum of their utilities. The reason is that Tom wants to maximize his own utility subject
to a constraint that George must receive his reservation utility level so that he accepts Toms offer.
Then Toms maximization problem is equivalent to the maximization problem to identify the Pareto
optimal choice of (t, g)..