Examiners commentaries 2011

Examiners commentaries 2011

120 Mathematical economics
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 201011. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Specific comments on questions Zone B

SECTION A
Answer ALL questions from this section (8 marks each).
Question 1
Answer all parts of this question.
(a) Define the indirect utility function.
(b) State Roys identity.
(c) Confirm that Roys identity holds for the Cobb-Douglas utility function
1/2 1/2
u(x1 , x2 ) = x1 x2 .
(a) See definition 20, page 38 of the subject guide.
(b) Roys identity is stated as:
xi (p, m) =

V (p, m)/pi
.
V (p, m)/m

(c) We need to solve the utility maximisation problem:

1/2 1/2

max x1 x2

subject to

p1 x1 + p2 x2 = m.

First order conditions are:

1 1/2 1/2
x
x2 p1
2 1
1 1/2 1/2
p2
x x
2 1 2

0.

Hence:
1 1/2 1/2
x2
2 x1
1 1/2 1/2
2 x1 x2

x2
x1

x2

p1
p2
p1
p2
p1
x1 .
p2

120 Mathematical economics

By substituting in the constraint:

p1
x1
p2
2p1 x1

p1 x1 + p2

x1
x2

= m
= m
m
=
2p1
p1
p1 m
m
=
x1 =
=
.
p2
p2 2p1
2p2

Indirect utility function is:


V (p, m) =

m
2p1

1/2 

m
2p2

1/2
=

m
.
2(p1 p2 )1/2

Here:
1/2 1/2

mp1 p2
4p1 p2
1
.
2(p1 p2 )1/2

V (p, m)/p1

V (p, m)/m

Hence:
1/2 1/2

V (p, m)/p1
mp1 p2
=
V (p, m)/m
4p1 p2

1/2 1/2

2(p1 p2 )1/2 =

mp1 p2
m
=
1/2
2p1
2(p1 p2 )

which verifies Roys identity. Similar for x2 .

Question 2
Answer all parts of this question.
(a) Explain the meaning of the nonsatiation and transitivity assumptions in
consumer theory.
(b) Suppose that preferences can be represented by a utility function u(x1 , x2 ). Do
these preferences satisfy the transitivity assumption?
(c) Suppose that the utility function is differentiable and that the first order
derivatives of the utility function with respect to x1 and x2 are strictly positive.
Is it possible that the solution to the consumers utility maximisation problem
does not satisfy the budget constraint as an equality?
(a) See page 34 of the subject guide.
(b) Answer is yes. Candidates should prove this as follows. Take three bundles: x, y and z.
Assume that: x  y and y  z. We want to show that x  z. If preferences are represented
by a utility function u(.), then:
xy
yz

u(x) u(y)
u(y) u(z).

From above it follows that:

u(x) u(z)
which in turn implies that preferences satisfy transitivity:
x  z.

Examiners commentaries 2011

(c) Suppose that the utility function is differentiable and that the derivatives of the utility
function are strictly positive. Is it possible that the solution to the consumers utility
maximisation problem does not satisfy the budget constraint as an equality? No. Strictly
positive derivatives imply:
u(x + dx, y) u(x, y)
>0
lim
dx0
dx
hence, when dx > 0, we have u(x + dx, y) > u(x, y), which implies nonsatiation:
(x + dx, y)  (x, y) and in turn the fact that the budget constraint will be satisfied as an
equality at the optimum (i.e. utility can be increased if more income is spent on
consumption).

Question 3
Answer all parts of this question.
(a) Explain why ordinary differential equations have families of solutions rather
than unique solutions.
(b) Find the entire family of solutions to the following ordinary differential
equations:
i. y 00 61 y 0 16 y = 0
ii. y 00 + y 0 2y = 0
(a) See page 138 of the subject guide.
(b) i. Roots of the characteristic polynomial are 1/3, 1/2. It follows that:
y(x) = Aex/3 + Bex/2
for arbitrary A and B.
ii. Roots of the characteristic polynomial are 2, 1. It follows that:
y(x) = Ae2x + Bex
for arbitrary A and B.

Question 4
Answer all parts of this question.
(a) Define quasiconcavity.
(b) Prove that for any quasiconcave function f (x), the function f (x) is quasiconvex.
(c) Prove that all concave functions are quasiconcave.
(a) See definition 26, page 69 of the subject guide.
(b) Learning activity 5.1, page 69 of the subject guide.
(c) See theorem 16, page 70 of the subject guide.

Question 5
Let f (x; a) be a continuous function of x Rn and the scalar a. For any a, consider
the problem of finding the maximum of f (x; a) with respect to x. Let x (a) be the
maximiser which we assume to be differentiable with respect to a.

120 Mathematical economics

(a) Prove that:

da f (x (a); a)

a f (x (a); a).

(b) Provide an economic application of this result.

(a) This is the Envelope Theorem. See page 26 of the subject guide.
(b) Economic applications of the Envelope Theorem are, for example, Shephards lemma, or
Roys identity.

SECTION B
Answer THREE questions from this section (20 marks each).
Question 6
A firm with labour input L and capital input K has a production function,
f (L, K) = L0.25 K 0.25 .
The firm operates competitively in both the output good market and the input
factor markets. In the firms cost minimisation problem, the firm wishes to find the
combination of inputs (L, K) to minimise its production cost C = wL + rK of
producing an output of at least y, i.e. with an output constraint of f (L, K) y. w is
the wage level and r is the cost of the capital. w and r are both strictly positive.
(a) In the long-run, both the firms capital and labour are freely variable. Using the
Kuhn-Tucker conditions, find the long-run conditional labour and capital
demands L (w, r, y) and K (w, r, y) of the cost minimisation problem. What is the
resulting minimum cost C(w, r, y) of producing at least y?
Using
(b) In the short-run the firms choice of capital is constrained by K K.
Kuhn-Tucker conditions, find the short-run conditional labour and capital
demands L (w, r, y) and K (w, r, y) of the cost minimisation problem. What is the
resulting minimum cost C(w, r, y) of producing at least y?
(c) Prove that the cost function C(w, r, y) is homogeneous of degree one in input
prices (w, r) in all above cases.
(d) Are the conditional factor demands L (w, r, y) and K (w, r, y) homogeneous in
input prices (w, r)? If so, of what degree?
(a) First note that Kuhn-Tucker is a sufficient condition for x to be the solution to max g(x)
subject to h(x) k, where g(.) and h(.) are both defined on a convex set U Rn , if (i) g is
quasi-concave and differentiable, (ii) g 0 not all 0, and (iii) h is quasi-convex and
differentiable. Here the problem is,
min wL+rK
L,K

subject to

L0.25 K 0.25 y

max wLrK
L,K

subject to

L0.25 K 0.25 y.

Check: The domain (L, K) 0 is convex, wL rK is linear (and hence is quasi-concave)

and differentiable, and L0.25 K 0.25 is quasi-convex (as L0.25 K 0.25 is quasi-concave) and
differentiable. So form the Lagrangian,


L = wL rK + y + L0.25 K 0.25 .
The Kuhn-Tucker conditions are:


y L0.25 K

L
L
L
K

y

0.25

= w + 0.25L0.75 K 0.25 = 0
= r + 0.25L0.25 K 0.75 = 0
0
L0.25 K 0.25
= 0.

Examiners commentaries 2011

From the FOCs, we cannot have = 0 when w, r > 0. Hence we have > 0. The
complimentary slackness condition then implies that the output constraint must bind at y.
Solving the simultaneous equations yields,
L (w, r, y) =

 r 0.5
w

K (w, r, y) =

y2 ,

 w 0.5
r

y2 .

The cost function is then,

C(w, r, y) = wL + rK = 2(wr)0.5 y 2 .
This constraint is linear, and so is
(b) Now we have an additional constraint K K.
quasi-convex. From the argument above all conditions of the Kuhn-Tucker theorem are
satisfied. The Lagrangian is, this time,


K).
L = wL rK + y + L0.25 K 0.25 + (K
The Kuhn-Tucker conditions are:
L
L
L
K
,
y

0.25

= w + 0.25L0.75 K 0.25 = 0
= r + 0.25L0.25 K 0.75 = 0


0.25
yL K
=
K



K K =

0
L0.25 K 0.25
0

K
0.

The problem is the same as above if = 0. Then the solutions are:

L (w, r, y) =

 r 0.5
w

y2 ,

K (w, r, y) =

 w 0.5
r

y2

C(w, r, y) = 2(wr)0.5 y 2

provided that K is feasible, i.e.

K (w, r, y) K

 r 0.25
w

0.5 .
K

0.25 0.5

Again from the

When y > wr
K
this is not feasible, and we have the binding K = K.
first FOC cannot equal 0. So the first complimentary slackness implies that
0.25 = y, or
L0.25 K
1 y 4 .
L (w, r, y) = K
From the FOCs then,
0.25 = 4wK
1 y 3
= 4wL0.75 K
0.75 = wK
2 y 4 r.
= r + 0.25L0.25 K
is clearly non-negative. is non-negative if
2 y 4 r
wK

 r 0.25
w

0.5 .
K

In this case the cost function is

1 y 4 + rK.

C(w, r, y) = wK
Thus in summary:

0.25 0.5




, L = r 0.5 y 2 , K = w 0.5 y 2 and C = 2(wr)0.5 y 2 .
If y wr
K
w
r

0.25 0.5
,L =K
1 y 4 , K = K
and C = wK
1 y 4 + rK.

If y > wr
K

120 Mathematical economics

(c) For the long-run case

C(tw, tr, y) = 2(twtr)0.5 y 2 = 2t(wr)0.5 y 2 = tC(w, r, y).

0.25 0.5

The short-run case when y wr

K
is the same as in the long-run. When


r 0.25 0.5
y> w
K ,
1 y 4 + trK
= tC(w, r, y).
C(tw, tr, y) = twK
Therefore the cost functions are homogeneous of degree 1 in all cases.
(d) For the long-run case
 0.5
 0.5
tw
tr
2

y = L (w, r, y),
y 2 = K (w, r, y).
K (tw, tr, y) =
L (tw, tr, y) =
tw
tr

0.25 0.5

The short-run case when y wr

K
is the same as in the long-run. When


0.25
r
0.5

K , both factor demands are independent of the factor prices. Hence the
y> w
factor demands are homogeneous of degree 0 in all cases.

Question 7
You find that consumer As Arrow-Pratt coefficient of absolute risk aversion rA is
constant at b > 0, where
Coefficient of absolute risk aversion rA =

u00A (w)
u0A (w)

(.1)

and uA (w) is the utility function of wealth w for consumer A. Given this, you decide
to investigate the family of functions uA (w) with the property rA = b. You also know
that the utility of no wealth uA (0) = 0.
(a) By letting v(w) = u0A (w) in (.1), solve the first-order differential equation for the
function v(w). Hence solve for the family of functions uA (w) that satisfy rA = b.
In contrast, you find that consumer Bs coefficient of absolute risk aversion is
linearly decreasing in wealth, i.e.

u00B (w)
c
= rB =
0
uB (w)
w

(.2)

where c > 0 is a constant.

(b) Solve for the family of functions uB (w) that satisfy (.2) for all values of c > 0.
Hence show that such function cannot exist with property uB (0) = 0 when c = 1.
(c) What restrictions on the parameters are required for consumers A and B to
have monotonically increasing and strictly concave utility functions? You may
assume that c 6= 1.
(a) By letting v(w) = u0A (w), (.1) becomes
dv
= bv.
dw
Solving this,
Z

dv
= b
v

Z
dw

ln v = bw + C

v = k1 ebw

for some constant k1 . Now substituting back u0A (w) = v(w),

duA
= k1 ebw
dw

uA =

k1 bw
e
+ k2
rA

Examiners commentaries 2011

for some constant k2 . Finally we know that uA (0) = 0, and hence,

uA (0) =
Thus uA (w) =

k1
b (1

k1
+ k2 = 0
b

k2 =

k1
.
b

ebw ).

(b) Similarly by letting v(w) = u0B (w), (.2) becomes

dv
cv
= .
dw
w
Solving this,
Z
Z
dv
dw
= c
v
w

ln v = c ln w + D

v = k3 ec ln w = k3 wc

for some constant k3 . Substituting back u0B (w) = v(w) then,

 k3 1c
du
+ k4 ,
c
1c w
= k3 w
uB =
k3 ln w + k4 ,
dw

c 6= 1
c=1

for some constant k4 . For c 6= 1, uB (0) = 0 implies k4 = 0. However, there is no feasible

solution for c = 1 as uB (0) = for all values of k3 and k4 .
(c) Monotonically increasing utility function means u0 (w) > 0; strict concavity requires
u00 (w) < 0. For A then,
u0A (w) = k1 ebw

u00A (w) = bk1 ebw .

Then given that b > 0, we require k1 > 0. For B, for c 6= 1,

u0B = k3 wc

u00B = ck3 wc1 .

c > 0 then implies that k3 > 0.

Question 8
Dr London has to mark N exam scripts in T days, where 2 < T < . If on day t he
marks st scripts, then his disutility on that day is s2t . Dr London therefore solves the
following dynamic optimisation problem with discount factor , where 0 < 1,
min

{st }T
1

T
X

t s2t

T
X

subject to

t=1

st = N

and

st 0, t = 1, 2, . . . , T.

t=1

(a) Formulate this problem as a dynamic programming problem, and write down
the Bellman equation.
(b) Solve the problem by backward induction to find st , t = 1, . . . , T , in terms of N , ,
t and T . You may guess the form of the Bellman value function, but you must
verify your guess by showing that the Bellman equation is satisfied.
(c) Is st increasing, decreasing or constant over time? In particular, what can you
say about Dr Londons optimal marking schedule when = 1?
(a) Turning the minimisation problem into a maximisation problem by changing the sign of the
objective function, define the Bellman value function as,
V (n , ) = max
{st }T
1

T
X

t s2t

subject to

t=

The Bellman equation is then



V (n , ) = max s2 + V (n +1 , + 1)
s

T
X

st = n .

t=

subject to

n +1 = n s .

120 Mathematical economics

(b) On the last day Dr London has to mark all remaining scripts, i.e. sT = nT . There is
therefore no maximisation on the last day, and his value function is V (nT , T ) = n2T . Next
consider day T 1:


V (nT 1 , T 1) = max s2T 1 + V (nT , T )
subject to
nT = nT 1 sT 1
sT 1


= max s2T 1 + V (nT 1 sT 1 , T )
sT 1


= max s2T 1 (nT 1 sT 1 )2 .
sT 1

The first order condition is

2sT 1 + 2(nT 1 sT 1 ) = 0

nT 1 .
1+

sT 1 =

Plugging back in

V (nT 1 , T 1) =

nT 1
1+

2


nT 1

nT 1
1+

2
=

n2 .
1 + T 1

Try another day:

V (nT 2 , T 2)

=
=



max s2T 2 + V (nT 2 sT 2 , T 1)
sT 2



(nT 2 sT 2 )2 .
max s2T 2
sT 2
1+

The first order condition is

2sT 2 + 2

2
(nT 2 sT 2 ) = 0
1+

sT 2 =

2
nT 2 ,
1 + + 2

in which case

2
n2 .
1 + + 2 T 2
So we conjecture that Dr London will mark s on day with the Bellman value function
V (n , ), where,
T
T
s = PT n ,
V (n , ) = PT n2 .
(.3)
i
i
i=0
i=0
V (nT 2 , T 2) =

To verify this, we show that this solves the Bellman equation for any given date ,


V (n , ) = max s2 + V (n s , + 1)
s
(
)
T 1
2
2
= max s + PT 1 (n s ) .
s
i
i=0
Substituting in s in (.3) on the RHS,
!2
!2
T
T
T
+ PT 1
n PT n
PT n
i
i
i
i=0
i=0
i=0
!2
!
PT 1 i 2

T
T
2
i=0
n + PT 1
n2
= PT
PT i
i
i

i=0
i=0
i=0

P
2
T 1 i
T
+ T i=0
2

=
n
P
2
T i
i=0
P

T i

T
i=0
2
=
P
2 n
T i
i=0
=

T
PT
i=0

n2

Examiners commentaries 2011

which equals the LHS as given in (.3).

So starting from t = 1, where n1 = N , Dr London marks s1 leaving n2 for day 2 and
beyond, where,
!
PT 2 i

T 1
T 1
N.
N = PTi=0
s1 = PT 1 N n2 = N s1 = 1 PT 1
1 i
i
i
i=0
i=0
i=0
Similarly on day 2,
s2
n3

PT 2 i

T 2
T 2
T 2
= PT 2 n2 = PT 2 Pi=0
N
=
N
P
T 1 i
T 1 i
i
i
i=0
i=0
i=0
i=0
!
PT 2 i
PT 3 i

T 2
i=0
= n2 s2 = PT 1 PT 1
N
N = Pi=0
T
1
i
i
i
i=0
i=0
i=0

and so on. Hence,

T
s = PT 1
i=0

PT

and

n = Pi=0
T 1
i=0

i
i

N.

(c) For < 1, s is increasing in . For = 1, it is constant at N/T , i.e. Dr London marks an
equal number of scripts.

Question 9
A planning agency is interested in the impact of consumption on the level of
pollution faced by a society. Let ct be the societys consumption at date t, and t the
level of pollution measured at date t. The planner seeks to determine the pair (c, )
that maximises social welfare under the constraint of pollution accumulation.
Formally, the problem to be solved is the following:
Z
max
et [u(ct ) v(t )] dt
0

subject to:
t = act bt d
with 0 given, where is the discount factor, and a, b and d are positive constants.
Both u(.) and v(.) are continuous and differentiable functions; u(.) is increasing and
concave in ct and v(.) is increasing and convex in t .
(a) Determine which are the control and state variables. Comment on the economic
interpretation for the objective function and the constraint.
(b) Set up the Hamiltonian.
(c) Show that the following condition must hold at the optimum:
u0 (ct ) = at et .
(d) Using the Hamiltonian system, show that the optimal consumption satisfies the
following condition:
u00 (ct )ct = (b + )u0 (ct ) av 0 (t ).
(a) State variable is t and control variable is ct . Welfare is increasing with consumption but
decreasing with pollution. There is a trade-off between consumption and pollution because
an increase in consumption has a positive impact on pollution through the constraint, which
in turn decreases welfare.

120 Mathematical economics

(b) The present value Hamiltonian can be written as:

H = et [u(ct ) v(t )] + t (act bt d)
where t is the co-state variable.
(c) The first order condition is
H
=0
ct

et u0 (ct ) + t a = 0.

Hence we obtain
u0 (ct ) = at et
as requested.
(d) We have that:
H
t
H
+
t

t = et v 0 (t ) + t b

t = act bt d.

Also, the transversality condition:

lim t = 0.

Recall that
u0 (ct ) = at et .
We differentiate with respect to time, to find:
u00 (ct )ct = a t et at et .
Recall:
t
t

= et v 0 (t ) + t b
u0 (ct ) t
=
e .
a

By substituting, we get:
u00 (ct )ct

= a[et v 0 (t ) + t b]et at et
= av 0 (t ) at bet at et
= av 0 (t ) at (b + )et
u0 (ct ) t
= av 0 (t ) + a
e (b + )et
a
= (b + )u0 (ct ) av 0 (t ).

Question 10
Answer all parts of this question.
(a) Consider a consumer with the following indirect utility function:
V (p1 , p2 , m) = p1m
+p2 .
i. Find the consumers demand functions x1 (p1 , p2 , m) and x2 (p1 , p2 , m).
ii. Find the consumers expenditure function e(p1 , p2 , u).
iii. From your answer to (ii), what can you say about the type of preferences
that this consumer has? What is his utility function u(x1 , x2 )?
(b) Consider a consumer with preferences: u(x1 , x2 ) = max{x1 , x2 }.
i. Find the consumers indirect utility function.

10

Examiners commentaries 2011

ii. Find the consumers expenditure function.

(a) i. We use Roys identity to find the consumers demand functions:
x1 (p, m)
x2 (p, m)

m
V /p1
=
V /m
p1 + p2
V /p2
m
=
=
.
V /m
p1 + p2
=

ii. We invert the indirect utility to find the expenditure function:

V (p, e(p, u)) = u
e(p, u)
= u
p1 + p 2
e(p, u) = u(p1 + p2 ).
iii. This expenditure function shows us that to get u utils we need to buy u units of good 1
and u units of good 2. Hence the two goods are perfect complements and the utility
function is:
u(x1 , x2 ) = min{x1 , x2 }.
(b) i. With utility function u(x1 , x2 ) = max{x1 , x2 } the two goods are perfect substitutes.
Demands are:
If p2 p1 , then x1 = pm1 and x2 = 0.
If p2 p1 , then x1 = 0 and x2 = pm2 .
Hence the indirect utility function is:
V (p, m) =

m
.
min{p1 , p2 }

ii. We find the expenditure function by inverting the indirect utility function:
V (p, e(p, u)) = u
e(p, u)
= u
min{p1 , p2 }
e(p, u) = u min{p1 , p2 }.

11