Answer to Problem 2

First we solve the cost minimization problem in sector 1. The Lagrangian

is L = wL + rK + (1 K L1 ). The first order conditions are

r = K 1 L1 and w = (1 )K L

From the two equations and the constraint

(1 )
K=
r and L = w
(1)

Substituting into the constraint

   (1 )  1
= (2)
r w

From (1) and (2)

w 1 1 w





aK (w, r ) = r 1 and a L (w, r ) = r 1
(3)

1. Remember that c(w, r ) = c(w, r ) = w a L (w, r ) + r aK (w, r ). From

(3) the unit cost function for sector 1 is

c1 (w, r ) = r w1 C ()

1



where C () := 1 + 1 .

2. Remember the iso-cost curves are defined by pi = ci (w, r ) for i =

 1 1
p
1, 2. Hence, r = r1 (w, p1 ) := C(1) w1 . We obtain r10 (w, p1 ) =

  1
Cp(1) 1 w < 0 and r100 (w, p1 ) > 0. Note from p.10 in lecture
note 2 that in equilibrium dr
dw = aa1K
1L
= wr 1 which coincides with
r10 (w, c1 (w, r )) = wr 1 .
1 1
1 1
 1

p1 p2
w 1

3. Equating r1 (w, p1 ) and r2 (w, p2 ), C ()
= C ( )
w . Solv-

 1   1 
p2 C ()
ing for w, w =

C ( ) p1 .

1
4. Now r10 (w ) > r20 (w ) < . This is when the capital share in
production in sector 1 is smaller than in sector 2; when sector 1 is
labor intensive.

5. You must make your own case by providing evidence (data, obser-
vation, survey, etc.) and argue based on the model. Tell your own
story!