ECONOMICS 1011A, PROBLEM SET 1

Stefan Spataru
Pfortzheimer House, Wolbach 304
Cambridge, MA 02138
stefanspataru@college.harvard.edu
Problem 1
(1) (K, r, P, A) = pf (K, A) rK
(K, r, P, A)
= pfK (K, A) r
K
The first order condition is thus
r
p
(2) The second order derivative is fK,K (K , A) < 0.
(a)
fK (K , A) =

1
1
fK (K, A) = A K 2
2
The 2nd order condtion is satisfied, since
3
1
fK,K (K, A) = A K 2 < 0
4
Now, we have to solve

A K 2 =

2r
p

)2 .
and thus K (r, p, A) = ( Ap
2r
(b)
fK (K, A) = A K
fK,K = 1
Now, this means that f is convex and the 2nd order condition is satisfied. Well
just need to solve
fK (K, A) = A K
since well assume the solution is interior. Thus, we have to solve for
A K (r, p, A) =

r
r
Ap r
K (r, p, A) = A =
p
p
p

c)
Date: September 13, 2016.
1

fK (K, A) =
fK,K =

eK
A

eK
<0
A

Thus, we have to solve for

eK(r,p,A)
r
=
A
p
or
eK

(r,p,A)

Ar
p

p
) = ln( Ar
).
or K (r, p, A) = ln( Ar
p
Ar
Now, if p 1, then this is the answer. Otherwise, this is negative, and since
fK (K, A) > 0, it means that the maximum is not achieved, and since

peK
p
= pfK (K, A) r =
r r <0
K
A
A
and thus is decreasing in K and thus the maximum is achieved at K = 0. Thus,
for Ar
1, we have that K (r, p, A) = 0. However, for the rest of the problem, I will
p
asumme this pathological case does not occur (i.e p > Ar)

measures the partial change in the optimal quantity(the profit maximizing

(3) a) K
r
quantity) with a marginal change in the price of droids.
b) We have to solve for
fK (K (r, p, A), A) =

r
p

Differentiate with respect to r to get:

fK,K (K (r, p, A))

K (r, p, A)
1
=
r
p

Therefore,
1
K (r, p, A)
=

r
pfK,K (K (r, p, A), A)
Now, for each of the 3 functions, we have:
a)
1
K (r, p, A)
=

r
pfK,K (K (r, p, A), A)
1
=
3
1

p 4 AK (r, p, A) 2
=

4
Ap
A2 p2
( )3 =
Ap 2r
2r3
2

 b)
K (r, p, A)
1
1
1
=
=
=

r
pfK,K (K (r, p, A), A)
p
p
c)
K (r, p, A)
1
=

r
pfK,K (K (r, p, A), A)
K (r, p, A)
=
r
p

1
eK(r,p,A)
A

1
K (r, p, A)
=
Ar
r
p Ap
K (r, p, A)
1
=
r
r
c) We now have to differentiate directly. The theory tells us that the two procedures
should give us the same result. Indeed:
a)
( Ap
)2
1
A2 p2
K (r, p, A)
2r
=
= (Ap)2 (2) r3 =
r
r
4
2r3
b)
Apr
p
r

r
p

r
p

1
p

c)
)
ln( Ar
p
r

1 A
1
= Ar =
p
r
p

Thus, we achieve identical results through the two methods.

(4) a)
2

(Ap)2
K
Ap2
= 4r = 2 > 0
A
A
2r
This means that a marginal increase in technology would result in an increase in
the optimal price.
1

= pf (K, A) rK = pAK 2 rK
1

= pAK 2 rK
= pA

Ap
A2 p2
r 2
2r
4r
3

(Ap)2 (Ap)2

2r
4r2

(Ap)2
=
4r2

Now,
(Ap)2

=
>0
A
4r2

Now,
> 0 and thus a marginal increase in technology results in a marginal
A
increase in profits.
c) K = ln Ar
p
Then,
K
r p
1
=
= >0
A
p Ar
A
This means that a marginal increase in technology implies a marginal reduction in
the optimal price.
Now,
= pf (K , A) rK

= p(1

eK
) rK
A

eK
rK )
= p(1
A

= p(1
= p

Ar
p

) + r ln

Ar
p

1
Ar
+ r ln
r
p

r p
=r
A
p Ar
r
= >0
A
Therefore, a marginal increase in technology would result in a marginal increase
in profits.
A priori, it makes sense for the profits do not decrease (and even increase), cause
they cannot make less profits than before. (at the end of the day, they could use the
former, worse technology to get the same output).
(5) a)
Lets analyze the two proposals
4

 For the first proposal, remark that the model is the same, except r r (1 sK )
(we tehnically just have a lower price r. Thus, by the model developed in part
b), the demand curve should be given by
Ap
)2
2r(1 sK )
For the second proposal, lets set up the profit function.
K = (

= pf (K, A) rK + S

Thus,
= pfK (K, A) r, which is the same as the derivative of the profit
function in part 2. Thus, the 1st and 2nd order conditions are the same, and
thus the maximizing quantity Q is the same, i.e. K = ( Ap
)2 .
2r
b) We can obviously see that the 2nd proposal does not result in an increase of the
output. However, for any procentual subsidy, doesnt matter how small, the output
quantity will increase. (since 1s1 K > 1).
Ap
c) When sK 1, ( 2r(1s
)2 , so therefore with larger subsidies they will tend
K)
to produce larger and larger quantities of output. For sk 1, then the quantity
2 2
of output will be A16rp2 . Therefore, a technical doubling of prices results in the firm
making a quarter as much output as before.
(6) a) The profit function is just
= pf (K, A) r(1 sK )K S
b)
Now,

= pfK (K, A) r(1 sK ), and thus the firm maximizes for K =

1
= 4(1s
2.
4r2 (1sK )2
K)
Thus, the profit function is
A2 p 2

= f(

1
1 sK
, 1)
S
2
4(1 sK )
4(1 sK )2

Therefore,
=

1
1

S
2(1 sK ) 4(1 sK )

1
S
4(1 sK )
1
Now, 4(1s
14 , and thus for S < 14 , there is no SK with this property, since
K)
profits would always be non-negative. Therefore, the firm would operate even with
no subsidy(so sK = 0). Otherwise:
=

1
=S
4(1 sK )
1 sK =
5

1
4S

sK =

4S 1
4S

Problem 2
(1)
1
K
1
= (K1 + (1 )K2 ) 1 K11
K1

= (K1 + (1 )K21 ) 1 K11

Now, absolutely similar,
1
K
= (1 ) (K1 + (1 )K2 ) 1 K21
K2

Thus,
X=

K
K1
K
K2

K1
( )1
1 K2

Thus,
X(1 )
K1 1
) = log
log(
K2

Thus,
( 1) log

K1
= log X + log(1 ) log
K2

(1 ) log

K2
= log X + log(1 ) log
K1

Thus,
log

K2
log X + log(1 ) log
=
K1
1

And thus
Thus,
=
A(K1

K2
log K
1

log X

1
1

)K2 ) .

(2) g(K1 , K2 ) =
+ (1
We will compute the partials:
gK1 =

A
A(K1 + (1 )K2 ) 1 K11

gK1 = A (K1 + (1 )K2 ) 1 K11

Then
6

gK1 ,K1 = A((K1 +(1)K2 ) 1 (1)K12 +( 1)(K1 +(1)K2 ) 2 K11 K11 ) =

gK1 ,K1 = A(K1 + (1 )K2 ) 1 K12 (( 1)(K1 + (1 )K21 ) + (

1)K1 )

= A(K1 + (1 )K2 ) 2 K12 (( 1)(K1 + (1 )K2 ) + ( )K1 )

= A(K1 + (1 )K2 ) 2 K12 (( )K1 + ( 1)(1 )K2 )

Now, gK1 ,K1 < 0, since A(K1 + (1 )K2 ) 2 K12 > 0, since it is only
composed of positive terms. However, < 0, since > 0 and < 1. Similarly,
1 < 0, since < 1. Thus, the last paranthesis is a negative term and therefore
the whole thing is negative. Similarly,

gK2 ,K2 = A(1 )(K1 + (1 )K2 ) 2 K22 ((1 )( 1)K2 + ( 1)K1 )

and it is negative. Now, we want to compute
gK1 ,K2 =

g1
= A(1 )( )(K1 + (1 )K2 ) 2 K11 K21
K2

Now,
gK1 ,K1 gK2 ,K2
(( 1)K1 + ( 1)(1 )K2 )((1 )( 1)K2 + ( 1)K1 )
=
2
gK
(1 )( )2 K1 K2
1 ,K2
=

(1 )(( 1)2 + ( 1)2 )K1 K2 + (1 )(1 )2 K12 + (1 )2 (1 )(1 )K22

(1 )( )2 K1 K2
(1 )(( 1)2 + ( 1)2 )K1 K2
>
(1 )( )2 K1 K2
(1 )2 + (1 )2
=
( )2
Now, I claim that x2 + y 2 (x y)2 for non-negative x, y. To see why this is true,
remark that (x y)2 = x2 + y 2 2xy x2 + y 2 and for x = 1 and y = 1 we
get that
gK1 ,K1 gK2 ,K2
>1
2
gK
1 ,K2
and thus this is the last step to prove g is concave.
7

(3) The profit functions is

= p g(K1 , K2 ) r1 K1 r2 K2
Lets remark that the 2nd order conditions for a maximum are satisfied since
K1 ,K1 = gK1 ,K1 , K1 ,K2 = gK1 ,K2 , K2 ,K2 = gK2 ,K2
Now, the 1st order conditions are
g

=0p
= r1
K1
K1

or

(K1 + (1 )K2 ) 1 K11 =

r1
Ap

Absolutely similar,

(K1 + (1 )K2 ) 1 K21 =

r2
A(1 )p

Then,
(

K1 1 r1 (1 )
)
=
K2
r2

Thus,
1
K1
r1 (1 ) 1
)
=(
K2
r2

(K2 ( (

1
r1 (1 ) 1
r2
)
+ (1 ))) 1 K21 =
r2
A( 1)p

K21 ( (

1
r1 (1 ) 1
r2
)
+ (1 )) 1 =
r2
A( 1)p

Therefore,
s

1
r2
r1 (1 ) 1
( (
)
+ (1 )) 1
A( 1)p
r2
Absolutely similarly
r

1
r2
r1

1
K1 =
((1 ) (
) 1 + ) 1
Ap
r1 (1 )
(4) Remember that

K2 =

r1
p
r
2
gK2 (K1 , K2 ) =
p
Use the implicit function theorem for K1 , K2 , and differentiate the last 2 equations
w.r.t r. We get
gK1 (K1 , K2 ) =

K1
K2
+ gK1 ,K2
=0
r2
r2
K2
1
K1
+ gK2 ,K2
=
gK1 ,K2
r2
r2
p
Multiply the first line by gK2 ,K2 , the 2nd by gK1 ,K2 and subtract them to get that
gK1 ,K1

2
(gK1 ,K1 gK2 ,K2 gK
)
1 ,K2

K1
gK ,K (K , K )
= 1 2 1 2
r2
p

therefore,
K1
gK1 ,K2 (K1 , K2 )
=
2
r2
p(gK1 ,K1 gK2 ,K2 gK
)
1 ,K2
2
Now, we know that gK1 ,K1 gK2 ,K2 gK1 ,K2 ) is positive since g is convex. It means
it all depends on the sign of gK1 ,K2 . Rembember that

gK1 ,K2 = A(1 )( )(K1 + (1 )K2 ) 2 K11 K21

The sign of this expression obviously depends only on the sign of . Therefore,
K
if > , then r21 < 0, so the quantity of K1 decreases with an increase in r2 , if
K

= , then r21 = 0, and thus K1 remains constant, and if < , then

and K1 increases with an increases in r2 .

K2
r2

> 0,