SPRING 2012; BRAC UNIVERSITY, ESS ECO 205: Assignment 4 Solutions 1.

. Suppose that a rms advertising expenditures aect prots as follows: t = aEt (1 Et ) where, t is prot in period t and Et is advertising expenditure in period t. Assume further that the rm devotes a constant share, b > 0, of its current prots to the next years advertising campaign. This means: Et+1 = bt (a) Derive the dierence equation for advertising expenditure. (b) Find the steady-state values of E. (c) Derive the parametric restrictions that must be imposed for ensuring convergence of Et to the steady state. It is not necessary to draw a graph for this answer; just use your intuition and simple mathematics. (d) Given E0 = 0.690, calculate Et for t = 1, 2, 3, 4. Answer: (a) The dierence equation for advertising expenditures is obtained as: Et+1 = bt = abEt (1 Et ) (b) Steady state occurs when Et+1 = Et = E, which means: E = abE 1 E E 1 ab + abE = 0 where, either E = 0, or: 1 ab + abE = 0 ab 1 E= ab Therefore, the two steady states are 0 or ab1 . Note, however, that the second steady state is ab meaningful only if ab > 1. A strictly negative value for advertising expenditure at the steady state does not any economic sense. (c) For purposes of stability, compute the derivative: dEt+1 = ab 2abEt dEt Now, evaluating at the two steady states: At E = 0 : At E = ab 1 : ab dEt+1 = ab dEt dEt+1 = 2 ab dEt where, |ab| > 1, so, steady state is UNSTABLE where, steady state is STABLE if 1 < ab < 3

(d) The dierence equation for advertising expenditure is: Et+1 = abEt (1 Et )
2 = abEt abEt

Therefore, if E0 = 0.690( 0.7), then: E1 = ab(0.7) ab(0.7)2 = 0.21ab

2 E2 = abE1 abE1 = ab(0.21ab) ab(0.21ab)2 = 0.21a2 b2 0.044a2 b2 = 0.166a2 b2 2 E3 = abE2 abE2 = ab(0.166a2 b2 ) ab(0.166a2 b2 )2 = 0.166a3 b3 0.027a5 b5 2 E4 = abE3 abE3 = ab 0.166a3 b3 0.027a5 b5 ab 0.166a3 b3 0.027a5 b5 2

2. Let the demand and supply functions be: Qd = P + dP dt and Qs = + P

where, , , , > 0. Assume that the initial price is known to be P0 (when t = 0). (a) Assuming that the rate of change of price over time is directly proportional to the excess demand, nd the time path for price (the general solution). (b) What is the market-clearing equilibrium price? (c) What restriction on the parameter would ensure dynamic stability? Answer: (a) Price adjusts to excess demand according to the equation: P = (Qd Qs ) where, is a positive constant. Substituting the demand and supply functions: P = ( P + P + P ) (P P ) + (P + P ) = 0 (1 )P + ( + )P ( + ) = 0 ( + ) ( + ) P =0 P+ 1 1 ( + ) ( + ) P = P+ 1 1

(1)

where, equation (1) or (1a) is the autonomous, linear, rst-order dierential equation in price. Comparing with the standard form (y + ay = b), we nd that: a= ( + ) 1 and b= ( + ) 1

Now, to obtain the general solution, rst, nd the general solution to the homogeneous equation: Ph (t) = Ce 2
(+)t 1

Second, nd the particular (or steady state) solution: P = b ( + ) 1 + = = a 1 ( + ) +

where, it is assumed that + = 0. Therefore, the complete solution is: P (t) = Ce

(+)t 1

+ +

(b) The market-clearing equilibrium price will be the same as the steady state price (P ). (c) Since , , and are all positive, stability will be ensured if (1 ) > 0 or < 1. If < 1, then: Ce
(+)t 1

as

3. Let the demand and supply functions be: Qd = P 2 and Qs = 8P

Assume that price adjusts according to the equation P = (Qd Qs ), where, > 0. (a) Find the steady state price and check if the steady state is stable. (b) Draw a phase diagram and show/explain your results qualitatively. Answer: (a) The dierential equation for price can be obtained as: P = (Qd Qs ) P = P 2 + 8P = 0 P where, steady state occurs if P = 0: 8P = 0 P2 8P 2 = 0 1 p3 = 8 1 P = = $0.5 2 To check for stability, calculate: dP 2 = 3 8 dP P
1 And, at the steady state of P = 2 :

1 8P P2

Substituting the demand and supply functions

dP 2 = 1 8 = 16 8 = 24 < 0 dP 8 Therefore, the steady state is STABLE. 3

Since, > 0

(b) The following gure shows the phase diagram, where, the vertical axis plots the rst deriva tive of price, P , and the horizontal axis plots price, P . As can be seen from the gure, the P = 0 line intersects the horizontal axis when P = P = 0.5; which means that the steady state occurs at a price of $0.5.

change in price 20 10 0.2 10 20

For any price starting below the steady state, P > 0, and price will increase towards the steady state. For any price starting above the steady state, P < 0, and price will decrease towards the steady state. Therefore, the steady state price level is a STABLE equilibrium.

0.4

0.6

0.8

1.0

price