EVALUATION GUIDELINES - Course paper

Component of continuous assessment

GRA 65161
Economics for Finance

Department of Economics

Start date: 13.11.2020 Time 12:00

Finish date: 20.11.2020 Time 12:00

For more information about formalities, see examination paper.

 Midterm Exam-2020

GRA 6516-Economics for Finance

Demand Functions

1. Let x1 and x2 denote two goods. Consider the problem of a consumer

choosing a bundle ( x1 , x2 ) in a shop, given prices p1 Euros and p2 Euros,
and given that total income available is m Euros. Suppose further that
tastes can be represented by a Cobb Douglas utility x11/2 + x21/2 .
This problem can be written mathematically as

max x11/2 + x21/2

x1 ,x2

st:

p1 x1 + p2 x2 = m

(a) Setup the Lagrangian for this problem.

Answer.
L = x11/2 + x21/2 − λ( p1 x1 + p2 x2 − m)

(b) Derive the first order condition for x1 , x2 and m.

1
 Answer. The FOCs are
1 −1/2
x − λp1 = 0
2 1
1 −1/2
x − λp2 = 0
2 2
p1 x1 + p2 x2 − m = 0

(c) Derive the demand for x1 and x2 .

Answer. Compute the MRS

x1−1/2 p1
=
x2−1/2 p2

Solving for x2 we get

! "2
p1
x2 = x1
p2

Plus this into the budget constraint

! "2
p1
p1 x1 + p2 x1 = m
p2

and solving for x1

m
x1 = # $
p1
p1 1 + p2

and hence using the MRS we get

m
x2 = # $
p2
p2 1 + p1

(d) Are goods x1 and x2 substitutes or complements?

Answer. The goods are substitutes, as an increase in p2 rises the

demand for x1 .

2
 (e) Compute the share of income spent on x1 .

Answer. The share spent on good 1 is

p1 x1 p2
=
m p1 + p2

Hence, the higher the price of p2 more is spent on good 1.

Market Equilibrium

2. Suppose the demand function for merino ewes is D ( p) = 100/p, and

the supply function is S( p) = p.

(a) Plot both curves on a graph.

Answer.

(b) Compute the equilibrium quantity and price.

3
 Answer. S( p) = D ( p) implies that p = 100/p, which gives as an
equilibrium price p = 10. The equilibrium quantity is S( p) = 10

(c) Now, consider that the effect of an ad-valorem tax of 300% im-
posed on merino ewes, so the price paid by demanders is four
times the price deceived by suppliers. What is the equilibrium
price paid by demanders, suppliers and the equilibrium quantity?

Answer. In the case of consumers, they have to pay a higher price,

100
p(1 + τ ), so now the demand function is D ( p) = p (1+ τ )
where
τ = 300%.

We know that τ = 300%, so the equilibrium is now S( p) = D ( p) =

100 100
p (1+ τ )
which simplifies to p = 4p solving gives p = 5. This is
the value recieved by producers. The prices paid by consumers is
pc = p(1 + τ ) = 4p = 20. The quantity produced and consume is
the same and it is S( p) = D ( p) = 5

(d) Compute the deadweight loss of this tax.

Answer. To compute the deadweight loss we should compute the

area A + B in the figure below:

4
 Since the demand is not linear we need to integrate to find the
areas A and B.
! 10
100 log( p) = 69.3
5

Hence, the deadweight loss is

DW L = 69.3 − 5x5 − (5x5)/2 = 31.8

An approximate solutions would be

( pc − p)(qo −q1 ) (20−5)(10−5) (20−5)(10−5)
The area A + B = 2 = 2 = 2 =
37.5

Cost Minimization

3. Nadine sells user-friendly software. Her firm’s production function is

f ( x1 , x2 ) = x1 + 2x2 , where x1 is the amount of unskilled labor and x2 is

5
the amount of skilled labor that she employs.

(a) Draw the isoquant representing input combinations to produce 20

units of output. Draw another isoquant representing input com-
binations to produce 40 units of output.

Answer. In general y = x1 + 2x2 , so for any value of y the isoquant

is found by setting x1 = 0 and x2 = 0, to find the points of the
isoquant in the plane ( x1, x2 ). For y = 20, we have that when
x1 = 0 the value of x2 = 10. In the same way, if x2 = 0 then
x1 = 20. In the figure below this is the blue line.

For y = 40, we have that when x1 = 0 the value of x2 = 20. In the

same way, if x2 = 0 then x1 = 40. In the figure below this is the
red line.

(b) If Nadine uses only unskilled labor, how much unskilled labor
would she need to produce y units of output? How about is she

6
 uses only skilled labor, how much unskilled labor would she need
to produce y units of output?

Answer. Only unskilled labor implies that x2 = 0. In this case the

unskilled workers needed is x1 = y.

Only skilled labor implies that x1 = 0. In this case the skilled

workers needed is x2 = y/2.

(c) If Nadine faces factor prices (w1 , w2 ) = (1, 1), what is the cheapest
way for her to produce 20 units of output?

Answer. In this case the relative cost w1 /w2 = 1 which is greater

than the relative wage which makes the producer indiferent: w1 /w2 =
1/2. In this case the producer will only hire skilled labor: they
have the same cost than the unskilled ones, but twice as much
productivity. The quantity hired is x2 = 10.

(d) If Nadine faces factor prices (w1 , w2 ) = (1, 3), what is the cheapest
way for her to produce 20 units of output?

Answer. In this case the relative cost w1 /w2 = 1/3 which is smaller
than the relative wage which makes the producer indiferent: w1 /w2 =
1/2. In this case the producer will only hire unskilled labor: they
have lower cost than more than compensates for the smaller pro-
ductivity. In this case, x1 = 20.

7
Production in General Equilibrium

4. Consider a representative agent with the utility function

U = log Ct + γt log(1 − Nt )

The budget constraint is

Ct = wt Nt + Dt

where where wt is the wage and Dt is non-wage income (i.e. a dividend

from ownership in the firm). The agent lives for only one period (period
t), and hence its problem is static.

(a) Derive an optimality condition characterizing optimal household

behavior.

Answer. Replace the budget constraint into the utility function to

get

max U = log(wt Nt + Dt ) + γt log(1 − Nt )

Nt

The derivative wrt to Nt is

wt γt
=
wt Nt + Dt 1 − Nt
or
γt (wt Nt + Dt )
wt =
1 − Nt

(b) Solve for the optimal quantities of consumption and labor.

Answer. Solving for Nt we get

8
 1 γt Dt
Nt = −
1 + γt 1 + γt w t
which can be negative. Hence, we have

% &
1 γt Dt
Nt = max 0, −
1 + γt 1 + γt w t
Consumption can be found using the budget constraint, Ct =
w t + Dt
1 + γt

(c) Suppose that the government implements a lump sum subsidy to

all workers, Tt . It engages in no spending and has no budget con-
straint to worry about; hence it can choose Tt however it pleases.
The household’s budget constraint is now:

Ct = wt Nt + Dt + Tt

How are the optimal quantities of Ct and Nt affected by the intro-

duction of the subsidy? Specifically, do people consume more or
less leisure? What is the economic intuition for this?

Answer. The tax raises the income that is not related to wages. The
solution (ignoring negative values) is

1 γt Dt + Tt
Nt = −
1 + γt 1 + γt w t
and consumption

wt Dt + Tt
Ct = wt Nt + Dt + Tt = +
1 + γt 1 + γt

9
 Consumption goes up and labor goes down. The lump sum trans-
fer is a pure income effect.

The New Keynesian Model

5. Consider the Neoclassical and the Standard New Keynesian Models. In

particular, recall that when per period utility is u(Ct , 1 − Nt ) = log(Ct ) +
θt log(1 − Nt ), the parameter θt represents an exogenous preference pa-
rameter. An increase in θt means that the households value leisure more
relative to consumption. This questions asks you to consider the effect of
an increase in θt in the two models.

(a) Graphically show how consumption, investment, the real wage,

and the labor input change change in response to a change in θ in
the Neoclassical model.

Answer. The labor supply curve shifts to the left. The equilibrium
wage increase and labor decrease. Equilibrium output falls and
real interest rises. Hence, consumption and investment decrease
lowering aggregate expenditure.

10
(b) Graphically show how this affects the endogenous variables of
the in the simple sticky-price model. Discuss how consumption,
investment, real interest rate, the real wage, and the labor input
change.

Answer. Since the price is fixed, there is no change in the AS curve,

and no change in Yt and rt . Since interest rate does not change

Since there is no change in the production function, there no change

in Nt .

11
(c) Graphically show how this affects the endogenous variables of the
in the partial sticky-price model. Discuss how consumption, in-
vestment, the real wage, and the labor input change.

Answer.

12
13