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# ECON 8010 PROBLEM SET #2 SOLUTIONS FALL 2016

Total Points: 40

## x(K,L) = 0.5K1/2 + 0.5L1/2

Derive the profit-maximizing, competitive firm’s demand function for labor L*(r,w,p),
where r is the per-unit price of capital, w is the per-unit price of labor, and p is the per-unit
price of output, and, if possible, determine the sign of ∂L*/∂w.

## The profit equation is

π = pX(K,L) – rK – wL

= p[0.5K1/2 + 0.5L1/2] – rK – wL

## The F.O.C.s for a profit maximum are

∂π/∂K = p(1/4)K-1/2 – r = 0

∂π/∂L = p(1/4)L-1/2 – w = 0.

(L/K)1/2 = r/w

K = (w/r)2L

## Because X(K,L) = 0.5K1/2 + 0.5L1/2 is strongly (additively) separable in K and L, we

can obtain the demand function for labor by solving for L in the F.O.C. for labor:

L*(p,r,w) = (p/4w)2
∂L*/∂w = - 2p24-2w-3 = - (1/8)p2w-3< 0

## (10) 2. Suppose that the profit function for a firm is

π*(p,w) = p[loge (p/w)] – p

where p is the per-unit price of output, and w is the per-unit price of labor. Use Hotelling’s
Lemma to derive the firm’s

## - ∂π*/∂w = -(-p/w) = p/w = L*(p,w)

(20) 3. Suppose that a worker-owned firm produces a single output X by combining the variable
inputs labor L and materials M according to the production function X = f(L,M), exhibiting
strictly positive and diminishing marginal products. Fixed inputs already in place, such as
office space and equipment, are ignored. The output of the firm is sold in a competitive
market at the fixed price p and materials are purchased at fixed price r. The firm’s net
earnings e = pX – rM are distributed equally among the workers as “dividends” or “profit
shares” w = e/L. The firm chooses L and M to maximize w = (pX – rM)/L subject to the
technology constraint X = f(L,M). The optimal values of the choice variables can be
expressed as the solution functions L*(p,r) and M*(p,r) which, in turn, imply solution
functions for optimal output X*(p,r), net earnings e*(p,r), and profit shares w*(p,r).

a. Derive expressions for and determine the signs of ∂w*/∂p and ∂w*/∂r.

The firm chooses L and M to maximize w = (pX – rM)/L, subject to the technology
X = f(L,M). Substituting f(L,M) for X into the maximand we have

## w*(p,r) ≡ {pf[L*(p,r),M*(p,r)] – rM*(p,r)}/L*(p,r).

Differentiate this identity with respect to p, substituting from the F.O.C.s for a
maximum of w, noting that ∂M*/∂p[p∂f/∂M* – r] = 0, and rearranging terms, we
have

## Analogously, after differentiating the identity with respect to r, substituting from

the F.O.C.s for a maximum of w, and rearranging terms, we have

## ∂w*/∂r = – M/L < 0.

These results reveal that the dividend function w*(p,r) is analogous to a profit
function, expressed in per capita terms. Application of Hotelling’s Lemma to
w*(p,r) yields the desired results directly.

b. What happens to output per worker (“labor productivity”) if output price p rises?
Why?

## since w*(p,r) is convex in p.

c. What happens to output per worker if the price of materials r rises? Why?