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ECON 8010 PROBLEM SET #2 SOLUTIONS FALL 2016

Due: September 15, 2016


Total Points: 40

(10) 1. Suppose the firm’s production function is

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.

Combining the F.O.Cs, we have

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

(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

a. output-supply function x*(p,w).

∂π*/∂p = loge(p/w) + p(1/p) – 1 = loge(p/w) = x*(p,w)

b. labor-demand function L*(p,w).

- ∂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(L,M) = [p f(L,M) – rM)]/L

The F.O.C.s with respect to L and M are, respectively,

∂w/∂L = [LpfL – pf(L,M) + rM]/L2 = 0 ↔ LpfL – pf(L,M) + rM = 0

∂w/∂M = (pfM – r)/L = 0 ↔ pfM = r

Evaluated at the optimal values of L and M, the objective function is

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

∂w*/∂p = X/L > 0.

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?

∂2w*/∂p2= ∂(X/L)/∂p > 0

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

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

∂2w*/∂p∂r = ∂(X/L)/∂r = – ∂(M/L)/∂p = ∂2w*/∂r∂p < 0

since w*(p,r) is symmetric in p and r.