Microeconomic Theory Dr.

Heman Das Lohano

Key of Assignment 2
Q1:
Choices of consumption over time are known as intertemporal choices. A consumer’s utility
function for intertemporal choices is as follows:

𝑈(𝑐1 , 𝑐2 ) = 𝑐1 0.5 𝑐2 0.5

where 𝑐1 and 𝑐2 denote the planned consumption of composite good in period 1 and period 2,
respectively. The consumption is on composite good and is expressed in thousand rupees.
Suppose there is no inflation, so the prices of the composite good in each period are constant
at 1 rupee.

The amount of money (income or endowment) the consumer will have in each period is denoted
by 𝑚1 and 𝑚2 , which is in thousand rupees. The consumer can borrow or save (lend) money
at some interest rate 𝑟. Assume: 𝑚1 = 100, 𝑚2 = 100, and 𝑟 = 0.2 (20 percent).

(a) Find the optimal choice of composite good for each period that maximizes the consumer’s
utility function subject to the budget constraint. Compute the saving/borrowing in period
1.
(b) Suppose the interest is: 𝑟 = 0.10 (10 percent). Find the optimal choice of composite good
for each period that maximizes the consumer’s utility function subject to the budget
constraint. Compute the saving/borrowing in period 1. Compare the results of parts (a) and
(b) in a table to analyze the effects of interest rate.

Key:
(a)
The consumer’s utility maximization problem is as follows:

max 𝑈(𝑐1 , 𝑐2 ) = 𝑐1 0.5 𝑐2 0.5

𝑐1 ,𝑐2
subject to:
(1 + 𝑟)𝑐1 + 𝑐2 = (1 + 𝑟)𝑚1 + 𝑚2

Define the Lagrangian function for this utility maximization problem as:

ℒ(𝑐1 , 𝑐2 , 𝜆) = 𝑐1 0.5 𝑐2 0.5 + 𝜆((1 + 𝑟)𝑚1 + 𝑚2 − (1 + 𝑟)𝑐1 − 𝑐2 )

First order necessary conditions for interior solution are as follows:

𝜕𝐿
= 0.5𝑐1 −0.5 𝑐2 0.5 − λ(1 + r ) = 0
𝜕𝑐1
(1)
𝜕𝐿
= 0.5𝑐1 0.5 𝑐2 −0.5 − λ = 0
𝜕𝑐2
(2)
𝜕𝐿
= (1 + 𝑟)𝑚1 + 𝑚2 − (1 + 𝑟)𝑐1 − 𝑐2 = 0
𝜕λ
(3)

Equation (3) is budget constraint. From equations (1) and (2), we get equation (4):

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 0.5𝑐1 −0.5 𝑐2 0.5
=1+𝑟
0.5𝑐1 0.5 𝑐2 −0.5
𝑐2
=1+𝑟
𝑐1
(4)
Given values are: m1 = 100, m2 = 100, r = 0.2.

Equation (3) of budget constraint can be written as:

(1 + 𝑟)𝑐1 + 𝑐2 = (1 + 𝑟)𝑚1 + 𝑚2

1.2𝑐1 + 𝑐2 = 220
(5)
Equation (4) can be written as:
𝑐2
= 1.2
𝑐1
(6)
Solving equation (5) and (6) yields:

𝑐1 = 91.67 thousand rupees

𝑐2 = 110 thousand rupees

Saving in period 1 = 𝑚1 − 𝑐1 = 100 − 91.67 = 8.33 thousand rupees

(b)
Given values are: m1 = 100, m2 = 100, r = 0.1.

Equation (3) of budget constraint can be written as:

(1 + 𝑟)𝑐1 + 𝑐2 = (1 + 𝑟)𝑚1 + 𝑚2

1.1𝑐1 + 𝑐2 = 210
(7)
Equation (4) can be written as:
𝑐2
= 1.1
𝑐1
(8)
Solving equation (7) and (8) yields:

𝑐1 = 95.45 thousand rupees

𝑐2 = 105 thousand rupees

Saving in period 1 = 𝑚1 − 𝑐1 = 100 − 95.45 = 4.55 thousand rupees

Interest rate Interest rate

𝑟 = 0.2 𝑟 = 0.1

Consumption in period 1 (thousand rupees) 𝑐1 91.67 95.45

Consumption in period 2 (thousand rupees) 𝑐2 110 105
Saving in period 1 (thousand rupees) 8.33 4.55

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Q2:
A firm’s production function is given by the following Cobb-Douglas function:

𝑞 = 2𝑘 0.5 𝑙0.5

where q is the total output per time period, k is the quantity of capital input employed per time
period, and l is the quantity of labor input employed per time period. Suppose that the firm is
operating in a perfectly competitive market, where the rental rate of capital is v rupees per unit
of capital, and the wage rate of labor is w rupees per unit of labor.

Find the firm’s cost function, 𝐶(𝑣, 𝑤, 𝑞).

Key:
The cost minimization problem is as follows:
min 𝑣𝑘 + 𝑤𝑙
𝑘,𝑙
subject to:
𝑓(𝑘, 𝑙) = 𝑞
𝑘 ≥ 0, 𝑙 ≥ 0

Define the Lagrangian function for this utility maximization problem as:

ℒ(𝑘, 𝑙, 𝜆) = 𝑣𝑘 + 𝑤𝑙 + 𝜆(𝑞 − (𝑓(𝑘, 𝑙))

First order necessary conditions for interior solution (k>0, l>0) are as follows:

𝜕ℒ 𝜕𝑓
=𝑣−𝜆 =0
𝜕𝑘 𝜕𝑘
(1)
𝜕ℒ 𝜕𝑓
= 𝑤−𝜆 =0
𝜕𝑙 𝜕𝑙
(2)
𝜕ℒ
= 𝑞 − 𝑓(𝑘, 𝑙) = 0
𝜕λ
(3)
Using equations (1) and (2), we get the following:

𝑑𝑓/𝜕𝑙 𝑤
=
𝑑𝑓/𝑑𝑘 𝑣
(4)
The left-hand side of the above equation is marginal rate of technical substitution (RTS).

The two equations for solving this problem are equations (3) and (4). For the given production
function, these two equations can be written as:

𝑘 0.5 𝑙−0.5 𝑤
=
𝑘 −0.5 𝑙0.5 𝑣
(4’)
2𝑘 0.5 𝑙0.5 = 𝑞
(3’)
Equation (4’) can be simplified as:
𝑘 𝑤
=
𝑙 𝑣
(4’’)
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Solving two equations (3’) and (4’’) for two unknowns k and l yields the contingent input
demand functions:
𝑐∗
𝑤 0.5 𝑞
𝑘 =
2𝑣 0.5
(5)
0.5
𝑣 𝑞
𝑙𝑐∗ =
2𝑤 0.5
(6)

Putting the above contingent input demand functions, equations (5) and (6), into the objective
function yields the cost function:
𝐶 ∗ = 𝑣𝑘 𝑐∗ +𝑤𝑙𝑐∗

∗
𝑤 0.5 𝑞 𝑣 0.5 𝑞
𝐶 = 𝑣 0.5 + 𝑤 +
2𝑣 2𝑤 0.5

𝐶 ∗ = 𝑣 0.5 𝑤 0.5 𝑞
Thus, the cost function is:

𝐶(𝑣, 𝑤, 𝑞) = 𝑣 0.5 𝑤 0.5 𝑞

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