ECON104 Practice for chapter 4

Suggested practice for Chapter 4

You can do further practice for Chapter 4 with the following textbook questions (5th edition):

Section Questions
Review Exercises for Chapter 8 Q3, Q5, Q9, Q10 (ignore c)

13.2 Q4, Q6, Q8

13.3 Q1, Q2
13.4 Q2, Q5
13.6 Q1
Review Exercises for Chapter 13 Q2, Q7, Q8, Q10

14.1 Q1, Q2, Q5, Q8, Q9, Q10

14.8 Q3 (ignore c)
14.9 Q1, Q6 (ignore a)

Sections to ignore: 8.4, 8.7, 13.5, 13.7.

You’re welcome to do more questions in the textbook, but stick to questions that are similar to these
questions given here. You don’t have to do questions that test things that are not covered in our syllabus.

Some more practice questions (with answers)

1. Suppose an airline has two types of customers, one for business trips (market 1) and the other for
tourists (market 2). Tourists are more sensitive to price, and thus the demand curves are:
𝑞! = 100 − 𝑝! for market 1
𝑞" = 100 − 2𝑝" for market 2
The cost function of the firm is 𝐶(𝑞! , 𝑞" ) = 20(𝑞! + 𝑞" ).
a. What is the profit function of the firm?
b. Using the first-order condition, find the optimal price and quantity for each market. Which ticket is
more expensive?
c. What is the maximum profit?

2. Consider a firm using quantities 𝐿! and 𝐿" of two kinds of labor as its only inputs in order to produce
output Q according to the simple production function
𝑄 = 𝐿! + 𝐿"
The firm is a monopsonist in the labor market, so it can set the wages for the two kinds of labor,
according to the following labor supply curves:
𝐿! = 𝑎! + 𝑏! 𝑤!
𝐿" = 𝑎" + 𝑏" 𝑤"
a. Assuming that the price of the product is 1, write the profit function of the firm.
b. What are the optimal wages 𝑤!∗ and 𝑤"∗ that maximize the firm’s profit?

3. Suppose a consumer who can borrow or lend at an annual rate of interest 𝑟 > 0 anticipates receiving
positive income 𝑦! this year and 𝑦" next year. (The consumer ignores the future more than one year
ahead.) The same consumer chooses the levels of consumption 𝑐! this year and 𝑐" next year in order to
maximize the utility function:
𝑈(𝑐! , 𝑐" ) = ln 𝑐! + ln 𝑐" (𝑐! , 𝑐" > 0)
subject to the budget constraint:
𝑐" 𝑦"
𝑐! + = 𝑦! +
1+𝑟 1+𝑟
a. Write out the Lagrangian for the constrained maximization problem.
b. Write out the first-order conditions for a constrained maximum.
c. Find the utility maximizing expenditures in both periods, as well as the Lagrange multiplier λ, all as
functions of the parameter triple (𝑟, 𝑦! , 𝑦" ).
d. Find the utility-maximizing expenditures in both periods for the special case when the interest rate
𝑟 = 0, and also when 𝑟 = 10%.

4. Suppose 𝑈(𝑥, 𝑦) denotes the utility enjoyed by a person when having 𝑥 hours of leisure per day (each
day having 24 hours) and 𝑦 units per day of other goods. The person gets an hourly wage of 𝑤 and pays
an average price of 𝑝 per unit of the other goods.
a. Form the daily constraint for this person (assuming that the person spends all that is earned).
b. Show that maximizing 𝑈(𝑥, 𝑦) subject to the constraint leads to the equation 𝑝𝑈$% (𝑥, 𝑦) = 𝑤𝑈&% (𝑥, 𝑦).

5. Consider the consumer demand problem max √𝑥 + =𝑦 s.t. px + qy ≤ m. Find the demand functions.

6. Solve the following consumer demand problem where, in addition to the budget constraint, there is
an upper limit 𝑥̅ which rations how much of the first good can be bought:
max αlnx + (1 − α)lny s.t. px + qy ≤ m and x ≤ 𝑥̅ (0 < α < 1)

Solutions
1.a. The profit function is
𝜋(𝑞! , 𝑞" ) = (100 − 𝑞! )𝑞! + (50 − 𝑞" /2)𝑞" − 20(𝑞! + 𝑞" )
b. FOCs:
𝜋!% (𝑞! , 𝑞" ) = 100 − 2𝑞! − 20 = 0
𝜋"% (𝑞! , 𝑞" ) = 50 − 𝑞" − 20 = 0
Thus,
𝑞!∗ = 40
𝑞"∗ = 30
𝑝!∗ = 60
𝑝"∗ = 35
c. Maximum profit is
𝜋 ∗ = 2050

2.a. The profit function is

𝜋 = 𝑄 − 𝑤! 𝐿! − 𝑤" 𝐿" = 𝑎! + 𝑏! 𝑤! + 𝑎" + 𝑏" 𝑤" − 𝑤! (𝑎! + 𝑏! 𝑤! ) − 𝑤" (𝑎" + 𝑏" 𝑤" )

b. The FOCs are

𝜋!% = 𝑏! − 𝑎! − 2𝑏! 𝑤! = 0
𝜋"% = 𝑏" − 𝑎" − 2𝑏" 𝑤" = 0
Thus
𝑏! − 𝑎!
𝑤!∗ =
2𝑏!
𝑏" − 𝑎"
𝑤"∗ =
2𝑏"
3.a. The Lagrangian is
𝑐" 𝑦"
𝐿(𝑐! , 𝑐" , 𝜆) = ln 𝑐! + ln 𝑐" − 𝜆 F𝑐! + − 𝑦! − G
1+𝑟 1+𝑟

b. The FOCs are

1
𝐿%! = −𝜆 =0
𝑐!
1 𝜆
𝐿%" = − =0
𝑐" 1 + 𝑟
𝑐" 𝑦"
𝐿%' = 𝑐! + − 𝑦! − =0
1+𝑟 1+𝑟

c. Solving
1 𝑦"
𝑐! = F𝑦! + G
2 1+𝑟
1
𝑐" = (1 + 𝑟)𝑐! = (𝑦! (1 + 𝑟) + 𝑦" )
2
1 2(1 + 𝑟)
𝜆= =
𝑐! (1 + 𝑟)𝑦! + 𝑦"

d. When 𝑟 = 0:
1
𝑐! = (𝑦 + 𝑦" )
2 !
1
𝑐" = 𝑐! = (𝑦! + 𝑦" )
2
When 𝑟 = 10%:
1 𝑦"
𝑐! = F𝑦! + G
2 1.1
1
𝑐" = (1 + 𝑟)𝑐! = (1.1𝑦! + 𝑦" )
2

4.a. The daily constraint is

𝑝𝑦 = 𝑤(24 − 𝑥)

b. The Lagrangian is
𝐿(𝑥, 𝑦, 𝜆) = 𝑈(𝑥, 𝑦) − 𝜆(𝑝𝑦 − 𝑤(24 − 𝑥))
The FOCs are:
𝐿%! = 𝑈$% − 𝜆𝑤 = 0 (1)
𝐿%" = 𝑈&% − 𝜆𝑝 = 0 (2)
𝐿%' = 𝑝𝑦 − 𝑤(24 − 𝑥) = 0
(1) and (2) give us
𝑈$% = 𝜆𝑤
𝑈&% = 𝜆𝑝
or
𝑈$% 𝑤
=
𝑈&% 𝑝
or

𝑝𝑈$% (𝑥, 𝑦) = 𝑤𝑈&% (𝑥, 𝑦)

5. The Lagrangian is:
𝐿(𝑥, 𝑦, 𝜆) = √𝑥 + =𝑦 − 𝜆(𝑝𝑥 + 𝑝𝑦 − 𝑚)

The FOCs:
(i) 1/(2√𝑥) – λp = 0
(ii) 1/(2=𝑦) – λq = 0,

The complementary slackness condition:

(iii) λ ≥ 0, and λ = 0 if px + qy < m.

(i) and (ii) give 1 = 2λp√𝑥 = 2λq=𝑦, from which we infer that x, y, λ must all be positive, and also that
y = p2x/q2.

Since λ > 0, the budget equation px + qy = m holds, implying that x = mq/(pq + p2). The corresponding
value for y is easily found, and the demand functions are:
x = x(p, q, m) = mq/p(p + q)
y = y(p, q, m) = mp/q(p + q).

6. The Lagrangian is:

𝐿(𝑥, 𝑦, 𝜆, 𝜇) = 𝛼 ln 𝑥 + (1 − 𝛼) ln 𝑦 − 𝜆(𝑝𝑥 + 𝑝𝑦 − 𝑚) − 𝜇(𝑥 − 𝑥̅ )

The FOCs:
(i) α/x – λp – μ = 0
(ii) (1 – α)/y – λq = 0,

and the complementary slackness conditions:

(iii) λ ≥ 0, and λ = 0 if px + qy < m,
(iv) μ ≥ 0, and μ = 0 if x < 𝑥̅ .

If λ = 0 and μ = 0: no solutions.

If λ = 0 and μ > 0: no solutions.

If λ > 0 and μ > 0: the two constraints must bind, thus:

px + qy = m
x = 𝑥̅

Thus, x = 𝑥̅ , and so y = (m − p𝑥̅ )/q. Putting x and y back into the FOCs:
λ = (1 − α)/(m − p𝑥̅ ) and μ = (αm − p𝑥̅ )/[𝑥̅ (m − p𝑥̅ )].

Since we must have that λ > 0 and μ > 0, this requires αm − p𝑥̅ > 0, which is m > p𝑥̅ /α.
M/α, we have x = 𝒙
Thus, if m > p𝒙 M and y = (m − p𝒙 M)/q as solutions to the maximization problem.

If m ≤ p𝑥̅ /α: then the following is the only possible scenario:

λ > 0 and μ = 0: the budget constraint must bind:

px + qy = m

with the two FOCs becoming:

α/x – λp = 0
(1 – α)/y – λq = 0
 Solving the three equations: x = mα/p, y = (1 − α)m/q, λ = 1/m (> 0).

M/α, we have x = mα/p and y = (1 − α)m/q as solutions to the maximization problem.

Thus, if m ≤ p𝒙