Scribd
Upload
52 views

Assignment 2

This document provides an assignment for an Advanced Microeconomics course. It includes 4 questions about topics such as household preferences and demand, portfolio choice with risk aversion, firm production and technology, and consumer surplus and compensating variation. Students are asked to show results, derive equations, and interpret economic concepts related to these microeconomics topics. The deadline for the assignment is November 21, 2018.

Uploaded by

duc anh
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
52 views

Assignment 2

This document provides an assignment for an Advanced Microeconomics course. It includes 4 questions about topics such as household preferences and demand, portfolio choice with risk aversion, firm production and technology, and consumer surplus and compensating variation. Students are asked to show results, derive equations, and interpret economic concepts related to these microeconomics topics. The deadline for the assignment is November 21, 2018.

Uploaded by

duc anh
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 5

Advanced Microeconomics - Assignment 2

(deadline: Wednesday, November 21, 2018, 13:30pm)

Prof. Dr. Andreas Irmen & Ka-Kit Iong


University of Luxembourg
Fall 2018

Question 1. (Aggregation)

Consider an economy with n < ∞ goods, each denoted by i = 1, . . . , n, and


J < ∞ households, indexed by j = 1, . . . , J . Each household has preferences
for the goods represented by
" σ
# σ−1
n
X  σ−1
uj (xj1 , . . . , xjn ) = xji − ξi
j σ
,
i=1

where, σ ∈ (0,P∞) and ξij ∈ [−ξ, ξ]. Moreover, each household's income, y j ,
satises y j > ni=1 pi ξ . Denote pi > 0 the price of good i.

a.) Derive the Marshallian demand of household j and its indirect utility
function.
b.) Derive the aggregate Marshallian demand of all households.
c.) Show that the preferences of all households can be represented by those
of a representative household with indirect utility
[− ni=1 pi ξi + y]
P
v(p, y) = P  1 ,
n 1−σ 1−σ
p
i=1 i

where p ≡ (p1 , . . . , pn ), y ≡ j=1 y and ξi ≡ Jj=1 ξij .


PJ j P

1
c.) Show that the aggregate Marshallian demand derived in Question b.)
results from the maximization of the direct utility function of the rep-
resentative household given by
" σ
# σ−1
n
X σ−1
U (x1 , . . . , xn ) = (xi − ξi ) σ

i=1

subject to j=1 pt xi ≤ y. Show also that this maximization gives rise


PJ
to the indirect utility function v(p, y).

Question 2. (Constant Relative Risk Aversion (CRRA))

Consider an investor with initial wealth w > 0 and the following measure of
risk aversion 00
−u (w)
Rr (w) ≡ w · Ra (w) = w · ,
u0 (w)
where u is the von Neumann-Morgenstern utility of w. Rr (w) is called the
measure of relative risk aversion. There is one risky asset and one safe asset.

Suppose there are i = 1, . . . , n future states of the world, each of which will
occur with probability pi . The rate of return of the risky asset in each state
of the world is ri > −1. Let β ≥ 0 denote the amount of wealth to be put in
the risky asset. There is also a safe asset yielding a rate of return s > −1 for
sure. Moreover, it holds that ri < s in at least one state of the world.
a) Show that an expected utility maximizing investor determines β by
solving
n
X
max pi u(w(1 + s) + β(ri − s)), 0 ≤ β ≤ w.
β
i=1

b) Suppose the investor is risk-averse. Show that the expected utility


maximizing investor chooses β ∗ > 0 if and only if
n
X
pi ri > s.
i=1

Interpret this nding.

2
c) Suppose that β ∗ > 0. Show the following: If Rr (w) declines as w in-
creases, then the proportion β/w, i. e. the fraction of the initial wealth
invested in risky asset, increases. Compare this result to the portfolio
choice problem discussed in class (Application 5.1).

Question 3. (Firms)

Consider a competitive sector with a continuum [0, 1] of rms. All rms have
access to the same technology. Therefore, we conduct the analysis through
the lens of a single representative rm that behaves competitively.

The representative rm produces output with a technology involving the


production function
3 2

Y = θ + (1 − θ)L 3 , 0 ≤ θ ≤ 1,
2
where Y is output, L is employed labor, and θ is a technology variable.
a) Suppose θ is xed.
1) Let w > 0 denote the real wage expressed in units of Y . Show
that the rm's labor demand is
 3
d 1−θ
L = .
w

Interpret. How does Ld respond to an increase in θ?


2) Suppose the labor supply in this sector is
1
Ls = w. (1)
2
Show that the labor market equilibrium is given by
1 3
w∗ = 2 4 (1 − θ) 4
3 3
L∗ = 2− 4 (1 − θ) 4 .

Interpret.

3
b) Now, suppose that the rm also chooses its technology, θ, by investing
C(θ) = 3θ2 /4 of the output it produces.
1) What is the eect of θ on output Y ? Interpret.
2) Show that the prot-maximizing levels of θ and Ld satisfy
θ∗ = max 0, 1 − w2 ,


w3 if θ∗ > 0,
(
Ld = 1
w3
if θ∗ = 0.
Interpret this nding. (Hint: Do not check the second-order con-
ditions, they are satised.)
3) Suppose the labor supply in this sector is still given by (1). Show
that there are two labor market equilibria given by
1 1
w ∗ = √ , L∗ = √ if θ∗ > 0,
2 2 2
w = 2 4 , L = 2− 4 if θ∗ = 0.
1 3
∗ ∗

Interpret.

Question 4. (Compensating Variation)

When the income elasticity of demand is independent of price, so that


∂q(p, y) y
≡ η(y)
∂y q(p, y)
for all p and y in the relevant region, then for the base price p0 and income y 0 ,
the consumer surplus, CS , and the compensating variation, CV , are related
as follows: 0
Z CV +y Z ζ 
η(ξ)
−∆CS = exp − dξ dζ.
y0 y0 ξ
a) Show that when the income elasticity is constant but not equal to unity,
then   1
−∆CS 1−η
CV = y 0 (1 − η) + 1 − y0.
y0

4
b) Use this result to show the following: if demand is independent of
income, i. e., −∆CS = CV , then CS is an exact measure of the welfare
impact of a price change.
c) Derive the relation between CV and ∆CS when the income elasticity
is unity.
d) We can use the result of part a) to establish a convenient rule of thumb
that can be used to quickly gauge the approximate size of the devi-
ation between the change in consumer surplus and the compensating
variation for the case of a constant income elasticity. Show that
(CV − |∆CS|)/|∆CS| ≈ (η|∆CS|)/(2y 0 )

holds if the income elasticity is constant and not equal to unity.

You might also like