Foundations of Economics for International Business

Supplementary Exercises 2

INSTRUCTOR: XIN TANG

Department of World Economics
Economics and Management School
Wuhan University

Fall 2015

These tests are only for your practice, you do NOT have to hand them in. However, all materials in the
supplementary tests are also subject to be tested in exams. Check the answers carefully!

1 MULTIPLE CHOICES

1. If Y = AK 0.5 L0.5 and A, K and L are all 100, the marginal product of capital is:

(A) 50.
(B) 100
(C) 200
(D) 1,000

2. If the production function describing an economy is Y = 100K 0.25 L0.75 , then the share of output
going to labor

(A) is 25 percent.
(B) is 75 percent.
(C) depends on the quantities of labor and capital.
(D) depends on the state of technology.

3. If the consumption function is given by C = 500 + 0.5(Y − T ), and Y is 6,000 and T is given by
T = 200 + 0.2Y , then C equals:

(A) 2,500.
(B) 2,800.

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 (C) 3,500.
(D) 4,200.

4. The equation Y = C (Y − T ) + I (r ) + G may be solved for the equilibrium level of:

(A) income.
(B) consumption.
(C) government purchases.
(D) the interest rate.

Figure 1: The Capital-Labor Ratio

5. Refer to Figure 1, starting from capital-labor ratio k1 , the capital-labor ratio will:

(A) decrease.
(B) remain constant.
(C) increase.
(D) first decrease and then remain constant.

2 NUMERICAL PROBLEMS AND SHORT ANSWERS

1. (10%) Consider a Cobb-Douglas production function with three factors. K (number of machines)
and L (number of workers) are as usual aggregate capital and labor, H is human capital (you could
think of it as the number of college degrees among the workers). The production function is given
by
Y = K 1/3 L1/3 H 1/3

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 (a) Derive an expression for the marginal product of labor. How does an increase in the amount of
human capital affect the marginal product of labor?
(b) Derive an expression for the marginal product of human capital. How does an increase in the
amount of human capital affect the marginal product of human capital?
(c) What is the income share paid to labor? What is the income share paid to human capital? In
the national income accounts of this economy, what share of total income do you think workers
would appear to receive? (Hint: Consider where the return to human capital shows up.)
(d) An unskilled worker earns the marginal product of labor, whereas a skilled worker earns the
marginal product of labor plus the marginal product of human capital. Using your answers to
parts (a) and (b), find the ratio of the skilled wage to the unskilled wage. How does an increase
in the amount of human capital affect this ratio? Explain.
(e) Some people advocate government funding of college scholarships as a way of creating a more
egalitarian society. Others argue that scholarships help only those who are able to go to college.
Based on your answers to part (d), explain your attitude towards this issue.

2. (6%) When the government subsidizes investment, such as with an investment tax credit, the subsidy
often applies to only some types of investment. This question asks you to consider the effect of such
a change. Suppose there are two types of investment in the economy: business investment and
residential investment. And suppose that the government institutes an investment tax credit only
for business investment.

(a) How does this policy affect the demand curve for business investment? The demand curve for
residential investment?
(b) Draw the economy’s supply and demand for loanable funds. How does this policy affect the
supply and demand for loanable funds? What happens to the equilibrium interest rate?
(c) Compare the old and the new equilibria. How does this policy affect the total quantity of
investment? The quantity of business investment? The quantity of residential investment?

3. (9%) (This question helps your to grasp the proof of Euler Theorem step by step, you may wish to
turn to your notes of my lecture and the recitation.) Prove that if function Y = F (K, L) exhibits
constant returns to scale, then Y = FK K + FL L. FK and FL represent the partial derivatives to the
according argument in the subscripts.

(a) ∀z > 0, what property does F (zK, z L) holds if it is constant returns to scale?
(b) Use the definition of derivatives by limits to show the derivative with respect to z for the func-
tion zY ?
(c) Use the definition of derivatives by limits to show the derivative with respect to z for the func-
tion F (zK, z L)? (Hint: Apply the trick of first adding up and then substracting a specific term.)
(d) Based on your answers to question (b) and (c), how do you reach the final conclusion of Euler
Theorem?

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 (e) Guess the Euler Equation for production function with n arguments where n is any finite inte-
ger.

4. (10%) (This final question demonstrates to you the basic logic of Solow-Swan model.) Consider
a neoclassical growth model, the production function Y = F (K, L) satisfies Inada conditions and
constant returns to scale. Let y = f (k) be the per capita production function.

(a) How do you derive y = f (k) from Y = F (K, L) using constant returns to scale? Demonstrate in
details.
(b) What are the four items in Inada conditions? Explain each term.
(c) Suppose that the saving rate s, what are the consumption and investment in terms of capital per
capita in this economy?
(d) Suppose that the depreciation rate δ is exogenous, what is the equation that characterizes the
law of motion of capital per capita ∆k in terms of k.
(e) What is the steady-state condition that pins down the level of capital per capita?
(f) Let k ∗ represent the steady state level of capital per capita, explain graphically (better if mathe-
matically) what happens if the initial capital per capita k0 is less than k ∗ ? What if k0 > k ∗ ?

3 SOLUTIONS

Multiple Choices: A B B D C

Short Answers:

1. (a) The marginal product of labor MPL is found by differentiating the production function with
respect to labor:
dY 1
MPL = = K 1/3 H 1/3 L−2/3
dL 3
An increase in human capital will increase the marginal product of labor because more human
capital makes all the existing labor more productive.
(b) The marginal product of human capital MPH is found by differentiating the production func-
tion with respect to human capital:

dY 1
MPH = = K 1/3 L1/3 H −2/3
dH 3
An increase in human capital will decrease the marginal product of human capital because there
are diminishing returns.

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 (c) The labor share of output is the proportion of output that goes to labor. The total amount of
output that goes to labor is the real wage (which, under perfect competition, equals the marginal
product of labor) times the quantity of labor. This quantity is divided by the total amount of
output to compute the labor share:
1
3
(K 1/3 H 1/3 L−2/3 )L 1
Labor Share = =
1/3 1/3 1/3 3
K H L
We can use the same logic to find the human capital share:
1
3
(K 1/3 L1/3 H −2/3 )H 1
Human Capital Share = =
1/3 1/3 1/3 3
K H L
so labor gets one-third of the output, and human capital gets one-third of the output. Since
workers own their human capital (we hope!), it will appear that labor gets two-thirds of output.
(d) The ratio of the skilled wage to the unskilled wage is:
Wskilled MPL+ MPH
=
Wunskilled MPL
1 1/3 1/3 −2/3
3
K H L + 13 K 1/3 L1/3 H −2/3
=
1 1/3 1/3 −2/3
3
K H L
L
=1+
H
Notice that the ratio is always greater than 1 because skilled workers get paid more than unskilled
workers. Also, when H increases this ratio falls because the diminishing returns to human
capital lower its return, while at the same time increasing the marginal product of unskilled
workers.
(e) If more college scholarships increase H , then it does lead to a more egalitarian society. The
policy lowers the returns to education, decreasing the gap between the wages of more and less
educated workers. More importantly, the policy even raises the absolute wage of unskilled work-
ers because their marginal product rises when the number of skilled workers rises.

2. (a) The demand curve for business investment shifts out to the right because the subsidy increases
the number of profitable investment opportunities for any given interest rate. The demand
curve for residential investment remains unchanged.
(b) The total demand curve for investment in the economy shifts out to the right since it represents
the sum of business investment, which shifts out to the right, and residential investment, which
is unchanged. As a result the real interest rate rises as in Figure 2. The total quantity of invest-
ment does not change because it is constrained by the inelastic supply of savings. The investment
tax credit leads to a rise in business investment, but an offsetting fall in residential investment.
That is, the higher interest rate means that residential investment falls (a movement along the
curve), whereas the rightward shift of the business investment curve leads business investment
to rise by an equal amount. Figure 3 shows this change. Note that I1B + I1R = I2B + I2R = S

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 Figure 2: Loan Market

Figure 3: Investment Market

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3. (a) F (zK, z L) = z F (K, L).
(b) The derivative of zY with respect to z is simply Y .
(c) The derivative of F (zK, z L) with respect to z is FK K + FL L. The easiest way to get this answer
is to use chain rule which can be found in any calculus textbook. However, it˛ aŕs still possible to
get this using limits, for which you should go back to your classnotes.
(d) Since we have F (zK, z L) = z F (K, L) = zY , take derivative with respect to z on both sides will
give you the answer.
(e) Suppose we have a constant return to scale production function with n inputs, that is
F (z x1 , z x2 , · · · , z xn ) = z F (x1 , x2 , · · · , xn )
for any positive z, then the Euler theorem in this case is
Y = F (x1 , x2 , · · · , xn ) = F1 x1 + F2 x2 + · · · + Fi xi + · · · + Fn xn
in which Fi denotes the derivative of F with respect to its ith input.

4. (a) Since F exhibits constant return to scale, we have per capita output
y = Y /L = F (K, L)/L = F (K/L, 1),
note we have the per capita capital stock k = K/L, therefore we get
y = f (k) = F (k, 1).

(b) The four items of Inada condition concern with the behavior of the (per capita) production at
both 0 and infinity:
• f (k) → 0 as k → 0
• f (k) → ∞ as k → ∞
• f 0 (k) → ∞ as k → 0
• f 0 (k) → 0 as k → ∞.
(c) Consumption equals output net of saving, i.e. c = y − s y = (1 − s) f (k). Investment equals
saving, i.e. i = s f (k).
(d) If we let k 0 denote the next period (year) capital stock (per capita), then we have
k 0 = i + (1 − δ)k = s f (k) + (1 − δ)k

(e) At steady state, we have k 0 = k, so from last equation we have

k = k 0 = s f (k) + (1 − δ)k,
which can be simplified as δk = s f (k).
(f) If you start from a k0 which is less than k ∗ the steady state value of (per capita) capital stock,
then you can use the equation in (d) to compute k1 , k2 , · · · , etc. This sequence of capital stock
will converge to k ∗ . The key point can be found by looking how this sequence evolves starting
from a k0 < k ∗ , by drawing a figure of s f (k) + (1 − δ)k against k, which is similar to Figure 1.