Scribd
Upload
11 views

Problem Set 2

Uploaded by

Pb H
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
11 views

Problem Set 2

Uploaded by

Pb H
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 2

Fall 2024, Macroeconomics I

Jun Hee Kwak, Sogang University

PROBLEM SET 2

Due electronically (via Cybercampus) on Monday, October 21, at 11:59pm. No late submissions are
accepted.

Part 1. Optimization Problem: Firm and Consumer

1. Consider the consumer’s optimization problem in the one-period model. Utility is:

𝑢(𝑐, 𝑙) = 𝑙𝑛(𝑐) + 𝛾𝑙𝑛(𝑙)

where 𝑐 is consumption of goods, 𝑙 is leisure, and 𝛾 > 0 is a constant. The consumer’s nominal
budget constraint is:

𝑃𝑐 = 𝑊(ℎ − 𝑙)

where 𝑃 is the price of goods; 𝑊 is the nominal wage; and ℎ is the total hours in the period.

a. Suppose the government decides to impose a lump-sum tax (𝑇) on the consumer. Her nominal
budget constraint becomes:

𝑃𝑐 = 𝑊(ℎ − 𝑙) − 𝑇
Use a diagram to show how this change affects the consumer’s optimal choice of 𝑐 and 𝑙, relative
to the no-tax benchmark. Your diagram should have 𝑙 on the x-axis and 𝑐 on the y-axis. Be sure
to label the old and new optima clearly. What explains the change in consumer behavior?

b. Now suppose instead of a lump-sum tax, the government imposes a consumption tax. The
consumer’s nominal budget constraint becomes:

𝑃(1 + 𝜏𝑐 )𝑐 = 𝑊(ℎ − 𝑙)

where 𝜏𝑐 > 0 is the consumption tax rate so that if the consumer wishes to consume c, she must
pay 𝑃(1 + 𝜏𝑐 )𝑐. Use a diagram to show how the consumer’s optimal choice of 𝑐 and 𝑙 changes
relative to the no-tax benchmark. What explains the change in consumer behavior?

2. Consider an economy with one representative consumer and one representative firm. There is no
government (no taxes). The consumer’s utility function is 𝑈 = log(𝑐) − 𝑁 𝑆 , where c is consumption
and 𝑁 𝑆 is labor supply. The consumer’s budget constraint is 𝑐 = 𝑤𝑁 𝑆 + π in real terms, and π is
firm’s profit. The representative firm has a standard Cobb-Douglas production function
𝐹(𝑧, 𝐾, 𝑁 𝑑 ) = 𝑧𝐾 𝛼 (𝑁 𝑑 )1−𝛼 , where 𝑁 𝑑 is labor demand. Suppose that z=1 and K=1 so that the
production function is simplified to 𝐹(𝑁 𝑑 ) = (𝑁 𝑑 )1−𝛼 .
a. Set up and solve the consumer’s problem and firm’s problem.

b. Find the labor market clearing condition and solve for the equilibrium wage. (Hint: your
equilibrium wage must be solved in terms of parameters only.)

1/2
Fall 2024, Macroeconomics I
Jun Hee Kwak, Sogang University
Part 2. Competitive Equilibrium and Pareto Optimum

1. Consider an economy where


(i) the representative consumer maximizes its utility 𝑈(𝑐, 𝑙) subject to budget constraint, 𝑐 =
𝑤(ℎ − 𝑙) + 𝜋 − 𝑇. 𝑐 is consumption, 𝑙 is leisure, 𝑤 is a real wage, 𝜋 is a dividend income from firms,
𝑇 is lump-sum taxes, and labor supply is given by 𝑁 𝑠 = ℎ − 𝑙.
(ii) the representative firm maximize its profit given by 𝜋 = z𝐹(𝐾, 𝑁 𝑑 ) − 𝑤𝑁 𝑑 where z is a total
̅ is a fixed level of capital, 𝑁 𝑑 is a labor demand of the firm.
factor productivity, 𝐾
(iii) The government budget is balanced: 𝑇 = 𝐺.
(iv) Labor market clears: 𝑁 𝑑 = 𝑁 𝑠 .

a. Write down a consumer’s problem with the Lagrangian method.

b. Solve the consumer’s problem and show optimal condition (first-order condition).

c. Write down a firm’s problem.

d. Solve the firm’s problem and show optimal condition (first-order condition)..

e. Define a competitive equilibrium using optimal conditions and relevant constraints that
determine equilibrium values of endogenous variables given exogenous variables.

2. The social planner noticed that individual consumers and firms in the competitive market do not
consider the social consequences of their behaviors characterized as follows: total hours ℎ
decrease when consumption 𝑐 increases (𝑐 includes dining out, which makes other people more
likely to be infected by diseases and less productive due to COVID-19 virus). Mathematically, ℎ is
now a function of consumption rather than a constant. ℎ = ℎ(𝑐), ℎ′ < 0. The social planner’s
objective is to maximize its people’s happiness, i.e., the representative consumer’s utility subject to
the resource constraint, taking into account the social consequences of COVID-19 virus.

a. Derive the resource constraint (or income-expenditure identity) using relevant constraints in
the competitive equilibrium.

b. Set up the social planner’s problem using Lagrangian method.

c. Solve the social planner’s problem and derive the optimal condition (first-order condition).

d. Define a Pareto optimum which is described by the social planner’s optimal condition and the
relevant constraints.

e. Does the first fundamental theorem of welfare economics hold in this economy? Explain the
reason using results you obtained in Problem 1 and 2.

2/2

You might also like