International Economics

Problem Set 0: Solutions

1 1
(1) Consider a consumer with utility function u(x1 ; x2 ) = x12 x22 . The consumer faces
given prices p1 and p2 for goods 1 and 2, and her income equals I. Find the
consumer’s optimal choices of x1 and x2 as functions of p1 , p2 and I. What is the
intuition behind the first-order conditions?

We solve this question using constrained optimization. The problem can be

formulated as:
max u(x1 , x2 )
{x1 ,x2 }
subject to
I ≥ p 1 x1 + p 2 x2 .
That is, the consumer maximizes utility subject to total expenditure on the two
goods being less or equal to the consumer’s income. The Lagrangian for this
problem is:
1 1
L = x12 x22 + λ[I − p1 x1 + p2 x2 ].
Ignoring the possibility of corner solutions, the first order conditions (FOCs) for
this problem are:
1 − 21 12
x x = λp1 ,
2 1 2
1 21 − 12
x x = λp2 ,
2 1 2
I = p 1 x1 + p 2 x2 .
The first (second) FOC states that in a maximum, the consumer will consume the
two goods in such a way that marginal utility of the first (second) good equals the
good’s price multiplied by the marginal utility of income λ. Suppose the marginal
utility of good 1 was higher than the right hand side (RHS). Then the consumer
should buy more of that good, because the next unit will give her more utility
(left hand side, LHS) than it would cost her (RHS). The reverse is true if marginal
utility was lower and both situations would not be utility maximising behaviour.
The third FOC restates the budget constraint.
To find the demand functions of the consumer divide the first by the second
FOC to eliminate the Lagrange multiplier:
1 1
1 −2 2
x
2 1
x 2 λp1
1 1 = ,
1 2 −2 λp2
2
x 1 x 2
which can be rewritten as
x2 p1
= .
x1 p2
Now solve this equation for x2 and substitute it into the third FOC, which results
in:
p1
I = p 1 x1 + p 2 x1 ,
p2
which can be solved for the demand function of good x1 :
1I
x1 = ,
2 p1
1
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while the demand function for x2 is:

1I
x2 = .
2 p2
(2) Redo question 1 with the following utility function u(x1 ; x2 ) = min[x1 ; x2 ], where
min[x1 ; x2 ] should be read as the minimum of x1 and x2 . (Useful hint: the function
min[x1 ; x2 ] is not differentiable.)
The approach taken in question 1 does not work anymore, because the minimum
function is not differentiable and hence we cannot obtain the first order conditions
by taking the derivatives. However, thinking deeply about how this utility function
works, we are able to find a necessary condition here, too. Suppose the consumer
chooses quantities such that x1 > x2 . In this case, her utility will be equal to x2
and the expenditure is p1 x1 + p2 x2 . Clearly, the amount of x1 that exceeds the
one of x2 is wasted: choosing a lower x1 would yield the same level of utility as
long as it is not less than x2 , but expenditure would be lower. The savings could
be spent on more x2 and therefore a higher level of utility could be reached – the
original x1 could not have been a utility maximizing choice. The same is true in
case x2 > x1 . We can therefore conclude that in an optimum, it must be the case
that
x1 = x2 .
This necessary condition can be inserted to the usual budget constraint to obtain
I
I = p 1 x1 + p 2 x1 ↔ x1 =
p1 + p2
and consequently
I
x2 = .
p1 + p2
(3) Consider a market where demand and supply are given, respectively, by xD = 10−p
and xS = 2 + p. What are the equilibrium price and quantity in this market?
Assume that consumers have to pay a tax of t = 2 per unit of x that they consume.
What is the new equilibrium price and quantity?
In equilibrium, demand has to equal supply. Equating demand and supply gives
us

10 − p = 2 + p ↔ p = 4
and therefore

xD = xS = 6.
The tax levied on consumption increases any given price by two, so that the
new demand curve will look like x0D = 10 − (p + 2) = 8 − p. Again, equating the
demand and supply functions yields

8−p=2+p ↔ p=3
and therefore

xD = xS = 5.
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Note that the tax has driven a wedge between the price consumers pay, which
is p + 2 = 5 > 4, and the price suppliers get for their products, which is p = 3 < 4.
Correspondingly, consumers want to buy less and firms want to supply less. Tax
revenue for the government is x × t = 5 × 2 = 10. In terms welfare, consumer
surplus has decreased by areas a + b, producer surplus by areas c + d, and the
government earns tax revenues equal to areas a + c = 10. The triangle b + d is
the dead weight loss of the tax, i.e. the inefficiency that occurs because of the
introduction of the tax.
(4) Consider a monopolist that faces a demand curve x = 100−p, and has cost function
c(x) = 2 + 2x. Find the monopolist’s profit-maximizing choice of x. Discuss the
intuition behind the first order condition. Compute the monopolist’s profits.
A monopolist has market power and can therefore set prices. In her decision
how much to produce, she takes into account the effect a change in her price has
on demand. An optimal choice will be at the point where marginal revenue are
equal to marginal costs. To see this suppose marginal revenue was higher than
marginal costs. In this case, an additional unit of output would yield (marginal
revenue) more than it would cost (marginal cost) and therefore the monopolist
could increase her profits by increasing output. The reverse is true if a quantity
is chosen so that the last unit produced cost more than the marginal revenue
from selling this unit. Therefore, profit maximizing behavior implies the above
relationship.
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Revenues can be computed as R = p × x = (100 − x) × x = 100x − x2 , so that

marginal revenues are:
dR
MR = = 100 − 2x.
dx
Marginal costs are M C = dc(x)/dx = 2 (note that the cost function has a com-
ponent that is fixed and one that is variable), so that profit maximization implies
that

M R = M C ↔ 100 − 2x = 2 ↔ x = 49.
Substituting the optimal output back into the demand function gives us the equi-
librium price
49 = 100 − p ↔ p = 51.
We can now compute the monopolist’s profit as:
π = p × x − c(x) = 51 × 49 − (2 + 2 × 49) = 2399.
A final observation is that we could have arrived at the first order condition above
in a more formal way. The profit function is π = p × x − c(x). Substituting the
demand and cost function and maximizing profits with respect to x results in the
first order condition:
100 − 2x − 2 = 0 ↔ 100 − 2x = 2.