ECON 201 - Problem Set 02

Thien Toan(220107), Minh Khoi (220056), Ha Vy (220159), Dan Khue(220168)

February 2025

Exercise 1
(a) If I don’t buy the season pass and opt for daily pass, my budget constraint is y = 1000 − 10x. It intercepts
with the y-axis at (1000,0) and intercepts with x-axis at (0,100).

(b) When I buy the season pass, I’ll have y = 1000 − 750 = $250 to spend on other activities. Thus, my budget
constraint is a vertical line go through (250,0).

(c) • If I visit the zoo every day (100 times) using daily passes, I will spend all of my $1000 on zoo tickets
and have nothing left for swimming. If I buy the season pass, I will have $250 left for other activities,
giving me more chances to go swimming.
• If I visit the zoo fewer than 75 times using daily passes, I will have more money left for swimming than
if I bought the season pass.

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 • If I visit the zoo more than 75 times, the season pass is the better option because it saves me money.
• If I visit the zoo exactly 75 times, I will have the same money as if I buy the season pass.

(d) Imagine I reached a certain utility level u during the summer. The compensated (Hicksian) demand curve
shows the number of zoo visits I would choose at different prices while staying on that same utility level. In
our context:

• The horizontal axis represents zoo visits.

• The vertical axis represents the price per zoo visit.
• At the actual price of $10, mark the point corresponding to my chosen number of visits under the daily
pass.

My consumer surplus is the area between the demand curve and the horizontal line at p=10

(e) With the season pass: The marginal cost per zoo visit is $0. Therefore, the entire benefit from zoo visits is
the area under the Hicksian demand curve (up to the number of days I visit).
• The “gross” consumer surplus is the area between the demand curve and the line at p=0 (since each
visit costs nothing extra).
• The cost of the season pass is represented by a rectangle of area $750.
• The net consumer surplus is the gross consumer surplus minus this $750.

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(f) We want to solve
max xα 1−α
1 x2 subject to 10 x1 + x2 = 1000.
x 1 , x2

Define the Lagrangian:

1−α
L(x1 , x2 , λ) = xα
1 x2 + λ (1000 − 10x1 − x2 ).
FOC:
∂L
= α x1α−1 x1−α
2 − 10 λ = 0,
∂x1
∂L −α
= (1 − α) xα
1 x2 − λ = 0,
∂x2
∂L
= 1000 − 10 x1 − x2 = 0.
∂λ
From the second equation,
−α
λ = (1 − α) xα
1 x2 .

Substitute into the first:

−α
α x1α−1 x1−α
2 = 10 (1 − α) xα
1 x2 .

Rearranging gives
α x1 10 (1 − α)
= =⇒ x2 = x1 .
10 (1 − α) x2 α
Use the budget constraint 10 x1 + x2 = 1000:
 
10 (1 − α) 1−α
10 x1 + x1 = 1000 =⇒ 10 x1 1 + = 1000.
α α

Since
1−α 1
1+ = ,
α α
it follows that
1
10 x1 · = 1000 =⇒ x1 = 100 α.
α
Hence
x2 = 1000 − 10 x1 = 1000 − 10(100 α) = 1000 (1 − α).
Therefore, the optimal solution under the daily pass is

x∗1 = 100 α, x∗2 = 1000 (1 − α).

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(g) As each unit of x2 corresponds to $1 of spending. In other words, the "price" of each unit of x2 is automatically
p2 = 1. The indirect utility v(p1 , p2 , M ) is the maximum utility achievable given prices and income. From
the optimal demands above,
αM (1 − α)M
x∗1 = , x∗2 = .
p1 p2
Plug these into u(x1 , x2 ) = xα 1−α
1 x2 :
 α  1−α
αM (1 − α)M
v(p1 , p2 , M ) = .
p1 p2

For our specific numbers p1 = 10, p2 = 1, M = 1000, we get

 α  1−α
α × 1000 (1 − α) × 1000
v(10, 1, 1000) = .
10 1

(h) • Number of Zoo Visits

x∗1 = 100 × 0.5 = 50.
• Spending on Other Amusements
x∗2 = (1 − 0.5) × 1000 = 500.

• Utility √ √
u∗ = 500.5 × 5000.5 = 50 × 500.
√ √
Numerically, 50 ≈ 7.07 and 500 ≈ 22.36, giving

u∗ ≈ 7.07 × 22.36 ≈ 158.

Thus, with α = 0.5, I spend $500 on zoo visits (50 visits at $10 each), $500 on other amusements, and attain
a utility of about 158.

(i) The marginal willingness to pay (MWTP) for one more zoo visit is given by the marginal rate of substitution
(MRS) between x1 and x2 :

∂u/∂x1 αxα−1 x1−α α x2

MRSx1 ,x2 = − =− 1
α
2
−α = − .
∂u/∂x2 (1 − α)x1 x2 1 − α x1

If I am already visiting the zoo 100 days and spending your entire $1000 on those visits (so x1 = 100, x2 = 0
, then
α 0
MRSx1 ,x2 = = 0.
1 − α 100
In other words, if I am at a corner solution of 100 zoo visits and $0 for other activities, my marginal willingness
to pay for one more zoo day is zero—there is no money left to trade-off, and I cannot go more than 100 days
anyway.
(j) For the Cobb-Douglas utility with α = 0.5:

u(x1 , x2 ) = x10.5 x0.5

2 .

1 x2 = u. I have the x1 , x2 :
Solving the cost-minimization problem min{p1 x1 + p2 x2 } subject to x0.5 0.5

 α 
(1−α)
1−α
α
x1 = u
p1p2
 α−1  (1−α)+1
α 1−α
x2 = u
p1 p2

The final result is:

√
e(p1 , p2 , u) = 2 p1 p2 u.

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Exercise 2
(a) Answer:

(b) Answer:

(c) Answer:

(d) Answer below in (e)

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(e) Answer:

(f) Use Lagrange:

√
L = p1 x1 + x2 + λ(u − 10 x1 − x2 )

 
∂L 10 5λ
= p1 − λ √ ⇒ p1 = √ (1)
∂x1 2 x1 x1

∂L
=1−λ=0 ⇒λ=1
∂x2
Plug into λ = 1(1)
5 25 25
⇒ p1 = √ =⇒ = p21 =⇒ x1 = 2
x1 x1 p1
√ √
new max u(x1 , x2 ) = 10 x1 + x2 subject topx1 + x2 = 50 10 x1 is the benefit of consuming one more unit
of pho. We have:
d √ 1 −1/2 5
M Ux1 = (10 x1 ) = 10 · x1 =√
dx1 2 x1
⇒ marginal utility for x1 : √
M U x1 5 x1
= (1)
P1 P1
M Ux2 1
= =1 (2)
P2 1

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 ⇒ Since (1) = (2) : P1 = √5
x1
25
⇒ x1 = P12
Compensated

min P1 x1 + P2 x2 s.t. u = u(x1 , x2 )

x1 ,x2
√
or min P1 x1 + x2 s.t. 10 x1 + x2 = u
x1 ,x2

(g) • Before tax: P1 = 1

• ⇒ x1 = 2
1 =2
• After tax: P1 = 1.25
• x′1 = 25
1.252 = 16
• Change: 25 − 16 = 9

(h) T = t · x′1 = 0.25 · 16 = 4 Government collects 4$/per week from your pho consumption.
(i)

E = 1 · x1 + x2 = 50
E ′ = 1.25x′1 + µ − 10x1′0.5
25 25
x′1 = 2 = ≈ 16
p1 1.252
25 10 · 5
⇒ E ′ = 1.25 · + 75 − = 55
1.252 1.25
⇒ L = I − E ′ = 50 − 55 = −5$

(j) DWL = 5 - 4 =1

Exercise 3
(a) With the cost c imposed by the government, the company’s profit is calculated by π = px − (w + c)l =⇒
x = πp − wp l. The iso-profit curve intercepts the y-axis at x = πp with the slope w+c
p .

(b) The profit-maximizing plan occurs at the point where the iso-profit curve intersects the production frontier,
as this represents the highest possible profit given the firm’s production constraints. At point A, marginal
revenue per labor M Pl × p equal to the cost of hiring it w + c.

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(c) As c goes up, the slope w+cp of every isoprofit line increases. Because the production function eventually
has diminishing marginal product, a steeper isoprofit line will be tangent at a lower level of l. Conclusion:
the firm’s optimal labor input decreases and thus output decreases if c rises, assuming the firm still finds it
profitable to produce.

(d) If c becomes large enough, every isoprofit line that intersects the production function would lead to negative
(or zero) profit. At some high c, the best the firm can do is not produce at all: set l = 0 and x = 0, which
produces zero revenue and zero labor cost. This is the shutdown outcome.

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(e) We calculate the company’s profit by π = px − (w + c)l with. With Price of output p = 1, w = 10 and
−(l−5) . We have the profit maximization problem:
x = 1+e100

100
π(l) = px − (w + c)l = − (10 + c)l.
1 + e−(l−5)
 
(f) FOC: dπ
dl = d
dl
100
1+e−(l−5)
− (10 + c) = 0. Let

X ≡ e−(l−5) = e−l+5 .

Then
100
x= .
1+X
We have
dX
= −e−l+5 = −X.
dl
Hence,  
d 100 1 d 1
= −100 (1 + X) = −100 (dX/dl).
dl 1 + X (1 + X)2 dl (1 + X)2
Substitute dX/dL = −X:
100X
x′ (l) = .
(1 + X)2
Therefore, the first-order condition is
100X
= 10 + c.
(1 + X)2
Let a ≡ 10 + c. Then
100X
= a =⇒ 100X = a(1 + X)2 .
(1 + X)2
Expand (1 + X)2 = 1 + 2X + X 2 :

100X = a(1 + 2X + X 2 ) = a + 2aX + aX 2 .

Rearrange:
0 = a + 2aX + aX 2 − 100X,
aX 2 + (2a − 100)X + a = 0.
Hence X solves the quadratic

aX 2 + (2a − 100)X + a = 0, where a = 10 + c.

By the quadratic formula, p

−(2a − 100) ± (2a − 100)2 − 4a2
X= .
2a

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 Because X = e−(l−5) must be positive, we choose the positive root that makes economic sense (usually the
smaller root, to ensure X < 1 if l > 5). Once X ∗ (c) is found, we use

X = e−(l−5) =⇒ ln(X) = −(l − 5) = 5 − l =⇒ l = 5 − ln[X].

Thus
l∗ (c) = 5 − ln[X ∗ (c)].
And the corresponding optimal output is
100
x∗ (c) = .
1 + X ∗ (c)

(g) Let c = 0. Then a = 10 + 0 = 10. The quadratic becomes

10X 2 + (20 − 100)X + 10 = 0 =⇒ 10X 2 − 80X + 10 = 0.

Divide by 10:
X 2 − 8X + 1 = 0.
Solve via the quadratic formula:
√ √
8± 64 − 4 8 ± 60 8 ± 7.746
X= = ≈ .
2 2 2
The two roots are about 0.127 and 7.87. We want the positive root less than 1 (so that l > 5). Hence

X(0) ≈ 0.127.

Optimal labor:
l∗ (0) = 5 − ln(0.127) ≈ 5 − (−2.06) = 7.06.
Optimal output:
100 100
x∗ (0) = ≈ ≈ 88.7.
1 + 0.127 1.127
Hence, when c = 0, the profit-maximizing plan is

l∗ (0) ≈ 7.06, x∗ (0) ≈ 88.7.

(h) Using the similar approach, when c = 3:

l∗ (3) ≈ 6.71, x∗ (3) ≈ 84.7.

Exercise 4
Consider an athlete who has to determine how much training effort to exert for an upcoming competition. We
can model such an athlete as a “producer of good performance levels.”
a) Begin with a graph that puts “effort” on the horizontal axis and “performance levels” on the vertical axis.
Assume that the marginal payoff from exerting effort initially increases with additional effort but eventually
declines. Illustrate the athlete’s feasible “production plans.”

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b) Suppose that the athlete dislikes expending effort but likes the higher probability of winning the competition
that results from better performance. Assume that tastes are rational, continuous, and convex. Illustrate
what indifference curves for this athlete will look like.

c) Combining your two graphs, illustrate the optimal level of effort exerted by the athlete for the competition.

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 Figure 1: Enter Caption

d) Based on the optimal bundles of the opponent and the athlete shown on the graph, we can conclude that the
opponent will win

Let effort be denoted by ℓ and "performance levels" by x. Suppose that an athlete’s tastes are defined by
u(x, ℓ) = x − αℓ, and suppose that the production frontier for producing "performance levels" is given by
x = ℓ2 − 0.25ℓ3 .
e) When effort ℓ is on the horizontal and x is on the vertical, what is the marginal rate of substitution for this
athlete? What does your answer imply for the shape of indifference curves?
We can find the MRS by taking the ratio of the marginal utilities:
∂u
MRS = M Uℓ
M Ux = ∂ℓ
∂x = −α
1 =α
∂ℓ

This implies that the indifference curves are straight lines with a slope of −α.
f) Setting this up similar to a profit maximization problem of a firm, solve for the athlete’s optimal level of
effort.
To find the optimal level of effort, we can set up the problem similar to a profit maximization problem.
The athlete wants to maximize utility, which is analogous to maximizing profit. The production function
is analogous to the revenue function, and the cost of effort is analogous to the cost of production.

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 The athlete’s "profit" is given by:
π = x − αℓ = ℓ2 − 0.25ℓ3 − αℓ
To find the optimal level of effort, we take the derivative of the profit function with respect to effort and
set it equal to zero:
dπ
dℓ = 2ℓ − 0.75ℓ2 − α = 0
Solving for ℓ, we get:
√
2± 4−3α
ℓ= 1.5
We can discard the negative solution, so the optimal level of effort is:
√
2+ 4−3α
ℓ∗ = 1.5

g) Compare the optimal effort level for the athlete for whom α = 1 and the athlete for whom α = 0.77. Which
one will win the competition?
For α = 1, the optimal effort level is:
√
2+ 4−3
ℓ∗1 = 1.5 = 2+1
1.5 =2
For α = 0.77, the optimal effort level is:
√ √
2+ 4−3(0.77)
ℓ∗2 = 1.5 = 2+1.51.69 = 2+1.3
1.5 = 2.2
The athlete with α = 0.77 will exert more effort and therefore win the competition. This is because they
have a lower cost of effort, so they are willing to put in more effort to achieve a higher level of performance.

Exercise 5
Suppose that successful performance on group projects requires a combination of focused individual work time
and productive meetings. Neither by itself produces high project completion rates—but in the right combination,
they maximize project productivity.
We can model project productivity as emerging from a production process that takes hours of focused work
and hours of productive meetings as inputs. Suppose this production process is homothetic and has decreasing
returns to scale.
a) On a graph with hours of meetings on the horizontal axis and hours of focused work on the vertical, illustrate
an isoquant that represents a particular project productivity level x∗ .

b) Suppose you are always willing to pay $5 to get back an hour of meetings and $20 to get back an hour of
focused work. Illustrate on your graph the least cost way to get to the project productivity level x∗ .

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c) Since the production process is homothetic, where in your graph are the cost minimizing ways to get to
the other project productivity isoquants?

d) Using your answer to (c), can you graph a vertical slice of the production frontier that contains all the cost
minimizing meeting/work input bundles.

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 Figure 2: image 5d

e) Suppose you are willing to pay $p for every additional percentage point of project productivity. Can you
illustrate on your graph from (d) the slice of the "isoprofit" that gives you your optimal project productivity?
Is this necessarily the same as the project productivity level x∗ from your previous graph?

f) Suppose the introduction of AI-powered productivity tools has generated a significant productivity boost
to your work—making you twice as productive when you focus on individual work. Illustrate the changes
that AI productivity tools would do to your graph (draw a new graph to illustrate the changes instead of
overlaying on the existing one).

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Suppose that the production technology described above can be captured by the production function x =
40l0.25 s0.25 , where x is your project productivity level, l is the number of hours spent on focused work, and
s is the number of hours spent in productive meetings.
g) Assume again that you’d be willing to pay $5 to get back an hour of meetings and $20 to get back an
hour of focused work. If you value each percentage point of project productivity at p, what is your optimal
"production plan"? The production function is given by:

x = 40l0.25 s0.25

where x is project productivity, l is hours of focused work, and s is hours of productive meetings.
You value each percentage point of project productivity at p dollars. Therefore, your revenue is px. The
cost of focused work is 20 dollars per hour, and the cost of meetings is 5 dollars per hour. Your profit, π,
is therefore:

π = px − 20l − 5s
= p(40l0.25 s0.25 ) − 20l − 5s

To find the optimal production plan, we need to find the values of l and s that maximize π. Taking the
partial derivatives of π with respect to l and s and setting them equal to zero, we get:

∂π
= 10pl−0.75 s0.25 − 20 = 0
∂l
∂π
= 10pl0.25 s−0.75 − 5 = 0
∂s

Solving these equations simultaneously, we get:

2
l=
p2
8
s = 4l =
p2

Therefore, the optimal production plan is to spend 2

p2 hours on focused work and 8
p2 hours in productive
meetings.
h) Solve for the same optimal plan using the two-step profit maximization method ("profit maximization via
cost minimization") (e.g., the method involving the calculation of the cost function).
The two-step profit maximization method involves first minimizing cost for a given level of output and then
maximizing profit over the chosen output level.
Step 1: Cost Minimization
The cost function is given by:

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 C = 20l + 5s

We want to minimize C subject to the constraint x = 40l0.25 s0.25 . Setting up the Lagrangian, we get:

L = 20l + 5s + λ(x − 40l0.25 s0.25 )

Taking the partial derivatives of L with respect to l, s, and λ and setting them equal to zero, we get:

∂L
= 20 − 10λl−0.75 s0.25 = 0
∂l
∂L
= 5 − 10λl0.25 s−0.75 = 0
∂s
∂L
= x − 40l0.25 s0.25 = 0
∂λ

Solving these equations simultaneously, we get:

x2
l=
6400
4x2 x2
s= =
6400 1600
x
λ=
80

Substituting these values back into the cost function, we get the cost function in terms of x:

x2 x2 x2
   
C(x) = 20 +5 =
6400 1600 160

Step 2: Profit Maximization

Profit is given by:

x2
π(x) = px − C(x) = px −
160
Taking the derivative of π with respect to x and setting it equal to zero, we get:

dπ x
=p− =0
dx 80
Solving for x, we get:

x = 80p

Substituting this value back into the expressions for l and s from Step 1, we get:

(80p)2  p 4
l= =
6400 8
(80p)2  p 4
s= = 16
1600 8

This is the same optimal production plan as we found in part (g).

i) What is your optimal production plan when you value each percentage point of project productivity at $2?
Substituting p = 2 into the expressions for l and s from part (g), we get:

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  4
2 1
l= =
8 256
 4
2 1
s = 16 =
8 16

Therefore, the optimal production plan when p = 2 is to spend 1

256 hours on focused work and 1
16 hours in
productive meetings.

Exercise 6
(a) The firm chooses the profit-maximizing production plan (xA , lA , k A ) given the wage w, rental rate r, and
output price p. The isoquant represents all combinations of labor l and capital k that produce xA . To
minimize cost, the firm ensures that the marginal rate of technical substitution (MRTS) equals the ratio of
input prices:M RT Sℓ,k = M Pk = r where M Pℓ and M Pk are the marginal products of labor and capital,
M Pℓ w

respectively. The firm adjusts its input choice (ℓA , k A ) so that it is on the lowest possible isocost line while
still producing xA . The optimal point is where the isocost line is tangent to the isoquant.

(b) The cost function is given by: C(x) = wl + rk

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(c) Assuming the cost of producing each additional unit remains constant, the marginal cost curve is a horizontal
line:

(d) Increasing the wage rate raises the cost of hiring labor. The new cost function:

C ′ (x) = (1 + t)wℓ + rk

• Given any level of input (with w,r fixed), the new cost is higher than the original cost function.
• Since labor is now more expensive relative to capital, the iso-cost line rotates inward and becomes
steeper (New slope − (1+t)w
r < − wr ). The firm substitutes capital for labor, increasing k and decreasing
ℓ.
• As the total cost rises, the marginal cost also increases with each additional unit of input. Since the
output price remains fixed, the firm will reduce production to the point where the new marginal cost
equals the price.

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(e) Raising r increases the cost of capital. The new cost function:

C ′ (x) = wℓ + (1 + t)rk

Graphically:
• The isocost line pivots inward (flatter), meaning capital becomes relatively more expensive.
• The firm substitutes labor for capital, increasing ℓ and decreasing k.
• Using the same logic as in question d, the cost curve shifts upward, increasing marginal cost (MC) and
decreasing the output.
(f) When both input costs increase proportionally, the new cost function becomes:

C ′ (x) = (1 + t)(wℓ + rk)

Graphically:
The isocost line shifts inward without changing slope, as both inputs become equally expensive. The firm
cannot substitute between labor and capital as their relative price remains unchanged. The cost curve shifts
upward, increasing MC and reducing xA .
(g) If the government imposes a profit tax at rate t, the firm’s after-tax profit is:

π ′ = (1 − t)π

Effects:
Since a profit tax does not alter the firm’s cost structure, the firm still chooses xA where MC = p. The
production plan remains unchanged in the short run. However, in the long run, firms may reduce investment
if they anticipate lower post-tax returns.

Suppose your firm has a decreasing returns to scale, Cobb-Douglas production function of the form x = Alα k β .

h) Calculate input demand and output supply functions using the one-step profit maximization method.
Solution. Let x be the output, l be labor input, k be capital input, A be a positive constant, and α, β > 0
with α + β < 1 (decreasing returns to scale). Let p be the price of the output, w be the wage rate (price
of labor), and r be the rental rate of capital.
The profit function is given by:
π = px − wl − rk
Substituting the production function into the profit function:

π = pAlα k β − wl − rk

To find the input demand functions, we take the partial derivatives of the profit function with respect to l
and k, and set them equal to zero:
∂π
= pAαlα−1 k β − w = 0
∂l
∂π
= pAβlα k β−1 − r = 0
∂k

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From the first equation, we get:
pAαlα−1 k β = w
w
lα−1 k β =
pAα
 1
 α−1
w β
l= k 1−α
pAα

From the second equation, we get:

pAβlα k β−1 = r
r
lα k β−1 =
pAβ
 1
 β−1
r α
k= l 1−β
pAβ

Substitute the expression for l into the equation for k:

α
 1
 β−1 " 1
 α−1 # 1−β
r w β
k= k 1−α
pAβ pAα

 1
 β−1  α
 (α−1)(1−β)
r w αβ
k= k (1−α)(1−β)
pAβ pAα
 1
 β−1  α
 (α−1)(1−β)
αβ
1− (1−α)(1−β) r w
k =
pAβ pAα
  β−11  α
 (α−1)(1−β)
(1−α)(1−β)−αβ r w
k (1−α)(1−β) =
pAβ pAα
 1
 β−1  α
 (α−1)(1−β)
1−α−β r w
k (1−α)(1−β) =
pAβ pAα
 α−1
 1−α−β  −α
 1−α−β
r w
k=
pAβ pAα

Similarly, substitute the expression for k into the equation for l:

β
 1
 α−1 " 1
 β−1 # 1−α
w r α
l= l 1−β
pAα pAβ

 1
 α−1  β
 (β−1)(1−α)
w r αβ
l= l (1−α)(1−β)
pAα pAβ
 1
 α−1  β
 (β−1)(1−α)
αβ
1− (1−α)(1−β) w r
l =
pAα pAβ
 1
 α−1  β
 (β−1)(1−α)
1−α−β w r
l (1−α)(1−β) =
pAα pAβ
 β−1
 1−α−β  −β
 1−α−β
w r
l=
pAα pAβ
Now, substitute the input demand functions into the production function to find the output supply function:
" β−1
 1−α−β  −β
 1−α−β #α " α−1
 1−α−β  −α
 1−α−β #β
w r r w
x=A
pAα pAβ pAβ pAα

 α(β−1) 
 1−α−β −αβ
 1−α−β   β(α−1)  −αβ
 1−α−β
w r r 1−α−β
w
x=A
pAα pAβ pAβ pAα

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  α(β−1)−αβ   −αβ+β(α−1)
w 1−α−β
r 1−α−β
x=A
pAα pAβ
 α
 1−α−β  β
 1−α−β
w r
x=A
pAα pAβ
 α
 1−α−β  β
 1−α−β
w r
x=A
pAα pAβ

i) Now derive again the input demand and output supply functions but using the cost function (e.g., using the
two-step profit maximization method). When doing so, also derive the conditional input demand functions.
Solution. Step 1: Derive the Cost Function
The cost minimization problem is:
min wl + rk s.t. Alα k β = x
l,k

The Lagrangian for this problem is:

L = wl + rk + λ(x − Alα k β )

Taking the partial derivatives with respect to l, k, and λ and setting them equal to zero, we get:
∂L
= w − λAαlα−1 k β = 0
∂l
∂L
= r − λAβlα k β−1 = 0
∂k
∂L
= x − Alα k β = 0
∂λ
From the first two equations, we get:
w αk
=
r βl
αkr
l=
βw
Substituting this into the production function, we get:
 α
αkr
x=A kβ
βw
 α
αr
x=A k α+β
βw
 α
α+β x βw
k =
A αr
  1
α  α+β
x βw
k=
A αr
Substituting this back into the expression for l, we get:
  1
α  α+β
αr x βw
l=
βw A αr
" 1
 β # α+β
x αr
l=
A βw

These are the conditional input demand functions.

Substituting these back into the cost equation, we get the cost function:
" 1 1
 β # α+β   α  α+β
x αr x βw
C(w, r, x) = w +r
A βw A αr

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 "   α+ββ α #
  α+β
1 1
− α+β α α β α β β
C(w, r, x) = x A
α+β w r α+β + w α+β r α+β
α+β
β α
"  β   α+β α #
1
− 1 α β α α+β
β
C(w, r, x) = x α+β A α+β w α+β r α+β +
β α
  β α 
  α+β
1 α+β
− α+β
Let B = A α
β
β
+ α , then the cost function can be written as:

1 α β
C(w, r, x) = Bx α+β w α+β r α+β

Step 2: Derive the Output Supply and Input Demand Functions

The profit maximization problem is:
max px − C(w, r, x)
x

Substituting the cost function, we get:

1 α β
max px − Bx α+β w α+β r α+β
x

Taking the derivative with respect to x and setting it equal to zero, we get:
1 1 α β
p− Bx α+β −1 w α+β r α+β = 0
α+β
1−α−β p(α + β)
x α+β = α β
Bw α+β r α+β
 α+β
 1−α−β
p(α + β)
x= α β
Bw α+β r α+β
This is the output supply function.
Substituting this back into the conditional input demand functions, we get the input demand functions:

1
"  β # α+β  1
 1−α−β
1 αr p(α + β)
l= α β
A βw Bw α+β r α+β
  1
α  α+β  1
 1−α−β
1 βw p(α + β)
k= α β
A αr Bw α+β r α+β

j) Derive the profit function.

Solution. Recall that the profit function is given by:

π = px − C(w, r, x)

where p is the price of the output, x is the output, and C(w, r, x) is the cost function.
From the previous derivation, we know that the cost function is:

1 α β
C(w, r, x) = Bx α+β w α+β r α+β

where
"  β α #
  α+β
1
− α+β α α+β β
B=A +
β α

Substituting the cost function into the profit function, we get:

1 α β
π = px − Bx α+β w α+β r α+β

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 Now, substitute the output supply function, which we derived earlier:

 α+β
 1−α−β
p(α + β)
x= α β
Bw α+β r α+β
Substituting this into the profit function gives:

 α+β
 1−α−β  1
 1−α−β
p(α + β) p(α + β) α β
π=p α β −B α β w α+β r α+β
Bw α+β r α+β Bw α+β r α+β

This expression can be simplified further, but it is quite lengthy. The key takeaway is that we have expressed
the profit function in terms of the exogenous variables p, w, and r. This allows us to analyze how profits
change in response to changes in these variables. ■

k) Consider a tax on labor that raises the labor costs for firms to (1 + t)w. How does this affect input demand
functions, output supply functions, and conditional input demand functions, and the cost function?

Solution. When a tax on labor is imposed, the effective wage rate becomes (1 + t)w. We can simply
substitute this new wage rate into the previously derived functions.
Input Demand Functions:

 1−β
 1−α−β  β
 1−α−β
(1 + t)w r
l=
pAα pAβ

 1−α
 1−α−β  α
 1−α−β
r (1 + t)w
k=
pAβ pAα

As expected, the demand for labor decreases, and the demand for capital (a substitute) increases.
Output Supply Function:

 α
 1−α−β  β
 1−α−β
(1 + t)w r
x=A
pAα pAβ

Output supply decreases due to the increased cost of labor.

Conditional Input Demand Functions:

" 1
 β # α+β
x αr
l=
A β(1 + t)w

  1
α  α+β
x β(1 + t)w
k=
A αr

Holding output constant, the demand for labor decreases, and the demand for capital increases.
Cost Function:

1 α β
C(w, r, x) = Bx α+β ((1 + t)w) α+β r α+β

The cost function increases due to the higher effective wage rate.

l) Repeat (k), but for the case of a tax on capital that raises the capital cost for the firm to (1 + t)r.

Solution. This case is analogous to the tax on labor. We substitute (1 + t)r for r in the original functions.
Input Demand Functions:

 1−β
 1−α−β  β
 1−α−β
w (1 + t)r
l=
pAα pAβ

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  1−α
 1−α−β  α
 1−α−β
(1 + t)r w
k=
pAβ pAα

The demand for capital decreases, and the demand for labor increases.
Output Supply Function:

 α
 1−α−β  β
 1−α−β
w (1 + t)r
x=A
pAα pAβ

Output supply decreases.

Conditional Input Demand Functions:

" 1
 β # α+β
x α(1 + t)r
l=
A βw

  1
α  α+β
x βw
k=
A α(1 + t)r

Holding output constant, the demand for capital decreases, and the demand for labor increases.
Cost Function:

1 α β
C(w, r, x) = Bx α+β w α+β ((1 + t)r) α+β

The cost function increases. ■

m) Repeat (k), but for the case of a tax on profit as described in (g).
Solution. A tax on profit does not directly affect the cost minimization problem, so the conditional input de-
mand functions and the cost function remain unchanged. However, it affects the firm’s profit maximization
decision.
The profit function becomes:

π = (1 − t)(px − C(w, r, x))

This effectively reduces the firm’s profit margin, leading to a decrease in output supply. However, the input
demand functions remain the same because the relative prices of labor and capital are not affected by the
profit tax.

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