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

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 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.

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 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.

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 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

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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.