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    Assignment 2

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    This document provides an assignment for an Advanced Microeconomics course. It includes 4 questions about topics such as household preferences and demand, portfolio choice with risk aversion, firm production and technology, and consumer surplus and compensating variation. Students are asked to show results, derive equations, and interpret economic concepts related to these microeconomics topics. The deadline for the assignment is November 21, 2018.

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    Assignment 2

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    duc anh
    43 views5 pages
    This document provides an assignment for an Advanced Microeconomics course. It includes 4 questions about topics such as household preferences and demand, portfolio choice with risk aversion, firm production and technology, and consumer surplus and compensating variation. Students are asked to show results, derive equations, and interpret economic concepts related to these microeconomics topics. The deadline for the assignment is November 21, 2018.

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    This document provides an assignment for an Advanced Microeconomics course. It includes 4 questions about topics such as household preferences and demand, portfolio choice with risk aversion, firm production and technology, and consumer surplus and compensating variation. Students are asked to show results, derive equations, and interpret economic concepts related to these microeconomics topics. The deadline for the assignment is November 21, 2018.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    43 views5 pages

    Assignment 2

    Uploaded by

    duc anh
    This document provides an assignment for an Advanced Microeconomics course. It includes 4 questions about topics such as household preferences and demand, portfolio choice with risk aversion, firm production and technology, and consumer surplus and compensating variation. Students are asked to show results, derive equations, and interpret economic concepts related to these microeconomics topics. The deadline for the assignment is November 21, 2018.

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    © All Rights Reserved
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    of 5

    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

    1
    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.

    2
    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.

    3
    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

    4
    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.

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