Problem Set 3

ECO 503

Summer 2015

Due: Saturday, August 22, 2015

Problem 1: A consumer has the following utility over two goods x and y:
, = / / .
The initial price vector is (1, 2) and initial income m is 200. The new price vector is (4, 2).
a) What are the generic functional forms of the Marshallian and Hicksian demand functions for
the above utility function?
b) What are the generic functional forms of the Indirect Utility and Expenditure functions for the
above utility function?
c) What is the utility at the initial prices and income?
d) What is the utility at the new prices and initial income?
e) Calculate the Compensating Variation amount. What is its interpretation?
f) Calculate the Equivalent Variation amount. What is its interpretation?
g) Draw two separate figures to show the CV and EV for this example.
h) Relate the CV and EV amounts found above with the Hicksian demand functions.
i) What is the change in the Consumer Surplus? Show that graphically and compare with CV and
EV amounts.
Problem 2: A firm in perfect competition has the following Cobb-Douglas production
function:
, = / / .
The wage rate is w, the rental rate is r, and price of the final good is p.
a) What is the returns to scale associated with this production function? Why do we need to
assume this returns to scale for Cobb-Douglas production functions?
b) Derive the input demand functions from the profit maximization problem.
c) What is the supply function of the perfectly competitive firm?
d) What is the profit function of the perfectly competitive firm?
e) How can we derive the supply function and input demand functions from the profit function?

f) Suppose the wage rate is w = 1, the rental rate is r = 2, and price of the final good is p = 3.
Find the optimal input demands, supply and profit of the firm.
g) For the same firm, solve the cost minimization problem to find the conditional input demand
functions as functions of prices and output.
e) What is the Long-run Cost function of the firm?
f) What are the Long-run Average Cost (LRAC) and Long-run Marginal Cost (LRMC) functions
of the firm?
g) Does this Long-run Cost function exhibit diseconomies of scale? Explain. Relate your answer
to part (a).
h) How can we derive the conditional input demand functions from the Long-run Cost function??
i) Suppose the wage rate is w = 1, the rental rate is r = 2, and output level is q = 6. Find the
optimal conditional input demands, and long-run cost of the firm.