Mid-Term Examination: Suggested Answer

Econ 501
18th October, 2013
Duration: 1 Hour

Total Marks 50

Question 1. Consider a Solow model with no technical progress. Let the production
function be
Y = F (K, L)
where K and L are capital stock and labor force respectively. Production function is
strictly increasing and concave function of K and L. Assume that production function has
constant returns to scale. Let n and be the labor force growth rate and the depreciation
rate respectively. Suppose that capital and labor are paid their marginal products. In
addition, all capital income is saved and all labor income is consumed. Thus,
K = M P K K K
where M P K is the marginal product of capital.
(i) Denote the capital-labor ratio by k(= K/L). Derive the differential equation
characterizing the time path of k. [Marks 7]
(ii) Derive the equation which characterizes the steady state values of k. Let Y =
K L1 with 0 < < 1. Using a diagram show that this economy will converge to a
balanced growth path for any initial value of k 0. Suppose that the initial value of k > 0.
Discuss the process by which the economy would reach its balanced growth path. [Marks
13]

(iii) Derive the expression for steady state value of k(> 0), wage rate, w, and the real
rate of interest, r. [Marks 5]
Suggested Answer:
By taking the derivative of k w.r.t. time and using the expression for K above you
can derive
k = M P K k ( + n)k = (M P K ( + n))k.

(1)

The steady state is characterized by

(M P K ( + n))k = 0.

(2)

Two steady states k1 = 0 and k2 > 0. k2 will be stable steady state and given by
M P K k 1 = n + .

(3)

You can draw the standard diagram, one depicting ( + n)k and other M P K k.
Alternatively, you can draw the phase diagram. For any initial value of k > 0 the economy
1

will converge to k2 . If k < k2 , then M P K > + n and the capital investment will be
larger than the break-even point increasing the capital stock. This process will go on till
the economy reaches k2 . Opposite will be the case if k > k2 .
With Y = K L1 ,
k2 = (

1
1
)
.
+n

w = M P L = (1 )(

1
)
.
+n

r = M P K = n.
Question 2. Consider a two-period economy with competitive markets. Suppose that the
representative consumer has endowment of y units good in the first period and 1 unit of
time in the second period. Suppose that the second period production function is k n1 ,
where k is the investment made in the first period and n is the labor supplied in the
second period. Suppose that the depreciation rate is 100 %. The objective function of the
consumer is
ln c1 + ln c2 + ln(1 n).
i. Set-up the social planner problem. [Marks 5]
ii. Derive the first order conditions characterizing the optimal choices of k and n and
interpret them. Solve for the optimal choices of k and n. [Marks 12]
iii. Define the competitive equilibrium. [Marks 3]
iv. Derive the equilibrium prices. [Marks 5]
Suggested Answer:
The social planners problem:
max lnc1 + ln c2 + ln(1 n)

c1 ,c2 ,k,n

subject to resource constraints:

c1 + k = y

(1)

c2 = k n1 .

(2)

=
yk
k

(3)

The f.o.cs are

k:
and
2

n:

1
1
=
.
1n
n

(4)

As usual these conditions equate the SMC and SMB of choices of k and n respectively.
(3) and (4) imply
k=

y
1+

(5)

n=

1
.
2

(6)

Using (1) and (2), you can derive the expression for c1 and c2 as well.
Definition of Competitive Equilibrium:
Competitive Equilibrium: A competitive equilibrium consists of prices {w, r} and
allocations {c1 , c2 , k, n} such that:
(a) consumers maximize their utilities given prices and subject to their budget constraints;
(b) firms maximize profits given prices and technology; and
(c) markets clear:
c1 + k = y, c2 = k n1 , nd = ns
where nd and ns are demand and supply of labor respectively.
w = M P L and r = M P K 1. Just put the values of optimal k and n from (5) and
(6) in relevant expressions.