API 111 / Econ 2020a / HBS 4010

Maciej H. Kotowski / Harvard University

Problem Set 4
Due: October 27, 2014 at 13.00

Legibly write your name (and the names of any collaborators) on your independently written-up solutions.
Submit your solutions to the assignment drop box. Do not bring solutions to lecture.
Show your work. Include brief and precise explanations of intuition and derivations as appropriate.
Help us out.

Enclose final answers with a box.

1. George and Crop Insurance

Read the class handout George and Crop Insurance, which is available on the course website. Complete
the review questions (a)(f) on that handout.
2. Canonical Single-Output Production Functions
A firm produces a single output good output good (y) using two input goods (z1 , z2 ). Its production function
is f (z1 , z2 ). Let p be the price of the output good. Let w1 and w2 be the input good prices. For each of the
production functions below, compute the following:
(i) The firms conditional factor demand function, z (w, y), for each input good .
(ii) The firms cost function, c(w, y).
(iii) The firms profit-maximizing output level, y (p, w). (Be mindful of returns to scale. Sometimes a firm
might not have a profit-maximizing output level.)
In each of the cases below, , > 0 are constants.
a) The Cobb-Douglas production function: f (z1 , z2 ) = z1 z2 .
b) The Leontief production function: f (z1 , z2 ) = min{z1 , z2 }.
c) The Linear production function: f (z1 , z2 ) = z1 + z2 .
1

d) The Constant Elasticity of Substitution (CES) production function: f (z1 , z2 ) = (z1 + z2 ) . Assume
1.
3. Production with Start-Up Costs
A firm produces a single output good (y) using a single input good (z). Let p be the price of the output
good and let w be the price of the input. The firms production function f : R R is
(
0
z<1
f (z) =
.
log(z) z 1
a) Assuming free disposal, sketch the firms production set, Y = {(z, y) : y f (z)}.
b) As a function of prices, what is the firms profit-maximizing production level?
c) Suppose that the production function is f (z) = log(z + 1) instead. How does your answer to part (b)
change?

4. Production with Multiple Plants

A large electricity generator has two power plants. Both burn coal
to produce electricity. Plant 1 is old and
inefficient. For every z tons of coal burned, it produces f1 (z) = z units of electricity.
Plant 2 is new. Its
k-times as efficient as plant 1. For every z tons of coal burned, it produces f2 (z) = k z units of electricity.
Suppose that coal costs w per ton. The plants are located in close proximity to each other; hence, any
differences in transmission costs are negligible.
a) Find the electricity companys cost function to produce y units of electricity.
b) Suppose the electricity company produces y units of electricity at lowest cost. What fraction of the
electricity (if any) comes from plant 1 and what fraction (if any) comes from plant 2? Briefly outline the
intuition behind your conclusion.
c) Verify Shephards Lemma (MWG, Prop 5.C.2(vi)) in the context of this problem.

5. Production and the (Simple Version of the) Second Welfare Theorem

Consider a firm that produces a single output y with inputs z = (z1 , . . . , zL ). Its production function is
y = f (z). Let p be the price of the output good. Let wj be the price of input j.

a) Suppose the firms production function is f (z1 ) = z1 . Consider the production plan y = 4 and z1 = 16.
Is this production plan efficient? If so, find prices (p, w1 ) such that it is the firms profit-maximizing
production plan. If not, explain why.

b) Suppose the firms production function is f (z1 , z2 ) = z1 z2 . Consider the production plan y = 4,
z1 = 2, and z2 = 8. Is this production plan efficient? If so, find prices (p, w1 , w2 ) such that it is the firms
profit-maximizing production plan. If not, explain why.
c) Suppose the firms production function is f (z1 , z2 ) = min{z1 , z2 }. Consider the production plan y = 5,
z1 = 5, and z2 = 5. Is this production plan efficient? If so, find prices (p, w1 , w2 ) such that it is the firms
profit-maximizing production plan. If not, explain why.

Additional Practice Problems (Do Not Hand In)

6. Quasilinear Production

Suppose that a firm produces a single output (y) with the quasilinear production function f (z1 , z2 ) = z1 + z2 .
The prices of the two input goods are w1 and w2 , respectively. The price of the output good is p.
a) Does the firm have constant, increasing, or decreasing returns to scale?
b) Find the firms optimal choice of inputs as a function of input prices and output price.
c) Find the firms cost function c(w, y).

7. More Practice with Canonical Production Functions

A firm produces output good y with inputs z = (z1 , z2 , . . . , zL ). Let p be the price of the output good. Let
w = (w1 , w2 , . . . , wL ) be the prices of the input goods. For each of the production functions below, compute
the following:
(i) The firms conditional factor demand function, z (w, y), for each input good .
(ii) The firms cost function, c(w, y).
In each cases, suppose that 1 , 2 , . . . , L are strictly positive constants and that
QL
a) The Cobb-Douglas production function: f (z) = =1 z .

PL

=1

= 1.

b) The Leontief production function: f (z) = min{1 z1 , . . . , L zL }.

P
c) The linear production function: f (z) = L
=1 z .

(Just provide the generic solution. Do not worry about the case(s) where the firm is indifferent among
employing one of several factors.)
PL
1
d) The CES production function: f (z) = ( =1 z ) . Assume 1.
8. Production with Non-Convex Technology
A firm produces a single output good (y) using a single input good (z). Let p be the price of the output
good and suppose that the price of the input good is normalized such that w = 1. The firms production
function f : R R is

z<0
0
2
f (z) = (3 2z)z 0 z 1 .

1
z>1
a) Sketch the firms production function. (You may consider using a computer to expedite this step.)

b) Assuming free disposal, sketch the firms production set, Y = {(z, y) : y f (z)}. Verify algebraically
that the production set is not convex.
c) As a function of p what is this firms profit-maximizing output?

9. Bettys Artisanal Bakery

Bettys Artisanal Bakery makes delicious bread. Typically, it uses both whole grain flour (good 1) and
bleached flour (good 2) in equal proportion in its signature bread recipe. However, if one type of flour is
3

really inexpensive, it only uses that variety in its baking. Specifically, suppose that its production function
for loaves of bread is


y = f (z1 , z2 ) = min 4z1 + 2z2 , 2z1 + 4z2

Additionally, suppose Bettys Artisanal Bakery has a capacity constraint. Even if it wanted to, it cannot
produce more than 60 loaves of bread.1
The market price for bread is p per loaf2 and w1 and w2 are the prices per kilogram of whole grain and
bleached flour, respectively.
a) Suppose that Bettys Artisanal Bakery produces at capacity and bakes 60 loaves of bread. In a clear,
well-labeled diagram (with z1 on the horizontal axis and z2 on the vertical axis), sketch the set of input
choices that it could have used to produce 60 loaves efficiently.
b) Derive the cost function, c(w, y), for Bettys Artisanal Bakery.3
c) Suppose the price of bread is p = 1, whole grain flour sells for w1 = 3 and bleached flour is w2 = 1. These
prices are fixed and will not change in the foreseeable future.
A manufacturer of artisanal bread ovens suggests that Bettys Artisanal Bakery should replace its existing
oven with a brand new unit. With this new unit, the bakerys production function would be

g(z1 ) = 18 z1
(Yes, the new oven only works for bread made with only whole-grain flour. There are some pre-set settings
which make it unsuitable for white breads.) However, this oven does not have a capacity constraint. What
is the most Bettys Artisanal Bakery is willing to pay (if anything) to replace its existing oven with this
brand new unit?

1 To account for the capacity constraint, an alternative way of writing the production function is f (z , z ) =
1 2



min 60, min 4z1 + 2z2 , 2z1 + 4z2 .
2 The price is the same regardless of the type of flour used in the bread.
3 Do not worry about the case y > 60 since this production level is not feasible. Intuitively, we could say c(w, y) =
whenever y > 60.