P ROBLEM SET 3: S OLUTION

1. Suppose a consumer lives for two time periods only and spends only on consumption
((C1 , C2 )). His income in period 1 is $500 and that in $250. The price of consumption in
period 1 is $1 and in period 2 is $2. He can borrow or save in period 1 but has to exhaust his
income or repay his debt by period 2. The rate of interest on savings is 3% while the rate of
interest on borrowing is 6%. What is his budget line?

If the consumer does not borrow or save, then his consumption bundle is (C1 = 500, C2 =
125).
If he consumes C1 > 500, He actually needs to borrow the amount S = C1 − 500. He has to
pay an interest on it of 6%. So, in the second period his income after paying off the debt
will be 250 − (C1 − 500) − .06(C1 − 500) = 250 − 1.06(C1 − 500) = 780 − 1.06C1 . Hence,
2C2 = 780 − 1.06C1
⇐⇒ 0.53C1 + C2 = 390.
If C1 < 500, his savings are S = 500 − C1 . So, in the second period 2C2 = 250 + 1.03(500 −
C1 ) = 715 − 1.03C1 .
⇐⇒ 0.515C1 + C2 = 357.5.
The expression of the budget line is
0.53C1 + C2 = 390 when C1 ≥ 500, and
0.515C1 + C2 = 357.5 when C1 < 500.

2. A consumer’s preference on all consumption bundles (X, Y ) is represented by the utility

function U (X, Y ) = (X − 5)Y .

(i) Does the consumer’s preferences satisfy the more is better principle?
The consumer’s preferences do not satisfy the more is better principle. Consider the
bundles (2, 5) and (3, 10). By the more is better principle U (2, 5) < U (3, 10) should hold.
Note that U (2, 5) = −15 and U (3, 10) = −20 which means that the consumer prefers
the bundle (2, 5) to (3, 10).

(ii) If the price of X is Rs 100, price of Y is Rs 20 and the consumer’s income is Rs 450, find
his utility-maximizing consumption bundle.
The budget constraint is 100X + 20Y = 450. Note that if the consumer only consumes

1
 X, then he can consume X = 4.5. As long as X < 5, if Y > 0, we will have U (X, Y ) < 0.
However, if Y = 0, then U (X, Y ) = 0. So,the utility maximizing bundles are any
consumption bundle (X ≤ 4.5, Y = 0).

3. Brian uses wool (K) and labour (L) to produce t-shirts (q).

(i) If he uses 0.5 kg of wool and 3 hours of labour, he can produce 1 t-shirt, what is his
production function?
1
The production function is q = min{2K, L}.
3
(ii) The wage per hour is given by w = $10 and the price of each kg of wool is given by
r = $4. What is the long run total cost function, C(q)?
1
At the cost minimizing bundle 2K = L. This means q = 2K ⇐⇒ K = 0.5q =
3
1
and q = L ⇐⇒ L = 3q. Hence, the long-run total cost function is C(q) = w(3q) +
3
r(0.5q) = 30q + 2q = 32q.

(iii) What is the average cost function? Does the firm enjoy economies of scale at q = 25?
C(q)
The avarage cost function is = 32. The avreage cost is constant and hence the
q
firm does not experience economies of scale.

4. Does the production function Q = LK 2 − K exhibit constant, increasing or decreasing

returns to scale? If the wage rate is w, the rental rate of capital is r and the capital is fixed at
K̄ in the short run, what is the short run cost function?
Take some λ > 1. Since λ > 1, we have λL(λK)2 −λK = λ(λ2 LK 2 −K) > λ(LK 2 −K) = λQ.
Hence, the production function exhibits increasing returns to scale. In the short-run, since
capital is fixed Q = LK̄ 2 − K̄
Q − K̄
⇐⇒ L =
K̄ 2
If Q ≤ K̄, then L = 0. So, the short-run cost function is
C(Q) = rK̄ when Q ≤ K̄, and
Q − K̄
C(Q) = w × + rK̄ when Q > K̄
K̄ 2

q12
5. A company has two production facilities (factory). Each plant’s cost function is c1 (q1 ) =
2
and c2 (q2 ) = q2 . Derive the company’s overall cost function C(q). (Hint: If the firm produces
q units of output, then find the cheapest way to distribute q between the two facilities.)

2
 If we produce q1 units in facility 1 and q2 units in facility 2, then the company’s cost to
q2
produce q1 + q2 units will be C(q1 + q2 ) = c1 (q1 ) + c2 (q2 ) = 1 + q2 . Suppose q1 + q2 = q.
2
q12
Then substituting q2 = q − q1 , C(q1 , q2 (q1 )) = + (q − q1 ).
2
dC(q1 , q2 (q1 ))
Minimizing costs, = q1 − 1 = 0
dq1
⇐⇒ q1 = 1.
d2 C(q1 , q2 )
Second-order condition, = 1 > 0.
dq1
So, cost is minimum when we produce q1 = 1. This means if q < 1, q2 = q − 1 < 0. So, q2 = 0
when q < 1 and if q > 1 we produce q1 = 1 and q2 = q − 1.
q2
So, the cost function of the firm is C(q) = when q ≤ 1 and C(q) = 0.5 + (q − 1) = q − 0.5
2
when q > 1.

6. Let q = min{L2 , K} be a production function.

(i) Does it exhibit constant, increasing or decreasing returns to scale?

Case I: q = K ≤ L2 .
Consider any λ > 1. Note that λ2 L2 > λK.
Hence, min{λ2 L2 , λK} = λK = λ min{L2 , K}.
Thus, we have constant returns to scale.
Case II: q = L2 < K. Consider any λ > 1.
K
If λ ≤ 2 , then λ2 L2 ≤ λK. Hence, min{λ2 L2 , λK} = λ2 L2 = λ2 min{L2 , K} >
L
2
λ min{L , K}.
K
If λ > 2 , then λ2 L2 > λK. Hence, min{λ2 L2 , λK} = λK > λL2 = λ min{L2 , K}.
L
Thus, we have increasing returns to scale.

(ii) Find the firm’s cost function and the least-cost combination of L and K to produce Q if
the wage rate is w and the rental rate is r.
√
At the cost-minimizing bundle L2 = K. So, L = q and K = q is the least-cost
√
combination of L and K. The cost function is C(q) = w q + rq.

Suppose that capital is scarce and as a result the rental rate depends on the amount of capital
the firm employs according to the following formula r(K) = K 2 .

(iii) In this scenario what is the firm’s cost function?

√
The cost function is C(q) = w q + q 3 .

3
(iv) Does the firm enjoy economies or diseconomies of scale?
C(q) w
The average cost is AC(q) = = √ + rq 2 . The firm enjoys economies of scale for
q q
w
0.4 w
0.4
q< and diseconomies of scale for q >
4r 4r