EconS 501 - Micro Theory I1

Recitation #7 - Competitive Markets

Exercise 1
1. Exercise 12.5, NS: Suppose that the demand for stilts is given by Q = 1; 500 50P
and that the long-run total operating costs of each stilt-making …rm in a competitive
industry are given by C(q) = 0:5q 2 10q.

Entrepreneurial talent for stilt making is scarce. The supply curve for entrepreneurs is given
byQs = 0:25w where w is the annual wage paid. Suppose also that each stilt-making …rm
requires one (and only one) entrepreneur (hence, the quantity of entrepreneurs hired is equal
to the number of …rms). Long-run total costs for each …rm are then given by:

C(q; w) = 0:5q 2 10q + w

(a) What is the long-run equilibrium quantity of stilts produced? How many stilts are
produced by each …rm? What is the long-run equilibrium price of stilts? How many …rms
will there be? How many entrepreneurs will be hired, and what is their wage?
(b) Suppose that the demand for stilts shifts outward to

Q = 2; 428 50P

How would you know answer the questions posed in part a.

(c) Because stilt-making entrepreneurs are the cause of the upward-sloping long-run supply
curve in this problem, they will receive all rents generated as industry output expands.
Calculate the increase in rents between parts (a) and (b). Show that this value is identical
to the change in long-run producer surplus as measured along the stilt supply curve.
Solution:
This problem introduces the concept of increasing input costs into long-run analysis by
assuming that entrepreneurial wages are bid up as the industry expands. Solving part (b)
can be a bit tricky; perhaps an educated guess is the best way to proceed.
(a) The equilibrium in the entrepreneur market requires Qs = 0:25w = QD = n or, solving
for w, we obtain w = 4n.
Hence, given C(q; w) = 0:5q 2 10q + w, the marginal cost is M C = q 10 and the average
cost is AC = 0:5q 10 + wq = 0:5q 10 + 4n q
In long run equilibrium the M C = AC, thus:
1
Felix Munoz-Garcia, School of Economic Sciences, Washington State University, Pullman, WA, 99164-
6210. Email: fmunoz@wsu.edu.

1
 4n
q 10 = 0:5q 10 + q

4n
q 0:5q = q
4n
0:5q = q
p
q 2 = 8n then q = 8n

Total output is given in terms of the number of …rms by

p
Q = nq = n 8n

Now in terms of pro…t-maximization in perfectly competitive markets requires P = M C, or

q = P + 10
Hence aggregate supply becomes QS = nq = n(P + 10)
p
Since total output requires Q = n 8n and aggregate supply requires Q = n(P + 10), we
have
p
n 8n = n(P + 10)

p
P = 8n 10

Therefore,
p we can use the demand function QD evaluated at the equilibrium price P =
8n 10,
p p
QD = 1500 50P = 1500 50( 8n 10) = 2000 50 8n

Then since in equilibrium we require that demand is equal to supply, QD = QS , we obtain

p p
2000 50 8n = n 8n thus n = 50 entrepreneurs

Finally, we can also calculate:

p
Total output: Q = n 8n = 1000

Q
Individual output by every …rm: q = n
= 20

Equilibrium price: P = q 10 = 10

2
 w = 4n = 200.

(b) Using the results of the previous part and if the demand function is Q = 2; 428 50P
then,
p p
(n 8n) = 2; 428 + 50( 8n 10)

p p
(n 8n) + 50 8n = 2; 928

p
(n + 50) 8n = 2; 928, therefore n = 72

and, we can then recalculate:

p
Q = n 8n = 1728

Q
q= n
= 24

P =q 10 = 14

w = 4n = 288.

So, as the demand shifts outward, the number of …rms in the industry increases, the total
production and …rm production increases, the price increases and the wages increase.
(c) The long-run supply curve is upward sloping because as new …rms enter the industry the
cost curves shift up:

4n
AC = 0:5q 10 + q

as n increases the average cost also increases.

Using linear approximations, the increase in the producers surplus (PS) from the supply
curve is given by 4 1000 + 0:5 728 4 = 5456. If we use instead the supply curve for
entrepreneurs the area is 88 50 + 0:5 88 22 = 5368. These two numbers agree roughly.
To get exact agreement would require recognizing that the long-run supply curve here is not
linear –it is slightly concave.

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Exercise 2
2. Exercise 12.9, NS: Given an ad valorem tax rate (ad valorem tax is a tax on the
value of transaction or a proportional tax on price) of t (t = 0:05 for a 5% tax), the gap
between the price demanders pay and what suppliers receive is given by PD = (1+t)PS .

(a) Show that, for an ad valorem tax,

d ln PD
dt
= eSeSeD and d lndtPS = eSeDeD
(b) Show that the excess burden of a small tax is
DW = 0:5 eeSD eeSD t2 P0 Q0
(c) Compare these results to those for the case of a unit tax.

Solution:
This problem shows that the comparative statics results for ad valorem taxes are very similar
to the results for per-unit taxes
(a) Given that the gap between the price demanders pay and what suppliers receive is
PD = (1 + t)PS
Then, the introduction of a tax implies a small price change, i.e., dPD = (1+t)dPS +dt PS =
(1 + t)dPS + dt PS , where we can evaluate this expression at t = 0 since the tax is impossed
before any tax was present. Hence, the previous expression collapses to dPD = dPS +dt PS =.
We know also that

@QD P @QS P
eD = @P QD
and eS = @P QS

In equilibrium with a tax rate of t, we will have

QD (PD ) = QS (PS )

@QD @QS
@PD
dPD = @PS
dPS
but since dPD = dPS + dtPS then,
@QD @QS
@PD
(dPS + dtPS ) = @PS
dPS
@QD @QD @QS
@PD
dPS + @PD
dtPS = @PS
dPS

rearranging

@QD @QS @QD

@PD
dtPS = @PS
dPS @PD
dPS
@QD @QS @QD
@PD
dtPS = @PS @PD
dPS
@QD
@PD dPS 1
@QS @QD = dt PS
(*)
@PS @PD

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Hence, we can express this ratio in terms of elasticities, as follows,
@QD @QD P0
dPS 1 d ln PS @PD @PD Q eD
dt PS
= dt
= @QS @QD = @QS P0 @QD P0 = eS eD
@PS @PD @PS Q @PD Q

(b) A linear approximation of the DWL accompanying a small tax dt is given by:

DW L = 0:5(P0 dt)(dQ)

as depicted in the next …gure.

Figure 1. Introducing a tax in a competitive equilibrium market.

@QD P dlnQ
Since eD = @P QD
= dlnP

then dQ = eD QP0 dP and substituting into DWL

DW L = 0:5(P0 dt) eD QP0 dP

dP 1
DW L = 0:5 P0 (dt)2 eD Q0 dt P

dPD 1 eS
but from (*) we know dt PD
= eD eS
then

eS
DW L = 0:5 P0 (dt)2 eD Q0 eD eS

eD eS
DW L = 0:5 eD eS
(dt)2 Q0 P0

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We can now generalize this result for any small t:

eD eS
DW L = 0:5 eD eS
t2 Q0 P0

(c) The unit tax described in this chapter is equivalent to the value of the ad-valorem tax.
In other words, the unit tax is equal to the ad-valorem tax multiplied by Ps. Therefore, the
results obtained using the ad-valorem tax are equivalent to the ones obtained using the unit
tax.

Exercise 3
3. (Ramsey rule) Consider a three-good economy (k = 1; 2; 3) in which every consumer
has preferences represented by the utility function U = x1 + g(x2 ) + h(x3 ), where the
functions g( ) and h( ) are increasing and strictly concave. Suppose that each good
is produced with constant returns to scale from good 1, using one unit of good 1 per
unit of good k 6= 1. Let good 1 be the numeraire and normalize the price of good 1 to
equal 1. Let tk denote the (speci…c) commodity tax on good k so the consumer price
is qk = (1 + tk ).

(a) Consider two commodity tax schemes t = (t1 ; t2 ; t3 ) and t = (t01 ; t02 ; t03 ). Show
that if (1 + t0k ) = (1 + tk ) for k = 1; 2; 3 for some scalar > 0, then the two tax
schemes raise the same amount of tax revenue.
(b) Argue from part (a) that the government can without cost restrict tax schemes
to leave one good untaxed.
(c) Set t1 = 0, and suppose that the government must raise revenue of R. What are
the tax rates on goods 2 and 3 that minimize the welfare loss from taxation?
(d) Show that the optimal tax rates are inversely proportional to the elasticity of the
demand for each good. Discuss this tax rule.
(e) When should both goods be taxed equally? Which good should be taxed more?

Solution:

(a) The budget constraint for the consumer with tax scheme t = (t1 ; t2 ; t3 ) is:

(1 + t2 )x2 + (1 + t3 )x3 = (1 + t1 )x1

where the consumer sells units of the numeraire in order to purchase units of goods 2 and
3. (Note that all prices take into account taxes.) The above budget constraint can be
alternatively writen as

(1 + t1 )x1 + (1 + t2 )x2 + (1 + t3 )x3 = 0

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Hence tax revenue R is:

R t1 x1 + t2 x2 + t3 x3 = (x1 + x2 + x3 )

Similar reasoning shows that with tax scheme t0 = (t01 ; t02 ; t03 ) the tax revenue R0 is:

R0 t01 x01 + t02 x02 + t03 x03 = (x01 + x02 + x03 )

But the demand for each commodity is homogeneous of degree zero (Recall that, by propos-
ition 3.D.2 in MWG, Walrasian demand is homogeneous of degree zero in prices). Hence,
we have that

xi = xi (1 + t1 ; 1 + t2 ; 1 + t3 )

xi = xi ( (1 + t1 ); (1 + t2 ); (1 + t3 ))
xi = xi (1 + t01 ; 1 + t02 ; 1 + t03 ) = x0i

Therefore

(x1 + x2 + x3 ) = (x01 + x02 + x03 )

and R = R0 .
(b) The value for can be chosen arbitrarily. In particular, a tax system with a tax tk on
good k can be shown to be equivalent to one with no tax on good k by choosing

1
= 1+tk

(c) The optimization decision for the consumer is

max U = x1 + g(x2 ) + h(x3 )

fx1 ;x2 ;x3 g

s.t. x1 + (1 + t2 )x2 + (1 + t3 )x3 = 0

Substituting the constraint into the objective function for x1 reduce the F.O.C. to

g 0 (x2 ) (1 + t2 ) = 0 and h0 (x3 ) (1 + t3 ) = 0

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These necessary conditions result in demand functions x2 = x2 (1 + t2 ) and x3 = x3 (1 + t3 ),
where x2 is a function of the e¤ective price of good 2, 1 + t2 , and similarly for the demand
of good 3. Thus, the above budget constraint can be written as a function of these demands

x1 = (1 + t2 )x2 (1 + t3 )x3 .

The optimization of the government can now be written as

max U = (1 + t2 )x2 (1 + t3 )x3 + g(x2 ) + h(x3 )

ft2 ;t3 g | {z }
x1

s.t. R = t2 x2 + t3 x3

where x2 and x3 are, in turn, functions of (1 + t2 ) and (1 + t3 ) respectively.

The solution to this problem provides the tax rates that minimize welfare loss. The necessary
conditions are:

g 0 x02 x2 (1 + t2 )x02 (x2 + t2 x02 ) = 0

h0 x03 x3 (1 + t3 )x03 (x3 + t3 x03 ) = 0.

From the consumer’s choice problem g 0 = 1 + t2 and h0 = 1 + t3 . These allow the implicit
solutions
x2 1+ x3 1+
t2 = x02
and t3 = x03

(d) The elasticity of demand for good k is de…ned as

(1+tk )x0k
"dk = xk

by this de…nition,
t2 1 1+
1+t2
= "d2

and
t3 1 1+
1+t3
= "d3
.

The tax rate on good k is therefore inversely proportional to the elasticity of demand for
that good. Setting the relative taxes in this way minimizes the excess burden resulting from
the need to raise the revenue R. This relationship between tax rates and elasticity is often
referred to as the "inverse elasticity rule"
(e) This tax rule implies that the good with the lower elasticity of demand should have
higher tax rate. The two goods should be taxed at the same rate only if they have the same
elasticity of demand.

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Exercise 4
4. Consider the utility function U = log(x1 ) + log(x2 ) l and budget constraint wl =
q1 x 1 + q2 x 2 .

(a) Show that the price elasticity of demand for both commodities is equal to -1.
(b) Setting producer prices at p1 = p2 = 1, show that the inverse elasticity rule implies
t1
t2
= qq12 .
(c) Letting w = 100 and + = 1, calculate the tax rates required to achieve revenue
of R = 10.

Solution:
(a) The consumer’s demands is solve

max log(x1 ) + log(x2 ) l

fx1 ;x2 ;lg
s.t. wl = q1 x1 + q2 x2

or equivalently

max log(x1 ) + log(x2 ) ( qw1 x1 + q2

w 2
x)
fx1 ;x2 ;lg

The F.O.C.s are then

q1 q2
x1
= w
and x2
= w

Then, the demands are

w w
x1 = q1
and x2 = q2

The elasticity of demand is de…ned by

dxi qi
"di = dqi xi

Calculating this for good 1 obtains

w q1
"d1 = q12 ( qw )
= 1
1

Calculating this for good 2 obtains

w q2
"d2 = q22 ( w )
= 1
q 2

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(b) The inverse elasticity rule (see exercise 3) states that

ti 1
1+ti
= "di
, i = 1; 2.

Hence

t1 t2
"d
1+t1 1
= = "d
1+t2 2

But "di = 1 and 1 + ti = qi , so

t1 t2 t1 q1
q1
= q2
and rearranging we have t2
= q2
.

(c) Revenue is de…ned by

R = t1 x1 + t2 x2

w w
Using the solutions for the demands x1 = q1
and x2 = q2
we have

R = t1 ( qw1 ) + t2 ( qw2 )

t1 q1 q1
Using the relation t2
= q2
we just found in part b as t1 = t
q2 2

R = ( qq12 t2 )( qw1 ) + t2 ( qw2 ) = w[( qq12 )( q1 ) + q2

]t2 = w
q2
( + )t2

Finally, since 1 + ti = qi , + = 1, R = 10 and w = 100, the optimal tax on good 2 solves

100
10 = t
1+t2 2

which has solution t2 = 19 , and hence t1 = 19 .

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Exercise 5
5. Let the consumer have the utility function U = x11 + x22 l.
h i1=[1 1]
1w
(a) Show that the utility maximizing demands are x1 = q1
and x2 =
h i1=[1 2 ]
2w
q2
.
(b) Letting p1 = p2 = 1, use hthe inverse
i h elasticity
i rule to show that the optimal tax
1 1 1 1
rates are related by t2 = 1 2 1
+ 1 t1
.
2 2

(c) Setting w = 100, 1 = 0:75, 2 = 0:5, …nd the tax rates required to achieve
revenue of R = 10 and R = 300.
(d) Calculate the proportional reduction in demand for the two goods comparing the
no-tax position with the position after introduction of the optimal taxes for both
revenue levels. Comment on the results.

Solution:

(a) If the consumer maximization problem is max U = x11 + x22 l s.t. q1 x1 + q2 x2 = wl

Thus we can rewrite the budget constraint l = q1 x1 +q
w
2 x2
and we can replace into the utility
function for an unconstrained optimization problem as:

q 1 x1 q 2 x2
max U = x11 + x22 w w

Taking …rst order condtions with respect to every good, xi , yields

@U 1 qi
@xi
= i xi
i
w
=0

and rearranging, we obtain

1 qi
i xi =
i
w

Solving for xi we get the utility maximizing demands as required.

1
w i 1 i
xi = qi

(b) The …rst step is to calculate the price elasticity using the demand function we just found:

1
"di = 1 i

With p1 = p2 = 1 the inverse elasticity rule states that (see previous exercise):

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 t1 t2 1+t2 d 1+t1 d
"d
1+t1 1
= "d
1+t2 2
or t2
"1 = t1
"2

Substituting for the elasticities

1+t2 1 1+t1 1
t2 1
= t1 1
1 2

1 1+t2 1 1+t1
t2 1 1
= t1 1 2
1 1
t2
2
(1 + t2 ) = t1
1
(1 + t1 )
1 1 1 1
t2
2
+ t2
2
t2 = t1
1
+ t1
1
t1
1 1 1 1
t2
2
= t1
1
+ t1
1
t1 t2
2
t2
1 1
t2
2
= t1
1
+ (1 1) (1 2)

…nally
h i h i
1 1 1 1 1 1
t2
= 1
1
t1
+ 2
1
1
or t2
= 1
2 1
+ 1
1
t1
.
2 2 2 2

(c) Using the parameter values gives

1
t2
= 0:5 + 0:5 t11

so

2
t2 = 1
1
t1

Then, given the revenue constraint

R = t1 x1 + t2 x2

but we know the optimal values for the demand and using the fact that 1 + ti = qi , then

1=(1 1) 1=(1 2)
w 1 w 2
R = t1 q1
+ t2 q2

1=(1 1) 1=(1 2)
w 1 w 2
R = t1 1+t1
+ t2 1+t2

and t2 is also known, then

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 0 11=(1 2)

1=(1 1)
w 1 2 B w C
R = t1 1+t1
+ 1
1 @ 2 !A
t1 2
1+ 1
t1 1

Replacing the values of the parameters

0 12
4
75 2 B 25 C
R = t1 1+t1
+ 1
1 @ !A
t1 2
1+ 1
t1 1

which simpli…es to
50625t1 16t41
R = 625 + (1)
(1 + t1 )4 (x2 1)2
The revenue curve has a maximum level of revenue around t1 = 0:4, this is known as La¤er
property. For R = 10 the solution is t1 = 0:0031 and t2 = 0:0062; as depicted in the following
…gure which illustrates expression (1) evaluated at R = 10 as a function of t1 . In the case
R = 300 the solution is t1 = 0:1814 and t2 = 0:4431.

Figure 2. Tax revenue R = 10 as a function of t1 .

(d) The proportional reduction in demand for the two goods comparing the no-tax position
with the position after introduction of the optimal taxes for both revenue levels is in the
next table.

R x1 % x2 %
0 3; 164 25
10 3; 125 1:23 24:69 1:24
300 1; 624 48:67 12:00 52:00

As we can see, the optimal taxes do reduce demand in approximately the same proportion
for both commodities. In this case the interpretation of the Ramsey rule is applicable even
when the tax intervention has a signi…cant e¤ect on the level of demand.

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