EF3441 Assignment 2

Due: 23:59, Mach 04, 2024

Question 1.

Suppose that the representative household’s utility function is given by U (c, ℓ) = ω ln(c) + (1 −
ω) ln(ℓ), Where c is consumption, ℓ is leisure, and δ ∈ (0, 1) is a parameter that determines how
much the representative household values consumption versus leisure. Let h be the total time
endowment and normalize it to 1, w the wage, π the dividend payments, and T is the lump-sum
tax. For simplification, assume T = 0.
A representative firm has the following technology: Y = zF (K, N ) = K α N 1−α , where K is the
given capital stock (the representative firm owns K but no market value if the firm sells it), N is
labor demand by paying competitive market wage rate w, z is total factor productivity (TFP) and
is normalized to z = 1, and α ∈ (0, 1) Let’s further assume the production function is a continuous
concave function. Without loss of generality, let’s assume the output good price equals 1.

(a) Write down the representative firm’s profit function, then graphically determine and mathe-
matically prove the profit maximization condition. (2 marks)

Solution: Profit= total revenue – total cost = zF (K, N )–wN .

Math: maxN zF (K, N ) − wN . The firm chooses N to maximize profit. From the first-
order derivative, we get the marginal productivity of labor is equal to w. For details, see
Page 14 in Lecture3.pdf.
Graph: at point A, AE line tangents to the revenue curve. AE line parallels to BD line.
That ensures we get the largest gap between the revenue curve and BD line. i.e., profit
maximization. AB is the optimal profit. For the graph, see Page 13 in Lecture3.pdf.

(b) Show the firm’s optimal labor demand is negatively correlated with wage. (2 marks)

Solution: From (a), we get the firm’s optimal profit condition as: M PN = w. As w goes
up, M PN goes up as well. This implies N goes down. Therefore, as w goes up, N goes
down. The cost of labor goes up, so the demand for labor goes down. For the graph, see
Page 18 in Lecture3.pdf.

(c) Suppose that the pandemic interrupted the global supply chain. The representative firm is
required to pay workers during the interruption periods. Discuss the change in the labor
demand curve and graph the change. (2 marks)
 Solution: Because the pandemic interrupted the global supply chain, the representative
firm has no guarantee to keep the firm operating as expected. That causes labor productivity
to go down. This causes the labor demand curve to shift in/down.

(d) Definite the competitive equilibrium for this economy. (2 marks)

Solution: See Page 11 in Lecture4.pdf

(e) Solve the Pareto optimal c, ℓ, and GDP for this economy. (4 marks)

Solution: First, write down the PO for this economy:

max ω ln(c) + (1 − ω) ln(ℓ)

c,ℓ

s.t. c = K α N 1−α

Then rewrite the PO as:

max ω ln(K α N 1−α ) + (1 − ω) ln(1 − N )

N

F OC :

K α (1 − α)N −α −1
ω + (1 − ω) =0
K α N 1−α (1 − N )

ω(1−α)
Solve for N , we get N ∗ = 1−ωα .

(f) Solve the competitive equilibrium for this economy by recovering wage w. (4 marks)

ω(1−α)
Solution: Apply the second welfare theorem, we get the optimal N ∗ = 1−ωα . Apply the
CE optimal condition M PN = w, we get w = M PN = (1 − α)K α N −α = (1 − α)( K α
N) =
(1 − α)( NK∗ )α . and GDP = c = K α (N ∗ )1−α . They are functions of exogenous variables.

(g) Suppose z increases in this economy, determine the change of consumption, employment,
wage, and GDP. (4 marks)

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Solution: z increases leads to higher M PN . So is wage. We need to use the income
effect and substitution effect to discuss the changes of c and ℓ. Intuition from Q2. Higher
z leads to a higher marginal product of labor M PN , the firm is willing to pay a higher
wage, w, to hire more labor that generates the substitution effect and income effect. From
the substitution effect, higher wage leads to less leisure and more consumption. From the
income effect, higher wage leads to higher consumption and leisure. To sum up, wage goes
up (higher M PN ), c goes up (net effect), ℓ and N are undetermined (net effect), GDP
goes up (because of c goes up). For the graph, see Page 36 in Lecture4.pdf.

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Question 2.
Historical data, as the following picture shows the GDP per capita (in real terms) and total
population in the past 2000 years in the “West”. The data shows that GDP per capita is almost
constant prior to 1800 even given the improvement in technology. However, in the same period, the
population increases fivefold.

(a) Write a model in detail and provide key assumptions and definite the steady-state to explain
the data facts. (15 marks)

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Solution: A Malthusian model can explain this fact. First, key assumptions. In this
model, we assume for households: 1) fixed labor supply, 2) a closed economy without
government and saving; for firm: 1) constant return to scale; 2) factors of input are land
L and labor N ; the population growth is governed by living standard, c, as the following,
′
N /N = g(c). As the improvement on technology, we get z improves over time. To
simplify our discussion, let’s assume this economy is at a steady state at time 0 and the
consumption at time 0 is c0 . As z improves at time 1, output per capita must goes up
since y = zf (L/N ). From our key assumption, we get y = c, so c goes up. As the living
standard goes up, g(c) goes up, which means the population starts to grow. As population
growth, L/N decreases. i.e. the land per capita decreases. This implies the output per
person starts to decline from the peak, and so is the population growth rate. However, the
population growth rate is still growing because c is higher than the original steady state
consumption c. Therefore, we see the living standard has no change and only population
growth in the long run. We can graph our discussions with the following two pictures.

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(b) Can the model you wrote down on (a) also explain the post-1800s economic growth phe-
nomenon? Why or why not? (5 marks)

Solution: The Malthusian model concerns the agricultural economy. Since the post-
1800s, manufacturing has become the dominant sector in Western economies. Capital
became a much more important factor input than land in aggregate production.

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Question 3.
A closed economy has a constant return to scale production technology as follows: Y =
zF (K, N ), where Y is the aggregate output of consumption goods, z is the total factor produc-
tivity, K denotes aggregate capital stocks, and N is the labor size. The capital stock accumulation
function is:
′
K = (1 − δ)K + I

where K ′ represents the aggregate capital stock of tomorrow, K denotes the aggregate capital
stock of today, δ is the depreciation rate of capital, and I is today’s aggregate investment. The
rate of growth in the population equals to n which is a constant over time. Consumers consume a
constant fraction of their income. i.e. C = (1 − s)Y , where s is the saving rate, Y > 0, and C is
the aggregate consumption, with 0 < s < 1.

(a) Derive the state-steady capital/labor ratio equation for this economy. (5 marks)

Solution: For details, see Page 9 in Lecture6.pdf.

(b) Graphically or mathematically, but not both, determines the optimal saving rate for this econ-
omy. (5 marks)

Solution: For details, see Page 22-4 in Lecture6.pdf.

(c) Assume there are two identical countries in the world, but they differ on the capital level.
Let’s denote the high capital country as the rich country and the other country as the poor
country. Show why the poor country should grow faster than the rich one in this model? (5
marks)

Solution: First, the model predicts the poor country accumulates capital faster than the
rich country. Second, the poor country has a higher marginal product of capital than the
rich country. See Page 31-33 in Lecture6.pdf for more details.

(d) On February 22, 2023, South China Morning Post published an article which entitles Budget
2023-24: Hong Kong earmarks billions to drive innovation and technology industry, starting
with microelectronics institute. Use this model to explain the connection between technological
innovation and economic growth. (5 marks)

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Solution: To generate higher growth for rich countries, rich countries can improve the
T F P . See Page 37 in Lecture6.pdf for more details..
Or improve education (more education or better quality of education). See Page 45 in
Lecture6.pdf for more details.

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