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# International Trade (EC 351)

## Problem Set 0: Solutions

1. Consider a consumer with utility function u(x
1
; x
2
) = x
1
2
1
x
1
2
2
. The consumer faces
given prices p
1
and p
2
for goods 1 and 2, and her income equals I. Find the con-
sumers optimal choices of x
1
and x
2
as functions of p
1
, p
2
and I. What is the
intuition behind the rst-order conditions?
We solve this question using constrained optimization. The problem can be
formulated as:
max
{x
1
,x
2
}
u(x
1
, x
2
)
subject to
I p
1
x
1
+ p
2
x
2
.
That is, the consumer maximizes utility subject to total expenditure on the
two goods being less or equal to the consumers income. The Lagrangian
for this problem is:
L = x
1
2
1
x
1
2
2
+ [I p
1
x
1
+ p
2
x
2
].
Ignoring the possibility of corner solutions, the rst order conditions (FOCs)
for this problem are:
1
2
x

1
2
1
x
1
2
2
= p
1
,
1
2
x
1
2
1
x

1
2
2
= p
2
,
I = p
1
x
1
+ p
2
x
2
.
The rst (second) FOC states that in a maximum, the consumer will con-
sume the two goods in such a way that marginal utility of the rst (second)
good equals the goods price multiplied by the marginal utility of income
. Suppose the marginal utility of good 1 was higher than the right hand
side (RHS). Then the consumer should buy more of that good, because the
next unit will give her more utility (left hand side, LHS) than it would cost
her (RHS). The reverse is true if marginal utility was lower and both situ-
ations would not be utility maximising behaviour. The third FOC restates
the budget constraint.
To nd the demand functions of the consumer divide the rst by the second
FOC to eliminate the Lagrange multiplier:
1
2
x

1
2
1
x
1
2
2
1
2
x
1
2
1
x

1
2
2
=
p
1
p
2
,
1
which can be rewritten as
x
2
x
1
=
p
1
p
2
.
Now solve this equation for x
2
and substitute it into the third FOC, which
results in:
I = p
1
x
1
+ p
2
p
1
p
2
x
1
,
which can be solved for the demand function of good x
1
:
x
1
=
1
2
I
p
1
,
while the demand function for x
2
is:
x
2
=
1
2
I
p
2
.
2. Redo question 1 with the following utility function u(x
1
; x
2
) = min[x
1
; x
2
], where
min[x
1
; x
2
] should be read as the minimum of x
1
and x
2
. (Useful hint: the function
min[x
1
; x
2
] is not differentiable.)
The approach taken in question 1 does not work anymore, because the min-
imum function is not differentiable and hence we cannot obtain the rst or-
der conditions by taking the derivatives. However, thinking deeply about
how this utility function works, we are able to nd a necessary condition
here, too. Suppose the consumer chooses quantities such that x
1
> x
2
. In
this case, her utility will be equal to x
2
and the expenditure is p
1
x
1
+ p
2
x
2
.
Clearly, the amount of x
1
that exceeds the one of x
2
is wasted: choosing a
lower x
1
would yield the same level of utility as long as it is not less than
x
2
, but expenditure would be lower. The savings could be spent on more
x
2
and therefore a higher level of utility could be reached the original x
1
could not have been a utility maximizing choice. The same is true in case
x
2
> x
1
. We can therefore conclude that in an optimum, it must be the case
that
x
1
= x
2
.
This necessary condition can be inserted to the usual budget constraint to
obtain
I = p
1
x
1
+ p
2
x
1
x
1
=
I
p
1
+ p
2
and consequently
x
2
=
I
p
1
+ p
2
.
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3. Consider a market where demand and supply are given, respectively, by x
D
= 10p
and x
S
= 2 + p. What are the equilibrium price and quantity in this market?
Assume that consumers have to pay a tax of t = 2 per unit of x that they consume.
What is the new equilibrium price and quantity?
In equilibrium, demand has to equal supply. Equating demand and supply
gives us
10 p = 2 + p p = 4
and therefore
x
D
= x
S
= 6.
The tax levied on consumption increases any given price by two, so that the
new demand curve will look like x

D
= 10 (p +2) = 8 p. Again, equating
the demand and supply functions yields
8 p = 2 + p p = 3
and therefore
x
D
= x
S
= 5.
Note that the tax has driven a wedge between the price consumers pay,
which is p +2 = 5 > 4, and the price suppliers get for their products, which
3
is p = 3 < 4. Correspondingly, consumers want to buy less and rms want
to supply less. Tax revenue for the government is xt = 52 = 10. In terms
welfare, consumer surplus has decreased by areas a+b, producer surplus by
areas c+d, and the government earns tax revenues equal to areas a+c = 10.
The triangle b + d is the dead weight loss of the tax, i.e. the inefciency that
occurs because of the introduction of the tax.
4. Consider a monopolist that faces a demand curve x = 100p, and has cost function
c(x) = 2 + 2x. Find the monopolists prot-maximizing choice of x. Discuss the
intuition behind the rst order condition. Compute the monopolists prots.
Amonopolist has market power and can therefore set prices. In her decision
how much to produce, she takes into account the effect a change in her price
has on demand. An optimal choice will be at the point where marginal
revenue are equal to marginal costs. To see this suppose marginal revenue
was higher than marginal costs. In this case, an additional unit of output
would yield (marginal revenue) more than it would cost (marginal cost) and
therefore the monopolist could increase her prots by increasing output.
The reverse is true if a quantity is chosen so that the last unit produced cost
more than the marginal revenue from selling this unit. Therefore, prot
maximizing behavior implies the above relationship.
Revenues can be computed as R = p x = (100 x) x = 100x x
2
, so
that marginal revenues are:
MR =
dR
dx
= 100 2x.
Marginal costs are MC = dc(x)/dx = 2 (note that the cost function has a
4
component that is xed and one that is variable), so that prot maximization
implies that
MR = MC 100 2x = 2 x = 49.
Substituting the optimal output back into the demand function gives us the
equilibrium price
49 = 100 p p = 51.
We can now compute the monopolists prot as:
= p x c(x) = 51 49 (2 + 2 49) = 2399.
A nal observation is that we could have arrived at the rst order condition
above in a more formal way. The prot function is = p x c(x). Substi-
tuting the demand and cost function and maximizing prots with respect
to x results in the rst order condition:
100 2x 2 = 0 100 2x = 2.
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