ECO 503 Problem Set 3

1. Suppose that c (w, y) is the cost function for a firm that produces a single output using a technology associated with the

continuous and increasing production function f (x), and let z(w, y) be the conditional factor demand. Assume all input

prices are positive. Show that if f (x) is a concave function, then c (w, y) is convex in y. DO NOT assume either f (x) or

c (w, y) is differentiable. Instead, take x1 = z (w, y1 ), x2 = z (w, y2 ); then try using the definitions of concave and convex

function on an arbitrary convex combination of y1 and y2 .

2. This is a guided exercise in proving a few important (although obvious) results in Firm Theory. The techniques that you

will be using here are described in more detail in the Monotone Comparative Statics Notes. The purpose of this problem

is to prove the law of supply using a first-order condition (FOC) approach. This approach requires that the production

function f (x) be concave (or equivalently, that the cost function c(w, y) be convex in y). Throughout this problem, you

can assume that every function you come across is differentiable.

(a) Consider the following maximization problem:

max π(a, t)
a∈R+

where t ∈ R is an exogenous parameter. Assume that π(a, t) is twice differentiable and strictly concave in a, and that

for any given t, a unique interior solution to the maximization problem exists, and call it a∗ (t). Assume that for any
∂π(a,t) ∂ 2 π(a,t)
(a, t) the payoff function is strictly increasing in t and strictly supermodular (that is, ∂t > 0 and ∂a∂t > 0).

Applying implicit differentiation to the first-order condition (by differentiating the FOC with respect to t), show that
′
a∗ (t) > 0. Also, identify which properties of the payoff function you used in showing this. In order to apply the

result in the next two parts, you will have to show that these properties hold.

(b) Now consider a price-taking profit-maximizing firm facing strictly positive prices. It produces output y using a

single input x and has strictly increasing and strictly concave production function f (x). Assume again an interior

solution to the profit-maximization problem for this firm. Consider first the one-step profit maximization problem

max pf (x) − wx. Using the result from part (a), first show that the unconditional factor demand x (p, w) is strictly
x∈R+
∂x(p,w)
increasing in p; that is, ∂p > 0. Next, using this result, show that the law of supply holds for this firm. That is,
′
show that for fixed input price w, y(p) = f (x∗ (p)) is strictly increasing in the output price p, which means y (p) > 0.

(c) Now consider the two-step problem where c(w, y) is the solution to the cost-minimization problem, and show that the

law of supply holds by applying the result from part (a) in the maximization problem max+ py − c(w, y).
y∈R

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3. Show that the profit function π (p, w) is convex in (p, w). That is, For arbitrary (p̂, ŵ), (p̃, w̃) and α ∈ [0, 1], define

pα = αp̂ + (1 − α) p̃, and wα = αŵ + (1 − α) w̃. Then, show that:

π (pα , wα ) ≤ απ (p̂, ŵ) + (1 − α) π (p̃, w̃)

Hint: Consider xα = x (pα , wα ) as the optimal bundle when prices are (pα , wα ). Write out the full expression for profit

for this xα bundle, and notice that as prices change, even if the firm keeps choosing the same xα bundle, their profit

(T R − T C) changes linearly in prices. If they instead optimize when prices change, then their profits can be even higher.

4. Consider a price-taking firm that produces electricity, and must meet all demand it faces. This question is about cost-

minimization, so we can ignore the output price. It turns out that the amount of electricity demanded is always the same

over every 24-hour period, but demand differs from day (6:00 A.M. to 6:00 P.M.) to night (6:00 P.M. to 6:00 A.M.). During

the day, 4 units are demanded, whereas during the night only 3 units are demanded. Total output for each 24-hour period

is thus always equal to 7 units. The firm produces electricity according to the following production function:

1
yi = (kFi ) 2 ; i = day, night

Here, k is the size of the electricity-generation plant, and Fi is the amount of fuel. The firm must build a single plant; it

cannot change plant size from day to night. If a unit of plant size costs wk > 0 per 24-hour period and a unit of fuel costs

wf > 0 , what size plant will the utility build?