This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON 279 0120 ZA

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and
the Social Sciences, the Diploma in Economics and Access Route for Students in the
External Programme

Mathematical Economics

Wednesday, 9 June 2010 : 10.00am to 1.00pm

Candidates should answer FOUR of the following SIX questions: TWO from Section A
and TWO from Section B. All questions carry equal marks.

Workings should be submitted for all questions requiring calculations. Any necessary
assumptions introduced in answering a question are to be stated.

© University of London 2010

UL10/0111 PLEASE TURN OVER
D01 Page 1 of 6
 SECTION A

Answer two questions from this section.

1. Suppose there are two goods x and y, whose quantities must be non-
negative, and whose prices are p and q respectively. Consider a consumer
with income I and the utility function u(x; y) = y + a log x, where a is a
given constant and log is the natural logarithm.

(a) State formally the constrained utility maximisation problem for this
consumer.
(b) Which restriction, if any, is needed on the parameter a for the Kuhn-
Tucker theorem to apply?
(c) Under the restriction you impose in (b), solve the problem using
Kuhn-Tucker conditions.
(d) You are now given that p = q = 1 and a = 25. If the initial level of
income I is 100, what is the impact on the utility level achieved by
this consumer of an increase in the income by 10? What if the initial
level of income was 20? Explain your answer.

2. A perfectly competitive …rm produces one output with two inputs, capital
(k) and labour (l). The rental cost of capital is equal to r > 0 and the wage
rate is equal to w > 0. The production function is f (k; l) = (k + 1) l1
with 0 < < 1. The …rm wishes to minimise total costs while achieving
a given level of production y > 0.

(a) State formally the optimisation problem which this …rm faces.
(b) Is the restriction 0 < < 1 on the parameter su¢ cient for the
Kuhn-Tucker theorem to apply?
(c) Solve the problem using Kuhn-Tucker conditions, assuming that the
constraint binds at the optimum.
(d) You are now given that w = 20; r = 10 and = 1=2: If the desired
level of production is y = 0:5, what is the impact on the …rm’s total
cost of an increase in the rental cost of capital of 5? What if y was
1? Explain your answer.

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 3. You are given the following duality identity in Consumer Theory,

xi (p1 ; p2 ; e(p1 p2 ; u)) = hi (p1 ; p2 ; u) , i 2 f1; 2g

where p1 and p2 are the prices of goods 1 and 2, xi (p1 ; p2 ; m) is the

consumer’s uncompensated demand given the prices and his income m,
hi (p1 ; p2 ; u) is his compensated demand for given utility level u, and
e(p1 p2 ; u) is the expenditure function.

(a) Starting from the duality identity above, derive the Slutsky equation
for the e¤ect of a change in p1 on the demand of good 1.
@h1 (p1 ;p2 ;u)
(b) What is the sign of the substitution e¤ect term @p1 in the
Slutsky equation? Explain your answer.
(c) A normal good is de…ned as a good whose demand increases as a
consumer’s income increases, i.e. @x
@m > 0, while an ordinary good is
i

a good whose demand decreases as its price increases, i.e. @x

@pi < 0.
i

Using the Slutsky equation, show that if a good is a normal good,

then it must also be an ordinary good. Is the reverse true?
(d) You are given that a consumer has the following uncompensated de-
mand for good 1,
m
x1 (p1 ; p2 ; m) =
3p1
Further, his expenditure function is given by,
2
1 p2 2
e(p1 ; p2 ; u) = 3p13 u
2
What must the utility level u be for the Slutsky equation to be sat-
is…ed? Comment on your answer.

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 SECTION B

Answer two questions from this section.

4. An in…nitely living representative agent maximises his lifetime utility given

by,
1
X
t
u(ct )
t=0

where u(ct ) is a strictly concave function of the consumption level ct and

2 (0; 1) is the discount factor. The agent has access to a production
technology given by
yt = kta , a 2 (0; 1]
where yt denotes output produced by the agent with access to kt units
of capital in period t. The agent is born with an initial endowment of
k0 units of capital. The capital accumulates according to the following
transition equation,

kt+1 = yt ct + (1 d)kt

where d 2 (0; 1).

(a) Write the Bellman equation for this problem.

(b) Derive the Euler equations. If a = 1, for what values of and d can
you obtain an exact answer without knowing the functional form of
u(:)?
(c) Assume now that u (ct ) = ln ct . By guessing that the value function
is of the form V (kt ; t) = A + B ln kt , derive the policy function for ct
in terms of d, and kt when a = 1.
(d) Hence verify your answer to (b).

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 5. Answer both parts.

(a) Solve the following second order ordinary di¤erential equation,

2t
x 4x + 4x = 8e

subject to the initial conditions

5
x(0) = , x(0) = 2
2

(b) Analyse the following system of linear di¤erential equations:

z1 = 2z1 + 5z2 3
z2 = 2z1 z2 2

i. Find the steady state of the system. Is the steady state stable,
unstable or saddle-path stable?
ii. Find the family of solutions of the system.
iii. What are the slopes of the separatrices in the z1 -z2 space?

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 6. Consider the optimisation problem of a household that holds two cate-
gories of assets: money and government bonds. Domestic money bears no
interest but the transactions technology is such that holding cash balances
reduces liquidity costs of purchasing consumption goods. For this reason,
real money balances m are an argument (together with consumption c) of
the utility function: Z 1
t
max e u(c; m)dt
0
The real …nancial wealth of the representative household, a, is given by
a = m + b, where b denotes the real stock of bonds. The ‡ow budget
constraint is:
a = y + rb c m;
where r is the real interest rate on bonds, and is the in‡ation rate. The
utility function is assumed to be u(c; m) = ln c + ln m. Households treat
y; r; as given.

(a) Determine the sets of control variables and state variables. If you
have more endogenous variables, factor them out to obtain a standard
optimal control problem.
(b) Set up the Hamiltonian. Write down the necessary conditions for a
maximum.
(c) Factor out the co-state variable to obtain the law of motion of c.
(d) Characterise the relationship between real money balances and con-
sumption on the optimal path.

END OF PAPER

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