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Chapter 5 Henderson and Quandt Microeconomics, Questions 5.4-5.8_ Solutions








5-4 Use Shephard's lemma to find the production function that corresponds to the cost function

C=(+2 √ +)q, and demonstrate that it is CES.


Shephard's lemma states that the partial derivative of the cost function with respect to the price of an input is equal to the amount of that input used in the production function, holding output constant.


Let's find the partial derivative of C with respect to r_1:



∂C/∂r_1 = (∂C/∂q) * (∂q/∂r_1)


Since the production function is homogeneous of degree one, we have q=r_1*f(x_1,x_2). Taking the derivative of both sides with respect to r_1, we get:


∂q/∂r_1 = f(x_1,x_2) + r_1*∂f(x_1,x_2)/∂r_1


Using the cost function, we can find ∂C/∂q:


∂C/∂q = r_1+2 √ r_1 r_2+r_2


Putting it all together, we get:




∂C/∂r_1 = (∂C/∂q) * (∂q/∂r_1) = (r_1+2 √ r_1 r_2+r_2) * [f(x_1,x_2) + r_1*∂f(x_1,x_2)/∂r_1]


Solving for f(x_1,x_2), we get:


f(x_1,x_2) = [∂C/∂r_1 - r_1*∂C/∂r_1]/[r_1+2 √ r_1 r_2+r_2]


Substituting the cost function, we get:


f(x_1,x_2) = [1 - (r_1/2√r_1r_2+r_2/2√r_1r_2)]/[(r_1/2√r_1r_2+r_2/2√r_1r_2)^2]


Simplifying, we get:



f(x_1,x_2) = [2√r_1r_2]/[r_1 + r_2 + 2√r_1r_2]


To demonstrate that this is a CES production function, we can rewrite it as:


q = A(x_1^a + x_2^a)^(1/a)


where a = 1/(1+b) and A = 2^(1/a)√r_1r_2.


Thus, we have shown that the production function corresponding to the cost function C=(r_1+2√r_1r_2+r_2)q is CES with elasticity of substitution a=1/(1+b) and A = 2^(1/a)√r_1r_2.



5-5 A farmer, who sells at a fixed price of 5 dollars per unit and has the cost function

C= 3.5+0.5, plants to maximize profit under certainty. After planting she discovers that she

can have a fertilizer applied that will increase her yield 40 percent with a probability of 0.25, 60

percent with a probability of 0.5, and 88 percent with a probability of 0.25. Her utility function is

U=. Determine the maximum amount that she is willing to pay for the fertilizer application.

Contrast this amount with the expected value of the increase in her profit as a result of fertilizer

application.


The farmer's profit function is given by:

$$\pi(q)=pq-C(q)=5q-(3.5+0.5q^2)=4.5q-0.5q^2$$



The expected value of the profit function if the fertilizer is applied is:

$$\begin{aligned}\mathbb{E}[\pi(q_f)]&=0.25\pi(1.4q)+(0.5)\pi(1.6q)+(0.25)\pi(1.88q)\&=0.25(7q-4.9q^2)+0.5(8q-5.12q^2)+0.25(9.4q-6.9936q^2)\&=6.35q-4.604q^2\end{aligned}$$


The expected profit without fertilizer application is simply $\pi(q)=4.5q-0.5q^2$.


To determine the maximum amount the farmer is willing to pay for the fertilizer application, we need to find the value of the increase in expected profit resulting from the fertilizer application that makes the farmer indifferent between applying the fertilizer and not applying it. Mathematically, this means solving for $\Delta$ such that:


$$\sqrt{\pi(q+\Delta)}=\sqrt{\mathbb{E}[\pi(q_f)]}$$



Substituting in the expressions for $\pi(q+\Delta)$ and $\mathbb{E}[\pi(q_f)]$ we get:


$$\sqrt{5(q+\Delta)-3.5-0.5(q+\Delta)^2}=\sqrt{6.35q-4.604q^2}$$


Squaring both sides and simplifying, we get a quadratic equation in $\Delta$:


$$0.25\Delta^2+1.5q\Delta+0.5625q^2-2.8875q+3.0625=0$$


Solving for $\Delta$, we get:


$$\Delta=-3q/10+2\sqrt{7q^2/100-9/400}$$




The maximum amount the farmer is willing to pay for the fertilizer application is equal to the expected increase in profit resulting from the application:


$$\mathbb{E}[\pi(q_f)]-\pi(q)=6.35q-4.604q^2-(4.5q-0.5q^2)$$


Simplifying, we get:


$$1.85q-4.104q^2$$


Substituting $q=1$ (which corresponds to one unit of output), we get the maximum amount the farmer is willing to pay for the fertilizer application:


$$1.85-4.104=\boxed{-2.254}$$



The negative value implies that the farmer is not willing to pay anything for the fertilizer application, as the expected increase in profit is not enough to compensate for the cost of the application.


Comparing this amount with the expected increase in profit, we see that the expected increase in profit is positive (equal to $1.85$) whereas the maximum amount the farmer is willing to pay for the application is negative. This implies that the farmer should not apply the fertilizer, as the expected increase in profit is not sufficient to cover the cost of the application.

5-6 A linear production function contains four activities for the production of one output using

two inputs. The input requirements per unit output are


= 1 = 2 = 3 = 5

= 6 = 5 = 3 = 2


Are any of the activities inefficient in the sense


that there is no input price ratio at which they

would be used?


To determine whether any of the activities are inefficient, we need to check if any of the activities have a negative shadow price for all possible input price ratios. We can find the shadow prices using the dual problem:


Maximize: p_1 + 6p_2

Subject to:

2p_1 + 5p_2 ≤ 1

3p_1 + 3p_2 ≤ 1

5p_1 + 2p_2 ≤ 1