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# EconS 501: ADVANCED MICROECONOMIC THEORY I

## (Ph.D. program in Economics)

PRACTICE EXERCISES ON
ADVANCED MICROECONOMIC THEORY - I

Felix Munoz-Garcia
1

School of Economic Sciences
Washington State University

1
103G Hulbert Hall, School of Economic Sciences, Washington State University. Pullman, WA 99164-6210,
fmunoz@wsu.edu. Tel. 509-335-8402.
Micro Theory I
Recitation #1 - Preferences and Choice
1. MWG 1.B.2. Prove property (ii) of Proposition 1.B.1: If a preference relation % is
rational then:
(a) ~ is both irreexive (r ~ r never holds) and transitive (if r ~ and ~ ., then
r ~ .).
(b) ~ is reexive (r ~ rfor all r), transitive (if r ~ and ~ ., then r ~ .), and
symmetric (if r ~ , then ~ r).
(c) if r ~ % ., then r ~ ..
Reexivity: Since r % r for every r A, r ~ r for every r A as well. Thus ~ is
reexive.
Transivity: Suppose that r ~ and ~ .. Then on one hand r % and % r, and
on the other hand % . and . % . By transitivity of %, this implies that r % . and
. % r. Thus r ~ .. Hence ~ is transitive.
Symmetry: Suppose that r ~ . Then r % and % r. Thus % r and r % . Hence
~ r. Thus ~ is symmetric..
2. MWG 1.C.1. Consider the choice structure (E. C()) with 1 = (r. . r. . .) and
C(r. ) = r. Show that if (E. C()) satises the weak axiom, then we must have
C(r. . .) = r. = .. o: = r. ..
Recall that the choice structure (E. C()) satises the WARP if,
1. for some budget set 1 E with r. 1 we have that element r is chosen, r C(1),
then
2. for any other budget set 1
0
E where alternatives r and are also available, r. 1
0
,
and where alternative is chosen, C(1
0
), then we must have that alternative r is
chosen as well, r C(1
0
).
Then, if C(r. . .), then the WARP would imply that C(r. ). But
contradicts the equality C(r. ) = r. Hence , C(r. . .). Thus
either C (r. . .) = r , or
C (r. . .) = . , or
C (r. . .) = r. . , but
C (r. . .) ,=
1
3. MWG 2.D.3(b). Consider an extension of the Walrasian budget set to an arbitrary
consumption set A such that
1
p;w
= r A : j r _ n.
Show that if A is a convex set, then 1
p;w
is convex as well.
Let r 1
p;w
and r
0
1
p;w
. Now consider the linear combination of these two bundles
r
00
= `r + (1 `)r
0
where ` [0. 1]. Since A is convex, r
00
A. Moreover,
j r
00
= `(j r) + (1 `) (j r
0
) _ `n + (1 `) n = n
Thus r
00
1
p;w
.
4. MWG 2.D.4 Show that the budget set in Figure 2.D.4 is not convex.
It follows from a direct calculation that consumption level ` can be attained by
8+
M8s
s
0
hours of labor. It follows from the denition that (24. 0) and

16
M8s
s
0
. `

are in the budget set (the latter is the kink where the worker obtains a wealth of `).
But their convex combination of these two consumption vectors with ratio

M8s
s
0
8 +
M8s
s
0
.
8
8 +
M8s
s
0
!
is not in the budget set: the amount of leisure of this combination equals to 16 (so the
labor is eight hours), but the amount of the consumption good is
`
8
8 +
M8s
s

8
8 +
M8s
s
0
= `
8
M
s
= 8:
5. MWG 3.B.1 Show the following:
(a) If % is strongly monotone, then it is monotone.
(b) If % is monotone, then it is locally nonsatiated.
Answer: (a) Assume that % is strongly monotone and r , i.e., bundle r is higher
than bundle in every component. Then r _ and r ,= . Hence r ~ . Thus % is
monotone.
Answer (b). Assume that % is monotone, r A, and c 0. Let c = (1. . . . . 1) R
L
and = r +

p
L
c. Then | r| _ c and ~ r. Thus % is locally nonsatiated.
2
6. MWG 3.B.3 Draw a convex preference relation that is locally nonsatiated but is not
monotone.
Following is an example of a convex, locally nonsatiated preference relation that is not
monotone i R
2
+
. For example, r but ~ r.
7. [Checking properties of preference relations]. Check that the following prefer-
ence relations dened in A = R
2
+
satisfy: (i) completeness, (ii) reexivity, (iii) transi-
tivity, (iv) monotonicity, and (v) weak convexity.
(a) (r
1
. r
2
) % (
1
.
2
) if r
1
>
1
1.
Let us rst build some intuition on this preference relation. Take a bundle
(2. 1), you can take any other of course! Then, the upper contour set of this
bundle is given by
lCo
%
(2. 1) = (r
1
. r
2
) % (2. 1) == r
1
_ 2 1 = (r
1
. r
2
) : r
1
_ 1
while the lower contour set is dened as
1Co
%
(2. 1) = (2. 1) % (r
1
. r
2
) == 2 _ r
1
1 = (r
1
. r
2
) : r
1
_ 3
Finally, the consumer is indierent between bundle (2,1) and the set of bun-
dles where
1`1
%
(2. 1) = (r
1
. r
2
) ~ (2. 1) == 1 _ r
1
_ 3
Graphically, all bundles in R
2
+
such that r
1
_ 1 belong to the set of bundles
weakly preferred to (2,1), all bundles such that r
1
_ 3 belong to the set of
bundles weakly preferred to (2,1), and those bundles in between, 1 _ r
1
_ 3,
are indierent to (2,1).
Completeness. We need that for any pair of bundles (r
1
. r
2
) and (
1
.
2
), ei-
ther (r
1
. r
2
) % (
1
.
2
) or (
1
.
2
) % (r
1
. r
2
), or both (i.e., (r
1
. r
2
) ~ (
1
.
2
)).
Since this preference relation only depends on the rst component of every
bundle, we have that, for every pair of bundles (r
1
. r
2
) and (
1
.
2
), either:
3
1. r
1
_
1
1, which implies that (r
1
. r
2
) % (
1
.
2
), or
2. r
1
<
1
1, which implies
1
_ r
1
1, and hence (
1
.
2
) % (r
1
. r
2
), or
3.
1
1 r
1
_
1
1, which implies that (r
1
. r
2
) ~ (
1
.
2
). Hence, this
preference relation is complete.
Reexivity. We need to show that, for every bundle (r
1
. r
2
), (r
1
. r
2
) %
(r
1
. r
2
). In this case, (r
1
. r
2
) % (r
1
. r
2
) implies that r
1
_ r
1
1, which
is indeed true for any r
1
R
+
.
Transitivity. We need to show that, for any three bundles (r
1
. r
2
), (
1
.
2
)
and (.
1
. .
2
) such that
if (r
1
. r
2
) % (
1
.
2
) and (
1
.
2
) % (.
1
. .
2
), then (r
1
. r
2
) % (.
1
. .
2
)
This property does not hold for this preference relation. In order to show
that, let us consider the following three bundles (that is, we are nding a
counterexample to show that transitivity does not hold):
(r
1
. r
2
) = (5. 4)
(
1
.
2
) = (6. 1)
(.
1
. .
2
) = (7. 2)
First, note that (r
1
. r
2
) % (
1
.
2
) since r
1
_
1
1 (i.e., 5 _ 6 1). Addi-
tionally, (
1
.
2
) % (.
1
. .
2
) is also satised since
1
_ .
1
1 (i.e., 6 _ 7 1).
However, (r
1
. r
2
) (.
1
. .
2
) since r
1
.
1
1 (i.e., 5 7 1). Hence, this
preference relation does not satisfy Transivity.
Continuity. Continuity requires that both the upper and the lower contour
sets are closed, which is satised given that they both contain their boundary
points.
Monotonicity. This property does not hold. For a small increase c 0 in the
amount of good 1, r
1
+c, we dont necessarily have that (r
1
+c. r
2
) % (r
1
. r
2
)
since for that we need r
1
+ c _ r
1
1, which is not true for any c smaller
than 1, c < 1.
Weak Convexity. This property implies that the upper contour set must be
convex, that is, if bundle (r
1
. r
2
) is weakly preferred to (
1
.
2
), (r
1
. r
2
) %
(
1
.
2
), then the linear combination of them is also weakly preferred to
(
1
.
2
),
`(r
1
. r
2
) + (1 `) (
1
.
2
) % (
1
.
2
) for any ` [0. 1]
In this case, (r
1
. r
2
) % (
1
.
2
) implies that r
1
_
1
1; whereas `(r
1
. r
2
) +
(1 `) (
1
.
2
) % (
1
.
2
) implies
`r
1
+ (1 `)
1
_
1
1 == r
1
_
1
1
which is true given that (r
1
. r
2
) % (
1
.
2
). Hence, this preference relation is
weakly convex.
(b) (r
1
. r
2
) % (
1
.
2
) if r
1
_
1
1 and r
2
_
2
+ 1.
4
Let us rst build some intuition on this preference relation. Take a bundle
(2. 1). Then, the upper contour set of this bundle is given by
lCo
%
(2. 1) = (r
1
. r
2
) % (2. 1) == r
1
_ 2 1 and r
2
_ 1 + 1
= (r
1
. r
2
) : r
1
_ 1 and r
2
_ 2
which is graphically represented by all those bundles in R
2
+
in the lower right-
hand corner (below r
2
= 2 and to the right of r
1
= 1). On the other hand,
the lower contour set is dened as
1Co
%
(2. 1) = (2. 1) % (r
1
. r
2
) == 2 _ r
1
1 and 1 _ r
2
+ 1
= (r
1
. r
2
) : r
1
_ 3 and r
2
_ 0
which is graphically represented by all those bundles in R
2
+
in the left half of
the positive quadrant (above r
2
= 0 and to the left of r
1
= 3).Finally, the
consumer is indierent between bundle (2,1) and the set of bundles where
1`1
%
(2. 1) = (r
1
. r
2
) ~ (2. 1) == 1 _ r
1
_ 3 and 0 _ r
2
_ 2
Completeness. From the above analysis it is easy to note that this property
is not satised, since there are bundles in the area r
1
3 and r
2
_ 2 where
our preference relation does not specify if they belong to the upper contour
set, the lower contour set, or the indierence set. Another way to prove that
completeness does not hold is by nding a counterexample. In particular, we
must nd an example of two bundles such that neither (r
1
. r
2
) % (
1
.
2
) nor
(
1
.
2
) % (r
1
. r
2
). Let us take two bundles,
(r
1
. r
2
) = (1. 2) and (
1
.
2
) = (4. 6)
We have that:
1. (r
1
. r
2
) (
1
.
2
) since 1 4 1 for the rst component of the bundle,
and
2. (
1
.
2
) (r
1
. r
2
) since 6 2 + 1 for the second component of the bun-
dle. Hence, there are two bundles for which neither (r
1
. r
2
) % (
1
.
2
)
nor (
1
.
2
) % (r
1
. r
2
), which implies that this preference relation is not
complete.
Reexivity. We need to show that, for every bundle (r
1
. r
2
), (r
1
. r
2
) %
(r
1
. r
2
). In this case, (r
1
. r
2
) % (r
1
. r
2
) implies that r
1
_ r
1
1, which
is indeed true for any r
1
R
+
, and r
2
_ r
2
+ 1 which is also true for any
r
2
R
+
.
Transitivity. We need to show that, for any three bundles (r
1
. r
2
), (
1
.
2
)
and (.
1
. .
2
) such that
if (r
1
. r
2
) % (
1
.
2
) and (
1
.
2
) % (.
1
. .
2
), then (r
1
. r
2
) % (.
1
. .
2
)
This property does not hold for this preference relation. In order to show
that, let us consider the following three bundles (that is, we are nding a
5
counterexample to show that transitivity does not hold):
(r
1
. r
2
) = (2. 1)
(
1
.
2
) = (3. 4)
(.
1
. .
2
) = (4. 6)
First, note that (r
1
. r
2
) % (
1
.
2
) since r
1
_
1
1 (i.e., 2 _ 3 1), and
r
2
_
2
+ 1 (i.e., 1 _ 4 + 1). Additionally, (
1
.
2
) % (.
1
. .
2
) is also satised
since
1
_ .
1
1 (i.e., 3 _ 4 1), and
2
_ .
2
+ 1 (i.e, 3 _ 4 + 1). However,
(r
1
. r
2
) (.
1
. .
2
) since r
1
.
1
1 (i.e., 2 4 1). Hence, this preference
relation does not satisfy Transivity.
Continuity. Continuity requires that both the upper and the lower contour
sets are closed, which is satised given that they both contain their boundary
points.
Monotonicity. This property does not hold. For a small increase c 0 in the
amount of good 1, r
1
+c, we dont necessarily have that (r
1
+c. r
2
) % (r
1
. r
2
)
since for that we need r
1
+ c _ r
1
1, which is not true for any c smaller
than 1, c < 1.
Weak Convexity. This property implies that the upper contour set must be
convex, that is, if bundle (r
1
. r
2
) is weakly preferred to (
1
.
2
), (r
1
. r
2
) %
(
1
.
2
), then the linear combination of them is also weakly preferred to
(
1
.
2
),
`(r
1
. r
2
) + (1 `) (
1
.
2
) % (
1
.
2
) for any ` [0. 1]
In this case, (r
1
. r
2
) % (
1
.
2
) implies that r
1
_
1
1 and r
2
_
2
+ 1;
whereas `(r
1
. r
2
) + (1 `) (
1
.
2
) % (
1
.
2
) implies
`r
1
+ (1 `)
1
_
1
1 for the rst component, and
`r
2
+ (1 `)
2
_
2
+ 1 for the second component.
which respectively imply
`(r
1

1
) _ 1, and
`(r
2

2
) _ 1
and since (r
1

1
) _ 1 and (r
2

2
) _ 1 by assumption, i.e., (r
1
. r
2
) %
(
1
.
2
), then both of the above conditions are true for any ` [0. 1]. Hence,
this preference relation is weakly convex.
(c) (r
1
. r
2
) % (
1
.
2
) if min 3r
1
+ 2r
2
. 2r
1
+ 3r
2
min 3
1
+ 2
2
. 2
1
+ 3
2
.
Let us rst build some intuition on this preference relation. Take a bundle
(2. 1). Then, the upper contour set of this bundle is given by
lCo
%
(2. 1) = (r
1
. r
2
) % (2. 1)
= min 3r
1
+ 2r
2
. 2r
1
+ 3r
2
7 = min 8. 7
6
which is graphically represented by all those bundles in R
2
+
which are strictly
above both lines 3r
1
+ 2r
2
= 7 and 2r
1
+ 3r
2
= 7. On the other hand, the
lower contour set is dened as
1Co
%
(2. 1) = (2. 1) % (r
1
. r
2
)
= 7 min 3r
1
+ 2r
2
. 2r
1
+ 3r
2

## which is graphically represented by all those bundles in R

2
+
which are strictly
below both lines 3r
1
+ 2r
2
= 7 and 2r
1
+ 3r
2
= 7..Finally, there are no
bundles for which the consumer is just indierent between bundle (2,1) and
any other bundle (note that there are no bundles for which the upper and
lower contour set coincide). Hence,
1`1
%
(2. 1) = ?
Completeness. For all (3r
1
+ 2r
2
) R
+
and (2r
1
+ 3r
2
) R
+
, the minimum
min 3r
1
+ 2r
2
. 2r
1
+ 3r
2
= c exists and c R
+
. Similarly, the minimum
min 3
1
+ 2
2
. 2
1
+ 3
2
= / exists and / R
+
. Therefore, we can easily
compare c and /, obtaining that either c / which implies (r
1
. r
2
) % (
1
.
2
),
or c < / which implies (
1
.
2
) % (r
1
. r
2
).
Reexivity. We need to show that, for every bundle (r
1
. r
2
), (r
1
. r
2
) %
(r
1
. r
2
). In this case, (r
1
. r
2
) % (r
1
. r
2
) implies that
min 3r
1
+ 2r
2
. 2r
1
+ 3r
2
min 3r
1
+ 2r
2
. 2r
1
+ 3r
2

## holds strictly, which cannot be true, for any r

1
. r
2
R
+
. Therefore this pref-
erence relation does not satisfy Reexivity. [Note that this preference relation
asks for the above inequality to hold strictly; if the preference relation were in-
stead (r
1
. r
2
) % (
1
.
2
) if min 3r
1
+ 2r
2
. 2r
1
+ 3r
2
_ min 3
1
+ 2
2
. 2
1
+ 3
2

## with weak inequality, the preference relation would satisfy Reexivity].

Transitivity. We need to show that, for any three bundles (r
1
. r
2
), (
1
.
2
)
and (.
1
. .
2
) such that
if (r
1
. r
2
) % (
1
.
2
) and (
1
.
2
) % (.
1
. .
2
), then (r
1
. r
2
) % (.
1
. .
2
)
First, note that (r
1
. r
2
) % (
1
.
2
) implies
c = min 3r
1
+ 2r
2
. 2r
1
+ 3r
2
min 3
1
+ 2
2
. 2
1
+ 3
2
= /
and (
1
.
2
) % (.
1
. .
2
) implies that
/ = min 3
1
+ 2
2
. 2
1
+ 3
2
min 3.
1
+ 2.
2
. 2.
1
+ 3.
2
= c
Combining both conditions we have that
min 3r
1
+ 2r
2
. 2r
1
+ 3r
2
min 3.
1
+ 2.
2
. 2.
1
+ 3.
2

## and we can conclude that this preference relation is Transitive.

7
Continuity. Continuity requires that both the upper and the lower contour
sets are closed, which is not satised for this preference relation given that
neither of them contains their boundary points.
Monotonicity. We need to show that, for a small increase c 0 in the amount
of good 1, r
1
+ c, we have that (r
1
+ c. r
2
) % (r
1
. r
2
). That is, we need to
show that
min 3 (r
1
+ c) + 2r
2
. 2 (r
1
+ c) + 3r
2
min 3r
1
+ 2r
2
. 2r
1
+ 3r
2

## rewriting the above inequality as

min c
0
. /
0
min c. /
we have that: (1) if r
2
r
1
then / c; or (2) if r
2
c r
1
then /
0
c
0
.
Given that r
1
(r
2
c. r
2
), then we have that
3r
1
+ 2r
2
< 2(r
1
+ c) + 3r
2
and if r
1
< r
2
2c, then min c. c
0
= c. On the other hand, if r
1

(r
2
2c. r
2
), then min c. / = c and if min /. /
0
= /.
Weak Convexity. This property implies that the upper contour set must be
convex, that is, if bundle (r
1
. r
2
) is weakly preferred to (
1
.
2
), (r
1
. r
2
) %
(
1
.
2
), then the linear combination of them is also weakly preferred to
(
1
.
2
),
`(r
1
. r
2
) + (1 `) (
1
.
2
) % (
1
.
2
) for any ` [0. 1]
In this case we must show that min c. / min c. d implies
min `c + (1 `) c. `/ + (1 `) d min c. d
1. First case: min c. / = c, min c. d = c and without loss of generality,
c c.Therefore,
min `c + (1 `) c. `/ + (1 `) d = `c + (1 `) c
and `c + (1 `) c min c. d = c. For this case, convexity is satised.
2. Second case: min c. / = c, min c. d = d and without loss of generality,
c d.Therefore,
min `c + (1 `) c. `/ + (1 `) d = `c + (1 `) c
and `c + (1 `) c min c. d = d given that c d and c d. For this
case, convexity is satised as well. Analogously for the other two cases.
8
[More preference relations properties]. [This is not an exercise] Let us rst introduce
some properties of the strict preference relation, ~, dened in A = R
2
+
.
1. (a) The strict preference relation, ~, satises Asymmetry since there are no pair of
bundles (r
1
. r
2
) and (
1
.
2
) such that
(r
1
. r
2
) ~ (
1
.
2
) and (
1
.
2
) ~ (r
1
. r
2
).
(b) The strict preference relation, ~, satises Negative Transitivity given that for
every pair of bundles (r
1
. r
2
) and (
1
.
2
) where (r
1
. r
2
) ~ (
1
.
2
), then for every
other bundle (.
1
. .
2
) we must have that either
1. (r
1
. r
2
) ~ (.
1
. .
2
) (without specifying whether (.
1
. .
2
) ~ (
1
.
2
) or (
1
.
2
) ~
(.
1
. .
2
)), or
2. (.
1
. .
2
) ~ (
1
.
2
) (without specifying whether (r
1
. r
2
) ~ (.
1
. .
2
) or (.
1
. .
2
) ~
(r
1
. r
2
)), or
3. both, i.e., (r
1
. r
2
) ~ (.
1
. .
2
) ~ (
1
.
2
).
4. Intuition: if we can order two bundles such that one is preferred to other,
(r
1
. r
2
) ~ (
1
.
2
), then a third bundle (.
1
. .
2
) can be ordered either: in be-
tween of them (as in iii), or after one or both of them (as in i), or before one
or both of them (as in ii).
5. Note: Note that, despite the name, Negative Transivity is not a negation
of Transivity.
(c) The strict preference relation, ~, satises Irreexivity since there is no bundle
(r
1
. r
2
) for which (r
1
. r
2
) ~ (r
1
. r
2
).
9
Micro Theory I
Recitation #2 - Utility and Demand
1. Check if the utility function n(r
1
. r
2
) = r

1
r

2
where c. , 0 satises the following
properties:
(a) Local non-satiation;
(b) Decreasing marginal utility for both goods 1 and 2;
(c) Quasiconcavity.
(d) Homogeneous
(e) Homothetic.
1. (a) Local non-satiation (LNS). When working with a dierentiable utility function we
can check LNS by checking that the marginal utility from additional amounts of
goods 1 and 2 are non-negative,
Jn(r
1
. r
2
)
Jr
1
= cr
1
1
r

2
= c
r

1
r

2
r
1
0 if and only if c 0
Jn(r
1
. r
2
)
Jr
2
= ,r

1
r
1
2
= ,
r

1
r

2
r
2
0 if and only if , 0
(b) Decreasing marginal utility. We need to show that the marginal utilities we found
above are nonincreasing. That is,
J
2
n(r
1
. r
2
)
Jr
2
1
= c(c 1)r
2
1
r

2
0 if and only if c 1
J
2
n(r
1
. r
2
)
Jr
2
2
= ,(, 1)r

1
r
2
2
0 if and only if , 1
(c) Quasiconcavity. Let us rst simplify the expression of the utility function by
applying a monotonic transformation on n(r
1
. r
2
), since any monotonic transfor-
mation of a utility function maintains the same preference ordering. That is, if a
utility function is quasiconcave, any monotonic transformation of it will also be
quasiconcave. In this case, we apply
.
1
= ln n() = cln r
1
+ , ln r
2
We now need to nd the bordered Hessian matrix, then nd its determinant, if
this determinant is greater than (or equal to) zero, then this utility function is
1
quasiconcave; otherwise it is quasiconvex (see Appendix M.D. in MWG, or Simon
and Blumes Mathematics for Economists). The bordered Hessian matrix is

0 .
1
.
2
.
1
.
11
.
12
.
2
.
21
.
22

0

x
1

x
2

x
1

x
2
1
0

x
2
0

x
2
2

## and the determinant of this matrix is

(+)
x
2
1
x
2
2
0 for all r
1
. r
2
2 R
+
, which
implies that n() is quasiconcave.
(d) Homogeneous. It is easy to show that this Cobb-Douglas utility function repre-
sents preferences which are homogeneous of degree c + , in r
1
and r
2
,
n(`r
1
. `r
2
) = (`r
1
)

(`r
2
)

= `
+
r

1
r

2
= `
+
n(r
1
. r
2
)
(e) Homothetic preferences. First note that
`1o
1;2
=
cr
1
1
r

2
,r

1
r
1
2
scaling up all goods by a factor t, we obtain
`1o
1;2
=
c(tr
1
)
1
(tr
2
)

, (tr
1
)

(tr
2
)
1
=
t
1+
t
+1
cr
1
1
r

2
,r

1
r
1
2
=
cr
1
1
r

2
,r

1
r
1
2
which shows that the `1o
1;2
does not change when we scale up all goods by a
common factor t, i.e., the slope of the indierence cuve at a given point is not
changed.
A couple of remarks on Homothetic preferences. When preferences are homo-
thetic, the MRS between the two goods is just a function of the consumption
ratio between the goods,
x
1
x
2
, but it does not depend on the absolute amounts
consumed. As a consequence, if we double the amount of both goods, the
MRS does not change.
Recall that this type of preferences induce wealth expansion paths that are
straight lines from the origin, i.e., if we double the wealth level of the in-
dividual, then his wealth expansion path (the line connecting his demanded
bundles for the initial and the new wealth level) are straight lines. A corollary
of this property is that the demand function obtained from homothetic pref-
erences must have an income-elasticity equal to 1, i.e., when the consumers
income is increased by 1%, the amount he purchases of any good / must
increase by 1% as well.
Examples of preference relations that are homothetic: Cobb-Douglas (as in
the previous example), preferences over goods that are considered substitutes,
preferences over goods that are considered complements and CES preferences.
In contrast, quasilinear preference relations are not homothetic.
2
2. Let us check the quasiconcavity of a utility function that is not dierentiable, n(r
1
. r
2
) =
max fr
1
. r
2
g .
In order to check for quasiconcavity, we now use the denition: n(r
1
. r
2
) =
max fr
1
. r
2
g is quasiconcave if, for every bundle (r
1
. r
2
), the set of bundles (
1
.
2
)
such that the consumer obtains a higher utility level than from (r
1
. r
2
) is convex.
That is, for every bundle (r
1
. r
2
), its upper contour set
f(
1
.
2
) : n(
1
.
2
) n(r
1
. r
2
)g is convex
that is,
f(
1
.
2
) : max f
1
.
2
g max fr
1
. r
2
gg is convex
As we can see from the gure below representing this preference relation, we can
nd bundles, like r, for which its upper contour set is not convex. That is,
% r but `r + (1 `) r for all ` 2 [0. 1]
x
2
x
1
x
y
That is, max f
1
.
2
g max fr
1
. r
2
g (which implies % r) [In this example
max f
1
.
2
g =
1
, and max fr
1
. r
2
g = r
2
, and
1
r
2
]. However, constructing a
linear combination of these two bundles `r + (1 `) we have that
max f`r
1
+ (1 `)
1
. `r
2
+ (1 `)
2
g < max f
1
.
2
g =
1
This inequality is indeed satised because either:
(a) max f`r
1
+ (1 `)
1
. `r
2
+ (1 `)
2
g = `r
1
+ (1 `)
1
(i.e., if the linear
combination of r and is below the main diagonal), then `r
1
+(1`)
1

1
for any ` 2 [0. 1]; or
(b) If, instead, max f`r
1
+ (1 `)
1
. `r
2
+ (1 `)
2
g = `r
2
+ (1 `)
2
(i.e., if
the linear combination of r and is above the main diagonal), then we also
have `r
2
+ (1 `)
2

1
for any ` 2 [0. 1].
3
RECITATION #2
ECON 501

MWG 3.D.1. Verify that the Walrasian demand function generated by the Cobb-Douglas utility function
satisfies:
(i) Homogeneity of degree zero in (p,w):
x(p,w)=x(p,w) for any p,w and for any scalar >0
(ii) Walras law:
px=w for all x that belong to x(p,w)
(iii) Convexity/Uniqueness: If the preference relation is convex, so that u() is quasiconcave, then
x(p,w) is a convex set. Moreover, if the preference relation is strictly quasiconvex, so that u()
is strictly quasiconcave, then x(p,w) consists of a single point.
Solution:
Assume the Cobb-Douglas utility function to be
1
1 2
U Ax x

= , then UMP will be
1 2
1
1 2
,
max
x x
Ax x

, subject to
1 1 2 2
w p x p x
Take FOCs, we can solve for the Walrasian demand function, and get
( )
1 1
, / x p w w p = , ( )
2 2
, (1 ) / x p w w p =
Thencheckcondition(i),
( ) ( ) ( ) ( )
1 1 1
, / /
1
, , x p w w p w p x p w = = =
( ) ( )( ) ( ) ( ) ( )
2 2
, 1 / 1 / ,
2 2
. x p w w p w p x p w = = =
checkcondition(ii),
( ) ( ) ( )
1 1 2 2 1 1 2 2
, , / 1 / . px p x p w p x p w p w p p w p w = + = + =
1

Condition(iii)isobvious.
MWG 3.D.2. Verify that the indirect utility function
v(p,w)=[ln+(1-)ln(1-)]+lnw-lnp
1
-(1-)lnp
2

satisfies the following properties:
(i) Homogeneous of degree zero in (p,w):
v(p,w)=v(p,w) for any p,w and for any scalar >0
(ii) Strictly increasing in w and nonincreasing in p
l
for any l.
(iii) Quasiconvex: the set {(p,w) : v(p,w)v} is convex for any v.
(iv) Continuous in p and w.
Solution.
Tocheckcondition(i),

( )
( ) ( ) ( )
( ) ( ) ( ) ( )
( ) ( ) ( )
( )
1 2
1 2
1 2
,
ln 1 ln 1 ln ln 1 ln
ln 1 ln 1 ln ln ln ln 1 ln 1 ln
ln 1 ln 1 ln ln 1 ln
, .
v w
w
w
w
v w

= + +
= + + +
= + +
=

. <

Tocheckcondition(ii),

( )
( )
( ) ( )
1 1
2 2
, / 1/ 0,
, / / 0,
, / 1 / 0
v w w w
v w
v w

= >
= <
=
Wecanprovethattheset ( )
{ }
: ,
L
v w v
++
\ isconvex.
Define ,andassume ( ) ( ) ln 1 ln 1 ln w = + +
2

( ) ( )
( ) ( )
( ) ( )
1 2
1 2
, ln 1 ln
, ln 1 ln
, (1 ) ,
v w V
v w
w w

= +

= +

= +

V
Ifwecanprovethat ( ) , v w +V ,thenthe set ( )
{ }
: ,
L
v w v
++
\ is convex.
( ) ( ) ( ) ( ) (
1 2 1 1 2
, ln 1 ln ln (1 ) 1 ln (1 ) v w )
2

= = + +
( ) ( )
( ) ( )
( ) ( )
( )
( )
( )
3

1 2
1 2
1 1 2 2
, ln 1 ln
(1 ) , (1 ) (1 ) ln 1 (1 ) ln (1 ) (1 )
(1 ) , ln (1 ) ln 1 ln (1 ) ln
v w V
v w V
v w V

= +

= +

+ = + + + , v w
Therefore,
( ) ( ) ( ) ( )
( )
( )
( )
( )
1 1 2
1 1 2
, ln (1 ) 1 ln (1 )
ln (1 ) ln 1 ln (1 ) ln
,
v w
V
v w V

= + + +

+ + +

+
+
2
2

(Accordingtothepropertyofln(.),wehave ( )
1 2 1
ln (1 ) ln (1 ) ln
2
x x x + + x .)
Therefore,the set ( )
{ }
: ,
L
v w v
++
\ is convex.
Condition(iv)followsthefunctionalformof
( ) v .

MWG 3.D.6. Consider the three good setting in which the consumer has utility function
u(x)=(x
1
-b
1
)

(x
2
-b
2
)

(x
3
-b
3
)

a) Why can you assume that ++=1 without loss of generality? Do so for the rest of the problem.
Solution. Define
( ) ( )
( )
( ) (
1/
1 1 2 2
u x u x x b x b ) ( )
3 3
, x b

with
+ +
= =
( ) ( ) ( ) / , / , / . = + + = + + = + + Then 1 = + +
and ( ) u represents the same preferences as ( ) u , because the function
( ) 1/
u u
+ +

is a monotone transformation. Thus we can assume without loss of generality that
1. + + =
b) Write down the first-order conditions for the UMP, and derive the consumers Walrasian demand
and indirect utility functions. [This system of demands is known as the linear expenditure
system, and it is due to Stone (1954)].
Solution.Useanothermonotonetransformationofthegivenutilityfunction,
( ) ( ) ( ) ( ) ( )
1 1 2 2 3 3
ln ln ln ln . u x u x x b x b x b = = + +

( ) ( ) ( )
1 1 2 2 3 3 1 1 2 2 3 3
1
1 1 1
1 1 1 1
2
2 2 2
2 2 2 2
3
3 3 3
3 3 3 3
1 1 2 2 3 3
1 1 2 2
ln ln ln ( )
0
0
:
0
0
x b x b x b w p x p x p
p
x x b
p x p b
p
x x b
FOCs p x p b
p
x x b
p x p b
w p x p x p x
p x p x

= + + +

= =

= +

= =

= +

= =

= +

= =

+ +
A
A
A
A
A
x
3 3 1 1 2 2 3 3
p x p b p b p b w

+ +
= + + + =

Let
1 1 2 2 3 3
. p b p b p b p b = + +

( )
1 1 1
1 1 1
2 2 2
2 2 2
3 3 3
3 3 3
( )
( )
( )
( )
( )
( )
1
w pb
w pb
1
2
3
x b b w
p p p
w pb
pb b
x b b
p p p
w pb
w pb b
x b b w
p p p
pb b

+ +
=

= + = + = +

+ +

= + = + = +

+ +

= + = + = +

+ +

+ + =

Getdemandfunction ( ) ( ) ( )( )
1 2 3 1 2 3
, , , / , / , / x p w b b b w p b p p p = +
Pluginto u(x)=(x
1
-b
1
)

(x
2
-b
2
)

(x
3
-b
3
)

,thenweobtaintheindirectutilityfunction
( ) ( )( ) ( ) ( )
1 2 3
, / / v p w w p b p p p / .

=
4

c) Verify that these demand functions satisfy the properties listed in Propositions 3.D.2 for the
osition 3.D.3 for the indirect utility function. Walrasian demand function, and in Prop
Tocheckthehomogeneityofthedemandfunction,
( ) ( ) ( )( )
( ) ( )( ) ( )
1 2 3 1 2 3
1 2 3 1 2 3
, , , / , / , /
, , / , / , / ,
x w b b b w b
b b b w b x p w

= +
= + = .

TocheckWalraslaw,
( ) ( ) ( ) ( )
( )( )
( )( )
1 1 2 2 3 3
1 1 2 2 3 3 1 1 2 2 3 3
, , , ,
/ / /
.
x w x w x w x w
b b b w b
b w b w

= + +
= + + + + +
= + + + =

Theuniquenessisobvious.
Tocheckthehomogeneityoftheindirectutilityfunction,
( ) ( )( ) ( ) ( )
( )
( )( ) ( ) ( )
( )( ) ( ) ( ) ( )
1 2 3
1
1 2
1 2 3
, / / /
/ / /
/ / / ,
v w w b
w b
w b v p w
3
.

+ +
=
=
= =

, >

Tocheckthemonotonicity,

( ) ( ) ( ) ( )
( ) ( ) ( )
( ) ( ) ( )
( ) ( ) ( )
1 2 3
1 1
2 2
3 3
, / / / / 0
, / , / 0,
, / , / 0,
, / , / 0.
v w w
v w v w
v w v w
v w v w

=
= <
= <
= <
5
Thecontinuityfollowsdirectlyfromthegivenfunctionalform.

In order to prove the quasiconvexity, it is sufficient to prove that, for any v and the set \ 0, w>
( )
{ }
3
: , v w v \ isconvex.Consider
( ) ( )
1 2
ln , ln ln ln ln ln ln ln v w w b
3.
= + + +

Sincethelogarithmicfunctionisconcave,theset
( )
{ }
3
1 2 3
: ln ln ln ln w b v \
is convex for every Since the other terms, ln ln . v \ ln , + + do not depend on , this
impliesthattheset ( )
{ }
3
\ : ln , v w v isconvex.Hencesois ( )
{ }
3
: , v w v \ .
(OrfollowthesamestepinMWG 3.D.2 .)

MWG 3.D.7. There are two commodities. We are given two budget sets B
p
0
,w
0
and B
p
1
,w
1
described,
respectively, by
p
0
=(1,1) and w
0
=8
p
1
=(1,4) and w
1
=26
The observed choice at (p
0
, w
0
) is x
0
=(4,4), and at (p
1
, w
1
) the consumers choice satisfies px
1
=w.
a) Determine the region of permissible choices for x
1
, if the choices x
0
and x
1
are consistent with
maximiz of preferences. ation
Since
1 0 1 1 0
and , x w x x < the weakaxiom implies
0 1 0
. x w > Thus
1
x hasto be
ontheboldlineinthefollowingfigure.
6

In the following four questions, we assume the given preference can be a differentiable
utilityfunction

( ). u

b) Determine the region of permissible choices for x
1
, if the choices x
0
and x
1
are consistent with
maximization of preferences that are quasilinear with respect to the first good.
If the preference is quasilinear with respect to the first good, then we can take a utility
function ( ) u so that ( )
1
/ u x x
( )
/
t t
u x x
1 = for every x (Exercise 3.C.5(b). Hence the firstorder
condition implies
2 2 1
/
t t
= for each 0,1 t = . Since
0 0 1 1
2 1 2 1
/ / < and
( ) u isconcave,
0 1
2 2
x x > .Thus
1
x hastobeontheboldlineinthefollowingfigure.
7

## c) Determine the region of permissible choices for x

1
, if the choices x
0
and x
1
are consistent with
maximization of preferences that are quasilinear with respect to the second good.
If the preference is quasilinear with respect to the second good, then we can take a utility
function ( ) u sothat ( )
2
/ u x x
( )
/
t t
u x x
1 = foreveryx(Exercise3.C.5(b)).Hencethefirstorder
condition implies
1 1 2
/
t t
for each 1, 0 t = = . Since
0 0 1 1
1 2 1 2
/ / > and
( ) u isconcave,wemusthave
0 1
1 1
x x < .Thus
1
x hastobeontheboldlineinthefollowing
figure.

## d) Determine the region of permissible choices for x

1
, if the choices x
0
and x
1
are consistent with
maximization of preferences for which both goods are normal.
Since
1 0 1
x w < andtherelativepriceofgood1decreased,
1
t
x hastoincreaseifgood1is
normal. If good 2 is normal, then the wealth effect (positive) and the substitution effect
(negative)goinoppositedirectionwhichgivesusnoadditionalinformationabout
2
x .Thus
1
x hastobeontheboldlineinthefollowingfigure.
8

## e) Determine the region of permissible choices for x

1
, if the choices x
0
and x
1
are consistent with
maximization of preferences when preferences are homothetic.
Ifthepreferenceishomothetic,themarginalratesofsubstitutionatallvectorsonarayare
the same, and they become less steep as the ray becomes flatter. By the firstorder
conditions and
1
1 2 1 2
/ / ,
0 0 1 1
x > has to be on the right side of the ray that goes
through
0
x .Thus
1
x hastobeontheboldlineinthefollowingfigure.

9

EconS501 Fall2008
FelixMunoz

ExercisesRecitation#3

Exercise 1. Find the demanded bundle for a consumer whose utility function is u(x
1
,x
2
)= x
1
3/2
x
2
and her
budget constraint is 3x
1
+4x
2
=100.

Solution. Write the Lagrangian
1 2 1 2
3
( , ) ln ln (3 4 100) x x x x x = + +
2

(Be sure you understand why we can transform u this way.) Now, equating the derivatives with respect to
x
1
, x
2
, and to zero, we get three equations in three unknowns
1
2
1 2
2
1
4 ,
3 4 100.
x
x
x x
=
+ =
3
3 , =
1
(3, 4,100) 20 x

Solving, we get
2
(3, 4,100) 10 x = = . , and
Note that if you are going to interpret the Lagrange multiplier as the marginal utility of income, you must
be explicit as to which utility function you are referring to. Thus, the marginal utility of income can be
measured in original utils or in ln utils. Let u*=lnu and, correspondingly, v*=lnv; then
*
( , ) v p m
( , )
,
( , ) ( , )
v p m
m
m v p m v p m

= = =

denotes he Lagrange multiplier in the Lagrangian Where
3/2
1 2 1 2
( , ) (3 4 100). x x x x x = +
3/2
20
4
= Check that in this problem wed get ,
1
=
3/2
(3, 4,100) 20 10 v =
1/2 1/3
1 2 1 1 2 2
( , ) ( ),
40
, and .

Exercise 2. Use the utility function u(x
1
,x
2
)= x
1
1/2
x
2
1/3
and the budget constraint m=p
1
x
1
+p
2
x
2
to calculate
the Walrasian demand, the indirect utility function, the Hicksian demand, and the expenditure function.

Solution. The Lagrangian for the utility maximization problem is
x x x p x p x m = +
Taking derivatives,
1/2 1/3
1 2 1
1
,
1/2 2/3
1 2 2
1 1 2 2
2
1
,
3
.
x x p
x x p
p x p x m

=
+ =

=

1

EconS501 Fall2008
FelixMunoz
Solving, we get
1 2
1 2
3 2
( , ) , ( , ) .
5 5
m m
x p m x p m
p p
= =
Plugging these demands into the utility function, we get the indirect utility function
( )
1/2 1/3 1/2 1/3
5/6
1 2 1 2
3 2 3 2
( , ) ( , ) .
5 5 5
m m m
v p m U x p m
p p p p

= = =

Rewrite the above expression replacing v(p, m) by u and m by e(p, u). Then solve it for e(.) to get
3/5 2/5
6/5 1 2
( , ) 5
3 2
p p
e p u u

=

Finally, since , the Hicksian demands are /
i
h e p =
i
2/5 2/5
6/5 1 2
1
3/5 3/5
6/5 1 2
2
( , ) ,
3 2
( , ) .
3 2
p p
h p u u
p p
h p u u

=

=

Exercise 3. Consider a two-period model with Daves utility given by ( )
1 2
, u x x where
1
x represents
his consumption during the first period and
2
x is his second periods consumption. Dave is endowed
with (
1 2
, ) x x which he could consume in each period, but he could also trade present consumption for
future consumption and vice versa. Thus, his budget constraint is
1 1 2 2 1 1 2 2
, p x p x p x p x + = +
where
1
p and
2
p are the first and second period prices respectively.

a) Derive the Slutsky equation in this model. (Note that now Daves income depends on the value
of his endowment which, in turn, depends on prices:
1 1 2 2
m p x p x = + .)

Solution. Differentiate the identity ( ) ( , ) , ( , )
j j
h p u x p e p u with respect to
i
p to get
( ) ( , ) ( , ) , ( , )
( , )
j j j
i i i
We must be careful with this last term. Look at the expenditure minimization problem
h p u x p m x p e p u
e p u
p p m p

= +

{ } ( , ) min ( ) : ( ) e p u p x x u x u = =
By the envelope theorem, we have
( )
( , )
( , ) , ( , )
i i i
i
e p u
h p u x x p e p u x
p

i
= =

Therefore, we have
( )
( )
( , ) ( , ) , ( , )
( , )
j j j
i i
i i
h p u x p m x p e p u
x p m x
p p m

= +

And reorganizing we get the Slutsky equation
2

EconS501 Fall2008
FelixMunoz
( )
( )
( , ) ( , ) , ( , )
( , )
j j j
i i
i i
x p m h p u x p e p u
x x p m
p p m

= +

b) Assume that Daves optimal choice is such that
1
. x x < If
1
p goes down, will Dave be better off
or worse off? What if
2
p goes down?
Solution. Draw a diagram, play with it and verify that Dave is better off when p
2
goes down and
worse off when p
1
goes down. Just look at the sets of allocations that are strictly better or worse
than the original choicei.e., the sets ( ) { : } SB x z z x = and ( ) { : } SW x z z x = . When p1
goes down the new budget set is contained in SW(x), while when p2 goes down theres a region
of the new budget set that lies in SB(x).

Exercise 4. The utility function is ( ) { }
1 2 2 1 1 2
, min 2 , 2 u x x x x x x = + + .
a) Draw the indifference curve for ( )
1 2
, 2 x = 0. u x Shade the area where ( )
1 2
, 20. u x x
Solution. Draw the lines and
2 1
2 2 x x + = 0 0
1 2
2 2 x x + = . The indifference curve is the
northeast boundary of this X.
b) For what values of
1 2
/ p p will the unique optimum be
1
0? x =
Solution. The slope of a budget line is
1 2
/ p p . If the budget line is steeper than 2,
1
0 x = .
Hence the condition is .
1 2
/ 2 p p >
c) For what values of
1 2
/ p p will the unique optimum
2
0? x =
Solution. Similarly, if the budget line is flatter than 1/2,
2
x will equal 0, so the condition is
.
1 2
/ 1/ p p < 2
d) If neither
1
x nor
2
x is equal to zero, and the optimum is unique, what must be the value of
1 2
/ ? x x
Solution. If the optimum is unique, it must occur where
2 1 1 2
2 2 . x x x x = This implies that
1 2
x x = , so that .
1 2
/ 1 x x =

Exercise 5. Under current tax law some individuals can save up to \$2,000 a year in an Individual
Retirement Account (I.R.A.), a savings vehicle that has an especially favorable tax treatment. Consider
an individual at a specific point in time who has income Y, which he or she wants to spend on
consumption, C, I.R.S. savings, , or ordinary savings S . Suppose that the reduced form utility
function is taken to be:
1
S
2

( )
1 2 1 2
, , . U C S S S C S

=
(This is a reduced form since the parameters are not truly exogenous taste parameters, but also include the
tax treatment of the assets, etc.) The budget constraint of the consumer is given by:

3

EconS501 Fall2008
FelixMunoz
1 2
, C S S Y + + =

and the limit that he or she can contribute to the I.R.A. is denoted by L.

a) Derive the demand functions for
1
S and
2
S for a consumer for whom the limit L is not binding.
Solution. This is an ordinary Cobb-Douglas demand:
1
S Y

=
+ +

and
2
S Y

=
+ +

b) Derive the demand function
1
S and
2
S for a consumer for whom the limit L is binding.
Solution. In this case the utility function becomes

1 1
( , , ) U C S L S L C

= . The L term is just a
constant, so applying the standard Cobb-Douglas formula
1
S Y

=
+
.

Exercise 3.E.7. Show that if a preference relation is quasilinear with respect to good 1, the Hicksian
demand functions for the remaining goods 2, 3, , L do not depend on u. What is the form of the
expenditure function in this case?

Solution. Exercise 3.C.5(b) in MWG shows that every quasilinear preference with respect to good
1 can be represented by a utility function of the form ( ) (
1 2
, ,
L
u x x u x x = + ) . Let
( )
1
1, 0, , 0
L
e = . We shall prove that for every with 0
1
1, , p u p , =
if ( ) and ,
L
x
+

1
,

( ) , x h p u = , then ( ) , . h p u
1
x e + + = Note first that
( )
1
, u x e u + + that is,
1
x e + satisfies the constraint of the EMP for ( ). , , p u + Let
( ) and
L
y u y u
+
+ . Then ( )
1
e . u u y Hence ( )
1
. p y e p x Thus
( )
1
. p y p x e + Hence ( ) , . u
1
x e h p + + =

Therefore, for every { } ( ) ( ) 2 , , , and , , , L u u h p u h p u =

2, L
( ) ( )
1
en , h p u h p ue = = +

. That is, the Hicksian
demand functions for goods are independent of utility levels. Thus, if we define
. ( ) ( ) , 0 , th h p h p
Since ( ) ( ) ( ) ( )
1
, , , we have , , h p u h p u e e p u e p u . + = + + = + Thus, if we define
( ) ( ) ( ) ( ) , 0 , then e , . e p p u e p u = = + e p

4

EconS501 Fall2008
FelixMunoz
Exericse 3.E.8. For the Cobb-Douglas utility function, verify that the following relationships in (3.E.1)
and (3.E.3) respectively hold.
e(p,v(p,w))=w and v(p,e(p,u))=u, and
h(p,u)=x(p,e(p,u)) and x(p,w)=h(p,v(p,w))

Note that the expenditure function can be derived by simply inverting the indirect utility function, and
vice versa.

Solution. We use the utility function ( )
( ) 1
1 2
. u x x x

= To prove (3.E.1),

( ) ( ) ( ) ( )
( )
( ) ( ) ( ) ( )
( )
1 1
1 1
1 2 1 2
1 1
1 1
1 2 1 2
, , 1 1
, , 1 1 .
e p v p w p p p p w w
v p e p u p p p p u u

= =
= =
,

To prove (3.E.3),
( ) ( ) ( )
( )
( ) ( )
( )
( )
( )
( ) ( ) ( )
( )
( )
( ) ( ) ( )
1
1
1 2 1 2
1
1
2
1 2
1
1
1 1 2
1 2
1 2
1 2
, , 1 , 1
1
, , ,
1
1
, , 1 ,
1
, 1 , .
x p e p u p p u p p
p
p
u u h p u
p p
p
p
h p v p w p p w
p p
w p p x p w

=

= =

=

= =

Exercise 3.E.9. Use the relations in 3.E.1:

e(p,v(p,w))=w and v(p,e(p,u))=u

to show that the properties of the indirect utility function v(p,w) identified in Proposition 3.D.3:

1. Homogeneity of degree zero.
2. Strictly increasing in w and nonincreasing in p
k
for any good k.
3. Quasiconvex; that is, the set {(p,w): v(p,w)v} is convex for any v.
4. Continuous in p and w.
imply the properties of the expenditure function e(p,u) identified in Proposition 3.E.2:

1. Homogeneous of degree one in prices.
2. Strictly increasing in u and nondecreasing in p
k
for any good k.
5

EconS501 Fall2008
FelixMunoz
3. Concave in prices.
4. Continuous in p and w.
Likewise, use the relations
e(p,v(p,w))=w and v(p,e(p,u))=u

to prove that the properties of e(p,u) identified in Proposition 3.E.2 imply the properties of v(p,w)
identified in Proposition 3.D.3.

Solution. First, we shall prove that Proposition 3.D.3 implies Proposition 3.E.2 via (3.E.1). Let
0, 0, , , and 0. p p u u

(i) Homogeneity of degree one in p: Let 0. > Define ( ) ( , , then , w e p u u v p w = = ) by the
second relation of (3.E.1). Hence

( ) ( ) ( ) ( ) ( ) ( ) , , , , , e p u e p v p w e p v p w w e p u = = = = , ,
where the second equality follows from the homogeneity of ( ) , v and the third from the first
relation of (3.E.1).

(ii) Monotonicity: Let . u u > Define ( ) ( ) ( , and , , then , w e p u w e p u u v p w = = = ) and
( ) , . By the monotonicity of u v p w = ( ) , v in w, we must have , w w > that is,
( ) u ( ) , , e p u e p > .

Next let . p p Define ( ) , w e p u = and ( ) , w e p u , = then, by the second relation of
(3.E.1), By the monotonicity of ( ) , p w = = ( u v v p
) , . w
( ) , v , we must have , w w that
is, ( ) ). u ( , , e p u e p

(iii) Concavity: Let
[ ]
0,1 . Define ( ) , w e p u and ( ) , , then
, . Define
= w e p u =
( ) , u v p w v = = ( ) p w
( ) p 1 p p and = + ( ) 1 w . w w = + Then, by
the quasiconvexity of ( ) , v , ( ) , w u . v p Hence, by the monotonicity of ( ) , v in w and
the second relation of (3.E.1), ( ) , . w e p u That is,

( ) ( ) ( ) ( ) ( ) 1 , , 1 , e p p u e p u e p u . + +

(iv) Continuity: It is sufficient to prove the following statement: For any sequence
( ) { }
1
,
n n
n
p u

=

with ) ,
( )
( ,
n n
p u p u and any w, if
( )
,
n n
e p u w for every n, then ( ) , e p u w ; if
for every n, then
( )
,
n n
u w e p ( ) , p u e Suppose w .
( )
e ,
n n
p u w for every n. Then, by
6

EconS501 Fall2008
FelixMunoz
the monotonicity of ( ) , v in w, and the second relation of (3.E.1), we have
n n
u for
every n. By the continuity of
( )
, v p w
( ) ( ) , , , . v w By the second relation of (3.E.1) and the
monotonicity of (
u v p
) , v in w, we must have ( ) , . e p u w The same argument can be applied
for the case with
(
,
n
e p u y n.
)
w for ever
and 0.
n
w

,

Lets next prove that Proposition 3.E.2 implies Proposition 3.D.3 via (3.E.1). Let
0, 0, p p w ,

i. Homogeneity: Let 0. > Define ( ) , . p w Then, by the first relation of (3.E.1), u v =
( ) , e p u . = Hence w

( ) ( ) ( ) ( ( ) ( ) ) , , w = , , , p e p w v p = = , e p , v p u u v p = w v

where the second equality follows from the homogeneity of ( ) , e and the third from
the second relation of (3.E.1).

ii. Monotonicity: Let . w w > Define ( ) , u v p w and ( ) , , then u v p w = =
( ) , e p u ( ) , . u w e p = w = and By the monotonicity of ( ) , e and w w > , we must
have u u > , that is, ( ) ( ) , , v p w v p w > .

. Define ( ) , p w p p u v = Next, assume that and then
By the monotonicity of
( ) , , u v p w =
( ) u ( , e p = ) , . w = ( ) , e and p u p e p , we must have
,
that is, u u ( ) ( ) , , w v p w v p
.

iii. Quasiconvexity: Let
[ ]
0,1 . Define ( ) , u v p w and ( ) , . u v p w Then
= and
= =
( ) , e p u w ( ) , e p u w = . Without loss of generality, assume that u u
.
Define
1 p
and
( ) p p = +
( ) 1 w w w = +
( )
( ) ( )
( ) ( )
( )
,
, 1
, 1
1 ,
e p u
e p u e
e p u e
w w

. Then

(
(
,
,
p u
p u
w
)
)
+
+
= + =

7

EconS501 Fall2008
FelixMunoz
8

where the first inequality follows from the concavity of ( ) , e u the second from the
monotonicity of ( ) , e in u and . u u We must thus have ( ) , . w u v p
iv. Continuity: It is sufficient to prove the following statement. For any sequence
( ) { }
1
,
n n
n
p w
=

with
( )
( ,
n n
) , p w p w and any u, if
( )
,
n n
v p w u for every n,
then ( ) , v p w u ; if
( )
,
n n
v p w u for every n, then ( ) , v p w u . Suppose
for every n. Then, by the monotonicity of (
( )
,
n n
v p w u ) , e in u and the first
relation of (3.E.1), we have
( )
,
n
p u for every n. By the continuity of
n
w e
( ) ( ) , , e w , . e p u We must thus have ( ) , . w u v p The same argument can be
applied for the case with
( )
,
n n
v p w u for every n.
Alternative: An alternative, simpler way to show the equivalence on the
concavity/quasiconvexity and the continuity uses what is sometimes called the epigraph.
For the concavity/quasiconvexity, the concavity of ( ) , e u is equivalent to the convexity
of the set ( ) ( ) { }
, : , p w e p u w and the quasi-convexity of ( ) v is the equivalent to the
convexity of the set ( ) ( ) { }
, : p w , v p w u for every u. But (3.E.1) and the
monotonicity imply that ( ) , v p w u if and only if ( ) , u . e p w Hence the two sets
coincide and the quasiconvexity of ( ) v is equivalent to the concavity of ( ) , e u .
As for the continuity, the function ( ) e is continuous if and only if both
( ) ( ) { }
, , : , p w u e p u w and ( ) ( ) { }
, , , p w u u w : e p are closed sets. The function
( ) v is continuous if and only if both ( ) ( ) { }
, , : , p w u v p w u and
( ) ( ) { }
, , : , p w u v p w u are closed sets. But, again by (3.E.1) and the monotonicity,

( ) ( ) { } ( ) ( ) { }
( ) ( ) { } ( ) ( ) { }
, , : , , , : , ;
, , : , , , : ,
p w u e p u w p w u v p w u
p w u e p u w p w u v p w u
=
=

Hence the continuity of ( ) e is equivalent to that of ( ) v .
FelixMunoz Fall2008
EconS501
MicroeconomicTheoryR

1. JansutilityfunctionforgoodsXandYis
.75 .25
7200 . U X Y = Shemustpay\$90fora
unitofgoodXand\$3

ecitation#3Exercises.
0foraunitofgoodY.Jansincomeis\$1200.
a. DeterminetheamountsofgoodsXandYJanpurchasestomaximizeherutility
givenherbudgetconstraint.

FelixMunoz Fall2008
EconS501
b. DeterminethemaximumamountofutilityJanreceives.

c. Determinethevalueof * associatedwiththisproblem.

d. Interpretthevalueof * youcomputedinpartc.asitspecificallyappliestoJan.

FelixMunoz Fall2008
EconS501
2. a. Formulatethedualconstrainedexpenditureminimizationproblemassociated
with4.3anddeterminetheoptimalamountsofgoodsXandYJanshould
purchase.

FelixMunoz Fall2008
EconS501
b. DeterminetheminimumamountofexpendituremadebyJan.

c. Determinetheoptimalvalueof
D

andprovideawritteninterpretationofthis
valueasitspecificallyappliestoJaninthisproblem.

d. ComparetheoptimalvaluesofX,Yand youcomputedinexercise4.3with
thoseyoucomputedinpartsa.andc.ofthisexercise.

FelixMunoz Fall2008
EconS501

3. RaymondderivesutilityfromconsuminggoodsXandY,wherehisutilityfunctionis
.25 .25
80 . U X Y = Hespendsallofhisincome,I,onhispurchasesofgoodsXandY,
andhemustpaypricesof
x
P and
y
P foreachunitofthesegoods,respectively.
Assumethathisincomeis\$3200,theunitpriceofgoodXis\$100,andtheunitprice
ofgoodYis\$100.
a. DeterminetheamountsofgoodsXandYthatRaymondshouldpurchaseto
maximizehisutilitygivenhisbudgetconstraint.

FelixMunoz Fall2008
EconS501

b. DeterminethemaximumamountofutilityRaymondcanreceive.

. fe 4 Re rtoyourresponsetoexercise5.1.
a. DeriveRaymondsownpricedemandcurveforgoodX.

b. DeriveRaymondsownpricedemandcurveforgoodY.

FelixMunoz Fall2008
EconS501

5. fe Re rtoyourresponsestoexercise5.1.
a. DeriveRaymondsEngelcurveforgoodX.

b. IsgoodXanormalgoodoraninferiorgood?Justifyyourresponse
mathematically.

FelixMunoz Fall2008
EconS501

c. DeriveRaymondsEngelcurveforgoodY.

d. IsgoodYanormalgoodoraninferiorgood?Justifyyourresponse
mathematically.

FelixMunoz Fall2008
EconS501
6. AssumeanindividualsownpricedemandfunctionforgoodXis
( )
, , 200 4 1.5 0.008
x y x Y
X X P P I = whereof P P I = +
x
P and
y
P denotetheunit
e. pricesofgoodsXandY,respectively,andIdenotestheconsumersmoneyincom
a. ComputetheindividualscrosspricedemandcurveforgoodXwhentheunit
priceofgoodXis\$2andtheconsumersincomeis\$40,000.

b. AregoodsXandYgrosssubstitutesorgrosscomplements?Justifyyour
responsemathematically.

FelixMunoz Fall2008
EconS501
7. Recallfromexercise5.1Raymondsutilityfunction,whenheconsumesgoodsXand
Y,is
.25 .25
80 . U X Y = Onceagain,assumetheunitpriceofgoodX,
x
P ,is\$100,and
theunitpriceofgoodY,
y
P ,is\$100.DeterminethequantitiesofgoodsXandY
Raymondshouldpurchasethatwillminimizehisexpendituresonthesegoodsand
yield320unitsofutilitytohim.

10

FelixMunoz Fall2008
EconS501

8. fe Re rtoyourresponsetoexercise5.5.
a. DetermineRaymondscompensateddemandcurveforgoodX.

b. DetermineRaymondscompensateddemandcurveforgoodY.

11

FelixMunoz Fall2008
EconS501

. Isitpossibleforanindividualsdemandcurveforagoodtobepositivelysloped?
Supportyourresponsewithanappropriategraphicalanalysis.
9

12

FelixMunoz Fall2008
EconS501
13

## EconS501 Recitation#4 Fall2010

FelixMunoz
1

Exercise 1. Prove that Proposition 3.G.1 in MWG is implied by Roys identity (Proposition 3.G.4).
Note: we are always assuming that we are at an optimum.
Answer. Since the identity ( ) ( )
, , v p e p u u = holds for all p, differentiation with respect to p yields
( ) ( )
( ) ( )

( )
( ) ( ) ( )
( , )
, ,
, , , 0.
where we differentiate the first term , and the second term , ,
We apply the chain rule when differentiating the second term
p p
e p u
v p e p u
v p e p u e p u
w
v p v e p u

+ =

By Roys identity,
( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
( )
( ) ( )
( )
, , , ,
( , )
, , , ,
( , ) , 0
, ,
( , ) , 0
l
l
l p
l p
v p e p u v p e p u
x p w
w p
v p e p u v p e p u
x p w e p u
w w
v p e p u
x p w e p u
w

=

+ =

+ =

By ( ) ( )
If we have more money to spend
we can reach a greater utility
, , / 0 v p e p u w >

and ( ) ( ) ( )
considered at an optimum
, , , , h p u x p e p u =

we obtain ( ) ( ) , , .
p
h p u e p u =

Exercise 2. Verify for the case of a Cobb-Douglas utility function that all of the propositions in
Section 3.G hold.
Answer. From examples 3.D.1 and 3.E.1, for the utility function ( )
1
1 2
u x x x

= , we obtain
( )
( )
( )
( )
( )
( )
( )
( ) ( )
( )
( ) ( )
( ) ( )
1
2
2
1
2
2
1
1 2
1
2
2
1 2
1
1 2
1
2
1 2
2
, ,
1
0
, ,
1
0
, ,
1
1
1 1
, ,
1 1
1
w
p
p p
p
D x p w
p
w
p
D x p w
w
p
p
p p
e p u u
p
p p
p
p p
D e p u D h p u u
p p
p

= =

EconS501 Recitation#4 Fall2010
FelixMunoz
2

## The indirect utility function for ( )

1
1 2
u x x x

= is
( )
( )
1
1 2
, .
1
p p
v p w w

(Note here that the indirect utility function obtained in Example 3.D.2 is for the utility function
( ) ( )
1 2
ln 1 ln u x x x = + .) Thus
( ) ( ) ( ) ( )
( )
( )
1 2
, , / , 1 / ,
,
, .
p
w
v p w v p w p p
v p w
v p w
w
=
=

Hence, ( ) ( ) , , ,
p
h p u e p u = ( ) ( )
2
, , ,
p p
D e p u D h p u = which is negative semidefinite and
symmetric,
( ) , 0,
p
D h p u p = ( ) ( ) ( ) ( ) , , , , ,
T
p p w
D h p u D x p w D x p w x p w = + and
( )
( ) ( )
( ) ( )
, /
, .
, /
v p u p
x p w
v p u w

=

Exercise 3. A utility function ( ) u x is additively separable if it has the form ( ) ( ). u x u x =

Show that the induced ordering on any group of commodities is independent of whatever fixed values
we attach to the remaining ones. It turns out that this ordinal property is not only necessary but also
sufficient for the existence of an additive separable representation.
Answer. Define { } 1, , S L = and let T be a subset of S. The commodity vectors for those in S are
represented by { }
#
1
T
T
z z
+

and the like, and the commodity vectors for those outside S are
represented by { }
#
2
L T
T
z z

+

and the like. We shall prove that for every
# # #
1 1 2
, , ,
T T L T
z z z

+ + +

and ( )
( )
#
2 1 2 1 2
, , ,
L T
z z z z z

if and only if
( ) ( ) 1 2 1 2
, , . z z z z

## In fact, since ( ) u represents

, ( )
( ) 1 2 1 2
, , z z z z

if and only if
( ) ( ) ( ) ( ).
T T T T
u z u z u z u z

+ +

Likewise,
( ) ( ) 1 2 1 2
, , z z z z

if and only if
( ) ( ) ( ) ( ).
T T T T
u z u z u z u z

+ +

But both of these two inequalities are equivalent to
( ) ( ).
T T
u z u z

EconS501 Recitation#4 Fall2010
FelixMunoz
3

## Hence they are equivalent to each other.

b)Show now that the Walrasian and Hicksian demand functions generated by an additively separable
utility function admit no inferior goods if the functions ( ) u

## are strictly concave. (You can

assume differentiability and interiority to answer this question.)
Answer. Suppose that the wealth level w increases and all prices remain unchanged. Then the
demand for at least one good (say, good ) has to increase by the Walras law. From (3.D.4) we
know that ( ) ( ) ( ) ( ) ( )
, / ,
k k k
u x p w p p u x p w =

for every 1, k L = . Since ( ) , x p w

increased and ( ) u

is strictly concave, the right hand side will decrease. Hence, again since
( )
k
u is strictly concave, ( ) ,
k
x p w will have to increase. Thus all goods are normal.

Exercise 4. If leisure is an inferior good, what is the slope of the supply function of labor?
Answer. Use Slutsky equation to write:
( )
S
L L L
L L
w w m

= +

, where L is leisure, w is wage rate, m is income.
Note that the substitution effect is always negative, i.e.,
S
L
w

<0, term
( )
L L measures the amount
of working hours and it is always positive. Hence, if leisure is a normal good, 0
L
m

>

## , and the sign

of the total effect is negative and unambiguous, as the following expression illustrates.
( )
( ) +! ( ) (+)
S
L L L
L L
w w m

= +

+

In contrast, if leisure is inferior, 0
L
m

<

L
w

## , is not necessarily negative. Indeed,

( )
( ) ? ( ) (+)
S
L L L
L L
w w m

= +

In order to provide a more general analysis of this case, let us rearrange the equation above, solving
for the total effect,
EconS501 Recitation#4 Fall2010
FelixMunoz
4

( )
S
L L L
L L
w w m

=

Thus the slope of the labor supply curve depends on whether the total effect is positive or negative,
which ultimately depends on whether the (negative) substitution effect dominates the (positive)
income effect. Comparing the Substitution and Income effects, and noting that
( ) L L L
w w

=

,
then:
1. If SE>IE, then
( )
0, 0
L L L
and
w w

> <

. This implies that the total effect is positive,
which implies that the slope of the leisure curve is positive. Therefore the slope of the labor
supply curve must be negative.
2. If SE<IE, then
( )
0, 0
L L L
and
w w

< >

. This implies that the total effect is negative,
which implies that the leisure curve is negatively sloped. As a consequence, the labor supply
curve is positively sloped.
Micro Theory I
Recitation #5
1. Exercise 3.I.7 MWG: There are three commodities (i.e., L=3) of which the third is
a numeraire (let p
3
= 1) the market demand function x(p; w) has
x
1
(p; w) = a + bp
1
+ cp
2
x
2
(p; w) = d + ep
1
+ gp
2
a) Give the parameter restrictions implied by utility maximization.
Intuitively, note that:
1. b _ 0 for ULD to be satisced ( p
1
=| x
1
)
2. g _ 0 for ULD to be satisced ( p
2
=| x
2
)
3. What about the sign of c (or e)?
(a) c > 0 := p
2
= x
1
(x
1
and x
2
are substitutes)
(b) c < 0 := p
2
=| x
1
(x
1
and x
2
are complements)
Lets analyse this more formally. By applying Walras law and the homogeneity of degree
zero, we can obtain the demand functions for all three goods dened over the whole domain
(p; w) R
3
R : p 0. Thus, we can obtain the whole 3 3 Slutsky matrix as well from
the demand functions. In particular, since there are no income eects
_
@x
k
(p;w)
@w
= 0
_
for any
good k, we can express the Slutsky matrix as follows:
S(p; w) =
_

_
@x
1
(p;w)
@p
1
@x
1
(p;w)
@p
2
@x
1
(p;w)
@p
3
@x
2
(p;w)
@p
1
@x
2
(p;w)
@p
2
@x
2
(p;w)
@p
3
@x
3
(p;w)
@p
1
@x
3
(p;w)
@p
2
@x
3
(p;w)
@p
3
_

_
The 2 2 submatrix of the Slutsky matrix that is obtained by deleting the last row and the
last column is equal to:
S(p; w) =
_
@x
1
(p;w)
@p
1
@x
1
(p;w)
@p
2
@x
2
(p;w)
@p
1
@x
2
(p;w)
@p
2
_
=
_
b c
e g
_
The 33 Slutsky matrix is symmetric if and only if this 22 matrix is symmetric. Moreover,
just as in the proof of Theorem M.D.4(iii), we can show that the 3 3 Slutsky matrix is
negative semidenite on R
3
if and only if the 2 2 matrix is negative semidenite. In
particular this matrix is symmetric if c = e, and negative semidenite if b _ 0, g _ 0, and
bg c
2
_ 0 .
1
b) Estimate the Equivalent Variation for a change of prices from (p
1
; p
2
) = (1; 1)
to (p
1
; p
2
) = (2; 2). Verify that without appropriate symmetry, there is no
path independence. Assume independence for the rest of the exercise.
We have to verify that:
1. the corresponding Hicksian demand functions for the rst two commodities are inde-
pendent of utility levels, h
l
(p; u) = h
l
(p; u
0
), and,
2. Hicksian demand functions coincide with the Walrasian demand functions.
Let p be any price vector and u, u
0
be any two utility levels. By (3.E.4) in MWG we have:
h
l
(p; u) = x
l
(p; e(p; u)) and h
l
(p; u
0
) = x
l
(p; e(p; u
0
)) for l = 1; 2
also, since the walrasian demands x
l
() do not depend on wealth, we can write
x
l
(p; e(p; u)) = x
l
(p; e(p; u
0
))
then we have h
l
(p; u) = h
l
(p; u
0
). Hence, the hicksiand demands h
l
(p; u) do not depend on
utility level and they are the same as the x
l
(p; w) in this specic example.
Let us now examine how the path of price increases might aect the size of the equivalent
variation (EV):
Let us rst assume that prices change following the path (1; 1) (2; 1) (2; 2): First, we
must nd the EV of increasing in p
1
from p
1
= 1 to p
1
= 2. Second, we must nd the EV of
increasing in p
2
from p
2
= 1 to p
2
= 2.
EV =
2
_
1
h
1
(p
1
; 1; u)dp
1
+
2
_
1
h
2
(2; p
2
; u)dp
2
And since Hicksian and Walrasian demands coincide in this exercise,
EV =
2
_
1
x
1
(p
1
; 1; w)dp
1
+
2
_
1
x
2
(2; p
2
; w)dp
2
Replacing by the Walrasian demand functions,
EV =
2
_
1
(a + bp
1
+ c)dp
1
+
2
_
1
(d + 2e + gp
2
)dp
2
Where we xed p
2
= 1 in the rst term and p
1
= 2 in the second term. Integrating,
EV = (a +
3
2
b + c) + (d + 2e +
3
2
g) (1)
Let us now consider that prices change following following the path (1; 1) (1; 2) (2; 2).
Note that using this path for increasing prices, we rst raise p
2
from p
2
= 1to p
2
= 2, and
then we raise p
1
from p
1
= 1 to p
1
= 2. Hence, in order to nd the EV of these price changes,
2
we must rst nd the EV of increasing p
2
(p
2
= 1to p
2
= 2), and second, for a xed level of
p
2
= 2, we must nd the EV of increasing p
1
(from p
1
= 1to p
1
= 2).
EV =
2
_
1
h
2
(1; p
2
; u)dp
2
+
2
_
1
h
1
(p
1
; 2; u)dp
1
And since Hicksian and Walrasian demands coincide in this exercise,
EV =
2
_
1
x
2
(1; p
2
; w)dp
2
+
2
_
1
x
1
(p
1
; 2; w)dp
1
Replacing by the Walrasian demand function,
EV =
2
_
1
(d + e + gp
2
)dp
2
+
2
_
1
(a + bp
1
+ 2c)dp
1
Where we xed p
1
= 1 in the rst term and p
2
= 2 in the second term. Integrating,
EV = (d + e +
3
2
g) + (a +
3
2
b + 2c) (2)
Note that the equivalent variation following the rst path (expression 1) and following the
second path (expression 2) coincide if and only if c = e (which we required in order to have
a symmetric Slustky matrix).
Hence, when the Slustky matrix is symmetric we can guarantee that an increase in the
price of two goods is path independent.
3
c) Let EV
1
, EV
2
and EV be the equivalent variations for a change of prices
from (p
1
; p
2
) = (1; 1) to respectively (2; 1); (1; 2); and (2; 2). Compare EV with
EV
1
+EV
2
as a function of the parameters of the problem. Interpret.
Let us be precise about the notation we will use in this part of the exercise.
EV
1
measures the EV for the price change (1,1) to (2,1) - Only p
1
increases.
EV
2
measures the EV for the price change (1,1) to (1,2) - Only p
2
increases.
EV measures the EV for the price change (1,1) to (2,2) - Both prices increase.
(For a graphical representation, see the gures of EV
1
, EV
2
and EV at the end of the
handout)
As we calculated before:
EV
1
=
2
_
1
x
1
(p
1
; 1; w)dp
1
= a +
3
2
b + c
EV
2
=
2
_
1
x
2
(1; p
2
; w)dp
2
= d + e +
3
2
g
We now want to nd the EV from an increase in the price of both goods. Remember from
exercise (b) that we can increase the price of both goods following two dierent paths. Let
us rst nd the EV from increasing the price of both goods by following the rst path:
EV =
2
_
1
x
1
(p
1
; 1; w)dp
1
+
2
_
1
x
2
(2; p
2
; w)dp
2
EV = (a +
3
2
b + c) + (d + 2e +
3
2
g)
Let us now nd the EV by following the second path:
EV =
2
_
1
x
2
(1; p
2
; w)dp
2
+
2
_
1
x
1
(p
2
; 2; w)dp
1
EV = (d + e +
3
2
g) + (a +
3
2
b + 2c)
And in the case that the Slutsky matrix is symmetric, c = e, we have that the EV from
increasing the price of both goods is path independent and takes the value:
EV = a +
3
2
b + 3c + d +
3
2
g
Let us now nd the dierence between EV (resulting from increasing the price of both goods)
and the sum of EV
1
and EV
2
.
4
EV (EV
1
+ EV
2
) = (a +
3
2
b + 3c + d +
3
2
g) (a +
3
2
b + 2c + d +
3
2
g) = c:
The sum EV
1
+ EV
2
does not contain the eect on equivalent variation due to the shift
of the graph of the demand function for the second commodity when p
1
goes up to 2 (or
equivalently, the shift of the graph of the demand function for the rst commodity when p
2
goes up to 2). (See gures at the end of the handout, for a graphical comparison between
the area EV
1
+ EV
2
and the area EV .
5
d) Suppose that the prices increases in (c) are due to taxes. Denote the dead-
weight losses for each of the three experiments by DW
1
, DW
2
; and DW.
Compare DW with DW
1
+DW
2
as a function of parameters of the problem.
We rst calculate the deadweight loss if the tax aects the price of good 1 alone, DW
1
, raising
it from p
1
= 1 to p
1
= 2. First, note that the tax rate is \$1. Hence, since x
1
(2; 1; w) =
a+2b +c, the tax revenue from the rst good is equal to T
1
= 1x
1
(2; 1; w). (See the gure
representing DW
1
at the end of the handout, page 2 of gures). Thus,
DW
1
= T
1
EV
1
= (a + 2b + c) (a +
3
2
b + c) =
b
2
:
We secondly calculate the deadweight loss if the tax aects the price of good 2 alone, DW
2
,
raising it from p
2
= 1 to p
2
= 2. First, note that the tax rate is \$1. Hence, since x
2
(1; 2; w) =
d + e + 2g, the tax revenue from the second good is equal to T
2
= 1 x
2
(1; 2; w). (See the
gure representing DW
2
at the end of the handout, page 2 of gures). Thus,
DW
2
= T
2
EV
2
= (d + e + 2g) (d + e +
3
2
g) =
g
2
:
Third, we now nd the deadweight loss from a tax that aect both the price of good 1 and the
price of good 2. First, note that since x
1
(2; 2; w) = a+2b +2c, and x
2
(2; 2; w) = d+2e +2g,
the tax revenue from taxing both commodities is equal to:
T = 1 (a + 2b + 2c) + 1 (d + 2e + 2g) = a + 2b + 4c + d + 2g
Then, the deadweight loss in this case is DW = T EV
DW = T EV = (a + 2b + 4c + d + 2g) (a +
3
2
b + 3c + d +
3
2
g) =
b
2
+ c +
g
2
Let us nally examine the dierence between calculating the deadweight loss of the tax that
aects the price of both commodities, and the sum of the deadweight loss of the tax aecting
the price of each commodity separately. It is easy to check that
DW (DW
1
+ DW
2
) = c
6
e) Suppose the initial tax situation has prices (p
1
; p
2
) = (1; 1). The government
wants to raise a xed (small) amount of revenue R through commodity
taxes. Call t
1
and t
2
the tax rates for the two commodities. Determine
the optimal tax rates as a function of the parameters of demand if the
optimality criterion is the minimization of the deadweight loss.
The governments problem is:
min
(t
1
;t
2
)
DW(t
1
; t
2
)
subject to
2

l=1
h
l
(1 +t
1
; 1 +t
2
; u) t
l
_ R
where DW(t
1
; t
2
) = TR(t
1
; t
2
) EV (t
1
; t
2
). That is,
DW(t
1
; t
2
) =
2

l=1
h
l
(1 +t
1
; 1 +t
2
; u)t
l
e(1 +t
1
; 1 +t
2
; u) + e(1; 1; u)
Set up the Lagrangian by
L(t
1
; t
2
; ) = DW(t
1
; t
2
) + (R TR(t
1
; t
2
))
Then the rst order condition with respect to t
l
is:
@DW(t
1
; t
2
)
@t
l

@TR(t
1
; t
2
)
@t
l
= 0
but,
@DW(t
1
; t
2
)
@t
l
=
2

k=1
@h
k
(1 +t
1
; 1 +t
2
; u)
@t
l
t
k

@e(1 +t
1
; 1 +t
2
; u)
@t
l
+ h
l
(1 +t
1
; 1 +t
2
; u)
since
@e(1+t
1
;1+t
2
;u)
@t
l
= h
l
(1 +t
1
; 1 +t
2
; u). Then,
@DW(t
1
;t
2
)
@t
l
=

2
k=1
@h
k
(1+t
1
;1+t
2
;u)
@t
l
t
k
, and
@TR(t
1
; t
2
)
@t
l
= h
l
(1 +t
1
; 1 +t
2
; u) +
2

k=1
@h
k
(1 +t
1
; 1 +t
2
; u)
@t
l
t
k
Hence the above rst order condition can be written as:
2

k=1
@h
k
(1 +t
1
; 1 +t
2
; u)
@t
l
t
k

_
h
l
(1 +t
1
; 1 +t
2
; u) +
2

k=1
@h
k
(1 +t
1
; 1 +t
2
; u)
@t
l
t
k
_
= 0
And rearranging,
2

k=1
@h
k
(1 +t
1
; 1 +t
2
; u)
@t
l
t
k
(1 +) h
l
(1 +t
1
; 1 +t
2
; u) = 0 for all l = 1; 2:
7
From this expression and TR =

2
l=1
h
l
(1 +t
1
; 1 +t
2
; u) t
l
we obtain
=
bt
1
+ ct
2
a + b(1 + 2t
1
) + c(1 + 2t
2
)
=
ct
1
+ gt
2
a + c(1 + 2t
1
) + g(1 + 2t
2
)
and
R = (a + b(1 +t
1
) + c(1 + t
2
))t
1
+ (d + c(1 + t
1
) + g(1 +t
2
))t
2
Therefore, any combination of tax rates (t
1
; t
2
) that satises the previous condition minimizes
the total deadweight loss of taxation, DW, and allows the tax authority to reach a minimal
tax revenue of TR dollars.
8
Micro Theory I
Recitation #6
1. Show that if the preferences are n(r
1
. r
2
) =
1
x
1
+r
2
with r
1
0, then the following
relation holds:
Jr
2
Jj
1
=
Jr
1
Jj
2
r

1
Jr
2
J:
[Note that in this relation only Walrasian demand functions are involved, no Hicksian de-
mands]
Solution:
The Marginal Rate of Substitution (MRS) is:
`1o
1;2
=
`l
1
`l
2
=
1
r
2
1
=
j
1
j
2
Using the budget set constraint, j
1
r
1
+j
2
r
2
= :, we have the following Walrasian demand
functions:
r
1
(j. :) =
_
j
2
j
1
_1
2
and r
2
(j. :) =
:
j
2

_
j
1
j
2
_1
2
We can now calculate the derivatives to show the relation:
@x
2
@p
1
=
@x
1
@p
2
r

1
@x
2
@m
,

@x
2
@p
1
=
1
2(p
1
p
2
)
1=2

@x
1
@p
2
=
1
2(p
1
p
2
)
1=2

@x
2
@m
=
1
p
2
Thus,
Jr
2
Jj
1
=
Jr
1
Jj
2
r

1
Jr
2
J:
=
1
2(j
1
j
2
)
1=2

_
j
2
j
1
_1
2
_
1
j
2
_
=
1
2(j
1
j
2
)
1=2
Generally, we can show that this relation holds for any quasilinear preference relation
n(r
1
. r
2
) = ,(r
1
) + r
2
. Indeed, since the preferences are quasilinear, the income eect
is null, because the demand of the good 1 does not depend on income:
@x
1
@m
= 0. Then, the
Slutsky equation of good 2 with respect to j
1
is:
Jr
2
Jj
1
=
J/
2
Jj
1
r

1
Jr
2
J:
(1)
The Slutsky equation of the good 1 with respect to j
2
is:
Jr
1
Jj
2
=
J/
1
Jj
2
r

2
Jr
1
J:
1
but since
@x
1
@m
= 0 thus
@x
1
@p
2
=
@h
1
@p
2
.
Also by the symmetry of the Slutsky matrix we know that
@h
1
@p
2
=
@h
2
@p
1
. Then, we can rewrite
(1) as:
Jr
2
Jj
1
=
Jr
1
Jj
2
r

1
Jr
2
J:
2. The preferences of some consumer can be represented as: n(r
1
. r
2
) = :i:fr
1
. r
2
g.
We have been informed that only the price of the good 2 has changed, from j
0
2
to j
1
2
,
but we have not informed about by how much did it change. We know, however, that
the amount of income that has to be transferred to the consumer in order to recover
his initial utility level is:
j
0
2
:
j
0
1
+j
0
2
dollars
where : is the initial income, and j
0
1
and j
0
2
are prices of goods 1 and 2 respectively. Can
you provide some information about the size of the price change, i.e., the dierence between
j
0
2
and j
1
2
?
Solution:
According to the information,
_
p
0
2
m
p
0
1
+p
0
2
_
is the amount of income that, at the new price ratio,
has to be transferred to the consumer in order to recover his initial utility level, which is the
denition of CV. Then,
C\ =
_
j
0
2
:
j
0
1
+j
0
2
_
Since we can calculate the CV as:
C\ = v(P
1
; P
0
. m
0
) v(P
1
; P
1
. m
1
)
Or using the expenditure function as follows:
C\ = e(P
1
; u
0
) e(P
0
; u
0
)
From the last homework assignment, we know that under this utility function n(r
1
. r
2
) =
min fr
1
. r
2
g, Walrasian demands are:
r
1
(j. :) = r
2
(j. :) =
:
j
1
+j
2
thus the Indirect Utility Function is:
(j. :) = min
_
:
j
1
+j
2
. :
:
j
1
+j
2
_
=
:
j
1
+j
2
Using the identity (j. c(j. n
0
)) = n
0
into the previous Indirect Utility Function we have
that
2
c(j. n
0
)
j
1
+j
2
= n
0
.
and solving c(j. n
0
) = (j
1
+j
2
)n
0
.
On the other hand, we also know that:
e(P; v(P
0
. m)) = e(P; u
0
) =(p
1
+ p
2
)
m
p
0
1
+ p
0
2
We can use this expression to calculate CV:
C\ = e(P
1
; u
0
) e(P
0
; u
0
) = (j
1
1
+j
1
2
)
:
j
0
1
+j
0
2
(j
0
1
+j
0
2
)
:
j
0
1
+j
0
2
=
j
0
2
:
j
0
1
+j
0
2
where the last equality C\ =
p
0
2
m
p
0
1
+p
0
2
was given in the introduction of the exercise. Since we
know that the price of good one is not changing j
1
1
= j
0
1
.
C\ =
j
0
2
:
j
0
1
+j
0
2
= (j
0
1
+j
1
2
)
:
j
0
1
+j
0
2
:
Rearranging,
j
0
2
j
0
1
+j
0
2
=
j
0
1
+j
1
2
j
0
1
+j
0
2
1
j
0
2
= j
0
1
+j
1
2
j
0
1
j
0
2
j
0
2
= j
1
2
j
0
2
=) j
1
2
= 2j
0
2
Then we can conclude that the price of the good 2 has doubled.
3
3. Consider a consumer with regular preferences that consumes an n-dimensional basket:
r = (r
1
. r
2
. .... r
n
) 2 R
n
+
. The price vector is P
0
= (j
o
1
. j
o
2
. .... j
o
n
) 0. The consumers
wealth is : dollars. Assume that the prices of all of the goods change in the same
proportion o 1. Calculate analytically the CV and the EV.
Solution:
First note that all prices change from P
0
to P
1
= P
0
where 1 (proportional price
increase).
We can rst nd the CV using the expenditure function:
C\ = c(P
1
. u
0
) c(P
0
. u
0
)
According to the information we know P
1
= P
0
, then we can rewrite the CV as:
C\ = c(P
0
. u
0
) c(P
0
. u
0
)
Since the Expenditure Function is homogeneous of degree one, c(P
0
. u
0
) = oc(P
0
. u
0
),
then:
C\ = oc(P
0
. u
0
) c(P
0
. u
0
)
Thus, C\ = o::. Then the CV can be expressed as: C\ = :(o 1)
Second, to nd the EV:
1\ = c(P
1
. u
1
) c(P
0
. u
1
)
Since P
1
= P
0
thus P
0
=
1

P
1
then we can rewrite EV as
1\ = c(P
1
. u
1
) c(
1

P
1
. u
1
)
Since the Expenditure Function is homogeneous of degree one, c(
1

P
1
. u
1
) =
1

c(P
1
. u
1
),
then:
1\ = c(P
1
. u
1
)
1
o
c(P
1
. u
1
)
1\ = :
1
o
:
Then the EV can be expressed as: 1\ = :(1
1

)
And note that, for all 1, the C\ 1\ .
Finally, note that these are the C\ and 1\ measuring welfare change due to a pro-
portional increase in the prices of all goods.
4
4. [Midterm #1, Fall 2008] An individual consumes only good 1 and 2, and his preferences
over these two goods can be represented by the utility function
n(r
1
. r
2
) = r

1
r

2
where c. , 0 and c +, ? 1
This individual currently works for a rm in a city where initial prices are j
0
= (j
1
. j
2
),
and his wealth is n.
(a) Find the Walrasian demand for goods 1 and 2 of this individual, r
1
(j. n) and
r
2
(j. n).
Walrasian demands are
r
1
(j. n) =
cn
(c +,) j
1
and r
2
(j. n) =
,n
(c +,) j
2
b. Find his indirect utility function, and denote it as (j
0
. n).
Plugging the above Walrasian demand functions in the consumers utility
function, we obtain
(j. n) =
_
cn
(c +,) j
1
_

_
,n
(c +,) j
2
_

=
_
n
c +,
_
+
_
c
j
1
_

_
,
j
2
_

c. The rm that this individual works for is considering moving its oce to a dierent
city, where good 1 has the same price, but good 2 is twice as expensive, i.e., the
new price vector is j
0
= (j
1
. 2j
2
). Find the value of the indirect utility function in
the new location, i.e., when the price vector is j
0
= (j
1
. 2j
2
). Let us denote this
indirect utility function (j
0
. n).
(j
0
. n) =
_
n
c +,
_
+
_
c
j
1
_

_
,
2j
2
_

## d. This individuals expenditure function is

c(j. n) = (c +,)
_
j
1
c
_
+
_
j
2
,
_

+
n
1
+
Find the value of this expenditure function in the following cases:
1. Under initial prices, j
0
, and maximal utility level n
0
(j
0
. n), and denote
it by c(j
0
. n
0
).
c(j
0
. n
0
) = (c +,)
_
j
1
c
_
+
_
j
2
,
_

+
_
_
n
c +,
_
+
_
c
j
1
_

_
,
j
2
_

_
. .
u
1
+
=
= (c +,)
_
j
1
c
_
+
_
j
2
,
_

+
_
n
c +,
_
+
+
_
c
j
1
_
+
_
,
j
2
_

+
= n
5
2. Under initial prices, j
0
, and maximal utility level n
0
(j
0
. n), and denote it
by c(j
0
. n
0
).
c(j
0
. n
0
) = (c +,)
_
j
1
c
_
+
_
j
2
,
_

+
_
_
n
c +,
_
+
_
c
j
1
_

_
,
2j
2
_

_ 1
+
= (c +,)
_
j
1
c
_
+
_
j
2
,
_

+
_
n
c +,
_
+
+
_
c
j
1
_
+
_
,
2j
2
_

+
=
1
2

+
n
3. Under new prices, j
0
, and maximal utility level n
0
(j
0
. n), and denote it
by c(j
1
. n
0
).
c(j
1
. n
0
) = (c +,)
_
j
1
c
_
+
_
2j
2
,
_

+
_
_
n
c +,
_
+
_
c
j
1
_

_
,
j
2
_

_ 1
+
= (c +,)
_
j
1
c
_
+
_
2j
2
,
_

+
_
n
c +,
_
+
+
_
c
j
1
_
+
_
,
j
2
_

+
= 2

+
n
4. Under new prices, j
0
, and maximal utility level n
0
(j
0
. n), and denote it
by c(j
0
. n
0
).
c(j
0
. n
0
) = (c +,)
_
j
1
c
_
+
_
2j
2
,
_

+
_
_
n
c +,
_
+
_
c
j
1
_

_
,
2j
2
_

_ 1
+
= (c +,)
_
j
1
c
_
+
_
2j
2
,
_

+
_
n
c +,
_
+
+
_
c
j
1
_
+
_
,
2j
2
_

+
= n
e. Find this individuals equivalent variation due to the price change. Explain how
your result can be related with this statement from the individual to the media:
I really prefer to stay in this city. In fact, I would accept a reduction in my
wealth if I could keep working for the rm staying in this city, instead of moving
to the new location
We know that
1\ = c(j
1
. n
1
) c(j
0
. n
1
) = :
1
2

+
n
That is, this individual would be willing to accept a reduction in his wealth
of n
1
2

+
n in order to avoid moving to a dierent city. [Alternatively, the
individual is willing to accept a reduction of
_
1
1
2

+
_
% of his weatlh ]
f. Find this individuals compensating variation due to the price change. Explain
how your result can be related with this statement from the individual to the
media: I really prefer to stay in this city. The only way I would accept to move
to the new location is if the rm raises my salary.
6
We know that
C\ = c(j
1
. n
0
) c(j
0
. n
0
) = 2

+
n n
That is, we would need to raise this individuals salary by 2

+
n n in
order to guarantee that his welfare level at the new city (with new prices)
coincides with his welfare level at the initial city (at the initial price level).
[Alternatively, the individual must receive an increase of
_
2

+
1
_
of his
wealth]
g. Find this individuals variation in his consumer surplus (also referred as area
variation). Explain.
We know that area variation is given by the area below the Walrasian demand
between the initial and nal price level. That is,
\ =
_
2p
2
p
2
r
2
(j. n)dj =
_
2p
2
p
2
,
(c +,) j
n dj
=
,
(c +,)
n
_
2p
2
p
2
1
j
dj =
,
(c +,)
nln 2
Hence, moving to the new city would imply a reduction in this individuals
welfare of

(+)
nln 2, or
_

(+)
ln 2
_
% of his wealth.
h. Which of the previous welfare measures in questions (e), (f) and (g) coincide?
Which of them do not coincide? Explain.
None of them coincide, since this individuals preferences are not quasilineal
in any of the goods.
i. Consider how the welfare measures from questions (e), (f) and (g) would be mod-
ied if this individuals preferences were represented, instead, by the utility func-
tion (r
1
. r
2
) = cln r
1
+, ln r
2
.
Since we have just applied a monotonic transformation to the initial utility
function, n(r
1
. r
2
), this new utility function represents the same preference
relation than function (r
1
. r
2
). Hence, the welfare results that we would
obtain from function (r
1
. r
2
) would be the same as those with utility function
n(r
1
. r
2
).
7
(b)
@xz
@e
/
z
(n. j. ) is the income eect:
1. if
@xz
@e
0 then an increase in wages makes that worker richer, and he decides
to work more (this would be an upward bending supply curve), or
2. if
@xz
@e
< 0 then an increase in wages makes that worker richer, and he decides
to work less (e.g., nurses in Massachussets).
5. [15 points] Measuring welfare changes through the expenditure function]. A
consumer has a utility function n(r
1
. r
2
) = r
1=2
1
r
1=2
2
, where good r
1
is the consumption
of alcoholic beverages, and r
2
is her consumption of all other goods. The price of alcohol
is j 0, and the price of all other goods is normalized to 1.
(a) [2 points] Set the consumers expenditure minimization problem. Find rst order
conditions, and nd his optimal consumption of r
1
and r
2
.
The consumers minimization problem is
min
x
1
;x
2
j
1
r
1
+j
2
r
2
+`
_
l r
1=2
1
r
1=2
2
_
And the rst order conditions are
j
1
=
1
2
r
1=2
1
r
1=2
2
j
2
=
1
2
r
1=2
1
r
1=2
2
r
1
=
j
2
r
2
j
1
Substituting in the constraint, we have
l =
_
j
2
r
2
j
1
_
1=2
(r
2
)
1=2
And solving for r
2
in this expression, we nd the Hicksian demand for good
2,
r
2
= l
_
j
1
j
2
_
1=2
And similarly for r
1
, we nd the Hicksian demand for good 1,
r
1
= l
_
j
2
j
1
_
1=2
(b) [4 points] Substituting your results from part (a) into your objective function,
nd the expenditure function c(j
1
. j
2
. l) for this consumer.
Substituting r
2
and r
1
into j
1
r
1
+j
2
r
2
,
c(j
1
. j
2
. l) = j
1
l
_
j
2
j
1
_
1=2
+j
2
l
_
j
1
j
2
_
1=2
= 2l (j
1
j
2
)
1=2
5
For convenience, we can denote j
1
= j be the price of alcohol, and j
2
= 1 be
the price of all other commodities. Hence, the expenditure function can be
rewritten as
c(j. l) = 2l (j)
1=2
(c) [9 points] Let us now consider a proposal to reduce the price of alcohol from
j = \$2 to j = \$1 per unit. If the new utility enjoyed by the consumer after the
price change is l = 100,
1. [4 points] what is his minimum expenditure in order to reach l = 100 when
j = \$2? And when j = \$1? [Hint: Use the expression of the expenditure
function c(j
1
. j
2
. l) you found in part (b)]
His minimum expenditure in order to reach l = 100 when j = \$2 is
c(\$2. 100) = 2 100 (2)
1=2
= 282.84
And when j = \$1 is
c(\$1. 100) = 2 100 (1)
1=2
= 200
2. [5 points] what is then the maximum amount that this consumer would be
willing to pay for this price reduction?
The maximum amount that this consumer would be willing to pay for
this price reduction is the dierence in the minimum expenditure he need
to maintain the same utility level (U=100). This is the EV. That is,
c(\$2. 100) c(\$1. 100) = 82.84
6. [20 points] [Measuring welfare changes when preferences are quasilinear] Show
that the compensating and the equivalent variation coincide when the utility function is
quasilinear with respect to the rst good (and we x j
1
= 1). [Hint: use the denitions
of the compensating and equivalent variations in terms of the expenditure function
(not the hicksian demand). In addition, recall that if n(r) is quasilinear, then we can
express it as n(r) = r
1
+ c(r
1
), and rearranging r
1
= n(r) c(r
1
) where r
1
represents all the reamining goods, | = 2. 3. .... 1.]
From the denition of the compensating and the equivalent variation, we know
that
C\
_
j
0
. j
1
. n
_
= c
_
j
1
. n
1
_
c
_
j
1
. n
0
_
1\
_
j
0
. j
1
. n
_
= c
_
j
0
. n
1
_
c
_
j
0
. n
0
_
Moreover, we know that if n(r) is quasilinear, then we can express it as
n(r) = r
1
+c(r
1
) ()r
1
= n(r) c(r
1
)
where r
1
represents all the reamining goods, | = 2. 3. .... 1. Therefore, the
expenditure function becomes
c (j. n) =
L

i=1
j
i
r
i
= j
1
..
\$1
r
1
+
L

k=2
j
k
r
k
. .
p
1
x
1
= r
1
+j
1
r
1
6
EconS 501 - Micro Theory I
Recitation #5 - Production Theory
Exercise 1
1. Exercise 5.B.2 (MWG): Suppose that , () is the production function associated
with a single-output technology, and let 1 be the production set of this technology.
Show that 1 satises constant returns to scale if and only if , () is homogeneous of
degree one.
Suppose rst that a production set 1 exhibits constant returns to scale [See gure
corresponding to Exercise 5.B.2 at the end of this handout]. Let . R
11
+
and
c 0. Then (.. , (.)) 1 . By constant returns to scale, (c.. c, (.)) 1 .
Hence c, (.) _ , (c.).
By applying this inequality to c. in place of . and
1
c
in place of c, we obtain
1
c
, (c.) _ ,
_
1
c
(c.)
_
= , (.) . or , (c.) _ c, (.)
Hence , (c.) = c, (.). The homogeneity of degree one is thus obtained.
Suppose conversely that , () is homogeneous of degree one. Let (.. ) 1 and
c _ 0, then _ , (.) and hence c _ c, (.) = , (c.). Since (c.. , (c.)) 1 ,
we obtain (c.. c) 1 . The constant returns to scale is thus obtained.
Exercise 2
2. Exercise 5.B.3 (MWG): Show that for a single-output technology, the production
set 1 is a convex if and only if the production function , (.) is concave.
In order to prove this if and only if statement we need to show rst that: if the
production set 1 is convex, then the production function , (.) is concave. And
second, we need to show the converse: that if the production function , (.) is
concave then the set 1 must be convex.
First, suppose that 1 is convex. [See gure corresponding to Exercise 5.B.3 at
the end of this handout]. Let .. .
0
R
11
+
and c [0. 1] . then (.. , (.)) 1
and (.
0
. , (.
0
)) 1 . By the convexity,
((c. + (1 c) .) . c, (.) + (1 c) , (.)) 1 .
Thus, c, (.) + (1 c) , (.) _ , (c. + (1 c) .). Hence , (.) is concave.
1
Let us now suppose that , (.) is concave. Let (. .) 1. (
0
. .
0
) 1 , and
c [0. 1], then _ , (.) and
0
_ , (.
0
). Hence
c + (1 c)
0
_ c, (.) + (1 c) , (.
0
)
By concavity,
c, (.) + (1 c) , (.
0
) _ , (c, + (1 c) .
0
)
Thus
c + (1 c)
0
_ , (c. + (1 c) .
0
)
Hence
((c. + (1 c) .
0
) . c + (1 c)
0
) = c(.. ) + (1 c) (.
0
.
0
) 1
Therefore 1 is convex.
Exercise 3
3. Given a CES (Constant Elasticity of Substitution) production function:
= ,(.
1
. .
2
) = [o.
j
1
+ (1 o).
j
2
]
1

## , where 0 and 0 < o < 1

Calculate the Marginal Rate of Technical Substitution (MRTS) and the Elasticity of
Substitution (o).
(a) Is it an homogeneous production function?
(b) Show, using MRTS and o, that:
1. when j the CES production function represents the Leontief produc-
tion function;
2. when j = 1 the CES production function represents a perfect substitutes
technology; and
3. when j = 0 the CES production function represent a Cobb-Douglas technol-
ogy.
Solution:
a) We can calculate the MRTS between the two factors as:
`11o
2
1
=
0q
0:
1
0q
0:
2
=
_
1
j
_
[o.
j
1
+ (1 o).
j
2
]
1

1
jo.
j1
1
_
1
j
_
[o.
j
1
+ (1 o).
j
2
]
1

1
j(1 o).
j1
2
=
o.
j1
1
(1 o).
j1
2
Using the denition of the Elasticity of Substitution we have:
o =
d ln (.
2
,.
1
)
d ln `11o
=
d ln (.
2
,.
1
)
d ln
_
0q0:
1
0q0:
2
_
2
to nd this expression we can use the expression of the MRTS we just found:
`11o =
o
(1 o)
_
.
2
.
1
_
1j
and using a logarithmic transformation
ln(`11o) = ln
_
o
1 o
_
+ (1 j) ln
_
.
2
.
1
_
solving for ln(.
2
,.
1
) we have:
ln
_
.
2
.
1
_
=
_
1
1 j
__
ln(`11o) ln
_
o
1 o
__
thus,
o =
d ln
_
:
2
:
1
_
d ln `11o
=
1
1 j
As we can observe, the elasticity of substitution, o, is a constant value for any pro-
duction process and any output value. This is the reason for the name of the CES
function.
b) To verify that it is an homogeneous production function:
,(o.
1
. o.
2
) = [o (o.
1
)
j
+ (1 o) (o.
2
)
j
]
1

= [oo
j
(.
1
)
j
+ (1 o)o
j
(.
2
)
j
]
1

and rearranging
,(o.
1
. o.
2
) = o[o (.
1
)
j
+ (1 o) (.
2
)
j
]
1

= o,(.
1
. .
2
)
then the function is homogeneous of degree one.
c) Now we analyze what happens for dierent values of parameter j :
i) When j : From part (a) we have `11o
2
1
=
c:
1
1
(1c):
1
2
, the limit of MRTS
when j is
lim
j!1
`11o
2
1
= lim
j!1
o.
j1
1
(1 o).
j1
2
=
o
(1 o)
_
.
2
.
1
_
1
As we can see, if .
2
.
1
the MRTS goes to , if .
2
< .
1
the MRTS goes to zero.
Remember that this values of the MRTS are the same of the Leontief or Fixed
Proportions production function.
ii) When j = 1:
= ,(.
1
. .
2
) = o.
1
+ (1 o).
2
this production function is a perfect substitutes inputs technology.
iii) When j 0: `11o =
c
(1c)
_
:
2
:
1
_
. which corresponds to the Cobb-Douglas
production function MRTS. In the extreme case where j = 0. the elasticity of
substitution o =
_
1
1j
_
becomes o = 1.
3
Exercise 4
4. Assume a standard technology represented by the production function = ,(.
1
. .
2
),
show:
(a) If the function represents always Constant Returns to Scale (CRS) , it is true
that marginal productivity of the factors are constant along the same production
process?
(b) What if the degree of the production function is dierent from one?
Solution:
a) If the production function has CRS, then the function is homogeneous of degree one,
thus, the marginal productivity of the factors (rst derivatives of the production func-
tion) are also homogeneous, but one degree less than the original function (degree
zero).
,
1
(o.
1
. o.
2
) = o
0
,
1
(.
1
. .
2
) = ,
1
(.
1
. .
2
)
,
2
(o.
1
. o.
2
) = o
0
,
2
(.
1
. .
2
) = ,
2
(.
1
. .
2
)
This result indicates that the marginal product of every input is constant along a given
ray (i.e., for production plans using the same ratio of inputs
:
1
:
2
). Note that since the
marginal product of every input is constant along a given ratio of input combinations
:
1
:
2
, then we must have that the ratio of marginal products
)
1
(:
1
, :
2
)
)
2
(:
1
, :
2
)
is also constant
along a given ray
:
1
:
2
. Finally, since
,
1
(.
1
. .
2
)
,
2
(.
1
. .
2
)
= `11o(.
1
. .
2
)
then the MRTS between inputs 1 and 2 is constant along a given ray
:
1
:
2
. Therefore,
the production function is homothetic.
b) If the production function is homogeneous of degree / ,= 1, then by Eulers theorem we
know that the marginal product of every input is homogeneous of degree / 1. That
is
,
1
(o.
1
. o.
2
) = o
I1
,
1
(.
1
. .
2
) for the marginal product of input 1, and
,
2
(o.
1
. o.
2
) = o
I1
,
2
(.
1
. .
2
) for the marginal product of input 2
In this case, the marginal product of every input is not constant along a given ray
:
1
:
2
(in
which we increase both .
1
and .
2
keeping their proportion
:
1
:
2
unmodied). However,
the production function is still homothetic since:
`11o(o.
1
. o.
2
) =
o
I1
,
1
(.
1
. .
2
)
o
I1
,
2
(.
1
. .
2
)
=
,
1
(.
1
. .
2
)
,
2
(.
1
. .
2
)
= `11o(.
1
. .
2
)
4
Exercise 5
5. Assume a rm with the production function:
= ,(.) = o(1 + .
c
1
.
.
2
)
1
where o. o. 0
Calculate the product-elasticities of the two inputs and comment the type of returns
to scale that the function represents.
Solution:
The product-elasticity of the input i, j
i
, is dened as the percentage change in output
= ,(.) with respect to a percentage change in the amount used of the input i, .
i
. We can
calculate it as:
j
i
=
J,(.)
J.
i
.
i
,(.)
For the case of this particular functional form, we have that the product elasticity of input
1 is
j
1
=
J,(.)
J.
1
.
1
,(.)
= o(1+.
c
1
.
.
2
)
2
(o)(.
c1
1
.
.
2
)
.
1
o(1 + .
c
1
.
.
2
)
1
= o(1+.
c
1
.
.
2
)
1
.
c
1
.
.
2
and the product elasticity of input 2 is
j
2
=
J,(.)
J.
2
.
2
,(.)
= o(1+.
c
1
.
.
2
)
2
()(.
c
1
.
.1
2
)
.
1
o(1 + .
c
1
.
.
2
)
1
= (1+.
c
1
.
.
2
)
1
.
c
1
.
.
2
The elasticity of scale can help us nd this production functions returns to scale. In partic-
ular, dene elasticity of scale, j, as the percentage change in total output as a consequence
of a percentage change in all inputs.
j =
J,(t.)
Jt
t
,(t.)

t=1
Alternatively, the scale elasticity can be calculated as the sum of the product-elasticities for
all inputs in the production process:
j =
a

i=1
j
i
which in this case is
j =
a

i=1
j
i
= j
1
+ j
2
= (o + )(1 + .
c
1
.
.
2
)
1
.
c
1
.
.
2
This function does not represent global, but local, returns to scale. That is, the type of
returns to scale depends on the production level (or the amount of inputs used). We can use
the scale elasticity to determine for which values of inputs .
1
and .
2
the production function
exhibits constant, increasing or decreasing returns to scale, as follows.
5
For values of .
1
and .
2
for which j = 1,
(o + )(1 + .
c
1
.
.
2
)
1
.
c
1
.
.
2
= 1
the production function has constant returns to scale for these levels of .
1
and .
2
.
For values of .
1
and .
2
for which j 1,
(o + )(1 + .
c
1
.
.
2
)
1
.
c
1
.
.
2
1
the production function has increasing returns to scale for these levels of .
1
and .
2
.
Finally, for values of .
1
and .
2
for which j < 1,
(o + )(1 + .
c
1
.
.
2
)
1
.
c
1
.
.
2
< 1
the production function has decreasing returns to scale for these levels of .
1
and .
2
.
Exercise 6
6. Obtain the conditional factor demand functions, the cost function, supply correspon-
dence and prot function for the technology: = .
c
1
.
o
2
with c. , _ 0.
Solution: The technology is a Cobb-Douglass production function, then, the conditional
factor demand functions can be calculated as the solution of the costs minimization problem:
min
:
1
,:
2
n
1
.
1
+ n
2
.
2
subject to .
c
1
.
o
2
_
The rst order conditions are:
`11o
2
1
=
,
1
(.)
,
2
(.)
=
c.
2
,.
1
=
n
1
n
2
and = .
c
1
.
o
2
.
This is a system of two equations and two unknowns (.
1
and .
2
) that can be solved for the
conditional factor demand functions /
1
and /
2
.
From the MRTS we have .
2
=
o
c
&
1
&
2
.
1
, which we can replace into the constraint as follows
= .
c
1
.
o
2
= .
c
1
_
,
c
n
1
n
2
.
1
_
o
= .
c+o
1
_
,
c
n
1
n
2
_
o
and rearranging
.
c+o
1
=
_
cn
2
,n
1
_
o
6
.
1
= /
1
(n
1
. n
2
. ) =
_
cn
2
,n
1
_
o(c+o)

1(c+o)
Now replacing .
1
= /
1
(n
1
. n
2
. ) into .
2
=
o
c
&
1
&
2
.
1
we have:
.
2
= /
2
(n
1
. n
2
. ) =
_
,n
1
cn
2
_
c(c+o)

1(c+o)
Using these values we can nd the cost function as:
C(n. ) = n
1
/
1
(n
1
. n
2
. ) + n
2
/
2
(n
1
. n
2
. )
that is,
C(n. ) = n
1
_
cn
2
,n
1
_
o(c+o)

1(c+o)
. .
I
1
(&
1
, &
2
, q)
+ n
2
_
,n
1
cn
2
_
c(c+o)

1(c+o)
. .
I
2
(&
1
, &
2
, q)
Let o =
o
(c+o)
and 1 =
_
c
o
_
0 _
o
c

10
. We can rewrite the function as:
C(n. ) = 1
1(c+o)
n
10
1
n
0
2
In order to nd the supply correspondence and the prot function, we have to solve the
prot maximization problem as follows:
max
q
:() = j C(n. )
max
q
:() = j 1
1(c+o)
n
10
1
n
0
2
The rst order conditions are:
J:()
J
= j
_
1
c + ,
_
1
1
+
1
n
10
1
n
0
2
(1)
And the second order derivative must satisfy:
J
2
:()
J
2
=
_
1
c + ,
1
__
1
c + ,
_
1
1
+
2
n
10
1
n
0
2
< 0
Note that when (c + ,) < 1 the above second order condition is satised. Intuitively, this
condition holds when the function shows decreasing returns to scale. Hence, only under
decreasing returns to scale for this Cobb-Douglas production function we can nd supply
correspondences that maximize the prots and a supply function that is nondecreasing in
price (satisfying the law of supply). Solving for from (1) we have:
j
_
1
c + ,
_
1
1
+
1
n
10
1
n
0
2
= 0
(n. j) =
_
c + ,
1

j
n
10
1
n
0
2
_
+
1
7
and now using this expression we can obtain the conditional factor demand for factors .
1
and
.
2
.
1
(n
1
. n
2
. ) =
_
cn
2
,n
1
_
o(c+o)

1(c+o)
=
_
cn
2
,n
1
_
o(c+o)
_
_
c + ,
1

j
n
10
1
n
0
2
_
+
1
_
1(c+o)
.
2
(n
1
. n
2
. ) =
_
,n
1
cn
2
_
c(c+o)

1(c+o)
=
_
,n
1
cn
2
_
c(c+o)
_
_
c + ,
1

j
n
10
1
n
0
2
_
+
1
_
1(c+o)
And rearranging,
.
1
(n
1
. n
2
. ) =
_
cn
2
,n
1
_
o(c+o)
_
c + ,
1

j
n
10
1
n
0
2
_ 1
1
.
2
(n
1
. n
2
. ) =
_
,n
1
cn
2
_
c(c+o)
_
c + ,
1

j
n
10
1
n
0
2
_ 1
1
Finally, we can calculate the prot function :() = j n
1
.
1
n
2
.
2
as:
:() = j
_
c + ,
1

j
n
10
1
n
0
2
_
+
1
n
1
_
cn
2
,n
1
_
o(c+o)
_
c + ,
1

j
n
10
1
n
0
2
_ 1
1
. .
:
1
(&
1
, &
2
, q)
n
2
_
,n
1
cn
2
_
c(c+o)
_
c + ,
1

j
n
10
1
n
0
2
_ 1
1
. .
:
2
(&
1
, &
2
, q)
Exercise 7
Consider the following production function:
= min .
c
1
. ,.
2

## with c. , _ 0, with as the output and .

1
, .
2
as the inputs.
1. Calculate the conditional factor demand functions and the cost function.
2. Assume that the rm sells the output at a xed price j, nd the parameter values for
c and , that verify the sucient conditions (second order) for prot maximization.
8
3. Assume that c = 1. Obtain the expression for the supply function of the output and
the prot function.
Solution:
1. The function = min .
c
1
. ,.
2
with c. , _ 0, is a Leontief (or xed proportions)
production function, thus, the optimal amount of factors must verify .
c
1
= ,.
2
, then
= min .
c
1
. .
c
1
= .
c
1
Thus, the conditional demand for factor 1 is /
1
(n. ) =
1c
and the conditional de-
mand for factor 2 is /
2
(n. ) =
q
o
.
The costs function is then
C(n. ) = n
1
/
1
(n
1
. n
2
. ) + n
2
/
2
(n
1
. n
2
. ) = n
1

1c
+ n
2

,
2. According to the cost function we just found in (a), the maximum prots are:
max
q
:() = j C(n. )
= j n
1

n
2

,
and the rst order conditions are:
J:()
J
= j
1
c
n
1

(
1

)1
n
2
1
,
= 0
And the second order conditions are:
J
2
:()
J
2
=
_
1
c
1
_
1
c
n
1

(
1

)2
< 0
therefore, for the S.O.C.s to hold we need that c < 1 for any value of ,.
3. If c = 1 then the above second order conditions do not hold. Let us see what happens
under this assumption. First, we nd the conditional factor demand correspondence
from the production function under c = 1. This function is
= min .
1
. ,.
2
with , _ 0
The optimal amount of factors must satisfy
.
1
= ,.
2
Then
= min .
1
. ,.
2
= min .
1
. .
1
= .
1
Thus, the conditional demand for factor 1 is
/
1
(n. ) = .
9
Using .
2
=
:
1
o
from above, and the result we just obtained that = .
1
, we nd that
the conditional demand for factor 2 is
/
2
(n. ) =

,
The costs function is then
C(n. ) = n
1
/
1
(n
1
. n
2
. ) + n
2
/
2
(n
1
. n
2
. ) = n
1
+ n
2

,
The maximum prots are:
max
q
:() = j C(n. )
= j n
1
n
2

,
where the rst order conditions are
J:()
J
= j n
1
n
2
1
,
= 0. j = n
1
+ n
2
1
,
Then, the supply function is perfectly elastic, thus we cannot determine the factor
demands. This result is due to the fact that the production function shows constant
returns to scale (homogeneous of degree one). Note that at prices j = n
1
+n
2
1
o
, rms
prots are zero.
max :() = j C(n. )
=
_
n
1
+ n
2
1
,
_
n
1

1c
n
2

,
= 0.
10
Micro Theory I
Recitation #6 - Production Theory-II
Exercise 1
Consider the following prot function that has been obtained form a technology that uses a
single input:
(j. n) = j
2
n
c
where j is the output price, n is the input price and c is a parameter value.
1. For which values of c the prots function is a real prot function with all of the
appropriate properties.
2. Calculate the supply function of the product and the demand for inputs.
Solution:
1. The prot function has to be homogeneous of degree one. Thus,
(oj. on) = o(j. n)
In this case we have:
(oj. on) = (oj)
2
(on)
c
= o
2+c
j
2
n
c
(1)
and, on the other hand,
o(j. n) = oj
2
n
c
(2)
since, by homogeneity, expressions (2) and (3) must coincide. Then,
o
2+c
j
2
n
c
= oj
2
n
c
which implies that 2 + c = 1. That is, we need c = 1. As a consequence, the prot
function that we obtain is
(j. n) =
j
2
n
In this case the prot function satises the following the properties:
(a) Continuous: this property holds for every value of n ,= 0.
(b) Non decreasing in the output price, j:
0(j,&)
0j
=
2j
&
_ 0
(c) Non increasing in the factor prices:
0(j,&)
0&
=
j
2
&
2
_ 0
(d) Homogeneous of degree 1: if c = 1 then (oj. on) = o(j. n)
1
(e) Convex in prices, factor prices and output prices:

0
2
(j,&)
0j
2
0
2
(j,&)
0j0&
0
2
(j,&)
0&0j
0
2
(j,&)
0&
2

2
&

2j
&
2

2j
&
2
2j
2
&
3

= 0
Since the Hessian is a positive semi-denite matrix, the function (j. n) is convex.
(f) Dierentiable: we checked this when checking for previous properties.
2. Using Hotellings Lemma we can nd the supply function,
(j. n) =
J(j. n)
Jj
=
2j
n
and the conditional factor demand correspondence
.(j. n) =
J(j. n)
Jn
=
j
2
n
2
2
Exercise 2
Exercise 5.C.11 Show that
0:
`
(&,q)
0q
0 if and only if marginal cost at is increasing in
n

.
1. Assume that c () is twice continuously dierentiable. By Proposition 5.C.2(vi),
. () is continuously dierentiable and
J.

(n. )
J
=
_
J
J
__
Jc (n. )
Jn

_
=
_
J
Jn

__
Jc (n. )
J
_
.
Hence
J.

(n. )
J
0
if and only if
_
J
Jn

__
JC (n. )
J
_
0,
that is, marginal cost is increasing in n

.
Exercise 3
Exercise 5.C.13 A price-taking rm produces output from inputs .
1
and .
2
according to
a dierentiable concave production function , (.
1
. .
2
). The price of its output is j 0, and
the prices of its inputs are (n
1
. n
2
) 0. However, there are two unusual things about this
rm. First, rather than maximizing prot, the rm maximizes revenue (the manager wants
her rm to have bigger dollar sales than any other). Second, the rm is cash constrained.
In particular, it has only C dollars on hand before production and, as a result, its total
expenditures on inputs cannot exceed C.
Suppose one of your econometrician friends tells you that she has used repeated observations
of the rms revenues under various output prices, input prices, and levels of the nancial
constraint and has determined that the rms revenue level 1 can be expressed as the fol-
lowing function of the variables (j. n
1
. n
2
. C):
1(j. n
1
. n
2
. C) = j [ + ln C cln n
1
(1 c) ln n
2
] .
( and c are scalars whose values she tells you.) What is the rms use of input .
1
when
prices are (j. n
1
. n
2
) and it has C dollars of cash on hand?
Denote the production function of the rm by , (). Then its optimization problem is
max
(:
1
,:
2
)0
j , (.
1
. .
2
) .
subject to n
1
.
1
+ n
2
.
2
_ C
3
This is analogous to the utility maximization problem in Section 3.D and the function
1() corresponds to the indirect utility function. Hence, analogously to Roys identity
(Proposition 3.G.4), the input demands are obtained as

1
\
C
1(j. n. C)
\
&
1(j. n. C) =
_
cC
n
1
.
(1 c) C
n
2
_
.
Exercise 4
Exercise 5.D.4 Consider a rm that has a distinct set of inputs and outputs. The rm
produces ` outputs; let = (
1
. ....
A
) denote a vector of its output levels. Holding factor
prices xed, C (
1
. ....
A
) is the rms cost function. We say that C () is subaddittive if
for all (
1
. ....
A
), there is no way to break up the production of amounts (
1
. ....
A
) among
several rms, each with cost function C (), and lower the costs of production. That is, there
is no set of, say J rms and collection of production vectors
)
= (
1)
. ....
A)
)
J
)=1
such that

)
= and

)
C (
)
) < C () .
When C () is subadditive, it is usual to say that the industry is a natural monopoly because
production is cheapest when it is done by only one rm.
a. Consider the single-output case, ` = 1. Show that if C () exhibits decreasing average
costs, then C () is subadditive.
Suppose that =

J
)=1

)
. By the decreasing average costs (and C (0) =
0).
_
q
j
q
_
C () _ C (
)
). By summing over ,, we obtain C () _

J
)=1
C (
)
).
Hence there is no way to break up the production of among multiple rms and
lower the cost of production. Hence C () is subadditive.
b. Now consider the multiple-output case, ` 1. Show by example that the following
multiple-output extension of the decreasing average cost assumption is not sucient
for C () to be subadditive:
C () exhibits decreasing ray average cost if for any R
A
+
.
C ()
C (/)
/
for all / 1.
Let ` = 2 and dene C
() =
_
min
1
.
2

## , then C () exhibits decreasing ray average cost. But let

1
= (1. 8),
2
= (8. 1), and
=
1
+
2
= (9. 9). Then C (
1
) = C (
2
) = 1 and C () = 3. Hence
C () C (
1
) + C (
2
)
Therefore, C () is not subadditive.
4
Exercise 5
Exercise 5.E.5 (MWG) (M. Weitzman) Suppose that there are J single output plants.
Plant ,s average cost is C
)
(
)
) = c + ,
)

)
for
)
_ 0. Note that the coecient ,
)
may dier from plant to plant. Consider the problem of determining the cost minimizing
aggregate production plan for producing a total output of , where <
c
max
j
jo
j
j
.
a) If ,
)
0 for all ,, how should output be located among the J plants?
b) If ,
)
< 0 for all ,, how should output be located among the J plants?
c) If ,
)
0 for some plants and ,
)
< 0 for others?
Solution: Let us rst solve for the specic case where , = 1. 2. The cost-minimization
problem in which we nd the optimal combination of output
1
and
2
that minimizes the
total cost of production across rms is
min
q
1
,q
2
1C
1
(
1
) + 1C
2
(
2
)
subject to
1
+
2
=
or equivalently, the maximization problem in which rms choose the optimal combination of
output
1
and
2
that maximizes the total prots across all rms is
max
q
1
,q
2
j
1
1C
1
(
1
)
. .

1
+ j
2
1C
2
(
2
)
. .

2
subject to
1
+
2
=
If the average cost is C
)
(
)
) = c +,
)

)
then the total cost is 1C
)
(
)
) = (c +,
)

)
)
)
, thus
we can rewrite the PMP as:
max
q
1
,q
2
j
1
(c + ,
1

1
)
1
+ j
2
(c + ,
2

2
)
2
subject to
1
+
2
=
The F.O.C. are
0(
1
+
2
)
0q
1
= j c 2,
1

1
= `
0(
1
+
2
)
0q
2
= j c 2,
2

2
= `
0(
1
+
2
)
0A
=
1
+
2
=
Using the rst two order conditions:
5
j c 2,
1

1
= j c 2,
2

2
,
1

1
= ,
2

2
thus
1
=
o
2
o
1

2
Replacing this expression into the F.O.C. wrt ` we have:

1
+
2
= then
1
+
o
1
o
2

1
=

1
_
1 +
o
1
o
2
_
= thus
1
=
o
2
o
1
+o
2
(1)
In a more general set up, with , number of rms:
If the average cost is C
)
(
)
) = c+,
)

)
then the total cost must be 1C
)
(
)
) = (c+,
)

)
)
)
then, plant js marginal cost is `C
)
(
)
) = c+2,
)

)
. Since ,
)
0 for every j, the rst order
necessary and sucient conditions for cost minimization are that:
1.

)

)
=
`C
)
(
)
) = `C
)
(
)
) for all , and ,

.
From these conditions we obtain
)
=
q

j
P
h
1

h
.
Note that this expression coincides with (1) for N=2 rms.
q
o
1
1
o
1
+
1
o
2
=
,
2
,
1
+ ,
2

## b. and c. In both cases it is cost-minimizing to concentrate on plants with the smallest

,
)
< 0, because the average cost is decreasing at the highest rate at such plants.
6
Exercise 6
Assume there is a rm that has a regular production function given by = ,(.
1
. .... .
a
) with
Constant Returns to Scale (CRS). Show that if the rm pays the use of each input according
to its exact marginal productivity, then prots are equal to zero.
Solution: Since the production function shows CRS we know that it is homogeneous of
degree one, then, according to Eulers theorem for homogeneous functions:
J,(z)
J.
1
.
1
+
J,(z)
J.
2
.
2
+ ... +
J,(z)
J.
a
.
a
= ,(.
1
. .... .
a
) (3)
Then, if the rm pays each input according to the market value of the marginal productivity
of each input:
j
0)(z)
0:
i
= n
i
:=:
0)(z)
0:
i
=
&
i
j
, for every input i
Using this result on (1),
&
1
j
.
1
+
&
2
j
.
2
+ ... +
&n
j
.
a
= ,(.
1
. .... .
a
)
n
1
.
1
+ n
2
.
2
+ ... + n
a
.
a
= j,(.
1
. .... .
a
)
j,(.
1
. .... .
a
) (n
1
.
1
+ n
2
.
2
+ ... + n
a
.
a
) = 0
Since j,(.
1
. .... .
a
) is the total revenue of the rm and (n
1
.
1
+n
2
.
2
+... +n
a
.
a
) is the total
cost, then this dierence is the total prot of the rm, which is zero, as we wanted to show.
7
Exercise 7
Derive an expression for the cost function given the following information about the prot
function:
(j. w) =
j
2
4&
1
+
j
2
4&
2
Solution: Recall that using Hotellings Lemma we can nd the input demand correspond-
ence as follows:
.
1
(j. w) =
0(j, w)
0&
1
=
j
2
4&
2
1
.
2
(j. w) =
0(j, w)
0&
2
=
j
2
4&
2
2
Which do not depend on q (they are one of the results from the PMP).
In a similar manner we can nd the total output:
(w. j) =
0(j, w)
0j
=
2j
4&
1
+
2j
4&
2
=
j(&
1
+&
2
)
2&
1
&
2
From this equation we can solve for j as:
j =
2&
1
&
2
q
(&
1
+&
2
)
In order to obtain the conditional factor demand functions /
i
(w. ), we can replace the price
we just found into the input demands .
1
(j. w) and .
2
(j. w) as:
/
1
(w. ) =
1
4&
2
1
(j)
2
=
1
4&
2
1
_
2&
1
&
2
q
(&
1
+&
2
)
_
2
=
&
2
2
(&
1
+&
2
)
2

2
/
2
(w. ) =
1
4&
2
2
(j)
2
=
1
4&
2
2
_
2&
1
&
2
q
(&
1
+&
2
)
_
2
=
&
2
1
(&
1
+&
2
)
2

2
Which depend on q (they are a result from the CMP).
Finally, using the conditional factor demand functions we can nd the cost function:
C(w. ) = n
1
/
1
(w. ) + n
2
/
2
(w. ) = n
1
&
2
2
(&
1
+&
2
)
2

2
+ n
2
&
2
1
(&
1
+&
2
)
2

2
=
&
1
&
2
&
1
+&
2

2
8
Exercise 8
Given a technology with just two variable inputs, nd the production function that originates
the following prot function:
(j. w) =
j
2
8(&
1
&
2
)
1=2
Solution: Using Hotellings Lemma we can nd the demand for inputs as:
.
1
(j. w) =
0(j, w)
0&
1
=
j
2
16(&
1
&
2
)
1=2
&
1
.
2
(j. w) =
0(j, w)
0&
2
=
j
2
16(&
1
&
2
)
1=2
&
2
We can normalize input prices by using the output price as the numeraire:
_
n
I
=
&
k
j
; where / = 1. 2
_
,
then
.
1
(j. w) =
1
16(&
1
&
2
)
1=2
&
1
.
2
(j. w) =
1
16(&
1
&
2
)
1=2
&
2
From this system, we can obtain the values for n
1
and n
2
in terms of .
1
and .
2
,
n
1
(j. z) =
1
4:
1=2
1
(:
1
:
2
)
1=4
n
2
(j. z) =
1
4:
1=2
2
(:
2
:
1
)
1=4
In a similar manner we can nd output function:
(w. j) =
0(j, w)
0j
=
j
4(&
1
&
2
)
1=2
Assuming the normalization of input prices and replacing the values of n
1
(j. z) and n
2
(j. z)
into the above output function then:
(w. j) =
1
4(&
1
&
2
)
1=2
=
1
4
"
1
4z
1=2
1
(z
1
=z
2
)
1=4
!
1
4z
1=2
2
(z
2
=z
1
)
1=4
!#
1=2
(w. j) =
1
4
__
4.
12
1
(.
1
,.
2
)
14
__
4.
12
2
(.
2
,.
1
)
14
__
12
Thus, the production function is:
(w. j) = .
14
1
.
12
2
= ,(.
1
. .
2
)
9
Micro Theory I
Recitation #7 - Competitive Markets
Exercise 1
1. Exercise 12.5, NS: Suppose that the demand for stilts is given by Q = 1. 500 501
and that the long-run total operating costs of each stilt-making rm in a competitive
industry are given by C() = 0.5
2
10.
Entrepreneurial talent for stilt making is scarce. The supply curve for entrepreneurs is given
byQ
c
= 0.25n where n is the annual wage paid. Suppose also that each stilt-making rm
requires one (and only one) entrepreneur (hence, the quantity of entrepreneurs hired is equal
to the number of rms). Long-run total costs for each rm are then given by:
C(. n) = 0.5
2
10 +n
(a) What is the long-run equilibrium quantity of stilts produced? How many stilts are
produced by each rm? What is the long-run equilibrium price of stilts? How many rms
will there be? How many entrepreneurs will be hired, and what is their wage?
(b) Suppose that the demand for stilts shifts outward to
Q = 2. 428 501
How would you know answer the questions posed in part a.
(c) Because stilt-making entrepreneurs are the cause of the upward-sloping long-run supply
curve in this problem, they will receive all rents generated as industry output expands.
Calculate the increase in rents between parts (a) and (b). Show that this value is identical
to the change in long-run producer surplus as measured along the stilt supply curve.
Solution:
This problem introduces the concept of increasing input costs into long-run analysis by
assuming that entrepreneurial wages are bid up as the industry expands. Solving part (b)
can be a bit tricky; perhaps an educated guess is the best way to proceed.
(a) The equilibrium in the entrepreneur market requires Q
c
= 0.25n = Q
1
= : or n = 4:.
Hence, given C(. n) = 0.5
2
10 + n, the `C = 10 and C = 0.5 10 +
&
q
=
0.5 10 +
4a
q
In long run equilibrium the `C = C, thus:
10 = 0.5 10 +
4a
q
1
0.5 =
4a
q
0.5 =
4a
q

2
= 8: then =
p
8:
Total output is given in terms of the number of rms by
Q = : = :
p
8:
Now in terms of supply-demand equilibrium,
Q = 1500 501 and 1 = `C = 10 or = 1 + 10
Hence Q
S
= : = :(1 + 10)
Have 3 equations in Q, n, P. Since Q = :
p
8: and Q = :(1 + 10), we have
:
p
8: = :(1 + 10)
1 =
p
8: 10
Q
1
= 1500 501 = 1500 50(
p
8: 10) = 2000 50
p
8:
Then since Q
1
= Q
S
2000 50
p
8: =
p
8: thus : = 50 entrepreneurs
Finally, we can also calculate:
Q = :
p
8: = 1000
=
Q
a
= 20
1 = 10 = 10
n = 4: = 200.
(b) Using the results of the previous part and if Q = 2. 428 501 then,
2
(:
p
8:) 50(
p
8: 10) = 2. 428
(:
p
8:) 50
p
8: = 2. 928
(: 50)
p
8: = 2. 928, therefore : = 72
and, we can then recalculate:
Q = :
p
8: = 1728
=
Q
a
= 24
1 = 10 = 14
n = 4: = 288.
So, as the demand shifts outward, the number of rms in the industry increases, the total
production and rm production increases, the price increases and the wages increase.
(c) The long-run supply curve is upward sloping because as new rms enter the industry the
cost curves shift up:
C = 0.5 10 +
4a
q
as n increases the average cost also increases.
Using linear approximations, the increase in the producers surplus (PS) from the supply
curve is given by 4 1000 + 0.5 728 4 = 5456. If we use instead the supply curve for
entrepreneurs the area is 88 50 + 0.5 88 22 = 5368. These two numbers agree roughly.
To get exact agreement would require recognizing that the long-run supply curve here is not
linear it is slightly concave.
3
Exercise 2
2. Exercise 12.9, NS: Given an ad valorem tax rate (ad valorem tax is a tax on the
value of transaction or a proportional tax on price) of t (t = 0.05 for a 5% tax), the gap
between the price demanders pay and what suppliers receive is given by 1
1
= (1+t)1
S
.
(a) Show that, for an ad valorem tax,
o ln P
D
ot
=
c
S
c
S
c
D
and
o ln P
S
ot
=
c
D
c
S
c
D
(b) Show that the excess burden of a small tax is
1\ = 0.5
c
D
c
S
c
S
c
D
t
2
1
0
Q
0
(c) Compare these results to those for the case of a unit tax.
Solution:
This problem shows that the comparative statics results for ad valorem taxes are very similar
to the results for per-unit taxes
(a) Given that the gap between the price demanders pay and what suppliers receive is
1
1
= (1 +t)1
S
Then, the introduction of a tax implies a small price change, i.e., d1
1
= (1 +t)d1
S
+dt1
S
,
where we can evaluate this expression at t = 0 since the tax is impossed before any tax was
present. Hence, the previous expression collapses to d1
1
= (d1
S
+dt1
S
.
We know also that
c
1
=
0Q
D
01

1
Q
D
and c
S
=
0Q
S
01

1
Q
S
In equilibrium with a tax rate of t, we will have
Q
1
(1
1
) = Q
S
(1
S
)
0Q
D
01
D
d1
1
=
0Q
S
01
S
d1
S
but since d1
1
= d1
S
+dt1
S
then,
0Q
D
01
D
(d1
S
+dt1
S
) =
0Q
S
01
S
d1
S
0Q
D
01
D
d1
S
+
0Q
D
01
D
dt1
S
=
0Q
S
01
S
d1
S
rearranging
0Q
D
01
D
dt1
S
=
0Q
S
01
S
d1
S

0Q
D
01
D
d1
S
0Q
D
01
D
dt1
S
=
_
0Q
S
01
S

0Q
D
01
D
_
d1
S
@Q
D
@P
D
@Q
S
@P
S

@Q
D
@P
D
=
o1
S
ot

1
1
S
(*)
4
using ln we can have
|:
_
@Q
D
@P
D
@Q
S
@P
S

@Q
D
@P
D
_
= |:
_
o1
S
ot
_
+|:
_
1
1
S
_
or |:
_
o1
S
ot
_
+|:
_
1
1
S
_
= |:
_
@Q
D
@P
D
@Q
S
@P
S

@Q
D
@P
D
_
Thus,
d|:
_
o1
S
ot
_
= d|:
_
@Q
D
@P
D
@Q
S
@P
S

@Q
D
@P
D
_
=
_
c
D
c
S
c
D
_
d|:
_
o1
S
ot
_
=
c
D
c
S
c
D
Similarly if we use 1
S
= (1 +t)1
1
we can obtain
d|:
_
o1
D
ot
_
=
c
S
c
D
c
S
(b) A linear approximation of the DWL accompanying a small tax dt is given by:
1\1 = 0.5(1
0
dt)(dQ)
Since c
1
=
0Q
D
01

1
Q
D
=
olnQ
oln1
then dQ = c
1
Q
0
1
d1 and substituting into DWL
1\1 = 0.5(1
0
dt)
_
c
1
Q
0
1
d1
_
1\1 = 0.5 1
0
(dt)
2
c
1
Q
0

o1
ot
1
1
but from (*) we know
o1
D
ot

1
1
D
=
c
S
c
D
c
S
then
1\1 = 0.5 1
0
(dt)
2
c
1
Q
0

c
S
c
D
c
S
1\1 = 0.5
_
c
D
c
S
c
D
c
S
_
(dt)
2
Q
0
1
0
We can now generalize this result for any small t:
1\1 = 0.5
_
c
D
c
S
c
D
c
S
_
t
2
Q
0
1
0
(c) The unit tax described in this chapter is equivalent to the value of the ad-valorem tax.
In other words, the unit tax is equal to the ad-valorem tax multiplied by Ps. Therefore, the
results obtained using the ad-valorem tax are equivalent to the ones obtained using the unit
tax.
5
Exercise 3
3. Consider the utility function l = clog(r
1
) +,log(r
2
) | and budget constraint n| =

1
r
1
+
2
r
2
.
(a) Show that the price elasticity of demand for both commodities is equal to -1.
(b) Setting producer prices at j
1
= j
2
= 1, show that the inverse elasticity rule implies
t
1
t
2
=
q
1
q
2
.
(c) Letting n = 100 and c+, = 1, calculate the tax rates required to achieve revenue
of 1 = 10.
Solution:
(a) The consumers demands is solve
:cr
fa
1
,a
2
,|g
clog(r
1
) +,log(r
2
) |
s.t. n| =
1
r
1
+
2
r
2
or equivalently
:cr
fa
1
,a
2
,|g
clog(r
1
) +,log(r
2
) (
q
1
&
r
1
+
q
2
&
r
2
)
The F.O.C.s are then
c
a
1
=
q
1
&
and
o
a
2
=
q
2
&
Then, the demands are
r
1
=
c&
q
1
and r
2
=
o&
q
2
The elasticity of demand is dened by

o
i
=
oa
i
oq
i
q
i
a
i
Calculating this for good 1 obtains

o
1
=
c&
q
2
1
q
1
(
w
q
1
)
= 1
Calculating this for good 2 obtains

o
2
=
o&
q
2
2
q
2
(
w
q
2
)
= 1
6
(b) The inverse elasticity rule states that
t
i
1+t
i
=
cA
A
1
.
d
i
, i = 1. 2.
Hence
t
1
1+t
1

o
1
=
cA
A
=
t
2
1+t
2

o
2
But
o
i
= 1 and 1 +t
i
=
i
, so
t
1
q
1
=
t
2
q
2
and rearranging we have
t
1
t
2
=
q
1
q
2
.
(c) Revenue is dened by
1 = t
1
r
1
+t
2
r
2
Using the solutions for the demands r
1
=
c&
q
1
and r
2
=
o&
q
2
we have
1 = t
1
(
c&
q
1
) +t
2
(
o&
q
2
)
Using the relation
t
1
t
2
=
q
1
q
2
we just found in part b as t
1
=
q
1
q
2
t
2
1 = (
q
1
q
2
t
2
)(
c&
q
1
) +t
2
(
o&
q
2
) = n[(
q
1
q
2
)(
c
q
1
) +
o
q
2
]t
2
=
&
q
2
(c +,)t
2
Finally, since 1 +t
i
=
i
,c +, = 1, 1 = 10 and n = 100, the optimal tax on good 2 solves
10 =
100
1+t
2
t
2
which has solution t
2
=
1
9
, and hence t
1
=
1
9
.
7
Exercise 4
4. Let the consumer have the utility function l = r
j
1
1
+r
j
2
2
|.
(a) Show that the utility maximizing demands are r
1
=
_
j
1
&
q
1
_
1[1j
1
]
and r
2
=
_
j
2
&
q
2
_
1[1j
2
]
.
(b) Letting j
1
= j
2
= 1, use the inverse elasticity rule to show that the optimal tax
rates are related by
1
t
2
=
_
j
2
j
1
1j
2
_
+
_
1j
1
1j
2
_
1
t
1
.
(c) Setting n = 100, j
1
= 0.75, j
2
= 0.5, nd the tax rates required to achieve
revenue of 1 = 10 and 1 = 300.
(d) Calculate the proportional reduction in demand for the two goods comparing the
no-tax position with the position after introduction of the optimal taxes for both
revenue levels. Comment on the results.
Solution:
(a) If the consumer maximization problem is :cr l = r
j
1
1
+r
j
2
2
| s.t.
1
r
1
+
2
r
2
= n|
Thus we can rewrite the budget constraint | =
q
1
a
1
+q
2
a
2
&
and we can replace into the utility
function for an unconstrained optimization problem as:
:cr l = r
j
1
1
+r
j
2
2

q
1
a
1
&

q
2
a
2
&
F.O.C.
0l
0a
i
= j
i
r
j
i
1
i

q
i
&
= 0
j
i
r
j
i
1
i
=
q
i
&
Solving for r
i
we get the utility maximizing demands as required.
r
i
=
_
&j
i
q
i
_ 1
1
i
(b) The rst step is to calculate the price elasticity using the demand function we just found:

o
i
=
1
1j
i
With j
1
= j
2
= 1 the inverse elasticity rule states that (see previous exercise):
t
1
1+t
1

o
1
=
t
2
1+t
2

o
2
or
1+t
2
t
2

o
1
=
1+t
1
t
1

o
2
8
Substituting for the elasticities
1+t
2
t
2
_

1
1j
1
_
=
1+t
1
t
1
_

1
1j
2
_
1
t
2
_
1+t
2
1j
1
_
=
1
t
1
_
1+t
1
1j
2
_
1j
2
t
2
(1 +t
2
) =
1j
1
t
1
(1 +t
1
)
1j
2
t
2
+
1j
2
t
2
t
2
=
1j
1
t
1
+
1j
1
t
1
t
1
1j
2
t
2
=
1j
1
t
1
+
1j
1
t
1
t
1

1j
2
t
2
t
2
1j
2
t
2
=
1j
1
t
1
+ (1 j
1
) (1 j
2
)
nally
1
t
2
=
1j
1
1j
2

1
t
1
+
j
2
j
1
1j
2
or
1
t
2
=
_
j
2
j
1
1j
2
_
+
_
1j
1
1j
2
_
1
t
1
.
(c) Using the parameter values gives
1
t
2
= 0.5 + 0.5
1
t
1
so
t
2
=
2
1
t
1
1
Then, given the revenue constraint
1 = t
1
r
1
+t
2
r
2
but we know the optimal values for the demand and using the fact that 1 +t
i
=
i
, then
1 = t
1
_
&j
1
q
1
_
1(1j
1
)
+t
2
_
&j
2
q
2
_
1(1j
2
)
1 = t
1
_
&j
1
1+t
1
_
1(1j
1
)
+t
2
_
&j
2
1+t
2
_
1(1j
2
)
and t
2
is also known, then
1 = t
1
_
&j
1
1+t
1
_
1(1j
1
)
+
_
2
1
t
1
1
_
_
_
_
&j
2
1+

2
1
t
1
1
!
_
_
_
1(1j
2
)
9
Replacing the values of the parameters
1 = t
1
_
75
1+t
1
_
4
+
_
2
1
t
1
1
_
_
_
_
25
1+

2
1
t
1
1
!
_
_
_
2
The revenue curve has a maximum level of revenue around t
1
= 0.4, this is known as Laer
property. For 1 = 10 the solution is t
1
= 0.0031 and t
2
= 0.0062. In the case 1 = 300 the
solution is t
1
= 0.1814 and t
2
= 0.4431.
(d) The proportional reduction in demand for the two goods comparing the no-tax position
with the position after introduction of the optimal taxes for both revenue levels is in the
next table.
1 r
1
% r
2
%
0 3. 164 25
10 3. 125 1.23 24.69 1.24
300 1. 624 48.67 12.00 52.00
As we can see, the optimal taxes do reduce demand in approximately the same proportion
for both commodities. In this case the interpretation of the Ramsey rule is applicable even
when the tax intervention has a signicant eect on the level of demand.
Exercise 5
5. (Ramsey rule) Consider a three-good economy (/ = 1. 2. 3) in which every consumer
has preferences represented by the utility function l = r
1
+ q(r
2
) + /(r
3
), where the
functions q() and /() are increasing and strictly concave. Suppose that each good
is produced with constant returns to scale from good 1, using one unit of good 1 per
unit of good / 6= 1. Let good 1 be the numeraire and normalize the price of good 1 to
equal 1. Let t
I
denote the (specic) commodity tax on good / so the consumer price
is
I
= (1 +t
I
).
(a) Consider two commodity tax schemes t = (t
1
. t
2
. t
3
) and t = (t
0
1
. t
0
2
. t
0
3
). Show
that if (1 +t
0
I
) = c(1 +t
I
) for / = 1. 2. 3 for some scalar c 0, then the two tax
schemes raise the same amount of tax revenue.
(b) Argue from part a that the government can without cost restrict tax schemes to
leave one good untaxed.
(c) Set t
1
= 0, and suppose that the government must raise revenue of R. What are
the tax rates on goods 2 and 3 that minimize the welfare loss from taxation?
(d) Show that the optimal tax rates are inversely proportional to the elasticity of the
demand for each good. Discuss this tax rule.
(e) When should both goods be taxed equally? Which good should be taxed more?
Solution:
10
(a) The budget constraint for the consumer with tax scheme t = (t
1
. t
2
. t
3
) is:
(1 +t
1
)r
1
+ (1 +t
2
)r
2
+ (1 +t
3
)r
3
= 0
Hence tax revenue 1 is:
1 t
1
r
1
+t
2
r
2
+t
3
r
3
= (r
1
+r
2
+r
3
)
Similar reasoning shows that with tax scheme t
0
= (t
0
1
. t
0
2
. t
0
3
) the tax revenue 1
0
is:
1
0
t
0
1
r
0
1
+t
0
2
r
0
2
+t
0
3
r
0
3
= (r
0
1
+r
0
2
+r
0
3
)
But the demand for each commodity is homogeneous of degree zero so that
r
i
= r
i
(1 +t
1
. 1 +t
2
. 1 +t
3
)
r
i
= r
i
(c(1 +t
1
). c(1 +t
2
). c(1 +t
3
))
r
i
= r
i
(1 +t
0
1
. 1 +t
0
2
. 1 +t
0
3
) = r
0
i
Therefore
(r
1
+r
2
+r
3
) = (r
0
1
+r
0
2
+r
0
3
)
and 1 = 1
0
.
(b) The value for c can be chosen arbitrarily. In particular, a tax system with a tax t
I
on
good / can be shown to be equivalent to one with no tax on good / by choosing
c =
1
1+t
k
(c) The optimization decision for the consumer is
:cr
fa
1
,a
2
,a
3
g
l = r
1
+q(r
2
) +/(r
3
)
s.t. r
1
+ (1 +t
2
)r
2
+ (1 +t
3
)r
3
= 0
Substituting the constraint into the objective function for r
1
reduce the F.O.C. to
q
0
(r
2
) (1 +t
2
) = 0 and /
0
(r
3
) (1 +t
3
) = 0
11
These necessary conditions result in demand functions r
2
= r
2
(1 + t
2
) and r
3
= r
3
(1 + t
3
)
so
r
1
= (1 +t
2
)r
2
(1 +t
3
)r
3
.
The optimization of the government can now be written as
:cr
ft
2
,t
3
g
l = (1 +t
2
)r
2
(1 +t
3
)r
3
+q(r
2
) +/(r
3
)
s.t. 1 = t
2
r
2
+t
3
r
3
where r
2
and r
3
are, in their turn, functions of (1 +t
2
) and (1 +t
3
) respectively.
The solution to this problem provides the tax rates that minimize welfare loss. The necessary
conditions are:
q
0
r
0
2
r
2
(1 +t
2
)r
0
2
`(r
2
+t
2
r
0
2
) = 0
/
0
r
0
3
r
3
(1 +t
3
)r
0
3
`(r
3
+t
3
r
0
3
) = 0.
From the consumers choice problem q
0
= 1 + t
2
and /
0
= 1 + t
3
. These allow the implicit
solutions
t
2
=
a
2
a
0
2
1+A
A
and t
3
=
a
3
a
0
3
1+A
A
(d) The elasticity of demand for good / is dened as

o
I
=
(1+t
k
)a
0
k
a
k
by this denition,
t
2
1+t
2
=
1
.
d
2
1+A
A
and
t
3
1+t
3
=
1
.
d
3
1+A
A
.
The tax rate on good / is therefore inversely proportional to the elasticity of demand for
that good. Setting the relative taxes in this way minimizes the excess burden resulting from
the need to raise the revenue 1.
(e) This tax rule implies that the good with the lower elasticity of demand should have
higher tax rate. The two goods should be taxed at the same rate only if they have the same
elasticity of demand.
12
Micro Theory I
Recitation #8 - Uncertainty-I
Exercise 1
1. Exercise 6.B.2, MWG: Show that if the preference relation % on / is represented
by a utility function l () that has the expected utility form, then % satises the
independence axiom.
Assume that the preference relation % is represented by an .` ` expected
utility function l (1) =

n
n
n
j
n
for every 1 = (j
1
. .... j
N
) /. Let
1 = (j
1
. .... j
N
) /. 1
0
=
_
j
0
1
. .... j
0
N
_
/. 1
00
=
_
j
00
1
. .... j
00
N
_
/,
and c (0. 1). Then 1 % 1
0
if and only if

n
n
n
j
n
_

n
n
n
j
0
n
. This inequality
is equivalent to
c
_

n
n
n
j
n
_
+ (1 c)
_

n
n
n
j
00
n
_
_ c
_

n
n
n
j
0
n
_
+ (1 c)
_

n
n
n
j
00
n
_
.
This latter inequality holds if and only if
c1 + (1 c) 1
00
% c1
0
+ (1 c) 1
00
.
Hence 1 % 1
0
if and only if
c1 + (1 c) 1
00
% c1
0
+ (1 c) 1
00
.
Thus the independence axiom holds.
Exercise 2
2. Exercise 6.B.5, MWG: The purpose of this exercise is to show that the Allais
paradox is compatible with a weaker version of the independence axiom. We consider
the following axiom, known as the betweenness axiom [see Dekel (1986)]:
For all 1. 1
0
and c (0. 1) . if 1 ~ 1
0
, then c1 + (1 c) 1
0
~ 1.
Suppose that there are three possible outcomes.
a. Show that a preference relation on lotteries satisfying the independence axiom also
satises the betweenness axiom.
1
Answer: This follows from Exercise 6.B.1 (in your homework assignment). Fol-
lowing the independence axiom we can state that
if 1 ~ 1
0
then (1 c)1 +c1
. .
L
~ c1 + (1 c)1
0
Thus 1 ~ c1+(1 c)1
0
. This means that if the preference relation satises the
independence axiom it then also satises the betweenness axiom.
b. Using a simplex representation for lotteries similar to the one in Figure 6.B.1, show
that if the continuity and betweenness axioms are satised, then the indierence curves
of a preference relation on lotteries are straight lines. Conversely, show that if the
indierence curves are straight lines, then the betweenness axiom is satised. Do these
straight lines need to be parallel?
Answer: Indierence courves are straight lines if for every pair of lotteries 1,
1
0
, we have that 1 ~ 1
0
implies c1 + (1 c)1
0
~ 1 for all c (0. 1). That is, if
decision maker is indiferent between the compond lottery c1+(1c)1
0
(the linear
combination of two simple lotteries) and either of the simple lotteries 1 or 1
0
that
generated such compound lottery. (See gure representing the betweenness axiom
at the end of the handout). The independence axiom guarantees that indierence
curves over lotteries must be not only straight lines but also parallel (See gure
representing the independence axiom at the end of the handout).
c. Using (b), show that the betweenness axiom is weaker (less restrictive) than the inde-
pendence axiom.
Answer: Any preference represented by straight, but not parallel indierence
curves, satises the betweenness axiom but does not satisfy the independence
axiom. Hence the betweenness axiom is weaker than the independence axiom.
In other words, the IA == BA, but IA:BA. (See gure 3 at the end of the
handout, illustrating an example of indierence curves that satisfy the BA but do
not satisfy the IA).
Exercise 3
3. Suppose that all individuals have a Bernoulli utility function n(r) =
_
r.
a. Calculate the Arrow-Prat coecients of absolute and relative risk aversion at the level
of wealth n = 5.
n(r) =
_
r = r
1
2
n
0
(r) =
1
2
r

1
2
=
1
2
_
r
n
00
(r) =
_

1
2
__
1
2
_
r

3
2
=
1
4
r

3
2
2
Arrow-Pratt coecient of absolute risk aversion:
:
A
(r) =
n
00
(r)
n
0
(r)
=

1
4
r

3
2
1
2
r

1
2
=
1
2
r
(
3
2
(
1
2
))
=
=
1
2
r

3
2
+
1
2
=
1
2
r
1
=
1
2r
when r = 5
:
A
(5) =
1
2 5
=
1
10
= 0.1
Arrow-Pratt coecient of relative risk aversion:
:
R
(r. n) = r
n
00
(r)
n
0
(r)
= r :
A
(r) =
= r
1
2r
=
1
2
= 0.5
regardless of the specic value of r (but this is just for this case).
b. Calculate the certainty equivalent and the Probability Premium for a gamble
_
16. 4;
1
2
.
1
2
_
n(r) =
_
r
n() =
_
16
1
2
+
_
4
1
2
= 4
1
2
+ 2
1
2
= 2 + 1 = 3
n() = 3 == r = 9
c (1. n) = 9 Certainty Equivalent
_
1
2
+:
_
n(r +) +
_
1
2
:
_
n(r ) = n(r)
_
1
2
+:
_
_
16
..
utility derived from the prize 16.
+
_
1
2
:
_
_
4 =
_
10
..
u(EV )
since 1\ =
1
2
16 +
1
2
4 =
1
2
(16 + 4) =
1
2
20 = 10
_
16
2
+
_
16: +
_
4
2

_
4: =
_
10
_
_
16
_
4
_
: =
_
10
_
16
2

_
4
2
2: =
_
10 3
: =
_
10 3
2
Probability Premium
3
Calculate the Certainty Equivalent and the Probability Premiumfor the gamble
_
36. 16;
1
2
.
1
2
_
.
Compare this result with the one in part (b) and interpret.
n(r) =
_
r
n() =
_
36
1
2
+
_
16
1
2
= 6
1
2
+ 4
1
2
= 3 + 2 = 5
n() = 5 == r = 25
c (1. n) = 25 Certainty Equivalent
_
1
2
+:
_
n(r +) +
_
1
2
:
_
n(r ) = n(r)
_
1
2
+:
_
_
36 +
_
1
2
:
_
_
16 =
_
26
..
u(EV )
since 1\ =
1
2
36 +
1
2
16 =
36 + 16
2
=
52
2
= 26
1
2
_
36 +
_
36: +
1
2
_
16
_
16: =
_
26
_
_
36
_
16
_
: =
_
26
_
36
2

_
16
2
(6 4) : =
_
26
6
2

4
2
2: =
_
26 5
: =
_
26 5
2
Probability Premium
The dierence between the mean and the c (1. n) is equal to 1 for both of them.
However, the rst lottery has a higher : (r. . n) where :
R
(r. n) is constant in n and
:
A
(r. n) is decreasing in n.
Exercise 4
4. A security agency with vNM utility function n evaluates two disaster plans for the
evacuation of an area prone to ooding. The probability of ooding is 1%. There are
four possible outcomes:
_

_
c
1
: no evacuation, no ooding,
c
2
: no evacuation, but ooding,
c
3
: evacuation, no ooding,
c
4
: evacuation, ooding.
The agency is indierent between the sure outcome c
3
and the lottery of c
1
with
probability j (0. 1) and c
2
with probability 1 j and between the sure outcome c
4
4
and the lottery of c
1
with probability (0. 1) and c
2
with probability 1. Further,
n(c
1
) = 1 and n(c
2
) = 0. Moreover,
c
3
~ (c
1
. c
2
; j. 1 j)
c
4
~ (c
1
. c
2
; . 1 )
n(c
1
) = 1. n(c
2
) = 0
a. Express n(c
3
) and n(c
4
) in terms of j and .
Answer: Given % on / can be represented by a utility function n()
n(c
3
) = jn (c
1
) + (1 j) n(c
2
) = j
n(c
4
) = n(c
1
) + (1 ) n(c
2
) =
The two disaster plans are summarized as follows:
Plan 1: results in an evacuation in 90% of the cases where a ooding does occur and
in 10% of the cases where no ooding occurs.
Plan 2: results in an evacuation in 95% of the cases where a ooding does occur and
in 15% of the cases where no ooding occurs.
b. For each of these two plans, compute the probability distribution over the four outcomes
c
1
. c
2
. c
3
. c
4
.
Insert Figure here (to be discussed during the Review Session)
c. Compute the expected utility of each of the two plans. When is plan 1 strictly preferred
over plan 2?
Answer:
n(c
1
) = 1
n(c
2
) = 0
n(c
3
) = j
n(c
4
) =

n(1|c:
1
) = 0.891 n(c
1
) + 0.001 n(c
2
) + 0.099 n(c
3
) + 0.009 n(c
4
)
= 0.891 + 0.099j + 0.009
n(1|c:
2
) = 0.8415 n(c
1
) + 0.0005 n(c
2
) + 0.1485 n(c
3
) + 0.00954 n(c
4
)
= 0.8415 + 0.1485j + 0.0095
Hence, Plan 1 is strictly preferred to Plan 2 if and only if
n(1|c:
1
) n (1|c:
2
)
5
== 0.891 + 0.099j + 0.009 0.8415 + 0.1485j + 0.0095
== 0.0495j + 0.0005 < 0.0495
== < 99 (1 j)
But given that (0. 1) . this condition can always be satised when,
1 < 99 (1 j) ==
98
99
j
i.e., for almost all possible values of j, Plan 1 will always be strictly preferred to Plan 2.
Exercise 5
5. Assume there is an apartment complex with 10 units, each of the houses has a market
value of \$100.000. Each of the neighbors that lives in this houses has a total wealth of
\$200.000 dollars. Assume that a piromaniac is surrounding the area and is intending
to burn just one of the houses. The neighbors are trying to set a private security found,
in which each of them will deposit \$10.000. All of the money collected in the found
will be given to the neighbor that will suer the lost. If you were one of the neighbors
and your utility function is a Bernulli type such as:
n(r) =
_
r
Will you take the insurance?
Answer: We can start calculating the expected wealth in the case the neighbor takes the
insurance and in the case he doesnt.
In the case he does not take the insurance, the neighbor is subject to a lottery where
r
0
represents the real part of the wealth:
GRAPH 1
In the linear form we can express: r
F
=
_
9
10
; 300.000; 200.000
_
The expected value of wealth is: r = 1(r
F
) =
_
9
10
_
+ 300.000 +
_
1
10
_
+ 200.000 = 290.000
In the case he pays the insurance, the neighbor is subject to a lottery where r
0
repres-
ents the real part of the wealth:
GRAPH 2
6
In the linear form we can express: r
0
F
=
_
9
10
; 290.000; 290.000
_
The expected value of wealth is in this case: r
0
= 1(r
0
F
) =
_
9
10
_
+ 290.000 +
_
1
10
_
+ 290.000 =
290.000
In both states of nature the payment of \$10.000 dollars is satised, but in the case when the
house is burned the amount received is \$100.000.
Note that, in the case where the neighbor takes the insurance, the wealth is no longer random,
since in both states of the nature the total wealth is \$290.000. Evidently, there is no variance
in this measure.
To nd the most convenient option for the neighbor, lets calculate the certain equivalence
in both cases:
No-insurance:
_
c(1. n(r
F
)) = 0. 9 +
_
300.000 + 0. 1 +
_
200.000 = 17.00267
This is:
c(1. n(r
F
)) = (17.00267)
2
= 289.090. 81
Insurance:
_
c(1. n(r
0
F
)) = 0. 9 +
_
290.000 + 0. 1 +
_
290.000 = 17.02939
This is:
c(1. n(r
0
F
)) = (17.02939)
2
= 290.000
Then, insurance is the best option.
7
Micro Theory I
Recitation #9 - Monopoly
Exercise 1
A monopolist faces a market demand curve given by: Q = 70 p.
(a) If the monopolist can produce at constant average and marginal costs of AC = MC = 6,
what output level will the monopolist choose in order to maximize prots? What is the price
at this output level? What are the monopolists prots?
(b) Assume instead that the monopolist has a cost structure where the total costs are de-
scribed by:
C(Q) = 0:25Q
2
5Q+ 300
With the monopolist facing the same market demand and marginal revenue, what price-
quantity combination will be chosen now to maximize prots? What will prots be?
(c) Assume now that a third cost structure explains the monopolists position, with total
costs given by:
C(Q) = 0:0133Q
3
5Q+ 250
Again, calculate the monopolists price-quantity combination that maximizes prots. What
will prot be? Hint: Set MC = MR as usual and use the quadratic formula to solve the
second order equation for Q.
(d) Graph the market demand curve, the MR curve, and the three marginal cost curves from
parts a, b and c. Notice that the monopolists prot-making ability is constrained by (1) the
demand curve (along with its associated MR curve) and (2) the cost structure underlying
production.
Solution:
(a) We have that the demand is given by Q = 70 p or p = 70 Q thus the total revenue is
TR = p Q = (70 Q)Q, then the marginal revenue for the monopolist is MR = 70 2Q.
We know that the monopolist prot maximization condition is MR = MC and by the
information we know that MC = 6 then we can set 70 2Q = 6 and solving for the
quantities we have that Q = 32, P = 38 and = (p MC)Q = (38 6)32 = 1024.
(b) If the total costs are described by C(Q) = 0:25Q
2
5Q + 300 then the marginal costs
are MC = 0:5Q 5. Thus, equalizing again MR = MC we have that 70 2Q = 0:5Q 5.
In this case Q = 30, P = 40 and = pQTC = (40 30) (0:25(30)
2
5(30) +300) = 825.
As we can see, the change in the costs structure reduces the total production, increases the
price and reduce the prots of the rm.
(c) If the total costs are described by C(Q) = 0:0133Q
3
5Q+ 250 then the marginal costs
are MC = 0:0399Q
2
5. Thus, equalizing again MR = MC we have that 70 2Q =
1
0:0399Q
2
5. In this case the positive solution of the quadratic equation is Q = 25, P = 45
and = pQ TC = (45 25) (0:0133(25)
3
5(25) + 250) = 792:2. The new change in
the costs structure reduces the total production, increases the price and reduce the prots
of the rm.
Exercise 2
Suppose a government wishes to combat the undesirable allocational eects of a monopoly
through the use of a subsidy.
(a) Why would a lump-sum subsidy not achieve the governments goal?
(b) Use a graphical proof to show how a per-unit-of-output subsidy might achieve the gov-
ernments goal.
(c) Suppose the government wants its subsidy to maximize the dierence between the total
value of the good to consumers and the goods total cost. Show that, in order to achieve
this goal, the government should set:
t
P
=
1
e
Q; P
,
where t is the per-unit subsidy and P is the competitive price. Explain your result intuitively.
Solution:
(a) The government wishes the monopoly to expand output toward P = MC. A lump-sum
subsidy (T) will have no eect on the monopolists prot maximizing choice, so this will not
achieve the goal. If the monopoly maximizes = pQTC+T then the prot maximization
condition is MR = MC.
(b) A subsidy per unit of output (t) will eectively shift the MC curve downward. If the
monopoly maximizes = p Q (TC t Q) then the prot maximization condition is
MR = MC t, thus if the marginal cost curve shifts to the right (or downward if the
monopoly has constant marginal costs), then the monopoly will produce more units at a
lower price.
(c) A subsidy (t) must be chosen so that the monopoly chooses the socially optimal quantity,
given t. Since the social optimality requires P = MC and prot maximization requires that
MR = MC t = P

1 +
1
e

, substitution yields P t = P

1 +
1
e

thus 1
t
P
= 1 +
1
e
and
t
P
=
1
e
as was to be shown.
Intuitively, the monopoly creates a gap between price and marginal cost and the optimal
subsidy is chosen to equal that gap expressed as a ratio to price.
2
Exercise 3
The taxation of monopoly can sometimes produce results dierent from those that arise in
the competitive case. This problem looks at some of those cases. Most of these can be
analyzed by using the inverse elasticity rule.
(a) Consider rst an ad valorem tax on the price of a monopolys good. This tax reduces
the net price received by the monopoly from P to P(1 t) where t is the proportional tax
rate. Show that, with a linear demand curve and constant marginal cost, the imposition of
such a tax causes price to rise by less than the full excent of the tax.
(b) Suppose that the demand curve in part a were a constant elasticity curve. Show that
the price would now increase by precisely the full extent of the tax. Explain the dierence
between these two cases.
(c) Describe a case where the imposition of an ad valorem tax on a monopoly would cause
the price to rise by more than the tax.
(d) A specic tax is a xed amount per unit of output. If the tax rate is per unit, total
tax collections are Q. Show that the imposition of a specic tax on a monopoly will reduce
output more (and increase price more) than will the imposition of an ad valorem tax that
collects the same tax revenue.
Solution:
(a) Recall that the Inverse Elasticity Rule is P =
MC
1+
1
e
when the monopoly is subject to an
ad valorem tax of t, this becomes P =
MC
(1t)

1
1+
1
e
.
With linear demand, e falls (becomes more elastic) as prices rises. Hence,
P
aftertax
=
MC
(1t)

1
1+
1
e
aftertax
<
MC
(1t)

1
1+
1
e
pretax
=
Ppretax
(1t)
(b) With constant elasticity demand e
aftertax
= e
pretax
, thus the inequality in part a becomes
an equality so P
aftertax
=
Ppretax
(1t)
.
(c) If the monopoly operates on a negatively sloped portion of its marginal cost curve we
have (in the constant elasticity case)
P
aftertax
=
MC
aftertax
(1t)

1
1+
1
e
>
MCpretax
(1t)

1
1+
1
e
=
Ppretax
(1t)
(d) The key part of this question is the requirement of equal tax revenues. That is tP
a
Q
a
=
Q
s
where the subscripts refer to the monopolys choices under the two tax regimes. Suppose
that the tax rates were chosen so as to raise the same revenue for a given output level, say Q.
Then = tP
a
hence > tMR
a
. But in general under an ad valorem tax MR
a
= (1t)MR =
MRtMR whereas under a specic tax, MR
s
= MR. Hence, for a given Q, the specic
tax that raises the same revenue reduces MR by more than does the ad valorem tax. With
an upward sloping MC, less would be produced under the specic tax, thereby dictating an
even higher tax rate. In all, a lower output would be produced, at a higher price than under
the ad valorem tax. Under perfect competition, the two equal-revenue taxes would have
equivalent eects.
3
Exercise 4
Consider the market for the G-Jeans (the latest fashion among people in their late thirties).
G-Jeans are sold by a single rm that carries the patent for the design. On the demand
side, there are n
H
= 200 high-income consumers who are willing to pay a maximum amount
of V
H
= \$20 for a pair of G-Jeans, and n
L
= 300 low-income consumers who are willing to
pay a maximum amount of V
L
= \$10 for a pair of G-Jeans. Each consumer chooses whether
to buy one pair of jeans or not to buy at all.
(a) Draw the market aggregate-demand curve facing the monopoly.
The aggregate demand curve should be drawn according to the following formula:
Q(p) =
8
<
:
0 if p > \$20
200 if \$10 < p \$20
200 + 300 if p \$10.
(b) The monopoly can produce each unit at a cost of c = \$5. Suppose that the G-
Jeans monopoly cannot price discriminate and is therefore constrained to set a uniform
market price. Find the prot-maximizing price set by G-Jeans, and the prot earned
by this monopoly.
Setting a high price, p = \$20 generates Q = 200 consumers and a prot of
H
=
(20 5) 200 = \$3000:
Setting a low price, p = \$10 generates Q = 200 + 300 consumers and a prot of

H
= (10 5) 500 = \$2500 < \$3000. Hence, p = \$20 is the prot-maximizing
price. Type L consumers will not buy under these prices.
(c) Compute the prot level made by this monopoly assuming now that this monopoly
can price discriminate between the two consumer populations. Does the monopoly
benet from price discrimination. Prove your result!
The monopoly will change p = \$20 in market H and p = \$10 in market L: Hence,
total prot is given by
=
H
+
L
= (20 5) 200 + (10 5) 300 = 3000 + 1500 = \$4500 > \$3000.
Clearly, the ability to price discriminate cannot reduce the monopoly prot since
even with this ability, the monopoly can always set equal prices in both mar-
kets. The fact that the monopoly chooses dierent prices implies that prot
can only increase beyond the prot earned when the monopoly is unable to price
discriminate.
4
Exercise 5
The demand function for concert tickets to be played by the Pittsburgh symphony orchestra
varies between nonstudents (N) and students (S). Formally, the two demand functions of
the two consumer groups are given by
q
N
= 240
1
p
2
N
and q
S
= 540
1
p
3
S
.
Assume that the orchestras total cost function is C (Q) = 2Q where Q = q
N
+q
S
is to total
number of tickets sold. Compute the concert ticket prices set by this monopoly orchestra,
and the resulting ticket sales, assuming that the orchestra can price discriminate between
the two consumer groups.
The demand price elasticity is 2 in the nonstudents market, and 3 in the students
market. In the nonstudents market, the monopoly sets p
N
to solve
p
N

1 +
1
2

= \$2 yielding p
N
= \$4 and hence q
N
=
240
4
2
= 15.
In the students market, the monopoly sets p
S
to solve
p
S

1 +
1
3

= \$2 yielding p
S
= \$3 and hence q
S
=
540
3
3
= 20.
5
Micro Theory I
Recitation #10 - Externalities
Exercise 1
If the two consumers in the economy have preferences l
1
= [r
1
1
r
1
2
]

[r
2
1
r
2
2
]
1
and l
2
=
[r
2
1
r
2
2
]

[r
1
1
r
1
2
]
1
, show that the equilibrium is ecient despite the externality. Explain this
conclusion.
Solution:
The marginal utility of good 1 for consumer 1 is:
@U
1
@x
1
1
= c[r
1
1
r
1
2
]
1
(r
1
2
)[r
2
1
r
2
2
]
1
= c
[x
1
1
x
1
2
]

[x
2
1
x
2
2
]
1
x
1
1
and the marginal utility of good 2 is:
@U
1
@x
2
1
= (1 c)[r
1
1
r
1
2
]

[r
2
1
r
2
2
]

(r
2
2
) = (1 c)
[x
1
1
x
1
2
]

[x
2
1
x
2
2
]
1
x
2
1
.
From these the marginal rate of substitution for consumer 1 can be calculated as:
`1o
1
1;2
=
_

1

x
2
1
x
1
1
Similar calculations for consumer 2 give
`1o
2
1;2
=
_

1

x
1
2
x
2
2
Notice that each of the marginal rates of substitution is independent of the externality eect.
Each consumer equates his or her `1o to the price ratio that ensures that the marginal
rates of substitution are equal. Therefore the externality does not aect the fact that the
equilibrium is ecient.
This conclusion holds because the externality does not aect the proportions in which the
two consumers purchase the goods. (Observe that the externality eect can be factored out
of the utility functions as a constant.) The same equilibrium is reached with the externality
as it is without. Such externalities are called Pareto irrelevant.
1
Exercise 2
There is a large number of commuters who decide to use either their car or the tube. Com-
muting by train takes 70 minutes whatever the number of commuters taking the train.
Commuting by car takes C(r) = 20 + 60r minutes, where r is the proportion of commuters
taking their car, 0 r 1.
(a) Plot the curves of the commuting time by car and the commuting time by train as a
function of the proportion of cars users.
(b) What is the proportion of commuters who will take their car if everyone is taking her
decision freely and independently so as to minimize her oun commuting time?
(c) What is the proportion of car users that minimizes the total commuting time?
(d) Compare this with your answer given in part b. Interpret the dierence. How large is
the deadweight loss from the externality?
(e) Explain how a toll could achieve the ecient allocation of commuters between train and
car and the benecial for everyone.
Solution:
(a) The commuting times are shown in the gure. The time by tube is constant, but the time
taken by car increases as car use increases. Every travellers decision d(r) can be expressed
as
d(r) =
_
car if C(r) 70, or
tube if C(r) 70
(b) The proportion of car users , if independent choices are made, will be such thet the times
of travel by tube and by car are equated.
Thus, 70 = 20 + 60r
m
solving for r
m
gives r
m
= 5,6 = 0.833. This solution corresponds to
the intersection point of the two commuting time courves.
(c) The total commuting time is (20 + 60r)r + 70(1 r), where r is the proportion of car
users. Setting the derivative with respect to r equal to zero gives: 20 + 120r 70 = 0 or
120r
o
50 = 0 thus r
o
= 5,12 = 0.416 is the time-minimizing car use.
(d) The free-market outcome for the proportion of car users is greater than the socially
optimal outcome because the individual commuters do not take into account the negative
externality generated by car travel, meaning the trac congestion. The deadweight loss
from the externality is the dierence between the total commuting times. Using the earlier
results obtains
1
m
=
_
20 + 60
_
5
6
___
5
6
_
. .
car
+ 70
_
1
6
_
. .
tube
=
420
6
= 70
and
1
o
=
_
20 + 60
_
5
12
___
5
12
_
. .
car
+ 70
_
7
12
_
. .
tube
=
715
12
= 59.58
2
The dierence is 1
m
1
o
= 70 59.58 = 10.41.
(e) Suppose that the commuters attach monetary value to their travel time. It takes 45
minutes per car user, and 70 per train user. Then a toll may induce car users to switch
from car to tube if the amount of the toll exceeds the benets of shorter travel time. Given
information on the monetary value of travel time, the amount of the toll can be computed
so that the proportion of commuters that still nd it benecial to travel by car is exactly
equal to the socially optimal level.
Exercise 3
On the island of Pago Pago there are two lakes and 20 anglers. Each angler can sh on either
lake and keep the average catch on his particular lake. On lake A, the total number of sh
caught is given by
1
x
= 10|
x

1
2
|
2
x
where |
x
is the number of people shing on the lake. For lake the relationship is
1
y
= 5|
y
(a) Under this organization of society, what will be the total number of sh caught?
(b) The chief of Pago Pago, having once read an economics book, believes it is posible to
raise the total number of sh caught by restricting the number of people allowed to sh on
lake A. What number should be allowed to sh on lake r in order to maximize the total
catch of sh? What is the number of sh caught in this situation?
(c) Being opposed to coercion, the chief decides to require a shing license for lake r. If the
licensing procedure is to bring about the optimal allocation of labor, what should the cost
of a license be (in terms of sh)?
(d) Explain how this example sheds light on the connection between property rights and
externalities.
Solution:
(a) 1
x
= 10|
x
0.5|
2
x
and 1
y
= 5|
y
First, show how total catch depends on the allocation of labor.
|
x
+|
y
= 20 thus |
y
= 20 |
x
1
T
= 1
x
+1
y
1
T
= (10|
x
0.5|
2
x
) + (5|
y
) = (10|
x
0.5|
2
x
) + (5 (20 |
x
))
1
T
= 5|
x
0.5|
2
x
+ 100
Equating the average catch on each lake gives
3
F
x
lx
=
F
y
ly
10 0.5|
x
= 5
then |
x
= 10 and |
y
= 10
and
1
T
= 5(10) 0.5(10)
2
+ 100
1
T
= 100
(b) The problem is to :cr 1
T
= 5|
x
0.5|
2
x
+ 100
thus the FOC wrt |
x
is
dF
T
dlx
= 5 |
x
= 0 then |
x
= 5, |
y
= 15 and then 1
T
= 112.5
(c) 1
x
case 1
= 10(10) 0.5(10)
2
= 50 average catch is 1
x
case 1
= 50,10 = 5
1
x
case 2
= 10(5) 0.5(5)
2
= 37.5 average catch is 1
x
case 2
= 37.5,5 = 7.5
thus the license fee on lake A should be equal to 2.5.
(d) The arrival of a new sher on lake A imposes an externality on the shers already there
in terms of a reduced average catch. Lake A is treated as a common property here. If the
lake were private property, its owner would choose |
x
to maximize the total catch less the
opportunity cost of each sher (the 5 sh he can catch on lake 1 ). So the problem is to
maximize 1
x
5|
x
which yields |
x
= 5 as in the optimal allocation case.
Exercise 4
Suppose the oil industry in Utopia is perfectly competitive and that all rms draw oil from
a single (and practically inexhaustable) pool. Assume that each competitor belives that it
can sell all the oil it can produce at a stable world price of \$10 per barrel and that the cost
of operating a well for one year is \$1,000. Total output per year (Q) of the oil eld is a
function of the number of wells (:) operating in the eld. In particular,
Q = 500: :
2
and the amount of oil produced by each well () is given by:
=
Q
n
= 500 :.
(a) Describe the equilibrium output and the equilibrium number of wells in this perfectly
competitive case. Is there a divergence between private and social marginal cost in the
industry?
(b) Suppose now that the government nationalizes the oil eld. How many oil wells should
it operate? What will total output be? What will the output per well be?
(c) As an alternative to nationalization, the Utopian gevernment is considering an annual
license fee per well to discourage overdrilling. How large should this license fee be if it is to
prompt the industry to drill the optimal number of wells?
4
Solution:
(a) Every rm increases until : = j 1000 = 0. That is, j(500 :) 1000 = 0, implying
: = 400.
In addition, note that revenue per well is
revenue
well
= 500010:, which declines in the number
of wells being drilled. There is hence an externality here because drilling another well reduces
output in all other wells.
(b) The social planner chooses the number of rms : in order to maximize aggregate prots
max
n
jQ1000: = 5000: 10:
2
1000:
Taking FOCs with respect to :, we obtain
5000 20: 1000 = 0
solving for :, : = 200. Hence, total output is Q = 200 (500 200) = 60. 000. So individual
production is = 300.
Alternatively, the social planner chooses Q where `\ 1 = `C of well. Total value:
5000: 10:
2
. `\ 1 = 5000 20: = 1000. Thus : = 200.
(c) Let tcr = r. Want
revenue
well
r = 1000 when : = 200. At : = 200 the average
revenue
well
= 3000.
So, charge r = 2000.
5

FIGURE EXERCISE 2

Commuting cost (in minutes):
1. Cost of commuting by train = 70 (flat horizontal line)
2. Cost of commuting by car = 20+60x (positively sloped line)

Micro Theory I
Recitation #12 - Public Goods
Exercise 1
[1.] Take an economy with 2 consumers, 1 private good, and 1 public good. Let each
consumer have an income of `. The prices of public and private good are both 1. Let the
consumers have a utility functions:
l

= |oq(r

) + |oq(G) and l
1
= |oq(r
1
) + |oq(G)
(a) Assume that the public good is privately provided, so G = q

+q
1
. Eliminating r

from
the utility function using the budget constraint, show that along an indierence curve:
dq

_
1
j
A
+j
B

1
Aj
A
_
+ dq
1
_
1
j
A
+j
B
_
= 0
and hence that:
oj
B
oj
A
=
j
A
+j
B
Aj
A
1
Solve the last equation to nd the locus of points along which the indierence curve of A is
horizontal and use this to sketch the indierence curves of A.
(b) Consider A choosing q

## to maximize utility. Show that the optimal choice satises:

q

=
A
2

j
B
2
(c) Repeat part (b) for consumer B, and calculate the level of private provision for the welfare
function \ = l

+ l
1
. Contrast this with the private provision level.
Solution:
(a) The utility of consumer A is given by l

= |oq(r

## ) + |oq(G), which can be written as

l

= |oq(` q

) + |oq(q

+ q
1
). Totally dierentiating gives:
dl

=
_

1
Aj
A
+
1
j
A
+j
B
_
dq

+
_
1
j
A
+j
B
_
dq
1
we know that along the indierence curve the chance in utility is zero, then, dl

= 0, thus:
_
1
j
A
+j
B

1
Aj
A
_
dq

+
_
1
j
A
+j
B
_
dq
1
= 0
(First result)
1
_
1
j
A
+j
B
_
dq
1
=
_
1
j
A
+j
B

1
Aj
A
_
dq

oj
B
oj
A
=

1
g
A
+g
B

1
Mg
A

1
g
A
+g
B

=
j
A
+j
B
Aj
A
1
oj
B
oj
A
=
j
A
+j
B
Aj
A
1
(Second result)
The indierence curve of A is horizontal when
oj
B
oj
A
= 0. Hence the locus of points where the
indierence curves of A are horizontal is the solution to:
0 =
j
A
+j
B
Aj
A
1 or
j
A
+j
B
Aj
A
= 1
q

+ q
1
= ` q

2q

= ` q
1
q

=
Aj
B
2
=
A
2

j
B
2
GRAPH (Best response function)
(b) The utility maximization decision of A is:
`cr
fj
A
g
l

= |oq(` q

) + |oq(q

+ q
1
)
which has a necessary condition:

1
Aj
A
+
1
j
A
+j
B
= 0
solving for q

we have:
q

=
A
2

j
B
2
(c) The utility maximization decision of B is:
`cr
fj
B
g
l
1
= |oq(` q
1
) + |oq(q

+ q
1
)
which has a necessary condition:

1
Aj
B
+
1
j
A
+j
B
= 0
solving for q

we have:
q
1
=
A
2

j
A
2
2
The consumers are identical, so the equilibrium will be symmetric with q

= q
1
= q. As a
result, the necessary condition gives:
q =
A
2

j
2
^ q =
A
3
with total provision
^
G = q

+ q
1
= 2^ q =
2A
3
(d) The ecient level of provision will have the cost equally allocated between the consumers.
Recall \ = l

+ l
1
, it therefore solves:
`cr
fGg
l

+ l
1
= |oq
_
` q

_
+ |oq(q

+ q
1
) + |oq
_
` q
1
_
+ |oq(q

+ q
1
)
`cr
fGg
l

+ l
1
= |oq (` q) + |oq(q + q) + |oq (` q) + |oq(q + q)
`cr
fGg
l

+ l
1
= 2|oq (` q) + 2|oq(2q)
`cr
fGg
l

+ l
1
= 2|oq
_
`
G
2
_
+ 2|oq(G)
The necessary condition is:

1
2
2
A
G
2
+
2
G
= 0
Solving for G we have:

G = `
As we can see comparing

G with
^
G shows that provision at the Nash equilibrium is below
what is optimal.
3
Exercise 2
[2.] Consider two consumers (1. 2), each with income ` to allocate between two goods. Good
1 provides 1 unit of consumption to its purchaser and c, 0 _ c _ 1, units of consumption to
the other consumer. Each consumer i, i = 1. 2, has the utility function l
i
= |oq (r
i
1
) + r
i
2
,
where r
i
1
is the consumption of good 1 and r
i
2
is the consumption of good 2.
(a) Provide an interpretation of c.
(b) Assume that good 2 is a private good. Find the Nash equilibrium levels of consumption
when both goods have a price of 1.
(c) By maximizing the sum of utilities, show that the equilibrium is Pareto-ecient if c = 0
but inecient for all other values of c.
(d) Now assume that good 2 also provides 1 unit of consumption to its purchaser and c,
0 _ c _ 1, units of consumption to the other consumer. For the same preferences, nd the
Nash equilibrium and show that it is ecient for all values of c.
(e) Explain the conclusion in part d.
Solution:
(a) The parameter c measures the degree of publicness of the good.
(b) l
1
= |oq (
1
1
+ c
2
1
) + r
1
2
where
i
1
is the purchase of good 1 by i. Using the budget
constraint (and assuming both goods have unit price) obtains
l
1
= |oq (
1
1
+ c
2
1
) + `
1
1
.
the choice of
1
1
satises:
1
j
1
1
+cj
2
1
1 = 0
The game is symmetric. So the solution is
1
1
=
2
1
=
1
=
1
1+c
. Hence the consumption level
in equilibrium is:
r
1
1
= r
2
1
= r
1
= [1 + c]
1
= 1.
(c) The level of social welfare is:
\ = |oq(
1
1
+ c
2
1
) + `
1
1
+ |oq(
2
1
+ c
2
1
) + `
2
1
Applying symmetry obtains:
\ = 2|oq((1 + c)
1
) + 2[`
1
]
so,
0W
0j
1
=
2
j
1
2 = 0.
Hence,
1
= 1 and r
1
= 1 + c. The two outcomes are the same if c = 0.
(d) Utility now becomes
l
1
= |oq (
1
1
+ c
2
1
) + `
1
1
+ c(`
2
1
).
The Nash equilibrium remains at
1
1
=
2
1
=
1
=
1
1+c
. With symmetry the level of welfare
is:
4
\ = 2|oq((1 + c)
1
) + 2(1 + c)[`
1
],
so
1
=
1
1+c
. The two outcomes are identical for all c.
(e) In part b there is one private good and one public good when c ,= 0. So free riding takes
place when c ,= 0. With c = 0, there are two private goods, so the outcome is ecient. In
part d both goods have an identical degree of publicness so the consumption externalities
are balanced. It is possible to free-ride on both goods, so eciency results.
Exercise 3
[3.] Suppose the production possibility frontier for an economy that produces one public
good () and one private good (r) is given by:
r
2
+ 100
2
= 5000
This economy is populated by 100 identical individuals, each with a utility function of the
form
utility =
_
r
i

where r
i
is the individuals share of private good production (= r,100). Notice that the
public good is nonexclusive and that everyone benets equally from its level of production.
(a) If the market for r and were perfectly competitive, what levels of those goods would
be produced? What would the typical individuals utility be in this situation?
(b) What are the optimal production levels for r and ? What would the typical individuals
utility level be? How should consumption of good r be taxed to achieve this result? Hint:
The numbers in this problem do not come out evently, and some approximations should
suce.
Solution:
(a) The solution here requires some assumption about how individuals form their expecta-
tions about what will be purchased by others. If each assumes he or she can be a free rider,
will be zero as will be each persons utility.
(b) Taking total dierential of production possibility frontier.
2rdr + 200d = 0
111 =
oa
oj
=
200j
2a
= 100
j
a
Individual `1o
i
=
Aly
Alx
=
0.5
_
a
i
j
0.5
_
ja
i
=
a
i
j
=
a100
j
=
1
100

a
j
For eciency require that the sum of MRS should equal RPT

i
`1o
i
=
a
j
. Hence
a
j
= 100
j
a
thus, r = 10.
Using production possibility frontier yields:
200
2
= 5000 then = 5, r = 50, r
i
= 0.5 and utility =
_
2.5.
Ratio of per-unit tax share of to the market price of r should be equal to the `1o =
a
i
j
=
1
10
.
5
Exercise 4
[4.] (M.W.G. 11.D.4) Reconsider the nondepletable externality example discussed in section
11.D, but now assume that the externalities produced by the J rms are not homogeneous.
In particular, suppose that if /
1
. /
2
. .... /
J
are the rms externality levels, then consumer is
derived utility is given by c
i
(/
1
. /
2
. .... /
J
)+n
i
for each i = 1. .... 1. Compare the equilibrium
and ecient levels of /
1
. /
2
. .... /
J
. What tax/subsidy scheme can restore eciency? Under
what condition should each rm face the same tax/subsidy rate?
Solution:
For the Pareto optimal outcome we solve:
`cr
fI
i
g
1

i=1
c
i
(/
1
. /
2
. .... /
J
) +
J

)=1
:
)
(/
)
)
which yields the F.O.C.s
1

i=1
_
0
i
(I
o
1
, I
o
2
, ..., I
o
J
)
0I
j
_
_ :
0
)
(/
c
)
)
with equality if /
c
)
0 for all , = 1. .... J.
On the other hand, in a competitive equilibrium each rm maximizes prots individually,
and we get the FOC:
:
)
(/+
)
) _ 0, with equality if /+
)
0.
To restore Pareto-optimal outcome in a competitive equilibrium, we must set an individual
tax for each , of
t
)
=
1

i=1
_
0
i
(I
o
1
, I
o
2
, ..., I
o
J
)
0I
j
_
Each rmwill face the same tax rate if and only if we have
1

i=1
_
0
i
(I
o
1
, I
o
2
, ..., I
o
J
)
0I
j
_
=
1

i=1
_
0
i
(I
o
1
, I
o
2
, ..., I
o
J
)
0I
k
_
for all ,. /.
6
Exercise 5
[4.] (M.W.G. 11.D.7) A continuoum of individuals can build their houses in one of two
neighborhoods, A or B. It costs c

## to build a house in neighborhood A and c

b
< c

to
build in neighborhood B. Individuals care about the prestige of the people living in their
neighborhood. Individuals have varying levels of prestige, denoted by the parameter o.
Prestige varies between 0 and 1 and is uniformly distributed across the population. The
prestige of neighborhood / (/ = . 1) is a function of the average value of o in that
neighborhood, denoted by o
I
. If individual i has prestige parameter o and builds her house
in neighborhood /, her derived utility net of building costs is (1 + o)(1 + o
I
) c
I
. Thus,
individuals with more prestige value a prestigious neighborhood more. Assume that c

and
c
1
are less than 1 and that (c

c
1
) (
1
2
. 1).
(a) Show that in any building-choice equilibrium (technically, the Nash equilibrium of the
simultaneous-move game in which individuals simultaneously choose where to build their
house) both neighborhoods must be occupied.
(b) Show that in any equilibrium in which the prestige levels of the two neighborhoods dier,
every resident of neighborhood A must have at least as high a prestige level as every resident
of neighborhood B; that is, there is a cuto level of o, say
^
o, such that all types o _
^
o build
in neighborhood A and all o <
^
o build in neighborhood B. Characterize this cuto level.
(c) Show that in any equilibrium of the type identied in (b), a Pareto improvement can be
achieved by altering the cuto value of o slightly and allowing transfers between individuals.
Solution:
(a) Assume in negation that only one neighborhood is occupied. First assume it is B, and
consider the most prestigious individual with o = 1. Since o
1
=
1
2
, then this individuals
utility from staying in neighborhood B is (1 +1)(1 +
1
2
) c
1
= 3 c
1
_ 3. If he would move
to neighborhood A his utility would be (1 + 1)(1 + 1) c

= 4 c

3, so all individuals
in neighborhood B cannot be an equilibrium. Now assume that only A is occupied and
again consider the most prestigious individual with o = 1. His utility from staying in the
neighborhood A is (1 +1)(1 +
1
2
) c

= 3 c

## , and his utility from moving to neighborhood

B is (1 + 1)(1 + 1) c
1
= 4 c
1
3 c

## so all individuals in neighborhood A cannot be

an equilibrium - contradiction.
(b) Let an equilibriumbe a pair (

.
1
), where
1
= o : type o locates in neighborhood i,
and let

.
1
be the average prestige levels associated with such an equilibrium.
Claim:

## must take the on the form [

^
o. 1] for some
^
o.
Proof: Assume o
0
prefers A to B: (1 + o
0
)(1 +

) c

(1 + o
0
)(1 +
1
) c
1
Rearranging gives us: (1 + o
0
) _
c
A
c
B

B
, which implies that all types locates in which
neighborhood, and it is calculated by solving:
(1 +
^
o)
_
1 +
1+
^
0
2
_
c

= (1 +
^
o)
_
1 +
^
0
2
_
c
1
which yields,
^
o = 2(c

c
1
) 1
7
(c) Starting at the equilibrium with
^
o as given above, if a small group of individuals from
the lower end of neighborhood A move to neighborhood B, then the average prestige in both
neighborhoods will rise. In particular, if for some 0 the segment [
^
o.
^
o +] moved from A
to B, the average prestige in both neighborhoods would rise by
.
2
. So, in both neighborhoods,
an individual of type o who did not move will have a positive change in utility of (1 + o)
.
2
.
For a type o individual who moved from A to B, there will be a negative change in utility
equal to (1 + o)
_
1 +
^
0
2
+
.
2
_
c
1
[(1 + o)
_
1 +
1
2
+
^
0
2
_
c

] = (1 + o)
_
.1
2
_
+ (c

+ c
1
).
We denote the total benet from such a change as 1, and the total cost as C, so that we
have:
1() =
_
^
0
0
(1 + o)
_
.
2
_
do +
_
1
^
0+.
(1 + o)
_
.
2
_
do
C() =
_
^
0+.
0
_
(1 + o)
_
.1
2
_
(c

c
1
)

do,
and we can evaluate the eect of such a change when = 0:
o1(.)
o.
[
.=0
=
_
^
0
0
(1 + o)
_
1
2
_
do +
_
1
^
0+.
(1 + o)
_
1
2
_
do (1 +
^
o + )
_
.
2
_
o1(.)
o.
[
.=0
=
^
0
2
+
^
0
2
2
+
1
2
+
1
4

^
0+.
2

(
^
0+.)
2
2
(1 +
^
o + )
_
.
2
_
=
3
4
and
oC(.)
o.
[
.=0
=
_
^
0+.
0
(1 + o)
_
1
2
_
do +
_
(1 + o + )
_
.
2
_
+ c

c
1

oC(.)
o.
[
.=0
=
^
0+.
2

^
0
2
+
(
^
0+.)
2
4

^
0
2
4
+ [2(c

c
1
) + ]
_
.1
2
_
+ c

c
1
= 0
Note that the last equality is true since from the conclusion of part (b)
8
1

## Review Session #12 - Exercise 11.E.1 MWG

Consider the setting studied in Section 11.E (where only the firm knows its type and only the consumer
knows his type ). Suppose that
( , ) / h h bh = + and ( , ) / h h ch = + ,
where and

## are random variables with expectation

[ ] [ ] [ ] 0 E E E = = =
, that all take strictly
positive values
( , , ) 0 b c
, and
0 >
. Denote
2 2
[ ] E

= and
2 2
[ ] E

= .
(a) Identify the best quota
*

## h for a planner who wants to maximize the expected value of aggregate

surplus. (Assume the firm must produce an amount exactly equal to the quota.)

SOLUTION:
Firm must produce exactly equal to the quota
*

## h . The social planner determines the optimal

quantity
*

h by choosing the value of h that maximizes expected value of aggregate surplus (since
the social planner does not know the precise realization of parameters and ),

max [ ( , )] [ ( , )]
h
E h E h

+
And taking FOC with respect to h, we obtain
* *

( , ) ( , )
0
h h
E E
h h

+

We can now substitute the functional forms for the marginal benefit for consumers,
( , ) h
h

,
and the marginal profits for the firm,
( , ) h
h

, we obtain
* *

[ ] [ ] 0 ch E bh E + + + ,
from which we can solve for
*

h to have
* *

with equality for 0 h h
c b
+

+
.

(b) Identify the best tax
*
t for this same planner.

SOLUTION:
Given a tax
*
t , the firm will maximize profits and will choose h that maximizes its profits
(reduced in tax payments), that is
max ( , )
h
h th
The firm hence takes FOC with respect to h, obtaining
2

( , )
0
h
t
h

=

And since we know that
( , ) h
bh
h

= +

## by definition, the above FOC becomes

0 bh t + = . Solving for h, we obtain the firms profit-maximizing externality ( , ) h t , as
a function of the tax rate t and its type , as follows
( , )
t
h t
b

+ +
=
Importantly, note that ( , ) h t describes the firms reaction function (or best response
function) after observing that the regulator imposes a particular tax rate t. Provided this best
response function, we can now find what is the optimal tax that the social planner imposes,
anticipating the firms best response function, as follows
*
max [ ( ( , ), )] [ ( ( , ), )]
t
E h t E h t +
(where note that, rather than writing any general level of h, we wrote the level of h that the firm
optimally chooses in the second stage, after observing the tax rate t imposed by the regulator in
the first stage).
Taking FOC with respect to h, we obtain
( ( , ), ) ( , ) ( ( , ), ) ( , )
0
h t h t h t h t
E E
h t h t

+ =

(note that we needed to use the chain rule in this FOC).
And since ( , )
t
h t
b

+ +
= then
( , ) 1 h t
t b

=

## is a constant, that can be taken out of the

expectation operator. Therefore, we can cancel out the
( , ) h t
t

## from the FOC.

Substituting the functional form of our marginal benefit and marginal profit functions, the above
FOC becomes:
[ ] [ ]
[ ] [ ] 0
E t E t
c E b E
b b

+ +
+ + + =
Rearranging, and solving for t, we obtain
*
( [ ] ) ( [ ] ) ( [ ] [ ] )
[ ] [ ] [ ] [ ]
( ) [ ] [ ] [ ] [ ]
Recall [ ] 0 and [ ] 0
( )
( )
c E t b E t b E E
cE c ct bE b bt bE b bE b
t c b bE b bE b cE c bE b
E E
t c b b b c b
c b
t
c b

+ + = + +
+ + = +
+ = + + + + + +
= =
+ = + +

=
+

(c) Compare the two instruments: Which is better and when?

SOLUTION:
3

We need to compare the expected difference in losses in order to determine when a tax or a quota
instrument is better.
Figure 11.E.1 illustrates the choices of
*
h and
*
t

In figure 11.E.1 the intersection of the expected marginal profits and marginal utility curves
determine
*
h and
*
t . Consider a realization of and that results in the curves intersecting at
point x . The optimal level of the externality would then be
*
h . If we use a quota instrument
*
h
the loss is the shaded triangle xuv . If we use a tax instrument
*
t then the firm will choose
*
( , ) h t and the loss is the shaded triangle xyz . Thus in the case pictured the tax instrument is
better. (This is, of course, not a proof, but an introduction to the proof). Lets consider when each
instrument will be best.

First we must introduce a non-standard way of calculating the area of a triangle. Area is normally
calculated as: Area=1/2* base *height. In figure 11.E.1(b) below this would be
1
2
A ed = .
4

We can divide the edge e into
1
e and
2
e , and we can then write
1
e
d
b
= , where b is the slope of
the top edge of the triangle. We can also write
1
b
e e
b c
=
+
. Combining
e
d
b c
=
+
. Next we
plug d back into our normal area calculation to get:
2
1
2
e
A
b c
=
+
.
We apply this non-standard area calculation to determine the area of triangle xuv . In words, the
calculation is the edge of uv squared, divided by twice the sum of the slopes of both marginal
curves. The height of the edge uv is
* *
( , ) ( , ) h h
h h
b c
c b c b

+ +
+ + +

+ +

+

We may therefore calculate the loss from quantity regulation (quota) as
2
( )
2( )
h
L
b c
+
=
+
. Next we
calculate the area of the loss from taxation. The height of the edge yz is
( )
* *
* *
* *
* *
* *
( ( , ), ) ( ( , ), )
We know
( ( , ) )
h t h t
h h
t t
c b
b b
c
t t
b
t c h
c h t h

+ +
+ +

+ +
=

5

Next calculate
* *
( , ) h t h
b

c
b

## . We may therefore calculate the loss

from taxation as
2
2( )
t
c
b
L
b c

=
+

Comparison of losses. Last we calculate the expected differences in losses
2
2
2
2
1
( ) ( )
2( )
( )

2
h t
c
E L L E
b c b
b c
b

= +

+

=

To conclude, we have just found that the optimal choice of quantity or tax instrument depends on
the sign of ( ) b c :
1. When this term is positive, b c > , the loss from the quota system is greater so the tax
instrument is preferred.
2. When instead c b > , the reverse is true and the quota instrument is preferred.

Recall that under the tax system the level of the externality is changed depending on the firms
realized marginal profits.
EconS 501
Recitation #13 Imperfect Competition

Exercise 15.3 (NS). [ON YOUR OWN] This exercise analyzes Cournot competition
when firms have different marginal costs. This departure from identical firms allows the
student to shift around firms best-responses independently on a diagram.
Let
i
c be the constant marginal and average cost for firm i (so that firms may have
different marginal costs). Suppose demand is given by 1 P Q = .
a. Calculate the Nash equilibrium quantities assuming there are two firms in a
Cournot market. Also compute market output, market price, firm profits, industry
profits, consumer surplus, and total welfare.

ANSWER:
1
1 1 2 1 1
1 2 1
1
2 1
1
1 2
2
max (1 )
:1 2
1
best response for consumer 1
2
Likewise
1
best response for consumer 2
2
q
q q q c q
q q c
q
q c
q
q c
q

=

=

Solving simultaneously,
1 2
1
1
1 1 2
1
1
1
2
2
4 1
1
2 2 2 2
q c
c
q
q q c
c

=
= + +

3 / ) 2 1 (
2 1
1
c c q
c
+ =
and 3 / ) 2 1 (
1 2
2
c c q
c
+ = .

2

Further,
1 2
(2 )
3
c
c c
Q

= ,
1 2
(1 )
3
c
c c
P
+ +
= ,
2
1 2
(1 2 )
9
c
i
c c

+
= ,
c c c
2 1
+ = ,
2
1 2
(2 )
18
c
c c
CS

= , and
c c c
CS W + = .
b. Represent the Nash equilibrium on a best-response function diagram. Show how a
reduction in firm 1s cost would change the equilibrium. Draw a representative
isoprofit for firm 1.

ANSWER:

Point E in Figure 15.3 represents the Nash equilibrium. The curved line represents
firm 1s isoprofit.

The reduction in firm 1s marginal cost shifts its best response out and shifts the
equilibrium from E to E. Firm 1 will produce more for any given
2
q .

Exercise 15.7 (NS). This exercise analyzes the Stackelberg game both with and without
the possibility of entry-deterring investment.
Assume as in Problem 15.1 that two firms with no production costs, facing demand
150 Q P = , choose quantities
1
q and
2
q .
a. Compute the subgame-perfect equilibrium of the Stackelberg version of the
game in which firm 1 chooses
1
q first and then firm 2 chooses
2
q .
ANSWER:
BR
2
(q
1
)

q
q
BR
1
(q
2
)
E
E

3

We solve the game using backward induction starting with firm 2s action. Firm
2 moves second and best responds to firm 1s choice. We saw from Problem 15.1
(b) that firm 2s best-response function is 2 / 75
1 2
q q = . We substitute this
back into firm 1s profit function so that firm 1 is making its optimal choice given
what it expects firm 2 to do
1
1 1 1 2 1 1
1 1
1
1
[150 ( )] 150 75
2
:150 2 75
75
q
q q q q q
q q
q
q

= + =

=
.
Taking the first-order condition with respect to
1
q and solving yields 75
*
1
= q .
Substituting this back into firm 2s best-response function yields

75
2 2
*
2
75
37.5
q
q
=
=
.

b. Now add an entry stage after firm 1 chooses
1
q . In this stage, firm 2 decides
whether or not to enter. If it enters it must sink cost
2
K , after which it is
allowed to choose
2
q . Compute the threshold value of
2
K above which firm 1
prefers to deter firm 2s entry.

ANSWER:
If firm 1 accommodates 2s entry, the outcome in part (a) arises. P=150 Q. P =
37.5. There are no production costs, thus profit for firm 1= P*Q=37.5*75=
2,812.5.
When firm 1 produces
1
q if firm 2 best responds to
1
q , and enters it will generate
profit
2
2
1
4 / ) 150 ( K q . In order to deter entry this profit must be less than or
equal to 0. Setting firm 2s profit function equal to zero
2
1
2
1 2
(150 )
0
4
150 2
q
K
q K

=
=

The threshold value of
2 1
2 150 K q = . Firm 1s profit from operating alone in
the market and producing this output is Q*P = ) 2 )( 2 150 (
2 2
K K , which

4

exceeds 2,812.5 if 6 . 120
2
K . (as can be shown by graphing both sides of the
inequality)

Exercise 15.9 (NS). This exercise examines the Herfindahl index of market
concentration. Many economists subscribe to the conventional wisdom that increases in
concentration are bad for social welfare. This problem leads students through a series of
calculations showing that that the relationship between welfare and concentration is not
this straightforward.
One way of measuring market concentration is through the use of the Herfindahl index,
which is defined as:
2
1
where
n
i
i i
i
q
H s s
Q
=
= =

Where
i
s is firm is market share. The higher is H, the more concentrated the industry is
said to be. Intuitively, more concentrated markets are thought to be less competitive
because dominant firms in concentrated markets face little competitive pressure. We will
assess the validity of this intuition using several models.
a. If you have not already done so, answer Problem 15.2(d) by computing the
Nash equilibrium of this n-firm Cournot game. Also compute market output,
market price, consumer surplus, industry profit, and total welfare. Compute
the Herfindahl index for this equilibrium.

ANSWER:

Firm is profit is ) ( c bQ bq a q
i i i

with associated first-order condition
0 2 =

c bQ b a
i
.
This is the same for every n firm so we may impose symmetry
[
* *
) 1 (
i i
q n Q =

]
Plugging in
*
*
2 ( 1) 0
( )
( 1)
i
i
a b b n q c
a c
q
n b
=

=
+

.Further,
*
( )
( 1)
n a c
Q
n b

=
+
,
*
( )
( 1)
a nc
P
n
+
=
+
,
2
* *
( )
( 1)
i
n a c
n
b n

= =

+

,
2
2
*
( )
( 1)
n a c
CS
b n

=

+

2
*
( )
( 1)
n a c
W
n b

=

+

.

5

Because firms are symmetric, n s
i
/ 1 = , thus we can solve for the Herfindahl index
2
1 1
( )
n n
H n = = .

b. Suppose two of the n firms merge, leaving the market with n-1 firms.
Recalculate the Nash equilibrium and the rest of the items requested in part
(a). How does the merger affect price, output, profit, and total welfare.
Compute the Herfindahl index for this equilibrium.

ANSWER:
We can obtain a rough idea of the effect of merger by seeing how the
variables in part (a) change with a reduction in n. Per-firm output, price,
industry profit, and the Herfindahl index increase with a reduction in n, caused
by the merger. Total output, consumer surplus, and welfare decrease with a
reduction in n, caused by the merger.

c. Put the model used in parts (a) and (b) aside and turn to a different setup: that
of Problem 15.3, where Cournot duopolists face different marginal costs. Use
your answer to Problem 15.3(a) to compute equilibrium firm outputs, market
output, price, consumer surplus, industry profit, and total welfare, substituting
the particular cost parameters
1
1 2 4
c c = = . Also compute the Herfindahl index.

ANSWER:
Substituting 4 / 1
2 1
= = c c into the answers for 15.3, we have 4 / 1
*
=
i
q ,
2 / 1
*
= Q , 2 / 1
*
= P , 8 / 1
*
= , 8 / 1
*
= CS , and 4 / 1
*
= W . Also, 2 / 1 = H .

d. Repeat your calculations in part (c) while assuming that firm 1s marginal cost
1
c falls to 0 but
2
c stays at
1
4
. How does the merger affect price, output,
profit, consumer surplus, total welfare, and the Herfindahl index.

ANSWER:
Substituting 0
1
= c and 4 / 1
2
= c into the answers for 15.3, we have
12 / 5
*
1
= q , 12 / 2
*
1
= q , 12 / 7
*
= Q , 12 / 5
*
= P , 144 / 29
*
= ,
288 / 49
*
= CS , and 288 / 107
*
= W . Also, 49 / 29 = H .

6

e. Given your results from parts (a)-(d), can we draw any general conclusions
about the relationship between market concentration on the one hand and
price, profit, or total welfare on the other?

ANSWER:
Comparing part (a) with (b) suggests that increases in the Herfindahl index are
associated with lower welfare. The opposite is evidenced in the comparison of
part (c) to (d): welfare and the Herfindahl increase together. General
conclusions are thus hard to reach.

Exercise 15.10 (NS). [ON YOUR OWN] This exercise extends the Inverse Elasticity
Pricing Rule (IEPR) from a market structure with only one firm (monopoly) to market
structures with more than one firm. It derives an alternatives form of the IEPR we know
under monopoly that we can apply into a Cournot model of quantity competition.
a. Use the first-order condition (Equation 15.2) for a Cournot firm to show that the
usual inverse elasticity rule form Chapter 11 holds under Cournot competition
(where the elasticity is associated with an individual firms residual demand, the
demand left after all rivals sell their output on the market). Manipulate Equation
15.2 in a different way to obtain an equivalent version of the inverse elasticity
rule:
,
where
i
i
Q P i
s P MC Q
s
P e q

= =
Where
i
s is firm is market share and
, Q P
e is the elasticity of market
demand. Compare this version of the inverse elasticity rule to that for a
monopolist from the previous chapter.
ANSWER:
Equation 15.2 can be rearranged as follows:
,
Equation 15.2
( ) ( ) ( ) 0
' / 1
| |
i
i
i i i
i
i
i i i
q P
P Q P Q q C q
q
P q P C
P P
P q dP dq q P C
P P P

= + =

=

= = =
,

7

where
P q
i
,
is the elasticity of demand with respect to firm i s output. The
second equality uses the fact that
i
dq dP dQ dP P / / = = . Multiplying numerator
and denominator by Q, we can also rearrange Equation 15.2 as
,
/
| |
i i
Q P
q s dP dQ Q
P Q

=

.

MWG 12.C.10. Consider a J-firm Cournot model in which firms costs differ. Let
( ) ( )
j j j j
c q c q = denote firm js cost function, and assume that ( ) c is strictly increasing
and convex. Assume that
1
...
j
> > .
(a) Show that if more than one firm is making positive sales in a Nash equilibrium of
this model, then we cannot have productive efficiency; that is, the equilibrium
aggregate output
*
Q is produced inefficiently.
ANSWER:
Each firm i chooses its output 0
i
q to maximize its profits
( ) ( )
i i i i i
p Q q q c q

= +
FOC, assuming a positive solution
: ( ) ( ) ( )
i i i
i
p Q c q p Q q
q

Where Q is the total output. Since ( ) c is increasing and convex, the right-hand
side of the FOC is increasing in
i
and decreasing in
i
q . Since the FOC holds for
every firm, we must have
i j
q q > whenever
j i
> .
The marginal cost of production for each firm i is ( )
i i
c q . Imagine the case
where firm i differs from firm j we may calculate the difference in marginal cost
between the two firms as
( ) ( )
j j i i
c q c q
From our FOCs we know that after canceling out the ( ) p Q terms this is
equivalent to
( )( )
i j
p Q q q
Imagine the particular case where
j i
> so that also
i j
q q > . Because ( ) p Q < 0
the entire term ( )( )
i j
p Q q q is positive. This implies that ( ) ( )
j j i i
c q c q > .
Thus the marginal cost for firm j is greater in this case, therefore marginal costs
across firms are not necessarily equalized. Likewise aggregate output is not
necessarily produced efficiently.

(b) If so, what is the correct measure of welfare loss relative to a fully efficient
(competitive) outcome? [Hint: Reconsider the discussion in Section 10.E]
ANSWER:

8

The correct measure of welfare loss relative to a fully efficient outcome in this
case is equal to the loss of consumer surplus due to non-competitive pricing plus
the higher production cost due to productive inefficiency. This productive
inefficiency was not considered in section 10.E.

(c) Provide an example in which welfare decreases when a firm becomes more
productive (i.e., when
j
falls for some j). [Hint: Consider an improvement in
cost for firm 1 in the model of Exercise 12.C.9.] Why can this happen?
ANSWER:
Lets use our results from Exercise 12.C.9 in order to provide an example in
which welfare decreases when a firm becomes more productive. From 12.C.9 the
Cournot equilibrium output and price levels are
1 2
1
2 1
2
1 2
2
3
2
3
3
a c c
q
b
a c c
q
b
a c c
p
+
=
+
=
+ +
=

Total profits of the two firms can now be computed as
2 2 2
1 1 2 2 1 2 1 2 1 2
( ) ( ) (2 5 5 2 ( ) 8 ) / 9 p c q p c q a c c a c c c c b + = + + +
Consumer surplus can be computed as
1 2 1 2
2
1 2 1 2
0 0
( ) ( / 2) ( )(5 ) / 18
q q q q
p q dq aq bq a c c a c c b
+ +
= = + +

Adding up total profits and consumer surplus, and differentiating with respect to
1
c , we obtain
1 2
1
9 9 4
9
c c a Surplus
c b

=

This derivative is positive when
4
1 2 9
( ) c c a > + . This will occur when firm 1s
costs are much greater than firm 2s costs. In this case a decrease in
1
c reduces
social welfare. The reason is that when
1
c slightly falls, firm 1 steals more
business from firm 2, which raises production inefficiency. When
1
c is
substantially larger than
2
c , this effect actually dominates the increase in
consumer surplus due to a lower price.

MWG 12.C.12. Consider two strictly concave and differentiable profit functions
( , ), 1, 2,
j j k
q q j = defined on [0, ]
j
q q .
(a) Give sufficient conditions for the best-response functions ( )
j j
b q to be increasing
or decreasing.
ANSWER:

9

Assume that
11
( , ) 0 for 1, 2
i
i j
q q i < = . Where the subscript ii means differentiate
twice with respect to the first element.
Each firm will maximize profit.
FOC:
11
12
( ) ( ( ), )
:
( ( ), )
i
i j i j j
i
j j i j j
b q b q q
q q b q q

=

Therefore, the sign of
( )
i j
j
b q
q

is the same as the sign of
12
( ( ), )
i
i j j
b q q .
This means firm is best-response function is increasing when
12
i
is positive.
Firm is best-response function is decreasing when
12
i
is negative.

(b) Specialize to the Cournot model. Argue that a decreasing (downward-sloping)
best-response function is the normal case.
ANSWER:
In the Cournot model
1
( , ) ( ) ( )
i j i j i i
q q p q q q c q = +
Then differentiating further w.r.t.
j
q
12
( , ) ( ) ( )
i
i j i j i i j
q q p q q q p q q = + + +
Which is negative if ( ) p is downward sloping and not to convex. This seems
likely for the inverse demand function, thus the normal slope of the best
response functions in the Cournot model is negative.

MWG 12.D.1. Consider an infinitely repeated Bertrand duopoly with discount factor
1 < . Determine the conditions under which strategies of the form in (12.D.1) sustain the
monopoly price in each of the following cases:
From page 401 (12.D.1):
1
1
if all elements of equal ( , ) or 1
( )
otherwise
m m m
t
jt t
p H p p t
P H
c

=
=

(a) Market demand in period t is ( ) ( )
t
t
x p x p = where 0 > is the rate of growth of
demand across periods.
ANSWER:
Monopoly profit in period t is
max ( )( ) max ( )( )
t t t m
p p
x p p c x p p c = =
If a firm deviates at t = , it can obtain
m
in that period, and it will get zero
forever after. If it does not deviate, its payoff is
0
1
( )
2 (1 ) 2
m m
t
t

=
=

10

Monopoly price can be sustained when deviation from the strategy is not
profitable. Deviation is not profitable if and only if
1 1
or
(1 ) 2 2
m
m

Hence, the minimal discount factor supporting cooperation decreases in the rate of
growth of demand, i.e., cooperation can be sustained under a larger set of discount
factors as demand grows faster across periods. [See figure].

1
2
1
4
1
6
1
1 2 3 4
Cooperation
Cheating

(b) At the end of each period, the market continues to exist with probability [0,1] .
ANSWER:
If a firm deviates, it can obtain
m
in that period, and it will get zero forever after.
If it does not deviate, its payoff is
0
1
( )
2 (1 ) 2
m m
t
t

=
=

Therefore, deviation is not profitable if and only if
1 1
or
(1 ) 2 2
m
m

Thus, cooperation cannot be sustained under any discount factor (between zero
and one) when the probability that demand continues existing is relatively low,
but can be sustained when the probability that demand continues existing is
sufficiently high (and decreases as this probability gets closer to 100%). [See
figure].

11

1
2
2
3
1
1
Cooperation
Cheating
3
4
1
2
1
4
Prob of demand
continuing

(c) It takes K periods to detect and respond to a deviation from the collusive
agreement.
ANSWER:
If a firm deviates, it can obtain
1
0
(1 )
(1 )
K
K
t m m
t

=

=

In the next K periods, and it will get zero forever after. If it does not deviate, its
payoff is
0
1
2 (1 ) 2
m m
t
t

=
=

Therefore, deviation is not profitable if and only if
1
1 (1 ) 1
or
(1 ) 2 (1 ) 2
m K
K
m

Hence, the more periods of time K that a cheating firm remains undetected by its
colluding partners, the more attractive cheating becomes. Cooperation therefore
can only be sustained under more restrictive sets of parameter values. [See
figure].

12

K

1
2
0.707
1
1 2 3 4
Cooperation
Cheating

Micro Theory I - EconS 501
Midterm #1 - Answer key
1. [20 points] [Checking properties of preference relations]. Let us consider the
following preference relations dened in A = R
2
+
. First, dene the upper countour
set, the lower contour set and the indierence set for every preference relation. Then,
check if they satisfy: (i) completeness, (ii) transitivity, (iii) monotonicity, and (v) weak
convexity. [Answer only one of the following 2 questions]
(a) [20 points] (r
1
. r
2
) % (
1
.
2
) if and only if r
1
_
1
1 and r
2
_
2
+ 1.
Let us rst build some intuition on this preference relation. Take a bundle
(2. 1). Then, the upper contour set of this bundle is given by
lCo
%
(2. 1) = (r
1
. r
2
) % (2. 1) ==r
1
_ 2 1 and r
2
_ 1 + 1
= (r
1
. r
2
) : r
1
_ 1 and r
2
_ 2
which is graphically represented by all those bundles in R
2
+
in the lower right-
hand corner (below r
2
= 2 and to the right of r
1
= 1). On the other hand,
the lower contour set is dened as
1Co
%
(2. 1) = (2. 1) % (r
1
. r
2
) ==2 _ r
1
1 and 1 _ r
2
+ 1
= (r
1
. r
2
) : r
1
_ 3 and r
2
_ 0
which is graphically represented by all those bundles in R
2
+
in the left half of
the positive quadrant (above r
2
= 0 and to the left of r
1
= 3).Finally, the
consumer is indierent between bundle (2,1) and the set of bundles where
1`1
%
(2. 1) = (r
1
. r
2
) ~ (2. 1) ==1 _ r
1
_ 3 and 0 _ r
2
_ 2
Completeness. From the above analysis it is easy to note that this property
is not satised, since there are bundles in the area r
1
3 and r
2
_ 2 where
our preference relation does not specify if they belong to the upper contour
set, the lower contour set, or the indierence set. Another way to prove that
completeness does not hold is by nding a counterexample. In particular, we
must nd an example of two bundles such that neither (r
1
. r
2
) % (
1
.
2
) nor
(
1
.
2
) % (r
1
. r
2
). Let us take two bundles,
(r
1
. r
2
) = (1. 2) and (
1
.
2
) = (4. 6)
We have that:
1. (r
1
. r
2
) (
1
.
2
) since 1 4 1 for the rst component of the bundle,
and
2. (
1
.
2
) (r
1
. r
2
) since 6 2 + 1 for the second component of the bun-
dle. Hence, there are two bundles for which neither (r
1
. r
2
) % (
1
.
2
)
nor (
1
.
2
) % (r
1
. r
2
), which implies that this preference relation is not
complete.
1
Transitivity. We need to show that, for any three bundles (r
1
. r
2
), (
1
.
2
)
and (.
1
. .
2
) such that
if (r
1
. r
2
) % (
1
.
2
) and (
1
.
2
) % (.
1
. .
2
), then (r
1
. r
2
) % (.
1
. .
2
)
This property does not hold for this preference relation. In order to show
that, let us consider the following three bundles (that is, we are nding a
counterexample to show that transitivity does not hold):
(r
1
. r
2
) = (2. 1)
(
1
.
2
) = (3. 4)
(.
1
. .
2
) = (4. 6)
First, note that (r
1
. r
2
) % (
1
.
2
) since r
1
_
1
1 (i.e., 2 _ 3 1), and
r
2
_
2
+ 1 (i.e., 1 _ 4 + 1). Additionally, (
1
.
2
) % (.
1
. .
2
) is also satised
since
1
_ .
1
1 (i.e., 3 _ 4 1), and
2
_ .
2
+ 1 (i.e, 3 _ 4 + 1). However,
(r
1
. r
2
) (.
1
. .
2
) since r
1
.
1
1 (i.e., 2 4 1). Hence, this preference
relation does not satisfy Transivity.
Monotonicity. This property does not hold. For a small increase c 0 in the
amount of good 1, r
1
+c, we dont necessarily have that (r
1
+c. r
2
) % (r
1
. r
2
)
since for that we need r
1
+ c _ r
1
1, which is not true for any c smaller
than 1, c < 1.
Weak Convexity. This property implies that the upper contour set must be
convex, that is, if bundle (r
1
. r
2
) is weakly preferred to (
1
.
2
), (r
1
. r
2
) %
(
1
.
2
), then the linear combination of them is also weakly preferred to
(
1
.
2
),
`(r
1
. r
2
) + (1 `) (
1
.
2
) % (
1
.
2
) for any ` [0. 1]
In this case, (r
1
. r
2
) % (
1
.
2
) implies that r
1
_
1
1 and r
2
_
2
+ 1;
whereas `(r
1
. r
2
) + (1 `) (
1
.
2
) % (
1
.
2
) implies
`r
1
+ (1 `)
1
_
1
1 for the rst component, and
`r
2
+ (1 `)
2
_
2
+ 1 for the second component.
which respectively imply
`(r
1

1
) _ 1, and
`(r
2

2
) _ 1
and since (r
1

1
) _ 1 and (r
2

2
) _ 1 by assumption, i.e., (r
1
. r
2
) %
(
1
.
2
), then both of the above conditions are true for any ` [0. 1]. Hence,
this preference relation is weakly convex.
(b) [20 points] (r
1
. r
2
) % (
1
.
2
) if and only if max r
1
. r
2
> max
1
.
2
.
1. Completeness. For all (r
1
. r
2
),(
1
.
2
) R
2
, either max r
1
. r
2
>max
1
.
2
,
or max
1
.
2
> max r
1
. r
2
, or both. It follows that either (r
1
. r
2
) _
(
1
.
2
), or (r
1
. r
2
) _ (
1
.
2
), or both. Hence, this preference relation is
complete.
2
2. Transitivity. Take some (r
1
. r
2
),(
1
.
2
) and (.
1
. .
2
) R
2
with (r
1
. r
2
) %
(
1
.
2
) and (
1
.
2
) % (.
1
. .
2
). Then, max r
1
. r
2
> max
1
.
2
, and
max
1
.
2
> max .
1
. .
2
. Therefore, max r
1
. r
2
> max .
1
. .
2
, and
so (r
1
. r
2
) % (.
1
. .
2
). Hence the preference relation is transitive. Since, it is
also complete, this preference relation is rational.
3. Monotonicity. Take any (r
1
. r
2
) and (
1
.
2
) R
2
with r
1

1
and r
2

2
.
Then, max r
1
. r
2
max
1
.
2
with strict inequality, and it follows that
(r
1
. r
2
) % (
1
.
2
). In addition, since max r
1
. r
2
max
1
.
2
, we can
also say that (
1
.
2
) (r
1
. r
2
). It follows that (r
1
. r
2
) ~ (
1
.
2
), and hence
the preference relation is monotone.
4. Weak Convexity. Take some (r
1
. r
2
),(
1
.
2
) and (.
1
. .
2
) R
2
with (
1
.
2
) %
(r
1
. r
2
) and (.
1
. .
2
) % (r
1
. r
2
). Therefore, max
1
.
2
> max r
1
. r
2
, and
max .
1
. .
2
> max r
1
. r
2
. However, the convex combination of (
1
.
2
) and
(.
1
. .
2
) with `,
max `
1
+ (1 `).
1
. `
2
+ (1 `).
2

## is not necessarily higher than max r

1
. r
2
. In order to see that, consider an
example in which max
1
.
2
>max r
1
. r
2
, and max .
1
. .
2
>max r
1
. r
2
,
such as (
1
.
2
) = (0. 4) and (r
1
. r
2
) = (3. 3) and (.
1
. .
2
) = (4. 0). Now, note
that the convex combination of (
1
.
2
) and (.
1
. .
2
) with `, will give us values
between 0 and 4. For intermediate values of ` (such as ` =
1
2
) we have that
max
_
1
2
0 +
1
2
4.
1
2
4 +
1
2
0
_
= max 2. 2 < max 3. 3
Hence, the preference relation is not convex.
2. [15 points] [Lexicographic preference relations are rational]. Let us dene a
lexicographic preference relation in a continuouous consumption set A 1 , where for
simplicity both A = [0. 1] and 1 = [0. 1], as follows:
(r
1
. r
2
) % (
1
.
2
) if and only if
_
r
1

1
, or if
r
1
=
1
and r
2
>
2
Show that % is a rational preference relation (i.e., it is complete and transitive).
Answer:
(a) Completeness. For all (r
1
. r
2
),(
1
.
2
) R
2
, either (r
1
. r
2
) % (
1
.
2
) or
(
1
.
2
) % (r
1
. r
2
), or both.Hence, we need to show that
(r
1
. r
2
) (
1
.
2
) == (
1
.
2
) % (r
1
. r
2
)
Indeed, note that
(r
1
. r
2
) (
1
.
2
) if
_

1
> r
1
, and if
r
1
,=
1
or
2
r
2
(1)
First, note that we changed or for and, and viceversa, in order to con-
struct a full negation of the argument in (1). Now, note that (2) implies
(
1
.
2
) % (r
1
. r
2
). Therefore, we have shown that (r
1
. r
2
) (
1
.
2
) implies
(
1
.
2
) % (r
1
. r
2
). Hence, the preference relation is complete.
3
(b) Transitivity. Let us take some (r
1
. r
2
),(
1
.
2
) and (.
1
. .
2
) R
2
with (r
1
. r
2
) %
(
1
.
2
):
(r
1
. r
2
) % (
1
.
2
) if
_
r
1

1
, or if
r
1
=
1
and r
2
>
2
and (
1
.
2
) % (.
1
. .
2
), that is
(
1
.
2
) % (.
1
. .
2
) if
_

1
.
1
, or if

1
= .
1
and
2
> .
2
Hence, we need to check for transitivity in the four possible cases in which
(r
1
. r
2
) % (
1
.
2
) and (
1
.
2
) % (.
1
. .
2
).
1. If r
1

1
, and
1
.
1
, then r
1
.
1
. As we know that r
1
.
1
implies
(r
1
. r
2
) % (.
1
. .
2
). Hence, transitivity is checked in this case.
2. If (r
1
=
1
and r
2
>
2
) and (
1
= .
1
and
2
> .
2
), then (r
1
= .
1
and r
2
> .
2
).
And we know that (r
1
= .
1
and r
2
> .
2
) implies (r
1
. r
2
) % (.
1
. .
2
), which
validates transitivity.
3. If r
1

1
, and (
1
= .
1
and
2
> .
2
), then r
1
.
1
. As we know that r
1
.
1
implies (r
1
. r
2
) % (.
1
. .
2
). Hence, transitivity is checked in this case.
4. If
1
.
1
and (r
1
=
1
and r
2
>
2
), then r
1
.
1
. As we know that r
1
.
1
implies (r
1
. r
2
) % (.
1
. .
2
), which validates transitivity. We have then checked all
four cases under which (r
1
. r
2
) % (
1
.
2
) and (
1
.
2
) % (.
1
. .
2
) may occur, and in
all of them we obtained (r
1
. r
2
) % (.
1
. .
2
), conrming that this preference relation
is transitive. Therefore, since the preference relation is complete and transitive,
we can conclude that it is rational.
1. [15 points] [Checking WARP]. Check whether the following demand function satises
the weak axiom of revealed preference (WARP). You can use gures to help your
discussion, but your nal reasoning must be in terms of the denition of the WARP:
Average demand: The consumers walrasian demand is the expected value of
a uniform randomization over all points on her budget frontier, for any (strictly
positive) prices j
1
, j
2
and wealth n.
Answer: First, note that if the consumer randomizes uniformly over all points
in her budget line, then the expected random demand is allocated at the
midpoint of the budget line.
x
2
B
p,w
x
1
x(p,w)
0.5w/p
2
0.5w/p
1
w/p2
w/p
1
Average demand
4
Let us now prove that WARP is satised for average demand. Let us work
by contradiction, by assuming that average demand violates WARP. There
are two possibilities in which this violation might take place, as the following
two gures illustrate.
x
2
B
p,w
x
1
x(p,w)
w/p2
w/p
1
B
p,w
x(p,w)
w/p1'
x
2
B
p,w
x
1
x(p,w)
w/p2
w/p
1
B
p,w
x(p,w)
w/p1' x
1
' x
1
Let us compute point r
1
and r
0
1
. Recall that these points have to be allocated
at the midpoint of the budget line. Hence,
r
1
=
1
2
n
j
1
and r
0
1
=
1
2
n
0
j
0
1
therefore 2r
1
=
w
p
1
and 2r
0
1
=
w
0
p
0
1
. Moreover, we can see in both gures that
r
0
1
< r
1
. Therefore, 2r
0
1
< 2r
1
, which implies
n
0
j
0
1
<
n
j
1
But in both gures we in fact see that
w
0
p
0
1

w
p
1
. Hence, we have reached a
contradiction, and average demand cannot violate WARP.
4. [5 points] [Concavity of the support function] We know that, given a non-empty,
closed set 1, its support function, j
K
(j), is dened by
j
K
(j) = inf j r for all r 1 and j R
L
Hence, the value of this support function, j
K
, satises j
K
_ j r for every element r
in the set 1. Given this denition, prove the concavity of the support function. That
is, show that
j
K
(cj + (1 c) j
0
) > cj
K
(j) + (1 c) j
K
(j
0
)
for every j. j
0
R
L
and for any c [0. 1].
First, from the denition of the support function we know that, for a given price
vector j, and for every element r in the set 1,
j
K
(j) _ j r, then cj
K
(j) _ cj r, for all c [0. 1] (2)
And similarly for any other price vector j
0
,
j
K
(j
0
) _ j
0
r, then cj
K
(j
0
) _ cj
0
r, for all c [0. 1] (3)
5
Similarly,
j
K
(j) _ j r, then (1 c) j
K
(j) _ (1 c) j r, for all c [0. 1] (4)
j
K
(j
0
) _ j
0
r, then (1 c) j
K
(j
0
) _ (1 c) j
0
r, for all c [0. 1] (5)
Summing up expressions (1) and (4), we have
cj
K
(j) + (1 c) j
K
(j) _ cj r + (1 c) j
0
r
which can be simplied to
cj
K
(j) + (1 c) j
K
(j) _ [cj + (1 c) j
0
] r
and by the denition of the support function, we know that j
K
(cj+(1 c) j
0
) =
[cj + (1 c) j
0
] r. Therefore,
cj
K
(j) + (1 c) j
K
(j) _ j
K
(cj + (1 c) j
0
)
and hence the support function j
K
(j) is concave.
5. [25 points] [Compensating and Equivalent variation] An individual consumes
only good 1 and 2, and his preferences over these two goods can be represented by the
utility function
n(r
1
. r
2
) = r

1
r

2
where c. , 0 and c +, ? 1
This individual currently works for a rm in a city where initial prices are j
0
= (j
1
. j
2
),
and his wealth is n.
(a) [1 point] Find the Walrasian demand for goods 1 and 2 of this individual, r
1
(j. n)
and r
2
(j. n).
Walrasian demands are
r
1
(j. n) =
cn
(c +,) j
1
and r
2
(j. n) =
,n
(c +,) j
2
(b) [1 point] Find his indirect utility function, and denote it as (j
0
. n).
Plugging the above Walrasian demand functions in the consumers utility
function, we obtain
(j. n) =
_
cn
(c +,) j
1
_

_
,n
(c +,) j
2
_

=
_
n
c +,
_
+
_
c
j
1
_

_
,
j
2
_

(c) [1 point] The rm that this individual works for is considering moving its oce to
a dierent city, where good 1 has the same price, but good 2 is twice as expensive,
i.e., the new price vector is j
0
= (j
1
. 2j
2
). Find the value of the indirect utility
function in the new location, i.e., when the price vector is j
0
= (j
1
. 2j
2
). Let us
denote this indirect utility function (j
0
. n).
(j
0
. n) =
_
n
c +,
_
+
_
c
j
1
_

_
,
2j
2
_

6
(d) [4 points] This individuals expenditure function is
c(j. n) = (c +,)
_
j
1
c
_
+
_
j
2
,
_

+
n
1
+
Find the value of this expenditure function in the following cases:
1. Under initial prices, j
0
, and maximal utility level n
0
= (j
0
. n), and denote
it by c(j
0
. n
0
).
c(j
0
. n
0
) = (c +,)
_
j
1
c
_
+
_
j
2
,
_

+
_
_
n
c +,
_
+
_
c
j
1
_

_
,
j
2
_

_
. .
u
1
+
= n
2. Under initial prices, j
0
, and maximal utility level n
0
= (j
0
. n), and denote it
by c(j
0
. n
0
).
c(j
0
. n
0
) = (c +,)
_
j
1
c
_
+
_
j
2
,
_

+
_
_
n
c +,
_
+
_
c
j
1
_

_
,
2j
2
_

_ 1
+
=
1
2

+
n
3. Under new prices, j
0
, and maximal utility level n
0
= (j
0
. n), and denote it
by c(j
1
. n
0
).
c(j
1
. n
0
) = (c +,)
_
j
1
c
_
+
_
2j
2
,
_

+
_
_
n
c +,
_
+
_
c
j
1
_

_
,
j
2
_

_ 1
+
= 2

+
n
4. Under new prices, j
0
, and maximal utility level n
0
= (j
0
. n), and denote it
by c(j
0
. n
0
).
c(j
0
. n
0
) = (c +,)
_
j
1
c
_
+
_
2j
2
,
_

+
_
_
n
c +,
_
+
_
c
j
1
_

_
,
2j
2
_

_ 1
+
= n
(e) [4 points] Find this individuals equivalent variation due to the price change.
Explain how your result can be related with this statement from the individual to
the media: I really prefer to stay in this city. In fact, I would accept a reduction
in my wealth if I could keep working for the rm staying in this city, instead of
moving to the new location
We know that
1\ = c(j
1
. n
1
) c(j
0
. n
1
) = :
1
2

+
n
That is, this individual would be willing to accept a reduction in his wealth
of n
1
2

+
n in order to avoid moving to a dierent city. [Alternatively, the
individual is willing to accept a reduction of
_
1
1
2

+
_
% of his weatlh ]
7
(f) [4 points] Find this individuals compensating variation due to the price change.
Explain how your result can be related with this statement from the individual
to the media: I really prefer to stay in this city. The only way I would accept to
move to the new location is if the rm raises my salary.
We know that
C\ = c(j
1
. n
0
) c(j
0
. n
0
) = 2

+
n n
That is, we would need to raise this individuals salary by 2

+
n n in
order to guarantee that his welfare level at the new city (with new prices)
coincides with his welfare level at the initial city (at the initial price level).
[Alternatively, the individual must receive an increase of
_
2

+
1
_
of his
wealth]
(g) [4 points] Find this individuals variation in his consumer surplus (also referred
as area variation). Explain.
We know that area variation is given by the area below the Walrasian demand
between the initial and nal price level. That is,
\ =
_
2p
2
p
2
r
2
(j. n)dj =
_
2p
2
p
2
,
(c +,) j
n dj
=
,
(c +,)
n
_
2p
2
p
2
1
j
dj =
,
(c +,)
nln 2
Hence, moving to the new city would imply a reduction in this individuals
welfare of

(+)
nln 2, or
_

(+)
ln 2
_
% of his wealth.
(h) [4 points] Which of the previous welfare measures in questions (e), (f) and (g)
coincide? Which of them do not coincide? Explain.
None of them coincide, since this individuals preferences are not quasilineal
in any of the goods.
(i) [2 points] Consider how the welfare measures from questions (e), (f) and (g) would
be modied if this individuals preferences were represented, instead, by the utility
function (r
1
. r
2
) = cln r
1
+, ln r
2
.
Since we have just applied a monotonic transformation to the initial utility
function, n(r
1
. r
2
), this new utility function represents the same preference
relation than function (r
1
. r
2
). Hence, the welfare results that we would
obtain from function (r
1
. r
2
) would be the same as those with utility function
n(r
1
. r
2
).
6. [10 points] [Slutsky equation in labor markets]. Explain the income and substitu-
tion eect in the labor market. Help your discussion with a gure, but you must relate
your gure with the Slutsky equation in labor economics.
8
(a) We know that the workers problem can be written as a EMP
min
y;z
^
` = j n. subject to (. .) =
where is the composite commodity, . is the number of working hours, j
is the price of the composite commodity, and n is the wage. Finally, note
that (. .) = represents the utility level that this worker wants to reach.
From this EMP we can nd the optimal hicksian demands, /
y
(n. j. ) and
/
z
(n. j. ), and inserting them into the objective function, we obtain the value
function of this EMP (the expenditure function):
c(n. j. ) = j/
y
(n. j. ) +n/
z
(n. j. )
We know that
r
z
(n. j. c(n. j. )) = /
z
(n. j. )
Dierentiating on both sides and using the chain rule
Jr
z
Jn
+
Jr
z
Jc
Jc
Jn
=
J/
z
Jn
==
Jr
z
Jn
=
J/
z
Jn

Jr
z
Jc
Jc
Jn
and since we know that
@e(w;p;v)
@w
= /
z
(n. j. ), then
Jr
z
Jn
=
J/
z
Jn
+
Jr
z
Jc
/
z
(n. j. )
Using the Slutsky equation (SE and IE) in the analysis of labor markets:
Jr
z
Jn
=
J/
z
Jn
+
Jr
z
Jc
/
z
(n. j. )
where:
1.
@hz
@w
0 is the substitution eect:
(a) an increase in wages increases the workers supply of labor, if we make his wealth
level constant; and
2.
@xz
@e
/
z
(n. j. ) is the income eect:
(a) if
@xz
@e
0 then an increase in wages makes that worker richer, and he decides to
work more (this would be an upward bending supply curve), or
(b) if
@xz
@e
< 0 then an increase in wages makes that worker richer, and he decides to
work less (e.g., nurses in Massachussets).
7. [10 points] [Aggregate demand]. Answer only one of the following 2 questions:
9
(a) [10 points] We know that aggregate demand can be expressed as a function of
aggregate wealth, i.e.,
I

i=1
r
i
(j. n
i
) = r
_
j.
I

i=1
n
i
_
if the following condition is satised for any two individuals i and ,, for a given
good /, and for any wealth of these two individuals, n
i
and n
j
.
Jr
ki
(j. n
i
)
Jn
i
=
Jr
kj
(j. n
j
)
Jn
j
Explain what this condition implies in terms of these individuals wealth expansion
paths (you can use a gure to help your discussion). Can you give an example of
a preference relation satisfying this condition?
This condition states that: for any xed price vector j, for any good /,
and for any wealth level of any two individuals i and ,, the wealth eect
is the same across individuals. In other words, the wealth eects arising
from the distribution of wealth across consumers cancel out. Graphically,
this condition is equivalent to say that all consumers exhibit parallel, straight
lines:
Straight, because the coincidence in wealth eects do not depend on the
individuals wealth level.
Parallel, because individuals wealth eects must coincide (and recall that
wealth expansion paths just represent how an individual demand changes as
he becomes richer). (See gure from Handout #8).
Examples of parallel, straigh wealth expansion paths? Homothetic prefer-
ences, and Quasilinear preferences (all consumers with respect to the same
good).
Recall that we can embody all these cases as special cases of a particular type
of preferences? If every consumers indirect utility function can be expressed
as

i
(j. n
i
) = c
i
(j) +/(j)n
i
(Gorman form)
with the same /(j)s for all consumers, then their wealth expansion paths are parallel, straight
lines. And as a consequence, aggregate demand can be represented as a function of aggregate
wealth.
1. b. [10 points] Show that if an individuals preference relation is homothetic, then
this individuals Walrasian demand satises the Uncompensated Law of Demand
(ULD). [Hint: instead of showing ULD, you can alternatively show that 1
p
r
i
(j. n
i
)
is negative semidenite, since we know that both properties are equivalent. In
order to show the latter, rst use the Slustsky equation, then use homotheticity,
and nally pre- and post-multiply all elements by dj]
10
As we observed in Homework #3, we rst write the Slutsky equation
o
i
(j. n
i
) = 1
p
r
i
(j. n
i
) +1
w
r
i
(j. n
i
)r
i
(j. n
i
)
T
and for homothetic preference relations, r
i
(j. n
i
) = c
i
n
i
, (or alternatively,
c
i
=
x
i
(p;w
i
)
w
i
), we have that 1
w
r
i
(j. n
i
) = c
i
, with we can write as 1
w
r
i
(j. n
i
) =
x
i
(p;w
i
)
w
i
. Plugging and rearranging,
1
p
r
i
(j. n
i
) = o
i
(j. n
i
)
r
i
(j. n
i
)
n
i
r
i
(j. n
i
)
T
Now we pre- and post-multiply all elements by dj,
dj 1
p
r
i
(j. n
i
) dj = dj o
i
(j. n
i
) dj
. .
< 0 if dj ,= cj
= 0 if dj = cj
dj
r
i
(j. n
i
)
n
i
r
i
(j. n
i
)
T
. .
0 if r
i
0
= 0 if r
i
= 0
dj
Either way, dj 1
p
r
i
(j. n
i
) dj < 0, except when zero consumption and the
change in prices is proportional to the initial price level, i.e., dj = cj. Since
1
p
r
i
(j. n
i
) is then negative semidenite, and a few minutes ago we saw that
ULD == 1
p
r
i
(j. n
i
) is negative semidenite
Hence, r
i
(j. n
i
) satises ULD.
11
Micro Theory I - EconS 501
Midterm #2 - Answer Key
Instructions: Please read the questions carefully, answer them in a formal and concise
manner, but include all your steps, this will allow you to obtain partial credit. You have
until 10:25a.m. to complete the exam. Good luck!!
1. [25 points] [True or false?] Identify which of the following statements are true, and
which are false, and provide a very short explanation of why this is the case.
(a) [3 points] All preference relations are rational.
False. See recitation #1 for examples of preference relations which do not
satisfy rationality.
(b) [3 points] If a preference relation is rational (satises completeness and transitiv-
ity), it can be represented by a utility function.
True. The Lexicographic preference relation satises rationality, and it cannot
be represented by a utility function when dened over continuous consump-
tion sets, e.g., A [0. 1]. since this preference relation is not continuous.
However, when the lexicographic preference relation is dened over discrete
consumption sets, A =
x11
.
x12
. .... r
1N
, this preference relation can be rep-
resented by a utility function (see Homework #1 for an example). If the
statement was If a preference relation is rational (satises completeness and
transitivity), it can be represented by a utility function for any consumption
set then it would have been false, since it cannot be represented when the
consumption set is continuous.
(c) [3 points] If a preference relation is quasilinear, the substitution eect is zero, and
the income eect is positive.
False. If a preference relation is quasilinear, the income eect is zero.
(d) [3 points] Gien goods does not need to be inferior.
False. Every Gien good must be inferior. The opposite direction is not true,
however: every inferior good does not need to be Gien.
(e) [3 points] The Walrasian demand is negatively sloped, for any preferences of the
consumer.
False. The Walrasian demand of Gien goods is positively sloped (quantity
demanded increases when prices increase, or alternatively, quantity demanded
decreases when prices decrease).
(f) [3 points] The area variation (change in consumer surplus) is never a good ap-
proximation of the change in consumer welfare resulting from price changes (or
equivalently, from tax changes), for any type of consumer preferences.
1
False. The area variation is a good approximation of the change in con-
sumer welfare for quasilinear preferences, and more generally, for goods with
relatively small income eects.
(g) [7 points] If a production function satises increasing average product, it must
also satisfy increasing marginal product.
False. Recall that the average product can be represented through the slope
of the rays from the origin to the production function, and the slope is simply
the slope of the production function at a given point. A counterexample of
the above statement is represented below:
f(z)
z
f(z)
2. [20 points] [Properties of the prot function] The prot function, :(j), is dened
as
:(j) = max j [ 1
or alternatively, :(j) > j for every 1 .
(a) [10 points] Show that the prot function :(j) is convex in prices.
We need to show that, for any c [0. 1] and j R
L
++
,
:(cj + (1 c)j
0
) _ c: (j) + (1 c) :(j
0
)
Proof. From the denition of the prot function we know that
: (j) _ j , for any 1 and j 0, and
: (j
0
) _ j
0
, for any 1 and j
0
0
And similarly, using that the prot function is homogeneous of degree 1 in
prices, we can take any c [0. 1],
c: (j) _ cj , for any 1 and j 0, and
(1 c) : (j
0
) _ (1 c) j
0
, for any 1 and j
0
0
Adding up the two previous inequalities,
c: (j) + (1 c) : (j
0
) _ cj + (1 c) j
0

2
where the right-hand side cj+(1 c) j
0
coincides with the prot function
for price level cj + (1 c) j
0
, i.e., : (cj + (1 c) j
0
). Hence,
c: (j) + (1 c) : (j
0
) _ : (cj + (1 c) j
0
)
and therefore we can conclude that the prot function is convex in prices.
(b) [10 points] Prove the Hotellings lemma using the Duality theorem. [Hint: easy,
just rewrite]
Hotellings lemma states that if the output function evaluated at prices c,
(j), consists of a single point, then the prot function : (j) is dierentiable
at the price level j; and moreover such derivative is \
p
.: (j) = (j).
Let us rst express the prot function as the support function that, for every
price vector j, chooses the inmum of j (), i.e., instead of choosing the
max of j , we redene it as the inf of j ().
: (j) = inf j () [ 1
In order to emphasize the similarities with the Duality Theorem, we reproduce
it here again: Let 1 be a nonempty and closed set, and let us j
K
(j) be its
support function. Then, there exists a unique element r in the set 1 such
that j
K
(j) = j r if and only if j
K
(j) is dierentiable at j. Moreover,
\
p
j
K
(j) = r.
Therefore, given that we have noticed that the prot function can be ex-
pressed as a support function, we can rewrite Hotellings lemma as a direct
application of the Duality Theorem.(just changing labels!): Let 1 be a non-
empty and closed (production) set, and let us j
Y
(j) be its support function.
Then, there exists a unique production function (j) in the set 1 such
that : (j) = j (j) if and only if : (j) is dierentiable at j. Moreover, this
derivative is \
p
: (j) = (j).
3. [8 points] [Independence axiom and convexity]. Show that the independence
axiom implies convexity, i.e., for three dierent lotteries 1, 1
0
and 1
00
, if 1 % 1
0
and
1 % 1
00
then 1 % c1
0
+ (1 c) 1
00
.
From 1 % 1
0
we can apply the independence axiom, and obtain
c1 + (1 c)1 ~ c1
0
+ (1 c)1
Similarly, from 1 % 1
00
we can apply the independence axiom, and obtain
(1 c)1 +c1
0
~ (1 c)1
00
+c1
0
And by transitivity (from the two previous expressions), we have
c1 + (1 c)1 ~ (1 c)1
00
+c1
0
and rearranging
1 ~ c1
0
+ (1 c)1
00
3
4. [18 points] [Purchasing health insurance] Consider an individual with the following
Bernouilli utility function
n(C. H) = ln C
c
H
where C is his expenditure in consumption goods and H is his expenditure on health
insurance. Parameter c denotes his losses if he becomes sick, where for simplicity
c =

1 if he is sick, and
0 if he is healthy
Note that this utility function implies that, when getting sick, this individuals disu-
tility is decreasing in the amount of health insurance that he purchased (e.g., he can
have access to better doctors and care facilities, and the negative eects of the illness
are reduced). Finally, the probability of getting sick is given by [0. 1], and this
individuals wealth is given by : 0, where : = C +H.
(a) [3 points] What is this individual utility maximization problem? [Hint: it is easier
to choose C as your choice variable. You can nd the optimal amount of H later
on]
max
C;H
(1 ) ln C +

ln C
1
H

where we subsitute c = 0 when the individual is healthy (which occurs with prob-
ability ), and c = 1 when the individual is sick (which occurs with probability
1 ). And since : = C +H, then H = :C, hence,
max
C
(1 ) ln C +

ln C
1
:C

which reduces the choice variables of this maximization problem to only one: C.
(b) [3 points] Find the rst order conditions associated to the previous maximization
problem.
1
C

(:C)
2
= 0
(c) [6 points] Determine the optimal amount of consumption goods, C

, and health
insurance, H

.
Rearranging,
C
2
(2:+)C +:
2
= 0
with solutions
C =
2:+ +
p

2
+ 4:
2
and C =
2:+
p

2
+ 4:
2
but given that the amount spent on consumption cannot exceed the indi-
viduals wealth, C _ :, the only feasible solution is C

=
2m+
_

2
+4m
2
.
Therefore, the optimal amount of health insurance that this individual buys
is
H

= :C

= :
2:+
p

2
+ 4:
2
=
p

2
+ 4:
2
4
(d) [6 points] Determine if the optimal amount of health insurance, H

, is increasing,
decreasing, or constant in :. Interpret.
Dierentiating H

with respect to :,
JH

J:
=

_
+ 4:
0 for all parameter values
That is, the optimal amount of health insurance, H

, is increasing in the
individuals wealth level, :.
5. [15 points] [Nonconstant coecient of absolute risk aversion]. Suppose that the
utility function is given by n(\) = c\ /\
2
, where c. / 0.
(a) [2 points] First, nd the coecient of absolute risk-aversion. Does it increases or
decreases in wealth? Interpret.
First, note that n
0
= c2/\ and n
00
= 2/. Hence, the coecient of absolute
risk-aversion is
:
A
(r. n) =
n
00
(r)
n
0
(r)
=
2/
c 2/\
Note that as \ rises, the denominator decreases, and as a consequence
:
A
(r. n) rises, i.e., the decision maker becomes more risk averse as he wealth
increases.
(b) [3 points] Let us now consider that this decision maker is deciding how much to
invest in a risky asset. This risky asset is a random variable 1, with mean 1 0
and variance o
2
R
. Assuming that his initial wealth is \, state the decision makers
(expected) utility maximization problem, and nd rst order conditions. [Hint:
First, note that the decision makers wealth (\ in his utility function) is now a
random variable \ + r1, where r is the amount of risky asset that he acquires.
You must insert this expression in the decision makers utility function, for every
\. Then, we must take expectations over the entire expression, since the risky
asset is a random variable.]
The choice problem of the decision maker is
max
x
1

c (\ +r1) / (\ +r1)
2

## And the associated rst order condition is

1 [c1 2/1(\ +r

1)] = 0
(c) [4 points] Simplify the rst order condition you found before. [Hint: Note that
you must use the property that 1[1
2
] = 1
2
+o
2
R
].
Simplifying the above rst order condition,
1 [c1 2/1(\ +r

1)] = c1 2/1\ 1

2/1
2
r

=
= c1 2/1\ 2/r

1
2
+o
2
R

= 0
5
(d) [4 points] What is the optimal amount of investment in risky assets?
Solving for r

## in the above expression,

r

=
(c 2/\) 1
2/

1
2
+o
2
R

(e) [2 points] Show that the optimal amount of investment in risky assets (the expres-
sion you found in the previous part) is a decreasing function in wealth. Interpret.
Dierentiating r

Jr

J\
=
1

1
2
+o
2
R

## which is negative, since 1. o

2
R
0. Intuitively, the larger the decision makers
wealth, the lower is the amount of risky assets he wants to hold. This expla-
nation is consistent with his coecient of absolute risk aversion found at the
beginning of the exercise, where we showed that the individual becomes more
risk averse as his wealth increases.
6. [12 points] [Concavity and Coecient of risk aversion] Let n and be two utility
functions, where (\) = , (n(\)), and ,() is a concave function, i.e., is more
concave than n.
(a) [4 points] Find the coecient of absolute risk-aversion for .
First, note that
0
= ,
0
n
0
and
00
= ,
00
[n
0
]
2
+,
0
n
00
. Therefore, the Arrow-Pratt
coecient of absolute risk aversion of is
:
A
(r. ) =

00
(r)

0
(r)
=
,
00
[n
0
]
2
+,
0
n
00
,
0
n
0
=
n
00
n
0

,
00
n
0
,
0
(b) [8 points] Prove that the coecient of absolute risk-aversion for is greater than
for n.
We want to compare the Arrow-Pratt coecient of absolute risk aversion of ,

u
00
u
0

f
00
u
0
f
0
, with respect to that of n,
u
00
u
0
. Hence, we want to know the sign
of
f
00
u
0
f
0
, First, note that n() is increasing in wealth, and then n/ 0. Second,
note that function ,() is a concave, i.e., ,
0
0 and ,
00
< 0. Summarizing,
the ratio
f
00
u
0
f
0
is negative, which implies

n
00
n
0

,
00
n
0
,
0

n
00
n
0
which implies that :
A
(r. ) :
A
(r. n). Intuitively, the coecient of absolute
risk aversion is higher the more concave is the utility function.
6
Micro Theory I - EconS 501
Final Exam - Answer Key.
1. [40 points] [True or false?] Identify which of the following statements are true, and
which are false, and provide a very short explanation of why this is the case.
(a) [3 points] Homothetic preferences have non-straight wealth expansion paths.
False. Recall that this type of preferences induce wealth expansion paths
that are straight lines from the origin, i.e., if we double the wealth level
of the individual, then his wealth expansion path (the line connecting his
demanded bundles for the initial and the new wealth level) are straight lines.
(b) [7 points] Homothetic preferences induce a demand function with non-constant
income elasticity.
False. As a corollary of the straight wealth expansion paths, we can conclude
that the demand function obtained from homothetic preferences must have
an income-elasticity equal to 1, i.e., when the consumers income is increased
by 1%, the amount he purchases of any good / must increase by 1% as well.
(c) [2 points] Consider the demand function of an individual with homothetic prefer-
ences. The marginal rate of substitution resulting from this individuals demand
function does not vary if we increase his consumption of one of the goods
False. When preferences are homothetic, the MRS between the two goods is
just a function of the consumption ratio between the goods,
a
1
a
2
, but it does
not depend on the absolute amounts consumed. As a consequence, if we
double the amount of both goods, the MRS does not change.
Let us consider an example of a Cobb-Douglas utility function, n(r
1
. r
2
) =
r
c
1
r
o
2
. First note that
`1o
1,2
=
cr
c1
1
r
o
2
,r
c
1
r
o1
2
scaling up all goods by a factor t, we obtain
`1o
1,2
=
c(tr
1
)
c1
(tr
2
)
o
, (tr
1
)
c
(tr
2
)
o1
=
t
c1+o
t
c+o1
cr
c1
1
r
o
2
,r
c
1
r
o1
2
=
cr
c1
1
r
o
2
,r
c
1
r
o1
2
which shows that the `1o
1,2
does not change when we scale up all goods
by a common factor t, i.e., the slope of the indierence cuve at a given point
(r
1
. r
2
) is not changed.
(d) [3 points] The Weak Axiom of Revealed Preference (WARP) states that, for any
two price-wealth situations (j. n) and (j
0
. n
0
),
if j r(j
0
. n
0
) _ n and r(j
0
. n
0
) ,= r(j. n), then j
0
r(j. n) n
0
1
False. WARP states that, for any two price-wealth situations (j. n) and
(j
0
. n
0
),
if j r(j
0
. n
0
) _ n and r(j
0
. n
0
) ,= r(j. n), then j
0
r(j. n) n
0
(e) [4 points] The utility function n(r
1
. r
2
) = max r
1
. r
2
is quasiconcave (i.e., the
upper contour set of any indierence curve is convex).
False. In order to check for quasiconcavity, we now use the denition: n(r
1
. r
2
) =
max r
1
. r
2
is quasiconcave if, for every bundle (r
1
. r
2
), the set of bundles
(
1
.
2
) such that the consumer obtains a higher utility level than from (r
1
. r
2
)
is convex. That is, for every bundle (r
1
. r
2
), its upper contour set
(
1
.
2
) : n(
1
.
2
) _ n(r
1
. r
2
) is convex
that is,
(
1
.
2
) : max
1
.
2
_ max r
1
. r
2
is convex
As we can see from the gure below representing this preference relation, we
can nd bundles, like r, for which its upper contour set is not convex. That
is,
% r but `r + (1 `) r for all ` [0. 1]
x
2
x
1
x
y
That is, max
1
.
2
_ max r
1
. r
2
(which implies % r) [In this example
max
1
.
2
=
1
, and max r
1
. r
2
= r
2
, and
1
r
2
]. However, construct-
ing a linear combination of these two bundles `r + (1 `) we have that
max `r
1
+ (1 `)
1
. `r
2
+ (1 `)
2
< max
1
.
2
=
1
This inequality is indeed satised because either:
max `r
1
+ (1 `)
1
. `r
2
+ (1 `)
2
= `r
1
+(1`)
1
(i.e., if the linear
combination of r and is below the main diagonal), then `r
1
+(1`)
1
_

1
for any ` [0. 1]; or
If, instead, max `r
1
+ (1 `)
1
. `r
2
+ (1 `)
2
= `r
2
+(1`)
2
(i.e.,
if the linear combination of r and is above the main diagonal), then we
also have `r
2
+ (1 `)
2
_
1
for any ` [0. 1].
2
(f) [2 points] One of your friends studying intermediate microeconomics meets you
and starts explaining how excited he is about all the concepts he is learning
in his micro course. At one point he says: I particularly enjoyed the second
fundamental welfare theorem. You know, that theorem showing that any Pareto
optimal allocation can be implemented by a central authority who transfers money
among consumers, and then allows the market work. It is fascinating that the
competitive equilibrium resulting from allowing the market work can induce the
utility levels of the Pareto optimal allocation, for all types of consumers and rms!
In other words, this theorem says that by redistributing money among people we
can achieve Pareto improvements. As a consequence, we would increase the utility
of at least some people, while not reducing the utility level of anybody else. Your
friend is denitely excited, but where is the aw in his statement?
False. The second fundamental welfare theorem cannot be generalized to
all types of consumers and rms. It can only be applied when consumers
preferences are convex, and rms production function is convex.
(g) [3 points] Consider an individual with Bernouilli utility function n(r) =
_
r.
When facing the gamble
_
36. 16;
1
2
.
1
2
_
his certain equivalent is c(1. n) =
_
26 and
his probability premium is : =
p
26
2
.
False. The certain equivalent c (1. n) of this gamble is
_
36
1
2
+
_
16
1
2
= 6
1
2
+ 4
1
2
= 3 + 2 = 5
n(c(1. n)) = 5
c (1. n) = 25 Certainty Equivalent
which implies that the decision maker must be given an amount of money
that provides him with a utility level of 5. Therefore, n(c(1. n)) = 5, and
c (1. n) = 25.
False too. The probability premium : of this gamble is
_
1
2
+ :
_
n(r + ) +
_
1
2
:
_
n(r ) = n(r)
_
1
2
+ :
_
_
36 +
_
1
2
:
_
_
16 =
_
26
..
&(1\ )
since 1\ =
1
2
36 +
1
2
16 =
36 + 16
2
=
52
2
= 26
1
2
_
36 +
_
36: +
1
2
_
16
_
16: =
_
26
_
_
36
_
16
_
: =
_
26
_
36
2

_
16
2
(6 4) : =
_
26
6
2

4
2
2: =
_
26 5
: =
_
26 5
2
Probability Premium
3
1. h. [2 points] The independence axiom states that, for all three lotteries 1, 1
0
and
1
00
, and c (0. 1) we have
1 % 1
0
==c1 + (1 c)1
0
% c1
0
+ (1 c)1
00
False. The independence axiom states that, for all three lotteries 1, 1
0
and
1
00
, and c (0. 1) we have
1 % 1
0
==c1 + (1 c)1
00
% c1
0
+ (1 c)1
00
i. [6 points] Consider the social welfare maximization problem
max
&
1
,...,&
I
\ (n
1
(r
1
) . n
2
(r
2
) . .... n
1
(r
1
))
subject to j
_

i
r
i
_
_ n
And denote by (j. n) the optimal solution of this problem, usually referred as
the indirect utility function. The indirect utility function (j. n) is increasing in
prices.
False. Let us take j
0
_ j. Let us (n
1
. n
2
. .... n
1
) be the solution to the
maximization problem given (j
0
. n). Hence,
(j
0
. n) = \ (
1
(j
0
1
. n
1
) .
2
(j
0
1
. n
2
) . ....
1
(j
0
1
. n
1
))
As j
0
_ j, we have that

i
(j
0
. n
i
) _
i
(j. n
i
) for all i
Since \ () is increasing in the utility levels of every individual,

i
(j
0
. n
i
) _
i
(j. n
i
) ==\ (
i
(j
0
. n
i
) . ....
1
(j
0
. n
1
)) _ n(
1
(j. n
1
) . ....
1
(j. n
1
))
Then, by the denition of (j. n) we have,
\ (
1
(j
0
. n
1
) .
2
(j
0
. n
2
) . ....
1
(j
0
. n
1
)) _ (j. n)
Therefore,
(j
0
. n) _ (j. n) for all j
0
_ j
Hence, the indirect utility function (j. n) is weakly decreasing in prices, or
alternatively non-increasing in prices.
j. [5 points] If a lottery 1 rst order stochastic dominates another lottery G, then
the mean value of 1 must be higher than that of G, and viceversa.
False. This statement says 1 %
1OS1
G == 1(r
1
) _ 1(r
G
), and the
contrary 1 %
1OS1
G == 1(r
1
) _ 1(r
G
).
4
The rst direction of the implication is true. Indeed, we know that distribu-
tion function 1(r) rst-order stochastically dominates G(r) if
_
n(r) d1(r) >
_
n(r) dG(r)
Using the fact that the utility function is weakly increasing, and using n(r) =
r, we have
_
rd1(r) >
_
rdG(r)
However, the second implication 1 %
1OS1
G == 1(r
1
) _ 1(r
G
) is false. It
can easily proved by providing any counterexample. Consider for instance the
example of a mean-preserving spread discussed in class. The mean of both
distribution functions 1(r) and G(r) was
5
2
. However, neither 1(r) FOSD
G(r), nor G(r) FOSD 1(r), for all r.
k. [3 points] If a monopolist can perfectly identify the consumers who belong to
two dierent segments of the market, he will set prices to each segment such the
corresponding marginal revenue coincides with the monopolist marginal cost, for
any cost structure and quantities.
False. This pricing rule is only valid when the monopolist does not face
capacity constraints. When the monopoly faces capacity constraints, the
monopolist sets the output produced in each of the ` segments of the market
(
1
.
2
. ....
.
) so that they satisfy
`1
i
(
i
) = `1
)
(
)
) for every segment i = 1. 2. .... ` , where i ,= ,
.
2. [14 points] [Expected utility] Consider an individual with Bernouilli utility function
n(r) = ,r
2
+r. Show that his expected utility for any given lottery 1(r) is determined
by the mean and variance alone. [Hint: recall that \ c:(r) = 1(r
2
) 1(r)
2
].
We know that the expression of the expected utility function for any lottery 1(r)
is 1l =
_
n(r) d1(r)
In this case, then, 1l =
_
_
,r
2
+ r

. .
&(a)
d1(r). And expanding it,
,
_
r
2
d1(r)
. .
1(a
2
)
+
_
rd1(r)
. .
1(a)
and on the other hand, we know that \ c:(r) = 1(r
2
) 1(r)
2
. Hence, 1(r
2
) =
\ c:(r) + 1(r)
2
. Substituing 1(r
2
) in the above expression,
,\ c:(r) + ,1(r)
2
+ 1(r)
and as a consequence, the 1l for the Bernouilli utility function n(r) = ,r
2
+r
is determined by the mean and the variance alone
5
3. [10 points] [Second-degree price discrimination] Let us consider two consumers
with the following quasilinear utility functions
n
1
(r
1
.
1
) = c
1
r
1

1
n
2
(r
2
.
2
) = c
2
r
2

2
The price of the composite commodity is 1, and each consumer has a large initial
wealth. We know that c
2
c
1
. Both goods can only be consumed in weakly positive
amounts, r
i
_ 0 and
i
_ 0. A monopolist supplies teh x-good. It has zero marginal
costs, but has a capacity constraint: it can supply at most 10 units of the r-good. The
monopolist will oer at msot two price-quantity packages (:
1
. r
1
) and (:
2
. r
2
), where
:
i
is the cost of purchasing r
i
units of the good (total revenue for the monopolist from
selling r
i
units to consumer i).
(a) [1 point] Check if the single-crossing property is satised. Interpret.
Indeed, the single-crossing property holds, since
Jn
2
(r. )
Jr

Jn
1
(r. )
Jr
==c
2
c
1
Intuitively, this property implies that the marginal utility that consumer 2
obtains from consuming additional amounts of good r is strictly higher than
that of consumer 1, for all r (irrespective of the amount of good r they are
consuming).
(b) [1 point] Write down the monopolists prot maximization problem. You should
have 4 constraints (two participation constraints and two incentive compatibility
constraints), plus the capacity constraint r
1
+ r
2
_ 10.

max
v
1
,v
2
:
1
+ :
2
subject to c
1
r
1
:
1
_ 0 (1C
1
)
c
2
r
2
:
2
_ 0 (1C
2
)
c
1
r
1
:
1
_ c
1
r
2
:
2
(1C
1
)
c
2
r
2
:
2
_ c
2
r
1
:
1
(1C
2
)
and r
1
+ r
2
_ 10 (Capacity constraint)
(c) [2 points] Which constraints will be binding in the optimal solution?
We know that 1C
1
is binding and 1C
2
is binding
c
1
r
1
= :
1
1C
1
c
2
r
2
:
2
= c
2
r
1
:
1
1C
2
and that the capacity constraint is binding as well,
r
1
+ r
2
= 10.
6
From 1C
2
,
:
2
= c
2
(r
2
r
1
) + :
1
:
2
= c
2
_
r
2
r
1
+
v
1
..
c
1
r
1
_
= c
2
_
_
10 r
1
. .
a
2
r
1
_
_
+ c
1
r
1
= 10c
2
2r
1
c
2
+ c
1
r
1
Hence, 1C
2
can be expressed as :
2
= 10c
2
2r
1
c
2
+ c
1
r
1
(d) [3 points] Substitute these binding constraints into the objective function. What
is the resulting expression?
The objective function :
1
+ :
2
can be rewritten using 1C
1
and 1C
2
from
above,
v
1
..
c
1
r
1
+
v
2
..
10r
2
2c
2
r
1
+ c
1
r
1
Simplifying,
2c
1
r
1
+ 10c
2
2c
2
r
1
= 10c
2
+ 2 (c
1
c
1
) r
1
(e) [3 points] What are the optimal values of the packages (:
1
. r
1
) and (:
2
. r
2
)?
Since the objective function (simplied in part c) is a function of r
1
only, we
just have to take FOC with respect to r
1
,
2c
1
2c
2
_ 0 ==c
1
_ c
2
since c
1
< c
2
by denition, then 2c
1
2c
2
< 0 strictly, which implies a
corner solution in the variable we were dierentiating, r
1
, where
r

1
= 0
Since r

1
= 0. then r

2
= 10.
Additionally, from 1C
1
,
:

1
= c
1
r

1
= c
1
0 = 0
And from 1C
2
,
:

2
= 10c
2
2r

1
c
2
. .
0
+ c
1
r

1
..
0
= 10c
2
4. [17 points] [Distribution of tax burden] An ad valorem tax of t is to be levied on
consumers in a competitive market with aggregate demand curve r(j) = j
.
, where
0 and < 0, and aggregate supply curve (j) = cj

, where c 0 and 0.
Calculate the percentage change in consumer cost and producer receipts per unit sold
for a small (marginal) tax. Denote i = (1 + t). Assume that a partial equilibrium
analysis is valid.
7
(a) [10 points] Compute the elasticity of the equilibrium price with respect to i.
To compute the price received by producers, we can use equation (10.C.8) in
the textbook:
j

0
(0) =
r
0
(j

)
r
0
(j

)
0
(j

)
=
j
.1

j
.1

cj
1

=
j
.

j
.

cj

=
=
r (j

)
r (j

) (j

)
=

.
(We have multiplied both the numerator and the denominator by j

and used
the fact that j

) = (j

## ).) The price

paid by consumers is (j

## ) + t, and its derivative with respect to t at t = 0 is

j
0
(0) + 1 =

+ 1 =

.
(b) [2 points] Argue that when = 0 producers bear the full eect of the tax while
consumers total costs of purchase are unaected.
From the above expression,
j
0
(0) + 1 =

+ 1 =

.
we can see that when = 0 (supply is perfectly inelastic),
lim
!0

= 0.
and the price paid by consumers is unchanged, and the price received by
producers
lim
!0

= 1.
decreases by the full amount of the tax.
(c) [3 points] Argue that when = 0 consumers bear the full burden of the tax.
When = 0 (demand is perfectly inelastic),
lim
.!0

= 0.
and the price received by producers is unchanged and the price paid by con-
sumers
lim
.!0

= 1.
increases by the full amount of the tax.
(d) [2 points] What happens when each of these elastiticities approaches in absolute
value?
8
When (demand is perfectly elastic), the price paid by consumers is
unchanged,
lim
.!1

= 0.
and the price received by producers decreases by the amount of the tax. In
contrast, when (supply is perfectly elastic),
lim
!1

= 0.
and the price received by producers is unchanged and the price paid by con-
sumers increases by the amount of the tax.
5. [19 points] [Cost reducing investment]. Consider a situation in which there is a
monopolist in a market with inverse demand function j(). The monopolist makes
two choices: How much to invest in cost reduction, 1, and how much to sell, . If the
monopolist invests 1 units in cost reduction, his (constant) per-unit cost of production
is c(1). Asume that c
0
(1) < 0 and that c
00
(1) 0, i.e., investing in cost reduction
reduces the monopolists per-unit cost of production, but at a decreasing rate. Assume
throughout that the monopolists objective function is concave in and 1.
(a) [7 points] Derive the rst-order conditions for the monopolists choices.
he monopolist will solve
max
q,1
j () c (1) 1
which yields the FOCs are
(i) j
0
(
n
)
n
+ j (
n
) = c (1
n
) ,
(ii) c
0
(1
n
)
n
= 1.
(b) [6 points] Compare the monopolists choices with those of a benevolent social
planner who can control both and 1 (a rst-best comparison). Interpret your
results.
The social planner will maximize total surplus,
max
q,1
_
q
0
j (r) dr c (1) 1,
and the FOCs are,
(iii) j (

) = c (1

) ,
(iv) c
0
(1

= 1.
The monopolist produces less output than is socially optimal,
n
<

, and
price is above marginal cost. Given this, equations (ii) and (iv) imply that
c
0
(1

) < c
0
(1
n
), which in turn implies that 1

1
n
(given that c
0
(1) < 0)
That is, the monopolist invests less in cost-reducing technologies than the
social planner would.
9
(c) [6 points] Compare the monopolists choices with those of a benevolent social
planner who can control for 1 but not for (a second-best comparison). In
particular, suppose that the social planner chooses 1 and then the monopolist
chooses .
Given a level

1 set by the government, the monopolist will set to maximize
its prots, i.e., it will set to equate `1 = `C. Therefore, the governments
problem is to maximize social surplus subject to the monopolistss behavior.
That is,
max
q,1
_
q
0
j (r) dr c (1) 1
subject to j
0
() + j () = c (1)
The Lagrangian is
1 =
_
q
0
j (r) dr c (1) 1 `[j
0
() + j () c (1)] ,
which yields the FOCs,
(v) j ( ) c
_

1
_
`[j
00
( ) + 2j
0
( )] = 0,
(vi) c
0
_

1
_
( `) = 1.
When comparing (ii) and (vi) we can see that
c
0
(1
n
)
n
= c
0
_

1
_
( `) , where ` 0
Hence, the social planners investment,

1 is greater than the optimal invest-
ment level 1

## , found in the previous exercise The intuition is that in this

second-best environment, the social planner chooses an investment level

1
larger than optimal for the given level of output in order to induce the mo-
nopolist to produce more.
10
Micro Theory I - EconS 501
Midterm #1 - October 5th, 2011.
Instructions: Please read the questions carefully, answer them in a formal and concise
manner, but include all your steps, this will allow you to obtain partial credit. You have
until 5:30p.m. to complete the exam. Good luck!!
Short exercises: The following two exercises are relatively short. Please do not use more
than approximately half a page to answer each of their sections.
1. Consider the preference relation dened on a consumption set A R
2
+
: for all any
two bundles r, r
0
2 A, bundle r is weakly preferred to r
0
, i.e., r % r
0
, if and only if
r
1
r
0
1
1 and r
2
r
0
2
+ 1.
Check if this preference relation satises completeness and transitivity.
2. Check if the following function is a proper cost function:
c(n. ) = 4n
2
1
n
2
2

1=4
.
where the vector of input prices n 2 R
2
++
, and output level 2 R
+
. [Hint: check the
properties of the cost function associated to the cost-minimization problem (CMP). If
one of the properties is violated, then this function cannot represent a cost function.]
3. Consider a prot-maximization problem (PMP) that produces the following prot func-
tion
:(j. n. :) =
j
2
4n
+
j
2
4:
,
where n 2 R
+
denotes the wage rate, : 2 R
+
represents the interest rate and j 2 R
+
denotes the price of the single output that the rm produces. Obtain the expression
of its associated cost function c(n. :. ).
Long exercises:
4. Consider the utility function
n(r) =
Y
n
i=1
r

i
i
.
where r denotes a vector of : dierent goods r 2 R
n
+
, and c
i
0. Check if n(r)
satises: (1) additivity, (2) homegeneity of degree /, and (3) homotheticity.
5. Consider a function 1(j. n) representing the inverse of the indirect utility function
(j. n), that is
1(j. n)
1
(j. n)
where the indirect utility function satises the usual properties, and (j. n) 6= 0.
1
(a) Use function 1(j. n) to nd the Walrasian demand of good i, i.e., r
i
(j. n).
(b) Let :
j
denote the share of income that the consumer spends on good ,. Show
that :
j
can be expressed as follows
:
j
=
@F(p;w)
@p
j
p
j
F(p;w)
@F(p;w)
@w
w
F(p;w)
6. Consider a consumer with the following expenditure function
c(j. n
0
) = q(j) +

n
0
,(j)

where functions q(j) and ,(j) depend on the price vector j alone. Show that the
income elasticity of any good i converges to one when the consumers wealth level
tends to innity, i.e., lim
w!1

x
i
;w
= 1.
7. Consider a consumer who, facing a initial price vector j
0
2 R
n
++
, purchases an :-
dimensional bundle r 2 R
n
+
with an income of n dollars. Assume that the price of all
goods experience a common increase measured by factor o 1.
(a) Compute the compensating variation (CV) of this price increase.
(b) Compute the equivalent variation (EV) of this price increase.
2
[You can use the following pages as scratch paper.]
Name: ________________________________
3
Name: ________________________________
4
Name: ________________________________
5
Micro Theory I - EconS 501
Midterm #2 - First part, November 16th, 2011.
Instructions: Please read the questions carefully, answer them in a formal and concise
manner, but include all your steps, this will allow you to obtain partial credit. Good luck!!
1. [25 points] [Preference relations] Let % be a preference relation dened over the
consumption set X = R
L
+
. We dene that preference relation % is monotone if x >> y
implies that x y. In addition, we dene that preference relation %is weakly monotone
if x y implies that x % y. Show that if the preference relation % is strictly convex
and weakly monotone, then it is monotone.
2. [30 points] [WARP] Let (B; C()) be a choice structure where B includes all nonempty
subsets of X, i.e., C(B) 6= ? for all sets B 2 B. We dene the choice rule C() to be
distributive if, for any two sets B and B
0
in B,
C(B) \ C(B
0
) 6= ? implies that C(B) \ C(B
0
) = C(B \ B
0
)
In words, the elements that choice rule C() selects both when facing set B and when
facing set B
0
, C(B) \ C(B
0
), coincide with the elements that choice rule would select
when confronted with the elements that belong to both sets B \ B
0
, i.e., C(B \ B
0
).
Show that, if choice rule C() is distributive, then choice structure (B; C()) does not
necessarily satisfy the weak axiom of revealed preference. (A counterexample suces.)
3. [40 points] [Production theory] Consider an economy with only one input (labor, l)
and one output (chairs, y). A rm has access to the following three technologies (A,
B and C) to produce chairs:
A. Each unit of labor leads to one chair.
B. 10 units of labor are required to buy a machine. After acquiring the machine,
each extra unit of labor produces 1.5 chairs.
C. 5 units of labor are required to build a machine. After that, each extra unit of
labor leads to 2 chairs.
Assume that free disposal holds. Then,
(a) [5 points] Graph the technology set Y , with l in the horizontal axis, where negative
numbers indicate inputs, and y in the vertical axis. Show feasible combinations
of inputs and output when less than 20 workers are used.
(b) [5 points] Is Y convex? Does it satisfy non-increasing returns to scale? Does it
satisfy non-decreasing returns to scale? Does it satisfy additivity? Justify.
(c) [12 points] Let the price of output be p = 1 and the price of labor be w = 4.
What is the quantity that this rm (university) will produce? What will be the
rms prots?
1
(d) [5 points] Now, assume that the rm can never use more than 20 units of labor.
Let the price of output be p = 1 and the price of labor be w = 1. What is the
quantity a rm will produce? What will be the rms prots?
(e) [13 points] Now, in order to use technology C, the rm has to pay a xed cost of
K. Find the supply and prot functions for any vector of prices (p; w) and any
value of K. You can normalize output prices to be p = 1.
2
[You can use the following pages as scratch paper.]
Name: ________________________________
3
Name: ________________________________
4
Name: ________________________________
5
Micro Theory I - EconS 501
Midterm #2 - Second part, November 18th, 2011.
Instructions: Please read the questions carefully, answer them in a formal and concise
manner, but include all your steps, this will allow you to obtain partial credit. Good luck!!
1. [20 points] [Consumer theory] Consider an individual with utlity function n(r
1
. r
2
. r
3
)
for three goods, where the cross-price elasticities are null, i.e.,
ij
= 0 for any two goods
i and ,. Show that the ratio of substitution eects
s
23
s
13
is equal to
@x
2
@w
@x
1
@w
.
2. [40 points] [Uncertainty.] Given an individual with utility function n() = log ,
where denotes this individuals income level,
(a) [10 points] Show that his Arrow-Pratt coecient of relative risk aversion, :
R
(),
is constant in income .
(b) [15 points] This individual declares an amount of money r to the IRS, where
r . With probability 1 j he is not audited and hence his income level is
tr. With probability j, he is audited and his income decreases to
t 1t( r)
That is, after an audit the IRS taxes this individual for his real income , reducing
his income in t, but in addition, applies a ne 1 for the amount of evaded taxes,
t ( r), further reducing his income in 1t ( r). Write down the expected
utility maximization problem for this individual. Then take rst-order conditions
with respect to this individuals choice of declared income, r.
(c) [15 points] Using the rst-order condition you found in part (b), show that the
proportion of income this individual does not declare,
x
y
, is independent of his
income level . [Hint: Since r , let r = c in the rst-order condition and
show that your results are independent on .]
3. [40 points] [Monopoly] Consider the following two-period monopoly model: A rm
is a monopolist in a market with an inverse demand function (in each period) of
j() = c/. The cost per unit in period 1 is c
1
. In period 2, however, the monopolist
has learned by doing, and so its marginal costs decrease to c
2
= c
1
:
1
, where
1
is the monopolists period 1 output level. Assume that c c 0 and / : 0. Also
assume that the monopolist does not discount future earnings, i.e., the discount factor
o = 1.
(a) [5 points] What is the monopolists output level in each of the periods,
1
and
2
?
Denote them by
M
1
and
M
2
.
1
(b) [14 points] Consider a benevolent social planner with social welfare function \
given by
\ = (Co
1
+ :
1
) + (Co
2
+ :
2
)
where Co
t
and :
t
represent respectively consumer surplus and prots during
a given period t = f1. 2g. What output levels would be implemented by the
benevolent social planner? Denote them by
SP
1
and
SP
2
.
(c) [10 points] Can you interpret the choice of
SP
1
as being selected according to the
price equal to marginal cost rule?
(d) [11 points] Given that the monopolist will be selecting the period 2 output level,

M
2
, would the social planner like the monopolist to slightly increase the level of
period 1 output above that identied in part (a),
M
1
? Can you given any intuition
for this?
2
[You can use the following pages as scratch paper.]
Name: ________________________________
3
Name: ________________________________
4
Name: ________________________________
5
Micro Theory I - EconS 501
Final Exam - December 13th 2011.
Instructions: Please read the questions carefully, answer them in a formal and concise
manner. Include all your steps, since this will allow you to obtain partial credit. You have
until 10:00a.m. to complete the exam. Good luck!!
1. [Consumer Theory] [20 points] The preferences of some consumer can be represented
as: u(x
1
; x
2
) = min fx
1
; x
2
g. We have been informed that only the price of the good
2 has changed, from p
0
2
to p
1
2
, but we have not informed about by how much did it
change. We know, however, that the amount of income that has to be transferred to
the consumer in order for him to recover his initial utility level is:
p
0
2
w
p
0
1
+ p
0
2
dollars
where w is the initial income, and p
0
1
and p
0
2
are the initial prices of goods 1 and 2,
respectively. The above information should allow you to measure the exact size of the
price change. What is the dierence between p
0
2
and p
1
2
?
2. [Monopoly: leasing vs. selling] [27 points] Consider a two-period game where a
monopolistic rm wants to sell its durable good. The durable good will last only two
periods, and after that it will become obsolete. There is no depreciation of the good
between the two periods. The discount factor is identical for all consumers and the
rm. Demand for the ulization of the good is given by p = 1 Q, where Q denotes
the aggregate quantity. Production is assumed to be costless. A resale market exists,
since consumers who buy the good in one period might want to re-sell (or lease) it in
the second period.
(a) [14 points] Consider rst the case where the rm sells in each period.
1. [3 points] Starting from the second period, set up the prot-maximization
problem for the monopolist, where it selects a production level q
2
given a
demand function p
2
= 1 q
1
q
2
. Determine q
2
, p
2
, and prots
2
during
this second period.
2. [8 points] Given the equilibrium price you found for the second-period monopoly,
p
2
, the rst-period demand is p
1
= (1 q
1
)p
2
, which intuitively represents
that the willingness to pay for the good in the rst period is given by the
current value that the consumer assigns to this good (given by the demand
function, 1q
1
), plus the discounted value of the good tomorrow (which arises
if the current consumer leases the good in the second period at a price p
2
).
Given this rst-period demand, set up the monopolists prot-maximization
problem, where its choice variable is now q
1
, and its objective function con-
siders not only rst-period but also the discounted value of second-period
prots,
2
. Determine q
1
, p
1
, and overall prots across both periods.
1
3. [3 points] Show that equilibrium prices decline over time, i.e., p
1
> p
2
.
(b) [8 points] Consider now that the monopolist leases (i.e., rents) the good in each
period, and nd equilibrium prices and output. [Hint: when leasing its goods, the
monopolists prots on a given time period t become independent on other period
prices, p
k
, where k 6= t]
(c) [5 points] Find the monopolists equlibrium prots from leasing. Are they higher
or lower than the prot the monopolist makes from selling the good, i.e., your
result from part a(3)?
3. [Mergers in a Cournot market] [28 points] Consider Cournot competition with
n identical rms. Suppose that the inverse demand function is linear, with p(X) =
a bX, where X is total industry output, and a; b > 0. Each rm has a linear cost
function of the form C(x) = cx, where x stands for individual output, and c denotes
the marginal cost of production, where a > c.
(a) [6 points] At the symmetric equilibrium of the Cournot model of quantity com-
petition,
1. what are the industry output and the price level?
2. what is the equilibrium social welfare?
(b) [12 points] Now let m 2 n rms merge. Show that the merger is protable for the
m merged rms if and only if it involves a pre-merger market share of 80 percent.
Otherwise, the merger is unprotable.
(c) [6 points] Show that each of the remaining (n m) nonmerged rms is better o
after the merger.
(d) [4 points] Show that the merger of m rms increases industry price and also lowers
consumer surplus.
4. [Externalities] [25 points] Consider two consumers with utility functions
u
A
= log(x
A
1
) + x
A
2

1
2
log(x
B
1
) for consumer A, and
u
B
= log(x
B
1
) + x
B
2

1
2
log(x
A
1
) for consumer B.
where the consumption of good 1 by individual i = fA; Bg creates a negative external-
ity on individual j 6= i. For simplicity, consider that both individuals have the same
wealth, m, and that the price for both goods is 1.
(a) [6 points] Equilibrium. Set up consumer As utility maximization problem, and
determine his demand for goods 1 and 2, i.e., x
A
1
and x
A
2
. Then operate similarly
to nd consumer Bs demand for good 1 and 2, i.e., x
B
1
and x
B
2
.
2
(b) [8 points] Social optimum. Calculate the social optimum amounts of x
A
1
, x
A
2
, x
B
1
and x
B
2
, considering that the social planner maximizes a utilitarian social welfare
function, i.e., W = u
A
+ u
B
.
(c) [11 points] Restoring eciency. Show that the social optimum you found in (b)
can be sustained by a tax on good 1 (so the after-tax price becomes 1 + t) with
the revenue returned equally to both consumers in a lump-sum transfer.
3
[You can use the following pages as scratch paper.]
Name: ________________________________
4
Name: ________________________________
5
Name: ________________________________
6
1

EconS 501 Microeconomic Theory I
Midterm Exam #1 October 5
th
2010

INSTRUCTIONS: Please read the questions carefully, answer them in a formal and concise manner, but
include all your steps, this will allow you to obtain partial credit. You have until 5:30p.m. to complete the
exam. Good luck!!

SHORT EXERCISES: The following two exercises are relatively short. Please do not use more than half a
page to answer each of their sections.

Exercise 1. [5 points] Show that if f: RR is a strictly increasing function, and u:XR is a utility function
representing a rational preference relation <, then the function v:XR defined by v(x)=f(u(x)) is also a
utility function representing the same rational preference relation <.

Exercise 2. [10 points] Let us define the income-elasticity of the demand for good j as
( , )
( , )
( , )
j
j
j
x p w
w
p w
w x p w

## , where p denotes the price vector of J goods, w represents the individuals

wealth level, and ( , )
j
x p w denotes this individuals Walrasian demand for good j.
a) [3 points] Show that if
'
( , ) ( , )
j j
p w p w = for any two different goods j and j, then it must be that
'
'
( , ) ( , )
j j
j j
x p w x p w
p p

=

. Explain.
Prove the following two properties [3.5 points each]:
b)
1
( , )
0
J
j
j
j
j
h p u
p
p
=

, where h
j
(p,u) denotes the Hicksian demand for good j, where j is one of J
goods in the economy, i.e., j={1,2,,J}.
c) Use your previous result to show that not all J goods can be net complements.

2

LONG EXERCISES:
Exercise 3. [27 points] Consider a household that is seen to purchase quantities of just two goods, bread and
cheese. Denote quantities of bread by x and quantities of cheese by y, with corresponding prices p
x
and p
y
.
The household comprises two individuals; Andrew, whose preference relation can be represented by the
utility function ( , )
A
u x y x = and Brenda, whose preference relation can be represented by the utility
function ( , )
B
u x y y = . Denote the wealth of Andrew by w
A
and that of Brenda by w
B
.
a) [3 points] Derive the uncompensated demand functions for both Andrew and Brenda and their
indirect utility functions.
b) [4 points] The households wealth w is divided evenly between Andrew and Brenda. Suppose that
you observe the aggregate demands of this household and you interpret it as if it came from just a
single consumer. Find the demands of the supposed single consumer.
Recall from the lectures that the equivalent variation of a change in prices and income from
0 0
( , ) p w to
1 1
( , ) p w can be defined as:
0 1 1 0 0 0
( , ( , )) ( , ( , )) EV e p v p w e p v p w = .
If
0 1
w w = and the change in prices are caused by the imposition of commodity taxes then the
deadweight loss (DWL) or excess burden of the taxes is given by:
1 0
1
( , )
L
l l
l
DWL EV t x p w
=
=

,
where
1 0
l l l
t p p = .
c) [5 points] Briefly explain why this measure may be viewed as a deadweight loss to (social)
economic efficiency.
d) [6 points] Suppose that the household initially faces prices
0
(1, 2) p = and has wealth
0
300 w = .
Then a specific tax of 2 is imposed on bread (i.e. good x) that leads to its price rising to 3 (with
the price of cheese, i.e. good y, and the households wealth both remaining unchanged). Calculate
the DWL under the false assumption that the household demands come from just one consumer.
e) [7 points] Using the individuals indirect utility functions derived in part (a) calculate the two
individual DWLs, and
A B
DWL DWL . Explain why
A B
DWL DWL + does or does not equal
DWL.

Exercise 4. [20 points] Consider an individual with Cobb-Douglas preferences u(x
1
,x
2
)=(x
1
x
2
)
0.5
, where x
1

and x
2
denote the amounts consumed of goods 1 and 2, respectively. The prices of these goods are p
1
>0
and p
2
>0, respectively, and this individuals wealth is w>0. The government needs to collect a large
amount of money to finance a new Health Care plan, and contemplates two options:
1. Introduce an income tax equivalent to 40% of individuals wealth; or
2. Charge a sales tax over the price of good 1 (e.g., fuels) which would imply an increase in the
price of good 1 from p
1
to p
1
(1+t), collecting the same dollar amount as with the income tax.
Using the indirect utility function of this individual under option 1 (income tax) and option 2 (sales tax),
explain which tax produces a smaller utility reduction to this individual (i.e., which tax is preferred by this
individual). You can accompany your discussion with an intuitive explanation and/or a figure if
necessary.

3

Exercise 5. [18 points] Consider the three good setting in which the consumer has utility function

u(x) = (x
1
- b
1
)
u
(x
2
- b
2
)
[
(x
3
- b
3
)
y

where b,b,b>0 represent the minimal amounts of goods 1, 2 and 3 that this individual must consume at
every period in order to remain alive (e.g., calories, water and shelter).
a) [3 points] Why can you assume that ++=1 without loss of generality? Do so for the rest of the
problem
b) [4 points] Write down the first-order conditions for the UMP, and derive the consumer's Walrasian
demand and indirect utility functions. [This system of demands is known as the linear
expenditure system, and it is due to Stone (1954), and the above utility function is usually
referred as the Stone-Geary utility function.]
[Hint: Use another monotone transformation, v(x)=ln u(x) of the given utility function
u(x)].
c) [2 points] Verify that the Walrasian demand functions x(p,w) obtained in part (b) satisfy
homogeneity of degree zero.
d) [4 points] Verify that the indirect utility function v(p,w) obtained in part (b) satisfies:
a. Homogeneity of degree zero,
b. Increasing in wealth,
c. Decreasing in prices, and
d. Quasiconvex in prices.
e) [5 points] Let us now restrict our analysis to a utility function with only two goods, u(x) =
(x
1
- b
1
)
u
(x
2
- b
2
)
[
, where +=1. Are the preferences represented by this utility function
homothetic? [Hint: find the share of income spent on each good (i.e., budget shares)]

Exercise 6. [20 points] A firm can produce one output q using two inputs called z
1
and z
2
by means of two
different technologies. Technology 1 is represented by the production function q=min{z
1
,z
2
} for z
1
,z
2
0.
Technology 2 is represented by the production function q=
1 2
3 3
z z
+ for z
1
,z
2
0. Prices of the inputs are
w
1
,w
2
0.
a) [4 points] Does Technology 1 exhibit constant returns to scale? What about Technology 2?
b) [8 points] Derive the cost function for both of them. (Hint: You do not need to set up the
Lagrangian, using a nice picture and/or explanation is enough).
c) [8 points] Suppose that w
1
<w
2
. Suppose also that the firm wants to produce some amount of output
q . For which values of w
1
will the firm use technology 1, and for which values of w
1
will the firm
use technology 2?

Micro Theory I - EconS 501
Midterm #2 (First part) - November 17th, 2010.
Instructions: Please read the questions carefully, answer them in a formal and concise
manner, but include all your steps, this will allow you to obtain partial credit. You have
until 11:00a.m. to complete the exam. Good luck!!
1. [60 points] [Production: Derived input demands] The demand for any input
ultimately depends on the demand for the good that input produces. This can be
shown more explicitly by deriving an entire industrys demand for inputs. To do so, we
assume that an industry produces a homogeneous good, Q, under constant returns to
scale using only capital and labor. The demand function for Q is given by Q = D(P),
where P is the market price of the good being produced. Because of the constant
returns to scale assumption, P = MC = AC. Throughout the problem let C(r; w; 1)
be the rms unit cost function, where r > 0 denotes the price of a unit of capital and
w > 0 represents the price of a unit of labor.
[IMPORTANT: each of the following questions informs you about the result you
are supposed to nd for that question. This will allow you to move forward
from one question to the next, using the information provided to you in previous
questions, even if some of your previous results are not completely right.]
(a) [8 points] Explain why the total industry demands for capital and labor are given
by K = QC
r
and L = QC
w
, where C
r
=
@C
@r
and C
w
=
@C
@w
.
(b) [10 points] Using
@K
@r
= QC
rr
+D
0
C
2
r
and
@L
@w
= QC
ww
+D
0
C
2
w
, prove that
C
rr
=
w
r
C
rw
and C
ww
=
r
w
C
wr
(c) [10 points] Use the results from part (b) together with the expression of the
elasticity of substitution between labor and capital described in class, =
CCrw
CrCw
,
to show that
@K
@r
=
wL
Q
K
rC
+
D
0
K
2
Q
2
and
@L
@w
=
rK
Q
L
wC
+
D
0
L
2
Q
2
(d) [15 points] Convert the derivatives in part (c) into elasticities to show that
"
K;r
= s
L
+s
K
"
Q;P
and "
L;w
= s
K
+s
L
"
Q;P
where s
j
is the share of input j on total cost, s
L
=
wL
QC
and s
K
=
rK
QC
(recall that
since C denotes unit cost, QC represents total cost), and "
Q;P
denotes the price
elasticity of demand for the product being produced.
1
(e) [17 points] Use your results in part (d) to identify the substitution and output
eects in production. Discuss their sign as well as what factors (s
L
, s
K
, , and
"
Q;P
) produce an increase or decrease in their relative values.
2. [40 points] [Cost reducing investment in monopoly]. Consider a situation in which
there is a monopolist in a market with inverse demand function p(q). The monopolist
makes two choices: How much to invest in cost reduction, I, and how much to sell,
q. If the monopolist invests I units in cost reduction, his (constant) per-unit cost of
production is c(I). Asume that c
0
(I) < 0 and that c
00
(I) > 0, i.e., investing in cost
reduction reduces the monopolists per-unit cost of production, but at a decreasing
rate. Assume throughout that the monopolists objective function is concave in q and
I.
(a) [10 points] Derive the rst-order conditions for the monopolists choices.
(b) [13 points] Compare the monopolists choices with those of a benevolent social
planner who can control both q and I (a rst-best comparison). Interpret your
results.
(c) [17 points] Compare the monopolists choices with those of a benevolent social
planner who can control for I but not for q (a second-best comparison). In
particular, suppose that the social planner chooses I and then the monopolist
chooses q.
2
[You can use the following pages as scratch paper.]
Name: ________________________________
3
Name: ________________________________
4
Name: ________________________________
5
Micro Theory I - EconS 501
Midterm #2 (2nd part) - November 19th, 2010.
Instructions: Please read the questions carefully, answer them in a formal and concise
manner, but include all your steps, this will allow you to obtain partial credit. You have
until 11:50a.m. to complete the exam. Good luck!!
1. [18 points] [Inverse elasticity rule for taxation in perfectly competitive mar-
kets] Consider the utility function l = clog(r
1
) +,log(r
2
) | and budget constraint
n| =
1
r
1
+
2
r
2
, where
i
denotes the price that consumers pay for good i = f1. 2g,
r
i
represents the number of units of good i, n is the wage rate per hour, and | denotes
the amount of hours that this individual works.
(a) [8 points] Show that the price elasticity of demand for both commodities is equal
to 1.
(b) [10 points] Setting producer prices at j
1
= j
2
= 1, show that the inverse elasticity
rule implies
t
1
t
2
=
q
1
q
2
.
2. [37 points] [Uncertainty about being audited by the IRS] Consider a taxpayer
with exogenous income 0 who faces a tax rate t, where 0 < t < 1. She is asked
to report a number r to the government and pays taxes tr. If the taxpayer is honest
she will report r = , but she may cheat by reporting a lower income 0 r < . Let
. = r represent the amount by which income is understated. The government does
not know the true income and must enforce compliance through a system of audits
and penalties. Assume that the enforcement policy, known by the taxpayer, is to audit
reports with probability j, where 0 < j < 1. Assume that j is constant and hence
independent of r. If there is an audit, we assume that the government always learns
the true income . If the taxpayer is caught cheating she must pay a penalty o on each
dollar of income evaded, o., in addition to the evaded tax. Assume that the taxpayer
is risk averse and maximizes expected utility.
(a) [8 points] For any ., where 0 . , write the income the consumer will enjoy
in each one of the two possible situations, i.e., if there is an audit and if there is
not an audit (notice that the choice variable for the consumer is .).
(b) [14 points] Calculate the minimum value of t such that she will choose to cheat
[Hint: You just have to provide a condition under which .

0).
(c) [15 points] Assume that the consumer chooses .

value of .

## decreases in the probability of being audited j and in the ne o. [Hint:

use the implicit function theorem].
1
3. [45 points] [Regulating a natural monopoly] A water supply company provides
water to Pullman. The demand for water in Pullman is j() = 10 , and this
companys costs are c() = 1 + 2.
(a) [5 points] Depict in a gure: the demand curve j(), the associated marginal
revenue `1(), the marginal cost of production `C() and the average cost of
production C(). Discuss why this situation illustrates a natural monopoly.
(b) [6 points] Determine the amount of water
m
that this rm will produce if left
unregulated as a monopolist. Determine the corresponding prices and prots for
the rm.
(c) [6 points] Determine the amount of water that this rm will produce if a regulatory
agency in Pullman forces the rm to produce an amount of output

that solves
j(

) = `C(

## ). Determine the corresponding prices and prots for the rm.

(d) [28 points] Consider now that the regulatory agency allows the monopoly to
charge two dierent prices: a high price j
1
for the rst
1
units, and a low price
j(

## ) for the remaining (

1
), i.e., the units from
1
until the output level you
found in part (b),

## . In addition, the regulatory agency imposes the condition

that the rm cannot make any prots, : = 0, when charging these two prices.
1. [20 points] Find the value of
1
, and the associated price j
1
. Using this
information, determine the number of units (

1
) sold at a low price j(

).
2. [8 points] Depict these two prices and quantities in a gure, and shade the
area of benets and losses for the rm.
2
[You can use the following pages as scratch paper.]
Name: ________________________________
3
Name: ________________________________
4
Micro Theory I - EconS 501
Final Exam - December 16th, 2010.
Instructions: Please read the questions carefully, answer them in a formal and concise
manner, but include all your steps, this will allow you to obtain partial credit. You have
until 10:00a.m. to complete the exam. Good luck!!
1. Exercise 1. [Consumer theory] [25 points]
An individual consumes only goods 1 and 2, and his indirect utility function, (j
1
. j
2
. n), is
given by the following expression
(j
1
. j
2
. n) =
n
j
1
+ cj
2
where c 0, and j
1
, j
2
, n 0
a. [8 points] Find this individuals Walrasian demand for good 1, r
1
(j. n), and good 2,
r
2
(j. n), where j denotes the price vector j (j
1
. j
2
) [Hint: you should use some
equivalence in order to go from indirect utility function to Walrasian demand. (One
step)] Then, nd the ratio
r
2
(j. n)
r
1
(j. n)
Explain the intuition behind your result.
b. [9 points] Find this individuals Hicksian demand for good 1, /
1
(j. n
0
), and good 2,
/
2
(j. n
0
).[Hint: you should use some equivalences here as well, one to go from indi-
rect utility function to expenditure function, and another one to go from expenditure
function to hicksian demand] Then, nd the ratio
/
2
(j. n
0
)
/
1
(j. n
0
)
Explain the intuition behind your result.
c. [8 points] Using Walrasian and Hicksian demands you found in parts (a) and (b), nd
the Slustky equation for goods 1 and 2. Explain your result, and connect it with some
of your intuitions in parts (a) and (b).
1
Exercise 2. [Regulating externalities under incomplete information.] [25 points]
Consider the setting studied in class where a regulator observes neither the type of the rm
emitting pollution (i.e., the realization of parameter o) nor the type of the consumers being
aected by such pollution (the realization of parameter j). Suppose that the rms marginal
benet from an addition unit of pollution is
J:(/. o)
J/
= , // + o,
and that the marginal utility from an additional unit of pollution for the consumer is
Jc(/. j)
Jj
= c/ + j,
where o and j are random variables with expectation 1[o] = 1[j] = 1[oj] = 0, and all
take strictly positive values, i.e., o. j 0. Parameters /. c and are also strictly positive by
denition, i.e., /. c. 0. Finally, denote 1[o
2
] = o
2

and 1[j
2
] = o
2

.
a. [10 points] Identify the best quota
b
/

## that a social planner selects to maximize the

expected value of aggregate surplus. (Assume that the rm must produce an amount
exactly equal to the quota.)
b. [10 points] Identify the best tax t

## for this same planner.

c. [5 points] Compare the two instruments in terms of their associated deadweight loss.
Two gures are enough: one where the quota performs better and another where the
tax performs better. [Note that I am not asking you to nd the precise parameter
conditions under which one instrument performs better than the other. A graphical
representation is ok.]
2
Exercise 3 [Tax Evasion under Uncertainty.] [25 points]
Given an individual with utility function n() = log , where denotes this individuals
income level.
a. [5 points] Show that his Arrow-Pratt coecient of relative risk aversion, :
R
(), is
constant in , where n
0
and n
00
denote the rst-order (second-order) derivative of utility
function n() with respect to , respectively. [Hint: just apply the formula of :
R
()]
b. [8 points] This individual declares an amount of money r to the IRS, where r .
With probability 1 j he is not audited and hence his income level is tr. With
probability j, he is audited and his income decreases to
t 1t( r)
That is, after an audit the IRS taxes this individual for his real income , reducing
his income in t, but in addition, applies a ne 1 for the amount of evaded taxes,
t ( r), further reducing his income in 1t ( r). Write down the expected utility
maximization problem for this individual. Then take rst-order conditions with respect
to this individuals choice of declared income, r.
c. [12 points] Using the rst-order condition you found in part (c), show that the pro-
portion of income this individual does not declare,
x
y
, is independent of income level
. [Hint: Since r , let r = c in the rst-order condition and show that can
eliminated, so all your results are independent on .]
3
Exercise 4 - Mixed Oligopoly [25 points]
Consider a market with one public rm, denoted by 0, and one private rm, denoted by 1.
Both rms produce a homogeneous good with identical and constant marginal cost c 0
per unit of output, and face the same inverse linear demand function j(A) = c /A with
aggregate output A = r
0
+ r
1
. It is assumed that c c. The private rm maximizes prot
:
1
= j(A)r
1
c r
1
,
and the public rm maximizes a combination of social welfare and prots
\
0
= o\ + (1 o):
0
where social welfare (\) is given by \ =
X
Z
0
j()d c (r
0
+ r
1
), and prots are :
0
=
j(A)r
0
c r
0
.
Both rms choose output as their choice variable in a simultaneous-move game (as in the
Cournot model of quantity competition).
a. [7 points] Calculate the best-response functions of the private rm, r
1
(r
2
), and of the
public rm, r
2
(r
1
).
b. [8 points] Use a gure of the best-response functions to illustrate how they are aected
when o increases. [Hint: you can restrict your analysis to o = 0, o = 1,2 and o = 1]
c. [5 points] Calculate the equilibrium quantities for the private and public rms. Find
the aggregate output in equilibrium as a function of o.
d. [5 points] Calculate the socially optimal output level (by using the marginal cost
pricing rule, j(A) = c) and compare it with the equilibrium outcome you obtained in
part (c).
4
[You can use the following pages as scratch paper.]
Name: ________________________________
5
Name: ________________________________
6
Micro Theory I - EconS 501
Midterm #1 - October 5th, 2009.
Instructions: Please read the questions carefully, answer them in a formal and concise
manner, but include all your steps, this will allow you to obtain partial credit. You have
until 6:30p.m. to complete the exam. Good luck!!
1. [15 points] [True or false?] Identify which of the following statements are true, which
are false, and provide a very short explanation of why this is the case.
(a) [6 points] If a preference relation satises local non-satiation, then it must also
satisfy monotonicity.
(b) [8 points] If two goods are gross complements, then they must be net substitutes.
2. [15 points] [Checking properties of preference relations]. Consider the following
preference relation dened in X = R
2
+
: (x
1
; x
2
) % (y
1
; y
2
) if and only if
min f3x
1
+ 2x
2
; 2x
1
+ 3x
2
g > min f3y
1
+ 2y
2
; 2y
1
+ 3y
2
g
(a) [5 points] For any given bundle (y
1
; y
2
), draw the upper contour set, the lower
contour set, and the indierence set of this preference relation.
(b) [10 points] Check if this preference relation satises: (i) completeness, (ii) transi-
tivity, (iii) monotonicity, and (iv) weak convexity.
3. [20 points] [Relationship between WARP and CLD] The gure at the end of
the exam illustrates the change in budget line B
p;w
to B
p
0
;w
(pivoting outwards), as a
result of the decrease in the price of good 1, maintaining both the price of good 2 and
wealth constant. Then, the consumer receives a wealth compensation (changing his
wealth level from w to w
0
) that guarantees he can still aord his initial consumption
bundle, x(p; w). Show that, if Walrasian demand satises the Weak Axiom of Revealed
Preference (WARP), then
(a) [12 points] x(p
0
; w
0
) cannot lie on segment A, but it must lie on segment B.
(b) [8 points] What conclusions can you infer from your results in part (a) about the
slope of the Walrasian demand function? What about the slope of the Hicksian
demand function?
1
4. [15 points] [Slutsky equation in labor markets]. Explain the income and substitu-
tion eect in the labor market. Help your discussion with a gure, but you must relate
your gure with the Slutsky equation in labor economics.
[Hint: rst, write the workers expenditure minimization problem, where the
worker minimizes py wz, subject to the constraint v(y; z) = v, where y is
the composite commodity, p is its price, z is the number of working hours,
and w is the current wage. Then write the (general) expression of the hick-
sian demands that you would obtain from this EMP, and use the duality property
x
z
(w; p; e(w; p; v)) = h
z
(w; p; v). Then dierentiate both sides, use the chain rule,
and the property that
@e(w;p;v)
@w
= h
z
(w; p; v), you should obtain the expression
of the Slutsky equation for labor economics. Explain]
(a) Explain under which conditions can we observe that the uncompensated labor
supply of a certain individual is negatively sloped (the individual decreases her
working hours as the wage per hour increases), but her compensated labor supply
is positively sloped (the individual increases her working hours as the wage per
hour increases).
5. [15 points] Measuring welfare changes through the expenditure function]. A
consumer has a utility function u(x
1
; x
2
) = x
1=2
1
x
1=2
2
, where good x
1
is the consumption
of alcoholic beverages, and x
2
is her consumption of all other goods. The price of alcohol
is p > 0, and the price of all other goods is normalized to 1.
(a) [2 points] Set the consumers expenditure minimization problem. Find rst order
conditions, and nd his optimal consumption of x
1
and x
2
.
(b) [4 points] Substituting your results from part (a) into your objective function,
nd the expenditure function e(p
1
; p
2
; U) for this consumer.
(c) [9 points] Let us now consider a proposal to reduce the price of alcohol from p = \$2
to p = \$1 per unit. If the current utility enjoyed by the consumer is U = 100,
1. [4 points] what is his minimum expenditure in order to reach U = 100 when
p = \$2? And when p = \$1? [Hint: Use the expression of the expenditure
function e(p
1
; p
2
; U) you found in part (b)]
2. [5 points] what is then the maximum amount that this consumer would be
willing to pay for this price reduction?
6. [20 points] [Measuring welfare changes when preferences are quasilinear] Show
that the compensating and the equivalent variation coincide when the utility function is
quasilinear with respect to the rst good (and we x p
1
= 1). [Hint: use the denitions
of the compensating and equivalent variations in terms of the expenditure function
(not the hicksian demand). In addition, recall that if u(x) is quasilinear, then we can
express it as u(x) = x
1
+ (x
1
), and rearranging x
1
= u(x) (x
1
) where x
1
represents all the reamining goods, l = 2; 3; :::; L.]
(a) Explain why the compensating and equivalent variations coincide under these
conditions.
2
Figure - Exercise 2
x
1
2
w
p
x
2
1
w
p
1
'
w
p
B
p,w
(uncompensated)
B
p,w
B
p,w
(compensated)
1
'
'
w
p
Compensation in wealth,
from w to w
x(p,w)
2
' w
p
3
[You can use the following pages as scratch paper.]
Name: ________________________________
4
Name: ________________________________
5
Micro Theory I - EconS 501
Midterm #2 - November 16th, 2009.
Instructions: Please read the questions carefully, answer them in a formal and concise
manner, but include all your steps, this will allow you to obtain partial credit. You have
until 6:30p.m. to complete the exam. Good luck!!
1. [25 points] [Short questions].
(a) [4 points] The betweeness axiom implies the independence axiom. True or false?
(b) [5 points] A production function = ,(.
1
. .
2
) satisfying constant returns to scale,
does not need to be homothetic. True or false?
(c) [6 points] Consider the extreme preference for certainty preference relation over
lotteries we discussed in class, where an individual weakly prefers lottery 1 =
(j
1
. j
2
. .... j
N
) to lottery 1
0
= (j
0
1
. j
0
2
. .... j
0
N
), 1 % 1
0
, if and only if
max
n2N
j
n
max
n2N
j
0
n
A friend (especially interested in macro) asks you the following: I am interested in
using this type of preference relation for my research. In particular, I want to test
if people select their investment portfolio nowadays according to this preference
relation. Before proceeding, however, I must be sure that I can use the standard
vNM expected utility functions in my research. I read section 6.B in MWG
again and I found that, according to the expected utility theorem, I need this
preference relation over lotteries to satisfy the independence axiom in order to
be able to use vNM expected utility functions. Can you please let me know if
this particular preference relation satises the independence axiom? You have
good and bad news for your friend: the good news is that he asked you (almost
an expert in micro by now!) before starting his research using that particular
preference relation over lotteries. The bad news is that this preference relation
does not satisfy the independence axiom. Justify.
(d) [4 points] Another crazy friend knocks on your door: this time he is an econome-
trician! It seems that he received very good comments about you from your macro
friend, and he is now coming to you for a question about micro. He is considering
the following Walrasian market demands for goods 1 and 2, respectively.
r
1
= c /j
1
cj
2
and r
2
= d cj
1
qj
2
According to his data, the market equilibrium price vector at year 2000 was
j
0
= (15. 3), while that in year 2008 was j
1
= (17. 5). He wants to measure the
change in consumer welfare due to this price change using the equivalent variation.
He rst found the equivalent variation from the change in both goods prices, by
1
following the path (15. 3) ! (17. 3) ! (17. 5). He then computed the equivalent
variation again, but using the path (15. 3) ! (15. 5) ! (17. 5). He realized
that the equivalent variation he found using the rst path does not necessarily
coincide with that using the second path. Which assumption can you recommend
him in order to guarantee that the computation of the equivalent variation is
independent on the path he uses to raise prices, i.e., that the equivalent variation
is path independent?
(e) [6 points] You are grading a term paper for a (bad) undergraduate student at
WSU, and read the following statement: The inverse elasticity rule used by tax
authorities to determine the proportional rate of tax on a given good i,
t
i
p
i
+t
i
, does
not have any relationship with the deadweight loss of taxation of the tax on good
i. Explain why this statement is wrong.
2. [8 points] Consider a production function = ,(.
1
. .... .
n
) satisfying Constant Returns
to Scale (CRS). Show that if the rm pays each input according to its exact marginal
productivity, then prots are equal to zero.
3. [15 points] The preferences of some consumer can be represented as: n(r
1
. r
2
) =
min fr
1
. r
2
g. We have been informed that only the price of the good 2 has changed,
from j
0
2
to j
1
2
, but we have not informed about by how much did it change. We know,
however, that the amount of income that has to be transferred to the consumer in
order for him to recover his initial utility level is:
j
0
2
n
j
0
1
+ j
0
2
dollars
where n is the initial income, and j
0
1
and j
0
2
are the initial prices of goods 1 and 2,
respectively. Can you provide some information about the size of the price change, i.e.,
the dierence between j
0
2
and j
1
2
?
4. [15 points] Consider the following prot function that has been obtained form a tech-
nology that uses a single input:
(j. n) = j
2
n

where j is the output price, n is the input price and c is a parameter value.
(a) [10 points] Check if the prot function satises: (1) non-decreasing in output price
j, (2) non-decreasing in input prices n, (3) homogeneous of degree one, (4) convex
in prices j and n. In particular, determine for which values of c these properties
are satised (some properties might be satised for all values of c, while others
might hold only for certain values of c).
(b) [5 points] Calculate the supply function of the product, (j. n), and the demand
for inputs, .(j. n).
2
5. [25 points] Let the consumer have the utility function l = r

1
1
+ r

2
2
|, where r
1
and r
2
are consumption goods, and | are labor hours (which creates a disutility to the
individual).
(a) [5 points] Show that the utility maximizing demands are r
1
=
h

1
w
q
1
i
1=[1
1
]
and
r
2
=
h

2
w
q
2
i
1=[1
2
]
.
(b) [7 points] Letting j
1
= j
2
= 1, use the inverse elasticity rule to show that the
optimal tax rates are related by
1
t
2
=
h

1
1
2
i
+
h
1
1
1
2
i
1
t
1
.
(c) [6 points] Setting n = 100, j
1
= 0.75, j
2
= 0.5, nd the tax rates required to
achieve revenue of 1 = 10 and 1 = 300.
(d) [7 points] Calculate the proportional reduction in demand for the two goods com-
paring the no-tax position with the position after introduction of the optimal
taxes for both revenue levels. Comment on the results.
6. [12 points] [Purchasing health insurance] Consider an individual with the following
Bernouilli utility function
n(C. H) = ln C
c
H
where C is his expenditure in consumption goods and H is his expenditure on health
insurance. Parameter c denotes his losses if he becomes sick, where for simplicity
c =

1 if he is sick, and
0 if he is healthy
Note that this utility function implies that, when getting sick, this individuals disu-
tility is decreasing in the amount of health insurance that he purchased (e.g., he can
have access to better doctors and care facilities, and the negative eects of the illness
are reduced). Finally, the probability of getting sick is given by 2 [0. 1], and this
individuals wealth is given by : 0, where : = C + H.
(a) [2 points] What is this individual utility maximization problem? [Hint: it is easier
to choose C as your choice variable. You can nd the optimal amount of H later
on]
(b) [2 points] Find the rst order conditions associated to the previous maximization
problem.
(c) [4 points] Determine the optimal amount of consumption goods, C

, and health
insurance, H

.
(d) [4 points] Determine if the optimal amount of health insurance, H

, is increasing,
decreasing, or constant in :. Interpret.
3
[You can use the following pages as scratch paper.]
Name: ________________________________
4
Name: ________________________________
5
Name: ________________________________
6
Micro Theory I - EconS 501
Final Exam - December 14th, 2009.
Instructions: Please read the questions carefully, answer them in a formal and concise
manner, but include all your steps, this will allow you to obtain partial credit. You have
until 5:00p.m. to complete the exam. Good luck!!
1. [10 points] [Gorman form for v
i
(p; w
i
)] Prove that if the indirect utility function
v
i
(p; w
i
) admits the Gorman form (i.e., it can be represented as a linear combination
of the individuals wealth, as follows),
v
i
(p; w
i
) = a
i
(p) + b(p)w
i
then all consumers exhibit parallel, straight wealth expansion paths at any price vector
p. [Hint: Use Roys identity].
(a) Show also that, if preferences admit Gorman-formindirect utility functions, v
i
(p; w
i
) =
a
i
(p) + b(p)w
i
, with the same b(p) for all individuals, then preferences admit ex-
penditure function, e
i
(p; u
i
), of the form
e
i
(p; u
i
) = c(p)u
i
+ d
i
(p)
2. [15 points] [Concavity and Coecient of risk aversion] Let u and v be two utility
functions, where v(W) = f (u(W)), and f() is a concave function, i.e. v is more
concave than u.
(a) [5 points] Find the coecient of absolute risk-aversion for v.
(b) [10 points] Prove that the coecient of absolute risk-aversion for v is greater than
for u.
1
3. [20 points] [Learning by doing in monopoly] Consider the following two-period
model: A rm is a monopolist in a market with an inverse demand function (in each
period) of p(q) = a bq. The cost per unit in period 1 is c
1
. In period 2, however,
the monopolist has learned by doing, and so its constant cost per unit of output
is c
2
= c
1
mq
1
, where q
1
is the monopolists period 1 output level. Assume that
a > c > 0 and b > m > 0. Also assume that the monopolist does not discount future
earnings.
(a) [5 points] What is the monpolists level of output in each of the periods, q
1
and
q
2
? Denote them by q
M
1
and q
M
2
.
(b) [5 points] Consider a benevolent social planner with social welfare function W
given by
W = (CS
1
+
1
) + (CS
2
+
2
)
where CS
t
and
t
represent respectively consumer surplus and prots during
a given period t = f1; 2g. What output levels would be implemented by the
benevolent social planner? Denote them by q
SP
1
and q
SP
2
.
(c) [2 points] Is there any sense in which q
SP
1
is selected according to the price equal
to marginal cost rule?
(d) [8 points] Given that the monopolist will be selecting the period 2 output level,
q
M
2
, would the social planner like the monopolist to slightly increase the level of
period 1 output above that identied in part (a), q
M
1
? Can you given any intuition
for this?
4. [20 points] [The problem of the commons] Lake Ec can be freely accessed by
shermen. The cost of sending a boat out on the lake is r > 0. When b boats are sent
out onto the lake, f(b) sh are caught in total (so each boat catches
f(b)
b
sh), where
f
0
(b) > 0 and f
00
(b) < 0 at all b 0. The price of sh is p 0, which is unaected by
the level of catch from Lake Ec.
(a) [5 points] Characterize the equilibrium number of boats that are sent out on the
lake.
(b) [5 points] Characterize the optimal number of boats that should be sent out on
the lake.
(c) [5 points] Compare your answers in parts (a) and (b). Explain.
(d) [5 points] Suppose that the lake is instead owned by a single individual who can
choose how many boats to send out. What number of boats would this owner
choose?
2
5. [35 points] [Private contributions to a public good] Take an economy with 2
consumers i = A; B, 1 private good x, and 1 public good G. Let each consumer have
an income of M. The prices of public and private good are both 1. Let the consumers
have a utility functions:
U
A
= log(x
A
) + log(G), for individual A, and
U
B
= log(x
B
) + log(G), for individual B
Assume that the public good is privately provided, so total contributions to the public
good are G = g
A
+ g
B
. Note that you can eliminate x
i
from the utility function using
the budget constraint M = x
i
+ g
i
.
(a) [7 points] Consider individual A choosing his contribution to the public good g
A
to maximize utility. Show that the optimal choice satises:
g
A
=
M
2

g
B
2
(b) [1 points] Repeat part (a) for consumer B.
(c) [5 points] Find the competitive (Nash) equililibrium contributions to the public
good by consumer A and B.
(d) [8 points] Show that along an indierence curve the following property must be
satised:
dg
A

1
g
A
+ g
B

1
M g
A

+ dg
B

1
g
A
+ g
B

= 0
and hence that:
dg
B
dg
A
=
g
A
+ g
B
M g
A
1:
(e) [7 points] Solve the last equation to nd the locus of points along which the indif-
ference curve of individual A is horizontal and use this to sketch the indierence
curves of the individual A.
(f) [7 points] Calculate the Pareto ecient level of private provision for the welfare
function W = U
A
+U
B
. Contrast this with the private provision level you found
in section (c).
3
[You can use the following pages as scratch paper.]
Name: ________________________________
4
Name: ________________________________
5
Name: ________________________________
6
Micro Theory I - EconS 501
Midterm #1 - October 2nd, 2008.
Instructions: Please read the questions carefully, answer them in a formal and concise
manner, but include all your steps, this will allow you to obtain partial credit. You have
until 10:25a.m. to complete the exam. Good luck!!
1. [20 points] [Checking properties of preference relations]. Let us consider the
following preference relations dened in A = R
2
+
. First, dene the upper countour
set, the lower contour set and the indierence set for every preference relation. Then,
check if they satisfy: (i) completeness, (ii) transitivity, (iii) monotonicity, and (v) weak
convexity. [Answer only one of the following 2 questions].
(a) [20 points] (r
1
. r
2
) % (
1
.
2
) if and only if r
1
_
1
1 and r
2
_
2
+ 1.
(b) [20 points] (r
1
. r
2
) % (
1
.
2
) if and only if max r
1
. r
2
> max
1
.
2
.
2. [15 points] [Lexicographic preference relations are rational]. Let us dene a
lexicographic preference relation in a continuouous consumption set A 1 , where for
simplicity both A = [0. 1] and 1 = [0. 1], as follows:
(r
1
. r
2
) % (
1
.
2
) if and only if

r
1

1
, or if
r
1
=
1
and r
2
>
2
Show that % is a rational preference relation (i.e., it is complete and transitive).
3. [15 points] [Checking WARP]. Check whether the following demand function satises
the weak axiom of revealed preference (WARP). You can use gures to help your
discussion, but your nal reasoning must be in terms of the denition of the WARP:
Average demand: The consumers walrasian demand is the expected value of
a uniform randomization over all points on her budget frontier, for any (strictly
positive) prices j
1
, j
2
and wealth n.
4. [5 points] [Concavity of the support function] We know that, given a non-empty,
closed set 1, its support function, j
K
(j), is dened by
j
K
(j) = inf j r for all r 1 and j R
L
Hence, the value of this support function, j
K
, satises j
K
_ j r for every element r
in the set 1. Given this denition, prove the concavity of the support function. That
is, show that
j
K
(cj + (1 c) j
0
) > cj
K
(j) + (1 c) j
K
(j
0
)
for every j. j
0
R
L
and for any c [0. 1].
1
5. [25 points] [Compensating and Equivalent variation] An individual consumes
only good 1 and 2, and his preferences over these two goods can be represented by the
utility function
n(r
1
. r
2
) = r

1
r

2
where c. , 0 and c + , ? 1
This individual currently works for a rm in a city where initial prices are j
0
= (j
1
. j
2
),
and his wealth is n.
(a) [1 point] Find the Walrasian demand for goods 1 and 2 of this individual, r
1
(j. n)
and r
2
(j. n).
(b) [1 point] Find his indirect utility function, and denote it as (j
0
. n).
(c) [1 point] The rm that this individual works for is considering moving its oce to
a dierent city, where good 1 has the same price, but good 2 is twice as expensive,
i.e., the new price vector is j
0
= (j
1
. 2j
2
). Find the value of the indirect utility
function in the new location, i.e., when the price vector is j
0
= (j
1
. 2j
2
). Let us
denote this indirect utility function (j
0
. n).
(d) [4 points] This individuals expenditure function is
c(j. n) = (c + ,)

j
1
c

+

j
2
,

+
n
1
+
Find the value of this expenditure function in the following cases:
1. Under initial prices, j
0
, and maximal utility level n
0
= (j
0
. n), and denote
it by c(j
0
. n
0
).
2. Under initial prices, j
0
, and maximal utility level n
0
= (j
0
. n), and denote it
by c(j
0
. n
0
).
3. Under new prices, j
0
, and maximal utility level n
0
= (j
0
. n), and denote it
by c(j
1
. n
0
).
4. Under new prices, j
0
, and maximal utility level n
0
= (j
0
. n), and denote it
by c(j
0
. n
0
).
(e) [4 points] Find this individuals equivalent variation due to the price change.
Explain how your result can be related with this statement from the individual to
the media: I really prefer to stay in this city. In fact, I would accept a reduction
in my wealth if I could keep working for the rm staying in this city, instead of
moving to the new location
(f) [4 points] Find this individuals compensating variation due to the price change.
Explain how your result can be related with this statement from the individual
to the media: I really prefer to stay in this city. The only way I would accept to
move to the new location is if the rm raises my salary.
(g) [4 points] Find this individuals variation in his consumer surplus (also referred
as area variation). Explain.
(h) [4 points] Which of the previous welfare measures in questions (e), (f) and (g)
coincide? Which of them do not coincide? Explain.
2
(i) [2 points] Consider how the welfare measures from questions (e), (f) and (g) would
be modied if this individuals preferences were represented, instead, by the utility
function (r
1
. r
2
) = cln r
1
+ , ln r
2
.
6. [10 points] [Slutsky equation in labor markets]. Explain the income and substi-
tution eect in the labor market. Help your discussion with a gure, but you must
relate your gure with the Slutsky equation in labor economics. [Hint: rst, write
the workers expenditure minimization problem, where the worker minimizes j n.,
subject to the constraint (. .) = , where is the composite commodity, j is its
price, z is the number of working hours, and n is the current wage. Then write the
(general) expression of the hicksian demands that you would obtain from this EMP,
and use the duality property r
z
(n. j. c(n. j. )) = /
z
(n. j. ). Then dierentiate both
sides, use the chain rule, and the property that
@e(w;p;v)
@w
= /
z
(n. j. ), you should
obtain the expression of the Slutsky equation for labor economics. Explain]
7. [10 points] [Aggregate demand]. Answer only one of the following 2 questions:
(a) [10 points] We know that aggregate demand can be expressed as a function of
aggregate wealth, i.e.,
I
X
i=1
r
i
(j. n
i
) = r

j.
I
X
i=1
n
i
!
if the following condition is satised for any two individuals i and ,, for a given
good /, and for any wealth of these two individuals, n
i
and n
j
.
Jr
ki
(j. n
i
)
Jn
i
=
Jr
kj
(j. n
j
)
Jn
j
Explain what this condition implies in terms of these individuals wealth expansion
paths (you can use a gure to help your discussion). Can you give an example of
a preference relation satisfying this condition?
(b) [10 points] Show that if an individuals preference relation is homothetic, then
this individuals Walrasian demand satises the Uncompensated Law of Demand
(ULD). [Hint: instead of showing ULD, you can alternatively show that 1
p
r
i
(j. n
i
)
is negative semidenite, since we know that both properties are equivalent. In
order to show the latter, rst use the Slustsky equation, then use homotheticity,
and nally pre- and post-multiply all elements by dj]
3
[You can use the following pages as scratch paper.]
Name: ________________________________
4
Name: ________________________________
5
Micro Theory I - EconS 501
Midterm #2 - November 18th, 2008.
Instructions: Please read the questions carefully, answer them in a formal and concise
manner, but include all your steps, this will allow you to obtain partial credit. You have
until 10:25a.m. to complete the exam. Good luck!!
1. [25 points] [True or false?] Identify which of the following statements are true, and
which are false, and provide a very short explanation of why this is the case.
(a) [3 points] All preference relations are rational.
(b) [3 points] If a preference relation is rational (satises completeness and transitiv-
ity), it can be represented by a utility function.
(c) [3 points] If a preference relation is quasilinear, the substitution eect is zero, and
the income eect is positive.
(d) [3 points] Gien goods does not need to be inferior.
(e) [3 points] The Walrasian demand is negatively sloped, for any preferences of the
consumer.
(f) [3 points] The area variation (change in consumer surplus) is never a good ap-
proximation of the change in consumer welfare resulting from price changes (or
equivalently, from tax changes), for any type of consumer preferences.
(g) [7 points] If a production function satises increasing average product, it must
also satisfy increasing marginal product.
2. [20 points] [Properties of the prot function] The prot function, :(j), is dened
as
:(j) = max fj j 2 1 g
or alternatively, :(j) > j for every 2 1 .
(a) [10 points] Show that the prot function :(j) is convex in prices.
(b) [10 points] Prove the Hotellings lemma using the Duality theorem. [Hint: easy,
just rewrite]
3. [8 points] [Independence axiom and convexity]. Show that the independence
axiom implies convexity, i.e., for three dierent lotteries 1, 1
0
and 1
00
, if 1 % 1
0
and
1 % 1
00
then 1 % c1
0
+ (1 c) 1
00
.
1
4. [18 points] [Purchasing health insurance] Consider an individual with the following
Bernouilli utility function
n(C. H) = ln C
c
H
where C is his expenditure in consumption goods and H is his expenditure on health
insurance. Parameter c denotes his losses if he becomes sick, where for simplicity
c =

1 if he is sick, and
0 if he is healthy
Note that this utility function implies that, when getting sick, this individuals disu-
tility is decreasing in the amount of health insurance that he purchased (e.g., he can
have access to better doctors and care facilities, and the negative eects of the illness
are reduced). Finally, the probability of getting sick is given by 2 [0. 1], and this
individuals wealth is given by : 0, where : = C +H.
(a) [3 points] What is this individual utility maximization problem? [Hint: it is easier
to choose C as your choice variable. You can nd the optimal amount of H later
on]
(b) [3 points] Find the rst order conditions associated to the previous maximization
problem.
(c) [6 points] Determine the optimal amount of consumption goods, C

, and health
insurance, H

.
(d) [6 points] Determine if the optimal amount of health insurance, H

, is increasing,
decreasing, or constant in :. Interpret.
5. [17 points] [Nonconstant coecient of absolute risk aversion]. Suppose that the
utility function is given by n(\) = c\ /\
2
, where c. / 0.
(a) [2 points] First, nd the coecient of absolute risk-aversion. Does it increases or
decreases in wealth? Interpret.
(b) [3 points] Let us now consider that this decision maker is deciding how much to
invest in a risky asset. This risky asset is a random variable 1, with mean 1 0
and variance o
2
R
. Assuming that his initial wealth is \, state the decision makers
(expected) utility maximization problem, and nd rst order conditions. [Hint:
First, note that the decision makers wealth (\ in his utility function) is now a
random variable \ + r1, where r is the amount of risky asset that he acquires.
You must insert this expression in the decision makers utility function, for every
\. Then, we must take expectations over the entire expression, since the risky
asset is a random variable.]
(c) [4 points] Simplify the rst order condition you found before. [Hint: Note that
you must use the property that 1[1
2
] = 1 +o
2
R
].
(d) [4 points] What is the optimal amount of investment in risky assets?
(e) [2 points] Show that the optimal amount of investment in risky assets (the expres-
sion you found in the previous part) is a decreasing function in wealth. Interpret.
2
6. [12 points] [Concavity and Coecient of risk aversion] Let n and be two utility
functions, where (\) = , (n(\)), and ,() is a concave function, i.e., is more
concave than n.
(a) [4 points] Find the coecient of absolute risk-aversion for .
(b) [8 points] Prove that the coecient of absolute risk-aversion for is greater than
for n.
3
[You can use the following pages as scratch paper.]
Name: ________________________________
4
Name: ________________________________
5
Name: ________________________________
6
Micro Theory I - EconS 501
Final Exam - December 15th, 2008.
Instructions: Please read the questions carefully, answer them in a formal and concise
manner, but include all your steps, this will allow you to obtain partial credit. Good luck!!
1. [40 points] [True or false?] Identify which of the following statements are true, and
which are false, and provide a very short explanation of why this is the case.
(a) [3 points] Homothetic preferences have non-straight wealth expansion paths.
(b) [7 points] Homothetic preferences induce a demand function with non-constant
income elasticity.
(c) [2 points] Consider the demand function of an individual with homothetic prefer-
ences. The marginal rate of substitution resulting from this individuals demand
function does not vary if we increase his consumption of one of the goods.
(d) [3 points] The Weak Axiom of Revealed Preference (WARP) states that, for any
two price-wealth situations (j. n) and (j
0
. n
0
),
if j r(j
0
. n
0
) _ n and r(j
0
. n
0
) ,= r(j. n), then j
0
r(j. n) n
0
(e) [4 points] The utility function n(r
1
. r
2
) = max r
1
. r
2
is quasiconcave (i.e., the
upper contour set of any indierence curve is convex). [Hint: draw some indier-
ence curves]
(f) [2 points] One of your friends studying intermediate microeconomics meets you
and starts explaining how excited he is about all the concepts he is learning
in his micro course. At one point he says: I particularly enjoyed the second
fundamental welfare theorem. You know, that theorem showing that any Pareto
optimal allocation can be implemented by a central authority who transfers money
among consumers, and then allows the market work. It is fascinating that the
competitive equilibrium resulting from allowing the market work can induce the
utility levels of the Pareto optimal allocation, for all types of consumers and rms!
In other words, this theorem says that by redistributing money among people we
can achieve Pareto improvements. As a consequence, we would increase the utility
of at least some people, while not reducing the utility level of anybody else. Your
friend is denitely excited, but where is the aw in his statement?
(g) [3 points] Consider an individual with Bernouilli utility function n(r) =
_
r.
When facing the gamble

36. 16;
1
2
.
1
2

## his certain equivalent is c(1. n) =

_
26 and
his probability premium is : =
p
26
2
.
(h) [2 points] The independence axiom states that, for all three lotteries 1, 1
0
and
1
00
, and c (0. 1) we have
1 % 1
0
==c1 + (1 c)1
0
% c1
0
+ (1 c)1
00
1
(i) [6 points] Consider the social welfare maximization problem:
max
w
1
;:::;w
I
\ (n
1
(r
1
) . n
2
(r
2
) . .... n
I
(r
I
))
subject to j

X
i
r
i
!
_ n
And denote by (j. n) the optimal solution of this problem, usually referred as
the indirect utility function. The indirect utility function (j. n) is increasing in
prices..
(j) [5 points] If a lottery 1 rst order stochastic dominates another lottery G, then
the mean value of 1 must be higher than that of G, and viceversa.
(k) [3 points] If a monopolist can perfectly identify the consumers who belong to
two dierent segments of the market, he will set prices to each segment such the
corresponding marginal revenue coincides with the monopolist marginal cost, for
any cost structure and quantities.
2. [14 points] [Expected utility] Consider an individual with Bernouilli utility function
n(r) = ,r
2
+r. Show that his expected utility for any given lottery 1(r) is determined
by the mean and variance alone. [Hint: recall that \ c:(r) = 1(r
2
) + 1(r)
2
].
3. [10 points] [Second-degree price discrimination] Let us consider two consumers
with the following quasilinear utility functions
n
1
(r
1
.
1
) = c
1
r
1

1
n
2
(r
2
.
2
) = c
2
r
2

2
The price of the composite commodity is 1, and each consumer has a large initial
wealth. We know that c
2
c
1
. Both goods can only be consumed in weakly positive
amounts, r
i
_ 0 and
i
_ 0. A monopolist supplies teh x-good. It has zero marginal
costs, but has a capacity constraint: it can supply at most 10 units of the r-good. The
monopolist will oer at msot two price-quantity packages (:
1
. r
1
) and (:
2
. r
2
), where
:
i
is the cost of purchasing r
i
units of the good (total revenue for the monopolist from
selling r
i
units to consumer i).
(a) [1 points] Check if the single-crossing property is satised. Interpret.
(b) [1 points] Write down the monopolists prot maximization problem.
(c) [2 points] Which constraints will be binding in the optimal solution?
(d) [3 points] Substitute these binding constraints into the objective function. What
is the resulting expression?
(e) [3 points] What are the optimal values of the packages (:
1
. r
1
) and (:
2
. r
2
)?
2
4. [17 points] [Distribution of tax burden] An ad valorem tax of t is to be levied on
consumers in a competitive market with aggregate demand curve r(j) = j
"
, where
0 and < 0, and aggregate supply curve (j) = cj

, where c 0 and 0.
Calculate the percentage change in consumer cost and producer receipts per unit sold
for a small (marginal) tax. Denote i = (1 + t). Assume that a partial equilibrium
analysis is valid.
(a) [10 points] Compute the elasticity of the equilibrium price with respect to i.
(b) [2 points] Argue that when = 0 producers bear the full eect of the tax while
consumers total costs of purchase are unaected.
(c) [3 points] Argue that when = 0 consumers bear the full burden of the tax.
(d) [2 points] What happens when each of these elastiticities approaches in absolute
value?
5. [19 points] [Cost reducing investment]. Consider a situation in which there is a
monopolist in a market with inverse demand function j(). The monopolist makes
two choices: How much to invest in cost reduction, 1, and how much to sell, . If the
monopolist invests 1 units in cost reduction, his (constant) per-unit cost of production
is c(1). Asume that c
0
(1) < 0 and that c
00
(1) 0, i.e., investing in cost reduction
reduces the monopolists per-unit cost of production, but at a decreasing rate. Assume
throughout that the monopolists objective function is concave in and 1.
(a) [7 points] Derive the rst-order conditions for the monopolists choices.
(b) [6 points] Compare the monopolists choices with those of a benevolent social
planner who can control both and 1 (a rst-best comparison). Interpret your
results.
(c) [6 points] Compare the monopolists choices with those of a benevolent social
planner who can control for 1 but not for (a second-best comparison). In
particular, suppose that the social planner chooses 1 and then the monopolist
chooses .
3
[You can use the following pages as scratch paper.]
Name: ________________________________
4
Name: ________________________________
5
Name: ________________________________
6

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